Good morning, and thank you for joining Lincoln Financial Group's third quarter 2013 earnings conference call. At this time, all lines are in a listening 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 the call, please press the star key followed by the 0 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. Please go ahead, sir.
Thank you, Shannon, and good morning and welcome to Lincoln Financial's third quarter earnings call. Excuse me. 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, expenses, 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 Form 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. At this time, I would like to turn the call over to Dennis.
Thank you, Jim. Good morning, everyone. Overall, it was another very good quarter for us with our results driven by an earnings mix benefiting from strong net flows, growing equity markets, and somewhat higher interest rates. We ended the quarter with operating return on equity just under 13%, and compared to the prior year quarter, normalized income from operations was up 13%, 18% on a per share basis, and operating revenue growth was up approximately 6%. These results are being supported by key actions. First, prompted by low interest rates, we began actively repricing our products 24 months ago to raise expected new business returns. With few exceptions, our current product offerings are achieving at or above our target returns. Second, equity-based margins are benefiting from strong cash flows and rising equity markets, and we are being rewarded now for our consistent market presence since the crises.
Third, increasing shelf space and distribution partnerships, along with a robust solution set, have elevated our ability to sell products on our terms. Finally, aggressive share repurchases totaling $1.4 billion since 2009 continue to boost operating earnings and book value per share. We will take similar key actions in the near term. I will touch on many of these as I move through business lines results, starting now with Individual Life. Third Quarter sales in Individual Life were up 46% from the prior year. Sales are at pre-pivot levels and are driven by a broad solution set offered to the marketplace through powerful distribution. Pivot products, which are more profitable and have a more balanced risk profile, were up significantly from last year. These products now comprise 63% of total life sales. Also, 80% of Third Quarter production is from products other than guaranteed universal life.
Over the past 24 months, we have implemented the major repricing actions required to meet our targeted returns of 12%-15% on new business. A new version of MoneyGuard will be rolled out in early 2014 and completes our major individual product repricing actions. Looking forward, product development will continue to reflect a broad portfolio of solutions to meet customer needs, diversifying risk and managing to excellent returns. In our annuity business, it was another outstanding quarter. Annuity sales of $3.6 billion, up 36% from the year-ago quarter, driving net flows of $1.2 billion. Account values increased 15% from the year-ago quarter, reaching $109 billion. VA sales in the Third Quarter were $3.4 billion, down from the Second Quarter as anticipated.
With new business profitability above targets of 15%-18%, we have sharpened our focus on risk diversification through benefit changes, living benefit risk sharing, reinsurance, and redirecting wholesalers to focus more on non-guaranteed sales. One tangible result is that in the quarter, 13% of our variable annuity deposits had no living benefit guarantees at all, up from 9% in the Second Quarter. We expect this trend to continue as we both direct sales efforts and add non-guaranteed product solutions. We reported last night that we entered into a 50% reinsurance treaty covering new sales of our most popular VA living benefit. We will cede up to $4 billion of living benefit risk on sales starting in November to Union Hamilton Re, a subsidiary of Wells Fargo. The profitability on the re-insured sales after reinsurance costs remains well above our target returns.
This is a significant transaction for us, which underscores our leadership in the VA market and commitment to risk diversification, as well as selling high ROE products on our terms and in the right amounts. Turning to Group Protection, sales growth in both our core and voluntary segments has been supported by the addition of brokers and new products. Worksite sales, a part of voluntary results, are being driven by third-party enrollment firms and traditional brokers. The goals of expanding shelf space and partner distribution are working in Group as it does in our other business lines. Reflecting this progress, Third Quarter sales of $107 million increased 10% from the prior quarter. In the voluntary segment, sales increased by 11%.
While we have been successful in achieving price increases throughout the year, we intend to push even harder on both renewal and new business pricing as we close 2013 and move into 2014. Our improved product offering and distribution strength better positions us to raise prices, and we remain focused on meaningfully improving our ROEs over the next 24 months. As we move forward with an eye on achieving stronger renewal rates and new business prices and maintaining persistency, we expect to produce solid results that enable us to deliver on our strategy for accelerated profitable growth in the group business. Moving to Retirement Plan Services, it was another solid quarter as well. Leading indicators were highlighted by strong total deposits and solid retention, resulting in another quarter of positive net flows.
Third quarter deposits of $1.9 billion were up 8% from a year ago, driven once again by sales momentum in the mid-large market. Total withdrawals in the quarter were $1.6 billion and are elevated compared to the prior year. This reflects the lumpiness primarily in the mid-large market. Net flows of $219 helped move account values to a record high $49 billion as of September 30th, up 14% from a year ago. Moving forward, our ability to grow retirement business will be fueled by our focus on the fastest-growing markets, such as healthcare and government, that are aligned with our high touch value proposition and have attractive profitability characteristics. We have made meaningful progress in growing our presence in the mid-large market segment, and we expect that to continue.
