There is no doubt that the whole subject of investment suitability is coming under increased scrutiny from the regulator.
After much debate on the subject, we saw the FSA issue the final guidance paper in March, entitled, Assessing suitability: Establishing the risk a customer is willing and able to take and making a suitable investment selection. More recently, we have seen the “Dear CEO” letter issued by the FSA to the heads of many wealth management businesses.
Unsurprisingly, core to all the principles detailed in these documents is that clients’ attitudes to risk should be given due consideration and met as accurately as possible when solutions are being recommended.
“Capacity for loss” was one particular subject which was also mentioned extensively in the March paper, where it was described by the FSA as “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 FSA said that although “most advisers and investment managers consider a customer’s attitude to risk when assessing suitability, many fail to take appropriate account of their capacity for loss”. The paper went on to say that failing to assess this aspect of a client’s circumstances was a key risk to adviser firms.
Using separate processes to assess a customer’s attitude to risk and capacity for loss was highlighted as “good practice”. The FSA felt that this ensured that both were appropriately considered as part of the overall suitability assessment.
However, communicating this to clients who remain nervous about the current volatile investment market and who may have suffered negative returns in the past is never an easy task.
A full analysis or risk assessment would need to be completed but it may well be that this type of client is regarded as “cautious” and therefore unsuitable for any investment which has a potential downside.
If this is the case, then, clearly, this is going to limit the options an adviser is able to consider. This could well be the type of client the FSA is concerned about. The following case study relates this specifically to the pension environment by looking at a client approaching retirement.
Catriona is 56 and has a pension fund of £200,000. She has regularly saved into a personal pension to achieve this fund value and was dismayed to find, a few years ago, that her fund predominantly invested in UK equities via a balanced managed fund had fallen in value by 25 per cent.
Although the fund has more or less recovered since, she feels that she should now move all of the fund into very safe investments perhaps even into cash.
Catriona plans to take her benefits at 65 years old and feels that if there is a significant fall in markets, she may not have enough time to make up the fall before needing to take benefits.
What are Catriona’s options? Clearly, based upon this illustrative evidence alone, it would be difficult to provide full guidance. However, purchasing a guarantee for the fund is one of the options worthy of consideration.
Many people insure a wide variety of items, including watches, televisions, cars (that one’s mandatory) and houses. It is interesting and perhaps worrying, therefore, that some of our most important items such as protecting one’s life or a future income stream are often overlooked.
Due to the fact that Catriona’s past experience has contributed to an increasingly cautious outlook, she might feel that “insuring” her pension fund is a sensible choice to make.
So, what does this mean? Well, for a relatively modest sum, Catriona could enter a multi-asset fund and “insure” the value against the possibility of it being worth less at retirement.
Given that this is nine years away, this is unlikely to be hugely expensive (a relatively modest increase to the AMC) ’Using separate processes to assess a customer’s attitude to risk and capacity for loss was highlighted as ’good practice’. The FSA felt that this ensured that both were appropriately considered as part of the overall suitability assessment’but it will give the following benefits:
- Catriona can sleep at night knowing there is a long-stop guarantee
- Her capacity for loss has been duly considered and taken account of
- Her pension fund can be invested in a multi-asset fund, providing real growth potential up until her retirement date.
Clearly, these types of arrangements will not suit everybody although their use could become increasingly widespread due to the appetite to protect funds which savers have worked hard to build up.
For example, a client in income drawdown could secure a future value using this method while drawing income or it could even be used in a phased drawdown scenario, where the client turns on an income stream at some point in the future.
In conclusion, the FSA has shown that capacity for loss must be given due consideration and should be assessed alongside a client’s attitude to risk.
Use of a capital guarantee is one way of helping advisers to meet these requirements.