Welcome to the third quarter 2012 earnings call. My name is Dawn, and I will be your operator for today's call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Please note that this conference is being recorded. I will now turn the call over to Alicia Charity. You may begin.
Thank you, welcome to Ameriprise Financial's third quarter earnings call. On the call with me today are Jim Cracchiolo, Chairman and CEO, and Walter Berman , Chief Financial Officer. Following their remarks, we'll be happy to take your questions. During the call, you'll hear references to various non-GAAP financial measures, which we believe provide insight into the underlying performance of the company's operations. Reconciliation of the non-GAAP numbers to their respective GAAP numbers can be found in today's materials on our website. Some statements that we make on this call may be forward-looking, reflecting management's expectations about future events and the operating plans and performance. These forward-looking statements speak only as of today's date and involve a number of risks and uncertainties.
A sample list of factors and risks that could cause actual results to be materially different from forward-looking statements can be found in today's earnings release, our 2011 annual report to shareholders or our 2011 10-K report. We undertake no obligation to update publicly or to revise these forward-looking statements. As a reminder, we will be conducting our annual meeting with the financial community on November 14th at 9:00 A.M. Meeting details can be found on our website. Let me turn it over to Jim.
Good morning, everyone. Thanks for joining us for our third quarter earnings discussion. I'll begin by giving you a bit of my perspective on our results. Walter will cover more of the numbers, then we'll take your questions. Overall, we had a pretty good quarter. We delivered strong results in our advisory business, including very good retail client net inflows. We're generating modest revenue growth even after the impact of low interest rates. At the same time, we're managing expenses appropriately and delivering double-digit growth in operating EPS. We continue to make good progress executing our strategy, our business metrics are sound. We're expanding our advisory client base. Our advisor force is strong and growing. Assets are up across the firm, we're improving asset management flows and maintaining good annuity and insurance books.
Even with the benefit of rising equity markets over the past year, we continue to manage expenses appropriately given interest rate pressure. Earlier this year, we stepped up our re-engineering efforts. We're seeing the benefits now and continue to invest for growth. Overall, Ameriprise continues to generate strong returns for our shareholders, an important differentiator in today's environment. Yesterday, we announced a $0.45 per share dividend, representing a 29% or $0.10 per share increase, the fifth increase since early 2010. In fact, we raised our dividend 165% over that period. Today, our implied dividend yield is above 3%, which puts us at the high end of the category for S&P Financials. We also repurchased $340 million worth of our stock this quarter, totaling $1 billion so far this year.
We announced a new $2 billion share repurchase program as we accelerated our buybacks over the past two years. Through the third quarter, we returned 138% of our operating earnings to shareholders. Let me talk about our Advice & Wealth Management segment performance. Adjusting for investment income a year ago, we were able to grow underlying revenues by 3% and underlying earnings by 8%. Total retail client assets were up 18% to $345 billion, aided by strong client inflows and equity market appreciation. For example, net inflows into wrap accounts more than doubled from a year ago. As I mentioned, our re-engineering is helping to fund our investment agenda. Our new brokerage platform was one of our largest technology undertakings since spin-off. We successfully moved our 10,000 advisors and more than 2.5 million client accounts to the new system. This last conversion completes our transition efforts.
We're focused on helping our advisors access the benefits of the new system. We're hearing good feedback from them. You'll see the related expenses decline accordingly in the coming quarters. You may have seen we're back on the air with our award-winning advertising campaign featuring Tommy Lee Jones. We feel that it is the right time to promote Ameriprise and strengthen consumers' and advisors' understanding of our value proposition. We expect advertising expenses in the fourth quarter will increase from the third but will remain relatively consistent with last year's level. I continue to hear positive feedback from our advisors regarding how they feel about the company and the investments we're making to help grow their businesses. Retention and satisfaction rates for our tenured advisors are excellent. In regard to experienced advisor recruiting, our efforts here continue at a steady pace.
106 experienced advisors moved their business to Ameriprise in the quarter. The advisors joining Ameriprise are on average three times more productive than advisors who leave. Our plan is to continue to grow our advisor base gradually, focused on adding productive advisors and maintaining high retention. In terms of productivity, operating net revenue per advisor was up slightly. We're seeing good fee-based business growth and increasing average assets per advisor. Low rates and lower transactional volumes continue to pressure revenues. The third quarter also tends to be a slower quarter in terms of client activity. This year, clients and advisors have added concerns about the upcoming election and how our elected officials will address the fiscal cliff. In terms of segment profitability, pre-tax operating margin was a strong 12.4%. This is good progress given the low rate environment and economic uncertainty.
As we told you last quarter, we are transitioning Ameriprise Bank from a federal savings bank to a non-depository trust company. While we will no longer offer our proprietary banking products and services, we're helping clients transition to other leading providers. The disposition of our deposit and loan portfolios is underway, and we will cease banking operations by the end of the year. Final regulatory approvals are pending, and Walter will speak more about the financial implications in a few minutes. Now let's move on to asset management. In the quarter, asset management delivered solid profitability improvement. Our asset growth reflected rising equity markets and re-engineering initiatives are taking hold. Total assets under management for the segment were $461 billion, up 11% from a year ago. With regard to flows during the quarter, we experienced $3.5 billion of net outflows.
These were largely driven by Zurich-related institutional outflows and outflows in hedge funds. Let me take you through the pieces. In institutional, we talked to you about ongoing outflows from the closed Zurich book, and in the quarter, that number was about $1.1 billion. We also had about $900 million in outflows from the retender of their pension assets, which we previously disclosed. The underlying institutional results were essentially flat. We continue to see improvement in Columbia's traditional third-party business. We're winning good mandates, and the pipeline remains solid. In alternatives, we experienced $1.6 billion in net outflows, primarily related to the termination of a hedge fund portfolio manager. We liquidated the fund he managed and experienced outflows and strategies where he was an analyst. We have a solid team in place, and we recently added two new members.
