Good morning, and thank you for joining the Lincoln Financial Group's second quarter 2013 earnings conference call. At this time, all lines are in listen-only mode. Later, we will announce the opportunity for questions, and instructions will be given at that time. If you should 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 Shirine. Please go ahead, sir.
Thank you, operator, and 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, 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. I would now like to turn the call over to Dennis.
Thank you, Jim, and good morning, everyone. Overall, it was a great quarter, with all of our businesses performing very well. At our recent investor conference, we reiterated our strategy to capitalize on Lincoln's key strengths in the current economic environment. An earnings mix driven by growing equity markets, rising interest rates, and mortality and morbidity, coupled with an unusually strong distribution franchise that allows us to pivot nimbly between products that maximize returns from among this earnings mix as market forces change and consumer demographics that increase the demand for what we sell. This quarter underscores those strengths and demonstrates our execution on that strategy, and the numbers speak for themselves. From the conference, you may recall that a little more than a third of our earnings are driven by equity charges.
The combination of strong net flows and rising equity markets consequently drove equity-based revenues up 20%, which contributed to company-wide revenue growth of 6%. You'll also recall that another roughly third of our earnings are driven by investment spreads. Those spreads have been declining as interest rates fell. Rates have firmed up a bit, allowing us to invest new money at about 190 basis points over the 10-year treasury today for a gross investment yield around 450. This gross yield is about 85 basis points less than our portfolio yield. The good news is that the rate of investment spread compression will abate at today's market yields. The possibility of a turning point to improving investment spread may be coming sooner than we expected.
Remaining earnings are derived mostly from mortality and morbidity. We saw much better mortality and morbidity results in our group life businesses as compared to the first quarter. We highlighted at the conference the strength of our distribution franchise and our ability to Pivot to both good customer solutions and more profitable products that improve ROE. This trend continued in the second quarter with outstanding sales results in every business accompanied by stronger new business returns. Following the collective pricing actions we have made, most of our products are expected to achieve unlevered returns in the 11%-13% range. With leverage, 13%-15%. A positive exception is our VA business, which is producing unlevered high teen returns. We will be focusing on improving product returns even further in the coming months.
Taking action to significantly improve new business returns, along with the repurchase of $150 million of our shares, reflects our continued focus on capital management and deploying capital at good returns. We also indicated during the conference that we lowered the amount of certain long-dated guarantee products. In other words, fewer sales of GUL and VAs with living benefits relative to total sales on a profit-adjusted basis. Despite a temporary spike in VA sales in the second quarter, these long-dated guarantee products represented about 40% of our product sales in the first half, down from 50% a few years ago. Our midterm plans focus on keeping long-dated guarantee sales around 30% of total sales. I'm also pleased to report that Moody's upgraded our ratings and Fitch affirmed them. The agencies cite diversified earnings mix, distribution strength, and superior risk management as key strengths for Lincoln.
Let me now share from our underlying segments some highlights, staying with the broad themes and starting with individual life. Second quarter sales in individual life of $183 million are back to pre-Pivot levels. Quite a remarkable accomplishment, which speaks to our broad solution set and our powerful distribution capability. Pivot products, which include variable universal life, indexed universal life, flexible premium MoneyGuard, and term insurance, were up 137% from the same quarter last year. Guaranteed UL sales continued to decline, accounting for just 15% of second quarter sales. Repricing continued, with new versions of single and joint life GUL products being introduced in the quarter. Changes to our MoneyGuard product were also introduced. We will continue to make revisions to boost returns while working towards the launch of a redesigned product early next year. In our annuity business, it was a very good quarter.
Annuity sales of $4.2 billion drove net flows of $1.7 billion. Account values increased 14%, reaching $103 billion. We anticipated strong VA sales in the second quarter, in part the result of accelerated sales ahead of benefit changes rolled out in May. Average sales volume has declined by roughly 25% off the May run rate. We expect VA sales to moderate in the last half of the year. Our risk managed fund strategies on our VA products continue to anchor new deposit flow. Of the $3.9 billion of deposits in the quarter, 80% included a guaranteed living benefit rider built on these strategies. 9% of deposits had no living benefit guarantees at all. Let me remind you of the significant value that our risk managed fund strategies provide to Lincoln clients alike.
These solutions embed volatility management inside client accounts, enhancing account value stability, and lowering our hedging costs. In group protection, second quarter sales of $95 million increased 7% from the prior year. Our performance remains driven by targeted strategies in the voluntary space and disciplined distribution expansion. We continue to achieve strong results in the voluntary market. Sales grew by 64% in the second quarter, led by good growth in both new and existing products. Our field force grew by 9% from the prior year, as we keep investing in the group business by making selective hires that complement our emphasis on the voluntary market and that can deliver our broad portfolio of solutions. As we have shared on the last few calls, we remain diligent in our efforts to achieve strong profitability through new sales, ROE, and renewal actions.
