Good morning and thank you for joining us for the second life insurance session of the day, where it is going to be my pleasure and privilege to introduce Randy Freitag, CFO of Lincoln Financial Group. Before we get started, I would remind everyone that for important disclosures, please see the Morgan Stanley research disclosure website at morganstanley.com/researchdisclosures. If you have any questions, please reach out to your Morgan Stanley sales representative. With that out of the way, Randy, thank you again for joining us. Really appreciate your participation. One of the questions that I get most with Lincoln is risk transfer, and I'm sure it's a question you get a lot as well, but kind of discuss your appetite to potentially look at transactions.
I thought that'd be a good place to start, overall progress that you've been making, what you're seeing, and where we stand with regards to that overall market.
Well, Nigel, first off, thank you for hosting us today. I always appreciate an opportunity to spend time with you and with the investors that are attracted to your conference. Well, you might be surprised, Nigel. This is the first time I've ever gotten this question, all right? I think the nature of anything like this is that until you announce something, it looks like from the outside like you're doing nothing. That's just sort of the nature of this. Let me assure you that consistent with what Dennis and I have said in repeated earnings calls, but also in other investor meetings we've done, we are allocating significant resources to researching whether the whole concept of block sales might be something that makes sense for Lincoln. I think the question is: Why are we allocating more resources than we have historically?
At a high level, Nigel, we have eyes, and so we can observe that there have been actual transactions being done at a pretty fast or rapid clip. We have ears, so we hear all the rumors about all the people interested in books of business. We have experience. This is stuff we've done in the past. It was 2018 when we sold a book of fixed indexed annuities to Athene. We have a lot of indications that there is an appetite from investors or from buyers for various reasons to look at books of business. We think that creates an opportunity to do something that will add to EPS and ultimately add to shareholder value because we believe there's an opportunity to find buyers who are willing to pay more than we're currently receiving via our share price.
Nigel, I guess that's at a high level what I'd say about that topic.
I guess when you talk about potentially being accretive to EPS, there's two parts of the equation there. There's one, the amount of capital which you could free up from a transaction, and two, where your own stock price is trading. Your own stock price has obviously improved materially from where it was this time last year. Does that meaningfully change the equation? Does that make it somewhat more challenging to find a transaction that kind of ticks all the boxes?
No. Well, I mean, yes, our share price is up. Let's be clear, from my standpoint, we've moved from a ridiculously low valuation to a ridiculously low valuation. A ludicrously low valuation to a ridiculously low valuation. I mean, the reality is where were we at $66, $67 per share yesterday? I don't know what your estimate is for next year, but that's probably, what, six times or so most analysts view of next year. That's just crazy in our opinion, for a company with our return profile, our history and record of returning capital to shareholders, our history and record of allocating capital appropriately to new business at appropriate returns. I don't see the current share price as an impediment at all. I think the share price could go up pretty significantly before you would get close to that.
At a high level, when we think about entering into these transactions, because there's a gap between when you announce something and when you actually transact, you sort of factor that in. We shoot for EPS accretion of 3%-4% at announcement date to allow for share price to move to still have something that's accretive at a high level. Those are just numbers. Obviously, they can change with the size or so. You've got that side of it. I don't see the share price as an impediment. Then you have the other side, which is the buyers, right? I think the prices you've seen for books has been pretty attractive. I think if you broke it up, we did a fixed annuity deal a couple of years ago.
There seems to be on the life book side, a tremendous amount of demand, and I am a believer. I took a lot of economics courses in college to boost my GPA, and so I am a believer in supply and demand, and so there's a ton of demand out there, and I believe that will drive really strong prices. I think there's a smaller group of buyers on the variable annuity side, so we'll have to see how that whole equation. We're looking across our portfolio in all of these areas, but I don't see share price as an impediment to anything.
Would you potentially do more on the fixed annuity side as well? It seems like that's been arguably the hottest part of the market, where there's been a large number of different players looking to buy blocks.
Of course, we would if something made sense. I would point out that we did an $8 billion transaction just a couple of years ago, so that was a pretty good chunk of our fixed annuity book at that time. Our fixed annuity book is not as large on a relative basis as, say, our life insurance book of business, where we haven't done anything over the years.
