A short guide to Capacity for Loss & Pre-Retirement Planning

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1 For Financial dviser use only short guide to Capacity for Loss & Pre-Retirement Planning Featuring Billy Burrows UPDTED for 2013

2 1 MetLife quick summary of the FS Guidance on Capacity for Loss The FS s own definition in their Guidance Consultation January 2011, states that, 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. Capacity for Loss is a distinct concept, but related to ttitude to Risk, and should therefore be considered and documented separately. Firms should ensure they have a robust process for assessing the risk a customer is willing and able to take. Firms should ensure: tools, where used, are fit for purpose and any limitations recognised and mitigated; any questions and answers that are used to establish the risk a customer is willing and able to take, and descriptions used to check this, are fair, clear and not misleading; they have a robust and flexible process for ensuring investment selections are suitable given all aspects of a customer s investment objectives and financial situation (including the risk they are willing and able to take) as well as their knowledge and experience; they understand the nature and risks of products or assets selected for customers; and they engage customers in a suitability assessment process (including risk-profiling) which acts in the best interests of those customers. Our particular focus is on Capacity for Loss when undertaking retirement planning. There is acceptance that whilst a person s attitude to risk may not change, due to life circumstances, their Capacity for Loss does. Given this, we believe effective retirement planning, whether you re looking for pre, at or in retirement clients, needs to incorporate Capacity for Loss. Peter Carter, Product Marketing Director, MetLife

3 short guide to Capacity for Loss & Pre-Retirement Planning 2 ssessing your clients Capacity for Loss in the 10 year countdown to retirement Whilst there is no definitive list set out by the FS to help determine a client s Capacity for Loss, here are some sample questions you may find useful to better understand a client s financial circumstances and assess their Capacity for Loss. What are your income and outgoings now and what will they be in retirement? Look at different scenarios with clients to identify their Capacity for Loss. MetLife research conducted in ugust 2012 has shown that one of the biggest concerns for those who are in the ten year countdown to retirement is redundancy or a drop in income. nd, only a third of women at this age are working full time. So it s important to understand how long a client could manage without an income, what impact this would have on funding their retirement and what they would do if the State pension age went up further. What assets and liabilities do you currently have and are likely to have at retirement? gain it is important to explore different scenarios with clients property values, inflation, annuity rates and investment volatility can all impact on a client s cash flow in retirement. This is particularly pertinent for those who are divorced, as our research indicates they have half the net asset value of other households. So, the key question here is, How much of your invested money could you stand to lose without having a significant impact on your standard of living in retirement? Do you have dependants in the run up to and into retirement? This was a big eye opener for us. Our research showed that pre-retirees are more likely to provide financial support to others than receive it. third of those aged 50 to 60 still had children or parents living with them and 63% had given an average of 3,135 in the past six months to dependants. With so many pre-retirees providing financial support to others, it will certainly impact their ability to absorb any losses. Most advisers will understand their client s circumstances but few actually challenge them about their Capacity for Loss. The key to understanding financial objectives is to determine future income requirements, how much flexibility is needed and their risk profile. Billy Burrows, retirement income expert and Director of Better Retirement Group

4 3 MetLife What are the key factors affecting clients Capacity for Loss? We ve undertaken extensive research to understand the major factors that are affecting clients Capacity for Loss, and have identified three Critical Loss Factors which you should consider when advising your clients. Critical Loss Factor 1 Critical Loss Factor 2 Critical Loss Factor 3 Life Changes in the run up to retirement Unexpected life changes can impact upon a client s ability to absorb investment losses. Based on consumer research conducted in ugust 2012, we understand the particular life changes which clients may face include: Redundancy divorce Supporting adult children or ageing parents The impact of nnuity Rate Volatility With falling annuity rates and gender no longer being taken into account when calculating life expectancy, clients may see an impact on their retirement income, and so affect their Capacity for Loss. Did you know? There has been a drop in annuity rates for men and women of 46% and 42% respectively over the past 15 years.* The Impact of Investment Volatility Investment volatility is of particular worry to clients who are close to retirement as they have little or no time to regain any investment losses due to a drop in the market. nd if clients are in drawdown investment volatility will impact directly upon their current and future income. I didn t expect at my age to have both children living at home with me again. ll those extra mouths to feed and utilities have put a strain on my budget and my ability to save. *Source: MetLife UGen Research 2012