We are seeing results, with new sales profitability in line with our expectations of 12%+, and renewal actions meeting or exceeding our expectations for both rate increase and persistency. Moving to retirement plan services, it was another excellent quarter for all leading indicators, with strong total deposits, solid retention results, resulting in positive net flows. Second quarter deposits of $1.6 billion were up 25% from a year ago, driven mainly by ongoing momentum in the mid-large market. Net flows for the quarter were $337 million, up 68% year-over-year. Strong inflows, combined with no large terminations, contributed to our eighth straight quarter of positive flows and record account values of $47 billion, up 14% from a year ago. We continue to broaden our market presence through new distribution opportunities.
Two notable examples are we recently expanded our partnership with Bank of America Merrill Lynch, one of the largest distributors of small employee DC plans, through the launch of our small market solutions. Our push in the mid to large government space is already adding to our sales pipeline. These initiatives, as well as others, will drive further growth of RPS and increase our overall presence in this business. In distribution, our retail, wholesale, and worksite sales teams continue to drive our core strategies and remain, again, a differentiating strength for Lincoln.
Annually, we reach more than 65,000 active producers. That reach is expanding, as evidenced by 16% more producers recommending our solutions in the first six months of this year versus the same period last year, and the expansion of strategic partnerships in the quarter, such as the Merrill Lynch partnership that I just mentioned, as well as the introduction of new fixed annuity products for Primerica and JPMorgan Chase. Selling additional products through our active producer base is a key strategy, with many of our sales initiatives tied to these results. We have seen good traction in the last year. Notably here, the number of advisors selling multiple Lincoln products increased by 9%.
We will keep making strategic investments in distribution as we look to expand a powerful footprint that already includes 8,400 advisors affiliated through LFN, 600 wholesalers in LFD, and approximately 550 representatives within our worksite teams. Spending a minute on investment management, I want to highlight the quarter's strong alternative investment performance compared to the first quarter. Pre-tax alternative net annualized return was about 14% in the second quarter compared to 3% last quarter. Our alternatives program has historically produced solid results, albeit variable. Going forward, we expect to see similar results, that being attractive long-term returns with period-to-period volatility. We have made progress in committing capital to our alternatives program, both private equity and hedge funds, with the carrying value of our alternatives program increasing by more than 20% year-over-year.
As we grow our program from 1% of total assets to about 1.5% of total assets over the course of the next two years. At 1.5% of total assets, this is well within our risk appetite and is significantly lower than the average of our peers. We continue to find more yield in select core strategies such as private placements, direct middle market loans, and commercial mortgage loans, as we have mentioned previously. Let me close by saying once again that it was an excellent quarter of reported results, with good progress made on actions to build our franchise and expand our growth potential. An environment of slowly rising interest rates, growing stock market, consumer preferences for certainty, and demographics are powerful tailwinds for our industry and Lincoln specifically, given our earnings mix. With that, let me turn things over to Randy.
Thank you, Dennis. Last night, we reported income from operations of $351 million or $1.27 per share for the second quarter, up 17% from the second quarter of 2012. Overall, it was a very strong quarter across all key metrics. Of note, excellent top-line performance with operating revenue growth of nearly 6%, up from the 4%-5% level of recent quarters. Tight management of controllable expenses with growth in G&A primarily attributable to strong production and share price performance. Adjusting for those two items, G&A was up roughly 3%. Account balances increased to a record level of $189 billion. Strong general account performance with realized losses related to investments coming in at a very manageable $22 million.
Balance sheet strength with GAAP book equity per share, excluding AOCI, up 13% to $43.21, $693 million of cash at the holding company, an RBC ratio of 485%, $150 million of share buybacks, and return on equity of 12.4% for the quarter. As noted in the press release, we had no normalizing earnings adjustments in the quarter, but we did quantify $19 million of positive earnings impact from higher than expected investment income on prepayment fees. All in all, a very good, clean quarter. Turning to segment results and starting with annuities. Reported earnings for the quarter, which included $9 million of higher than expected prepayment fees, came in at a record $195 million, while ROE came in at 26%. Operating revenues increased 11% from the second quarter of 2012, primarily on higher fees driven by a 15% increase in average account values to $104 billion.
