1. Cash Flow modelling & CAPACITY FOR LOSS ASSESSMENT
This presentation is directed at Professional Financial Advisers only.
It should not be distributed to or relied upon by retail clients.

2. Learning objectives
By the end of this session attendee’s will be able to:
Understand the importance of cash flow modelling and the need for this to be undertaken.
Understand why risk and capacity for loss should be measured independently of each other.
Identify various approaches for applying risk and capacity for loss to investment fund selection.

3. Why are we going to look at cash flow modelling & capacity for loss?
A little scene setting first;
In order to arrive at good client outcomes advisers have to contend with;
Extremely complex tax system.
Wide choice of investment funds and potential returns.
Multiple “wrappers” to place investments into with multiple goals.
Highly regulated and changing advice environment.
Advisers often turn to “tools” for assistance in navigating the complex area of financial advice.

4. What is cash flow modelling?
It is a tool which helps advisers plan to meet client’s financial objectives;
Sophisticated third party stochastic modelling tool.
Financial planning tools available via internet.
Product/investment provider calculators.
In house “Monte Carlo” calculators.

5. Cash flow modelling
How is it used?
Lifetime planning.
Retirement planning.
What is it not?
An all encompassing solution.
A substitute for knowing your customer, it is essentially a method to help in the process.

6. Cash flow modelling
Is there a growing requirement for cash flow modelling to be used?
Know Your Customer pressure from the regulator.
Differentiator between various advice models.
Part of your Central Retirement Proposition.
A demonstrable, reviewable and billable advice service.

7. In the new pension freedoms world is cash flow modelling a necessity
In the new pension freedoms world is cash flow modelling a necessity? The regulatory challenge FCA Thematic Review
“…..we intend to review retirement sale practices and, in particular, how firms are supporting consumers to make the right choices given the new, wider range of options available”.
FCA Business Plan 2015/16 Martin Wheatley, FCA Chief Executive Officer
Would analysis of goals, income and expenditure support consumers in making the right choices?

8. What does the FCA say about cash flow modelling
What does the FCA say about cash flow modelling? Finalised Guidance – Assessing Suitability – March 2011 Introduced the concept of risk the customer is “willing and able to take”
1.14 ….firms unduly focus on the risk a customer is willing to take and fail to take sufficient account of the customer’s other needs, objectives and circumstances
3.15 ….some customers may be willing to take a lower risk with their short-term savings needs and a higher risk with their longer-term pension arrangements
3.4 …. the investment objectives of a customer must include,…., information on the length of time for which they wish to hold the investment, their preferences regarding risk taking, their risk profile, and the purposes of the investment.
Assessing Suitability review – May 2017 – raised again concerns re “willing and able”

9. Advising on Pension Transfers - CP17/16 June 2017
3.12 ……in order to provide a suitable personal recommendation an adviser should consider the following elements: the client’s income needs and expectations and how these can be achieved.
4.9 ….what we expect the appropriate analysis to include, as a minimum: an assessment of the client’s outgoings and therefore potential income needs throughout retirement.

10. So why isn’t Cash Flow Modelling more widely used?
Cash flow modelling is only as good as the data and assumptions used.
The success of cash flow modelling relies heavily on the investment of time in the process by both the client and the adviser.
What is the demand and willingness to pay for cash flow modelling?
Full cash flow modelling is not for everybody. Have you examined the alternatives?

11. Retirement LifePlanning framework
A framework to help you discuss and manage the challenges and opportunities of retirement planning.

12. Retirement LifePlanning framework
For each client in plan, you can build a picture of their financial circumstances.

13. Retirement LifePlanning framework
Plot a range of goal types to their timeline, including financial milestones or life events.

14. Retirement LifePlanning framework
Build a picture of your clients’ investments, by adding their investment holdings.

15. Retirement LifePlanning framework
Show clients the potential effect of an income shortfall or income excess. See if their financial goals are achievable.

16. Retirement LifePlanning framework
Dial up or down investment performance to simulate the potential effect of different market conditions. Create ‘What If?’ plans. For example, show your client the potential the impact of increasing pension contributions.

17. Retirement LifePlanning framework
Show the potential effect of tax on your clients' retirement income for the year ahead.

18. Retirement LifePlanning framework
Use RIO to see the potential effect of making withdrawals from different tax wrappers to create tax efficient withdrawal strategies.

19. Due diligence
Remember – make sure you fully understand any “tool” you use.
How are the figures arrived at?
Identify shortcomings.