Right. I guess, even without a risk transfer transaction, the whole issue of capital management remains important. I think you, like everyone else, kind of put on pause when the pandemic hit, your plans to buy back stock as things began to normalize and you come back to the market. You're now in a position where you're buying back at pre-pandemic levels. Is that any alteration to expectations? Should that continue to be the case going forward? What are some of the factors that we should be watching out for? Is it credit or pandemic or as you're thinking about your capital management practices, what are the key variables?
Look, when we in the industry paused in the first or second quarter of last year, most of the industry paused in the first or second quarter of last year, there was a very strong belief. That belief was expressed through credit spreads that had blown out that we were staring down the barrel of a credit cycle, which is historically the item that is the main capital use during a time of stress at Lincoln and really across the industry. We all went into and enacted our action plans for that exact scenario. Which means that we largely cut back on share buybacks. Now, we never experienced the credit cycle. At Lincoln, we've seen our balance sheet grow tremendously. I think in the first quarter, capital was up $1 billion over the prior year. In the first quarter, it grew $400 million alone.
Our RBC ratio was up 13 points in the first quarter. We were at 464% from an RBC standpoint. We prepared or we enacted our plans for a credit cycle. We never experienced that credit cycle, our balance sheet at Lincoln is in tremendously strong shape. That allowed us in the first quarter to announce that we were going to get back to pre-pandemic buyback levels, I think much earlier than we would've originally thought or investors would've thought. I only talked about on the call about the next quarter, so I can't go beyond that.
I think the fact that we returned to pre-pandemic levels, I think the fact that the RBC and the capital position are so strong on an actual and on a relative basis, I think is just a good indication of our ability to continue to deploy capital in that fashion. We're feeling very good about the strength of Lincoln's balance sheet and what that means for our ability to return capital to the shareholders through buybacks.
I guess one of the other uses of capital would be M&A, given your prior comments on the ridiculously low valuation, it would seem the bar's pretty high to be considering anything. Your view as to whether that's an opportunity for you?
I think, M&A, first off, when we build our financial plans, we target building plans that allow us to grow EPS 8% to 10%, and we plan for three-year periods. We both plan for that and we've actually overachieved on that over the last decade. We don't use block sales or M&A as sort of a plug into this financial plan to meet our aspirations. They're not part of our core strategy as embedded in our three-year financial plans. They're things that are opportunistic when they make sense, right? Right now we've talked about why they may make sense. Our share price is depressed below where we believe it should be, and we believe there's a strong demand from buyers, which could create attractive prices above what's embedded in our share price.
We see these things as opportunistic. When you look at our businesses, we have four businesses. Every one of those businesses has everything it needs to be successful. Right? The last time we did big M&A was when we doubled the size of our group business. That was something we had talked about with investors for a number of years. We had capital on our balance sheet. If we were to use it would likely be for a group acquisition. We did that. That really put our group business to really a full-scale provider across the spectrum, all case sizes. That business is where it is. Obviously, our life and annuity business are our top five players in the U.S. Our retirement business is exactly what we want it to be, right?
We leverage our strengths in the retirement business to compete where we want to compete. We're not a record keeper. We're not a jumbo case provider, right? We leverage our ability to distribute through LFD, in our big broker-dealer or our partners. We leverage our capabilities from a service standpoint. All of our businesses have everything they need to be successful, so there aren't any holes that.
Yeah
I think that we would look to fill with M&A. I would say that is highly unlikely.
Right. Switching to another topic, the pandemic. Yeah, I think we have seen quite a significant improvement in the COVID case rates, and the resulting death statistics as well. Any reason to believe they shouldn't just work directly through your mortality experience that you would expect to be incurring? Any lag-
I can't think
in reporting or?
I can't think of any reason why it shouldn't. You've seen a tremendous decline in the number of people passing. We had 205,000 deaths in the first quarter. That was the peak. It looks like at current trends, that we'll end up a little over 50,000 for the second quarter. We'll be a quarter of what we were in the first quarter, and the trends, at least as we exit June, will be very positive for the summer months. I can't think of any reason why those shouldn't pass through to Lincoln. I think there are actually reporting lags in terms of at the state level, when they actually report COVID claims. I think what some of the things you see at the CDC are claims that happened a while ago because some states, some municipalities wait for the death certificate.
In Lincoln's case, we record a claim when we get a call that tells us that an individual has passed away. That happens in most cases relatively quickly. We record a claim when we get that call, then we wait for the death certificate, before we actually pay it out. It's already in our financial statement, I don't see any lag. You already started to see the benefit of the vaccinations in our life business in the first quarter. You saw the impact come down in the first quarter. I believe the group business is probably on a three- to four-month lag from the life business, just given its age demographics. It's more working-age population as opposed to our life businesses, which is more of an over age 65 population. Yeah, I think the trend is our friend here.
