All right, we're going to get going. Pleased to have Lincoln Financial with us again this year. Up on stage with me is Randal Freitag, who is the Chief Financial Officer and Head of the Individual Life business. Also want to recognize Chris Giovanni, Corporate Treasurer and Head of Investor Relations, and Jesse Brath from the IR team as well. To kick it off, you had your investor conference in June.
You reiterated the 8%-10% annual operating EPS growth target. At the time, you talked about some near-term upside from expense saves that would be partially offset by spread compression. The interest rate environment has worsened since then, I was hoping you could discuss how the drop in interest rate impacts your outlook compared to what you talked about a few months ago.
Well, thank you, Ryan, for having us here today, upgrading the hotel from the Crowne Plaza to this. I feel like I'm at Versailles or something doing a conference. Yeah. There's been a lot of puts and takes that have gone on in 2019. I think when you add them all up, and I'll get into them in a little bit, 8%-10% still represents a reasonable expectation for Lincoln's potential growth rate. As you referenced at our investor conference, we talked about 8%-10% with upside from expense savings and partially offset by interest rates where they were at that point in time. Implication being that there was a little bit of upside. Since then, come down, I think when you add them all, 8%-10% still represents a reasonable expectation.
In terms of those puts and takes, 2019 has seen over-performance from the equity markets relative to our expectations. We're getting more bang for the buck from each dollar of buybacks, unfortunately, with the share price down, and that's all offset by the interest rates coming down to where they are today. When you add it all up, 8%-10%. I think when you move forward, we do over the next few years have the ongoing benefit of the accruing savings plan program, the digital program that we talked about, providing some buffer to interest rate impacts.
Follow up more specifically on interest rates. You had said over the last 5 years there was about a 3% annual headwind to EPS growth from low interest rates. Just based on kind of where we are now, how would that compare to the current situation?
At the peak, interest rates spread compression represented about a 4%-5% headwind, and today we're about half that. We're two and a half, somewhere in that range. It's no fun. There are a lot of actions you have to take in the company when interest rates go down. We'll have to look at certain products inside of our portfolio that might need to be repriced, benefits that might need to be changed, et cetera. The headwind itself at the highest level is about half what it was at its peak.
Got it. You talked about on free cash flow, $850 million-$950 million annually over the near term.
Yes.
How do you expect that to evolve over the next few years? If we remain in a prolonged low interest rate environment, would you anticipate that impacting your free cash flow expectation?
Well, to start out, I still think $850-$950 is a reasonable expectation. If you look at what we're doing this year, we're on track for a number like that. When you think about the things that can impact free cash flow, one of the main drivers, of course, is the amount of new sales, especially in our two businesses, life and annuities, who are at the more capital intensive end of the range relative to the retirement and the group business. If you look over the past decade, I think you've seen a pretty good track record of prudently making that allocation decision between new business and returning capital to shareholders. Of course, in a world where you're getting whatever returns you want, we want to sell as much new business as we can.
Understanding that's not always the case, we're always taking actions in response to the capital markets, including the level of interest rates. You would expect to see us make those responses. I think $850 million-$950 million with the usual expectation that we would expect it to grow going forward. We would expect sales to grow. I think I pointed out at the investor day that the combined impact of 10% increase in life and annuity sales is about $175 million of allocated capital. When you factor that all in I think $850-$950 growing with the business making that decision about what capital should we allocate to the business, what capital should we allocate back to shareholders which we've done a good job of in the past.
Just on the low interest rate piece of that, you in the past have disclosed very strong asset adequacy testing margins, you did say there could be an impact just to the specific block of interest-sensitive life business if rates got, I think, approaching 1%. It's sad that I even have to ask you this, given that the 10-year's at 1.50%, I guess can you give any update on that?
Yeah. It's unfortunate that we're back at this rodeo. It was 2016 my recollection when at our investor day we put a table in there. I think I can picture it in my mind. It was in the lower right corner of the page, which showed that at that point in time the 10-year at 1.5%, we didn't see much impact. As the 10-year moved to 1%, our expectation was additional reserves that needed to be put up. The 10-year at 0.5%, which we also showed in that table, was rough. I think we haven't formally updated, I think there haven't been too many changes from that moment in time. I think it's a reasonable representation of what you might see in a low rate environment.
Those reserves, as you said, emerge from the sub-tests that are inside of cash flow testing on guaranteed universal life books of business.
I assume it would be a point-in-time impact. In other words, if the 10-year then subsequently went back up, you would release those reserves.