We foresee similar success in the small case market, where we will be adding wholesalers to support already expanded shelf space with our strategic partners. Turning to distribution, it was another excellent quarter for our retail, wholesale, and worksite sales teams. They remain instrumental in our ability to drive our core strategies. Our strong, flexible distribution franchise, as you see again this quarter, has enabled us to maintain a diversified sales mix at attractive returns, successfully pivot between products, and keep pace with increased consumer demand for what we sell. Through our wholesale distribution, Lincoln Financial Distributors, we continue to grow the base of producers choosing to sell Lincoln products, up 15% from a year ago.
With an eye towards maximizing the value of our model, our cross-sell initiative, which is focused on influencing producers to sell multiple Lincoln products, continues to gain traction, increasing the number of producers with multiple product sales by 14%. Highlighting our retail distribution, Lincoln Financial Network, we are investing in capabilities that will allow us to attract and retain advisors as well as enhance their productivity. This group continues to drive sales of Lincoln product, leading the way in our pivot strategy. Simultaneously, investment product revenues and assets under management are delivering solid growth. Advisor recruiting remains strong with 220 advisors choosing to move their practice to Lincoln over the last 12 months.
You've heard me say this today, distribution is a differentiating strength for Lincoln, and we will keep making strategic investments as we look to enhance a footprint that already includes 8,400 advisors affiliated through LFN, 580 wholesalers in LFD, and some 540 representatives within our worksite teams. Spending a minute on investment management with average quarter-over-quarter treasury rates up, we put $2.4 billion of new money to work at a gross yield of 4.65%, up more than 80 basis points from our average new money yield in the first half of the year. The 4.65% investment yield is within 60 basis points of our portfolio's fixed income yield, easing the investment spread compression we have been experienced, and maintaining our overall portfolio yield at its second quarter level.
We continue to find value in yield-enhancing assets, investing $260 million this quarter at a gross yield of 5.8% in select strategies such as direct private placements, real estate mezzanine debt, and middle-market loans that further supported our new money purchase yields during the quarter. We also continued to commit capital to our alternatives program, both private equity and hedge funds, and we expect to achieve commensurate investment income aligned with our fresh commitments over the longer term. Let me close by saying once again that it was an excellent quarter of reported results, with good progress made on delivering the strategies that drive the success of our franchise. Looking ahead, our ability to execute those strategies, combined with expected tailwinds of rising interest rates, strong equity markets, and a consumer appetite for certainty, position Lincoln well for the future. With that, let me turn things over to Randy.
Thank you, Dennis. Last night, we reported income from operations of $367 million, or $1.34 per share for the third quarter, up 6% from the third quarter of 2012. There are a lot of things to like about this quarter. Before I dive into some of the details, I'll point out a few qualitative highlights. Our key earnings drivers, including account balances across all businesses, life insurance in force, and group premiums, all ended the quarter at record levels. Higher yields on asset purchases are reducing the drag from interest spread compression. We are earning strong returns on new business sales and the balance sheet, with statutory capital at an all-time high, strong RBC and net financial debt nearly at a post-merger low, is in great shape. With those high-level points as a backdrop, let's dig a little deeper into the quarter.
Key items of note include excellent top-line performance with operating revenue growth of nearly 6%, a continued focus on managing expenses with G&A up about 2% on a normalized basis, account balances reaching the record level of $197 billion, net realized losses related to investments coming in at a very manageable $7 million, an 11% increase in book value per share, excluding AOCI, to $44.37, an estimated RBC ratio of 490%, $100 million of share buybacks, and return on equity of 12.7% for the quarter. As noted in the press release, we had normalizing adjustments of $28 million, or $0.10 per share in the quarter, primarily attributable to our annual review of DAC assumptions and expense and tax true-ups. I'm very pleased that once again, when viewed in total, the DAC unlocking process had only a modest and positive impact on our results.
It's also of note that the impact by segment was relatively small. Both of those points speak directly to the overall quality of the intangibles on our balance sheet and in our income statement. On an aggregate basis, our variable net investment income, including alternative investments and prepayment income, was close to expected. Overall, another very good quarter. Turning to segment results and starting with annuities. Reported earnings for the quarter came in at a record $198 million, while ROE came in at 26%. The only item of note impacting annuity earnings for the quarter was a favorable $4 million dividends received deduction impact. I'll point out that while this is of note for the quarter, it is not a normalizing adjustment when viewed from a year-to-date standpoint.
Operating revenues increased 13% from the third quarter of 2012 as positive net flows and strong equity markets drove a 15% increase in average account values that, at the end of the quarter, reached $109 billion. The annual review of DAC assumptions created very little impact in the annuity business this year. It's encouraging that the changes made to our key policyholder behavior assumptions last year were validated by another year's worth of experience. Net amount at risk on living and death benefit guarantees decreased and both ended the quarter at less than 1% of account value. Hedge performance was again very good, with no breakage. A strong, clean quarter for annuities. In retirement plan services, we reported earnings of $33 million.
