This old Chinese proverb reminds us that we have to take risks in life to build wealth.  When people choose drawdown, they potentially put their wealth at risk.

They have an expectation that the risk will pay off, but this is not guaranteed. In the short term, there is always the prospect of a global downturn in stock markets, which can be devastating.

To mitigate the impact of significant market falls, it’s important to assess a client’s capacity for loss. The FCA talks about ‘establishing the risk a customer is willing and able to take’.

The risk a customer is willing to take is largely subjective and is what we commonly call ‘attitude to risk’.

The risk a client is able to take is far more objective. It refers to the customer’s ability to weather falls in the value of their fund, which in turn could reduce their income and impact their lifestyle.   

The bare necessities

The starting point to calculate capacity for loss is to identify ‘essential’ expenditure. These are costs that simply have to be met. Food and heating are obvious examples, but categorising essential expenses like this may not go far enough.

There will be expenditure that isn’t essential in nature, but is seen as important by the client. These expenses will vary between people.

One client may consider two holidays a year important, while another would see this as a luxury. 

A new way

Historically, the retirement conundrum has been reduced to a simple binary decision: Annuity or drawdown? Yet an annuity can be a valuable asset within a retirement portfolio. Essential and important expenditure should be protected by a guaranteed income for life. This could include a defined benefit pension, state pension and an annuity. This approach means that any excess can be invested in riskier investments, which should deliver higher returns in the long term.

Different assets are appropriate for different types of expenditure