I feel very good about their ability to move forward from here. Overall, retail flows were much improved from a year ago. European retail investors have regained confidence, and we experienced strong net inflows at Threadneedle. At Columbia, retail equity flows remain under pressure consistent with the industry. We also continue to have outflows and funds managed by a third-party sub-adviser and in our Value and Restructuring Fund. That said, we experienced an improvement in net flows, namely into fixed income funds and in certain equity categories such as equity income. The underlying business is strong, and I feel very good about the progress we're making. Columbia and Threadneedle are generating consistently strong investment performance. We have broad product lines, renewed wholesaling strength, and improved flows. We continue to build new relationships both here in the United States and internationally.
As we move forward, we'll continue to focus on navigating the challenging environment and managing the business for profitable growth. Our business fundamentals are solid. We're making good progress, and we're focused on leveraging our global business model. Now I'll move on to annuities and protection. Walter will address the unlocking impacts on our financials, and I'll speak to the business. Let's start with annuities. Total variable annuity assets increased 15% to $68 billion due to market appreciation. Sales and flows have remained low as clients and advisors are learning more about our new managed volatility product. We began to see a slight uptick in sales towards the end of the quarter. On the fixed side, the asset and flow story hasn't changed. We feel good about the characteristics of our fixed annuity block, but aren't adding to it given the rate environment.
Overall, the underlying annuity business is performing well and generating good, consistent returns. In protection, our business continues to be a solid, steady contributor, complementing our more equity-sensitive businesses. We continue to help our advisors understand the benefits insurance products provide to meet client needs comprehensively. It is a core component of both our consumer and advisor value propositions. While our life insurance book remains at $191 billion, the UL/VUL product mix is becoming more balanced as we continue to expand our universal life business. We launched a refreshed VUL product during the quarter and continue to see good sales in our indexed UL book. In auto and home, our business results improved nicely. We generated solid premium growth and profits in the quarter and claims returned to more normal levels. In addition, our policy count was up a steady 8%. In closing, I will leave you with this.
Despite the uncertain environment and pressure from low interest rates, our results were solid. I feel good about the quarter. The business is operating well. We are increasing our core client base, strengthening our advisor force, and growing assets overall. Our focus remains on executing our strategy, driving improvements in the business, and achieving strong results in a low revenue growth environment. As we enter the fourth quarter, the U.S. elections and pending fiscal cliff are taking center stage. Important decisions will be made in the coming weeks, and we are working closely with our clients and advisors to help them navigate this environment. Walter?
Thank you, Jim. Our third quarter operating net revenue of $2.5 billion was marginally higher than last year, but included several disclosed items. Our underlying revenue growth was strong at 3%, excluding our non-cash unlocking and the additional investment income we recognized last year. Underlying revenue growth was driven by equity market appreciation and strong advisor client flows. These were partially offset by asset management outflows and the low interest rate environment. As you can see on Page four, both pre-tax operating earnings and operating earnings per diluted share grew nicely in the quarter. Pre-tax operating earnings grew 4% to $397 million. Adjusting for disclosed items, earnings grew over 7% versus last year. Pre-tax operating earnings in the Asset Management and Advice & Wealth Management segments comprised 60% of total operating earnings, ex the corporate segment.
Excluding the impact of the unlocking, earnings from Asset Management and Advice & Wealth Management were 52% of the total. Operating EPS growth outpaced operating earnings, up $0.11 year-over-year, or 14% after adjusting for disclosed items. This reflects our share repurchase activity of over $1.2 billion over the last year. Our strong balance sheet fundamentals and substantial excess capital generation have enabled us to return such a high level of capital to shareholders. Turning to Slide five. We delivered a solid 15.4% return on equity in the quarter, which is within our long-term target of 15%-18%. Return on equity was impacted by unlocking as well as the second quarter unusual tax item. Excluding these two items, return on equity would have been 16.5% this quarter. We returned $460 million to shareholders through dividends and share repurchase in the third quarter, about 140% of operating earnings.
At the same time, our excess capital position remains at $2 billion-plus due to our earnings growth and reduction in required capital. Our balance sheet fundamentals remain strong. We had $3.3 billion of cash and equivalents at the end of the quarter, with $800 million in free cash and more than $800 million in high quality, short duration securities at the parent company. Our variable annuity hedge program continues to be approximately 95% effective. RiverSource Life's estimated RBC ratio was 514%. Finally, we have a high quality, well-diversified investment portfolio that continues to perform well. The portfolio was at a net unrealized gain of $3.1 billion, with gross unrealized losses of less than $200 million. As part of the liquidation of the assets in the bank, we sold a portfolio of higher risk residential mortgage-backed securities, which improves the risk profile of the investment portfolio.
In Advice & Wealth Management, we delivered another quarter of good financial performance. Pre-tax operating earnings were up 8% and margins grew 60 basis points versus last year after excluding the additional investment income recognized a year ago. Operating net revenue was up 2% from last year. Excluding the additional investment income recognized in 2011, revenue was up 3% year-over-year. Our top-line growth in Advice & Wealth Management was driven by 18% growth in client assets from market appreciation and experienced advisor recruiting, which was offset by slow transaction-based activity consistent with the industry. We completed the implementation of the new brokerage platform in the third quarter, and the expense associated with it came in on target. These expenses should decline moderately in the fourth quarter but will be offset by a bit higher advertising expense. Turning to next slide.