Yeah, that's exactly what it is. It's a point in time. Even on its own, it would release over time. Yeah.
I guess on the more positive side, last year when your stock price was depressed, you took an action with the fixed annuity business to do a reinsurance transaction to free up more capital for buybacks. I guess, in the current environment, are there potential actions you could also take to actually increase buybacks to take advantage of the stock price?
Yeah. I think we are always looking at whether there are components of our balance sheet or in force where it makes sense to do something like a reinsurance transaction. You need both sides to exist. You need to have people willing to pay a price, that we find represents the true value of the business, and on the other side, you have to have a place to put the capital on our balance sheet. I think the Athene transaction, which you referenced, was a great example of that. There is a very competitive pool of companies willing to pay attractive prices for fixed annuities books of business. We felt we had a compelling opportunity on the other side, we took advantage of that. If you look at other books of business, like I said, we are always going to be looking at these things, whether they make sense.
I think the reality is, if you are referencing specifically books like variable annuities, the pool of available buyers isn't as large. I don't think the prices are competitive. Really, the only books of VAs that moved have been examples of companies who wanted to exit the business or were just tired of dealing with what were really lower quality books of business. That's not the situation we are in with our business. Yeah, of course, we are always looking at these things, but it's somewhat fact-specific on whether they actually happen.
On the variable annuity business, you have demonstrated the high-quality nature of your book, and you have given us a number of metrics like cash flow scenarios. You have showed limited impacts to your actual assumption changes over time, high ROE, low net amount at risk. You have shown a lot of attractive metrics. The market doesn't seem to be willing to give you much credit for the value of the VA block. I guess you kind of just answered it, but maybe the environment's not right. I guess, have you ever considered a transaction for at least a smaller piece of the block to try to prove to the market that there's more value there than it's describing?
Look, I'm not going to speak specifically to that, but we are always looking at things that make sense that we believe will maximize shareholder value. That being a big part of our balance sheet, we are always going to be thinking about things like that. As I mentioned, I think the pool of available buyers, pool of buyers looking for high-quality open books of businesses is not very large.
Okay
You never rule things out, but at least the past would not indicate that there's a lot of people out there looking for things like that.
Also on variable annuities, I guess a lot of the low-interest rate discussion is generally around spread compression. Low interest rates also impact hedging costs for
Yeah
the variable annuity block. Can you help us think about that impact, and I guess, how that kind of comes through your results?
Yeah. The biggest driver of day-to-day hedge costs is the level of interest rates
Yeah
in the VA business. What comes through our operating income is the difference between the amount we charge for hedging versus the cost of hedging, right? That is what comes through our operating income. To the extent the cost of hedging goes up, then that margin that comes through in the future will be a little smaller. A couple of points I would make on that. This is always going up and down. I mean, there are moments in time where we are getting very strong returns, and there are moments in times where we are getting a little weaker returns. Very rarely are we exactly right at the level we would expect.
This is one of those moments where you are a little below, but what we are selling today is just a tiny fraction of our overall book of business, and you would not expect it to have a large impact, an impact that you could even see. The other thing I would point out is that we do have the ability to do things to lower the cost of hedging, primarily through adjusting the benefits or raising the cost that we charge the consumer. Just recently, we lowered the guaranteed level on our VAs with guarantees, which has the impact of lowering the cost of hedging. I would imagine if rates were to stay low, we would continue to look at actions like that.
The other thing I would point out is that it is very different from, I guess I will use this phrase a few times today, this rodeo a number of years ago when VAs with guarantees were 90% of our sales. Today, they are 40%-50% of our sales as fixed annuities. Indexed variable annuities have become a much bigger piece of the sales pie at Lincoln.
Got it. I want to shift to the expense side. You have had this digital initiative in place for a few years. Can you give an update on how things are progressing, and also remind us of the expected benefits of this digital initiative over the next couple of years?
Been really, really happy, not only with the expense savings side of that, but the improvements in the customer experience that we've seen. I think there have been very positive customer experience changes that we've seen also. Specifically, when you look at the expenses, what we talked about 2017 and 2018 were the net investment years, roughly $40 million. We came in right in line with that. This year, we expected to be neutral. We're right in line with that. When you look forward, I would expect over the next few years that it would grow fairly ratably into that $90 million-$150 million ultimate net benefit that we anticipated from the program. We're right on track with the thesis at the beginning, and feel very, very good about our execution on that program.
