What risk capacity means in practice

Every adviser needs to assess clients’ capacity to take on investment risk. The FCA defines this as a “customer’s ability to absorb falls in the value of their investments”. In broad terms this means advisers have to take into account losses that would have a “materially detrimental effect on [a client’s] standard of living”.

That seems simple enough, but it can get trickier once you think about what it means in practice.

On one level, the idea is easy to grasp. The key factors for determining risk capacity are essentially objective and include:

  • The client’s level of income and wealth.
  • Their expenditure needs.
  • Their investment timescale.
  • Their need for liquidity.

Risk capacity is quite different from risk tolerance, which is about subjective and psychological issues – how the client feels about the possibility of losses or fluctuations when investing. There is generally a link between risk capacity and tolerance: the richer you are, the more relaxed you are about risk.

But in real-life capacity for risk has some substantial subjective aspects to it, even though it rests on objective factual foundations.

Case study one: Watching capital value

Meg lives on the income from her state pension and her investments. The capital value of her investments is of secondary importance to her. What concerns her is the flow of interest and dividends from her portfolio. The gross dividend yield (dividend plus tax credit) from the FTSE All-Share index has been remarkably steady over the past 15 years, according to Barclays Capital. After the 2008 crash, dividends fell by a tenth of their 2008 value but they recovered two years later.

Meg also recovered from her understandable queasiness about the drop in capital values in 2008 and 2009. They did not affect her standard of living. If she had held mostly cash deposits, her income would have fluctuated worryingly and finally fallen a lot, although her capital would have been safer and would have just gradually eroded.

If Meg had been drawing on her investment capital to supplement the natural income from her portfolio, her capacity for loss would have been significantly lower because of the effect of reverse pound cost averaging – or pound cost ravaging. 

But not all falls in capital value would be so relatively benign for a person like Meg. Some equity markets have bounced back but some have not. And some property and other investments might have caused her a sudden and permanent loss of both capital and income.

Case study two: Building a pension portfolio

Pete is in his early 40s and is building up funds for his retirement. He is vague about when this will happen but using reasonable scenarios he knows he needs to save about £20,000 a year and have a return of about 4 per cent a year. Could he afford to take a 40 per cent drop in the value of his investments? 

The sudden drop in Pete’s pension fund probably would not have an immediate impact on his standard of living. But it is likely to have consequences. One would depend on how long it might take the value of the portfolio to recover – assuming it does recover. Sometimes investments recover quickly, sometimes it takes several years (1972 until 1983 in inflation-adjusted terms) and sometimes it does not happen at all (Japan post-1989).

After a very deep fall, unless the recovery turns out to be very fast, Pete’s portfolio would probably experience a long-term loss of growth. So Pete might be well advised to increase his savings pattern to make up for the lower long-term rate of return and keep the position under review. Otherwise he could retire later or on a lower retirement income. 

Would the consequent loss of net spendable income either now – because of his higher level of regular pension savings or possible reduced standard of living in retirement – constitute that materially detrimental effect on Pete’s standard of living?

That depends partly on how many years Pete has until his target and how long he could boost his rate of savings. Increasing annual savings by a small amount of, say, £5,000 a year for 20 or 30 years is a lot less detrimental to one’s living standards than a shorter timeframe.

So the question should be – how much loss can you tolerate? Part of assessing risk capacity is subjective. 

As King Lear said: “Our basest beggars are in the poorest thing superfluous. Allow not nature more than nature needs.”

Danby Bloch is editorial director of Taxbriefs Financial Publishing

 

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