We are on track with our process to exit the bank. In accordance with the plan we filed with the OCC, we began disposing of bank deposits and loans in the third quarter, and we are on track to end bank operations by year-end. We had net realized losses of $62 million in the quarter associated with the sale of assets. However, we will generate a net gain that will more than offset this in the fourth quarter. We are working with both federal and state regulators, and we are awaiting final approval for our bank transition. We have incurred the majority of the non-operating expense associated with the bank transition, which will be approximately $20 million, excluding the impact of the interest rate hedge.
In the fourth quarter, Advice & Wealth Management segment pre-tax operating earnings will decline by approximately $13 million from exiting the bank, which translates into about 100 basis points of margin. In 2013, the annual impact to earnings will be approximately $60 million. We anticipate this impact will be neutralized from an EPS perspective by the end of 2013. We expect to redeploy the capital freed up from the bank transition, which will be above our guidance of returning 90%-100% of earnings next year. Turning to Asset Management. We saw strong earnings in the quarter, up 30% to $155 million. This was largely due to equity market appreciation, $7 million of accelerated hedge fund performance fees, and good expense management. The earnings growth also reflect the impact of outflows, as well as the industry shift towards fixed income from equity, which has a lower fee.
We saw a similar trend with our adjusted pre-tax operating margin, which increased to 37.6% in the quarter. As Jim said, investment performance remained strong with 116 four and five-star Morningstar-rated funds. Let's turn to flows on Slide 9. Overall, asset management flows improved in the quarter. Like the industry, we continue to see inflows in fixed income and outflows in equity. Retail flows were slightly positive as we saw a meaningful improvement in retail flows at Threadneedle, offset by outflows at Columbia. While Columbia continued to have outflows in the Value and Restructuring Fund and in the funds managed by a third-party sub-adviser, the trends in both of these improved in the quarter. In institutional, flows were neutral in the period, excluding the activity at Zurich.
We had outflows of $1.1 billion from the closed block of insurance assets at Threadneedle, and we lost about $900 million of previously announced Zurich pension assets that were recently retendered. Alternative net outflows were $1.6 billion, as Jim already discussed. Turning to annuities, earnings were within expectation, excluding the impact associated with several disclosed items you see on Slide 10. The negative unlocking impacted variable annuities largely from lower near-term interest spread assumptions. Fixed annuities had a favorable unlocking, as the impact of lower rates on policyholder persistency more than offset spread compression from lower interest spread assumptions. Variable annuity operating earnings were $31 million in the quarter, down from $60 million a year ago. Excluding disclosed items, variable annuity earnings were $91 million of 15% year-over-year, driven by account value growth. Fixed annuities operating earnings declined to $60 million.
Excluding the disclosed items, earnings were $46 million, down 23% from a year ago due to spread compression. This was consistent with our expectation given this low rate environment. In protection, pre-tax operating earnings increased to $89 million year-over-year. The annual non-cash unlocking was unfavorable $13 million, primarily from lower gains on reinsurance contracts due to favorable mortality experience. However, earnings in the segment were down 5%, excluding unlocking and other disclosed items. Results were strong in auto and home. We continued to see strong policy growth at 8%, along with improved loss experience compared to last year. Offsetting improved auto and home results were lower long-term care earnings. Long-term care was impacted by the low rate environment as well as higher claims. While long-term care claims were higher than a year ago, they remain within an acceptable range.
We continue to monitor our long-term care block and are increasing rates as appropriate. Turning to Slide 12. We returned $460 million to shareholders in the quarter, or 144% of operating earnings. We also announced a 29% increase in our quarterly shareholder dividend to $0.45 per share. This will bring our dividend yield to 3.2% based upon yesterday's closing share price, and it is consistent with our strategy to continue to increase the mix of capital return to shareholders via dividends. In the quarter, we repurchased 6 million shares for $340 million and had $482 million of share buyback remaining under the current authorization. Based upon this, the board authorized an additional $2 billion of share buyback through the end of 2014.
In 2013, we expect to return more than 100% of earnings to shareholders as we redeploy approximately $375 million that will be freed up from the bank transition. The ability to return capital to shareholders is driven by our strong excess capital position, generation of free cash flow, and our strong balance sheet fundamentals. These factors provide a foundation that uniquely positions us to perform well across market environments and have additional capital flexibility. With that, I will open it up to your questions.
Thank you. We will now begin the question and answer session. If you do have a question, please press star then one on your touchtone phone. If you wish to be removed from the queue, please press the pound sign or the hash key. If you are using a speakerphone, you may need to pick up the handset first before pressing the numbers. Once again, if you do have a question, please press star then one on your touchtone phone. Our first question comes from Alex Blostein from Goldman Sachs. Please go ahead. Alex, please go ahead. Okay, I'm going to go on to the second question. Our next question comes from Jay Gelb from Barclays. Please go ahead.
Thank you. First, on slide seven, where you talk about the $13 million impact from transitioning out of the bank unit, do you expect that to be included in operating earnings, or is that more of a below the line item?
It's operating earnings.
Okay. All right. Thanks. The other question I had was on asset management. When you updated guidance for this year on the second quarter call, you were looking at the 18%-19% pre-tax margin level. We're at 19.3% year to date, I just want to confirm that there's nothing we'd expect to see in the fourth quarter that might pull that down, but in fact, that you'd probably be past the upper end of your guidance.
Pretty much on the trend line.
Okay. Finally, I'm sorry, go ahead, Walter.
We're not anticipating any surprise.
Finally on RiverSource, the 514% risk-based capital ratio, where do you feel the normalized RBC ratio should be, taking into account your excess capital plans?
Yeah. As we indicate, we would try to get that under 500, it should stay in this range, a tad under. Again, depending on, there's a lot of moving parts to that, so you can't necessarily control. Again, this is an estimate. We do the final at the end of the year. I would say in this range you should anticipate.
