Investment management: 8 steps to improve performance: to help realize your organization's financial goals, it's important to employ an investment evaluation process based on sound, well-proven economic practices - Cover Story

Healthcare Financial Management, June, 2003 by Angelo A. Calvello

There's no denying times are tough. The average defined-benefit plan went from being 100 percent funded in January 2002 to 77 percent funded in September And of the 360 companies in the S&P 500 that have defined-benefit plans, 90 are underfunded.

Endowment funds are faring no better. Few are able to generate enough revenue to support the programs and projects to which they are dedicated. The typical endowment lost 6 percent last year, with many smaller endowments posting their third straight losing year. Worse still, early indicators for the year suggest the trend will continue for quite some time.

As a healthcare financial manager, you're probably beginning to realize that despite this tough economic climate, you're going to have to contribute to defined-benefit plans. Simply put, it's no longer feasible to wait for better times.

The good news?

By following a back-to-basics approach, you can take steps to help guide your board to the most desired position and improve the likelihood of future investment success.

Step 1: Define Your Goals

The first step is to review the organization's investment goals. Goals should be broad yet clearly defined for each pool of assets. For example, investment goals of the defined-benefit plan might be to ensure that the present and future liabilities of the pension plan are met, to fulfill the fiduciary responsibilities and obligations as stewards of the plan, and to be cost-effective while attempting to outperform comparable funds. Other typical investment goals are to maximize shareholder wealth by serving as a competitive tool that cost-effectively attracts and retains qualified employees, and to structure competitive employee benefits and ensure the security of these benefits for pension-plan participants today and in the future. For an endowment, investment goals might be to have adequate and consistent independent sources of investment income to fund the philanthropic work for which the endowment was established. For funded depreciation, the investment goal might be to have adequate funds to meet planned capital expenditures.

Once goals are defined, it's important to tie them to specific investment objectives. For example, the defined-benefit plan might seek a return of 8 percent to meet its projected liabilities and achieve the desired funding status. The investment objective for the endowment might be to earn a 7 percent real return to accomplish its philanthropic mission.

Step 2: Find the Right Fit

Next, you will need to determine whether these investment targets remain appropriate. For example, will a target return of 8 percent on the defined-benefit portfolio allow your organization to meet its pension liabilities?

To answer such questions, you should commission an actuarial study. Actuarial studies provide an estimate of benefit costs expected at a particular point in the future. The studies also project pension obligations and identify the return the defined-benefit plan must earn to meet these obligations. These estimates are based on certain assumptions about the compensation plan and the demographics of participants. Future obligations are discounted to a present value.

To fully understand the conclusions and implications of the study, you will need to discuss with the actuary the plan's assumptions. Even a slight change in these assumptions can have a profound impact on the plan and the sponsoring organization. The higher the expected return, the lower the pension obligation will be and the better the organization's earnings will hold up. The lower the discount rate, the higher the obligations will be and the greater the gap will be between current

Actuarial studies also provide information that can help you forecast needs that might influence the financial health of your organization. For example, consider a defined-benefit plan with assets equal to $100 million and a pension-benefit obligation of $115 million. Let us say that over the past five years, the pension-benefit obligation grew by about 10 percent and assets grew by 8 percent. If these assumptions were to remain the same and the organization wanted to simply maintain its current 13 percent underfunded status for the next five years, the organization would have to contribute about million a year.

Obviously, this liability would affect the organization's earnings and business development in general. Therefore, it is important to perform and analyze the actuarial study routinely, especially in times of market disjunction/disruption or when the organization's benefit structure or workforce has changed significantly, so senior management will have enough time to take steps to improve the financial situation.

Step 3: Examine Asset Allocation

Assume that the actuarial study discloses that the defined-benefit plan is in reasonably good shape and that an 8 percent target return is appropriate and sufficient. The next step is to review methods used to achieve these return targets. The first step in this review would be an evaluation of policy asset allocation because asset allocation ultimately drives portfolio returns. As David F. Swensen, chief investment officer, The Yale Endowment, says, "In many ways, establishing policy asset allocation targets represents the heart of the investment process. No other aspect of the portfolio management plays as great a role in determining a fund's ultimate performance, and no other statement says as much about the character of a fund." (a)