The 2022 List Issue, Part 3: 4 steps for hospital and health system fiduciaries to consider this year
As the COVID-19 pandemic stretches into 2022 and refuses to retreat quietly into the night, resulting in variant spread and rapidly increasing cases and hospitalizations, many hospitals and health systems continue to grapple with difficult financial realities. The health crisis has continued to squeeze hospitals and health systems in an all-too familiar, yet unsustainable, environment of increasing expenses and falling revenues. In December, Moody’s issued a negative outlook on the non-profit healthcare sector for 2022, anticipating that expense growth, driven by staff shortages and increased labor costs, will outpace revenue gains—which have been curbed by canceled elective procedures and a worsening payer mix.
To add fuel to the fire, historic inflationary pressures, driven by base effects, pent-up consumer demand from accumulated savings and supply-chain and labor issues linked to the pandemic, are only exacerbating the trend of higher operating expenses, making materials more expensive and inflating wages for nurses, clinicians and other staff. Moreover, rising interest rates and record-high equities mean hospitals and health systems also need to account for potentially higher borrowing costs and lower investment returns.
In this challenging landscape, hospital and health system fiduciaries are required to deftly perform a delicate balancing act between their organizations’ operations, finances and investments. With these three-pronged challenges in mind, here are four key themes and action items that we believe hospital and health system fiduciaries should be thinking about taking this year to help maintain the financial health of the overall enterprise.
1. Evaluate the economic impact of the COVID-19 pandemic on your organization and operations, and determine whether your investment strategy needs to change
The combination of skyrocketing expenses and plunging revenues, with operating margins still below pre-COVID levels, compounded by inflation, has posed financial challenges to many hospitals and health systems. If your financial situation has changed, as well as impacted your risk tolerance or required liquidity, we recommend reassessing your investment strategy and confirming whether it still aligns with your overall financial goals. This could mean that your investment program is supporting a greater portion of your operating budget, which will require a reassessment of your liquidity needs, or that your risk appetite has decreased in light of events over the past two years, which means you and your investment provider should determine a plan to reduce portfolio risk in the short term as well as set up a schedule to re-introduce risk to the portfolio over time in alignment with improvements in key operational metrics.
Put another way, it is critical to know whether you can or need to turn to your investments for help to address challenges on the operating side of the house. For some hospitals and health systems, this will mean adjusting the investment strategy to address short- to medium-term financial challenges; for others, few to no changes are required and the strategy can be left in place. However, now is a good time to assess the current financial health of the organization and evaluate how well the investment program supports the long-term financial plan.
2. Consider the impact of rising interest rates on the organization’s finances and investment pools
With interest rates creeping up in the long term, as the Federal Reserve bides its time to tighten monetary policy and / or combat inflation, hospitals and health systems will potentially have to face higher costs to issue debt or borrow for capital projects or merger and acquisition activities, even if their credit rating remains strong. Healthcare fiduciaries are wise to be aware of any exposure to interest-rate risk across their investment portfolios, especially considering the impact of rising interest rates on pension plan liabilities and returns on long-term investments. For instance, if the pension plan is underfunded, rising rates may help improve funded status; even though asset values (particularly fixed income assets) tend to fall in a rising rate environment, liability values tend to fall faster. However, while rising rates may improve the funded status of the pension assets, they may have a negative impact on returns achieved by long-term investments. Fiduciaries should assess whether expected returns for long-term assets align with the organization’s cost of capital.
To manage interest-rate volatility, healthcare fiduciaries can consider assets that are less sensitive to interest rates or maintain overweight positions to the financial sector, which has tended to benefit from higher interest rates. Fiduciaries might also adopt a pension de-risking strategy that reduces interest-rate risk by extending the duration of the fixed income portfolio to minimize the impact of interest rate changes on the plan’s funded status.
3. Understand key drivers of risk in the portfolio, and assess, adjust and diversify strategic asset allocation as appropriate
While many healthcare fiduciaries may have a high-level view of their portfolio allocation, they should also take a closer look at their asset mix to understand key drivers of risk in their investment strategy. These might include equity style factors such as growth versus value, country exposure (such as U.S. versus non-U.S. equities), or duration, credit, risk, etc. Fiduciaries should determine whether their portfolio has any biases that could limit exposure to upside opportunities—for example, a bias for growth equities or a home-country bias for U.S. equities—and consider if the portfolio has factored in the potential rotation in the markets toward value equities, or a future shift away from U.S. equities to non-U.S. equities. Fiduciaries should also be aware of the duration of their fixed income assets, and the relative weights between Treasuries, government bonds and corporate credit. Getting a closer look at all portfolio exposures helps fiduciaries understand whether they are truly comfortable with their risk exposures and ensure these fall within the confines of their risk tolerance.
Fiduciaries should also consider mining additional return sources to help improve the risk-adjusted return profile of the overall portfolio. For instance, diversifying assets in the alternatives space, such as private equity, credit, real estate, infrastructure and commodities, are rich sources of income and growth. They can also serve the dual purpose of an inflation hedge, as these assets are generally less sensitive to changes in inflation.
4. Consider sustainability applications in your portfolio with your board or investment committeeAccording to the Global Sustainable Investment Review 2020, sustainable investing assets reached a staggering $35 trillion, or 36% of all managed assets in the U.S.¹ There is little doubt that it is critical for fiduciaries to think seriously about sustainability and what it means for their organizations’ investment portfolios. In recent years, more and more institutional investors have been adopting ESG-themed strategies or considerations in the pursuit of superior, risk-adjusted returns. We believe that the integration of ESG factors, which can be achieved by focusing on investment managers that include ESG integration as part of their process, is an effective strategy for many investors. However, the beauty of ESG investing lies in its diversity of applications, which can also include exclusion strategies, thematic strategies such as low-carbon equity, or shareholder engagement strategies to make your voice heard and effect change in how a corporation operates.
In short, there’s a variety of ways to integrate ESG into the investment program. While getting started often seems like a daunting task, it doesn’t have to be. We believe the first step along the journey to ESG investing is educating investment committee members and other key stakeholders on important ESG definitions, as well as aligning your beliefs, goals and objectives around ESG investing. Fiduciaries also need to remember to capture their ESG beliefs and goals in their investment policy statements. Having a clear reporting system in place is also critical to any successful responsible investing framework, so that fiduciaries can monitor and measure how well ESG policies are being implemented. Additionally, fiduciaries should have a solid plan to effectively communicate efforts and results to stakeholders and maintain stakeholder confidence.
The problems that have been dogging hospitals and health systems in recent years aren’t going away soon, and healthcare fiduciaries have their work cut out for them in 2022. However, we believe that carefully considering the strategic issues and action items we’ve outlined above, and keeping one’s eyes on the prize, will serve fiduciaries well as they navigate the troubled waters ahead.
The good news is, you don’t have to go it alone. Let us know how we can help.
¹ Global Sustainable Investment Review 2020, Global Sustainable Investment Alliance. 2021