The substantial amount of excess capital, where else is that being driven from?
Well, the majority of the excess capital is actually in corporate at this stage. There is obviously this excess capital in the life company, but it's throughout all the other subs, the majority of that is now resident in corporate.
Thanks very much.
You're welcome.
Thank you. Our next question comes from Eric Berg from RBC Capital Markets. Please go ahead.
Thanks very much, good morning to everyone. I'm finally getting a handle for sort of what the exposure is at this point in Connecticut with the manager, in the situation with the manager who retired. At the Marsico funds and in California, whether there's going to be sort of ongoing fallout from the decision to let go of that PM out there. Could you address each of these three issues, the Connecticut situation, the Denver situation, and the California situation, quantifying as precisely as you can and feel comfortable the ongoing exposure there? Thank you.
Okay. In regard to when you said Let me start with the Value and Restructuring. Gentleman retired early in the year, end of second quarter, and we have continued to experience some of the outflows because a number of those funds, as you would imagine, are on platforms and models. As they come up for review, et cetera, sometimes they reevaluate because the manager has changed. We think that is starting to come down. We would expect that it gets less and less as we go forward in that regard. Regarding Marsico, there was the PM change. Again, what we're experiencing is model changes now on some of the platforms as they reevaluate those funds. We think that Marsico has stabilized their position in regard to their funds and activities. Having said that, they're still up for review when you have a change like that.
In regard to the hedge funds, we feel pretty much we have experienced the outflows that will occur there with the manager change. We feel, if anything, as we settle that down, hopefully we'll start to get some inflows back in next year in that regard. It's unfortunate as you go through some of the manager changes, et cetera, you have model changes that occur in review, and those things sometimes last a bit longer than you would think the change has occurred, why isn't it over? That's what we're experiencing. Hopefully we could continue to deal with that effectively as we get fund flows into other of our retail funds and get more of our funds on these model portfolio platforms. That's what we're working hard to do because we do have good funds with good performance.
We just got to get that more known out there in relationship to the ones that were on the platforms.
Could I ask a second and final question of sort of a related nature? In the past you have discussed holes in your product lineup, areas where you need to develop. It's surprising because Columbia is a big and complex organization. I would have think every box would've been checked. Where do you stand right now in terms of your product breadth? It's broad, but is it complete?
Eric, as we have evaluated, we'll discuss this a bit more at our financial community meeting, we do have a broad product set with good product, with good performance. It's unfortunate that a lot of the areas that we have been really strong in are not necessarily in the flow category right now, particularly in equities. We have been garnering a very large share in our dividend and opportunity funds, things such as that are more equity income related. In regard to the places where we haven't played as well are things like, and that's what we've been working on to ensure because we are putting our talent together in the product areas, is things like global bonds, emerging market debt, things such as that have garnered some larger flows, strategic allocation on a multi-asset basis.
Now we think we actually have some good product that we've been gearing and building the track records for, and positioning and repositioning now. We'll discuss that a bit more in two weeks. If you look at where large inflows have come from, those were some of the categories. Even in the fixed income, we actually have garnered good flows in places like high yield, et cetera. We do have good intermediate funds, but some of the things that have been selling have been positioned a bit differently, and we're working on that. Again, we can't dictate that that's where the flows will stay. We do have to ensure that we have a good product in those categories as we maintain the categories that we are strong with and hopefully as things rotate back in, we'll be situated well.
Thank you.
Thank you. Our next question comes from Suneet Kamath. Please go ahead from UBS.
Thanks, good morning. I had two questions. I wanted to start with Advice & Wealth. Looking at the experienced advisor recruits, it seems like that number keeps ticking up. I think you're annualizing to over 400 this year versus something like 337 last year. I guess the question is, can you talk a little bit about the compensation packages associated with these recruits? Just looking at the headlines, we're seeing a lot of teams move firms. I'd imagine that things are pretty competitive, but can you just talk about how these compensation programs compare to, say, what we have seen in the past just sort of directionally? I'll have a follow-up.
Suneet, in regards to what we're doing, yes, we have a good and consistent pipeline. We have ramped up our efforts a little more fully around the country, and we're recruiting now, not just into the employee section, but also into the franchisee area as well. In regards to the packages, the reason for us they've increased mainly is because we're recruiting more, I would call, higher-level advisors in. On a relative sense, we're not necessarily playing in some of the categories and the ratios that you've been seeing out in the marketplace. Our packages, we think, are competitive, but at the same time, it's also the type of advisor we're trying to attract that would help them build and grow.
In addition to that, we've set it up in a way that as they produce, they can actually achieve the higher what I would call transition comp on the back end. We feel very comfortable about that. Our returns are still very good and appropriate. I would say the rates have gone up mainly because we've been recruiting more higher-level productivity where you would always see the scale up in that regard. I would still say it's not to the points that I've been seeing in the industry as well.
Got it. Are we seeing the sort of the pickup in productivity from the folks that you started recruiting, I guess, back in 2010? I know in the past you talked about a, I don't know if it was a 12-month or 24-month time period before these guys are really onboarded. Can you give a sense of where we are based on the folks that you've already brought in?
Yeah. We track that very closely, and we do it on a vintage basis. As we add more people, of course, the newer people have less over and produce less, but as you go through the vintages of one, two, and three years. On average, we are very successful in bringing over a majority of their assets and books of what they've identified and what we have chatted with them and agreed to on the type of the arrangement. The second thing that occurs is that they then transfer over, and it takes them anywhere from one to three years to fully ramp up, depending on the type of book, the type of activity, product set, and where they're located in regard to an employee versus a franchisee. We have seen consistent ramp-ups consistent with our models and our payback schemes.
