Good morning, and thank you for joining Lincoln Financial Group's second quarter 2014 earnings conference call. At this time, all lines are in a listen-only mode. Later, we will announce the opportunity for questions, and instructions will be given at that time. If you need assistance at any time during today's call, please press star then zero on your touch-tone telephone, and someone will assist you. At this time, I would like to turn the conference over to the Senior Vice President of Investor Relations, Jim Sjoreen . Mr. Sjoreen , please go ahead.
Thank you, operator, good morning, and welcome to Lincoln Financial's second quarter earnings call. Before we begin, I have an important reminder. Any comments made during the call regarding future expectations, trends, and market conditions, including comments about sales and deposits, income from operations, and liquidity and capital resources, are forward-looking statements under the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from current expectations. These risks and uncertainties are described in the cautionary statement disclosures in our earnings release issued yesterday and our reports on forms 8-K, 10-Q, and 10-K filed with the SEC.
We appreciate your participation today and invite you to visit Lincoln's website, www.lincolnfinancial.com, where you can find our press release and statistical supplement, which include a full reconciliation of the non-GAAP measures used in the call, including income from operations and return on equity to their most comparable GAAP measures. Presenting on today's call are Dennis Glass, President and Chief Executive Officer, and Randy Freitag, Chief Financial Officer. After their prepared remarks, we will move to the question-and-answer portion of the call. I would now like to turn the call over to Dennis.
Thank you, Jim, good morning, everyone. Lincoln reported another quarter of outstanding results, including a 13% return on equity and record levels of operating revenue, operating earnings per share, and assets under management. Our strong performance is a continuation of good results, generally driven by strong sales with attractive returns, positive net flows, equity markets driving higher AUM and related fees, disciplined expense management, favorable alternative investment income and prepays, and active capital management, including $150 million of share repurchases in the last quarter. We also continue to make progress on our strategy to lean a little more toward the sales of products without long-term guarantees. 68% of total sales in the quarter were in products without long-term guarantees, up from 59% a year ago and against a target of 70%.
We also upsized our VA reinsurance deal with Union Hamilton by an additional $4 billion, covering sales through the end of 2015. We did miss expectations this quarter in Group Protection. Randy and I will touch on group results in more detail in a moment. However, I'd like to emphasize that we have the right strategy in place. We're taking necessary pricing actions and with new and strengthened leadership in place to address the issues, I'm confident that we'll get back on track. Let me turn now to the business lines. Starting with the Life segment. Sales of our individual life products grew by 7% from a year ago, excluding COLI. These results benefited from continued strong sales of indexed universal life, variable universal life, and term offsetting weaker MoneyGuard sales related to the rollout of a new product. We expect MoneyGuard sales to pick up in the second half.
The diversification of sales by product and the returns on new business in the 13%-15% range provides us with among the best risk-return positions we have seen for the Life business. Also, our portfolio of solutions is as broad and competitive as it's ever been. We will take further steps to enhance our offerings to maintain our position as a leader in the space. In the next quarter, we will introduce a survivorship version of our indexed universal life solution. Other product development activities include a new retail COLI product, along with enhancements to our term portfolio later this year. Based on market demand and our enhanced product portfolio, we expect to see strong sales results in the Individual Life business for the remainder of the year. Switching to our Individual Annuity business, it was another quarter of great results.
Total annuity sales of $3.6 billion drove positive net flows of $800 million plus. Sales were down 15% from the prior year quarter. However, you may recall in the second quarter of last year, we experienced an outsized lift to our variable annuity sales resulting from competitor dynamics. We maintained our emphasis on increasing variable annuity sales without living benefits. 23% of the quarter's VA sales had no living benefits, up from 9% a year ago, and a change made possible by the size and quality of our wholesaling force. We supported this key strategy further in the second quarter with the launch of Investor Advantage, our new investment-focused VA product that provides an efficient platform for account value performance. These actions continue to advance us toward achieving our organic goal of 30% of VA sales without a living benefit.
When factoring in the benefit of the reinsurance transaction, 42% of VA sales in the quarter had no living benefits. Also supplementing our sales mix strategy, fixed annuity sales carried the momentum from the first quarter into the second quarter, with sales up 49% from the prior year. As we move forward, our view of the annuity business remains unchanged. The right volume of sales and the profitability and risk profile of new business continues to make the annuity business very attractive. In Group Protection, we continue to address our profitability challenges. As I have pointed out before, we started implementing pricing actions in mid-2013, aimed primarily at our employee-paid life and disability business. These pricing actions are achieving mid- to upper single-digit increases in both new sales and renewals. We will continue to make pricing changes as needed in order to restore profitability.