5 short guide to Capacity for Loss & Pre-Retirement Planning 4 Pre-retirement planning and tackling Capacity for Loss & with Billy Burrows What are the key headlines for pre-retirement planning with clients? Many clients are between a rock and a hard place; low interest rates, volatile equity markets and many of the traditional options do not serve investors well in these difficult times. In the run up to retirement, clients face a number of unknowns, including: Don t know when they are going to fully retire Outlook for equity markets and interest rates How inflation will erode future spending power How long they will live The state of their health in the future Capacity for Loss is an important consideration for all clients in the run up to retirement; what are the key drivers at present? The three important factors to take into account: the client s overall financial position, their financial objectives and their risk profile. Many advisers will understand their clients circumstances but few actually challenge them about their Capacity for Loss. The key to understanding financial objectives is to determine future income requirements and agree how much flexibility is needed. 3.3 million Brits are financially supporting adult children aged 21 and over.* Clients find it useful to consider the worst case scenario. Finally, risk profiling is more than a simple 1-5 scale of risk; it involves a more detailed discussion about all the relevant factors, including Capacity for Loss. How does it work alongside risk assessment - isn t it quite confusing for clients? The important thing is to get a client to look at what would happen if their retirement plans all went wrong and they were to lose a significant amount of their capital, and ask how they would cope. Far from finding this confusing, clients find it very helpful to consider the worst case scenario, as it concentrates their mind.

6 5 MetLife Pre-retirement planning and tackling Capacity for Loss & with Billy Burrows (continued) What are the key questions to tackle? I have always said that there are three golden rules for advising in the run up to retirement: Does the client have other sources of income or capital to fall back on if their chosen strategy does not work? Do they understand all the risks involved? Have they explored all the relevant options? If these rules are followed the advice given will be sound, but if these rules are broken and things go wrong, the advice may be questioned. But isn t there a danger in the current market, that it makes clients even more cautious and worried about doing anything? I talk about the so-called risk paradox - clients may think they are reducing risk by investing in low yielding assets, but they do not escape the risk that their pension will not keep up with future inflation. Put simply, taking some risk, especially controlled risk, may turn out to be the less risky option in the long run. Sounds a bit of a contradiction, but clients get the message. So with clients who clearly have low/no Capacity for Loss, what are the solutions for them? There are a range of choices including traditional options such as lifestyle funds and annuities, but increasingly clients and their advisers are seeing the benefits of more modern and sophisticated approaches, such as unit-linked guarantees. s one client put it to me, I don t want to miss out on a new idea if it is going to benefit me. 1 million people in the UK are financially supporting elderly loved ones.* Controlled risk may turn out to be the less risky option in the long run. Summary at a glance Clients are currently finding themselves in a difficult position. To plan effectively it s essential to have a detailed discussion about all relevant factors - and that includes understanding their Capacity for Loss. Help clients to see what would happen if their plans all went wrong. nd for clients with low or no Capacity for Loss, it s important to look at all investment options - both traditional and more modern approaches. *Source: MetLife UGen Research 2012

7 short guide to Capacity for Loss & Pre-Retirement Planning 6 t retirement clients with low or no Capacity for Loss For clients on the cusp of retirement who have low or no Capacity For Loss, there are several issues to look at. re they ready to fully retire? Do they want to take an income now or would they prefer to defer their income? Do they realise that retirement can last for 20 to 30 years, so they could experience tremendous life changes and market volatility during this time? It s also essential to look at current annuity rates and speak to clients about the potential missed opportunity of market upswings, should they opt for an annuity. If clients are thinking about drawdown, be sure to look at Government imposed GD rates which limit what they would be able to take each year. Furthermore, if clients already have low or no Capacity for Loss, any further market drops could result in significant drops in their retirement income. Retirees in distressed drawdown s markets have suffered year after year, clients who are in drawdown may have seen their pension pot eroding, causing a dramatic decrease in their income. Clients with a low Capacity for Loss will have quite an urgent need to repair their eroded income as soon as possible, giving them more certainty for the future. The initial reaction may be to look at an annuity, but it s worth pointing out that with the continued drop in annuity rates, this may not deliver the income they need. nnuities are also not exposed to the market, and while this could give a degree of security, it would also mean losing out on potential market upswings in the future.

8 For adviser use only. Not approved for use with PRIVTE INVESTORS. MetLife Europe Limited (trading as MetLife) is authorised by the Central Bank of Ireland and subject to limited regulation by the Financial Services uthority. Details about the extent of our regulation by the Financial Services uthority are available from us on request. Registered address: 20 on Hatch, Lower Hatch Street, Dublin 2, Ireland. Registration number UK branch address: One Canada Square, Canary Wharf, London E14 5. Branch registration number BR M l FEB 2013 l JN 2013