Recalculating a Rule of Thumb for Entrance Fee Pricing

As investment consultants, we do a lot of modeling to see how different portfolios might perform in different market environments.  Of course, these quantitative pursuits are balanced against our qualitative judgments regarding asset classes and their correlation to both other asset classes and the markets in general.  The usefulness of any model, however, is only as good as the assumptions that underpin it.  Such inputs include the expected returns of various asset classes, the expected volatility of those returns and the correlation of those returns to one another. It is a complex mix of assumptions that we use as a reference to allocate capital.

So it was with great interest that I recently learned about another kind of model which involves the pricing of refundable entrance fee units.  A recent presentation at Leading Age Maryland cast some light for me on the thinking behind this potentially tricky calculation.  As a result, I am further convinced that investment policy is both integral to the inner workings of life plan communities and under-appreciated by decision makers in the LPC community as to its important role.

The session’s host laid the groundwork for his presentation by strongly suggesting that the LPC business model has a number of imbedded risks, particularly with regard to LPC contract types.  His focus quickly moved to the most popular contract type, the 90% refundable plan.  Life expectancy, attained levels of care, population size and health care costs were all mentioned as important factors, along with “investment yields”.  And then he volunteered that 2% might be the right “interest rate” to expect from investments currently.

He presented a simple model to illustrate the problem using an industry “rule of thumb” factor that has traditionally been applied to the base case non-refundable contract. He assumed that the nonrefundable pricing was $100,000 per unit, and then applied that common industry factor (1.70).  The result showed that a 90% refundable plan should be priced at $170,000(1.70 x $100,000).  He tested that pricing assumption against a simple matrix that combined average age expectancy of residents and interest rate assumptions.  The spectrum of interest rates varied from 2% to 8% and the age expectancy ranged from 5 to 13 years.  The model revealed that the breakeven point for the $170,000 90% refundable plan required a 6% interest rate with a life expectancy of 13 years.  This is a far cry from the 2% return he had earlier mentioned and a 13 year life expectancy is far beyond what some have estimated as 10 years or so.  At 2% invested for 10 years the model indicated that the unit should be priced at $382,000, a steep increase from $100,000 and most likely much more than the market could bear, all things equal.

What to do?  The presenter suggested that more than doubling the entrance fee to $382,000 would be unrealistic for most LPCs, given that their competitors (especially better-capitalized ones) have the option to remain less than optimally priced, thereby gaining market share.  Later on, he recommended that LPCs commit more equity to projects, which would reduce the pressure on entrance fee pricing.  However, it was not clear how this would affect the liquidity of the investment portfolio and the ability for LPCs to routinely and confidently refund the entrance fees they had promised.

My takeaway from this discussion is that investment portfolio returns are hugely important as inputs to the pricing of entrance fees and, more importantly, require that the process for allocating investment assets ideally should be part of the planning that senior executives and Board members engage in.

This point is driven home by the assumption made that 2% is today’s Interest rate. Today, 2% is close to the riskless rate of interest on 3 month T-bills.  Assuming a higher rate, it was stated, might entail too much risk.  Maybe, maybe not.  The models that we develop for asset allocation can add quite a bit to this “risk-return” discussion and take LPC communities far beyond simple assumptions regarding what can be earned.  Just like your project planning, everything we do is a balance between risk and return. Yes we take into account the risks in the markets.  But we marry those risks with an analysis of the unique risk thresholds for LPC communities.  When you think about age expectancy, we think about realistic time horizons for the investment portfolio.  When you worry about the impact of a deluge of refund requests, we think about financial ratios which may portend a particular vulnerability regarding turnover.  And when you wonder what returns the market may “give” you, we seek asset classes where we may have a better opportunity to “take” some return for you.

Perhaps our analysis of asset allocation should be part of your business process.

Jim Jeffery

[email protected]

 

 

About Jim Jeffery, CFA

Jim Jeffery, the founder and principal of Jeffery Asset Management has joined Solaris Advisors LLC as Managing Director where he will lead the non profit senior living effort. Jim is a Chartered Financial Analyst (CFA) with more than 20 years experience in the financial services industry. Have a question about your financial plan? ASK JIM

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