Fixed Income
Closing the funding and income gap
  • UK pension funds have made significant progress towards closing the funding and income gap, but staying on track is challenging given macroeconomic uncertainty and changing dynamics.
  • The forgotten middle ground – liquid assets with income and growth characteristics – can flexibly contribute towards cashflows or improving funding levels.
  • Higher-yielding fixed income’s consistent high income and total return credentials mean it can play an important role in pension funds meeting their long-term objectives.

In this current low-yield environment, how can UK defined pension schemes position their portfolios to improve funding levels and cashflows as they continue de-risking?

The balancing act UK pension funds face today

UK pension funds have made significant progress towards closing the funding and income gap over the past year. The aggregate funding position has improved to £83 billion as at the end of August 2021, up from -£101 billion, and the aggregate funding ratio has also shifted into surplus from 94% in August 2020 to 104% in August 20211.

In order to remain in surplus, plans will need to balance the complex dynamics of the following:

De-risking the portfolio. The last decade has seen a large shift in allocation to lower-risk assets. During the global financial crisis (GFC) in 2008, the ratio of equities to bonds stood at 58%/38% with 4% in other assets. By March 2020, equity allocations reversed in favour of bonds to 18%/55%2, at a time when longterm gilt yields declined by almost 4%3, to their lower bounds.

Meeting long-term objectives. Current market conditions create challenges. With more than half of a typical portfolio exposed to rock-bottom yields (through long duration gilts and corporate bonds), meeting pensioners investment objectives is not easy.

Generating cashflows. 73% of company plans are already cashflow negative (pensioner payments exceed contributions) and this is anticipated to reach around 90% by 2028, according to Mercer’s European Asset Allocation Insights.

The changing landscape for a UK defined benefit fund’s cashflows4

How can pension funds stay on track with their funding level objectives and continue to meet their cashflow requirements without increasing pressure on their sponsor?

Re-assessing the role of assets – do they generate income, growth or both?

In our view, the answer lies in maximising the potential of the investment portfolio.

Liability-driven investments (LDI) such as investment grade corporate bonds and gilts can provide a reliable cashflow stream, given their credit quality and low volatility. But with core fixed income yields at historical lows, LDI may not generate the required income and returns pensioners are seeking.

Many pension funds have therefore been drawn to alternative assets such as infrastructure, property and private credit in order to supplement their cashflow needs. Such “alternative” allocations climbed to 25% in March 2020, from less than 10% a decade ago2. While alternatives can offer higher yields, they can often be illiquid assets and, in some cases, capacity-constrained, which reduces the yield or return potential.

However, there is also a forgotten middle ground, where assets can have both income and growth characteristics that can flexibly contribute to cashflow requirements or growth of assets given their liquidity.

Source: Capital Group


1. Data as at 31 August 2021. Source: PPF 7800 index

2. Data as at 31 March 2020. Bonds includes investment grade government bonds, corporate bonds and other matching assets. Growth-oriented fixed income is categorised as alternatives. Source: Mercer European Asset Allocation Insights 2020

3. Based on yield from 31 December 2008 to 31 December 2020. Source: Refinitiv

4. Pensioners are those in receipt of benefits from the pension fund, deferred members have retained benefits but are not accruing any more, and active members are those whose employment with the employer qualifies them for benefits under the scheme, which continue to accrue. Cashflows shown are illustrative only. Sources: The Pensions Regulator, Capital Group


Risk factors you should consider before investing:
  • This material is not intended to provide investment advice or be considered a personal recommendation.
  • The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
  • Past results are not a guide to future results.
  • If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease. Currency hedging seeks to limit this, but there is no guarantee that hedging will be totally successful.
  • Depending on the strategy, risks may be associated with investing in fixed income, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.

Past results are not a guarantee of future results. The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment. This information is not intended to provide investment, tax or other advice, or to be a solicitation to buy or sell any securities.

Statements attributed to an individual represent the opinions of that individual as of the date published and do not necessarily reflect the opinions of Capital Group or its affiliates. All information is as at the date indicated unless otherwise stated. Some information may have been obtained from third parties, and as such the reliability of that information is not guaranteed.