This was a very good quarter for the annuity business that really exemplifies everything that we covered at our June investor conference. A history of responsible product pricing on VAs that has put us in a very favorable risk position relative to our peers with a net amount at risk on both living and death benefit guarantees at roughly 1% of account value. A high-quality book of business that has always delivered strong returns that are being pushed to record levels with the strength of the equity markets. A consistent and disciplined approach to controlling new business flows that saw us increase pricing on VA products during the second quarter, and a hedge program that continues to deliver excellent performance with no breakage in the quarter. In retirement plan services, we reported earnings of $39 million, which included $5 million of higher than expected investment income from prepayment fees.
Quarter-over-quarter revenue growth of 5% benefited from a 9% increase in insurance fees, the result of a 14% increase in average account values. The success of our retirement business to attract and retain assets under management continued in the quarter. Account balances at quarter end were $47 billion, a record level, and up 14% over the prior year quarter. Interest spread performance for the quarter was strong, coming in at 2.14% as retirement benefited from the prepayment fees mentioned earlier. Adjusting for this return on assets came in at 29 basis points, right in line with our expectations. Turning to our life insurance segment, earnings of $135 million included $5 million of excess investment income from prepayment fees. Life earnings drivers continued to grow at a mid-single-digit pace, with average account balances up 6% and life insurance in force up 3%.
Interest spreads came in at 1.98%, with the quarter's strong performance benefiting from the prepayment fees mentioned earlier. Group Protection earned $22 million in the second quarter, which marks a nice turnaround from recent quarters. The non-medical loss ratio returned to the targeted range, coming in at 73.5% for the quarter. I'd attribute the improving loss ratio to strong performance from the disability book as key metrics such as incidents continued to perform nicely, and an improvement in life mortality from last quarter's elevated levels. The group business is also benefiting from strong premium increases, with renewal pricing up in the mid-single digits during the second quarter. Non-medical premium growth, which came in at 9%, continues a positive trend of high single-digit growth rates, the result of increasing our distribution presence, new product offerings in the voluntary space, and pricing increases.
There was no change to the discount rate on new claim incurrals, which was reduced to 3.75% in the first quarter. Before moving to Q&A, let me comment on a few items of note. The increase in interest rates will have a positive impact on potential spread compression. Entering 2013, we had provided guidance that with the 10-year treasury at 1.5%, that we would experience roughly $100 million of negative earnings impact in 2014. Assuming that the 10-year treasury stays near current levels, I'd estimate that the negative impact on 2014 results has been reduced to approximately $35 million. We have also taken advantage of the slope in the forward curve by locking in the underlying treasury rates on another $850 million of future reinvestment needs.
Including previous rate locks, we now have in place hedges on over $1.8 billion of future investment needs at an average rate that is roughly 110 basis points in excess of today's rates. The majority of these rate locks are associated with our guaranteed universal life book of business and represent roughly 50% of in-force GUL cash flows over the next four to five years. The life company sent $215 million in cash to the holding company during the quarter, while statutory capital and RBC remained level for the quarter at $7.5 billion and 485%, respectively. With $250 million of share buybacks so far in 2013, we are on track to meet or exceed our beginning of the year guidance for $400 million of capital deployment. 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, then the number one key on your touch-tone 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 Yaron Kinar of Deutsche Bank. You may begin.
Good morning, everybody. I wanted to maybe dig in a little deeper on the rate sensitivity and start thinking about reverse sensitivity, namely, if the rates actually come in higher than your expectations. I know that on the 10-K you had given some disclosures as to roughly $35 million of headwinds that you just talked about in the opening comments as well. What happens if rates actually come in 50 basis points above your estimates or 100 basis points above your estimates? Have you done any sensitivity work on that?
Yaron, this is Dennis. This is sort of what I was driving at. We're about 85 basis points lower than our portfolio rate. To rough justice, if our new investment yields get up to our portfolio rate, that would stop spread compression.
Yaron, this is Randy. I'll just add, I want to make sure we're comparing apples and apples. The $35 million you referenced was what we put in the 10-K, and it was the impact on 2013 results with rates at 1.5%. $35 million is my updated estimate for 2014, which is down from $100 million previously. We've seen a significant reduction and improvement in potential spread compression because the treasury rates have increased 75 basis points or so.
Understood. Thank you for the clarification. I don't know what your forward estimates are, but let's say that you were actually 50 basis points below or 100 basis points, whatever number you want to choose. What impact does that have on 2014 numbers?
Yeah. We don't give the impact of X basis points. As Dennis mentioned, we're roughly 80, 85 basis points below our portfolio today, we've come about halfway, and it's cut the impact substantially. I would say if you got another 75 basis points or 80 basis points in an increase in treasury rates, you'd see the negative impact across Lincoln eliminated.
