As regular readers of our articles will be aware, we’ve covered Capacity for Loss (CfL) numerous times previously. Our last article dedicated to the subject was issued in November 2019 - Capacity for Loss – so misunderstood! – ATEB News (ateb-group.co.uk) so we decided to take another look.
We’ve also commented frequently on issues relating to risk profiling and attitude to risk, and it could be argued that the two subjects are closely related. Indeed, some of the ATR tools attempt to do just this, but few, if any, really provide definitive clarification of what a client’s CfL actually is.
The article from 2019 (written by Alistair MacDougall, our esteemed former Technical Manager) provides further clarification with: 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.
Followed with: 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.
Candidly, not much.
Some risk profiling tools attempt to provide a little more clarity, but this is often limited to the client selecting a particular portfolio from a range, or stating that they would be willing to accept a fall in the value of their portfolio of up to X%.
Many firms use cashflow forecasting to illustrate what impacts a significant market crash could have, but unless the client is fully engaged in this process it can be difficult for them to assimilate what the outputs tell them, particularly when the firm presents several different scenarios. The trouble with these exercises is that they can be scuppered the following day by the client spending some of their cash!
Regardless, it’s suitability reports where advisers attempt to articulate CfL to the client and more often than not it’s either described as ‘no capacity’, ‘low’, ‘medium’ or ‘high’, or expressed as a percentage based upon the answers provided in the risk profiling questionnaire. We even see ‘some’ as a description. What is ‘some’ when it’s at home? You couldn’t make this stuff up.
Well, would you be? And how would you bring this to life for the client?
The FCA has long opined that clients don’t fully understand percentages and requires information to be imparted in monetary terms as well, but this is rarely, based on our experience, applied to CfL, but imagine if it was.
Most files we check follow one of the paths described above, usually providing a basic explanation (largely generic) and a description, such as ’medium’. How a client is able to assess what this actually means is anybody’s guess. Some firms do use a percentage, frequently taken from the RPQ response.
Percentages and £ can also present the information in different contexts and this can be misinterpreted. For example, a 10% increase in a portfolio of £1million is £100,000 (a lot in monetary terms but not in percentage), whereas a 50% gain on a portfolio of £1,000 is £500 (not much in monetary terms but a lot in percentage).
So what does a say, 20% fall look like in reality?
For a client with investments/pension funds totalling say, £500k this equates to £100,000. The likelihood of a fall of this magnitude actually happening is quite remote, but theoretically possible, so how would a client react if CfL was presented this way? 10% falls have occurred fairly recently and in this instance that equates to £50,000, so this is feasible, but are clients ever presented with things in these terms?
Imagine the scenario at the first review meeting when the adviser tells the client that their portfolio has actually fallen by 10% (£50,000) and that the 2% initial charge plus the 1% ongoing advice charge in year one has taken a further £15,000 of their fund. This could result in a very challenging conversation, but if the client wasn’t willing to accept a loss on this scale and the adviser hadn’t established the fact, what chances would there be of putting up a defence to a complaint?
Fortunately, markets haven’t fallen significantly that often since the financial crisis of 2007/8, but at some point they will and clients who suffer losses are not generally well pleased. What story will your firm’s files tell if this happens?
The FCA has made a lot of noise about this and has placed further emphasis on it within Consumer Duty, but are the most vulnerable clients of all those who don’t actually understand what they’ve entered into?
So, is a client who’s CfL isn’t quantified likely to understand what they’ve entered into?
They may have the ability to withstand losses and it may not impact their income, lifestyle, ability to fund future capital spending plans or whatever, and this is probably an assessment that the adviser can (and should) perform, supported with cashflow forecasts and the like, but the client’s willingness to absorb a loss is an entirely different matter.
You may have completed a detailed RPQ and obtained your client’s risk ‘score’, they may have indicated that portfolio X was their preference, they may have plenty of money and there is little you can do to actually prevent losses, but if you present them with a big fall in value and it has a material impact that you hadn’t established you can expect some heat.
Alternatively, if they understand that a fall of £X is possible, they tell you that this is what they are willing to tolerate, are clear that it won’t have detrimental impacts then you’re on more solid ground, and if it does happen they’re not only aware, but far less likely to be able to successfully complain.
Many fail to appreciate that CfL is covered by FCA rules and is a component of KYC, but one that is often overlooked by a lot of advisers. When it’s pointed out it becomes clearer because COBS 9.2.2R states that:
A firm must obtain from the client such information as is necessary for the firm to understand the essential facts about him and have a reasonable basis for believing, giving due consideration to the nature and extent of the service provided, that the specific transaction to be recommended, or entered into in the course of managing:
1.(a) meets his investment objectives;
(b) is such that he is able financially to bear any related investment risks consistent with his investment objectives; and
(c) is such that he has the necessary experience and knowledge in order to understand the risks involved in the transaction or in the management of his portfolio.
2. The information regarding the investment objectives of a client must include, where relevant, information on the length of time for which he wishes to hold the investment, his preferences regarding risk taking, his risk profile, and the purposes of the investment.
3. The information regarding the financial situation of a client must include, where relevant, information on the source and extent of his regular income, his assets, including liquid assets, investments and real property, and his regular financial commitments.
Anyone not clear what “able financially to bear” means? And how does your firm define it?
Capacity for loss in many instances is largely dismissed and little attention is paid to it, but get this wrong and try defending a complaint if things go awry.
The rules don’t specify how you quantify CfL or what method you use, but does ‘medium’ or 20% really cut the mustard? We aren’t saying you must do this or that, but surely this is a big consideration for anyone investing money.
Any client who exhibits a cautious outlook is probably less concerned about the upside and more concerned about the downside, so if they’re not willing to financially bear a significant loss and they’re presented with one what do you think they’re likely to be inclined to do?
One of the key principles of CD is client communication and the way information is imparted can make the difference between a client understanding what they’re doing and them interpreting things the wrong way. I some cases it appears that this has been done on purpose, so if we can draw this conclusion, so can the FOS. Fair, clear and not misleading anyone?
Why not make it clear what could happen, quantify what this could be and record the client’s response? Might even change an unclear file to a suitable one!
For consideration, but is it worth updating your processes? Consumer Duty talks about prevention of foreseeable harm, so wouldn’t this help with that?
Making your processes and advice more robust has to be a good thing. How does your firm define CfL? Is it clear, or clear as mud?
Author - Paul Jay - Senior Compliance Consultant
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