In the Group Protection business, your margins have recently been around the midpoint of your 5%-7% target, but that's also before some benefits of additional expense actions. Also you're still working through the repricing of the Liberty book. I was just hoping you could give a little bit of an update there, particularly around where you see margins headed within that target over the next few years.
Well, in the most recent quarter, we reported 6.6%, which I would say represents our expectation for performance time in the upper half of our 5%-7% range, which is what we've talked about. We, and the industry, are benefiting at this moment in time from loss experience that is very good. Benefiting from the economy, the very low unemployment rates. We're seeing a benefit from that. I think in the quarter, our loss ratios are roughly a point lower than our longer-term expectations, point half or lower longer-term expectations. As you look forward, if and when loss ratios normalize, we do have the benefit of additional expense synergies rolling in from the transaction. We've talked about an expectation ultimately of getting to about $125 million. We originally had targeted $100 million, but we've moved that up to $125 million.
Coming out of the second quarter, we were at roughly a run rate of $80 million-$85 million or so. We do have that natural offset if and when loss ratios would go back to their normal level.
Have you given the favorable loss ratios within the industry as a whole? Have you seen any evidence of increased competitive pressures as a result of this or I guess behavior is still pretty rational?
When I talk to the team, they describe the market as rational but very competitive. This is a business that people want to be part of, so it's always going to be competitive. You're never out there getting a free ride at cases. You're always competing against somebody. I think the companies we're competing against at this moment in time are all behaving very rationally. I mean, they're all large, high-quality companies with similar aspirations and goals to Lincoln, and you're seeing that in their behavior. I think the industry itself this year has seen that sales have been a little challenged. On the other side, persistency has improved, which I think is a sign that companies are really trying to retain what they've worked so hard to get in the past.
Overall, you would never say this market isn't competitive, but it does seem to be pretty rational right now.
In the life insurance business, you had a pretty good pickup in sales in the second quarter. Can you talk about some of the actions you've taken to drive that? What type of new business returns you're seeing at this point and your outlook for growth in that business?
Extremely happy with our execution this year. At Lincoln, we feature a very diversified mix of new business sales. Coming into this year, we saw two areas where we were underrepresented with respect to our long-term expectations. That was smaller face term insurance and the indexed universal life space. We put specific strategies in place to grow those, and we've seen really good results. Term insurance, I believe we were up a little short of 30% quarter-over-quarter. On the indexed universal life side, we're up 79%, just a little short of 80% year-over-year. Really happy with the execution on these specific strategies we put in place. Additional benefits of those two products is that in the case of term insurance, you're talking about a product that's not really impacted by the level of interest rates.
In the indexed universal life space, you're talking about a product where you have things you can manage, like the cap levels you offer to consumers, which can offset the higher cost that comes with the lower interest rates. Really happy with the execution, really happy with where we sit today. If you go back to 6, 7 years ago, Lincoln was a company where two-thirds of its sales came from one product, guaranteed universal life. Happened to be the product that was most impacted by the level of interest rates. You saw significant impact on our level of sales as we had to reprice that product, which represented two-thirds of our sales.
Over the subsequent 6, 7 years, you've seen us greatly diversify our sales to the point today where guaranteed universal life is 5%, and two-thirds of our sales are really in products that aren't as impacted by the level of interest rates. That's variable universal life, that's the executive benefits business, that's term insurance, that's IUL. While there's some work we have to do, I think, on GUL, you're talking about a very small sliver of our portfolio. MoneyGuard is another product impacted recently announced price increases on that product, partly impacted by rollout next year. We're in so much better place than we were a number of years ago and feel good about the returns we're getting. There is some work we have to do product.
At your conference, you talked about some ongoing pressures from higher reinsurance costs in the life insurance business. Can you just talk about how meaningful that is, and I guess has been and continues to be, and also what actions you've been taking to mitigate the pressure?
It's been a pain. I pointed out Investor Day that the headwinds, if you want to call them that which have primarily been level of interest rates, spread compression, and then higher cost reinsurers have sum totaled up to $250 million of annual headwind over the last five, six years. Of course, we don't sort of look at that and stop there. We've been doing things to offset that. If you look at whether it's expense savings programs or things we've done with in-force management or the sale of new business, we've more than overcome that $250 million headwind. It's been real. I think it's in the case of reinsurance costs, it's an issue that all over the hump, I'd say we're 75%-80% through with our partner reinsurers.
While it has not been easy, it has not been something that we have sort of just stopped and said, "Oh, crap, we can't do things to offset that." We've done, which is what you would expect. Every single day, we've worked to overcome whatever headwinds we face. I would point out that every business faces headwinds right at any moment in time. Those just happen to be a couple that we face in that business.