Okay. The follow-up question is on the retirement business. Clearly, mid to large market accounts are growing. Can you give us an update as to what competitive trends you're seeing there and what demand's looking like there?
Yeah. Overall, I would say that it's a competitive marketplace. In the mid to large market, rebid activities remain high. Seeing a little more competition with small market providers move up into the middle market. Pricing pressures sort of continue to be there. In the small market, again, becoming more crowded, but we're still getting our fair share. What I say, in general, is in the small market, we're achieving our returns. We're getting good growth. We're expanding distribution. We have new systems. We have, again, expanding distribution. That's a good long-term market. We need to continue to invest in the expansion of distribution. Again, the shelf space is pretty remarkable, the achievements we've made there. In the mid to large market, we have this emphasis in the government space, as I mentioned. That has good growth characteristics.
A little bit less price sensitive, a little harder to get done. Overall, from Lincoln's perspective, I continue to see pretty good growth in this business and pretty good ROE development. A little tougher in the mid to large market to get the returns that we want. Again, I think we have a very good position getting better known in the marketplace for all the achievements that we've made over the last 24 months. We're pretty positive on the continued growth of that business too.
Well, thank you very much, and congratulations on a great quarter.
Thank you.
Thank you. Our next question is from John Nadel of Sterne Agee. You may begin.
Hey, good morning, everybody. A couple of questions for you really centered around annuities. If I look at the annuity segment results this quarter, and I strip out those higher prepayments that you mentioned, earnings really jumped about, I don't know, about 15%, 16% from the average of the past few quarters. I'd expect, I think we would all expect that higher account values, stronger markets, that the EGP are higher and that all else equal, even DAC amortization should come down a bit. Maybe you could update us on where you are. How much you expect that DAC amortization to be lower than it has been previously? And then within the corridor, given the strong market performance, I know you are already reasonably close, I know you're the upper end, where are you now?
Hey, John. It's Randy.
Hi, Randy.
Let me answer your question this way. First, I'm going to compare the second quarter to the second quarter of last year, and then I'll talk about the sequential quarter.
Okay.
When you look year-over-year, earnings are up 23% or so, and that's pretty much primarily driven just by AUM growth. The growth in the amount of fees we're collecting per dollar of assets. You look at average separate accounts year-over-year, they're up 19%. When you look at what we're getting from an expense assessment standpoint, they're up six basis points.
Bring those two items together, and what you see is expense assessments are up 21% year-over-year. That's pretty much the driver of earnings growth year-over-year. It all makes sense. When you look at the sequential quarter, it's that along with a couple other items that I'll mention. If you look sequentially, earnings are up 23%, 17% if you strip out the $9 million of strong prepayment fee income. The first and foremost, the driver is strong expense assessment growth. You see average separate accounts up 5%, and you see our average expense rate up another four basis points. You bring those two things together, and you get expense assessment growth of 7% or $27 million. That's the primary driver of the earnings growth. In addition, what you see is that we had very strong results in our broker-dealer during the quarter.
I'd attribute that to expense savings from the consolidation we did in our distribution system and the benefit in the retail channel of strong AUM growth. Strong results in our broker-dealer, which I believe are repeatable. Third, as you mentioned, is the cumulative benefit on DAC amortization.
Yeah
It was a period of very strong performance in the equity markets. I believe when you bring all those things together, I'm very comfortable with the annuity earnings in that mid $185, $180 range.
Got it. Okay. That's extraordinarily helpful. Thank you, Randy. The other question I just had is just to, Dennis, I think you mentioned in your opening remarks that let's not all get scared that VA sales jumped as much. There was some acceleration in front of your product refresh and benefit change. That the production levels have come down about 25% from the levels in May, but we don't really know what the levels were in May. I'm assuming they were significantly stronger in the front half of the quarter given the May new product launch. Can you give us a little bit more help there?
Yeah, I can. First let me remind all of us that Lincoln has had about a fifth market share where we've been number 5 for five years. We've done an exceptionally good job of getting the business on our terms without reaching for market share. We do that through price changes. If we see our demand getting too strong. We'll change prices as we did in May, and of course, we've done consecutively over the last 24 months. Sometimes in a quarter, it's hard to have that same consistent result, in part because competitors are making sharp turns, and we, for a moment in time, might get a little bit more market share from them because they've exited the market or changed their pricing. My point is that we've done a great job at this over five years.
