During a family vacation, my son, who is a hedge-fund VP, joined me for a workout at the YMCA. When he showed up wearing his company's intramural shirt, I couldn't help but laugh out loud. The hedge fund's team is named "The Fighting Betas."
I suppose I was the only one in the room who understood the double entendre, but truly, doesn't that team name perfectly describe the team members' job? They try to secure a return on assets that avoids correlating to a particular index or market, the so-called "beta." If the hedge fund's return doesn't correlate with the targeted index, they have effectively removed some of the risk of being invested in such assets.
It's somewhat like buying gold — or options in gold — during times you're afraid your stocks may sink in value. Typically, with a hedging strategy, you pay money to a third party to lay off some or all the risk of a particular investment strategy.
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Given that hedge funds and hedging are so much in the news, I began to think about the ways a company can hedge its employee benefit costs. Rather than lowering the risk of the return on assets, a hedging strategy for employee benefits would seek to smooth out the plan's cash flows. There are some obvious — and also some not-so-obvious — ways to hedge a company's benefit costs:
Stop-loss insurance, coverage caps, and other cost limiters
The fact that employers try to limit their benefit plan costs isn't news. By purchasing stop-loss insurance for self-insured plans, or limiting the coverage offered by a plan, companies seek to budget and contain the costs of the plan. In some ways, this was a goal of the insurance exchange program in the Patient Protection and Affordable Care Act (PPACA): Hedge medical insurance costs by spreading the risk over a larger pool of insureds. But other techniques can help hedge the costs of benefit plans as well.
Employee skin in the game
Many recent employee benefit-plan design changes have been aimed at containing costs by securing active employee participation. From health savings accounts (HSAs) for medical plans to matches on 401(k) plans for retirement, the idea has been not only to hedge plan costs, but also to gauge employee interest in the offered benefit. Employers want to align benefit expenses with participation; if the cost of a match is higher than expected for a plan, it can be a net positive because it indicates the benefit is valued by the employees. Through employee cost sharing, the employer is effectively hedging benefit costs against employee satisfaction.
Making it voluntary
Taken one step further, employers can hedge their benefits costs by adding employee benefits to the voluntary side of the ledger. Thirty percent of U.S. employers with 10 or more employees said they are considering adding a new voluntary option within the next two years, according to the new LIMRA report Voluntary Worksite Benefits: Penetration and Market Potential (2011).
Even if overall payroll is increased to reflect the increased costs of benefits to the employee (and decreased cost to the employer), the company has hedged its benefits plan exposure. The employer is using the flexibility of payroll as the cost measure rather than the intangible and sometimes inflexible cost of fixed benefits.
Financial hedging through cost-smoothing
Companies often desire a hedge against peaks and valleys in benefit-cost cash flows. When the benefit liability is long-term in nature, consider using life insurance on a select group of executives to smooth out the cash flows. For example, if a company has a nonqualified deferred compensation plan or an employee stock ownership plan (ESOP), it has the liability of paying out funds when participants retire, die, become disabled or leave.
The timing of these payments is difficult to predict. Through ongoing premium payments for life insurance, the company is essentially smoothing out the cash flow for the liability. The company can withdraw or borrow cash values if needed, and it will receive a tax-free death benefit at the executive's death. [GRAPH should be inserted in this article]
… But beware
When I read a headline saying "John Paulson, the billionaire who is betting on an economic recovery by the end of 2012, lost 11 percent in the first week of August in his largest hedge fund," I was reminded that some hedging strategies are wolves in sheep's clothing. They are strategies that increase risk rather than decrease it and, arguably, are not hedging strategies at all. In dealing with benefits, I've seen some promotions that reference benefit hedging, but actually increase a company's financial risk.
While none of these ideas is bad, per se, the following are examples of concepts in which some promoters have made these ideas risky: creating a captive insurance company, factoring receivables as a way to pay benefits, leveraging indexed life insurance policies, and using a professional employer organization (PEO) to save benefit costs. Properly used for the right reasons, these concepts may work, but be aware: You may want to hedge your bets!
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