Hello, everyone. I'm Jay Gelb from Barclays. I cover the insurance stocks. We're pleased to have with us Dennis Glass, who is President and CEO of Lincoln Financial Group. Lincoln benefits from a strong presence in U.S. life insurance, annuities, retirement savings, and group insurance. It also has a strong return on equity profile, as well as a great track record returning excess capital to shareholders. With that, I'm pleased to open or turn it over to Dennis for some opening remarks.
Thank you, Jay. Let me just make some comments about this slide. Thanks everybody for being here and showing interest in Lincoln. We appreciate it very much. We've been hearing conversations sort of in the background about how can Lincoln survive through a recession? Is there something different today that's much better than it was a few years ago in terms of strategy? Let me touch on that with this slide. The headline on this slide is something that I'd like everyone to keep in mind, is that management has taken significant actions, and the company is much different today along the lines of balance sheet strength and strategy than it was in the past. Just look at a couple of these things.
I'm starting with the balance sheet and answering the question of how much better prepared is Lincoln today to enter a recession, again, which seems to be an issue with some investors, than they were in 2008. It's quite dramatically different. Just starting at the top, we ran a negative $600 million borrowed position. Today, we have $474 million of cash on the balance sheet that has no specific purpose other than in case of stress. A billion dollars difference from back then until now. Statutory capital has grown from $5 billion to $9.4 billion. The strength of the capital position is much better to the extent that there are credit losses in a recession. If a recession happens, our investment portfolio, as reflected by below investment grade bonds, is much lower today than it was in 2008.
I would say overall within the portfolio, not just below investment grades, but I think we have a stronger credit portfolio overall than we did back then. Long-term interest rate assumptions, interest rates are lower. It's not good for a financial services company, but in most cases, it should be very manageable. From a goodwill perspective, we had 38% of our GAAP book value in the form of goodwill, and today it's 11%. The message is, from the balance sheet perspective, if we were going into a recession, a dramatically different situation than it was going into 2008. Now on top of that, strategically, now I'm just looking over the last five years because management continued to take actions to what I refer to as improve the overall architecture of our strategy.
One of those objectives was we had been selling a lot of long-term guaranteed business, and of course, if we're selling the amount of long-term guaranteed business today, it'd be a more difficult environment than it is where we are. Only 21% of our sales are long-term guaranteed products. The mix of capital earnings and sources of earnings. This sort of gets to the issue of where we get our earnings from. Back in 2008, 54% was from spread, 46% from fees and assets under management. Today, that's reversed itself, 40% from spread, 60% from fees. This goes to the fact that we have sort of a natural hedge in our sources of earnings. As interest rates get lower, equity markets get higher or vice versa. That's a strong position to be in.
A percentage of earnings from mortality and morbidity, less dependence in total on capital markets. It was 25%, it's now 30%. The strength of the company, both from its franchise perspective, the source of its earnings, and balance sheet, much different today than it was five years ago on those strategic issues, and 10 years ago entering into the recession. Also look at the right-hand side. Over the three, five, and 10-year periods, while we were doing all of these positive things, our results have really been good. Our operating earnings have grown 5%-6% in each of the three, five, and 10-year periods. Our adjusted earnings per share have grown between 11% and 12%. Not many life insurance companies can talk about that. We've expanded our ROE to 13.5%, one of the highest ROEs in the business.
Finally, we've had a very aggressive share repurchase program and reduced our outstanding shares by almost 43%. The story here is much change, all positive, and good results over three, five, and 10-year periods. Jay, we're proud of those results. Again, low interest rates create problems, and everybody has that on their mind. I believe it's manageable.
Excellent. That's a really good starting point, Dennis, and I'm glad you raised a lot of those points. Lincoln's results clearly have been strong year to date. What are you most encouraged about and perhaps where do you still have some work to do?
If we're just talking about 2019, I think the progress that we've made on the Liberty acquisition is very positive. We're exceeding our earnings expectations. We're exceeding our cost save expectations, that's been very good. In terms of cost saves in general, we're making good progress towards our target of sort of a combined, if you look at the savings from the integration and our digital programs, a couple of hundred million dollars over the next couple of years, and we're well on our way on those things. That's been good. Again, if I step back and talk about the franchise, both in the life insurance business and in the annuity business, we have a much broader portfolio of solutions. Our product mix is much better than it was a couple of years ago. Along with that comes additional distribution platforms.