Given the rate increases, new business levels were off in the second quarter. We continue to make inroads on our targeted strategy to further expand the employee-paid voluntary market. In the quarter, 43% of our sales were employee-paid, up from 39% in the prior quarter. This is an important element in our overall strategy to achieve and sustain profitable growth in this business. Achieving this shift in sales mix, combined with ongoing pricing actions and strengthening our management team, notably with the recent appointment of Dick Mucci as President, have us on the right path to achieve our strategic and earnings objectives over time. Moving to retirement plan services, it was a strong quarter with improvements in both sales and retention, leading to positive net flows of $366 million. Second quarter deposits of $1.8 billion were up 12% from a year ago, driven by a 27% increase in first-year sales.
Increased sales momentum is a direct result of the investments we are making in distribution and technology. We are expanding our small market sales force, now 25% larger than one year ago. Tapping into strategic relationships with leading distributors like Merrill Lynch, Wells Fargo, and Ameriprise, where sales have more than doubled from the last year. Increasing our competitiveness through an enhanced service offering enabled by our new platform. These efforts, along with the broader and deeper relationships, are affording us new opportunities with more consultants. Year to date, 44% of our mid to large market opportunities are from consultants who previously did not give us a look. Overall retention improved compared to the first quarter, the result of focused retention efforts, including dedicated retention teams and enhanced risk reporting. We're happy with the progress we've made and expect to see continued growth from our retirement business.
In distribution, we had another strong quarter as well. Our broad and deep distribution franchise continues to be a differentiator, enabling us to grow sales and shift our mix when necessary. Our wholesale franchise, Lincoln Financial Distributors, reaches more than 65,000 producers annually, a 3% increase from a year ago. In addition to growing, they were more productive, evidenced by repeat producers growing 4% over last year and a 12% jump in the number of producers selling multiple Lincoln products. Moving to our retail franchise, InvestmentNews ranked Lincoln Financial Network as the second largest independent producer sales force in 2013. We continue to grow our affiliated advisor base up 2% from a year ago, now reaching over 8,500. LFN drives more of Lincoln sales than any other firm, currently at 13% share, and we are committed to making investments to deepen this retail franchise.
You've heard me say this before, distribution is a competitive advantage for Lincoln, and we will continue to invest in and tap into the strength of our nearly 1,400 wholesale, retail, and worksite professionals across Lincoln who are telling our compelling story. On investment management, we continue to drive strong results while maintaining our portfolio's high investment-grade quality. Our fixed income portfolio yield stands at 5.14%, and our net unrealized gain is $7.5 billion or 9.5% of assets, which the long duration of our invested assets is driving our increase in that dollar amount. Despite a persistently low yield environment, our new money purchases of $2.4 billion were invested at an average yield of 4.5% 30 basis points over our average new money rate in 2013, with our yield-enhancing debt program contributing 18 basis points to our new money yields this quarter.
Our approach to the yield-enhancing debt has focused on less liquid asset classes where yields and the quality of underwriting remain attractive. We also continue to commit capital to our alternatives program as we expand this strategy. We maintain the flexibility for further growth as well as benefit from its portfolio diversification and higher income yields. Let me close my comments by saying once again that we had a very good second quarter. I'm confident that all the actions we are taking will enable us to achieve our long-term earnings growth, ROE, and diversification objectives. With that, I will now turn the call over to Randy.
Thank you, Dennis. Last night, we reported income from operations of $394 million, or $1.47 per share for the second quarter, up 16% from the prior year period. The quarter demonstrates the strength of a diversified set of earnings drivers as account value growth in the annuity, retirement, and life segments drove strong earnings that more than offset weak results in our group business. The quarter's earnings benefited from $11 million or $0.04 per share of normalized items, including $6 million in the other operations segment and $5 million in the life segment. In addition to record operating earnings, the quarter featured strong performance across most financial measures, including strong top-line growth, with operating revenues up 8%, continued expense discipline with G&A net of capitalized expenses remaining flat with the prior year.
Coupled with the strong revenue growth, we saw G&A as a percent of revenue decline 90 basis points from the prior year. Book value per share, excluding AOCI, grew 9% to $46.97, while return on equity increased to 13%. Turning to the investment portfolio, income from alternative investments was in line with our expectations, while income from bond and mortgage prepayments remained elevated during the quarter, primarily benefiting the individual life segment. Strong prepayment income has been a recurring theme for the past few years, which seems to be related to the environment that exists today. While it is a difficult number to project, we will not be at all surprised, and in fact would expect to see elevated levels of prepayment income should the current environment persist.
