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Capacity for loss in retirement planning

For financial professionals only

Wrong end of the stick?

Documenting a client’s capacity for loss in retirement planning is a regulatory requirement. The subject needs a little forethought as it’s something not many clients will be able to tell you much about for themselves. Yet remarkably, in a recent Platforum study, a little over half of responding advisers said they used risk questionnaires to establish their client’s capacity for loss.

As Platforum imply, reliance on questionnaires to document and assess loss capacity – as opposed to a client’s psychological attitude to risk – may be missing a key point.

The position is neatly summarised by compliance consultants ATEB, who say that while attitude to risk is a subjective concept, capacity for loss is a financial matter of fact(1).

Modelling the future

So the question is – how much net worth could you afford to lose without having to change your retirement plans? For those lucky enough to have very high levels of secure income in retirement, the question is probably irrelevant. Or for those with a sanguine attitude to equity release. But for everyone reliant on drawdown, what can change their net worth most dramatically are negative investment returns. Whether you have £1 or £1million more than you think you need to retire, negative returns may upset the apple cart. And you don’t know when they may arise.

The virtue of modelling retirement – and the chart above shows almost a quarter of advisers do use models – is that it puts a figure on how much excess net worth you have, over what’s a prudent tally for the cost of giving up employment. In other words, you’ll arrive at a basic figure for capacity for loss after running the model. And you find out if the excess is £1 or £1 million.

Rain on the way?

But that excess of net worth depends on assumptions for investment growth which necessarily imply the possibility of negative returns. Advisers look at stochastic modelling tools to get a handle on this. Stochastic forecasts offer a ‘weather forecast’. Just like the BBC’s forecasts offer a probability of rain every day.

Parmenion’s Income Manager Tool (IMT) shares with advisers the actuaries Hymans Robertson’s investment ‘weather forecast’ and gives probabilities for the likely success and therefore failure of retirement plans. Speak to your Regional Sales Manager or our Customer Success team if you’d be interested in comparing Hyman Robertson’s views of future market paths with your own and adding IMT to your desktop.

Taking shelter

Except in movies, no one stays out in the rain for long. They take avoiding action or come indoors. For this reason, everything will come back to a discussion between adviser and their drawdown client around their willingness and ability to react in circumstances where net worth has been impaired by bad markets. Someone with only just enough money to take the gamble to retire, but who could reliably roll with the punches if things turned stormy, might have all the capacity for loss they need. While someone with spare capital, but inflexible spending plans, might be unable to cope. And may need some coaching or a different strategy. Therefore, the ‘attitude to risk’ questionnaire and fact find discussion must cover – how readily would you cope if financial misfortune forced you to change your retirement plans? And does that go for both of you?

(1) https://news.ateb-group.co.uk/what-exactly-is-capacity-for-loss