Right. How about the non-COVID related mortality? That seemed to be an area that had deteriorated somewhat as well. A lot of people say the referral of care and various other things. Other people point towards opioids and other kind of things like that. Is that a trend which should also kind of track COVID, given that it's kind of indirectly related to COVID, or just your views on non-COVID mortality trends as well?
Look, our assessment of excess mortality in 2020, and in the first quarter of 2021, was that it was all related to the pandemic. We looked at causes of deaths. We're not seeing any increased deaths from opioids or suicides or those sorts of things. All the excess mortality was around, if it wasn't directly reported as COVID, it was all around causes of death that you would say were probably related to the pandemic, whether they're respiratory or cardiac. Our assessment as we look through the data, this is also supported I've read a number of CDC studies. I think in 2020, the reported COVID deaths were 360,000, the overall excess deaths in America were more in the five I've seen different studies on the low end in the 500,000s, on the high end in the seven or 800,000.
I think our experience is very consistent with America's overall experience in last year's and the first quarter's excess mortality was all influenced by the pandemic. We didn't see anything else, I don't expect there's any other trends in mortality that we would expect to persist.
I guess one of the other aspects of the pandemic is that it has illustrated the value of life insurance. Is that translating to a better sales prospects as people recognize just how important having life insurance protection in place can be?
Yeah, we've definitely seen that in our policy types that are geared more towards a younger age population. We have a very digitally focused product called TermAccel, for instance. You've seen the numbers, the case counts of that business go up tremendously. Now, the reality is, Term insurance, that TermAccel product, a lot of cases, but in terms of paid annualized premium, which is how we measure sales, it's a relatively small portion of our overall business. Our sales numbers are going to be driven by the more complex, more whole life type of business we sell, the VUL, the IUL, the MoneyGuard, for instance. Yeah, we've definitely seen an uptick in interest in the types of policies you would expect, but it hasn't had a huge impact on our sales.
I think, in the life business, as we talked about our sales, we did a boatload of repricing in the products that were impacted, either by low interest rates or by the new reserving regulation, PBR, that went into effect. I think we moved first, and that had a negative impact on sales. We believe we bottomed in the fourth quarter, first quarter of 2021. We'd expect to start growing again. I think we're still working through the other companies that are just sort of cleaning up and finishing up their repricing cycle, which has been behind us for some time now.
How about the rise in interest rates? Does that allow you to perhaps reverse some of those price increases and be a little more competitive in terms of your pricing?
Yeah, we're looking at it.
Have you still got such a low level that it doesn't matter?
Yeah. Look, I think rates are definitely up, and that helps. There's no doubt that the rates today, relative to the middle of last year, for instance, are in a better place, and that is supportive of pricing. I think on the other side of that, credit spreads, I mean, the risk-free rate is up 100 basis points year-over-year, credit spreads are down somewhat. You do have a little bit of an offset to that. Net net, I don't see the earned rate environment. I think it's supportive. It's supportive of the assumptions on our balance sheet. I think it's supportive of pricing, I don't see it as a huge driver of price decreases from where we are today.
I guess when interest rates dropped a lot last year, one of the actions that you took was largely backing out of the fixed annuity market. You just felt like the available returns there weren't at a point which justified running that business, generating your target returns. Are we at a point now where you potentially could reenter that market, would we still need higher spreads, higher Treasury rates in order for that to be a product which would reemerge as being more attractive?
Nigel, I think there are three things that impacted fixed annuity sales at Lincoln. The first one is what you mentioned is the absolute level of interest rates. That's not a Lincoln specific item. I think that the reduction in interest rates impacted the whole industry and brought fixed annuity sales as a percentage of overall annuity sales down. That was especially in conjunction with the growth in the other hot product, IVA. You saw from a macro standpoint, you saw industry fixed annuity sales come down. The other two items, I would say, are more Lincoln specific and had a bigger impact on our sales individually. The first step, I think is just a different view on how we view and price credit/liquidity risk. I think a slightly different approach than some companies take there.