Realized gain and loss performance was a net positive this quarter with $5 million of realized gains on investments, while the hedge program had another great quarter of performance. The unrealized gain on our investment portfolio increased to $7.5 billion pre-tax or over $12 of book value per share. Turning to segment results and starting with annuities. Reported earnings for the quarter were $227 million, a 16% increase over the prior year. Operating revenue growth of 13% was driven by fee income, which grew 24% as average account values grew 14%, and the average fee assessment rate increased by eight basis points. Negatively impacting revenue growth was net investment income, which declined 5.5% as prepayment income decreased from an elevated level in the second quarter of 2013. Consistent with recent quarters, the ROE in the annuity business came in at 26.7% for the second quarter.
The combination of strong equity markets, positive net flows, and strong new business returns provide an excellent backdrop for the annuity business. The benefit of that environment are evident in what was another outstanding quarter of results. In Retirement Plan Services, we reported earnings of $39 million, consistent with both the prior year and previous quarters. Revenues were flat year-over-year on lower net investment income, while fee revenue increased 7% on higher assets under management. Average account values increased to 12% from the prior year period and ended the quarter at a record $54 billion. Spread compression in the retirement segment remained fairly constant, with normalized spreads coming in nine basis points lower compared to a year ago and three basis points lower than the prior quarter.
Management actions to alleviate the effects of spread compression are helping to partially offset the impact of the current interest rate environment. Efforts to lower guaranteed minimum interest rates over the last year have lowered the credited interest rate by four basis points. Return on assets for the quarter of 30 basis points and a pre-tax net margin of 35% were again at the high end of our expectations. Another strong quarter for the retirement business as asset growth driven by the strength of the equity markets offset the drag that spread compression is having on the business. The life insurance segment reported earnings in the quarter of $148 million compared to $135 million in the prior year. Earnings drivers were strong in the quarter, with average account balances up 7% to $41 billion while life insurance in force increased 5% to $629 billion.
It was a very good quarter for the life business, with several items contributing to the results, including mortality return to expected levels after negatively impacting the first quarter by $18 million. As noted in the press release, earnings were positively impacted by $5 million, primarily related to expenses. The life segment was the primary beneficiary of the prepayment income that I noted earlier. This benefited the segment by approximately $6 million. The Group Protection segment reported earnings of $2 million in the quarter, down from $22 million in the year-ago quarter and $20 million in the first quarter of this year. Relative to the first quarter, earnings were negatively impacted by two items. Mortality was elevated due to the cleanup of claims related to unclaimed property. This one-time item impacted the quarter by $4 million and LTD claim experience, which impacted the quarter by $13 million.
LTD metrics were mixed in the quarter with elevated incidents, while severity and recoveries were in line with expectations. LTD incidents was driven primarily by more serious, complex disabilities and more subjective mental conditions such as musculoskeletal and psychiatric issues. We continue to investigate the quarter's experience, and as we learn more, we will appropriately enhance administrative capacity to deal with any elevated level of these types of claims. Our analysis also leads us to believe that the LTD claim experience is driven more by volatility than any trend downward in morbidity experience. For example, when we examine our incidents over the past few years, we do not see evidence of deteriorating morbidity trends in incidence patterns. Importantly, as Dennis mentioned, we are making progress on our planned pricing actions.
That, combined with managing premium persistency to reasonable levels and at the same time driving our business mix to the higher profit margin employee pay and voluntary segments are the right steps to restore profitability. Regarding our earnings guidance for the year, the quarter's results increased the likelihood that we will be at or below $60 million of earnings for the year, the low end of our guidance range. Turning to capital activities. We repurchased $150 million of our shares during the quarter, moving us to $300 million for the first half of the year. While statutory capital grew approximately $80 million over the quarter to $8.25 billion, with RBC coming in at 503%. During the quarter, we sent $210 million of dividends to the holding company, where we ended the quarter with $573 million of cash.
The strong statutory performance and balance sheet, coupled with the cash position at the holding company, put us in a very good position to meet or exceed our full-year guidance for $500 million-$550 million of share buybacks. To summarize, three of our businesses had excellent quarters that overcame weak performance in the group business. When you wrap it all together, it was another strong quarter for Lincoln with top line growth of 8%, disciplined expense management with solid improvement in expense ratios, continued capital deployment through share buybacks, consistent growth and strength in the balance sheet with book value per share up 9%, and a return on equity of 13%. With that, let's move to Q&A.
