I N V E S T M E N T S T R A T E G Y G R O U P

I n v e s t m e n t I m p l i c at i o n s o f t h e 2 0 1 0 A f f o r d a b l e C a r e A c t

September 2013

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Importance of Medicare Spending

Medicare spending was 15% of all federal outlays in 2010, and by 2020, it is projected to reach 17% of budget outlays or 4% of GDP. Controlling future Medicare costs is critical to solving our nation’s health care problem, as the following example will illustrate: The CBO assumes Medicare spending growth of GDP plus 1.7 percentage points in its federal budget projections. If the annual growth in Medicare spending over 10 years were 0.7 percentage points lower than CBO currently projects, the total 10-year spending would be reduced by about $300 billion. That’s roughly a 4% reduction or 21% of the entire cost of ACA. Successful Medicare cost controls have been implemented in the past, and the provisions in ACA for controlling future costs will be critical for its success and for the long-term sustainability of the federal budget.

BackgroundHealth care remains a critical issue for the U.S. economy. We spent $2.8 trillion in 2011 on health care (18% of GDP), with health care spending outpacing GDP growth in 34 of the last 40 years. Average per capita health care spending is $8,600 per year, having grown 8% a year since 1970—and that’s with 16% of the population uninsured. Un-fortunately, all of this spending has produced poor results. The 18% of GDP spent in 2011 is the high-est in the world, without the benefit of increased life expectancy. In addition, other “high spenders” like the Netherlands and France spend 12% of GDP, insure 100% of their populations, and have higher life expectancies than the U.S.

In summary, the U.S. has an unsustainable health care spending and coverage problem that needs to be addressed for the long-term health of the economy. The Affordable Care Act (ACA) is a major attempt to address the health care problem facing the U.S.

Key Points and ProvisionsThe ACA’s main focus is to create a near-universal system of health insurance for the country, with a

secondary aim of reducing the growth of health care costs. About 30 million Americans—roughly two-thirds of the nation’s uninsured—are expected to gain coverage under the law.

This will be accomplished by making families with incomes up to $32,500 eligible for Medicaid, and by providing subsidies (on a sliding scale for families making up to $117,600) toward the cost of buying health insurance. If they don’t get insurance from their employer next year, consumers will be directed to buy private plans through health insurance ex-changes run by states or the federal government.

If your employer doesn’t provide your health insur-ance, you can use these exchanges to shop for a 2014 health plan starting this October, regardless of your income. These marketplaces will work like popular travel sites, and allow you to compare plans side-by-side based on price and coverage.

Congressional Budget Office (CBO) estimates show that the total cost of the expanded coverage is about $1.4 trillion over the 2014–2023 period. This will be paid for with revenue (new taxes) and savings (primarily Medicare cuts), which the CBO projects will actually reduce the federal budget deficits over that period.

SummaryWhile the Affordable Care Act represents a major new entitlement program that will impact many aspects of the U.S. economy, most employers should see a manageable impact. We remain positive on our outlook for the U.S. economy and the Health Care sector as we head towards full implementation of the law in 2014.

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The numerous provisions that pay for the additional coverage have created significant angst, and will impact the economy in a major way, as discussed below. In addition, we discuss the secondary aims of the ACA to reduce the growth of health care costs.

Chart 1 provides a summary timeline of the law’s implementation, starting with those components enacted this year.

Chart 12013

January 1

• Anew2.3%taxonmedicaldevicemanufacturersstarts,asdoesafeeoninsurerstofundthecostofresearchthatcomparestheeffectivenessofmedicaltreatments.

• Medicarepayrolltaxonwagesandself-employmentincomeinexcessof$200,000($250,000joint)willincreaseby0.9%.

• Medicareinvestmenttaximposesanew3.8%taxoninvestmentincomeforhigher-incometaxpayers.

• Theamountofmoneypeoplecansaveintax-shelteredflexiblespendingaccountsisreducedto$2,500.

October 1• Open enrollment begins for insurance policies that will take effect the following January.Newinsurance

exchangesaresupposedtobeupandrunningforeverystate,sothatpeoplecanshopforinsuranceplansandapplyfortaxsubsidiestowardthecostofpremiums—orenrollinMedicaidinstatesthatchoosetoexpandtheirprograms.

2014

January 1

• The biggest insurance market changes take effect.Planscanhavenolifetimeorannuallimits,andmustbesoldtoeveryoneregardlessoftheirmedicalhistory—withoutvariationofratesbasedongender,andonlylimiteddifferencesbasedonage.Plansmustcoverabasicpackageofbenefitsandmustcoverasetproportionofconsumers’expenses.Newtaxesonplansalsotakeeffect.

