PA Healthcare System Adopts a New Strategy to Tackle Financial Challenges

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1 SEI Case Study PA Healthcare System Adopts a New Strategy to Tackle Financial Challenges Pension underfunding and balance sheet concerns trigger debt covenant violations. Important Information: This case study describes the attributes of a specific client that SEI has determined is comparable based on objective criteria, including organizational goals, asset size and industry sector. Any discussion of specific asset allocations is intended to help clients understand SEI s customized investment approach, and should not be regarded as a recommendation. Information concerning SEI s recommendations over the last year is available on request. Organization A single-state healthcare system serving western Pennsylvania with a network of hospitals, physician offices and outpatient centers. The system oversees more than $200 million in board-designated and pension assets. Challenge After some of the dust had settled from the global financial crisis, the healthcare system found itself highly leveraged and suffering from weak operational performance. In addition to a recent acquisition putting strain on the balance sheet, the system experienced a charge of approximately $17 million due to the underfunded status of its pension. The confluence of these events caused the organization to breach certain bond covenants. Facing pressures from investors and other related parties, the system needed sound advice on the best way to resolve these issues. The board had employed an investment consultant for more than 10 years but had grown dissatisfied with the one-dimensional aspect of the relationship. The consultant provided insight from an investment management perspective, but did not address the system s overall financial goals or balance sheet issues. The investment committee also began to question its ability to proactively select, monitor and change investment managers in this increasingly volatile and complex environment. The system issued a Request for Proposal (RFP) to both consultants and providers of manager of managers programs. After a lengthy due diligence process, SEI was chosen as the fiduciary.

2 Key to SEI s approach was the understanding that achieving one objective can create other issues. Solution Working with SEI would be a new experience for management. Unlike the consultantbased model where asset manager selection was the focus, SEI s focus was on providing a solution to address the system s overall financial concerns, with an immediate focus on maintaining and improving upon the existing Debt to Capitalization ratio. Key to SEI s approach was the understanding that achieving one objective can create other issues. For example, a portfolio for board-designated assets that was too conservative could create a concern with negative net interest margin. Likewise in the pension, managing volatility requires higher degrees of risk management, which could preclude them from achieving certain levels of funded status due to lower returns. To accomplish management s objectives, three things were necessary: Minimize the negative impact of the pension plan on the balance sheet Decrease the volatility of boarddesignated assets Make operational improvements to build cash flow and strengthen the balance sheet With the primary objective of maintaining and improving the existing Debt to Capitalization ratio, the focal point of the analysis was the ending value for unrestricted net assets. SEI s analysis used the projections provided by management and then interpreted the impact on capitalization through stress testing and stochastic modeling of the variables impacting the capitalization number, including: Return on investments and investment balances The change in the unfunded pension liability Accumulated Other Comprehensive Income (AOCI) and the cumulative difference between expense and contributions Amortization of debt Pension contributions SEI Case Study: PA Healthcare System Adopts a New Strategy to Tackle Financial Challenges 2

3 Rethinking the pension management strategy Because the pension funded status was having the largest impact on the balance sheet, SEI helped develop an asset allocation that was designed to control AOCI and its impact, control contributions and improve funded status. What the analysis demonstrated was that the level of fixed income in the current allocation was actually acting as a partial hedge, precluding full participation in market rallies and potentially locking in the underfunded status of the pension. Chart 1: Distribution of 10-Year Pension Contributions Under the proposed portfolio, projected net contributions decreased by approximately $5 million. There is no assurance that the asset allocation to the right was implemented by the client. Past performance is not indicative of future results. You should not assume that future recommendations will be as profitable or will equal the performance of past recommendations. See Important Information section for additional information on Capital Market Assumptions and projections shown to the right. $ Million Current Proposed Poor Scenarios (95th Percentile) Expected (50th Percentile) Good Scenarios (5th Percentile) The asset allocation recommendation for the pension plan was to actually increase the equity exposure, reduce the fixed income exposure and add strategic alternative asset classes to take advantage of then-current market opportunities to enhance yields. As shown above, the proposed portfolio was designed to provide higher potential returns, control and start to reduce the AOCI impact, and accelerate the improvement in the pension s funded status. Under the proposed portfolio, expected net contributions decreased by approximately $5 million over the next 10 years. A risk-managed approach for board-designated assets A similar strategy was used to develop the asset allocation for the board-designated assets. The need to manage volatility, match or exceed the organization s interest expenses on its debt, and generate sufficient returns to buffer the amount necessary from operations to rebuild the balance sheet were all considered. The proposed risk management portfolio reduced equity exposure and increased the fixed income allocation, with an emphasis on duration designed to reduce interest rate risk. This new strategy was projected to decrease the portfolio s standard deviation from 10.9% to 8.2%, while still maintaining acceptable levels of return. SEI Case Study: PA Healthcare System Adopts a New Strategy to Tackle Financial Challenges 3