20. Cash Flow Modelling Attitude To Risk Capacity For Loss Fund Solution
Integral to good cash flow modelling is a robust assessment of attitude to risk and capacity for loss

21. Cash flow modelling summary
Is the direction of travel from the regulator towards the use of cash flow modelling?
Without cash flow modelling can you truly assess the sustainability of income in retirement?
Have you examined the range of cash flow tools that are available?
Need to ensure you have the right “tool” for the right clients.

22. Simplified Cash Flow & Capacity for Loss
The suggested alternative approach to assess capacity for loss within this presentation is primarily aimed at advisers who do not currently utilise comprehensive cash flow modelling.
It may also be of assistance to those that do cash flow modelling as an additional layer in the assessment process.

23. Capacity for loss - background
The FSA finalised guidance, issued in March 2011, requires advisory firms to have a robust process to assess a client’s capacity for loss taking into account their objectives and personal circumstances.
This guidance is further supported by the FCA Conduct of Business Sourcebook (COBS).
FSA expressed concern in 2011 that many advisers failed to consider capacity for loss separately in the advice process and they concluded that an example of good practice would be to assess risk tolerance and capacity for loss separately.

24. Defining capacity for loss
Risk attitude is subjective, based upon personal opinions.
Capacity for loss is objective, based upon fact, and can vary over time.
Whilst an individual’s attitude to risk may not change, their capacity to bear loss may do so as their personal circumstances alter.
Capacity for loss refers to the ability to withstand a financial loss.
“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”. (FSA 2011).

25. Capacity for loss – still very topical!
“Poor practice:
Many firms within our sample had failed to demonstrate from the information on file whether they had considered a customer’s capacity for loss.”

26. Capacity for loss assessment
John Makin
MSc (Financial Planning and Business Management)
Chartered Financial Planner, FPFS, Chartered FCSI, ACII
Senior Technical Consultant Standard Life
“An empirical exploration of capacity for loss assessment” – a 133 page (31,000 word) Masters dissertation.
Awarded a distinction at Masters level and was top student award at MSc level at MMU in 2015.
Standard Life have adopted John’s work to produce a White Paper – “Assessing Capacity For Loss”.

27. The research: Participants providing data to this study

28. Building a process CONFUSION Creating Clarity Application FCA IFA
Consumer
Building a process
Tools
Discussion document
Mapping
Asset allocation

29. Capacity for loss – what needs to be considered?
The available academic literature reveals a wide range of objective variables, based on fact, to consider when assessing capacity for loss.
Capacity for loss variables*
Individuals age
Investment time horizon
Number of years before retirement
State of health
Number of dependants
Income and expenditure
Net worth (assets minus debt)
Amount of savings
Amount of debt
Availability of funds in the event of an emergency
Amount of insurance held
*Makin’s Financial Planning:- An empirical exploration of capacity for loss assessment (Department of Accounting, Finance and Economics - December 2014) – which uses info from Droms 1988; Hanna and Chen 1997; Malkiel 1999; Cordell 2001; Hallahan et al. 2004; Holzhauer 2010; Cavezzali and Rigoni 2012; Grable and Carr 2014; Blake and Haig 2014; Kitces 2014).

30. Capacity for loss research – summary of findings
Sixteen participants were asked to complete 3 risk tolerance questionnaires.
Seven participants were assessed with the same risk tolerance of 4 out of 7 and were selected for capacity for loss assessment on two objectives.
All seven individuals were assessed as having the same risk tolerance;
Did they all record the same capacity for loss?
Did they all record the same capacity for loss for both objectives?
Participant
Objective 1 3 7 8 9 14 15
Holiday
Medium capacity
High Capacity
No capacity
High capacity
Low capacity
Pension

31. Turning the theory into practical use….
Attitude
To Risk
Capacity
For Loss
Fund Solution
Objectives

32. Capacity for loss variables: A basis for a structured discussion and robust documentation
The variables can be used to produce a framework for use by advisers when discussing capacity for loss with clients.
Designed to assist an adviser in formulating a decision as to a client’s capacity for loss as well as a mechanism for providing evidence of this decision.

33. Capacity for loss: Structured Discussion and robust documentation Potential discussion themes when investing for income or growth
Question
How long do they intend holding this investment before they start drawing capital or taking an income from it?
Notes:
No / Low capacity
Medium capacity
High Capacity
2. How much would their standard of living be affected if the income or capital growth produced from this investment were to fall below their expectations?
High capacity
3. If they needed sudden access to a lump sum, how likely would they be to take it from this investment?

34. Matching risk profile to capacity for loss
Profile description
Profile portfolio
Capacity for loss 1
No/Low 2 3 4 5
Medium 6 7 8
High 9 10
What if an individual’s risk profile and capacity for loss does not correlate?