Thank you. Ladies and gentlemen, if you wish to ask a question at this time, please press star then one on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue, you can press the pound key. We please ask that you limit yourself to one question and one follow-up question, please. Our first question comes from the line of Suneet Kamath with UBS. Please go ahead. Your line is now open.
Great. Thanks. I just wanted to start with group protection, if I could. Dennis, in your prepared remarks, you said that some of the changes that you've made give you some confidence that you're going to get back on track. How long do you think it will take you to get back on track? Clearly, the year-to-date earnings annualized is going to come in well below that $60-$80, and Randy made some comments about that. What sort of a timeframe are we talking about here?
Suneet, great question. Cannily not entirely easy to answer, let me give you some facts. As we talked about last quarter, and I guess even in the quarter before that, we really have to reprice about $1 billion worth of employer-paid premium. It's going to take somewhere in the neighborhood of through the early part of 2015 to get that all repriced. The impact on earnings of that repricing will show up in the latter part of 2014 to some extent and then into 2015. It'll take through the end of 2015 for us to get back on plan.
Excuse me, back up to higher levels of earnings. It could be a bumpy road in between now and then because we're seeing some volatility as we've reported. I think it's 2015, sometime in 2015, one will begin to see some sort of back to more normal levels.
All right. You talked about the mid to high single-digit rate increases that you've been implementing since the middle part of last year, I think. Just based on what you know now, Ian, the quarter's experience, do you think that rate that you took is enough, or could we be looking at another round of increases that is required?
We're going to monitor that, Suneet, we're going to continue to make adjustments as needed. It's hard to say exactly how much more we'll need. We just have to see how the earnings continue to improve, how our loss ratios change. Let me just say it this way. We obviously have a rightful focus on getting the right ROEs on this business. It's a function of premium increases, it's a function of incidence changes. We're working very hard, adding the staff that's necessary to get that done.
I got it. Just one other one for Randy. I think when you originally did the VA reinsurance deal, either you or Dennis gave us some high-level comments about the economics of that transaction. Should we think about this new deal that you just announced, or you're pursuing to be roughly similar with that original transaction?
Yeah. The economics of the two tranches are roughly the same. As in the past, we're not getting into the details of what those economics are, other than say that as compared to a living benefit sale without the benefit of the reinsurance, maybe it's with the benefit of the reinsurance, maybe it's 1% or 2% off our internal rates of return.
All right. About in line with what you did before.
Yep.
Okay, thanks.
Thank you. Our next question comes from the line of Seth Weiss with Bank of America. Your line is open. Please go ahead.
Hi, good morning. I had a question about the annuity segment and the market leverage within there. Randy, last quarter you gave us sort of a rule of thumb, 1% increase in the S&P provides about $7 million in annual earnings. I think the results this quarter are very much in line with that kind of market growth. My question is, if we see the market come down, is the leverage on the way down the same as the way up? The reason I ask, because I believe you earn fees on guaranteed level, not asset level. I would expect the leverage to maybe not be as much on the way down or the sensitivity to not be as much as the way down. I appreciate your comments. Thanks.
Sure, Seth. You're absolutely correct. It's a little less on the way down. That sensitivity to movements is going to increase as the overall account balances in the annuity segment go up. Our latest analysis would have a 1% movement now having about an $8 million positive increase on the segment, as opposed to a 1% decrease, having roughly a six to seven million dollar negative impact. There's a little more leverage going up, given where we are in the corridor, which is the primary driver of that.
Okay. That's helpful. Just in terms of sensitivity to hedging costs, hedging costs have stayed low for some time, I believe that has a little bit of a positive bleed through on operating earnings. Is that something that we should think of as maybe a potential pressure if we see hedging costs increase, volatility increase in the market? Is the role on the hedge so subtle that you're not going to see that impact sharply in any given quarter?
Yeah. What you would see if the hedging costs go up is that the extraordinary profitability that we've been experiencing on new sales, and as we've talked about, the returns on new sales have been in the 20s, would come down. We don't expect to be in the 20s forever, I would say. I wouldn't be surprised to see the margin you're getting on that guarantee rider come down over time. We're currently experiencing strong returns, and we expect to see that for the foreseeable future, I should say. Yes, over the long term, I wouldn't be surprised to see that margin we're earning come down. For right now, it's very strong, and we continue to get those same excess returns.
Great. Thanks a lot.
You bet.
Thank you. Our next question comes from the line of Jimmy Bhullar with JP Morgan. Your line is open. Please go ahead.