We actually feel like within a 24-month period, as an example, we get about 98% of their assets under management from the beginning. Now, they might not be at 98% in productivity because, as you know, based on certain clients and certain activities and certain types of transactions that they might have sold in the past, you don't necessarily replicate that immediately or market conditions. We are seeing a consistent, nice ramp-up with our models. We feel very good about it. That's why we're consistently deploying resources to bring in people.
Got it. My second question is for Walter. Just on the excess capital. If I go back over the past couple of quarters, it seems like the excess capital number has consistently been $2 billion-plus, despite the fact that your payout ratio has been well over 100%. It seems like the reason is that required capital is going down. I was just wondering if you could really help us understand what is going on underneath the surface that keeps that excess capital position static despite the fact that your payout ratio has been so high. Thanks.
Sure. First, what has happened there, the market has certainly impacted this quarter, and looking at CTE98, that has lowered our requirement. We've also rebalanced some of our investments certainly as we exit the bank, which has also resulted in a lower requirement. Over the last year, we've been working on our hedges to make them more effective from that standpoint, from a statutory capital standpoint, and that work will continue. That is primarily the focus also as we get the mix shift in the business coming in more onto the asset management and Advice & Wealth Management. That certainly requires less capital. We're seeing a track on our new activity and the amount of capital required on that, and we're working on getting our basic requirement down primarily in the hedging area and the use of our hedges in the statutory capital area.
Should we expect that $2+ billion now to start to grade down, assuming that you're paying 90%-100% of earnings in terms of payout and then the bank capital? Should we start to see that number come down?
No. The plus is not defined from that standpoint, the canned answer is no because I think with the amount of activity and the amount of capital required as we're adding it in the mix, I look in the near term, I think we should be able to preserve that again, depending on the level of buyback that we execute on.
Thank you.
Thank you. Our next question comes from Thomas Gallagher from Credit Suisse. Please go ahead.
Walter, first one for you on Advice & Wealth Management. Have you all already received the benefit of the fall off in IT spend in that area? I know their 1Q, the expense level was elevated. If I look back to the run rate this quarter versus back to 1Q, we've had a $16 million reduction. Is it safe to assume we've gotten that full benefit of the fall off already, or is there still more to come?
As we indicated, I think Jim indicated, that we implemented the system in the third quarter. There is still expense that will be with us for a quarter or two as it trails off, but it will trail off. As it relates to training and certainly gearing up in our service delivery capability. On that basis, we will still incur expenses in the fourth quarter. In the first quarter, the expense will start decreasing. It should not be a dramatic change, but it will start coming off.
Walter, if we look at apples to apples versus the expense run rate from 3Q, if there's going to be a trail off of expenses through the end of 1Q, order of magnitude, are we talking about something that will be a material offset to the, we'll call it $15 million or so of lost earnings as a result of the bank sale? Is it material relative to that $15 million when you think about by 2Q of next year, or is it not that material?
If you're talking about from the standpoint as it relates to the $50 million we talked about as it relates to the lower expense once the system was fully integrated?
Yes. What we have is, if you saw in the first quarter of this year, we've had a lot of expenses. We had to complete a lot of the development for the conversion in the second and third quarter. In the second and third quarter, to Walter's point, we had a lot of expense for the training and the service delivery to actually migrate over the accounts and support that activity, including through clearing. What we now are doing is winding down the systems cost of carrying the two systems because the development was done. That was heavy in the first part of the year. We're winding down, to Walter's point, more of the service delivery and the training support cost, and that will gradually come off over time as people get ramped up more fully on the systems.
What I would say to your point is, we're not going to fully offset the bank margin because that's roughly about $15 million a quarter. We should, as you saw in the third quarter coming from the second quarter, that sort of run rate of reduction in G&A, we think will continue probably through the next 2 quarters or so in that regard. We're going to bring down, on average, the expenses for the whole migration over the course of next year, particularly in the first 2 quarters of next year. On an apples-to-apples basis, it is less than $15 million per quarter for the bank because we started to achieve some of that savings already in the third quarter. If you look at the third quarter below the second quarter, second quarter below the first quarter.
Some of that was in there, but there's still a remaining piece of that per quarter.
Okay, Jim. That's clear. If I look at the delta from 2Q to 3Q, it was $7 million. You're saying directionally, it could be about that amount.
Directionally, I think that's what we should see for another quarter, and then maybe it'll be a bit less of that into the first and second. There'll be a bit more. I'm just saying it would have offset fully if we didn't take some of that expense down in the third quarter of this year, which we did.
Okay. If I understand you numerically, by the time we get into 2Q of next year, you might have half to two-thirds of the lost earnings offset by lower expenses.
Yeah. I would say if you count the fourth quarter including in that, yeah, probably along those lines. I think Walter can probably do some calibrations and let you know a little clearer when we do the FCM.
Okay, great. The next question I had is just on long-term care. I know it's a small revenue line for you all, but you lost a little bit of money in the quarter on it. I guess my question is, should we be worried at all, or have you guys done a reserve adequacy analysis and/or a DAC review related to that business? Only because my understanding is with the FAS 60 accounting and the way it works, when you move into loss recognition territory, that typically precipitates a reserve review type of test, and a DAC test. If you could just comment on that would be helpful.
The answer is yes. In the third quarter, we did do a reserve review, and we felt that the reserve was adequate from that standpoint. Nothing was necessary to take down. We are certainly monitoring the situation. As we indicated, claims are up. We made an adjustment on an IBNR. We are putting in rate increases, and we feel that at this time, certainly based upon the review, it was not necessary to make a change.
