Capacity for Loss – so misunderstood!

We have written about Capacity for Loss (CFL) before, so we were interested when, earlier this summer, there were a couple of trade press articles on the topic. These articles came at the subject from different angles, one concluding that assessing CFL is ‘pointless’ and the other that CFL problems are a ‘language issue’. Many comments were posted that were generally in agreement with the articles.

The conclusion we reached from the articles and the comments was quite different, namely that there is an ongoing widespread and fundamental lack of understanding of the concept of CFL.

One of the articles, written by an adviser, suggested that “assessing a client’s CFL may keep the regulator happy but it is pointless” and that “focusing on losses is misguided compared to the real danger of inflation”. The article developed this paradigm into an argument that CFL was intended to drive clients into cash and fixed interest assets, which would expose those clients to a greater risk from the effects of inflation. 

In our view, this entirely misses the point and meaning of CFL. It is not about focusing on losses, or avoiding any possibility of losses, it is about making a reasonable assessment of the effect that losses might have on the client’s ability to meet future income and/or capital objectives. You could also think of CFL as an indication of the degree of reliance the client has on particular investment(s) in order to achieve those objectives.

In a follow up piece, PlanPlus Global director and Finametrica co-founder Paul Resnik suggested the problem with CFL was an absence of agreed definitions of CFL and other aspects of risk profiling and bemoaned the fact that he had not been able to persuade the industry of the need for precise definitions. 

We agree there is a problem with assessing capacity for loss, but it is nothing to do with definitions. There are already definitions in FCA rules and guidance. The problem is that the industry does not appear to understand CFL. We are not alone in that view. 

Way back in March 2011, by which time the need to assess a client’s risk profile, knowledge and experience and ability to bear losses had been in place for years, the FSA published final guidance on assessing suitability (FG11-05). One of the key findings was that while most firm assessed the client’s attitude to risk (as measured by volatility), many firms failed to assess the client’s capacity for loss. 

Despite this guidance, nearly four years later, the FCA was still concerned about the way CFL was being assessed. Under the headline, “FCA: Industry does not understand capacity for loss” a FCA spokesperson was quoted as stating, “Many advisers do not understand what capacity for loss means and should rely on their own calculations rather than clients’ emotional responses.”

As will be seen below, the key word here is ‘calculations’. 

So, what’s to be done?
First, advisers need to accept that assessing CFL is a regulatory requirement.

Second, advisers need to understand what CFL actually is – in COBS 9.2.2R, CFL is referred to as follows …

‘ … (advisers) ‘have a reasonable basis for believing … that the specific transaction to be recommended, or entered into in the course of managing … is such that he is able financially to bear any related investment risks consistent with his investment objectives.’

Contrary to popular opinion, this means that CFL does not only relate to the client’s ‘standard of living’, which normally focuses on income needs, but also relates to any capital objectives that the client might have, for example, purchasing a holiday home at retirement. 

Third, advisers need to have a means of assessing CFL that actually works. Our experience indicates that NONE of the well-known risk tools deal with CFL remotely adequately. Some treat it as another flavour of ATR (degree of willingness to accept volatility), while others ask a few questions which are both leading and misleading at the same time. Questions similar to this paraphrased example: 

“How much could you afford to lose without affecting your future standard of living?” 

This type of question is flawed in several respects. 

• It focuses firmly on ‘standard of living’ rather than the broader concept of investment objectives that the FCA definition implies.
• It requires the client to self-assess, without any suggestion of supporting quantification of the ‘standard of living. An FCA technical specialist told a PFS Conference audience, “If you are asking the client what their capacity for loss is, you are not meeting the FCA’s expectations because you are not getting the right answer.”
• There is no indication of when the ‘future’ is, so the client might be considering a period of time quite different to what the adviser has in mind. Sometimes, this question is more specific and refers to “In the next two years, how much etc.” In most respects, this is even worse. If asked of a client who is still working over the next two years, it is reasonable to conclude that the client’s standard of living would be unaffected by any level of loss. What matters for CFL is the period of time over which the investment will be intended to provide income or capital – the next two years is arbitrary and irrelevant – unless the next two years just happens to be the period over which the client will be relying on the investment for income or capital! 

The flaws in the question are exacerbated by the limited answer options – generally along the lines of ‘small losses’, ‘medium losses’, ‘large losses’ – where small, medium and large are undefined, with the result that any answer the client selects is meaningless! Where these undefined labels are replaced by numbers, for example, 10%, 20% and 30%, the answer is still essentially meaningless. 

Finally, the outcome of most of the tools out there is the labelling of the client’s CFL as small, medium or large (or similar) – again undefined and essentially meaningless.