In 2003, a reversal of fortunes on the high street coupled with a very public private equity approach prompted UK retailer WH Smith to take a serious look at its pension strategy. With earnings down and despite the failure of a debt-laden buyout approach in early 2004, the board suddenly became extremely uncomfortable about the deficit in its defined benefit scheme, then running at about £152m.

In addition, 60% of the pension funds’ assets were invested in equities and 40% were in bonds. If the market took a turn for the worse, the deficit might balloon even further, putting cash flow at risk and threatening to scupper the shareholder dividend.

“It was pretty clear that we had to de-risk the pension scheme pretty significantly,” recalls Alan Stewart, WH Smith’s group finance director. The board took a series of measures, including two one-off contributions totalling £170m, and a transfer of pension assets from equities and bonds to a far less volatile liability-driven investment (LDI) scheme.

The company made its first contribution of £120m into the scheme in 2004 and, around the same time, began to look at ways to escape the ups and downs of markets. It eventually settled on an LDI approach. “It was pretty clear from a relatively early stage that an LDI solution was one that fit our needs, but it took a lot of modelling to determine the optimum position,” says Mr Stewart.

At the end of September 2005, the company moved 94% of its pension assets into a large, liquid cash fund, hedging against inflation and interest rate rises with derivatives. “There really is no risk in the major cash portion, that 94% of our assets,” says Mr Stewart. Six percent (about £50m) was invested in equity options. The total portfolio is expected to return just above the expected liabilities.

Pension liabilities are far more predictable now, too. In April 2007, the company capped its service accrual for 2,500 current employees who are still part of the defined benefit scheme, which was closed to new members 11 years ago (most employees are part of the company’s defined contribution plan). In effect this means the risk to the company has gone down, because it is easier to predict the expected cash flow needed to cover payments for the 18,000 past and present employees currently covered by the closed plan.

The result has been dramatic—today the deficit is down to £42m and falling, and the board feels confident that the LDI approach has the company’s £635m in assets sufficiently hedged against a bear market. “In truth I don’t think I could have asked for a better outcome in terms of what we sought from our strategy,” says Mr Stewart.