35. Blending risk tolerance with capacity for loss….1 2 3 4 5 6 7 8 9 10
No/Low capacity
Medium capacity
High Capacity
Risk profile
Capacity
for loss
Risk tolerance assessed first and capacity for loss then mapped onto this assessment.
The lower the risk capacity a client has, the less investment risk they should take.
If a client is assessed as a risk profile 7 and they have a no/low capacity for loss then the portfolio should be in line with someone who has a risk profile of 1-4 rather than 7.

36. Blending risk tolerance with capacity for loss….1 2 3 4 5 6 7 8 9 10
No/Low capacity
Medium capacity
High Capacity
Risk profile
Capacity
for loss
An individual with a risk tolerance of 4 and a high capacity for loss should have a portfolio created appropriate to someone with a risk tolerance level of 4 or lower.
They should not be moved up the risk tolerance scale simply because their capacity for loss is higher.

37. Blending risk tolerance with capacity for loss….
Where a client invests in a red box portfolio this illustrates that they need to take more risk to meet an objective.
The suitability would need to be fully discussed and agreed with the client.
Would this course of action be suitable in relation to a DB pension transfer?

38. Centralised investment propositions
A number of options are available when constructing a centralised investment proposition:
Specific fund list
Multi asset / manager
Model portfolio
Bespoke
The following slides are just an illustration of how a centralised investment proposition could be mapped onto the risk tolerance / capacity table.

39. Example using Standard Life MyFolio Market funds Blending risk tolerance with capacity for loss…1 2 3 4 5 6 7 8 9 10
No/Low capacity
Market I
Market II
Medium capacity
Market II
III
Market IV
Market V
High Capacity
Market III
Risk profile
Capacity
for loss

40. Standard Life Myfolio investment solution
All 25 funds are risk profiled within the Dynamic Planner tool.
Also risk profiled across other risk assessment tools.
Provide 5 different investment styles covering: passive, active, growth and 2 income options across the 5 risk targets.
Available across all major platforms.
Standard Life MyFolio ‘lookthrough’ report offers client reporting to assist advisors with their client reviews and communications

41. Summary of findings
Appears to be widespread uncertainty amongst financial advisers as to the best practice that should be adopted for assessing capacity for loss.
Risk tolerance and capacity for loss should be assessed independently.
The research revealed advisers adopt two primary methods for assessing capacity for loss;
Cash flow modelling and
Questionnaire based approach.
Both methods have advantages and disadvantages.
A potential gap exists in the accurate assessment of capacity for loss between those individuals who pay for comprehensive cash flow modelling and those who do not.
The use of a specific capacity for loss document may help bridge this gap.

42. Assessing capacity for loss A white paper and framework to support you
An updated framework based on adviser feedback
Ensuring capacity for loss is not a ‘tick box’ exercise
Case studies to support the reconciliation of attitude to risk and capacity for loss
Copies available on the Standard Life stand

43. Conclusions
Is the direction of regulator travel towards the use of cash flow modelling?
How can you demonstrate your advice will meet client’s objectives without the use of cash flow modelling?
Without full cash flow modelling a documented process is required to pull together income and expenditure requirements, risk profiles and capacity for loss into a robust fund selection process.
Even with full cash flow modelling a separate documented process for risk profiling and capacity for loss might be considered good practice.
Take advantage of provider tools to dip your toes in the cash flow water.

44. By the end of this session attendee’s will be able to:
Learning objectives
By the end of this session attendee’s will be able to:
Understand the importance of cash flow modelling and the need for this to be undertaken.
Understand why risk and capacity for loss should be measured independently of each other.
Identify various approaches for applying risk and capacity for loss to investment fund selection.

45. IMPORTANT INFORMATION
Information about tax is based on our interpretation of current legislation and HM Revenue & Customs' practice. Tax treatment can change and depends on your personal circumstances. The information contained in this presentation does not constitute advice. It is designed for financial adviser use only and is not intended for use with individual investors. Any sample screen shots displayed are correct at date of issue but may be subject to change. Elevate, Winterthur Way, Basingstoke, RG21 6SZ (postal address). Elevate Portfolio Services Limited trades as Elevate and is part of Standard Life Aberdeen group. Elevate Portfolio Services Limited is registered in England ( ) at 14th Floor, 30 St Mary Axe, London, EC3A 8BF. Elevate Portfolio Services Limited is authorised and regulated by the Financial Conduct Authority. © 2017 Standard Life Aberdeen, images reproduced under licence. All rights reserved. This presentation (or any part of it) is not to be reproduced without the express written consent of Standard Life