Okay. My last question is just on the hedge fund outflows. Jim, can you provide a little more color on what happened there? Were those client redemptions as a result of an employee departure? Was that Seligman decided to give money back as a result of it? Also what are the assets remaining with that hedge fund team? Only asking because typically in situations I've seen in the past like this, once you have substantial outflows with a particular team, those can last a bit longer. Anyway, if you could provide a little more color on that.
Okay. No, when we terminated the manager, as you know, as people are invested in various hedge funds, particularly as you're going through a period where we are with the various market situations, people evaluate that, and sometimes they do remove that money if you allow them to do so, which we do. We have the funds open. We want them to make informed decisions there. They had notified us. They did pull the assets there. They will evaluate that over the next number of periods to see. That's exactly what had occurred. It's not that we gave the money back. They wanted to take it out at this point in time. We have a good team still there led by Paul Wick, and we have added back some additional talent to Paul's team.
We feel that Paul has had an excellent track record over the years, and that he is very much focused on continuing to maintain his performance. I think as we do that, we should hopefully garner some flows in the future. That's really the situation. It was unfortunate, but at the same time, we think appropriate.
Okay, thanks.
Thank you. Our next question comes from Alex Blostein from Goldman Sachs. Please go ahead.
Hey, good morning, guys. Sorry about earlier on phone issue here, wanted to go back to AWM for one second. Jim, can you talk about, I guess, competitive dynamics in the marketplace today? Clearly, your headcount growth has been very good. Where are you seeing incremental fees coming in from? Is it predominantly wire houses, or are you seeing it from other more regional players? More importantly, the way you guys thinking about structuring the compensation arrangements for the new financial advisors, how does that differ from, I guess, your current pool of FAs?
Yeah. Overall, we're seeing increased activity and consistent activity from a number of different places. We're seeing people continue to join us from the wire houses in a very focused way. We're also seeing now people joining us from some of the regionals, even a few of the independents as we look at, particularly into our franchise channel. We feel like where our story is getting out there in the marketplace, we are actually having good conversations, and people are becoming more familiar with us. We used to be known as the quiet company. They didn't necessarily understand who we were fully, I think we're starting to make the right noise out in the marketplace and positioning so that we are getting on more radar screens.
From that perspective, as people are becoming more familiar, as we've attracted more people over so they understand what we're able to do and who we are, we're seeing bigger and bigger producers as well becoming interested in us. I think that will continue at this point in time, I feel good about it. As far as the packages are concerned, I know there's a lot of headlines out there. Those headlines are particularly focused in the industry on the $1 million-plus producers. I think there is a bit more competition out there, particularly in the wires for those people. That's not necessarily the territory we're playing in. Very clearly, I think if people are choosing to come here, they're choosing to come for more of the value proposition, the culture, the type of positioning we have in the marketplace versus moving to another wire.
Again, we feel good about our ability to do this in more of an appropriate economic fashion. We're not going to appeal to all people. We're not going to appeal to those that just want a big check. That's good. We actually prefer not to. We feel good about where we are and what we're attracting, helping those people come over, helping them to actually take up a stronger advice value proposition.
Great. Then two on asset management. Jim, first one for you on the institutional business. I know there's, I guess, a little bit of noise with these one-off outflows. When you look at the pipeline, we've talked about it last couple of quarters, performance is really good. Your 3-year numbers are solid across a bunch of products. Can you give us a sense of how big of the pipeline is for you guys of potential wins, what's the pace of, I guess, those assets coming into the run rate?
I think we're also going to try to cover this in a bit more detail in 2 weeks. Ted Truscott will be actually discussing the various flows in our distribution activities in the various products. What I would say here is this. Our institutional pipeline is good and strong. It doesn't mean we're not going to lose some of the stuff that we had in the past as you experienced. But as I said, with all the large hump of a lot of the Bank of America activities, there's still BofA. Again, we mentioned that as a billion and a half. It's not a lot of money. We're going to have some lumpiness, like, as we said, from things like the Marsico or the VNR, things that are on various platforms as they continue to migrate out or get settled.
Even retail, we're starting to feel good. Our sales are actually a bit up. We look at market share gains in our focused area are positive. We need to get more of that. We need to get on more platforms, more intermediate recognized for deployments we have versus some of the named firms out there. We're working hard. Threadneedle's actually come back in a good way. Now that Europe has settled down a little, hopefully it will continue that way. We see retail flows came back very nicely, and institutional flows are very good. It doesn't look that way because you got the Zurich, we're always going to have $1 billion a quarter with Zurich. The pension fund tender was one that we identified because we had more call of the pensions, and they had to diversify.
If you take that out, Threadneedle was in a nice positive position this quarter. Columbia, it was unfortunate with the hedge fund. Columbia, our institutional funds neutralized that, including some of the portfolio platform changes. Retail, a good more than half of the outflows were in those just two fund category, the VNR and the sub-advise. I think we're making progress. This is not still a great time where everything's in inflows, listen, we've got a good underlying platforms. People are working hard. We're continuing to fill out the areas that we are not necessarily well-known for, that we think we can be in those areas. We'll go over that a bit more. I'm feeling pretty good about it. We got work to do.
This is not like declaring victory at any sense, I think we've got over the hump, at the same time, I think we've got a good platform, we're generating pretty good margins and profitability from what we have, investment performance is maintaining itself.
Got it. Yep, agreed. Walter, just one for you also on asset management. Taking into account what the outflows you had in the alternative business, I guess if you were to look at the whole complex, how much in AUM do you guys have right now that's kind of performance fee eligible? How are those assets performing this year?
Well, the performance has actually been okay in both the health and in the tech side. I'm not sure on the fund side. I'm not sure if we've about over $1 billion is in the funds.
