Rein in the ludicrous assumptions on capacity for loss

By Abraham Okusanya

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Nov 28, 2019

Abraham OkusanyaThere’s a lot of confusion around assessing capacity for loss, particularly for clients drawing down their portfolios. Much of it stems from the regulator not really seeming to know how it should be assessed.

The capacity for loss designation probably arose in the FCA’s 2011 guidance document FG11/05: “By ‘capacity for loss’, we refer to the customer’s ability to absorb falls in the value of their investment. If any loss of capital would have a materially detrimental effect on their standard of living, this should be taken into account in assessing the risk that they are able to take.” The phrase certainly doesn’t appear anywhere in the FCA’s Conduct of Business Sourcebook, which refers to the “ability to bear losses”.

Capacity for loss is a problematic term. The compliance camp take it to mean that investment risk should be avoided at all costs, even if there’s only a slight chance that investment loss will have a material impact on a client’s lifestyle. They’re content to leave inflation risk on the table and/or consign the client to a less affluent lifestyle in retirement, just so long as investment risk is not pursued.

The very idea of quantifying how much a client can afford to lose without material impact on lifestyle is nonsensical. Any attempt to assess if a client can afford to lose X per cent of their portfolio without a material impact on their lifestyle encounters a number of problems.

The first is, what is X per cent and why is this particular figure loss relevant? It has to be based on the asset class invested in. All sorts of forward-looking assumptions can be used to estimate it but, in reality, these are just guesses.

The second problem is the term capacity for loss conjures an image of permanent irrecoverable loss, yet the evidence overwhelmingly shows that large losses on mainstream asset classes tend to be followed by even larger gains.

It’s also worth noting that capacity for loss doesn’t account for the alternative to taking risk – in other words, does the client have the capacity not to take risk? For a retiree, avoiding investment risk often means accepting the risk of running out of money and/or severe inflationary risk, which can do untold damage to their income.

The point then is that capacity for loss can be determined only in the context of the empirical behaviour of the underlying asset class for the portfolio.

Here, the historical worst case scenario or even a 10th-percentile scenario has to be sufficient. It is ludicrous to suggest that worse outcomes than the historical worst case for an asset class should be considered. If it must be done for asset classes, then why not for annuities, DB and other income sources? The only logical conclusion here is that nothing is safe and the client has no capacity for loss in the event of a doomsday scenario. This does nothing to aid financial planning in any way.

Abraham Okusanya is director of FinalytiQ

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