Before the 1990s, not-for-profit hospitals didn't pay much heed to the stock market, preferring investments such as U.S. Treasury bonds, which offered solid returns without the risk. But in the past decade, hospitals shed their bearish ways and shifted more assets into the red-hot equities market. Their financial fortunes became inextricably tied to Wall Street, for better or worse.
Lately, it's been more of the latter.
The ill effects of hospitals' run with the bulls began to be felt as stocks started to slide last year. According to Fitch Ratings, median not-for-profit hospital investment income dropped to $18 million in 2001 from $24 million the previous year.
Investment losses are expected to take a much bigger bite out of cash reserves this year. As of mid-October, the Standard & Poor's 500 Index was down 26% since the beginning of the year, compared with a 4% decline during 2001. Some fear a prolonged slump could hammer balance sheets, particularly when combined with the industry's increasing debt load. That could make it harder for hospitals to access capital in the future.
In addition, the weakened stock market is forcing many institutions to lower earnings assumptions for their pension plans. As a result, hospitals expect to divert more cash from operations next year to meet pension funding requirements.
"A lot of hospitals weren't making contributions at all for the last several years because their pension fund was making money on its own," says S&P analyst Liz Sweeney. "All of a sudden, (hospitals) have to work that (pension contribution) into their budget."
Rating agencies, which are often reluctant to downgrade a facility based on investment losses that are out of management's control, nevertheless are starting to take notice. In recent months, investment losses have factored into ratings of several hospitals and systems. Consider some recent examples of downgrades by Moody's Investors Service:
* The multispecialty Cleveland Clinic stepped back from its longstanding aggressive investment strategy for its unrestricted funds and pension assets after its cash declined from a peak of more than $1 billion in December 1999 to $455 million as of July 31, according to Moody's. Investment losses and "sizable future requirements" to fund pension obligations played into Moody's decision to lower the system's bond rating in October to A1 from Aa3 and to assign a negative outlook on its $1 billion of outstanding bonds. That downgrade came despite improving operating results.
* Doylestown (Pa.) Hospital, a 472-bed stand-alone community hospital, recorded a $23 million loss in its investment portfolio that contributed to a 44% decline in liquidity. The investment loss exceeded a fiscal 2001 operating loss of $15.5 million on operating revenue of $140.6 million. Citing both poor operations and the liquidity drop, Moody's downgraded the hospital to A3 from A2 in August and changed its outlook to negative.
* Elliot Hospital in Manchester, N.H., a 249-bed stand-alone, suffered investment losses of $9.9 million on revenue of $210 million. In addition, it paid a cash contribution of $4 million to fund its pension liability, according to Moody's. In September, Moody's lowered the hospital's rating to Baa1 from A3.
Like many investors these days, a lot of hospital finance executives are hitting themselves on the head, even though investment losses are almost universal.
Several hospitals and systems that were contacted for this article declined to be interviewed. A spokeswoman for Doylestown Hospital says: "We don't want to be the poster child for bad finances right now."
According to a September 2001 survey of 461 hospitals and systems by Chicago-based CCM Advisors, independent hospitals had an average of 46% of their defined-benefit pension plan funds in U.S. equities and 43% of their foundation or endowment funds in equities. Multihospital systems had 54% of their defined-benefit pension plans in U.S. equities as well as 52% of their foundation and endowment funds.
For hospitals and healthcare systems, smaller percentages of stocks were allocated for depreciation reserves, self-insurance funds, working capital and short-term operating funds, according to CCM.
Historically, hospitals have been a conservative lot, and with good reason. Unlike other not-for-profits, such as universities, hospitals are subject to sudden and substantial swings in their operational income, necessitating a safe rainy-day fund. Yet as stocks rallied in the 1990s, hospitals came under criticism by some investment managers for being too old-school. Meanwhile, more systems were forming, with greater sophistication in financial management. Many pumped a greater percentage of assets into stocks, some intentionally and some simply because their stock portfolios ballooned with positive returns.
"If you're all fixed income or short-term cash and equivalents, that's probably too conservative," says Bruce Gordon, a senior vice president with New York-based Moody's. "On the other hand 75% equities is probably too risky for the typical hospital system."
Unlike for-profit hospitals, not-for-profits tend to accumulate excess cash. "For-profits don't tend to keep lots of investments around because they are in the business of paying dividends to shareholders," says Timothy Solberg, director of investments at CCM, which contracts with the American Hospital Association to operate the AHA's family of four investment funds. Those funds have slightly more than $200 million in assets from 45 hospitals. CCM, an affiliate of Convergent Capital Management, also is endorsed by the AHA to act as a financial consultant for its hospital members.