Quarter-over-quarter revenue growth of 6% benefited from an 11% increase in fee income as once again, positive net flows and equity markets led to a 14% increase in average account values, which at the end of the quarter climbed to $49 billion. The interest margin for RPS came in at 2.03% as the favorable impact of higher interest rates slowed the rate of spread compression in the retirement business. Adjusting for variable investment income, I'd estimate that normalized spreads decreased two basis points from the second quarter. As a reminder, interest spreads had been decreasing five to six basis points per quarter prior to the increase in Treasury rates. Return on assets came in at 27 basis points within our long-term range of 25 to 30 basis points. Turning to our life insurance segment, earnings of $140 million included $15 million of net favorable items, primarily attributable to unlocking.
The unlocking results were not driven by any one item, but rather reflected incremental changes to a number of the underlying assumptions. Life earnings drivers continued to grow at a mid-single-digit pace, with average account balances up 7% and life insurance in force up 4%. Mortality was somewhat elevated in the quarter, negatively impacting earnings by roughly $6 million-$7 million, while the prior year quarter was benefited by approximately $9 million of favorable mortality experience. Reserve financings completed over the last year reduced life's quarterly earnings by $3 million when compared to the third quarter of 2012. This factor, year-over-year compression in interest margins, and the previously mentioned mortality experience offset the underlying growth in life's earnings drivers. Group protection earned $23 million in the third quarter, compared to $16 million in the prior year quarter. The quarter's results included approximately $3 million of net favorable items.
Year-over-year improvement in the non-medical loss ratio of 73.4% was within our targeted range, down from 75.7% in the third quarter of 2012. Non-medical premium growth, which came in at 10% for the third quarter, has been consistent over recent quarters as the combination of expanded distribution and product offerings have expanded our sales footprint. Looking forward, while the overall economic environment will likely continue to interject some level of volatility into group's results, we expect to see continued gradual improvement from the group business as price increases on both new and renewal business benefit earnings. Before moving to Q&A, let me comment on a few items of note. During the quarter, we issued $350 million of debt to pre-fund upcoming maturities in early 2014. As a result, our holding company cash position of $1 billion will remain elevated through the end of the year.
Strong statutory results boosted total adjusted capital to $7.7 billion, while RBC came in at 490% for the quarter. As you may be aware, New York has announced that they are no longer recognizing the AG 38 solution for pre-2013 business that was reached with industry late in 2012. While the situation is fluid, based upon what we know at this time, we do not expect that there will be an impact on our capital deployment guidance. With $350 million of share repurchases through the third quarter, we do expect to exceed our beginning of the year guidance for $400 million of capital deployment. This will be the third straight year that strong statutory performance has allowed us to exceed our guidance. This was another strong quarter of financial performance. Reiterating those high level points, across the businesses, key drivers of earnings are all at record levels.
Higher interest rates are reducing the headwind of spread compression, pricing actions across the businesses have us earning strong returns on new business, our balance sheet is in a very strong position. Those points, the points that Dennis made in his comments, a gradually recovering economy have us well positioned to continue that strong performance as we look forward. With that, let me turn the call over to the operator for questions.
Thank you. Ladies and gentlemen, if you wish to ask a question at this time, please press the star and the number one key on your touchtone telephone. If your question has been answered or you wish to remove yourself from the queue, please press the pound key. We ask that you please limit yourself to one question and one follow-up. Our first question is from Randy Binner of FBR Capital Markets. You may begin.
Good morning. Thank you. I'm just going to pick up right at the end there where Randy left off on kind of the capital plan and buybacks. I appreciate the comments on this New York Department of Finance issue not impacting your capital plan. I guess what I'd say in my opinion and maybe other people's opinion is that you might be able to do more than $400 a year. I guess the first question is, there was $100 million in the quarter, that was a little lower than the first quarter. Are you holding back a little on what you might be able to do otherwise because of this? Is there any way to quantify what the RBC impact might be from this potential decision by the New York regulator?
Let's separate those questions. We're going to meet with New York in the coming weeks, so we'll have more clarity after we have that meeting. Based upon what I know today, and what do I know today? We're in a real strong overall capital position in total and in New York. We stopped selling SGO in New York earlier this year, I think in the first quarter. New York has indicated that any impact would likely be graded in. Based upon those facts, I don't expect any impact to our capital deployment plan. Over to the capital deployment that we talk about and which we have been able to exceed over the last few years. The numbers are right in line with what we said. We've upstreamed to the holding company so far this year, roughly $600 million.
