How Goldman’s derivatives saved a pension scheme

In 2005 the head of the General Motors pension scheme hit out at the new fashion for “liability-driven investing”.

Encouraged by the dotcom crash and new accounting and tax rules, pension schemes were overhauling their portfolios. No longer would they try to generate a decent return from shares. Instead, they would be laser-focused on matching investments with their obligations to future retirees, which implied buying mainly long-dated government securities.

“I struggle to understand why locking in the lowest possible rate of return is a good idea,” GM’s Allen Reed told Institutional Investor. He liked stocks, hedge funds and private equity that brought more risk but promised higher returns.

Now that LDI has blown up in the UK, prompting gilt yields to surge, an intervention from the Bank of England and a fire sale of assets to fund souring swaps, other critics have emerged. They include Next boss Lord Simon Wolfson, who described the strategy as a “time bomb”, and Fundsmith founder Terry Smith, who said it was “an explosive mixture of inappropriate accounting and a misguided investment strategy”.

But that is not the full story. At the same time as GM was rubbishing LDI, UK retailer WHSmith went all-in. The fund fired the managers who were heavily overweight equities and hired Goldman Sachs.

Like many companies, WHSmith was incentivised to move to LDI because accounting rules had begun forcing it to recognise volatile pension liabilities on its balance sheet.

One problem. “Because we were so underfunded we couldn’t possibly afford to buy enough gilts in order to achieve the funding stability that we wanted,” recalls Jeremy Stone, chair of the pension trustees.

Goldman instead brought out the finest derivatives available to humanity. This shiny new portfolio was 94 per cent “invested in inflation and interest rate hedged investments” and 6 per cent in equity call options.

“This was a useful technology,” says Stone. “We had an immense risk . . . in that [the fund] was in substantial deficit and also wildly mismatched because it had a very equity-heavy portfolio. Coming over the horizon was the likelihood that very large amounts of money would have to be put in.” And it was unclear that the news chain could afford it.

There were a host of complexities along the way. The fund had to hold cash to be able to pay collateral on swings in value of its derivatives. In 2008, it was not only worrying for the first time about the solvency of its counterparty Goldman but also, says Stone, “we discovered that cash in cash funds isn’t necessarily cash”. The “cash” was in “monoline-enhanced asset-backed bonds”, which were shaken by the crisis and generated a temporary loss of more than £100mn, says Stone.

It later incurred another temporary £100mn hit when the “repo” or repurchase market, where securities are exchanged for cash on short-term loans, froze up.

But the strategy worked. In August this year, the WHSmith pension fund was sold to Standard Life in a £1bn bulk purchase annuity deal. The retirement income of the members is now assured.

The WHSmith fund had people who knew what they were doing such as Stone, a banker with Rothschild and Lazard. Funds that have been stricken in the current crisis are usually trapped in pooled LDI investments where they have less control and often less understanding of the strategies.

Meanwhile, in GM’s case, the strategy mattered little in 2009 when the carmaker collapsed; the US government bailed out the pensions.

tom.braithwaite@ft.com