After not-for-profit hospitals free themselves from the burden of skyrocketing interest rates on the tax-exempt debt side of the coin, they can then look forward to facing the fluctuating rates of return on the investment side.
Hospitals managing pension funds for employees are particularly at risk as the Federal Reserve progressively slices the prime rate to stave off a recession, although it is only a loose and inverse correlation between the prime rate and pension liability.
When discount rates go down, (pension) liability goes higher, and the discount rates have been very low for a long, extended period of time, said Catherine Jacobson, senior vice president of strategic planning and finance, chief financial officer and treasurer at 674-bed Rush University Medical Center in Chicago. It just exacerbates the gap between investments and liability.
In general, sagging rates of return result in a vicious circle for hospitals that rely at least in part on investment income to fund their operations and pension plans and, ultimately, reduce their need to borrow. Pension funds are hit by market volatility on both the debt and investment side of the equation, and there has been a lot of volatility of late. From Dec. 1, 2006, to June 30, 2007, asset returnsbased on a portfolio composed 60% of domestic equities, 10% of international stocks and 30% of fixed incomeclimbed 6.58%, while pension-fund liabilities, which are tied to corporate AA-rated interest rates, declined 7.02%, according to research provided by SEI Investments, Oaks, Pa., an investment manager for institutions, including 49 hospitals with more than $7.7 billion in assets.
The situation nearly reversed itself in the second half of the year. From July 1 to Dec. 31, 2007, assets climbed only 1.03% while pension-sponsor liabilities jumped 14.34%. The resulting -13.31% change in funded status meant pension-fund sponsors had less assets available to meet their funding responsibilities to the plans. Meanwhile, in January, assets declined 4.02% and liabilities climbed 1.85%, resulting in a -5.87% change in funded status.
Right now from a pension-fund perspective, there are no winners, said James Morris, an SEI senior vice president. Pension-fund sponsors are dealing with unprecedented levels of volatility on both the asset side of the pension balance sheet and the liability side. Ultimately, pension sponsors need investment strategies that link their liabilities with their assets.
Actually, on the debt side of the equation, interest rates are on the decline, and the yield curve tracking the difference between short- and long-term interest rates is looking more normal, Morris said. But everything is in flux. To the extent that a hospital was poorly funded at the end of the year, the situation has gotten worse, he said. They wont see it until the end of the year, but when they calculate the liabilities again if the rates dont recover, they are looking at higher contributions.
Jacobson said she was dealing with an underfunded pension fund whose liability was a negative pull on our debt capacity. Rushs liability to the pension fund at the end of December was about $40 million, she said, a situation that traces its roots to two decades of a pension-funding policy that relied too much on just investment returns, deferring funding. There is a seven-year plan in place to catch up, but she said she expected that the hospitals liability will increase even further because of the markets volatility. In this current environment most pension liabilities are going to move the wrong way, Jacobson said. Nobody is hitting their long-term rate on their investments.
The pension fund, which is valued at approximately $500 million, was earning about -1%, which is actually a couple points above Rushs benchmarkdown even more, she said. But that is just a paper loss at the moment, while the meltdown for auction-rate securities means real dollars. Pension valuations are going to move around on the balance sheet, but the reality is how it translates into the seven-year funding plan, Jacobson said. She added that she is banking on the plans conservative investment strategy. It wont get infected so much because we have seven years to deal with it, she said. The auction-rate bonds are hurting me right now.
Earlier this month as part of its regular financial reporting for the quarter ended Dec. 31, 2007, the University of Pittsburgh Medical Center reported that investment income had plummeted from $220 million to $3 million, a 2.7% return on its investment portfolio compared with a 9.8% return in the year-ago period. UPMC said the reduction was because of an accounting change as well as lower returns in the financial markets.
Current market conditions have not changed our commitment to maintain a well-diversified investment portfolio, which we expect to outperform comparable market returns over the long-term, said C. Talbot Heppenstall Jr., UPMCs senior vice president and treasurer in a news release. Separately, but only days later UPMC said that it was seeking to purchase some of its auction bonds from investors at 100.01% of the par amount on any business day up until March 19.
Most hospitals, which generally take long-term, conservative investment strategies, are just trying to ride out the giant wave created by the credit market turmoil. Methodist Healthcare Ministries of South Texas, the charitable arm of Methodist Healthcare System in San Antonio, positioned itself to handle volatile markets like this when it was formed in 1995, said Peggy Cary, its CFO. The diversified portfolio, valued at approximately $200 million, allocates 10% of its assets in fixed income, 20% in market-neutral hedge funds and 70% in equities, she said. At the end of 2007, the portfolio was earning a 10% rate of return but as of the end of January, it had dipped to -4.7%, Cary said. In particular, the portfolios equity holdings skidded, decreasing 7% for the month of January, but the hedge funds did their job, earning a positive return, she added.
Similarly, David Salsberry, vice president of finance and CFO at 466-bed West Virginia University Hospitals in Morgantown, said its investment portfolio was constructed for the long haul with a highly diversified policy. We are having significant heartburn over what is happening (on the public-finance side) but on the investment side, were in it for the long-term, he said.