S&P Implies Hospital Pensions Are Not a Problem -- I'll Be the Judge

I read two excellent articles on the same topic recently. Both Rebecca Moore for Plan Sponsor and Jack O'Brien for Health Leaders Media wrote about an S&P study that implied that pensions are not a problem for not-for-profit hospitals in the US. I found the different perspectives interesting as Rebecca is a retirement plan journalist who was covering a hospital retirement issue while Jack is a hospital journalist who was covering a retirement issue with regard to hospitals.

In summary, here is what I learned:

• The U.S. not-for-profit health care sector has benefited from an increase in the median funded status of its pension plans in fiscal 2018—increasing from 80.6% to 85%, according to S&P Global Ratings;
• S&P measures the underlying pension liabilities using a "conservative municipal bond rate;"
• S&P applauded that many hospitals have focused on de-risking liabilities;
• S&P views the following as positive with respect to hospital pensions:
• Full funded status;
• Any sort of de-risking; and 
• No pension plan at all.

I'm not going to spend a lot of time dissecting what S&P thinks is good. As a firm, they employ many excellent economists while my formal economic training is quite sparse. But, I'd be remiss if I did not comment on the use of municipal bond rates. While they are not far from the measures typically used for corporate pension plans, I'm not sure how movement in yields on municipal bonds should affect the measurement of obligations in hospital pensions.

Let's return to the initial premise that being that hospital pensions are well-managed (I said not a problem in my title, but the words that were actually used were well-managed). Are they? Is 85% a good funded status? Are the hospitals managing frictional overhead costs? Is de-risking the right approach for a plan that is 85% funded? If so, which type(s) of de-risking should they be using?

While it's not the case for all of them, the majority of hospital pension plans are either [hard] frozen or they are soft frozen (no new entrants). This implies that the goal is to eventually terminate those plans. A plan that is 85% funded cannot be terminated. In fact, generally speaking, a plan that is 100% funded on the basis that S&P uses cannot be terminated (annuities have some level of built-in costs as compared to a traditional actuarial measurement of pension obligations). 

Getting from 85% funded to just a bit more than 100% funded is a tall task. There are a number of ways to make progress on this, some passive and some active. They include watching discount rates increase, investing more aggressively (and hoping that produces better returns), contributing more money to the plan, and cutting the overhead costs of the plan.

Let's attack those in order.

Unless a hospital has more control over the economy than I think it does, it cannot affect the yields on municipal bonds.

Investing more aggressively works well when it works well meaning that if you can beat your bogie, you improve your funded status and get closer to being able to terminate the plan.

Contributing more money to a plan is an easy concept. All it requires is having money to contribute. In 2019, hospitals, generally speaking, don't seem to have that kind of money laying around. On the other hand, hospitals do have lots of assets many of them not pulling as much weight as they might were they re-deployed into the hospital pension plan. I have some ideas in this vein, and would be happy to tell you about them.

Finally, for the last three years, October Three has published a report on PBGC premiums. The report has found that hospitals, compared to any other industry, are consistently paying more in needless PBGC premiums than any other industry. In other words, there are techniques available to them to lower those premiums that as a group, they are not using.

So, with all due respect to S&P, the judge has ruled. Hospital pension are a problem and generally speaking, hospitals are not managing those pensions well. The judge thinks those hospitals should contact him.

Managing the Risk in Active Pension Liabilities

If you work with defined benefit (DB) pension plans at all, or if you happen to be among those responsible for them at a company that still sponsors an ongoing DB plan, you know that de-risking has been all the rage in recent years. And, this is not to say that this is not without good reason. With the inherent volatility in cash flow and accounting expense that has been added to the DB world by what some (including me) would consider poorly conceived funding and accounting rules, risk mitigation is often critically important.

So, let's consider what have been the trends in de-risking. There have been a mass of so-called lump sum windows in which former employees have been offered one-time opportunity to take a single sum distribution of the value of their remaining benefits thereby removing those liabilities from the plan's 'balance sheet' and thus eliminating the company's future liabilities with respect to them. And, there has been lots of liability driven investing (LDI). That is, companies look to invest assets in fixed income instruments of durations similar to the liabilities in the plan. By doing this, liabilities in the plan tend to move roughly in lockstep with the underlying assets intended to support those liabilities.

All this is great, especially for well-funded plans, but how about all the rest of those plans? And, these strategies tend to look at the liabilities that currently exist. How about the liabilities that will exist in the future (we used to consider those in actuarial valuations, but the law changes made them irrelevant in the annual valuations)? What do I mean by that? Consider an example.

The XYZ Pension Plan currently has its funding target (liability for accrued benefits). We can split that out among three groups of participants, two of which are composed of former employees. Suppose they are broken out as follows:

Retired participants: 100,000,000
Terminated Vested participants (former employees who are not yet in pay status, but are entitled to a benefit in the future): 30,000,000
Active participants: 70,000,000

for a total funding target of $200,000,000.

What do we know about the liabilities that compose this funding target? We know that the amount attributable to current retirees will generally decrease because for each year that a retiree lives, there are 12 months fewer of benefit payments that the retiree will receive in the future. This might tend to imply that this group represents a diminishing risk.