• Individual Mandate.Mostindividualsmusthavehealthcoveragefromthisdateorpayapenalty,whichstartsat$95ayearorupto1%ofaperson’sincome,whicheverisgreater.

2015

January 1

• Thepenaltyfornothavinginsuranceincreasesto$325foranadult,or2%oftaxablehouseholdincome.

• Employer Mandate - Employers with at least 50 full-time workers have to offer an affordable, set level of insurance from this date, or pay a penalty starting at $2,000 per worker.Employersalsohavetopayfees,estimatedataround$63foreachpersoncovered,intoapooldesignedtocompensateinsurerswhoenduptakingonmoreriskycustomers.Theycanoffersomespecificdiscountstoemployeeswhoparticipateinwellnessprograms.Firmswithmorethan200employeeshavetoautomaticallyenrollworkersininsurance,althoughemployeescanchoosetooptoutofcoverage.

2016

January 1• Thepenaltyfornothavinginsuranceincreasesto$695foranadult,or2.5%oftaxablehouseholdincome.

• Statescanformarrangementstocombinetheirmarketplaceswithotherstates.

2017

January 1 • Statescanexpandhealthinsuranceexchangestoallowlargeemployerstopurchaseinsurancefortheiremployeesthere,aswellasmakeotherchangestotheirlocalmarketplaces.

2018January 1 • High-costhealthcareplansbecomesubjecttoa40%excisetax.

Impact on IndividualsThe primary objective of the law is to provide afford-able access to health care for everyone. There will be no change if an individual receives employer cover-age. In the absence of employer coverage, individuals will obtain insurance on exchanges, or through government programs (Medicaid or Medicare). If an individual doesn’t obtain health care coverage by 2014, they will be required to pay a tax of: $95 in 2014; $325 in 2015; $695 or up to 2.5% of income in 2016; and dollar amounts that are indexed post-2016. This is known as the “individual mandate,” and a recent Urban Institute report determined that it “is clearly a central component of the law and its antici-pated coverage expansion” (see Chart 2).

Chart2: Share of the Non-Elderly who are Uninsured Today Compared with Reform

(Source: Urban Institute Analysis)

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10

15

20

NoACA ACA

ACAWithoutEmployerMandate

ACAWithoutIndividualMandate

Impact on Individuals, Employers, and Health Care Industry

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Impact on EmployersThere will be minimal impact on employers if they continue to offer coverage. Beginning in 2015, if employers don’t offer coverage, they will be as-sessed a penalty of at least $2,000 per employee. This is known as the “employer mandate.” Compa-nies with less than 50 full-time workers (most small employers) are exempt from this requirement.

This employer mandate has been a source of major controversy for the new law, and its implementa-tion has been delayed until 2015. Despite the controversy around ACA and employment, the CBO estimates that 2 to 5 million fewer people will obtain coverage through their employer than would have been the case under prior law. This represents less than 3% of the 160 million people with employer coverage.

More than 95% of large firms already offer insur-ance, implying that a small pool of firms would need to alter their current benefit offering to com-ply with the employer mandate. Even before the law was passed, most large firms already faced IRS rules that prevented them from denying available health benefits to full-time workers. Importantly, the new law leaves the major tax incentives in place for employers and employees to obtain coverage through their employer.

Companies in low-wage or significant part-time employment industries such as restaurants, retail, and agriculture have cited difficulties posed by the law’s requirements, and there is concern that these industries will shift employees to part-time work to avoid the new law’s requirements. While some of these firms may be interested in moving full-time employees into exchanges, since they would get subsidies from the government, recent San Fran-cisco Fed and UC Berkeley research suggests that the ultimate increase in the incidence of part-time work when the ACA provisions are fully imple-mented is likely to be small—a 1–2% increase or less. Chart 2 (above) also shows the Urban Insti-tute’s finding of a negligible impact if the employer mandate were eliminated altogether.

Numerous other studies support the general con-clusions discussed above, including the experience of employer mandates implemented in Massachu-setts and Hawaii.

Impact on Health Care IndustryWhile the new law impacts all aspects of the Health Care sector, our Investment Strategy Group (ISG) continues to have a favorable view on the sector. Although the pace of growth may be slowed by new reforms, that should be outweighed by the positive impact on valuations from a lifting of health care reform uncertainty. There is also pent-up demand due to the weak economy, which will be augmented by the newly-insured 30 million patients.

Managed Health Care: The ACA expands health insurers’ pool of customers, rewrites many of the rules that govern their business, imposes new limits on how they spend premium dollars, and exposes them to new scrutiny.

The biggest benefit to the industry is the expected expansion of the insured. The CBO projects that 7 million new customers in 2014 will purchase plans from private insurers through the exchanges (new online marketplaces). This number is projected to grow to 25 million in 2018.