I think you could call our approach more conservative than some of the big providers today, I think that had a negative impact. Probably the biggest impact, Nigel, was what we did last year, when we've always been disciplined on capital allocation, but when we really sat down with share price at very low levels, when we upped our targeted returns for fixed annuities. You may have heard me say that since dinosaurs have roamed the Earth, the fixed annuity business has been a 10% business. We upped our targeted return to 12% last year, I think that had a fairly negative impact. One point on those, when I quote those numbers, because universally, every other company talks about higher returns on fixed annuities.
When I do that, I think the main difference is that when I do that, we include and we talk about returns on fixed annuities. We include an expected cost of credit, right? 15 to 20 basis points. I think when most companies talk about the returns they're getting on fixed annuities, they ignore credit losses, or the economics of credit losses. Typically you'll see or hear me talk about fixed annuity returns at lower levels than almost every other company I ever hear talk about them, I think that's the main difference.
Right. That makes sense. I guess one of the things that you did in response was pivot your portfolio or your product portfolio strategy and, clearly buffered annuities was one of the key areas that you kind of moved towards. Were able to put up some very good numbers there, industry-leading sales numbers. It also seems like every other company has adopted that strategy as well now. It does seem to be getting a little more crowded. Is that still a good market, or do we run the risk of I think we've all seen the movie in the past where, yeah, the influx of competitors leads to erosion in pricing and eventually an irrational market. Is that a risk at the moment, or are you still satisfied with the returns that you're generating in that part of the market?
Absolutely. We're still satisfied. I think IVAs or buffered annuities, whatever we want to call them, are still a very attractive marketplace. I think when we entered that business, we were able to leverage the things we do really well, right? Our ability, my assessment, our ability to get on the distribution platforms that sell a product like IVA, I believe, is unparalleled. I don't think anybody in America has a better ability to get on distribution platforms like Morgan Stanley than Lincoln. LFD is, I think, the unparalleled leader in that capability. We were able to leverage that along with the ability to manufacture these products, creative, innovative products, and I think that's what ultimately caused our sales to shoot up. I would point out on IVAs in general, IVAs were a product that took fixed index annuities and said, "Hey, you know what?
The capital markets are paying a lot if you'll accept a little risk," right? "And if you will accept a little of that risk, you can get a much more attractive upside value proposition." That proposition last year allowed companies that have 200% caps or so on IVAs. As volatility has come down, and when volatility comes down, the capital markets are paying a little less for a consumer to take on that risk. The value prop you can offer to the consumers has come down. I think from a value prop standpoint, they're a little less attractive than they were a year ago, but they're still a very attractive option. In terms of other companies coming in, this happens all the time. You may see some companies as they come in will have teaser rates for a period of time, but we still see rational behavior.
These are smart companies. They face the same dilemma that Lincoln does. Capital allocation, we always have buybacks and other things that we can do. We have to be disciplined with the returns we seek. I think you could see momentary noise, but I would expect that Lincoln will, as we've always been when we've entered and made a commitment to an industry, we'll be a top five player. We'll bounce around in there. I don't expect to be number one all the time like we were in the fourth quarter of last year, but we'll be a top five player.
Mostly kind of target returns there, fixed annuities has always been around 10 to 12, if you can stretch it. Are these IVAs a little higher than that? Other companies have talked around mid-teens. Is that a reasonable number, or is that a little aggressive?
I don't see that business as a mid-teen business, so I would position it just a little above fixed annuities. These are products without guarantees. They are a little more complex than a fixed index annuity. I talked about our target right now at 12 on fixed index annuities. I'd position IVAs, 12, 13, 14, somewhere in there. I wouldn't think of them as a mid-teen business. I wouldn't be surprised at all if the difference between what I say and others, once again, is credit and expectation for the cost of credit.
I guess another, just switching topic, one of the things that you've been talking about over the last several years has been the opportunity for technology-driven expense reduction.
The pandemic obviously led to a bit of a change and a bit of acceleration in the pace of some of those changes. Just an update there would be helpful as well.
I think expense management is a strong capability at Lincoln. I think it is something that differentiates us. It's the capability to both announce and talk about programs and then to actually be able, from an investor standpoint, to see those pronouncements come through in our results, right? So when we talk about a savings program, you can actually, and you have historically been able to see it come through. I hear a lot of companies talk about programs, but you have to be Inspector Clouseau to actually find their expense ratios come down. That's not the case with Lincoln. So you go back to the original technology-driven program, which we enacted a few years ago. We talked about ultimately getting $90 million-$150 million of savings from that program. We're well on the way to that. We were at roughly $50 million last year.