We know that the terminated vested group will become retirees. Generally, these are former employees with smaller benefits (they didn't work for the company until a retirement age). In the usual profile, they represent a far smaller liability than do retirees or actives. For a given vested term, the liability with respect to their benefit will generally increase as they approach retirement and then decrease. Lump sum windows were designed to target this group and have been quite successful. But, because their accrued benefits, and therefore attendant liabilities are smaller, the effect of having done this has not been as significant as it would be with a group of active employees.

The active employees currently accruing benefits are the most important group to de-risk. Why is this? There are several reasons:

• In our example, and typically, their accrued benefits represent a meaningful liability to the plan and plan sponsor.
• With each year that an active employee remains with the company, they are one year closer to retirement meaning that the discounting period until retirement has shortened.
• In an active plan, these employees continue to accrue benefits (more on this to follow).

Yes, active employees continue to accrue benefits. Suppose we consider a concept that used to be paramount to actuarial valuations of DB plans -- the actuarial present value of projected benefits under the plan (PVB). This is the actuarially determined amount that if it sat in a pool of assets today would be sufficient to eventually fund the benefits of that individual. 

For retirees and vested terms, the PVB and the accrued liability or funding target or accumulated benefit obligation (ABO in accounting parlance) are, save differences in actuarial assumptions, the same as each other and the same as the PVB.

For active participants, they are not. In fact, for a mid-career person, the PVB may be more than twice as large as the liabilities we are consider. And, if we are de-risking, isn't it really the eventual benefit liability that needs to be de-risked? 

If you agree, you're correct, and if you're a plan sponsor, we need to talk. 

If you disagree, you're likely not correct, and if you're a plan sponsor, we need to talk.

There is a really easy approach to this that many companies have taken and that is to freeze benefit accruals under the plan. But, not everyone wants to do that. Some companies actually philosophically like the concept of DB plans. But, the funding and accounting rules have made it more difficult to get comfortable with sponsoring them.

Suppose I told you that you could mitigate the risk in the active PVB. And, suppose I told you that you could do that without freezing accruals. 

You'd be interested, wouldn't you?

Let's talk. You won't regret it. Here is one way.

Derisking Your Defined Benefit Plan or Not

Every couple of years, there is a new trend in the remaining corporate defined benefit plans. Lately, it has been derisking in one sense or another. In fact, the Mercer/CFO Research 2015 Pension Risk Survey says that plan sponsors have been spurred by a perfect storm of events.

I'm not going to argue with there having been a perfect storm of events, but I think that everyone else's idea of what constituted the perfect storm is a bit specific and technical. They focus on falling interest rates, a volatile equity market, and a newly (last year) released mortality table. Instead, I would tend to focus on constantly changing pension rules both in the law and in financial accounting requirements that give plan sponsors a constantly moving target.

But, all that said, the study tells us that 80%-90% of plan sponsors are pleased with the risk management actions they have taken to date. What makes them pleased? Is it that they have cleaned up their balance sheets? Is it that their funding requirements have decreased? Has the derisking decision helped them to better focus on or run their businesses?

Isn't that last one what should be at the crux of the matter? The fact is that 2014 was not a good year to offer lump sum payments to individuals with vested benefits if what you were looking to do was to pay out those lump sums when the amounts would be low. Underlying discount rates were very low meaning that lump sums would be larger. Similarly, the cost of annuities was high, but many chose to purchase annuities for substantial parts of their terminated and retired participants.

What all of these plan sponsors did was to decrease future volatility in pension costs (however they choose to think of cost). For many, that truly was a good thing. But, at what cost?

For some, that cost was significant. For others, it was not.

Defined benefit pension plans used to be viewed as having a degree of permanence. That is, when funding them, calculations assumed that the plan would go on forever. While we know that forever is a very long time, we also know that plans with benefits that are based on participants' pay in the last years of their careers are wise to consider the amounts that they are likely to have to pay out in the future as compared to the amounts that would be paid out if everybody quit today. That is not reality. There used to be what are known as actuarial cost methods that allowed sponsors to do that and frankly, they resulted in larger current required contributions. But, those larger current contributions tended to be very steady as a percentage of payroll and that was something that CFOs were comfortable with.

But, the wise minds in Congress with the advice of some key government workers determined that this was not the right way to fund pension plans. Actually, their real reasons for doing so were to reduce tax deductions for pension plan funding thereby helping to balance the budget.

Sounds stupid, doesn't it? It is stupid if what you are doing is making sponsorship of a pension plan untenable for most corporations.

Risk truly became a 4-letter word for pension plan sponsors. As time went by, it became important for sponsors to find new ways to mitigate that risk.

Unfortunately, many of them have been so eager to do that over the last few years that they likely overspent in their derisking efforts. For others, it was clearly the prudent thing to do.

My advice is this if you are considering your first or some further tranche of derisking. Consider the costs. Consider how much risk you mitigate. Make the prudent business decision. What would your shareholders want you to do?

Then decide whether you should derisk.