This is one, physically, it popped up because although we made changes to the benefits on our single living benefits product, we waited until June to make the product changes on our joint life product. Typically, the joint life runs about one-third of overall sales. In the second quarter, again, in part because of competitor actions, this jumped up to 54%, so drove a lot of that increase. With the pricing changes, we're now back to that product being at its normal one-third level. You may then ask the question, what did we do? We reduced the payout rates by 50 to 100 basis points for the age 65, 74 bands in our joint life product, and we restricted some other benefits. That's sort of the big picture.
As we look for the second half of the year, we don't expect to see the same volume of sales that we saw in the second quarter. If, because of competitor reactions or just generally strong demand for this product we see sales inching up above our guidelines, we'll take additional actions. I would like to come back and say, that these pricing actions that we're taking are not being taken because the products that we're selling had too low of returns. All of the business that we sold over the last six to seven months, or we continue to talk about mid-teens to upper teens returns. Even before we made the product changes, we were getting that on this business. The stuff that we sold is good, profitable business.
It's just that, as I just said in my opening remarks, in total, we like the VA business, we like our long guarantee businesses, but we'd like to see it sort of become a smaller part of us over time. That may be more than you wanted, but that's my answer to your question. Okay?
I totally appreciate it, Dennis. Thank you very much, and congratulations.
Thank you.
Thank you. Our next question is from Suneet Kamath of UBS. You may begin.
Thanks. Good morning. Just have a couple things. First, Randy, on your comment on the, I think it was $1.8 billion of treasury locks that you purchased. Does that have any impact on that, in the past you've talked about this $500 million potential statutory charge on the UL block at some point kind of five years out, maybe a little bit longer. Have we started to chip away at that with some of the actions that you've taken so far, including these treasury locks?
Suneet, I think anytime you see either the interest rates move up or us take actions to lock in higher rates in the future, it has a benefit on the margin. Continue to feel very comfortable with where our reserves are today, and the trend in interest rates. Yeah, I feel very comfortable about any pressure on statutory reserves.
Okay. I guess on past calls, you've kind of given us a walk through of sort of capital generated and what your expectations are inclusive of reserve financings. I take it by your comment that you continue to try to beat the roughly $400 million of buybacks, that nothing there has really changed. I just wanted to kind of confirm that.
Yes, Suneet, nothing there has changed. I'll broaden your question out and talk a little bit about statutory in general. Talk about both what has happened over the last 10 quarters or so. I think it's very important to look at the reality, talk about some of the trends I see as we look forward. If you look over the last 10 quarters, you go back to the end of 2010, we were a company with an RBC ratio of 491%, and we were a company with roughly $700 million of capital at the holding company. In the next 10 quarters, we've bought back $1.3 billion of stock at an average price a little below $25. We've delevered by about $200 million, and we've raised our dividend by about 140%. We've put roughly $600 million of capital to work. Where are we at today?
We're a company with an RBC ratio of 485%, and we're a company with roughly $700 million of cash in the holding company, right where we started. The reality is that over the last 10 quarters, we have had a very strong capital deployment story. We continue to have a very strong balance sheet. Now, when you come up to today, you look at what we did in the second quarter, we had roughly $200 million of statutory earnings, which is right in line with my expectations. When you think about the things, when you look forward, we've got the strong equity markets, which are going to continue to help the annuity earnings. We've got an easing of spread compression as rates go up. As Dennis talked about, we've repriced all of our products.
GUL has fallen from what was 50%-60% of our sales to 15% of our sales today, that's our most capital intensive product. In addition, we just repriced that product in the second quarter to make it much more in line with today's reserve regime. The trends when I look forward are very
Positive. This year, just as said in my script, very comfortable that we can meet or exceed a $400 million. The trends, I think, as you go up beyond that are very favorable around statutory.
Got it. Helpful. Maybe one last follow-up question, either for Randy or for Dennis. Just thinking about your share repurchase program. A year ago, plus your stock was at, I don't know, 60%, 70% of book value, something like that, and the accretion from buybacks was significant. Now with your stock now getting closer to book value ex-AOCI, how do you and how does the board think about that trade-off between, in the past you've talked about the implied return on buybacks versus things like acquisitions. Obviously, that implied return will potentially narrow as the stock price goes up. How do you think about that trade-off?
Well, on the lighter side, it's certainly more fun to buy our stock back at 20 when it moves to 42 or 43 quickly. As the stock approaches the book value, the return that we would expect is different from share repurchases. I don't think necessarily that means we'll do less as we move forward. The return on that needs to be compared to returns on every other use of capital. Right now, I think Randy's guidance is pretty good. We're going to continue to buy our shares back, but the return has to be put into the broader perspective of other uses. At the moment, we're generating excess capital. We think continuing to buy our shares, even at this price, is a good idea.