We're right on track for our overall $800 million that we talk about sending to the holding company. Our holding company needs remain the same. Dividends are roughly $125 million. Interest expense is roughly $275 million, which leaves us that $400 million. We came into the year with a little bit of extra cash. We're using some of that extra cash to take us over the $400 million that we guided to coming into the year. When you move out going forward, we continue to look to leverage the balance sheet to hopefully exceed our guidance. Coming into any given year, we're going to continue to stick with that $400 million of guidance, because that is what the numbers indicate coming into any given year.
Okay. The free cash flow basically guides the buyback regardless of potential other buffer in a pretty high RBC ratio.
Yes.
I guess I'd reiterate the question. Is the outcome of the New York situation, could it affect RBC by 10% or 20%? Does it have the potential to? It's just hard to see the impact from the outside.
Randy, this is Dennis. We're in the midst of discussions with New York, I don't think we should front-run those discussions with having any more specific discussion about the New York situation.
All right. I understood. One final follow-up, which is important to this, that's on excess reserve financing. I know that's kind of implicit in the guide for the capital plan. We're getting late in the year here, has that been above or below or in line with expectations for now and the rest of the year?
Yeah, I think, Randy, in any given year, on average, we expect to do a couple of hundred million dollars of reserve financings. I think when all is said and done for this year, we'll meet or exceed that number.
Thank you.
Thank you. Our next question is from Erik Bass of Citigroup. You may begin.
Hi, thank you. I was just hoping you could talk a little bit more about the structure of the reinsurance transaction. Is the right way to think about this that it means that on the co-insured piece, you're essentially selling a VA without a living benefit guarantee?
Erik, I think the last comment is right. If I heard it correctly, we're essentially selling a VA without a living benefit guarantee. I think that's an accurate characterization. Let me step back a little bit on this. I have said company-wide, we are gradually changing the mix of the sales of long-dated guarantee products versus non-guaranteed products. Several years ago, this mix was 50/50. This year, we expect it to be 65% non-guaranteed, 35% guaranteed. We're moving in the direction strategically we want to go. With respect to this specific transaction, we're very pleased with the economics, and it's a good deal for both parties. To your point about profitability, the $8 billion reinsured block will remain well above our target returns and profitability after the cost of the reinsurance. I think it's a good transaction.
It's part of a broader strategic plan company-wide, as well as inside the annuity business. Again, inside the annuity business, you heard me talk about increasing the sales of non-guaranteed products, in part by directing our sales force that way. Also leveraged by our ability to create VA products who have as their benefit to the client, more asset-based opportunity and not guaranteed living benefits. It's just part, if you will, of a broader company strategy that we've been articulating. It's one tool. I think it's a very good transaction, again, for both parties. Very happy with it. It's part of this longer-term strategy that we have for Lincoln.
Thanks. That's helpful. Just one specific question on the structure. Do you retain the ability to adjust the living benefits feature, or are you locked into the current terms through year-end 2014? Meaning to change either the roll-up rates or the pricing on the feature?
I don't have the specifics, I think we retain, as we do with all products, the ability to adjust the underlying characteristics subject to the guarantees.
Okay. Just, Dennis, to your comment about shifting the mix, are there any other actions that you're considering to potentially accelerate the mix shift goals that you talked about?
Well, again, if you step back and look at the company in total, one very good example of this is in the life insurance business, where we've gone from long-dated guarantees representing 75% of our sales, to now only representing 19% of our sales, 19%-20%. That's a big change. If you look at the emphasis that we have on growing the retirement business and you hear about billions of dollars of sales, those are all sales without guarantees. That's important. If you go over to, of course, the group business, we're accelerating the growth of that business. Those are all sales without long-dated guarantees.
Company-wide, there's quite a few things, specifically inside the annuity business, reinsurance, products with a value proposition for the customer that is not living benefits, but is more high asset return inside a tax-deferred wrapper, the way we used to sell variable annuity products, sales incentives. It's a part of the broader scheme, or excuse me, the broader targets for Lincoln, strategic targets, and we're going to pull as many levers as we can. Let me finish by saying, excuse me, that the business that we're selling, the VA business with living benefits, in this particular marketplace have very, very strong returns, and we like that business.
As we go forward, we want to continue to grow our overall variable business at a good pace, but within the overall variable annuity business, we'd like the VA business with living benefit guarantees to be at a slower pace of growth. Okay?
Perfect. Yeah, appreciate your comments. It's just the last thing, you didn't mention any in-force actions. Is that something you would contemplate as well, or do you really see the mix shift being driven by kind of the actions you're taking on the new business front?
We've seen what some other companies have done on that. We've looked at our own products and our own profitability, and candidly, it just doesn't make sense. We've got very good business on the books, and we like the business that's on the books. It's been well-priced all along. I don't think we'll be tampering with contracts that are in place.
Okay. Thank you for the comments.
Thank you. Our next question is from Jimmy Bhullar of J.P. Morgan. You may begin.
Dennis, you mentioned looking at it as selling a VA without guarantees, but it's a 50% co-insurance contract, so I think the right way would be selling a benefit with lower or selling a contract with less guarantees, but not without guarantees, right?
