As the value of investments can go down as well as up, investors need to accept the possibility that they might lose money, and to consider whether they can afford it.
Some people have a robust attitude to risk, but others do not, as Ryan Medlock, senior investment development and technical manager at Royal London, says: “There will be some who will be very uncomfortable at the idea of volatility and the chance of losses within their investments, whereas others will be more relaxed.”
Capacity for loss is defined by the Financial Conduct Authority as “the customer’s ability to absorb falls in the value of their investment” and stipulates that if loss of capital would adversely affect their standard of living, this should be taken into account when assessing how much risk they are able to take.
It is therefore important that clients fully understand attitude to risk and capacity for loss when managing their pension savings.
Jonathan Cooper, head of paraplanning at Drewberry, says: “Pension savers need to be aware that attitude to risk and capacity for loss are two different things. Risk attitude is about how they feel about investment risk, whereas capacity for loss is about how much risk they can afford to take. These concepts need to be delineated and considered alongside clearly defined retirement goals.”
He adds: “Both are equally important parts of the broader risk discussion – just because someone feels that they want to take risk does not mean that they have the financial resources and stability to make it a good idea.”
Medlock also emphasises the difference between the two concepts: “Simply put, attitude to risk is more to do with an individual’s psychology, whereas capacity for loss is more to do with their financial circumstances and investment goals.”
To objectively consider and understand one’s own capacity for loss, detailed information about likely sources of income and expenditure plans in retirement is required.
Gavin Jobson-Wood, specialist business development manager at Scottish Widows, says: "The implications of making inappropriate retirement income choices are clearly very serious and any assessment should consider the impact of a reduction in income, which can help influence the level of risk an individual feels they can take, and how secure their overall income needs to be.
"Assessing whether their lifestyle could withstand a drop in income should therefore take priority. While attitude to risk still plays an important part in the advice process, its focus is more on one’s feelings and beliefs about investing and may not reflect the current financial situation; and is therefore more subjective.
"This contrasts with capacity for loss, which attempts to assess financial facts and is more objective, with a detailed analysis of income needs and likely expenditure in retirement."
Henry Tapper, executive chair at AgeWage, says that there can be a little more leeway with risk when it comes to pensions than with other investments.