Over $1 billion in the funds or just all of across everything?
Well, you were talking about the hedge fund. It's primarily concentrated in the two areas that I mentioned.
Got you. Okay. Thank you.
Thank you. Our next question comes from Jeff Schuman from KBW. Please go ahead.
Thank you. Good morning. I guess I want to do a little bit of hair splitting. On page seven, regarding the transition on the bank, it says neutral EPS impact in 2013. I think in Walter's comments, he said neutral by the end of 2013. I guess the difference is not immaterial to estimates. Which is kind of the more accurate expectation?
Well, obviously we will engage the redeploy the capital. Obviously, the capital's still in the bank this quarter, in the fourth quarter. Commencing in the first quarter of next year, we'll redeploy. We're not intending to match exactly on the earnings that are coming out of the bank. By the end, our target was to neutralize effectively for the year, the impact of that from an EPS standpoint.
Okay, not matching by quarter, on a full year basis, pretty much neutral. Is that correct?
That's what you should expect, yeah.
Okay. Going back to the loss of the alternative assets, $1.5 billion of outflows is not a big number relative to the size of the complex. As you've often pointed out, historically, not all assets earn equally. Some of the Zurich assets you lose apparently don't earn much. Presumably, the alternatives earn probably your best earning assets. Is the loss of these assets material enough that we should think about it in our numbers, or just how well did you earn on those assets?
Well, listen, these are earning assets, obviously higher than Zurich that you mentioned. Again, it's manageable. It will impact us, obviously, in the fourth quarter a bit. From that standpoint, we believe, we will be able to build it back. I would say it certainly has a higher profitability factor than some of the ones we've been talking about we've been losing from the bank. Again, it's manageable.
Okay. Lastly, you've given us some directional guidance on the ad spend, I think, up sequentially, maybe flat year-over-year. We don't really have great visibility into what the ad spend is. Should we just assume that corporate G&A is kind of flat year-over-year, or how do we account specifically for the ad spending given the limited visibility?
Well, we're pretty much on track versus what we've spent. It does get split between corporate and AWM. Obviously, there's a lot of institutional enterprise advertising. In the fourth quarter, we heavy up versus the third quarter.
Okay. Thank you.
It will increase in the fourth quarter.
The corporate G&A or just the ad spend piece within that?
No, a piece of it goes into corporate G&A, and then obviously, a portion is in AWM.
Okay. Thank you.
Thank you. Our next question comes from John Hall f rom Wells Fargo Securities. Please go ahead.
Great. Thanks very much. Jim, I have a question about M&A. Obviously, capital's building here, and you've done a couple of successful transactions, Columbia and Threadneedle, and characteristics of both of those transactions were that they had large books of legacy assets that created some outflows over time and continue to. I guess, given your experiences with each of those properties, what are your thoughts as you look at other properties out there that may have similar legacy asset characteristics?
Well, as you know, if you're going to buy an entity that's attached to any larger entity, particularly that's in the financial space, you're going to have assets that may have been attached. If asset managers are owned by banks or insurers, et cetera, you're actually going to have legacy assets. I think as we think about those legacy assets, and just like we did with Columbia, we thought about what the net value is of what you would be purchasing, how long those assets would live for, and then what's the value that you would be left with after enduring. We do evaluate those things, and if it's still a good opportunity for us based on combination of value and what that would add to us over time, we would definitely still consider it.
If you find that there's an independent entity, then in most cases, you don't have those legacy assets, but you still may have larger institutional contracts or other things that would still have to be evaluated if there's a change of ownership. What we do is look at the value of the entity fully with those assets incorporated and what happens if you maintain them or lose them to come up with a valuation. That's what we would do. Even though I'm sitting with the capital, as we said, when we don't see things, we buy more of our stock back and raise our dividend, et cetera, that's what we'll continue to do. We're not just looking to spend the capital on assets that are out there.
There are assets out there, but we have looked at various ones, and again, we look at what we're going to be left with in the end to decide whether it would be appropriate for us. We're not opposed to that. I think what I would do in the future is if I bid an asset like that again, I would help to be as clear as I can with you to understand what that outflow may be so that we understood it. It would be to really buy what would be underneath it that would maintain and live rather than just what you would buy on a transition basis. I hope that answers your question. That's what we tried to do with Columbia, and we think we were pretty good with that. Having said that, you still live with the outflows for periods of time.
Understood. That's great color. Thanks, Jim. Just to follow up on the increase to the dividend. Are you managing to some set payout ratio in the future that you're trying to get to?
Well, what we've said right now is, in combination, we wanted to return roughly as our starting point, about 90% of our earnings to the investor based on where we are, our capital position, our free cash flow. With that, we are trying to rebalance a bit more to have the mix a bit more in the dividends as investors have expressed that interest, and that's why over the last two years, we've raised the dividend 165%. We're over a 3% yield, which we like at this point based upon the interest that's there in the marketplace. We're not managing to a 3%. We're managing more to an overall payout ratio that we would give back to the investors between dividend and buyback.
We're not going to chase it up and down, we will look for a steady amount of dividend and a steady amount, if we can, of an increase. That's what we actually tried to do since we've been public. There's only one year that we didn't raise our dividend, and I more than made up for it with the five increases over the last two years. We try to maintain our dividend so that we wouldn't cut it, and we manage that to be a certain level of cash that we feel very comfortable with. At the same time, we would like to continue to grow the dividends over time consistent with that. We did increase it a bit more than we would have thought in the past because of what we think the combination interest in our cash flow is today.