I answered the question. I thought it was with the half that did not.
If you sell $1 billion in a way you've only sold $500 million with guarantees and $500 million without, that's sort of the way.
Yes. Right. If I'll come back to my other point is that if you do look at it in total, it being the $8 billion block, it does have a better risk profile, and the ROE on that business is still above our expectations.
As you looked at various alternatives than just the reinsurance option that you ended up choosing, what's your view on the availability of reinsurance or other solutions for legacy blocks, whether recently written or written around the financial crisis?
Yeah. You've heard me say this before, but I think smart money has been moving into this segment because of good risk-reward opportunities. Generally, as in this case, partnering with an experienced manufacturer. We've seen different transactions in the past 6 months. It's my expectation if the risk-reward dynamics stay the way they are now, I would guess some people would be more interested in looking at it.
On your retirement business, you had pretty strong deposits, and that's been a trend recently, but your lapses picked up this quarter. Wondering if you think that that's more of an aberration or did you see anything that was driving the uptick in lapses, whether they were concentrated in a certain market segment or industry?
Yeah. It goes to my comment about this business is lumpy. It's lumpy on the new sales side because when you make a sale, it's usually pretty big relative to our overall sales. The pattern of how often people reprice business that they have with us now fluctuates from quarter to quarter. We win some, we lose some. Just in general, it's the lumpiness. I don't see any different pricing characteristics at Lincoln over the past 12 months that would drive sales one way or the other.
Okay, thanks.
Thank you. Our next question is from Yaron Kinar of Deutsche Bank. You may begin.
Hi, good morning, everybody. Going back to that reinsurance treaty, can you talk a little bit about kind of choosing this alternative over other alternatives that were at your disposal, including maybe just shrinking sales altogether? Maybe if you could also touch upon just the pricing, which I'd been under the impression that for a very long time, reinsurance pricing on VA books was just exorbitant. Has that pricing come down a bit and make this alternative more palatable?
Well, let me once again repeat what I said. The economics both to the reinsurer and to Lincoln are excellent on this, or we wouldn't have done it. Said another way, our understanding of the overall liability and the price at which the transaction traded, again, is very positive for both parties. We will continue to look at every opportunity to diversify our risk across the company as well as within the individual annuity space, as I just mentioned. We've made good progress. We have several tools. We'll use those tools as they come about. Let me come back to why not stop selling the product. First of all, why stop selling a product that is getting exceptional returns in the current market? We just had that validated by some of our outside pricing consultants.
This particular period in time, the pricing on the VA is as good as it's been. The VA with living benefits is as good as it's been. We're going to stay in this marketplace because we're getting good returns. The volume, as I said as well, we continue to sell and see the VA business volume grow, the total growth is going to be faster than the VA living benefits. Finally, let me come back to the point about, just cutting off sales or in some artificial way, reducing sales. That is so contrary to the way we run this business. We're not going to artificially yank a product or cut off 1035 exchanges.
We have to be in the business consistently, and we think if you're in the business consistently, the long-term value with your partners, the long-term profitability, are going to be better if you're not in the business consistently.
Okay. One follow-up. You talked a little bit about the financial services, the developments with the superintendent there. Could you also maybe comment about the June proposal, FASB proposal, and your thoughts on that?
June FASB proposal. Randy, would you take that, please?
Oh, yes. Sure. We commented. I assume you're talking about the new approach to accounting for insurance contracts.
Yes.
Premise my response to that. We provided a response. In general, while we're supportive of FASB's efforts to come to a more converged system across the globe, we're not in support of the particular approach that was described in the exposure draft, and we expressed our opinion in our comment letter. I believe that the approach they've taken would not be good for investors. It would not lead to a better understanding of insurer financial statements. I think it would be a negative in terms of the metrics that historically have been used to measure performance in the insurance business. For all of those reasons, we're not in support of the exposure draft as described.
Thank you very much.
Thank you. Our next question is from Suneet Kamath of UBS. You may begin.
Thanks. A couple follow-ups on topics already talked about. Just on the reinsurance deal, just to make sure I understand the philosophy here. Should we expect a change in your appetite for variable annuity sales going forward? I know there's been some concern on recent calls that maybe you're gaining a little bit too much share as some companies have sort of pulled back. Now you have this reinsurance deal. Should we assume that whatever the sales plan was for 2014 before the deal is going to be roughly the same as what it is now that you have the deal?
I think that's a good way to think about it, yeah. We're not going to try to pump sales next year just because we have this plan. We're going to stick with our sustainable and consistent marketplace approach.
Got it. Okay.
Yeah.
Dennis, you had said in your opening comment that when you're talking about product profitability, that most of your products are achieving your target returns. I guess I'm wondering which products do you feel like you have some more work to do?
