Investment risk in a pension, operating reserve, endowment, and other asset portfolios can negatively impact financial resources and impede operating flexibility.
We believe hospitals and health care systems seeking greater financial efficiency and improved returns need to begin by quantifying investment opportunity and risks collectively across all of their investment pools, and to determine the appropriate balance between risk and reward on a total enterprise level. We feel there are three ways that finance and investment executives can strive to improve the efficiency of their investment pools.
1. Better understand your investment pool's mission
While many investment committees at hospitals and health care organizations include individuals who are knowledgeable about investments, they often make investment decisions based solely on asset risk and return features, unaware of the impact on the investment pool's mission.
Investment pools are often used to support the balance sheet and borrowing capabilities. Therefore, we believe it is wise to understand bond covenants, days cash on hand measures and other key metrics, as well as specific risk triggers related to these metrics. We feel modeling and stress testing can help organizations better understand how investment decisions would impact these metrics.
For example, we have seen a hospital invest in private equity and other illiquid assets that were then excluded by ratings agencies when calculating days cash on hand metrics. While it was decided not to make additional private equity investments, unfortunately, the private equity commitments already made were irreversible. In our opinion, a focus on the mission would have prevented a negative impact on borrowing capability.
Unfunded pension liabilities are considered debt by rating agencies. Therefore, we feel investment decisions on pension assets should also consider the impact on ratings.
2. Become familiar with distortions in the efficient frontier that pension plan regulations cause
Often convenience prompts a hospital to invest similarly for both a pension plan and other larger asset pools. Other times, a basic investment approach is used because it is smaller than other asset pools. However, we feel pension funding and accounting regulations can distort the typical risk/reward tradeoffs, so a different investment approach is often favorable.
U.S. pension funding rules changed in 2008. Regulations that might have once encouraged risk-taking in pension investments now discourage it. While trustees might like to think pension plan assets can take a long-term (20, 30, 40 year) investment horizon, in our opinion they no longer can. And although they might think they can wait for any market drop to later recover for the long term, the government has eliminated that option. In general, a hospital has seven years to pay off an unfunded liability created by a drop in market value. A hospital that also wants to avoid benefit restrictions and employee notices will pay off any underfunding under 80%, effectively reducing the time horizon to one year.
3. Take a holistic approach, but customize the strategy for each part of the asset pools
Accounting, auditor, rating agency, and funding requirements and regulations can make standard asset investment decisions complex. We believe there are benefits to knowing where to take different types and amounts of investment risk in the pursuit of rewards. For instance, we have seen benefits from increasing pension fund risk while reducing operating fund risk, as well as from taking duration risk in the pension pool while decreasing it in another asset pool. We have also seen where the shape of the yield curve required that duration risk be more carefully managed among pools.
While there are reasons to take a different investment approach for each asset pool, we feel important benefits accrue from considering the various pools together to know where and when to take different types of investment risk.
Decision makers need to focus on mission, set investment beliefs, and identify the financial metrics that matter to their organization. They should then evaluate how distinct strategies for each pool affect these metrics, and either look to improve performance or strive to reduce investment risk.
Mark has over 30 years of consulting experience in the health care industry working on asset allocation and spending policy studies for endowments as small as $50 million, foundations as big as $2 billion, and sovereign wealth funds with more than $300 billion. He can be reached at mark.ruloff@willistowerswatson.com
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