Great. Just one final thing on the bank. The decision process there to pull capital away from the bank is partly return-oriented and partly regulatorily-oriented. I was wondering if you could sort of draw a dotted line to what you're doing in the bank to your thoughts or whether you're thinking about things around your fixed annuity block of business where that's a market that there's an awful lot of external interest in.
Well, the bank decision is really driven based upon, I think, the combination of the pressure that would be. We only had a small banking institution, and the bank would subject the entire entity to certain other requirements that we didn't necessarily see as reasonable and appropriate at this point in time. For the bank itself, we had no issue or concern about the regulatory requirements for it. It was more of how that would subject the entire institution, and limit our abilities to operate in the businesses that we are, because we're very heavily regulated in those businesses to begin with. That was really the decision. It wasn't just to free up that capital.
In the end, it does free up that capital. Based on, again, that it was a smaller institution and the amount of capital we had in it sort of offsets the earnings that we had in that at this point in time. The fixed annuity book, we have looked at the various things that are out in the marketplace. We actually generate a nice return on that book. Yes, it is running off a bit. At the end of the day, we've evaluated those alternatives, and we don't think that would be favorable for us. Walter can comment a bit more on that. We constantly look at alternatives, but we felt that we're in a better position than what others may have that are needed to sell that off.
No, the only thing I'll just add is that we certainly do evaluate that from Jim's standpoint. The returns that have been provided, even with the runoff, have been actually within our targeted ranges. We don't need the capital. It certainly generates the earnings, and the portfolio that supports it is matched quite well, and we feel quite comfortable with the exposure profile.
Great. Thanks so much for the answers.
Thank you. Our last question comes from John Nadel from Sterne Agee. Please go ahead.
Hey, thanks for going over a little bit. Good morning, everybody. Just first, a quick comment, Jim, for you and the board. I don't want to typically say something like this, especially because I'm not allowed to invest in your company, but there's not a single company I cover that's doing a better job of returning capital to shareholders. I applaud you for continuing to deliver on that commitment. I do have two questions for you on asset management. It's sort of one line to Jeff Schuman's question. As the mix shift in the overall asset or AUM with fixed income, a larger share of the pie, equity is at least a little bit lower than has been the norm. More recently with the hedge fund outflow or-
Generates the earnings, the portfolio that supports it is matched quite well, and we feel quite comfortable with the exposure profile.
Great. Thanks so much for the answers.
Thank you. Our last question comes from John Nadel from Sterne Agee. Please go ahead.
Thanks for going over a little bit. Good morning, everybody. First, a quick comment, Jim, for you and the board. I don't want to typically say something like this, but especially because I'm not allowed to invest in your company, but there's not a single company I cover that's doing a better job of returning capital to shareholders. I applaud you for continuing to-
Generates the earnings, and the portfolio that supports it is matched quite well, and we feel quite comfortable with the exposure profile.
Great. Thanks so much for the answers.
Thank you. Our last question comes from John Nadel from Sterne Agee. Please go ahead.
Hey, thanks for going over a little bit, good morning, everybody. Just first, a quick comment, Jim, for you and the board. I don't want to typically say something like this, but especially because I'm not allowed to invest in your company, but there's not a single company I cover that's doing a better job of returning capital to shareholders. I applaud you for continuing to deliver on that commitment. I do have two questions for you on asset management. It's sort of one line to Jeff Schuman's question. As the mix shift in the overall asset or AUM with fixed income, a larger share of the pie, equity is at least a little bit lower than has been the norm. More recently with the hedge fund outflow or hedge fund closing, the alternatives are lower. How should we think about the impact?
How should we size the impact on the overall fee rate for that segment?
I think what I would say here is we have seen a bit more, as you've mentioned, of the shift in some of the flows between fixed and equity. Having said that, the markets, again, it depends on where the markets are holding, but the market increase has offset that a little bit. You saw a nice rise in the total assets, particularly in equities. What I can't predict, and I don't know if you can, maybe our elections and what happens in Washington to get the economy going will be a positive. My belief is that over time, there is so much money that has shifted to fixed income. At one point, if interest rates start to move, the economy picks up, there has to be a shift back because otherwise you're not going to be balanced correctly, either as a retail or institutional investor.
Right now, it has shifted. Walter, I don't know if you can give them a perspective on what that looks like, or you will in the two weeks.
I think it's probably Ted will cover it, there has been a shift, the fixed income obviously has a lower earnings profile for us. The shift, I guess is, if you look at it's maybe 20% of the 25% of the market appreciation. Obviously it's an industry phenomenon where it is shifting. There are other things that the team is doing to improve its revenue from re-engineering.
Can I ask you this, though? I think it's very clear that the margin on alternatives is higher. Is the margin on equities versus fixed income also higher?
Yes.
Okay. I guess, Jim, I did notice, it's only modest, but it was a slight downtick in the quarter in the number of four and five-star rated funds. Given that and the overall industry pressure on flows as you just discussed, I'm just wondering, and maybe this is more for two weeks from now, what outlook you can provide as far as your expectation for flows going forward, particularly Columbia Retail.
Right. On the number of funds, I think we're pretty stable. I don't know if it moved by one or two or something, I think we're pretty consistent and stable in that regard. I would say we will try to give you a flavor for how we're thinking about our distribution and flow activity. What I can't predict, to be very honest, is, again, will equities come back? When will it come back? What categories are most important right now? We know that in certain of the categories, we've been winning some good business. I think what's offsetting that are some of the things that we've mentioned to you, there's some other categories that get big inflows that we haven't played in.
I actually feel like we're in a reasonably good situation, but there's a lot more that we can continue to do, and we're working hard to do that. Why don't we leave it for two weeks from now, and that will be. That is a better way for us to lay that out and take some of your questions.
That's fair. I appreciate the responses. Thank you, Jim.
Thank you, ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.