Stronger product portfolio, stronger distribution. Why is that important? It's important all the time, but again, if we are in a period where the products may be different for consumers at the margin, the consumer may be buying different things. Some products will work better for us from a return on capital than others in a low interest rate environment. The fact that you have this product breadth and you have the distribution to make a difference in where you sell your products is a really huge advantage. You have seen us do this in the past, and I guess this pivot from 80% guaranteed to 20% guaranteed over the last 10 years. This, again, demonstrates our ability to make change even when the environment's moving quickly.
Right, of course. Okay. Lincoln's return on equity profile is currently very strong at around 13%. What's the company's ability to maintain that level or perhaps even improve it based on challenging macro factors such as persistent low interest rates and a flat or perhaps even inverted yield curve?
Low interest rates are not good for financial services companies. We put capital behind our products, if that capital is earning less going forward than it was in the past, you have to improve the pricing on your products. We will make changes to get the appropriate return on capital used to support our sales. We'll get back to our targets that themselves would continue to raise our ROE. You also have to contend with spread compression because of lower interest rates. Let me make a point on that, of course, that would affect our ROE. If you look at the amount of actual turnover that we have on our in-force that is faced off against products that have fixed crediting rates on them, we turn over about 5%.
5% of our general account turns over against products with fixed rates on them of some sort. It's a slow burn on lower spread because it's only a 5% turn. Of course, in our new business, you adjust the new rates to match, even if it's a lower interest rate, you adjust the crediting rates and so forth, increase the cost of the product so that you get your return on capital. It's a slow burn, and that gives us time to make changes to help with improving the ROE. Again, it's more difficult when interest rates are at these levels and you're fighting a little bit of spread compression over time. We've demonstrated, as I've just discussed, we take actions to replace spread earnings loss over the next couple of years. That's pretty significant.
Again, management will just have to continue to come up with ways to deal with the environment that we're in. We've demonstrated that we can do that, and I'm comfortable we can continue to do it.
Even though it comes up quite often in terms of investor conversation, you're essentially saying that the company should still be able to generate its current level of return on equity based on top line growth margins and return of capital despite the impact from low rates.
I'm saying that there's pressure, depending how much pressure there is, will determine the answer to that question in the long run. Management can take actions to keep our ROE. At some point, if you get really low interest rates, the action that we can take will be harder in order to be able to maintain that ROE.
I see. Okay. That also, I guess, sort of ties into the earnings per share target the company provided, I believe, most recently at its investor day, then also on the second quarter call, talking about the outlook for 8%-10% annual EPS growth. Given the environment we're in, you still have strong confidence in achieving that target as well?
I can only see out a couple of years in terms of our financial plan. At equity market levels today, at interest rate levels today, with all of the cost reductions that we have And we expect over the next couple of years, we're solidly in the 8%-10% earnings per share increase range. I had been saying that we might be north of 10% when interest rates are a little bit higher. Solidly in the 8%-10% is where we are today in our thinking. Of course, that's dependent on what level of equity market growth, interest rate levels, and so on and so forth. Based on today and the facts that exist today, particularly with these cost saves that I'm certain we're going to get, the 8%-10% is achievable.
Right. Despite even rates going meaningfully lower in Q3, you're still comfortable with that 8%-10%.
Yeah. Again, this gets back to spread compression is a slow burn.
Because our portfolio only turns over 5% a year against fixed price liability.
Right. Okay. Maybe you can talk a little bit about what actions Lincoln's taking in the investment portfolio to offset the headwind, including the allocations to less liquid securities or other factors.
Yeah. On the positive side, we've been able to maintain spreads over treasuries, I think of 180 basis points in that range. Part of our ability to do that has been an increased emphasis on a couple of investment categories. One, as you've just pointed out, less liquid but higher credit quality investments. Our mortgage loan portfolio. I saw a statistic the other day. I think we have $12 billion in commercial mortgage loans. I think one was over 60 days past due. It's really a pretty good portfolio. That's sort of been a consistent outcome across all of the life insurance companies, very strong performing mortgage loan portfolios these past five or seven years. We've done that. Importantly, and we've talked about this, we've been pairing our below investment grade portfolio.
Actually, it's a little bit below 4% as the percentage of general account assets as we sit here today. We've been pairing some of our BBB- exposure, and then selectively, we've been selling investments that we think have a higher likelihood of loss in a credit cycle.