Hi. Good morning. First on the disability business, if you just talk about the success you're having in raising prices in the business, how is it impacting persistency? A couple of years from now when you're done repricing the book, how much of the book do you expect to lose? Secondly, just comment on initial traction of the VA product without living benefit guarantees.
Let me ask Randy to talk about, in a little bit more detail than I did, about the timing of the repricing. Then when that repricing flows into earnings. My comment was about 2015, was more about the timing of the repricing. Randy, why don't you talk about how that affects earnings?
Sure.
The total amount of premium that we expect to be repriced in this employer-paid segment is $1.1 billion. Through the second quarter of this year, we've actually repriced $300 million of that. In terms of the earned premium we've experienced in the first half of the year, roughly $130 million of that premium has been at this increased level. Of the $1.1 billion, about $130 million of that we experienced in the first half of the year. As we move throughout this year, over the course of this year, we will reprice, in total, $500 million of that $1.1 billion. About $300 million of that premium will come through in this year. That's how you should experience. As you move into 2015, we'll pretty much complete the repricing as we hit the 1/1/2016 renewals.
You should see about $800 million-$900 million of that premium effectively repriced inside of our 2015 earned premium. Then it would all be repriced in 2016 effectively. In terms of the persistency on that, our historic persistency is roughly 80%. We've continued to experience persistency roughly in that range, and I wouldn't expect it to change in a material way from that.
On the VA?
I'm sorry, could you repeat the VA question?
On the variable annuity product, just initial traction of the new product without living benefits. Other companies have tried to do that, and they haven't had a lot of success. Just wondering what you've seen so far.
Yeah. First of all, we introduced it in June, so we sold a little bit of it, but not a lot of it. We're very excited about it. It has a great mutual fund lineup. It has asset allocations embedded in it. An important distinction from our competition is that it has an exit strategy, which is not a guaranteed exit strategy, but it's our i4LIFE patent, which permits distributions first to be in the nature of principal and then accumulated interest income. Great lineup, good asset allocation tools inside the product, and an exit strategy which differentiates us from the competition. I'll come back to it again. The strength of our distribution is really powerful, and it lets us make changes that maybe just that we can make changes. Let me come back to what I said a moment ago.
Without any new product, we've moved the mix to 23% non-guaranteed. I think with a good product, we can achieve over the next couple of years our 30% on an organic basis. As you know, in the meantime, we have the benefit of the reinsurance deal. We're actually ahead of our objectives on non-guaranteed VA business.
That's it. Thank you.
Thank you. Our next question comes from the line of Nigel Dally with Morgan Stanley. Your line is open. Please go ahead.
Great. Thanks, good morning. I have a question on interest rates and the sharp reduction we've seen this year. Randy, I know you're comfortable in being able to maintain your returns despite the low rate environment. In fact, this quarter we saw some solid improvements. Perhaps you can also touch on how we should be thinking about interest rates given your upcoming actuarial review in the third quarter.
Nigel, you were breaking up a little bit, I'm going to have to fill in the blanks on a couple of the words. As you mentioned, we will be doing our third quarter actuarial study in the third quarter. As part of that, we'll update our J-curve. I don't expect a huge impact. Rates are relatively similar to where they were. Of course, we'll update that as appropriate as we get there. I don't expect a huge impact from interest rates or a large impact from interest rates this year. In terms of how interest rates at current levels are hitting our statements, it continues to primarily be an issue for the life and the retirement segment. The life segment is seeing its spread decline roughly 8-12 basis points or so on an annual basis at current levels.
The retirement business is seeing its spread go down about 10-15 basis points on an annual basis. If you look at those numbers and what does that mean from a quarterly standpoint, it's roughly a $3 million or so headwind against earnings with rates at this level.
Great. Thanks a lot.
You bet.
Thank you. Our next question comes from the line of Randy Binner with FBR Capital Markets. Your line is open. Please go ahead.
Thank you. I want to ask a question about capital and liquidity and how that's relating to buybacks because $150 million in each of the first two quarters has been good. I guess the first question is just to clarify the $573 million of holdco liquidity. Is that total or is that above your buffer that you like to keep?
No, that's the total. The targeted amount is $500, and we're at $573 as we sit here today.
You said you had $210 of dividends that came up. Is that almost all of the statutory earnings in the quarter?
No, as I mentioned in my script, the stat capital grew by about $80 million during the quarter.
Okay.
Total stat earnings were roughly $290 million in the quarter.
Okay. That's a good level, I think. Was there anything unusual in that stat earnings in the quarter?