I still contend that using the metric of price book regression, we're still $8-$11 less than what we should be before we just get normal market appreciation. Long answer is, sure, as the price increases and the return on potential purchases goes down, we have to look at that, but there's nothing I can see right now that would change the plans that Randy's just outlined.
Great. Thanks very much.
Thank you. Our next question is from Ryan Krueger of Dowling & Partners. You may begin.
Thanks. Good morning. My first question was on life mortality. Could you just talk about how it was in the quarter relative to your expectations and maybe the actual to expected metrics that you've given in the past?
Hey, Ryan. Yeah, life mortality, as we noted, improved to right in line with our expectations. If you remember the first quarter, we talked about an A to E of 86%. If you look at the second quarter of last year, that number was 80%. When we came into this quarter, we were right in line with that 80%. I think mathematically we came in at 81%, but that's right in line with the expected range on mortality.
Okay, great. On the change in the sensitivity to low interest rates, that $100 million in 2014 going down to $35 million, was that purely due to the increase in higher interest rates, or does it also incorporate some of the proactive steps that you've taken so far along the way that impacted some of this guidance that you've given in the past?
I think it reflects both of those items. I'd also note that just factually, if you go back to the $100 million guidance for at the beginning of the year, two of those quarters have passed, right? There's two quarters of impact that are in our results right now, and the $35 million is an estimate relative to what we just reported in the second quarter. You've got some that's already in our results. That's some of the impact. I'd call that $20 million-$25 million. The rest of the impact is primarily attributable to the increase in interest rates a little bit the proactive things we've done.
Got you. Just one last one, just back to the discussion on share repurchase and M&A. Just wondering if, as interest rates have come up, if you've seen any change in the M&A type of activity going on behind the scenes.
Well, you all know we've built Lincoln, old Lincoln, old JP with thoughtful well-priced, well-executed executions. The people sitting around the table here are the same people who've done those successfully. We have a strength which, if the right circumstances occur, we would do a deal. I would have to say right now, though, that the activity is not anywhere in what we would find of interest. At the moment, what's in front of us, what's out in the marketplace, what might be coming down the road, there doesn't seem to be too much that would be of interest to us. Again, some of the deals that have been done recently have been done at very low discount rates, my view, and we're just not going to do that.
Okay. Thanks a lot.
Thank you. Our next question is from Jimmy Bhoola of JPMorgan. You may begin.
Hi. Some of my questions were answered, but just maybe one on variable annuities. Dennis, even if the business shrinks a little bit in the third quarter, it's still actually growing faster than other parts of your business. Is there a point at which variable annuities get too large as a percentage of your business mix?
That you decide to take a little bit more of a drastic action and maybe reduce the growth there. What would that point be, if there is one? Secondly, on your disability business, the margins had steadily improved the last few quarters. This quarter, the loss ratio went up about 1%. Still decent overall, but was wondering whether you're seeing any deterioration in losses or is that just normal volatility in claims trends?
Yeah. I think I'll take the first one and give the second one to Randy. Jimmy, we are moderating our VA sales to a level that I think is maintainable over a fairly long horizon. That's in part because we're growing other parts of the business as well. I'd also like to make the comment, we talk about annuities as a business. Number 1, you've got to pull out fixed and variable and the dynamics and the earnings impacts over time of those two things are different, I think, of our total variable annuity. Excuse me, of our total annuity earnings, about 25% is in the fixed side. Even stepping back farther, the lines of business, you calling it annuities, are a good indicator to me of how we source liabilities and the businesses reflect sort of the nature of our liabilities.
I don't look at the businesses per se as the final criteria on earnings mix. What I've been focusing you all on is the balance of capital market businesses and mortality and morbidity businesses. Again, back to what I said earlier, it's our goal to increase. Well, I didn't say this, but I will. We get about a third from equity charges across all of our business lines of our earnings. We get about a third from interest spreads and maybe at this moment, about 25% from mortality and morbidity. The goal is to change that mix more towards mortality and morbidity, to lower the percentage of sales in the long duration products. I would say that these are midterm goals over the next couple of years. I'm pretty confident both the market and again, the quality of our distribution.
To me, it's a pretty decent, there's some good examples of the strength of our model. We talked today about taking universal life sales, which were running 60%-70% of total life sales, down to 15% in the space of 24 months. By the way, now back at the same levels of sales we were when we started that Pivot. If you look at what we've done in the VA business, we were selling no protected strategy funds, and we went from 0 to 80% because our distribution was able to drive those results. As we set our sights on a more crisp business mix and product mix objectives, I'm pretty confident based on our history that we'll get there. This is a long story to say that the business mix is going to be moved more towards mortality and morbidity.
