More detail of how this can be gathered from PROD 3.3.11, which states that distributors should consider how the financial instruments to be offered or recommended fit with the end clients’ needs and risk appetite, and also the impact of fees and charges on end clients.
We will examine this in detail now.
Focusing on risk appetite, this is an area in which cashflow is vastly underused.
Calculating an attitude to risk is often done via psychometric questionnaire and does not need to link to risk profiling, but there is another part to the risk rating: the capacity for loss.
The capacity for loss (and similarly the need to take investment risk) is an excellent candidate for enhancing via a full risk-based cashflow forecast.
The FCA defines capacity for loss 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 FCA has often stressed that it should be taken into account on a mathematical basis and not based on the investor’s feelings for what they can stand to lose.
Some interpret this as needing to ask the client what percentage could be lost.
There are a couple of problems with this approach; firstly most people would not have a clue what percentage they could afford to lose but would probably answer 0 per cent.
Another issue is that any such statement could be viewed in the eyes of the client as a guarantee.
A client who states they can only afford to lose 5 per cent might be very displeased on finding that their investment has dropped 6 per cent, even if this has actually had no impact on their standard of living.
A risk-based cashflow forecast can demonstrate the amount of loss a client can financially withstand and therefore the amount of risk they can take.
For example, someone entering drawdown has to decide on the amount of risk they should take with their investments.
A cashflow plan, showing the likely expenditures (probably higher in early and late retirement, and lower in mid-retirement) can be set up, with the income coming from drawdown of their investments.
Stochastically forecasting the impact of the drawdown on the investments will show if and when they are likely to run out of money in a poor investment scenario.
The level of risk can be dialled up or down until the low scenario provides money for a satisfactory duration.
If no level of risk is tolerable, it might be appropriate to look at annuities, or to delay retirement.