No. As I mentioned, we had a really strong first quarter. I didn't expect that level at the first quarter to repeat where it was roughly $370 million.
Right.
I think that $290 million number is a reasonable number. I think what you're seeing in there are a couple of items. You're seeing the growth in earnings, right? You're seeing our GAAP earnings grow, and some of that should transfer through to statutory also. You're also seeing, and this is especially on the life side, less strain given that the mix of sales has changed. If you go back two years, we've talked about a dollar of strain for each dollar of life sales, and that number is roughly $0.80 per dollar of sales right now. You're seeing the benefit of the mix change, and part of that is flowing into earnings also.
Okay. Just kind of the final piece of that is, I think your commentary earlier in the year was that you were not planning on doing a reserve financing this year. I guess I'd ask, is that still the case? Because previously it seemed like, at least to me, that you kind of needed to do reserve financings to get the full buyback and maybe for the reasons you just explained, you have a little bit cleaner kind of cash flow coming up to the holding company. Is that the right takeaway? Can we kind of hit the high end of that buyback goal without a reserve financing this year?
You answered the question for me. Yes, I'm very comfortable with the earnings we experienced in the second quarter, which support the share buybacks and everything else that we've done. In terms of reserve financings, I don't expect that we will do one this year. The sales mix, given its change with GUL sales coming down quite a bit, means that it's roughly an every other year sort of thing for us from a reserve financing standpoint.
That's perfect. Thank you.
You bet.
Thank you. Our next question comes from the line of Tom Gallagher with Credit Suisse. Your line is open. Please go ahead.
Morning. Just a first question for Randy. Any geography changes we should be thinking about as an area of focus into balance sheet review for three Q related to either DAC or reserves? Whether it's the equity cushion in DAC or interest rate assumptions. Anything we should be aware of?
No big things that I would caution or alert you to as we go into the process. We made substantial changes on the annuity side to the underlying assumptions around lapse and utilization last year and the year before. I wouldn't expect huge changes in those assumptions this year. The corridor, we're still inside the corridor or the area where we would look at it. I feel comfortable where we are there. There's nothing in particular that I would alert you to as we go into the process.
A follow-up on the disability claims issue. Randy, you had mentioned you all had seen some more, what you described as subjective claims in disability. Can I take that commentary to mean that you're going to start emphasizing more claims adjudication and recovery, and focus more on sort of the scrutiny of the legitimacy and ability to get claims off the books? Is that going to be an area of focus going forward?
Let me try to answer that. Claims management is a big part of the Group Protection business, as I've watched it over the years, you see patterns. For example, if incidents start rising, your claims get higher. It may take a little while to increase the staff and train the staff in such a way that the amount of claims that are being approved or disapproved get back to sort of where they should be. This year, Randy's mentioned that we've had more complex claims. Sort of the same idea is that we'll have to upgrade our staff and move people into the areas that are dealing with these more sophisticated claims.
This stuff, I can't tell you whether it's going to increase or decrease claims, but over time, these things will even themselves out, whereas in a particular quarter, you could see more or less claims than you might over a longer period of time. Hopefully that's responsive to your question.
Yes, it is, Dennis. My final question is just in lieu of what's happening to your own Group Benefits results, and I would say several peers in terms of seeing some pressure on loss ratios, do you still have the same level of interest in the M&A? I know you've talked about Group Benefits being an area of potential focus. Can you give us an update, whether this has any bearing in terms of reducing your level of interest in M&A in that area?
It doesn't reduce our long-term interest in M&A in the group area. This gets back to some of these strategies that we've been talking about.
Business with shorter term guarantees, increase in the amount of earnings derived from mortality and morbidity. Of course, the group business is right in the sweet spot of that strategy. I think when you're going through the amount of change that we're going through, by that I don't just mean the pricing issues we've been talking about, but the shift in strategy, new systems, new people, building a stronger management team to deal with what has become for us at Lincoln, a little bit more complex business, is this the employee-paid direction. I think when you have all that going on, you might be a little bit more reluctant to add on top of it a M&A integration. Long term, I'm still as excited about that business and the opportunity to grow it both organically and with M&A.
Right now, I think I'd be a little bit more cautious about trying to add more complexity to something that is already complex.
Makes sense. Thanks.
Thank you. Our next question comes from the line of Eric Berg with RBC Capital Markets. Your line is open. Please go ahead.
Thanks. Good. Thanks very much, good morning to everyone. Randy, towards the end of one of your answers to a prior question, you mentioned an $800 to $900 million figure. Would that be the amount of premium that was earning at the higher rate, or that had been subjected to the higher rates but not yet earned?