I think that mix will improve our share price performance over both economic and capital market cycles, and I think we have the wherewithal to do it. Okay.
on disability?
Yeah. On the DI loss ratios, we didn't see any trend of deterioration in the quarter. It was a very strong quarter in the DI business. I think broader picture in the group business, there is some seasonality in the different businesses that moves in opposite ways, actually. You'll see DI incidents trend up a little bit over the course of the year. On the other hand, you'll see dental incidents trend down, and you'll see mortality typically improve in the last half of the year. You've got these things that work against each other. All in, very happy with the group results in the quarter and feel good about us moving forward.
Okay. Thank you.
Thank you. Our next question is from Steven Schwartz of Raymond James. You may begin.
Good morning, everybody. First, with regards to the interest rate guidance, Randy, just so I'm understanding this, I had historically thought of the guidance as okay, 2013 interest rates, that's going to hurt you by $35 million. If you think in 2014 that Lincoln's earnings were going to grow 9%, to pick a number, grow them out 9% and then take off another 65. 65, 35 equal to 100. Now I'm thinking about it. We have the 35, and I'm not even sure if it's still 35 for this year. You didn't say anything about that, Randy. If you could touch on that. If I'm going to grow out earnings for Lincoln 9%, 35 less 35 is zero, I'm going to keep it at 9%. Is that the right way to think about this?
Let me try to walk through that. First off, as I mentioned, $35 million was a number coming into the year, full year impact. Two quarters are behind us. There's some level of impact from spread compression in our second quarter results. As we've been saying all along, there are lots of levers we pull to manage interest spread compression. We've been managing expenses. We've got favorable impacts from the equity market. We have this very strong second quarter, which includes some level of spread compression impact, primarily in the life business and the retirement business. As you move forward, you'll see a small quarterly impact that will total up to $35 million, as I mentioned, next year. Last half of the year, it's a relatively small number.
It's a single-digit number in the second half of the year relative to what we reported in the second quarter. It says nothing of the fact that we will continue to do everything we can to manage the bottom-line impact of that spread compression.
I had to go on to something else, so I apologize if I missed this. Just let me know, and I'll check the transcript. I am interested in the Retirement Plan Services, particularly the success in the mid to large market. It wasn't clear to me from Dennis's statement whether that was being driven by government or whether that was being driven by 401(k) or by teachers. It's our understanding, I think, that mid and certainly large is probably the most competitive of the areas in the defined benefit business. Maybe you can touch on what you're seeing there, competition-wise.
Yeah. In the mid to large market, progress to date has been made by virtue of two things. One, well, many things, but if I can spike out two things. One, we have a new platform. Before we had the new platform, we weren't on any of the consultant lists, or we weren't on as many as we needed to be. Once we got the new platform in place, the number of consultants who drive this mid to large business started taking notice of Lincoln. That's number one. Number two, accessing the consultants requires feet on the street, and over the last 18 months, we've increased that, okay? Our product is as good as anybody's product. Now we have access to consultants because of the overall mix of our business.
If I remember correctly some of our business that we've been putting on the books comes from our expertise in the healthcare area, which has been a good growth area. That sort of brings us up to today. The government market is a new initiative that we started in the last 90 to maybe six months. The pipeline for new sales, whether or not we can close it, we'll see, has a lot of that business in it. Going forward, we expect additional push from the government market. So far, it's come from improving our platform, getting in front of more consultants, expanding the sales force that calls on the consultants.
Okay. Is the government market particularly price sensitive, Dennis?
Yeah. I guess the toughest place that we're finding to get well north of 10% on new business returns is in this mid to large market. I think the government may be a little bit less price sensitive, but it's less so than the 401 market.
Okay. All right. Thank you, guys.
Thank you. Our next question is from Seth Weiss of Bank of America Merrill Lynch. You may begin.
Yeah. Hi, good morning. Thanks a lot. I just wanted to follow up on the annuities business and the sustainability of sort of that mid-180s run rate that you mentioned, Randy. Just thinking about it from an ROE standpoint, if I normalize out the $10 million or so of higher investment income, we're still getting to an ROE of about 25% for the quarter, which is a pretty big jump quarter-over-quarter, year-over-year than what we've seen the last four or five quarters. I just want to make sure that I'm understanding that you're comfortable with the sort of the 185 as a normalized run rate to start from here. Maybe help us understand where the leverage is that makes for this pretty drastic increase in the ROE looking at that segment.
