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Low dependency investment allocation

This code of practice applies to activities related to valuations with effective dates on and after 22 September 2024. For activities related to valuations with effective dates before 22 September 2024, refer to the 2014 DB funding code (PDF, 401kb, 51 pages).

  1. A low dependency investment allocation is an investment strategy under which the value of the assets relative to the value of the scheme’s liabilities is highly resilient to short-term adverse changes in market conditions.
  2. The assumed investment strategy must meet the above requirement so that, when considering the overall prudence of the scheme’s low dependency funding basis, no further employer contributions are expected to be required.
  3. For the purposes of determining or revising a scheme’s funding and investment strategy, the following apply:
    1. Trustees must invest scheme assets so they are sufficiently liquid to enable the scheme to meet expected cash flow requirements, and with reasonable allowance for unexpected cash flow requirements.
    2. Trustees need to set an objective that, on and after the relevant date, scheme assets up to the minimum funding level will be invested in accordance with a low dependency investment allocation. Trustees must take this objective into account when determining or revising the funding and investment strategy. We expect this objective to be reflected in the intended investment allocation targeted at the relevant date in the funding and investment strategy. This objective does not apply to any surplus on a low dependency funding basis.
  4. The low dependency investment allocation is intended to be a notional investment allocation, supporting the low dependency funding basis actuarial assumptions. Targeting such a strategy for the purposes of the funding and investment strategy does not interfere with the trustees’ duty to invest in the best interest of members and their powers over the scheme’s actual investments as detailed in the scheme’s governing documents.

Mitigating the risk of requiring further employer contributions

  1. A scheme that depends on asset sales to meet its cash outflows can be exposed to the risk of selling assets during market volatility and crystallising a drop in the funding level. This could create a need for further employer contributions, going against the low dependency principle.
  2. There are two ways to mitigate the risks to the low dependency principle associated with selling assets. Trustees may choose a combination of both.
    1. ‘Cash flow matching’ – where schemes hold assets whose expected cash flows to the scheme mirror those of the scheme’s expected benefit and expense payments. This gives the trustees confidence that the assets they hold will be able to pay the benefits and expenses as they fall due.
    2. ‘Liquidity and low volatility’ – where the scheme’s expected benefit and expense payments are met by the sale of liquid assets, which are unlikely to be affected by significant price volatility.

Matching assets

  1. Scheme investments can be classified as being either ‘growth’ or ‘matching’ assets. A scheme’s low dependency investment allocation can contain a mix of ‘growth’ and ’matching’ assets.
  2. For the purposes of defining a low dependency investment allocation, there are two broad categories of ‘matching’ assets, which align with the two broad ways with which trustees can mitigate the risks to the low dependency principle associated with selling assets detailed above.
    1. ‘Cash flow generative’ matching assets.
    2. ‘Liquid and low volatility’ matching assets.
  3. We expect matching assets to be heavily weighted towards investment grade assets, but some sub-investment grade assets may usefully contribute to meet scheme outgoings.

Cash flow generative matching assets

  1. Assets that meet the below criteria can be considered cash flow generative matching assets:
    1. The income and capital payments are predictable (this includes assets denominated in a foreign currency, where appropriately hedged back to sterling).
    2. They provide either fixed cash flows, or cash flows linked to reference rates (such as inflationary indices or floating interest rates).
  2. Where an asset is owned indirectly (for example, via a pooled fund), the above criteria should be considered regarding the underlying assets. As such, the specific means of ownership should not limit a scheme’s ability to classify suitable assets as ‘matching.’
  3. The main asset classes that would meet the cash flow generative matching criteria include government bonds, corporate bonds and bulk annuities. Interest rate and inflation derivatives (including gilt repos) can also be deemed as matching where they provide payments to match the liabilities of the scheme. Illiquid and alternative credit including, for example, some property and infrastructure related investments, can also be used for matching purposes if they meet the criteria above.

Liquid and low volatility matching assets

  1. It may be appropriate for schemes to rely on asset sales to meet a portion of their cash flow needs. Where a scheme’s assets meet the following criteria, they can be counted as ‘liquid and low volatility’ matching assets:
    1. They are expected to be liquid in both unstressed and stressed market environments.
    2. They are expected to experience low price volatility in both unstressed and stressed market environments.
  2. Example asset classes that may, depending on their specific characteristics, meet the liquid and low volatility matching criteria include cash and cash-like securities, short-duration government bonds, short-duration corporate bonds, and floating-rate securities.
  3. A scheme’s low dependency investment allocation can contain a mix of ‘cash flow generative’ and ‘liquid and low volatility’ matching assets. When determining the appropriate mix of matching assets, in particular the degree of reliance on cash flow generation versus disinvestments, the trustees should consider the scheme’s specific circumstances, including scheme size. They should also be aware of the governance implications of relying more on cash flow matching (for example, the need to review the expected cash flow needs of the scheme frequently) compared to relying on disinvestments (for example, the need to ensure disinvestments are made in a timely manner to meet liquidity needs).
  4. Where a scheme relies on asset sales to meet a significant proportion of its cash flow needs, we expect the ‘liquid and low volatility’ matching assets used for such disinvestments to be well diversified.