That was specifically the big product change is MoneyGuard and the life business unit. That generates a lot of our premium, our sales. That's one example. As I said, it'll be ready to go in the first quarter. There may be much smaller products here and there that continue to need updating. What I'm trying to get at is on those products that drive most of our new sales, we're pretty much done with what we have to do. I'd also add to that, pretty much done with what we had to do based on the yield curve that was in place a couple of months ago. As I look forward over the next several years, if in fact interest rates rise, we're going to be beating our pricing expectations.
Quite a different story than the last two decades where you had secularly declining interest rates, and you were always chasing declining interest rates and having to reprice.
Got it. One other one on the new money investment rate, the 4.65%. I guess my question is how much more capacity do you have to pursue these yield-enhancing investments? In other words, how sustainable do you think that 4.65 is as we think about the next several quarters?
Yeah. I think the 4.65, in part, had that little bit of spike of up to 280, 293% in the 10-year in it. I think in the fourth quarter, we might be down 10 or 15 basis points off of that level. That's the dynamic of what's the sort of underlying interest rate that you start with. There was no significant mix difference in the third quarter than what we'd expect in the fourth quarter coming from those higher earning investments.
Okay. Just the last one on this New York issue. I thought in your press release, you had cited the RBC ratio of Lincoln Life & Annuity Company of New York as opposed to LNL. I guess I'm just trying to think about as we think about this issue, should we be considering whatever ends up happening, impacting just the New York sub or impacting potentially LNL as well, as well as the other subsidiaries?
Yeah. All indications are that this is just the New York sub. We pointed that out because I think at the end of the day, the New York sub will be able to handle any impact.
Right. Understood. Yeah, I guess there's an earlier question about RBC impact. Sounds like what you're saying is you're fine in terms of the New York sub, and we don't need to worry about LNL.
Yeah. I do not anticipate a major impact on the overall corporation's RBC. Remember, we ended the quarter at 490.
We're in a very strong position. New York represents roughly 10% of the overall capital of the organization, so the vast majority of our capital sits in LNL. I wouldn't anticipate a major impact on the total capital position of the company.
Thank you.
Clearly, if the New York needs a little more capital, that takes New York's included in the 490, just to be clear.
Right. I think you stated the RBC of New York was pretty high, right?
Yeah, it was in the five, high five.
Yeah. Right. Okay. All right. Thanks.
Thank you. Our next question is from Mark Finkelstein of Evercore. You may begin.
Hi, good morning. I want to go back to the VA question or the VA reinsurance transaction. Maybe just a very specific transaction in how it will function. Typically, with a co-insurance agreement, you split the economics at the said percentage. My question is this, are you essentially going to be giving to Wells Fargo the fee rider that you charge for the living benefit guarantee? Is it going to be more than that? Is it going to be less than that? How should we think about that?
Well, again, I appreciate all the questions around this, as a practical matter, we're not going to discuss the specifics of the pricing for a couple of different reasons. One, competitive. Why would we want to share that with our competitors? Two, in negotiations with a single entity, we're just not going to get into details about the give and take or who gets what and how. I think we're just going to stay with the point that I've made a couple of times, the economics were good for both parties, and we certainly analyzed this from the perspective of getting the right economics for the risk that we were being relieved of. That in total, after we pay the cost of the reinsurance transaction, our ROEs are going to be above our target ROEs for VA business.
Okay. All right. Well, thought I would try.
No harm in trying.
Exactly. I guess, Randy, can you just talk about the assumptions study a little bit? You didn't do anything, and I'm thinking more on the VA side here. You didn't do anything on the equity. It doesn't sound like you did much on the laps. Can you just talk about maybe those two areas and what led you to the decision to keep things as they were?
Sure. Mark, I'll remind you that in 2012, we made major changes to the lapse assumptions in the annuity business. As I noted, a year's worth of experience validated everything we did, both to lapses and utilization. There was no major need inside of those products, the annuity products, for any major impacts to the lapse assumption. To think about the life business and across the company, we made the big change to the J-curve, the long-term earned rate assumption the other year. That major impact was behind us, and rates are up some since then. We made a lot of the major changes in previous years. We came into this year with an expectation that we were in good shape and we weren't going to have major impacts.
Specifically to the long-term earned rate assumption, we made some small tweaks to specifically the bond return component of the long-term earned rate assumption. I think I noted in previous quarters that our average long-term assumption was 8.6%. The changes we made brought that down to 8.4%, so we did make some small changes. I would also note that we did not unlock our corridor. When you think about what is right now an immediate 14% drop in returns embedded in our DAC models, you have an overall lifetime effective return inside our DAC models right now in the mid sevens. That is a rate that is easily supportable, along with the 8.4% return assumption, by the way, by any set of long-term data that you can look at.
Okay. Maybe if I can just sneak one more in. Thinking about free cash flow a little bit, and we continue to talk about $400 million as how we start a year. You're pivoting to lower capital intensity products. You are growing a bit, I agree on that.
