Buttonwood: Stuck in the middle "DON'T save," say the governments of rich countries as they worry about demand in economies that are hovering between sluggish recovery and recession. Their injunctions are aided and abetted by central banks, which are keeping interest rates negative in real terms (ie, after inflation), a policy that transfers wealth from savers to borrowers. "Save," say those same governments as they contemplate the ageing of their populations and the potential strain on the public purse. As encouragement, they offer tax breaks to those who put money aside to fund their retirement. Pension funds are caught in the middle of these contradictory messages, and they are suffering. In Britain the Pensions Regulator, which oversees corporate schemes, recently relaxed its guidelines to help funds that are heavily in deficit. The same policies that have forced down government-bond yields have forced up the cost of providing pensions. Offering a pension is like incurring a debt, since it involves the promise of a series of future payments. When pension funds calculate the value of their liabilities, they therefore use a bond yield to discount future payments. As bond yields fall, the liabilities rise. This is not just a theoretical issue. It is possible for British companies to offload their pension liabilities to an insurance company. The insurance company largely funds such pensions by buying government bonds. So getting rid of the pension promise has become more expensive. There are some positive effects from lower interest rates, of course. Firms enjoy reduced financing costs on their other debts, freeing up cash that they can devote to the pension fund. As John Ralfe, a pensions consultant, points out, if companies have matched their liabilities by buying inflation-linked government bonds, they are hedged. And for those funds that still have lots of money in equities, low rates have propped up the stockmarket, boosting the asset side of the equation. Nevertheless, many pension funds are running fast simply to stay in the same place. According to Mercer, a consultancy, the combined deficit of FTSE 350 companies increased by £17 billion ($27 billion) in the year to March 31st, even though businesses paid in £20 billion of contributions. In these conditions a degree of flexibility on the part of the Pensions Regulator is understandable. Companies will be allowed a longer grace period to make up their deficits. Otherwise, a sharp rise in contributions might cause businesses to shed jobs, or even to go bust. But such forbearance does carry a risk. If companies were to go bust, their deficits would be larger than they otherwise would have been. That would mean bigger losses for the Pensions Protection Fund, a corporate-funded pot which underwrites the sector. The wounds to pension funds may simply be collateral damage from policies designed to revive the entire economy. Central banks argue that pensioners would suffer along with everyone else if economies were plunged into endless recession. But as yet the low-real-rates policy has not been quite as effective as its supporters hoped. Households may have been discouraged from saving (the latest figure for America is just 3.8% of income), but businesses are still hoarding cash rather than investing in new factories and creating jobs. Meanwhile, a longer-term problem is being stored up. Many companies have abandoned final-salary or defined-benefit (DB) pensions for new staff and switched to defined-contribution (DC) schemes, in large part because of the high cost of the former. These place the investment risk firmly on the employee. Low real interest rates imply that workers should save a bigger sum for their old age in order to generate their desired income. But currently payments into British DC schemes, from both employer and employee, are just 8.9% of salary (the American contribution numbers are similar). According to the Pensions Corporation, another consultancy, a 35-year-old who funds a DC scheme at such a level will retire on just 8% of his final salary if interest rates are low. To earn the equivalent of a DB pension worth half their final pay-cheque, they or their employer would have to contribute 55% of their salary. That might sound a tall order. But funnily enough, the Bank of England contributes 56.4% of its payroll to its DB scheme, which is almost entirely invested in inflation-linked bonds. It is a nice irony that the bank, which has done so much to discourage saving, is one of the most prudent savers of all.