High resilience to short-term adverse changes in market conditions

  1. The low dependency investment allocation must be set out so that the value of the assets relative to the value of the scheme’s liabilities (as assessed on a low dependency funding basis) is highly resilient to short-term adverse changes in market conditions.
  2. The low dependency investment allocation will contain matching assets, some of which may generate cash flows to match payments from the scheme. Changes in the short-term market value of such cash flow generative matching assets should not affect their ability to continue to meet the liability cash flows. In this scenario, it’s expected that the movement in the value of the assets, and the consequential movement in the yield on those assets, may be largely reflected in the movement in the value of the liabilities. More detail on this is available in the dynamic discount rate approach section of the low dependency funding basis module.
  3. Detrimental returns on growth assets would also reduce the level of assets in relation to the liabilities. Trustees should also be cognisant of the market and illiquidity risks of the growth assets. They should consider how this affects the riskiness of the investment strategy relative to the liabilities when considering the proportion of growth assets within any low dependency investment allocation portfolio.

Hedging considerations

  1. Trustees should consider the resilience of the funding level to changes in future interest rates and inflation expectations. For the purposes of their low dependency investment allocation, we expect schemes to target a minimum level of interest rate and inflation hedging of at least 90% on a low dependency funding basis.
  2. When determining the low dependency investment allocation, it is important to consider hedging against the shape of the interest rate yield curve or inflation yield curve rather than just the average duration of the liabilities. We expect the degree to which the trustees choose to hedge their interest rate and inflation risks along the yield curve, and the commensurate analysis to test such hedging arrangements, to be proportionate to the scheme’s size and time to the relevant date.

Testing high resilience

  1. We expect trustees to carry out a suitable level of analysis to enable them to assess the resilience of their low dependency investment allocation to short-term adverse market changes. The complexity and sophistication of this analysis will depend on the individual circumstances of the scheme, including the complexity of the low dependency investment allocation itself, as well as the scheme’s size and time to reaching the relevant date. Trustees need to consider both the asset and liability side when carrying out the analysis.
  2. We expect trustees to carry out a suitable test of the funding level resilience of their chosen low dependency investment allocation, by assuming they are fully funded on a low dependency funding basis and looking at the funding level change resulting from a stressed or downside scenario. Trustees should satisfy themselves that the scheme can recover back to full funding from such a stress within a reasonable timeframe, with low dependency on the employer and accounting for expected benefit payments and expenses. For example, where the trustees use a one-year stress with one-in-six likelihood, we expect the timeframe to return to full funding to be six years, with no further contributions from the employer. Where trustees choose a much stronger test, limited contributions from the employer may be considered. Trustees can determine the most appropriate approach for this test, based on the scheme’s circumstances.
  3. We would also expect trustees to consider other forms of analysis to understand the resilience of their low dependency investment allocation portfolio. For example, where trustees rely on disinvestments from liquid and low volatility matching assets to meet a significant proportion of their cash flow needs, they should consider how market volatility may impact their ability to make disinvestments without crystallising losses in the funding level. Where a scheme relies on cash flow generative assets to meet cash outflows, trustees should consider how the cash flows generated are likely to perform compared to the expected scheme outgo under a range of different scenarios.
  4. This could include consideration of alternative scenarios in relation to the matching assets for default rates (net of recovery), the impact of collateral calls for schemes using leverage and how the shape and level of the liability cash flows impact the resilience. When understanding cash flow projections, trustees should discuss with the scheme actuary the key assumptions underlying those projections and whether any adjustments are required to the funding assumptions for this purpose.

Liquidity

  1. When the trustees have identified a portfolio that meets the low dependency investment allocation criteria, they must consider whether the investments would provide sufficient liquidity.
  2. We do not expect a detailed assessment of liquidity for the purposes of setting the low dependency investment allocation. Instead, trustees should consider the general characteristics of the asset classes.
  3. More detail in relation to the liquidity of scheme assets is set out in the Application module of this code in the section on security, quality, liquidity and profitability.

Proportionality

  1. We expect schemes to take a proportionate approach in setting their low dependency investment allocation in line with the above expectations.
  2. We expect a greater focus on the granularity of the investment allocation and the risks associated with their low dependency investment allocation as a scheme approaches their relevant date.
  3. For a scheme whose relevant date is reasonably far in the future, it would be appropriate to articulate their low dependency investment allocation in terms of expected return, broad investment allocation and level of interest rate and inflation hedging. As a scheme approaches its relevant date, we would expect the level of detail for the low dependency investment allocation to increase.
  4. This is because, for the purposes of setting the funding and investment strategy, trustees must consider the objective that scheme assets up to the minimum funding level are invested in accordance with the low dependency investment allocation on and after the relevant date. When it comes to the way the scheme actually invests on and after the relevant date, our expectation is that investment decisions by trustees (and fund managers to whom decision-making has been delegated) will generally be consistent with the low dependency investment allocation from which the low dependency funding basis in the funding and investment strategy is derived. However, this does not interfere with the trustees’ duty to invest in the best interest of members. More detail on this can be found in the investment and risk management considerations module of this code.
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