Companies claim that healthcare cost inflation will stabilize to around 4% although their own history and estimates from pharma and health insurance companies contradicts this rosy assumption.
The S&P 500 may rise or fall. Interest rates may go up or down. Gold or Bitcoin may be in favor with investors or not. Virtually everything in markets is volatile except for one sure thing: healthcare costs will go up by around 7% every year.
In my class on understanding firm fundamentals at Columbia, we completed a six hour (two class) analysis of labor costs, where we comprehensively analyze salaries, bonuses, pension and health care costs, options and stock awards and comment on what these data might tell us about a firm’s employee turnover or retention and tentatively draw a few inferences about corporate culture and how well (or not) the firm manages its human capital.
In this piece, I want to talk about what the class discovered about health care costs. A few large legacy companies continue to provide health care coverage to their employees after retirement. This is meant to supplement Medicare coverage for US employees. To reflect such a commitment, the firm is expected to estimate the present value of such obligations as a liability in its balance sheet.
A crucial input to estimating the health care obligation is the expected rate of inflation in health care costs. It is especially interesting to compare the expected inflation in health care costs relative to actual realizations over time.
Consider the following disclosure in the 2016 10-K of Verizon:
Verizon disclosed that they expect health care costs to go up by 6% in 2016. However, the company expects the rate of healthcare inflation to gradually decline to 4.5% in 2024. Fast forward to the 10-K filed by Verizon in 2024 and look for same footnote:
Well, healthcare inflation in 2023 is stubbornly high at 7.3% but Verizon continues to expect such inflation to fall to 4.5% by 2032. What would the health care obligation look like if we assumed a steady state rate of 7% inflation? I don’t know. However, back in 2015, Verizon did provide a helpful sensitivity disclosure, which seems to have gone missing in its 2023 10-K:
As of December 31, 2015, Verizon reported a healthcare liability of $24.23 billion. A 250 bps (basis points) (7%-4.5%) increase in projected health care costs would have upped that number by $7.6 billion ($3.074*2.5). This increase would have reduced the book value of Verizon’s equity from $17.8 billion to $10.2 billion (a reduction of 43%!). One must wonder whether hoping for 4% number eight years out, year after year, is misplaced optimism or something else. Ironically, such utopian expectations of falling health care costs had been spotted way back in the 1990s by my colleague Trevor Harris at Columbia.
Whose estimate should we trust?
Who would know whether health care inflation would stabilize to that magical 4% number and by when? The common-sense answer might be to look at similar estimates provided by health care companies (pharma, doctors, health insurance firms).
To triangulate these estimates, consider Johnson and Johnson’s (J&J) 10-K where J&J expects their health care inflation to be 13.9% this year although they caveat that number is still being negotiated with providers and may fall once negotiations are done. More important for our purpose, J&J expects the magical 4% number to materialize in 2048!
Another candidate worth considering is United Healthcare, the country’s largest health insurer. That company does not offer post-retirement health care to its employees. Hence, I cannot find an analogous disclosure on future health care inflation. However, United Health’s consolidated earnings are up by 14% in 2023 relative to 2022. Surely, that number informs our estimates of health care costs that firms like Verizon must pay now, if not in the future.
Bottomline
Is it time to stop pretending that we will hit the nirvana world of 4% inflation in health care costs in our lifetime? Companies with post-retirement health care plans would do well to have an honest dialogue with their employees and shareholders on how to manage these spiraling costs. Are we surprised that employers hesitate to offer post-retirement health care to their employees? Is this simply pushing the risks one level up to the US government (via Medicare) and one level down back to employees?
I don’t have good answers to these questions. But I hope to keep looking.