A robust risk capacity calculator is the most important missing piece of most advisory firms’ suitability tech stacks. Nowhere is this gap more important than in retirement income advice.
Since pension freedoms legislation was introduced, retirement-income advice needs have become more complex, the importance of getting that advice right has rocketed, and the suitability of the advice actually given has… often been found lacking.
What it’s been lacking most is often a sufficiently robust methodology for calculating risk capacity and integrating it into the overall suitability process.
This is especially true for managing the transition from accumulation to decumulation.
How to assess risk capacity either side of retirement
An outcome can only ever be as suitable as the process that produced it. The backbone message of the FCA’s Thematic Review of Retirement Income is the need for evidence of and consistency in suitability assessment methodologies. The FCA do not, of course, prescribe any particular methodology. But they do very much prescribe that you have one; and that it’s more than a bodging together of disjointed systems with subjective fudges creeping into the gaps.
A good risk capacity assessment accounts for all relevant elements of an investor’s financial situation, and so automatically accounts for where somebody is in relation to ‘retirement’, whether that’s a hard stop or a decades-long withdrawal strategy.
Typical approaches are, however, not good; they are:
- Not quantified – Risk capacity measurements are either subjective guesses, or workarounds such as cash-flow modelling. While these may touch on important factors such as age and non-investible assets, they do so in an inconsistent manner.
- Not dynamic – Most suitability profiling is over-reliant on an initial assessment, and typically unresponsive to dynamically changing circumstances – either in a client’s life, or in the markets.
- Not holistic – They fail to recognise either the full array of wider financial circumstances, or the valuably flexible nature of a human’s system of interacting and changeable goals.
In addition to these mistakes of omission, there are mistakes of commission, for example, adding separate measures of ‘risk required’, or ‘time horizon’.
In the Review, the FCA note, as an example of good practice:
The firm also completed quarterly checks to ensure [capacity for loss] limits were not breached
Risk capacity (and therefore the ongoing suitability of advice) should reflect circumstances which are subject to change – sometimes suddenly and significantly so. But why stop at quarterly checks? A good risk capacity tool can monitor financial situations constantly.
Risk capacity should also not be confused with ‘capacity for loss’. Risk capacity wholly covers the far narrower concept of ‘capacity for loss’ and plays a far more fundamental role in assessing suitability.
The FCA’s 2011 guidance states:
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.
However, ‘capacity for loss’, by this definition, can only really apply to investors near to, at, or post retirement.
If your income covers your expenditure whilst you’re accumulating early in life then you could lose all your investible assets without any ‘materially detrimental effect’ on your standard of living. This is clearly far too narrow a view to hold for suitable advice.
We should want something instead that accounts for all relevant financial circumstances – whether in accumulation or decumulation. It’s questionable if you can give truly suitable advice by merely relying on the most basic measure of affordability, and ignoring wider financial circumstances, such as the degree of insurance held, the size and likelihood of future capital injections or extractions, or the extent of emotional attachments to (usually non-investible) assets.
‘Capacity for loss’ is fully contained within the broader notion of risk capacity. If you measure risk capacity, you are, by definition and by default measuring capacity for loss as a side-effect. The reverse is, however, not true. Understanding the distinction is crucial to giving suitable advice. We’ve written about it in more detail here.
How to combine risk capacity and risk tolerance at retirement
In the review, the FCA note that:
Our published final guidance indicates that assessing [attitude to risk] and [capacity for loss] separately avoids the risk of conflating these outputs (FG11/05).
This is of course true. But it opens the door to incorrect interpretation.
Just as important as the methodology for assessing each element of a risk profile is the methodology for combining those elements in arriving at an investor’s suitable risk level. Without a robust means of doing so, poor client outcomes are much, much, more likely… regardless of how well each individual component is assessed.
The review also highlights the same failing elsewhere, hammering home the message that approaches subject to adviser inconsistency should be avoided, even if they technically ‘cover off’ each of the elements the legislation tells them to.
It is never enough to simply tick every box and believe that because you’ve assessed, say, risk tolerance, risk capacity, behavioural capacity, and knowledge and experience in some way, that you will be giving suitable advice. The way that you assess them, and the way the outputs of those assessments are combined, is crucial if the advice is going to be accurate, consistent, and documented.
The role of tech in better evidence, better consistency, and better outcomes
Where the job requires consistent application of (and automatic evidencing of) a process that needs to analyse a ton of data points that move and interact constantly, it requires tech specifically designed for the task.
The use of tech is widespread in financial advice. However, the thoughtful and strategic use of tech is less common. Tech is often bolted on, rather than built in, and employed not because of its number-crunching and background monitoring skills, but because it’s shiny and new.
As we wrote when answering ‘How Should Risk Tolerance Assessments Differ Between Accumulation and Decumulation?’:
Oxford Risk’s risk capacity assessment was designed to function on both sides of the accumulation/decumulation dividing line – to account for all relevant financial circumstances, and consequently assess how reliant an investor is on their investible assets to fund their future expenditure. It seamlessly accounts for the transition between accumulation and decumulation by fully accounting for changing circumstances.
A robust risk capacity methodology manages the transition from accumulation to decumulation automatically. It makes it clear how an investor’s suitable risk level should respond to their financial circumstances – both pre- and post-retirement. And it does so seamlessly, with no need for clunky workarounds or separate processes either side of a dividing line between working and not – a line that for many is increasingly blurry, if not entirely arbitrary.
Greg B Davies, PhD, is head of behavioural finance at Oxford Risk