We're taking actions at the margin. I don't see, again, back to my comment about $5 billion worth of statutory capital in 2008 and $9.4 billion today. I don't see us having significantly higher credit losses if there's a modest cycle this time than we had in 2007 or 2008. It'd be less of a-
Right
capital call.
From a statutory standpoint, there's the ability, even if the economy moved into a recession and there was an adverse effect on the price of fixed income securities, there's the ability to have that not be immediately reflected in Lincoln's statutory results, correct? Also, it's not like Lincoln needs to sell bonds in a down market, right?
Well, if you're talking about what's the effect on our capital position-
Right
today of lower interest rates?
No, if you have more credit losses, right?
Yes, we can absorb credit losses without Well, it depends how significant the credit losses are. Yes, we don't have to issue bonds or if you had a real extreme case, you'd cut back on your share repurchase.
Solve it that way. We stress test to avoid having to reduce the dividend or raise any kind of capital in serious stress situations.
Right. Okay. That's not something I'm at all worried about, by the way. The annuities business, it's your largest business. It's important. It's high return. Can you talk about your outlook for the annuity business in terms of the potential for sales, net flows, operating earnings?
Yeah.
What's the outlook there?
Overall, it's fine. Again, let's come back to interest rates has dropped off. You're always having to be conscious of selling product at an appropriate return on capital. As interest rates have moved down, the longer term duration products that we sell have a little more pricing pressure than the shorter duration products. If you go to the annuity business, some of our products are still achieving the targeted returns. Others, we're going to have to make pricing changes too. In general, I would say for the rest of this year, the kind of progress that we've been making in the annuity business, and I will come back to this, which is a direct result of decisions that we made 36 months ago to broaden the parts of the market that we're participating in. Let me use a specific example.
Our Indexed-Variable Universal Life product, which is the best product launch that we've ever had. Is a product that is achieving pretty close to the expected capital returns, and that is very positive. Our products with guaranteed lifetime income are probably a little bit below our pricing targets because of the drop in interest rates. You can see what's going on. You can make pricing adjustments, or you can shift to the products that have the best returns. Now, you can't do that overnight, but if you have the breadth of distribution that we have, strength of product development, you can do it over time.
How about on the net flow front?
Annuities?
For annuities, yeah.
Yeah. I want to make a point here. We focused on positive net flows. To some extent, that's not the full story. Specifically, on variable annuities, you may have the same incidence of surrender, the number of policies surrendering, but because ac count balances are higher, you have more outflow. I say that's not the whole story because let's say we lose a billion and a half in outflows, but we're getting a much higher growth in the total account value because of the rise in the stock market.
Net flows by themselves aren't the whole story. Really, what's the outcome after account value growth, which includes net flows but also includes the increase related to equity market improvement.
Okay. When we talk about net flows being positive in variable annuities, is that the second half of this year?
In the annuity portfolio.
Okay. Overall annuities?
Yeah.
In the second half?
Expected.
Right. Okay. What type of return on equity do you feel you're achieving in the annuity business?
It's a little bit lower at this red-hot moment on our longer-term business than on our shorter-term annuity business. We will make the appropriate pricing changes at the right time to correct that.
Can you tell us a little bit more about what's going on there?
As I said, this is an oversimplification, but the insurance business is pretty simple. You've taken a premium, you invest the premium, then you pay out a claim down the road. Well, to the extent that you're taking in premiums with claims down the road, the effect of interest rates is much more leveraged, much more significant. An annuity with a long term with a living benefit guarantee falls into that category. Lower interest rates really is spot price. Our returns have come down a little bit, but we'll make the appropriate changes as necessary.
Okay. What's your latest thinking on the fiduciary rule put out by the SEC and also the potential individual state responses?
The SEC's fiduciary rule has everything in it that the life insurance industry could have hoped for. Certainly what Lincoln would have hoped for. Specifically, the idea of choice is clear. Investors ought to be able to pick what they want to invest in. It's clear that whereas the old DOL rule sort of discriminated against commission-based sales, the SEC approach is neutral so long as the customer understands the compensation structure. That's a really very positive outcome for the industry. Some of the states have sort of tried the Department of Labor rules. There was a little bit of a dust-up on that maybe six months ago. It seems to have died down a little bit at the moment.
I would say from where we were with the Department of Labor rule to where we are today is night and day difference positive for the industry.
Right. How could it shake out with the individual states applying their own more onerous rules?
New York, their fiduciary rule is a little bit more like the Department of Labor. We're managing that. I wouldn't expect the other states to follow New York en masse. Trade associations are paying attention to it, at the moment, we don't see a huge risk there.