That would be the amount of our earned premium that we experienced for 2015 that would have been experienced at the higher level of pricing. It would be the actual earned premium that had been repriced. Now, when you think about that $800 million of premium, you would lose some of that to persistency. You lose roughly 20% of that to persistency.
remainder comes through at the higher rate.
Okay. The other thing I wanted to ask about was to try to reconcile your comments. Maybe they don't need to be reconciled, maybe they were consistent, but I need some help. About the disability business in the following sense. You've talked at length in this call about how you have been and will be raising prices. That's typically done when an insurance company expects morbidity to deteriorate or morbidity is proving to be worse than it thought, and the business needs to be repriced. It's underpriced. Around the same time that you're talking about your pricing, you're saying that you're not seeing a downward, I'm paraphrasing now, I don't remember exactly what you said, but what I recall is that you said something along the lines of, you're not seeing a deterioration in incidence, a sort of a deterioration in incidence.
I'm not quite sure I understand the point you're trying to make. It's kind of nuanced, I think. I would think if you're raising prices, it would be because you're seeing deteriorating morbidity, including a deterioration in incidence. Can you kind of clarify how these two issues, pricing and deterioration of, I mean, absence of a deterioration in incidence could be going on concurrently? In other words, how could you be raising prices if you're not seeing a deterioration in incidence?
Eric, it's Dennis. That's a great question. I'm going to put it into longer time frames than a quarter. Sort of in the 2009, 2010 period, incidence was running lower in aggregate than it has since then. Randy's comments are more relevant to, say, the last couple of years. We were pricing based on a lower expectation than we had seen for a longer period of time, 2009, 2010, '11, and '12. They seem to have stabilized over the last 24 months. Incidence has sort again, on a longer-term basis. We still see volatility quarter-to-quarter, but we priced to an expected lower level of incidence, we have to reprice to this new higher level of incidence. Does that help?
It does. What I'm hearing is that things are worse than you thought. Why else would you be raising prices? Incidence levels are stable now at a higher level than you anticipated, but at a stable level nonetheless. That's sort of what I'm taking away.
Yeah. Yes, that's right.
Okay. Thank you very much. It's a helpful clarification.
Thank you. Our next question comes from the line of John Nadel with Sterne Agee. Your line is open. Please go ahead.
Hey, good morning, everybody. Just a couple of quick ones, and then maybe a slightly bigger picture one. One, Randy, I think you mentioned that alternatives were in line with your expectations. Could you just quickly remind us what that was?
We have a alternatives portfolio of about $1.1 billion right now, and we expect roughly to get a 10% return on that, and our returns in the quarter were right in line with that.
With the new $4 billion of capacity, I guess at the end of June anyway, what's the total capacity remaining through year-end 2015 on the reinsurance program?
$6 billion plus.
Got it. Then the last question is this. I'm just wondering how should I think about the excess returns on your new VA sales? I'm
You mentioned consistently, at least for the first half of this year, maybe a bit longer, that you're running in the low 20% range. How does that compare with the level you're actually baking into your pricing if we assumed hedging costs do over time, in fact, normalize? I guess I'm trying to ask, how much is lower hedging costs contributing to the higher return?
Let me sort of clarify the question about lower hedging costs. Actually, the hedging costs that we're experiencing today are closer to what we've seen over a long period of time with the exception of sort of 2009, 2010, and 2011, when volatility spiked up. There's no way for me to be able to predict if the historical level of volatility, which matches what we're pricing today, is going to be the future level of volatility. That puts that into perspective, I think.
Okay. I guess then, are you pricing overall to a 20%-plus type of ROE on this business, or is there something else that's, in at least the current environment, favorable relative to pricing such that it's given you some kind of boost?
No, the pricing today on our variable annuity product, fully loaded with the living benefits products, actually the total portfolio is at about 20% for new business.
That's the target?
Yep.
Got it.
John, nothing's changed in our approach to pricing the variable annuity business. You're not going to see us as the best product out there. You're not going to see us as the worst product out there. It's a good product that our top-shelf distribution channel can sell in the marketplace today. Nothing's changed about how we're pricing variable annuities. The returns we're able to get today are reflective of the same approach to this business that we've always had.
Okay, got it. I just wasn't aware that the market was bearing overall that kind of return hurdle for new business, perhaps I was wrong. Thank you.
Thank you. Our next question comes from the line of Steven Schwartz with Raymond James & Associates. Your line is open, sir. Please go ahead.