You also have said that the free cash flow should grow with earnings. Earnings, I think have grown better than most people are expecting. Why do we tend to go back to the $400 million as a starting point? Why shouldn't that number be higher?
Well, I think if you think about the last, let's talk about the last few years, which is when we've been talking about $400 million of free cash flow. You've had a lot of other anomalous items that have come into the equation. You've had an AG 38 solution that's coming. You've had a number of these items that have come along which have impacted the free cash flow number. I think that's why you've really been steady over the last few years. Looking forward, just as you said, and I'll reiterate, I expect that free cash flow will grow with the earnings of the organization, and it will grow as we shift our mix of business to lower capital intensive products. That's in the future, and we'll talk about those items when we get closer to that future.
You know we don't give guidance, we don't give guidance. These things happen over time. They don't happen immediately. I fully expect that free cash flow will grow as we look forward.
Okay, thank you.
Thank you. Our next question comes from Chris Giovanni of Goldman Sachs. You may begin.
Thanks. Going to follow up again on the reinsurance deal, wanted to see if you can talk a little bit about some of the economics, certainly there are a lot of strategic decisions for doing this. If you tried to compare maybe the differential, the comparison of the ROEs between pre-reinsurance deal versus the post-reinsurance deal, what would the differential on the ROEs be?
Chris, if we priced the block, if we looked at the block before reinsurance and then after reinsurance, the change in the ROE is 1% or 2%.
Okay, that's helpful. We haven't really seen these really since the financial crisis. I think a lot of your competitors are having to address kind of this deal today, but wondering, was it just this one reinsurer? Were there other reinsurers that were willing to share the risk with you? Do you think this is something unique to Lincoln where the metrics that you guys clearly have shown is that your business is more profitable than some of your peers? Just reinsurers in general are looking to get more involved in new business risk?
It's difficult to say, and this isn't going to be specifically responsive. We've continued to see, and I said it earlier, but we've continued to see smart money coming into the annuity space. My view, this is, in terms just of the balance of trade, if you will, between the reinsurer and us, was as good as anything that's been done in the marketplace for the last, well, since before the crisis. That's in part related to two things. The math for VA business today, in terms of generating returns, is so much better than it's been over the last three or four years. That's one dimension of it. Is the point that you're making. We do have one of the best track records in the industry for developing profitable business. We have one of the best track records for hedging this business.
It's a combination of, again, at this moment in time, good economics for everybody, people looking for a little bit of extra return on their businesses, and doing it with a really strong manufacturer.
Okay, totally agree. Just one maybe for Randy. Wanted to see if you could talk a little bit about maybe what the spread is of the living benefit rider fees that you're charging today versus the cost to hedge. Where does that spread stand today versus maybe 12, 18 months ago before the capital market movements that we've seen and kind of the tighter risk parameters that you've been putting on the products?
Sure, Chris. It bounces around, right? It bounces around day to day with the capital markets. On average, I'd say you're running in the 80% range right now. We charge 100 to 110 basis points, and the cost of hedging is roughly 80% of that.
Where would that have been 12 or 18 months ago? Would it have been similar? You've just been adjusting the fees to keep that 80% ratio constant?
Yeah, absolutely. We've been adjusting the benefits and the fees over time. There have been periods of time where the fee's been lower than the cost of hedging. There have been times when the fee's been quite a bit above the cost of hedging. I think with the adjustments we've been able to make, we've been able to keep that sort of 80% ratio pretty consistently over time, whether you're talking about today, a year ago, or five years ago.
Okay, thanks so much.
You bet.
Thank you. Our next question is from Thomas Gallagher of Credit Suisse. You may begin.
Good morning. First question is just on the business mix. How are you now, and Randy, I know you mentioned you're going to surpass the $400 million of buybacks for this year. As we think about going forward How are you now thinking about the balance of M&A versus share repurchase, especially considering a desire to rebalance the business mix in some way?
Tom, maybe I'll take that question. Again, this may not be specific, but I'll start with saying that we build the business on the basis of organic plans. We don't look to acquisitions as a sort of ongoing opportunity to do things. Our organic business plans are directed in getting us to the targets that we're talking about. On the sales mix, we'll get there faster organically than we would be able to change the earnings mix to a higher mortality component. That's just the math is, because math is math right now. We're going to continue to grind away on an organic strategy to accomplish what we want. If a deal comes along that helps us accelerate our organic plans, we will of course, look at it.
As you look at M&A all the time, the litmus test is, given the risk of what you're doing and given the return that you're going to get on it, how does that compare to the return you're going to get by buying your shares back? Now, obviously, with the share price moving up a little bit, the debate there gets a little closer. We'll continue with that general strategy and the general way we look at things.