Sure, Seth. Well, first off, yes, I'm comfortable with the mid-180s for all of the reasons that I went through before. Relative to the second quarter of last year, relative to the first quarter, this is driven by good solid AUM growth, good solid performance in our broker-dealer, and the powerful benefit on DAC amortization of all of those items. Yeah, it's very comfortable in the mid-180s. From a return standpoint, the 24%, 25% ROE that you referenced, once you normalize out the prepayment fees, that's just the end result of a business that was very well protected as we came through the last four to five years. I think what you see at a lot of companies is companies that weren't protected, didn't have hedge programs in place coming into the crisis, and had to build those hedge programs at costs that are
Probably twice what we had to spend to put that hedge program in place. That is the key component which differentiates our returns from other companies. There are a couple other companies out there, I won't name names, who have similar returns. Those happen to also be the companies that had very powerful, robust, and deep hedge programs coming into the crisis. That is the key differentiator. Yes, very comfortable with the 180s, very comfortable with the ROEs that we're reporting.
Okay, great. Thanks a lot. I guess just one follow-up on thinking about sort of new business returns and VA was a business that was, in terms of business mix, was obviously quite out of vogue just a year ago. Now with the S&P over 1,700, returns are looking better, as you mentioned. Some of the legacy business run over the last two, three years probably has pretty good returns. Is new business maybe at a slightly lower ROE when we think about the run rate of this going forward? It still may be above 20%, but this 25% is probably not the right level to think of as new business price. Is that fair to say?
That's sort of difficult to predict. In my remarks, I said we were pricing new business today at unlevered returns of 19. If you add leverage to that, it still gets you into the low 20s on the balance sheet.
Okay, that's helpful. Thanks a lot.
Thank you. We have time for one more question. Our last question is from Eric Berg of RBC Capital Markets. You may begin.
Thanks very much. Dennis, there appears to be a growing interest, not a stable interest, but a growing interest on the part of the public, both individuals and institutions, in tax efficiency and in low fees. We see this in the growing share of passive strategies in the asset management business. Annuities kind of go in the opposite direction from that trend. They tend to be tax inefficient, converting capital gains into ordinary income, I believe, when the money is distributed, and the fees on them are dramatically higher in most instances than on index-based alternatives. Why do you think that this extraordinary growth that we've seen over the last decade and more in guarantees can be sustained given this trend?
Relatedly, this whole longevity business that you're in and that the whole industry is in right now and is benefiting from, why should we think that the life insurance industry will prevail? I realize in the context of this call, you'll have only a minute or two to answer. It's something that we should probably get into in more detail offline. Even if you want to answer briefly, why should we think that the life insurance industry is going to prevail over competitors such as banks and asset managers, who are as equally aware of the longevity trends as you life insurers are?
Well, there is a lot in your question that we probably should take. We ought to have a two-hour lunch.
Right.
Let's just come back to what happened during the crisis. Pre-crisis, in terms of preferences for products that have more certainty. Prior to the crisis, everybody thought that the stock markets would forever increase. We had the crisis. People lost a lot of money, unfortunately, as we all know and read. Individual investors don't have a very good track record of market timing. I think the broad statistic on that is individual investors' performance is 2%-3% less than the overall growth in the S&P 500. They're not particularly good at it. Again, I think it comes from when markets decline, people get nervous, and they sell when they should hold. In any event, the individual investor hasn't had a good track record. He or she has seen the markets collapse and their earnings collapse likewise.
Remember during the crisis, people started referring to 401(k)s as 201s. There's been a pretty dramatic move in the preference of individuals to have some part of their portfolio invested in something that has more certainty. I think that's going to continue, and that's why we think in the right amounts, at the right returns, the VA business will continue to grow. With respect to the life insurance market, life insurance products have a variety of uses. Estate taxes aren't going away, so estate tax planning will remain an objective. Young families that want to provide protection in the case of the breadwinner dying prematurely are going to continue to buy life insurance. I think the fundamental needs of Americans for life insurance are going to continue to be very popular over the next decade.
Again, as we've said, as you've seen in our competitors' reports, none of us can predict or see that this is going to continue the way it has, a good growing stock market and slowly rising interest rates has got to be absolutely the best economic climate for the insurance industry on top of the demand that we're talking about.
Well, I look forward to that two-hour lunch and to hosting it. Thank you so much.
You're very welcome.
Thank you. I would now like to turn the call over to Jim Shirine for closing remarks.
We would just like to thank everybody for participating on this morning's call. If we didn't get to your questions, we'll be glad to talk to you with a call to my line or to the investor relations line. Again, appreciate your time today and have a good day. Thank you.
Ladies and gentlemen, this concludes today's conference. Thank you for your participation and have a wonderful day.