November 13, 2013
By Rene Letourneau

As hospitals and health systems try to protect their margins against declining reimbursements and soft patient volumes, many are looking at redesigning their traditional defined benefit pension plan as a way to cut costs. By offering a defined contribution plan instead—typically a 401(k) or 403(b)—hospitals can reduce their overall contribution to their retirement package and make their financial obligation predictable because it will no longer be vulnerable to market fluctuations.

Unlike a defined benefit plan where a predetermined benefit is payable to each retired employee, in a defined contribution plan the employer matches a set percentage of the amount each employee sets aside in an individual retirement account. [EXPAND Read more]

Corporate America and many state and local governments have already made the move to defined contribution retirement plans to a large extent. The healthcare industry has been slow to follow suit, but the tough economic conditions that most hospitals are facing appears to be changing that.

In April 2013, ratings firm Standard & Poor’s released a report showing that many hospitals and health systems have underfunded defined benefit pension plans and blamed low discount rates (interest rates) as one of the major reasons. Although the S&P report is specific to nonprofits, all provider organizations are struggling with the same issue, and low discount rates have increased pension liabilities across the board.

Low discount rates are wreaking havoc because pension plans use the rate to determine the amount of an organization’s liability, explains Liz Sweeney, S&P director and credit analyst and 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,” she says. “Discount rates have been dropping pretty dramatically in the past 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.”

Sweeney adds that an uptick in the discount rate will not provide immediate relief to organizations with underfunded pension plans. “If the discount factor trends up, it will immediately improve the measure that we call funded status. … However, the required contributions to a pension plan are based on a set of calculations that includes a number of smoothing mechanisms for both the discount rate and the assets, so there may not be an immediate reduction in funding requirements for pension plans, even if the discount rate starts to rise.”

Defined benefit plans

One of the largest healthcare institutions with a defined benefit plan is Johns Hopkins Medicine in Baltimore, a $6.7 billion integrated global health enterprise that includes the six-hospital Johns Hopkins Health System.

“Every five years we’ve done an analysis to see if we should stay in the defined benefit plan,” says Pamela Paulk, senior vice president for human resources at Johns Hopkins Health System and Johns Hopkins Medicine.

The institution’s leaders have based their periodic plan review on market activity, their competitors’ retirement offerings, and what is best in terms of recruitment and retention, Paulk says. So far, Johns Hopkins has stayed with the defined benefit plan, despite the precariousness of the markets and the low discount rate because the organization is large enough to generally withstand the financial pressure.

“The negative is the volatility with funding that might change from year to year because it’s driven by the discount rate,” she says. “We make sizable contributions to our plan every year anyway, but we’ve had to make higher contributions than we expected, than we budgeted for, to make up for the discount rate. It’s the discount rate that really kills you. But we’ve been able to absorb it, and our plans are well funded.”

Johns Hopkins is again in the process of reviewing its benefit plan structure, and Paulk is not sure which way the decision will go this time. Most healthcare organizations in its market have moved to defined contribution plans, she says, and the traditional defined benefit pension is not as important for recruiting new staff as it once was. However, making the cultural shift required to let go of the current plan is not easy.

“We struggle here thinking about it,” Paulk says. “We are a 125-year-old institution. Johns Hopkins put us here to be an anchor for the city of Baltimore, which he loved. Part of being an anchor is the workforce. … Knowing when they leave us they are still going to have a regular paycheck is important to us. It’s tied to our mission.”

Yet Paulk knows the numbers are tough to deny. “If we went to a defined contribution plan right now, we’d be paying 4% to 5% of our salary costs into our retirement plan, but last year 9% went to pensions. That’s about an extra 4% that we possibly could have used to give bigger raises.”

Defined contribution plans

Although federal legislation called the Moving Ahead for Progress in the 21st Century Act will help reduce the amount hospitals have to contribute to their underfunded defined benefit pension plans through 2014, this reprieve will be temporary. Rather than relying on fleeting legislative fixes, many hospitals are moving to a defined contribution plan.

Orlando Health, a 1,780-bed family of facilities located in central Florida, was ahead of the curve when it made the move to a defined contribution plan decades ago. The organization believed traditional pension plans were becoming unsustainable, says Christy Pearson, the system’s chief operating officer for human resources.

“Defined benefit plans have really fallen out of favor for not only healthcare but for most Fortune 500 companies” because of the funding challenges they create, Pearson says.