Tom, let me just add, over the last 12 quarters, we've spent $1.4 billion on share buybacks at an average price of $25 and just a little over $25.50. The analysis based upon what we do when you sat down and looked at whether or not share buybacks was a slam dunk, right? I mean, the expected return based upon our analysis was just world-class. That made the rate of return you needed to use as part of any M&A analysis pretty high because the hurdle for other uses of capital was pretty high. That's obviously changed a little bit, but I still think that share buybacks where we are today, trading right about book represent a pretty good place to put capital. We've done that, and we will continue to do that.
I'd also add to that you're not going to do acquisitions out of free cash flow. The guidance around stock buybacks comes from this holding company free cash flow. In any one year, we might have to take a harder look at that. The ongoing free cash flow is more about dividend levels and stock buybacks than it is about M&A.
No, that's helpful to hear both of your perspectives on that. I guess the follow-up is to what extent is, and I get the comparison between buybacks and M&A, and Randy, I hear you certainly 1 to 2 years ago, there was a pretty obvious disparity there. To what extent are you also factoring in enterprise risk management from the sense that the volatility and if things go bad in the market and what better balancing your business would do? I think the analysis of IRR looking at the ROE comparison doesn't factor in volatility and enterprise risk. I don't know if that's something that you've contemplated and how that would weigh in.
Yeah. Well, let me differentiate a little bit. I think what you're talking about, I would describe more as economic capital. It's what are your capital needs when you look at various stress tests.
Right.
It's obviously a key component of what we do as an organization when we think about our overall capital needs. You see it embedded when we talk about a long-term RBC requirement of 400%. You hear it when we talk about drawing that RBC down over time 10 to 15 points a year. Stress testing, driving capital requirements, looking at the tails, key part of how we run the business today. The broader topic of enterprise risk management is embedded in everything that we do. It's embedded in what Dennis talked about, the strategy of shifting to a mix of business that has a lower percentage of long-term guarantees. It's embedded in the product design that Mark and Chuck and their teams do on a daily basis. Enterprise risk management is a very broad topic that is practiced every day in almost everything that we do.
Okay, if I could just sneak in one last question, just a technical one. Randy, I think you had said for the variable annuity separate accounts, the new long-term return assumption is 8.4%?
Yes, on average, 8.4%.
On average. If you consider the cushion embedded in on the equity side, I think that would drop all the way down to 7.5?
Right around 7.5.
My question is, several peers have made that adjustment, then taken what in your case would be 8.4 down to 7.5. In your case, if you did that, there would be a neutral impact, right? I guess the backward-looking gains would be offset by lower prospective-looking assumptions. Why not just make that adjustment and have this 7.5 going forward? The only thing I can think, and maybe this isn't right, is that if you did make that adjustment, I think there would be a requirement to amortize more DAC going forward because of the way the accounting model works for future DAC amortization. I just wanted to ask you that question.
Sure. Well, first off, I don't know the net impact on amortization. I tend to think that the net impact on amortization wouldn't be that large one way or the other. As to the long-term earn rate assumption and the short-term corridor, I discriminate between those and differentiate between those two items. The long-term return expectation of 8.4 is linked to our view of what the market should support going forward over an extended period of time. When determining what that number should be, we spend a lot of time looking at history, a lot of time looking at expectations. I think in our analysis, based upon really any long-term view of history, 8.4 is a very supportable long-term assumption. In terms of the corridor, that's sort of a near-term expectation of the marketplace, and that's why you have that down 14%.
I differentiate between the two. I think the 8.4% long term is very supportable based upon history. I think the corridor, we're well with inside the corridor, so there really isn't a reason to unlock that. I don't believe, I haven't, once again, analyzed the numbers in any depth, but I don't believe you see a big difference in amortization coming out of either approach.
Okay, thanks. That's helpful.
Sure.
Thank you. We have time for one more question. Our last question is from Seth Weiss of Bank of America Merrill Lynch. You may begin.
Hi, thanks for taking the question. Just a question on the broader competitive environment of variable annuities. You've spoken several times about the very positive economics of the annuity space right now, and I think we clearly see that in terms of rider pricing trending up while features have tended to move less generous. I would say within the last year or so, part of that would probably be from capacity being removed from the system. If we look at smart money now coming in terms of this reinsurance agreement as one example, do you see any risk of this favorable competitive dynamic perhaps shifting in the future?
It's hard to predict what market participants will do. The trend over the last several years has been to more risk-sharing of the risks between the customer and the manufacturer. The trends have been to less rich benefits in total. The people who were aggressive have left the marketplace. I think there's going to be a pretty decent balance as we go forward. I'm pretty optimistic about there being a good balance, competitive balance.
Okay, thank you. Those comments are helpful.
Thank you. I would now like to turn the call back over to Jim Sjoreen for closing remarks.
Well, thank you, excuse me, thank you, everybody, for joining us this morning. I know we didn't get to all the questions. We're going to be available to take those questions. You can either give me a call or call our 800 line in investor relations at 237-2920, or email your questions on our website. Again, thank you for your participation today, and have a good day.