4 Chart 2: Projected Distribution of Returns (10-Year Annual Average) The risk management portfolio is projected to deliver comparable returns while reducing the risk and volatility within the portfolio. There is no assurance that the asset allocation to the right was implemented by the client. Past performance is not indicative of future results. You should not assume that future recommendations will be as profitable or will equal the performance of past recommendations. See Important Information section for additional information on Capital Market Assumptions and projections shown to the right. Return (%) 30% 20% 10% 0% -10% -20% 27.1% 15.3% 7.8% 0.8% -8.5% Current 21.5% 12.8% 7.2% 1.8% -5.5% Risk Management Good Scenarios (95th Percentile) Expected (50th Percentile) Poor Scenarios (5th Percentile) According to SEI s projected reductions to the Debt to Capitalization ratio (see following chart), the recommended strategy should allow them to get back into compliance quickly and feel comfortable that they have a sound plan to avoid these types of concerns going forward. Chart 3: Risk Management Mix: Distribution of Debt to Capitalization All projected values below the red line result in a Debt to Capitalization ratio that is in compliance. There is no assurance that the asset allocation to the right was implemented by the client. Past performance is not indicative of future results. You should not assume that future recommendations will be as profitable or will equal the performance of past recommendations. See Important Information section for additional information on Capital Market Assumptions and projections shown to the right. 80% 70% 60% 50% 40% 73.3% 71.0% 69.1% 67.7% 66.3% 63.8% 65.9% 63.6% 61.9% 60.1% 57.0% 59.6% 56.7% 55.0% 52.9% 49.8% 53.4% 50.7% 48.7% 46.7% 43.6% 47.0% 44.3% 42.2% 40.2% Poor Scenarios (5th Percentile) Expected (50th Percentile) Good Scenarios (95th Percentile) 37.2% 30% SEI Case Study: PA Healthcare System Adopts a New Strategy to Tackle Financial Challenges 4

5 Conclusion Through a coordinated approach that included changes to the pension portfolio, changes in the management of boarddesignated assets, and operational changes, SEI was able to recommend a strategy designed to help management get back into compliance. the recommended strategy should allow them to get back into compliance quickly and feel comfortable that they have a sound plan to avoid these types of concerns going forward. SEI at a Glance SEI s Institutional Group delivers integrated retirement, healthcare and nonprofit solutions to clients in eight countries. Our solutions help clients meet financial objectives, reduce business risk and fulfill their due diligence requirements through implemented strategies for the management of defined benefit plans, defined contribution plans, endowments, foundations and board designated funds. SEI Investments SEI Case Study: PA Healthcare System Adopts a New Strategy to Tackle Financial Challenges 5

6 How we create probability distributions and what they mean: The probability distribution graphs and tables are meant to provide an overview of the range of possible outcomes for a given variable (e.g., returns, pension contributions, expense) for a given asset allocation. The graphs are generated using SEI s proprietary modeling tool and simulated capital market behavior. Capital market behavior is simulated for 1,000 possible scenarios based on expected performance of each asset class and reflecting current economic conditions. Capital market assumptions such as return, standard deviation and covariances are inputs into this process, combining with model parameters to create market scenarios. We use these 1,000 capital market scenarios to create 1,000 output scenarios for each variable being considered. A 90% confidence interval should be interpreted as 90% of the projected output variables, falling between the 5% and 95% results, based on SEI Capital Market Assumptions. This projection is hypothetical in nature, does not reflect actual investment results and is not a guarantee of future results. 95th percentile: 95% of outcomes are less than or equal to this value 50th percentile: 50% of outcomes are greater than this amount, and 50% are less 5th percentile: 5% of outcomes are less than or equal to this value $ Millions Distribution of Probable Outcomes 95th Percentile Median (50th Percentile) 5th Percentile Important Information: This presentation is provided by SEI Investments Management Corporation (SIMC), a registered investment adviser and wholly owned subsidiary of SEI Investments Company. The material included herein is based on the views of SIMC. Statements that are not factual in nature, including opinions, projections and estimates, assume certain economic conditions and industry developments and constitute only current opinions that are subject to change without notice. Nothing herein is intended to be a forecast of future events, or a guarantee of future results. This presentation should not be relied upon by the reader as research or investment advice (unless SIMC has otherwise separately entered into a written agreement for the provision of investment advice). There are risks involved with investing including loss of principal. There is no assurance that the objectives of any strategy or fund will be achieved or will be successful. No investment strategy, including diversification, can protect against market risk or loss. Current and future portfolio holdings are subject to risk. Past performance does not guarantee future results. For those SEI funds which employ a manager of managers structure, SIMC is responsible for overseeing the sub-advisers and recommending their hiring, termination, and replacement. References to specific securities, if any, are provided solely to illustrate SIMC s investment advisory services and do not constitute an offer or recommendation to buy, sell or hold such securities. SIMC develops forward-looking, long-term capital market assumptions for risk, return, and correlations for a variety of global asset classes, interest rates, and inflation. These assumptions are created using a combination of historical analysis, current market environment assessment and by applying our own judgment. In certain cases, alpha and tracking error estimates for a particular asset class are also factored into the assumptions. We believe this approach is less biased than using pure historical data, which is often biased by a particular time period or event. The asset class assumptions are aggregated into a diversified portfolio, so that each portfolio can then be simulated through time using a Monte Carlo simulation approach. This approach enables us to develop scenarios across a wide variety of market environments so that we can educate our clients with regard to the potential impact of market variability over time. Ultimately, the value of these assumptions is not in their accuracy as point estimates, but in their ability to capture relevant relationships and changes in those relationships as a function of economic and market influences. The projections or other scenarios in this presentation are purely hypothetical and do not represent all possible outcomes. They do not reflect actual investment results and are not guarantees of future results. All opinions and estimates provided herein, including forecast of returns, reflect our judgment on the date of this report and are subject to change without notice. These opinions and analyses involve a number of assumptions which may not prove valid. The performance numbers are not necessarily indicative of the results you would obtain as a client of SIMC. We believe our approach enables our clients to make more informed decisions related to the selection of their investment strategies. For more information on how SIMC develops capital market assumptions, please refer to the SEI paper entitled Executive Summary: Developing Capital Market Assumptions for Asset Allocation Modeling. If you would like further information on the actual assumptions utilized, you may request them from your SEI representative. FOR INSTITUTIONAL INVESTOR USE ONLY. NOT FOR PUBLIC DISTRIBUTION SEI (01/14)