That'll grow $30 million-$40 million a year for a couple of years, and that program will be behind us. You've seen those numbers come through in our results. Last year, in response to the pandemic, we took $100 million of expenses out, then we committed to keeping them out forever, right? How did we do that? We did that with technology. We did that with changes in how we work. There's another $100 million that's out forever. You've heard Dennis and I talk about we believe there's further opportunity. The pace of technology, the pace of how work is done are changing at a rapid enough pace that we think there's another opportunity. We're currently doing a lot of research analysis around a next big program.
We'd expect, to the extent our analysis finds anything, and I'd expect it will, that that's something we could talk with investors sort of in the back half of this year about.
How about just as the pandemic winds down, some of the travel and associated expenses coming back, is that going to be a headwind that we need to be factored into some elements of your expense structure artificially low because the pandemic potentially could reverse?
No. I mean, yeah. People are going to start to travel again, at the end of the day, that's a small component of our overall expenses.
Yeah.
I think more fundamentally, the change in how we work, the number of employees who will be working virtually, to a far greater extent than they have in the past, will more than swamp that. I'd reiterate the $100 million we took out last year is out forever. Yeah, as I sit here today, I don't think about expenses bouncing back as a headwind to our EPS growth.
Okay. Not the most exciting topic, but one that everyone still wants to touch on. Accounting changes. LDTI, your views to where things are headed, the progress that you've made, when we potentially could see some quantification of the impact. Just an update there would be great.
Yeah. Unfortunately, still targeting the middle of next year. It's a big project. I think the FASB was prudent and appropriate when they extended the date by one year. We've been very successful operating during the pandemic. I think another year would've been appropriate even in the absence of the pandemic, but that sort of sealed the deal. From the FASB standpoint, there's just a lot of analysis we have to do. I'll point out one thing, and you and I have actually briefly talked about this. We have a hedge program that has been structured and has performed over the years to deliver the assets needed to pay off any claims. It's done that. It's done a tremendous job of that. I think of it as one of the best programs in the industry.
We've also had the benefit of that program matching our liabilities reported on our balance sheet. You haven't had that GAAP volatility that some of our peer companies, especially those in the GMIB space, have had to face. That's been, I think, a benefit for us. Well, now we're going to be looking at a different approach to accounting. We're going to have to analyze, does our hedge program make sense? The FASB insanely came out with a pronouncement that, for instance, return of premium death benefits need to be fair valued. Well, I think it's highly unlikely that Lincoln is going to look at a return of premium death benefit, the risk profile of that particular benefit, and say that that's something we should try to hedge in a fair valuation.
We're going to have to sort of analyze, potentially with hedge program that now differs from how things are accounted for. What are the implications of that? Are there things we should think about in terms of how we hedge? I can show you that any changes we do make, we'll communicate, and they will still be all geared around the exact same goal we've always had, which is making sure we have a hedge program that generates the assets required to pay off any claims for these guarantees. Which is fundamentally what you want to do. At the end of the day, the VA with guarantee business is the following things: It's the world's greatest asset management business. It's a high fee, high persistent asset management business with a guarantee.
You need to make sure you manage that guarantee in a way so it doesn't negatively impact the company over time by running a hedge program that generates the assets required to pay off the claims. Outside of that, the VA business, the VA with living benefit business is, and I don't think investors appreciate this enough, it is the world's greatest asset management business. Higher fee, higher persistency than any other asset management business in the world.
Know we're running short on time, but I do have one other one which just came across the web. Just regarding the reversion to the mean corridor in DAC and VOBA, if you can just provide us an update as to the size of that cushion, how that's been moving recently.
I believe, I'm going from memory here I believe at the end of the first quarter it was roughly $300 million in total positive. It's significant. It's actually an item that potentially could be an offset to any negative impacts from LDTI, for instance. Yeah, it's grown as the equity markets have continued to grow as our underlying assets have continued to grow. We've benefited in many ways from what the capital markets have done over the last year, whether that's interest rates increasing or whether that's the equity markets and the tremendous returns we've seen there. You see that in our results, including in a significant buffer in our reversion to the mean.
Right. Okay. I have a bunch of other questions, unfortunately we are at time. We better leave it there. Randy, thank you so much for taking the time to share your insights with us today. For everyone who joined, thank you for joining as well. We'll end it there. Thanks.