Okay. Well, also on a positive note, how much benefit on Lincoln's business do you think there will be from the SECURE Act, which offers an option to include annuity products in 401 plans?
Well, let me step back and say the SECURE Act is great for Americans, because it tremendously increases the opportunity for everyday Americans to have a retirement plan. It does that. One example of that would be multiple employer plans. Employers can band together to get a more cost-effective defined contribution plan than today where they have to do it individually. The idea that you have to make a plan available for your employees is positive. Insofar as the industry is concerned, the real big opportunity for us is that right now, I'm going to overstate this, but right now the plan managers or not the managers, the fiduciaries, sort of have to guarantee the solvency of companies that are providing lifetime income.
Which is kind of a goofy thing. The new rule eliminates that. Therefore, in-plan lifetime guarantees will become easier for plan participants to participate in and could really provide a very significant opportunity for those of us who are in the business of providing long-term guarantees.
Right
to individual Americans.
Variable as well as fixed and fixed index?
I'm not sure exactly what the right annuity structure will be for those plans.
We're working on coming up with a good plan. I think the plan, in-plan lifetime income products will be a little simpler.
Probably have a little lower payout rate, require less capital, and from the insurance perspective maybe a little bit better risk-reward profile.
Right. Okay. Let's turn to life insurance. What's the organic growth potential in your life insurance business?
I think we talk in the 4% plus range. I shouldn't say I think we talk, I know it's in my plans. 4% plus.
What are the drivers there?
It's the combination of new sales, we're up 30% this year. The rate of the runoff of the in-force. That's the front end, which drives the 3%-4%, 4% or 5%, in that range. You have interest rate spread compression, which is an issue. All those things together.
Right. Of course.
Right now, We've been the third largest seller of life insurance in the United States for quite a while. The two companies that would be larger than us are New York Life and Northwestern Mutual. Not that the size of your sales is important per se, but it sort of gets to our growth opportunities and expectations on where we think we can get in the next couple of years.
Yeah.
With the right return on capital.
Of course. 30% growth in sales is very high in that type of industry. What have been some of the factors there?
What we've done repeatedly over the last couple of years is we have broadened our focus on particular segments where we haven't penetrated. For example, in life insurance, we've done really good with our MoneyGuard product. We've done really good with our variable universal life product. We've stopped selling for the large part guaranteed universal life because it doesn't work as well. We were, I don't know, 25th out of 25 companies in index universal life sales. We revamped our product and now are taking significant share in that marketplace. It's another segment where we put a focus on and have had good results. There's no reason why Lincoln, when it decides to get into a product line where there is big share in the market, that we can't pretty quickly take our fair share.
Right. Of course. Okay. In group insurance, as you mentioned, the integration of the Liberty Mutual group insurance business that was acquired is going quite well. How much further do you think margins can expand in Lincoln's group business?
I think we've been consistently saying that we should be in the 5%-7% range. We thought it would take a little bit longer to get there, but because the industry is collectively seeing better loss ratios in LTD in particular, we've moved up in that range faster than our expectations. I would say sort of in the middle of the range over the long term, maybe toward the upper end of the range is what we'd expect.
Okay. One of the things I think that is not fully recognized about Lincoln is the strength of its distribution platform. Can you give us a little insight on that?
Yeah, the best way I would say it is that at Lincoln, this is by design, distribution is a business and it's a career. In the context of career, that's easy to demonstrate because the head of distribution is on my management team, the vast amount of our individual distribution. Now he also has the annuity business, but that was an add-on. At Lincoln, distribution is a career. You can come into Lincoln and get all the way up to the management committee and potentially the CEO position. That's not true in most of our competitors. In most of our competitors, they tuck distribution inside the business unit. We've done it this way for a decade. Allows us to attract talented people who want to stay in that career path.
When it comes to the business, it's very important that we break even on that distribution cost versus the allowables in the product or the fees that we get elsewhere. For example, Athene. When we did the Athene deal, we got paid more for their access to distribution than we were making on our own business return. That's an example of how powerful our distribution is. It has to be run as a business. What do I mean by run as a business? Obviously, breaking even on cost and expense, which is the way you manage distribution in the life insurance business, is important. Because it's such a big part of the business, you can have data analytics, you can have marketing programs, you can have career planning programs.
It's just the whole infrastructure of support for distribution that makes it easier for our wholesalers, as an example, to be successful.
