Assessing and Explaining Risk Capacity: It’s just not as simple as it seems, or is it?

The FSA’s guidance on investment suitability, issued in March 2011, has set the agenda for the rapid growth of customer focused financial planning. The emphasis on understanding the client’s risk capacity goes to the heart of planning relationships because they must based on the, often unique, circumstances and needs of customers. There are at last two parts of capacity: one revealed by the projections and the other in the client’s preferences and circumstances.

Risk capacity is the extent to which an individual’s financial plan can withstand the impact of unexpected (negative) events.

In a simplified advice scenario, suppose that a client is saving for her children’s’ education using an investment strategy which has an expected return sufficient to fund the anticipated expenses. What could go wrong?

Unfortunately 50% of the time the actual return will be less than the expected return. Additionally, there is the possibility that the educational expenses will be higher than anticipated. In either situation, the client’s risk capacity is the extent to which she can fund the shortfall from other sources, which could include a temporary reduction in lifestyle spending.

In some cases the client may be able to fully fund the shortfall, in others the client may have no capacity to fund it at all, and in others still, the client’s capacity will lie somewhere in between those two extremes. However, where a client draws funds from other sources to meet these particular expenses, those monies will not now be available for whatever other purpose they would have funded – robbing Peter to pay Paul, which leads us to consideration of a comprehensive advice scenario.

Here we will have multiple goals with different priorities and timing, and an investment strategy that may involve multiple portfolios. In addition to investment performance and the possible variability of future expenses, issues such as longevity will also need to be considered.

Clearly, unexpected negative outcomes might derail the client’s plan and this means that the plan must be stress-tested. All forms of stress testing (the most common of which is Monte Carlo Modelling) are driven by assumptions: Capital Market Assumptions for investment returns, life expectancy for longevity and so on. If we do a poor job on these assumptions any form of statistical stress test will be compromised.

Let’s suppose that there is only a single goal – an income stream in retirement – and investment returns are the only variable. Our stress test estimates the likelihood of achieving the goal. If the likelihood is 50%, then the plan has no risk capacity, because any underperformance by the investments will result in the goal not being achieved.

For a goal as important as income-in-retirement, a 50% chance of success is unlikely to be acceptable, which means that trade-offs will be required. In a comprehensive scenario, risk capacity is measured by the excess over 50% of the likelihood of achieving goals.

Of course, the client may also have optional flexibility in their plans. For example, while they may not wish to sell and move to a lower cost home to release spendable capital it’s an alternative to be explored.

With risk capacity, the science is in the calculations, particularly in a comprehensive advice scenario. The art lies in explaining the concept to the client and working with them to help articulate and prioritise their preferences.

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