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Low dependency is now required of all schemes - and will affect technical provisions
Achieving full funding on a low dependency basis is now the long-term funding goal that all DB schemes must achieve. This means that pension funds will have to transition their portfolios into low-risk cashflow matching assets by the time they achieve significant maturity, which is 12 years of liability duration. Beyond that, UK schemes will have to decide whether they go to buy-out or run-off.
Historically, the self-sufficiency funding basis for many schemes has been more conservative than technical provisions under the current funding regime, but not quite as conservative as buy-out valuation. Under new Fast Track requirements, technical provisions will be expressed as a percentage of full valuation on a low dependency basis, which will be proportionate to the duration of the scheme's liabilities.
Low dependency requirements will likely impact the technical provisions schemes will need to meet, especially under Fast Track, which two-thirds of schemes will aim for. Additionally, significant maturity may be closer than many schemes and managers anticipate, as the rising rates environment has improved funding for unhedged liabilities.
To understand how these changes will impact investment plans and funding strategy, mallowstreet plans to continue the research into pension risk transfer for a fourth year - and launch research into new areas which are open to sponsorship.
Low dependency asset allocation needs to match cashflows - but how?
Despite the systemic risks that LDI has created in the UK pensions industry, new DB funding regulation clearly requires schemes to adopt a cashflow-matching low-risk asset allocation in the time leading up to significant maturity and past it.
However, there is no requirement for precise cashflow matching, which is understandable given UK pension funds' long-standing concerns over the feasibility of such a strategy. Another challenge around CDI solutions is their ability to deliver the returns that schemes need - as illustrated below with historical mallowstreet data from 2020:
As a result, schemes have had to rely on asset allocation and cash distribution from their managers to meet their cashflow needs - but their stance will likely evolve after the new DB funding code comes into force.
Covenant risk assessment is changing fundamentally
UK pension funds will no longer grade their covenant as 'strong', 'tending to strong', 'tending to weak', or 'weak'. Instead, the new DB funding code of practice will focus on:
- Visibility over the sponsor's business forecasts for the next one to three years
- The reliability the trustees have over the sponsor's cashflows - and the time period thereof
- The maximum longevity of the sponsor - which is effectively the longevity of the covenant provided
This is bringing the sponsor's cashflows and contingency funding into much sharper focus than ever before. However, most UK schemes still adopt an ad-hoc analytical approach to understanding covenant risk, based on data from the Trustee Report 2021:
Specifically, contingency assets are key to securing the scheme in run-off, but very few schemes have been able to take advantage of them:
We are currently completing analysis for the Trustee Report 2022, in partnership with Janus Henderson, which will shed further light on these topics.
However, the key to understanding what a low dependency portfolio will look like is our upcoming research project on Cashflow Investing - and we are open to discussing sponsorship opportunities with proactive asset managers who are already stress-testing their offering for the world after the new DB funding code.