There are some risks to insurers. They will no longer be able to refuse coverage based on a customer’s pre-existing condition, or set premiums based on health history. They will have less room to vary rates, must include a set range of health benefits in plans, must cover preventative care services without any out-of-pocket consumer costs, must allow parents to include adult children on their plans up to their 26th birthday, and cannot cap payouts.

The ACA also limits insurers’ ability to vary prices based on age. Their premium increases are subject to review, and they have a requirement (already in effect) to spend at least 80% of premiums from in-dividuals and small companies—85% of those from big employers, on health-related costs. Insurers also face a fee to fund the costs of research com-paring the effectiveness of medical treatments.

ISG is overweight on health insurers, driven by stable pricing power and a falling cost structure that is enhanc-ing profitability. Meanwhile, Wall Street analysts remain overly bearish on the group.

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Health Care Facilities: The major good news is that hospitals will have 30 million new paying custom-ers—many of whom already show up for uncovered care in emergency rooms. This will come at the ex-pense of losing some federal funds for treating large numbers of uninsured patients. ACA will cut pay-ments to hospitals by $155 billion by 2019, and will impose penalties for things like readmissions—which ultimately could result in 3% cuts in payments to hospitals with poor performance. Since spending on hospital care will account for nearly one-third of the $2.9 trillion in 2013 U.S. health spending, hospitals are at the center of the efforts to rethink health care.

ISG remains neutral on health care facilities and expects valuations to remain volatile ahead of the implementa-tion of health care reform in 2014, as most industry participants have seen solid share price appreciation since the start of 2012.

Pharmaceuticals: Pharmaceutical companies have already cut by 50% the drug prices that the Medi-care Part D “doughnut hole” caused for 900,000 patients. PricewaterhouseCoopers estimates total costs of $140 billion over a decade for the industry, due to other fees and price cuts from the ACA.

While we view Pharmaceuticals as a core portfolio hold-ing, ISG remains concerned about the group’s demanding valuation in light of a lack of productivity growth and generic competition.

Health Care Equipment: Device companies face a 2.3% tax on their U.S. sales, to help cover the costs of the ACA. The tax will cost the industry about $29 billion by 2022. However, the industry will benefit from additional sales due to the 30 million newly insured.

ISG remains overweight on health care equipment manu-facturers. Outlays on medical equipment are picking up speed, which should sustain recent and impressive top-line industry growth—the opposite of what Wall Street analysts are expecting. A re-rating in sales and productivity growth expectations would be a strong catalyst to unlock latent value in this group.

Drug Retailers: Drug retailers should see signifi-cant increases in prescription volumes, as nearly 30 million people are expected to gain health care coverage under the ACA.

ISG remains overweight in drug retailers, and we see many other positives. The industry is experiencing pric-ing power while its wage costs and capacity expansion are under control—which will help profitability. Valua-tion is favorable, and Wall Street expectations are low.

Chart 3 below highlights companies that ISG believes are well-positioned for implementation of the ACA.

Chart 3Company Symbol P/E - Forward Div Yield Description CoverageCovidienPlc COV 16.4 1.7 Diversifiedproductlinewithsolidgrowthopportunities. S&P

MedtronicInc. MDT 13.9 2.0 Diverseproductlineandstrongcashflow. S&P/CS*

ZimmerHoldings,Inc. ZMH 13.8 1.0 Strongcashflowandbalancesheet. S&P/CS

UnitedHealthGroup UNH 13.3 1.3 Leadingmarketpositionwithproductdiversity. S&P/CS

Johnson&Johnson JNJ 15.9 2.9 AAA-ratedbluechipwithasoliddividend. S&P/CS

Merck&Co.Inc. MRK 13.7 3.6 Fullproductpipelinewithvaluationanddividendsupport. S&P

MylanInc. MYL 12.5 Nil Leadingmanufacturerofgenericswithvaluationsupport. S&P

PfizerInc. PFE 13.1 3.3 World’slargestpharmacompanywithvaluationanddividendsupport,solidpipeline,andexposuretoemergingmarkets. S&P

CVSCaremarkCorp. CVS 14.9 1.4 LargestpharmacyhealthcareproviderinU.S. S&P/CS

WalgreenCo. WAG 15.8 2.3 LargestU.S.retaildrugchainbasedonrevenues. S&P/CS

VanguardHealthcareETF VHT — — Cap-weightedbasketof293companiesoffersbroadexposure. —

iSharesMedicalDevices IHI — — Cap-weightedbasketof40manufacturersanddistributors. —

iSharesHealthcareProviders IHF — — Cap-weightedbasketof40healthcareproviders. —

iSharesPharmaceuticals IHE — — Cap-weightedbasketof36pharmaceuticalcompanies. —

* Credit Suisse

For more information, please contact your Janney Financial Advisor.

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