“For an employer, the reality is it is difficult to fund a defined benefit plan,” she says, noting that the financial environment for hospitals and health systems is only getting worse. “Healthcare is in an absolute white water right now with changing reimbursement models and the shift from inpatient to outpatient care delivery.”

Although Pearson says Orlando Health’s decision to move to a 403(b) retirement plan was based on the organization’s desire to respond to financial conditions, she believes it is also a win for employees who want more flexibility than a traditional pension plan can offer.

“Employees in the past tended to stay with healthcare organizations for a very long time. When they stayed with one organization for their career, then a defined benefit plan made a lot of sense. What we see now is more and more people are shortening their careers with an organization and having five to seven employers over their careers, or even looking for multiple careers … With a defined contribution plan, it is easier for employees to take it with them and easier for them to decide their own risk tolerance,” she says.

Pearson, who has been directly responsible for recruitment at Orlando Health for 15 years, says the employees she brings on are not surprised or disappointed by the 403(b) plan. “I don’t think there is any expectation on the part of new hires that there will be a defined benefit plan. It’s not even a blip,” she says.

Hybrid programs

Rather than moving fully to a defined contribution plan, some organizations are now offering their employees a hybrid plan, which combines a defined benefit plan with a 401(k) or 403(b) and generally includes an employer match.

Pittsburgh-based UPMC, which has 4,736 licensed beds and $10.2 billion in annual operating revenue, has had a hybrid program consisting of a cash balance plan and defined contribution plan since 1999, says John Galley, vice president of HR shared services.

“It looks and feels like a defined contribution plan, and it’s much simpler than a traditional plan to understand because the retirement benefits are expressed in terms of an account balance,” he says. “The account balances have earnings to help employees’ benefits grow for retirement. The defined benefit plan earns interest credits while the defined contribution plan earns in accordance with the investments selected by each employee.”

UPMC provides a combined retirement contribution of 5.5%–8.0% of salary to employees each year based upon their age and years of service. “By offering a hybrid approach, we can offer a richer benefit to employees than if we were defined contribution alone,” Galley says.

Another reason UPMC took this step rather than going solely to a defined contribution plan is that leadership was concerned that employees might not save enough for retirement if left completely on their own to do it.

“The last thing we want is for employees to reach retirement age and not have the wherewithal to retire. It’s not good for them, and it’s not good for us,” he says. “The danger is with employees who don’t save anything and don’t get the match. They can’t retire, and they are going to be an unhappy group.”

In an effort to assist employees in preparing for retirement, UPMC automatically enrolls them in the cash balance plan and escalates their retirement credits throughout the course of their employment.

Despite the transition in plan design, UPMC has still faced challenges with fully funding its pension. “We have had to fund the plan at greater levels,” Galley says, noting that the organization contributed $148.5 million to keep the plan fully funded in 2012. “Certainly, declining interest rates have increased our liability.”

New Albany, Ind.–based Floyd Memorial Hospital and Health Services, a 236-staffed-bed institution with a budgeted gross revenue of $905 million, moved to a hybrid retirement plan in 2010 because its liability grew too much in the mid-2000s due to low discount rates, says Edward Miller, the organization’s vice president of finance and CFO.

“In the late ’80s and ’90s when the market was roaring, we didn’t make contributions to our pension plan because we didn’t need to. Our assets were growing faster than our liabilities,” Miller says. “We thought it would come back, but it didn’t, so we made this change.”

Because the defined benefit piece of its retirement package is underfunded, Floyd Memorial is contributing $200,000 per month and has plans to increase that amount. “Now we are at a point like many individual investors of investing a set amount into the pension plan each month,” Miller says.

For the 403(b) part of its hybrid plan, Floyd Memorial matches up to 50% of the first 4% that an employee contributes to an account, which keeps the system competitive in its region.

“Our human resources team did a great job of looking at the market and saw we had the richest benefits plan in the area. We wanted to move away from that to being one of the richer plans, but not the richest,” Miller says. “We knew that if we kept our defined benefit plan in place, it would really absorb our ability to give pay increases.”

As part of its long-term financial plan around its retirement package, Floyd Memorial has also made a downward adjustment to the returns it expects its assets to realize, Miller says.

“The assumption we use now is a 7% return,” he says. [/EXPAND]