Low discount rates are making it challenging for U.S. nonprofit hospitals to fund their defined benefit pension plans, Standard and Poor's Ratings Services said in a report released last week.
Pension plans use the discount rate to determine the amount of an organization's liability, says S&P credit analyst Liz Sweeney, one of the report's lead authors.
"A defined benefit pension plan is essentially a promise to pay future benefits to people. It's a stream of future cash flow… The lower the rate, the higher the liability," Sweeney says. "This is not unique to pensions, it is just finance math."
"Discount rates have been dropping pretty dramatically in the last several years so liabilities have been growing. Assets have been growing, too, but the liabilities have grown even faster than the assets… When the liability exceeds the assets, we call that being underfunded. Over time, when a plan is underfunded, you are going to have to put more contributions into the plan," she added.
Al Pierce, managing director for the advice team at SEI, a global investment outsourcing firm, says hospitals are going to take an enormous hit because of the low rates.
"The average discount rate of some of these plans 10 years ago was probably close to 7% or 8%. Today it is more like 4%, so think about the impact of that on cash flows going out 30 or 40 years. It's going to be massive. It's an increase in excess of 40% to 45% in the amount of money they owe."
Even though interest rates are apt to rebound, Pierce says, this likelihood provides no relief to hospitals.
"The assumption is that rates will go back up, but here is how the rules work: If you are an accountant, you have to give an accurate representation of what you [would] owe today if you had to service all of your debts. You have to determine what it would cost to terminate the plan today based on prevailing rates," he says.
Meeting the financial obligations of a DB pension plan is not a challenge that is specific to the healthcare industry, but it adds an extra layer of complexity for hospitals and health systems already dealing with several financial challenges.
"To put it into context for hospitals, they are already dealing with what we consider to be a pretty difficult operating environment because of soft patient volumes, increasing integration with physicians, and low reimbursement increases. There are a number of operating challenges, and growing pension funding needs add to that struggle," Sweeney says.
Although recent federal legislation called the Moving Ahead for Progress in the 21st Century Act (MAP-21) will help reduce the amount hospitals have to contribute to their DB pension plans in 2013 and 2014, this reprieve will be temporary, says the report.
"The act requires plan sponsors to use a different formula for determining the discount rate used in calculating required minimum contributions. Based on the current rate environment, that would result in a much higher discount rate in the short term and lower required funding minimums. Many hospitals may even have no contribution requirements in 2013. However, the funding relief in MAP-21 is designed to be temporary and doesn't change the overall economics of pensions," the report states.
Rather than relying on temporary legislative fixes, Sweeney says many hospitals are looking at redesigning their retirement plans and moving away from DB pensions to 401(k) plans.
Sweeney says hospitals are taking two approaches to restructuring pension plans: a soft freeze where the benefit remains in place for current employees but is not offered to new hires, and a hard freeze where accruals are stopped for everyone in the plan, including current employees.
"It takes a while for it to improve the numbers on the pension plan, but we are seeing these kinds of changes at a lot of hospitals," she says.
The healthcare industry lags behind other industries when it comes to redesigning retirement benefits because it did not feel the same economic pinch that many did in the early 2000s when the technology bubble burst, Pierce says.
Now that hospitals and health systems are facing an uncertain financial future as reimbursements shift from a fee-for-service to a value-based model, healthcare executives are rethinking their options for the retirement benefits they offer to employees.
"Corporate America has been getting out of the defined benefit plan space ever since the tech crash when there was a drop in interest rates and a drop in asset value in the early 2000s. Corporate America did not want to be in a structure where they didn't know what their contribution would be every year. So they froze DB plans and moved to a 401(k) structure… The difference is they know the employee is bearing the risk in the 401(k), not them."
"I think for the most part, hospitals didn't move away from DB plans in 2001 and 2002 when Corporate America did because their business models were not impacted… What I would say is that probably the biggest thing causing the move away from DB plans is the combination of the uncertainty around the cost of the plans and the uncertainty of the business model moving forward," Pierce says.
Hospital executives are smart to examine their options for altering their defined benefit pension plans. While having an underfunded plan is not necessarily a nail in the coffin for a hospital's credit rating, it can potentially have a negative credit impact and leaves an organization vulnerable to the volatile nature of discount rates.
Finding a strategy to restructure a DB plan to make it a more predictable expense can help hospitals and health systems avoid future budgetary shortfalls.