Hey, on the subject of variable annuity profitability, well, first I just want to make sure I understand something. On the new VA, there is i4LIFE, but there's no GIB floor. Is that correct?
Yes.
Okay. Good. Okay. How do we think about the profitability of the new annuity versus the profitability of, I don't know, maybe what you sold last year that had guarantees on it. Obviously, it's very profitable because the market went up. Just thinking about it, I would think more risk, more return, less risk, less return.
Yeah. I'd break return up into two areas. First, your return on equity. I don't expect to see a materially different return on equity between the non-guaranteed VA and the living benefit guarantee VA. What you will see a lower return on is a lower return on assets on the non-guaranteed VA because you're not getting that return on assets that you get from the guaranteed. That's what we would see with the non-guaranteed product, is a lower ROA.
Okay. I don't know if you said this or not, the operator came in and asked me my name or something like that while you were talking for some reason. On the retirement plan side, Randy, did you talk about where gains were in terms of products, sales growth in 401 or 403 or 457? Did you touch on that at all?
No, we didn't, but we'd have to get the detail on that for you.
Okay. All right. I think that would be interesting. Okay, thanks, guys.
Thank you. Our next question comes from the line of Colin Devine with Jefferies. Your line is open. Please go ahead.
Good morning, gentlemen. I had a question on the VA business. Dennis, you've executed very strongly in sort of growing out of some of the older, more generous living benefit products from a few years back. Part of that, Lincoln very quickly adopted the managed risk funds, and they've been a big part of your story. Ameriprise commented they had, I think, about $1.5 billion voluntarily move into their funds this quarter. Perhaps you can give us an update as to how you've been able to change the risk composition of your block by how much you've seen moving into the managed risk funds and if that's had a benefit on earnings. I assume it's also materially lowering your hedge costs.
That's a big question. My recollection is that, Eddie, we're fading out a little bit there. Is this Colin?
Yes, it is.
Yeah, Colin, well, welcome back to the business, by the way.
Thank you.
We're happy to have you back on our phone calls. I think in terms of the risk protection
Probably have AUM in the $4 billion range. Excuse me.
It's roughly the risk managed fund AUM is $20 billion-$25 billion.
Oh, 20, 25 funds.
That's what I thought. Okay.
Yeah. What was the question, though, Colin, more specifically?
Well, in their earnings release, Ameriprise mentioned they'd had about $1.5 billion move over into those this quarter, and it popped earnings of about $10 million. My impression has been that Lincoln has seen the same very strong voluntary adoption of those types of investments by their policyholders. I guess if you could clarify, is that the case, and is that helping your earnings? I assume that's also starting to make a meaningful reduction to your overall hedging costs.
The majority of our risk-managed funds are coming from new sales. We did have some move over. We don't see a pop to earnings when that money moves over. Any incremental growth you're getting today is pretty much from new sales.
Dennis, perhaps you could just clarify for this for me. When you talked about the new product, I guess from a competitive perspective, I assume you're referring to Elite Access and Jackson's product which really opened up the old annuity business that we maybe knew from pre-2002.
Yep.
Can you just clarify what's different about your product versus Elite?
That would be a complex analysis, but you'd have to go mutual fund by mutual fund, asset allocation models. We do have protected fund capacity or options inside of it. The underlying investments that are going to generate the opportunity, Colin, would take a lot of work.
I just think it's a non-guaranteed product, I just wanted to understand what the difference was.
The big difference is, we think that our underlying mutual funds and all of the different asset allocations, to repeat what I said, are an improvement over what's in the market today. Obviously, people could catch up with us on those issues. We do have, to repeat what I said earlier, the exit strategy, i4LIFE, again, non-guaranteed, but are patented. Colin, you're as familiar with that as anyone on the phone in following Lincoln for a while. That's a differentiator for us. If I can come back to, we've already moved the dial without a product that's specifically designed for accumulation from 9% of sales to 23% of sales. We're only trying to get to 30% of variable annuity sales on a non-guaranteed basis.
We don't need a lot more lift to get to the 30% because we're already at 23%. It's not just the product, although we think the product is great. It's the strength of our distribution force.
Thank you.
Okay.
Thank you. I'm showing no further questions, and I would like to turn the call back over to Mr. Jim Sjoreen for any closing remarks.
Thank you, operator, and I want to thank everybody for joining us on the call this morning. As always, if you have any follow-up questions, please contact investor relations at our hotline number or investorrelations@lfg.com. Have a good day, and we'll talk to you next quarter.
Ladies and gentlemen, this does conclude today's program, and you may all disconnect. Everyone, have a great day.