The change in investment strategy during the past decade was particularly dramatic for independent hospitals, which can less afford to take risks than systems that boast more reserves and diverse revenue bases. For independent hospitals, the percentage of investments in equities went from an average of 7% in 1989 to about 20% in 1995, and to about 30% in recent years, Solberg says. Meanwhile, health systems have averaged 35% to 40% in equities, he says.
"Hospitals are more vulnerable now from the standpoint that they've generally got higher equity allocations than 10 years ago, and probably even five years ago," Gordon says. "I think they realized there was money to be made when the stock market was booming, and they were not reaping the benefits."
For a while, higher risk paid off: In many cases, stock market gains handily offset operational losses brought on by the Balanced Budget Act of 1997. From 1999 to 2001, when operating margins for A-rated hospitals sunk to an average of less than 2%, hospitals relied on investments for a majority of total profits, according to S&P (See chart, p. 36).
In hindsight, though, some institutions assumed too much risk.
In the case of the Cleveland Clinic, aggressive investing led to substantial losses. The system allocated 75% of its investments to stocks, a much higher percentage than average for all health systems. In its report, Moody's expressed concern about the system's concentration of investments with just three management firms, one of which invested heavily in technology companies and contributed to a disproportionate share of the losses.
According to Moody's, the Cleveland Clinic used a similar investment strategy for its pension assets, and current estimates are that the system will need to contribute $361 million to its pension plan from fiscal 2003 to 2006, more than two-thirds of which is required to be allocated over the next two years.
Cleveland Clinic officials declined to comment.
Solberg agrees that some hospitals "went pretty aggressive."
"I think a lot of hospitals that hired consultants or were working with brokers that didn't necessarily understand the hospital industry tried to model (hospital portfolios) as they would for an individual or a big corporation," he says.
Barring a dramatic turnaround in the markets and the general economy, more hospitals and systems will face similar problems, analysts say. Until now, slumping investment portfolios have been buffered by better operating margins at many institutions. In fact, S&P analyst Martin Arrick called the healthcare industry overall "a positive credit story" during a late September conference call with bond investors. He noted that operating margins for credits tracked by his firm improved last year, even though total margins and cash levels fell.
"That (operating margin) is the piece that hospital administrators can control," Arrick says during the investor call. "The (stock) market is going to have good years and bad years."
Still, operating margins averaged about 1.5% last year industrywide, just half of what they were five years earlier. No one expects a big increase in those meager numbers anytime soon. That leaves little buffer if investment losses continue.
Yet even healthy providers with comfortable operating margins are gritting their teeth a bit.
Take five-hospital Legacy Health System in Portland, Ore. After a 6% decline in its pension fund last year and an anticipated 15% drop this year, Legacy will have to increase its pension fund contribution in 2003 to $22 million, up from $12 million this year, says Chief Financial Officer Pamela Vukovich. The system anticipates 2003 net revenue of $762 million.
The system saw its net income plummet to $1 million in fiscal 2002 ended March 31 from $30.6 million in the previous fiscal year because of investment losses, even while its operating margin improved to 4.2% from 3.3% during the same period. "It's not been fun to look at the numbers for the last 21/2 years," says Vukovich, who gets a daily report of how the system's portfolio is performing.
Except for the pension fund contribution, Vukovich says the stock market decline has not affected operations. "We've always had the philosophy that gains from our investments weren't going to fund our operations," she says.
Legacy budgets for an annualized 8% rate of return for its long-term assets including its pension fund, and in some years it has made more than 20%, Vukovich says. In 1999, investment gains in the pension fund were so great that the system did not have to make any contributions from its operating income. "When we look at our investment returns over the last seven years, we still have positive returns of over $100 million, so you have to put it in perspective," Vukovich says.
Legacy hasn't shifted its allocation of 63% equities for its long-term assets, Vukovich says.
Similarly, Elliot Hospital hasn't changed its pension and endowment fund allocation, which is about 60% equities and 40% fixed income, despite its recent losses. "Anyone who invests in the stock market recognizes that there may be periods of great gain and of suppressed income," says Doug Dean, Elliot's president and chief executive officer. "We're really looking at stock market performance in the long run."
Dean also says that multiple factors besides the stock market, including a larger employee base, necessitated the sizable distribution to its pension fund.
Meanwhile, Solberg says, CCM has not changed its plans, announced in early 2001, to introduce two new funds to the AHA Investment Funds family, expanding the range of investment options. In the coming months, it will introduce a money market fund, which he says will be particularly useful for public hospitals that have restrictions on their investment options, and an international fund, which he says will be attractive since the dollar's value has weakened relative to other currencies.
CCM assumed a contract last year to operate the funds from the AHA's previous investment consultant, Hewitt Associates of Lincolnshire, Ill.
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