WHSmith doubles surplus through LDI hedging

The newsagent’s pension scheme has managed to double its accounting surplus through its liability-driven investment strategy, following continued low interest rates

The WHSmith pension fund has doubled its accounting surplus to £69.2m in a year by hedging interest rates through its liability-driven investment (LDI) strategy.

How falling yields affect your scheme

Pension schemes that want to remove some of their key interest rate risk hedge this by buying UK government bonds.

But schemes that have not previously hedged out their liabilities are now stuck with unattractively low gilt yields.

The yield on 30-year UK gilts had held between 3.7% and 5.1% in the period from 1999 until the middle of last year, when they fell sharply.

Some pension funds are now reluctant to hedge their liabilities at such low returns, in the hope yields will return to previous levels.

Schemes that have hedged their liabilities by purchasing gilts at higher yields in previous years are better placed to match their liabilities in the current low-yield environment.

By reducing their interest rate risk in this way, schemes can seek to control the future price of paying benefits out to members.

But schemes have been warned not to hold out in the hope yields will rise, as there is no guarantee they will return to previous levels.

The WHSmith scheme is currently 95% invested in an LDI strategy with an external fund manager, with the remaining 5% allocated to derivatives. These instruments benefit from a substantial increase in the value of equities.

Nick Gresham, chief financial officer of the scheme's sponsor Smiths News, said: “[The LDI fund] has increased in value significantly over the period due to current low interest rates.”

The £435m scheme is currently undergoing its triennial valuation. Its previous valuation at March 31, 2009 calculated the deficit at £50m.

Gresham added: “It is too early to speculate about its outcome – although I note three years ago the scheme was in a surplus for accounting purposes and a deficit for funding purposes.”

In 2009, the scheme set up a deficit funding schedule of £5.8m a year to be paid over 10 years.

When to hedge

Schemes that moved earlier to hedge their interest rate risk were able to purchase gilts at a better yield.

They have got much less of an issue than a lot of people do. They were relatively early adopters
Pete Drewienkiewicz, Redington

Those that waited for the value of these assets to improve have suffered as quantitative easing and the low-risk appetite of global markets have kept yields down.

Pete Drewienkiewicz, head of manager research at Redington, said the WHSmith scheme has benefited from taking up a strong hedging position earlier.

He said: “They have got much less of an issue than a lot of people do. They were relatively early adopters.”

Schemes had become "complacent" in the past that yields would stay affordable, he added. There is no guarantee those higher yields will return.

Simeon Willis, principal consultant in the investment advisory team at KPMG, said the accounting basis assumes liabilities perform in line with corporate bonds.

He said. “During 2011 corporate bonds underperformed gilts due to widening credit spreads.

“This meant an investment strategy that uses LDI and gilts to a high degree is likely to have outperformed the accounting basis – good news for balance sheets.”

But Willis added this accounting surplus could mask a funding deficit in the scheme, which is calculated on the assumption liabilities perform in line with gilts.

In fact, the WHSmith scheme's surplus cannot be counted as a reduction against the future contributions to be paid by the employer, so the employer has not recognised it on the balance sheet.

Simon Kew, director of pensions at Jackal Advisory, said this was not generally standard practice in his experience.

He added: "It could be that, because it is in LDI, the asset cannot be realised by the company, so is not on the balance sheet."