Right
in their businesses.
Okay, good. Yeah, let's go to questions first before the audience response system. I believe we have one right over here. Just wait for a mic, if you wouldn't mind, please.
I don't think this is on. There it is.
Marvin.
Your earnings per share last year were $8.48 a share. This year, the FactSet consensus is $9.35, and the following year is $10.35. The 10-year Treasury has ranged between 4% and 4.5% for 50 years on average. It's now about 1.5%. Specifically, if the 10-year were to go to 1% and stay there for a while, how badly would that impact your earnings? My second question is, where would you say your tangible book value per share is today? Where would the book value today be per share, including intangibles and AOCI included?
The guidance that we give on interest rates, Chris, help me with this, is in terms of earnings effect.
Do you want a mic? We need a mic.
Get a mic, please.
From a 1% 10-year. Chris, go ahead with this.
We've given the two businesses that are most impacted, we've provided some sensitivities to where we talked about, within the life business, a 100-basis point change in interest rates is about $12 million. Within the retirement plan services business, the same sensitivity, 100 basis points, would also be $12 million. That gives you a sense of the movement rates and what the impact is to earnings.
Yes. The other question, I'm going to talk about two things, Marvin. Both of them are important. The first one is what happens to our intangibles with interest rates lower. We get asked this question a lot, and we're in the process of doing, in this specific example, our DAC analysis, which will come out at the same time as our third quarter earnings do. What we've been saying is that, again, we're not going to front run the answer to that because the calculations are underway and there's a lot of variables that go into the calculations. I would only say that the interest rate assumption that we used last year, relative to where we are today, is lower. So that's one of the variables. I think, again, Chris, let's give the sensitivity on that, please.
Every 50 basis points change is about $160 million.
The book value.
Correct.
Of course, goodwill is such a smaller part, as I mentioned earlier. The other thing that I think investors are concerned about or should be concerned about is perpetually low interest rates and what does that do to your statutory capital and specifically an increase in your reserve requirements. In 2016, at our investor conference, we talked about sensitivity. Let me give you the sensitivities. At 1%, our sensitivity was we'd need an increase in our reserves of about $350 million. At 50 basis points, we'd need an increase in our reserve around $700 million. That is a one-time increase in reserves. I would just compare that to our free cash flow that we've been using to buy our shares back of about $600 million or $700 million a year.
You can see from that perspective of, I don't know, that we'd cut our share buybacks by 100% because you'd probably do it over time. There's certainly enough cash flow coming off of the portfolio to deal with that kind of a reserve increase.
That range of impact would still hold, I'd say.
I may have gotten it wrong, but I thought you said that was from a couple of years ago, that estimation.
We're in the process of it, but we don't actually do that analysis until the end of the year. I'm pretty confident that those numbers are
Okay
fairly reflective of the situation.
Clearly absorbable within existing earning power and perhaps taking some actions in terms of return of capital.
Yes. Let me expand this just for a moment. This gets back to my comment about low interest rates are not good for the financial services business. Just coming back to some specifics. At Lincoln, spread compression, which is a consequence, occurs over a long period of time, giving us an opportunity to take the kind of actions that we've already taken to produce these kind of results that you see here. That's an issue. From an interest rate perspective, I just gave you the numbers on the additional reserve requirement, which is manageable, and I'm going to come back to that in a second. The intangibles we've touched on, importantly, the product pricing. What level of price increase with lower interest rates can you put into the market that'll be accepted by the consumers.
The big picture, again, there's a lot of levers that we can have, that we can use. Let's say that we did have to come up with a little bit more cash because of the increase in reserve requirements. One option would be to, as I said, cut back on our share purchases. Another option would be to lower the overall volume of our sales. If it was better to be buying our shares back and selling a little bit less, which we have done in the past when the math supported it, we could do that as well. Today, actually, I think it's about neutral. We could quit selling new business, and maybe even buy our shares back and get a slightly better return on the share buybacks than we would on the new business.
What I'm trying to paint a picture of is all of this is manageable, and we have different levers that we can pull. Again, I'll point you to the three, five, and 10-year results here. 5% to 6% compound growth in earnings, 11% to 12% CAGR. Expand of the ROE. This has taken place during a variety of macroeconomic conditions, and we're committed to taking the necessary action to make sure that our shareholders are seeing increases in the value of their shareholdings.
Well, with that, I'm afraid we're out of time. Please join me in thanking Dennis Glass.
Thank you.