Are the higher reinsurance costs related to older age mortality, or is there something else that's been driving that?
Yeah, it's the fact that if you go back 10, 15, 20 years ago, reinsurer expectations for future mortality, going to get a little technical on you, were flatter than direct writers. You saw direct writers, including Lincoln, using a tremendous amount of reinsurance because we looked at the prices they were offering and said, "Hey, these are really attractive." The thing we didn't do is make sure they were guaranteed for the rest of time. I think we relied too much on the old reinsurance handshake that they'd never increase rates. Well, eventually they did, We've talked about where the reinsurers were with their mortality expectations relative to the direct writers at that point in time, Now the reinsurers are responding by adjusting the rates they charge.
In the variable annuity business, NAIC reform is finally going into effect starting next year. Can you talk about how that impacts your business either, and I guess does it impact your hedging strategy at all? I know you talked about being pretty well-positioned, but any positive or negative impacts from this?
A great example, I think, of industry and regulators working together to improve something that wasn't working, and that's how you capitalize and reserve for these products. We've been part of this from the beginning. We've known for a long, long time, we've communicated to you that this would not have a negative impact on Lincoln. That really had to do with the fact that the assumptions that underlie our products are on the conservative end. We've known for a long time it wouldn't be an impact. I think it's neutral to modest positive overall, and I think that in terms of what it means for the industry, I think it means that the regulators have a reserving and a capitalization model that is much more reflective of the economics.
It's not purely economic, and so I don't see it have an impact on how we hedge those products. Neutral to positive.
Just are there any other NAIC initiatives that are kind of on your radar at this point?
Look, we're active in pretty much every major regulatory initiative that comes down the pipe. Two of them that are going on right now that we're active in. One would be Group Capital Standards. That's more of a reporting environment. It's in the NAIC trying to figure out in the construct of a state-based system, can they come up with a tool that really outside of their historic mandate, aggregates capital across life and non-life entities across an organization? We've been actively a part of that. Yeah, I think the big one is probably the C1 bond factors. It's been roaming around out there. They tabled it last year. I think they'll get back to it again at some point in time.
The industry has pushed back because we're not able to understand the factors that were developed, unfortunately, by a body that I'm a member of, the American Academy of Actuaries. The industry itself has not been able to really be supportive of the proposed factors because we don't believe that it reflects historic data. There's been this push and pull between the different bodies. I think at some point in time, they'll resolve it. I can't tell you when, though. We are actively involved with that. Ellen, our chief investment officer, has really been the Lincoln liaison on that.
In your retirement business, you've guided to 8%-10% intermediate term outlook for earnings growth, which is pretty high given some of the things in the industry that are occurring, like fee pressure and
spread compression. I was hoping you could talk a little bit about how you're achieving that.
I think you're referring back to the IRB.
Yeah
The retirement at the level of sales we're experiencing and the level of interest rates at that point in time was 8%-10%. Retirement, along with life, is one of our two businesses that is negatively impacted by the lower interest rates. That particular.
Yeah
business. I think the key point, and I made it earlier, so I'll just reiterate it, is that when you come out of a particular business and realize the fact that we are four distinct businesses, all with different characteristics, and you think about the impact of lower interest rates, while they may be larger on the retirement, in total, we're at a level that's half of what we faced when spread compression was at its peak. Would note that despite the fact that spread compression has been higher in the past, we've been able to grow our EPS at what? 12% a year for the last five, six years. We never stop with just the negatives. We're doing whatever we can to grow this company.
Just pause to see if there's any questions in the audience.
Yeah. Within financials, there's a lot of focus on the impact of lower rates on whatever-
company guarantees.
I'm just curious from your perspective, as you look at the yield curve and the fact that rates, not only in the U.S. but globally, are collapsing-
what does that mean to you? Meaning, hey, it's signaling a recession and we're hunkering down for it, or it's something technical, or it's trade. Just interested in your personal opinion.
Well, what it means to me is what do we at Lincoln have to do in response to the environment that exists today and what it may exist in the future? What that means to me is that we need to go into our portfolio, and any products that are negatively impacted by interest rates, we need to make a rational response. Now, as I mentioned during one of your questions, it's less of an issue today for us because the products that are impacted by interest rates, guaranteed universal life, variable annuities with guarantees, are a much smaller piece of our sales mix. We need to go in and we need to address the business we're selling today to ensure that we're getting appropriate returns for the capital we allocate into those businesses. That's one.
We have to go into our balance sheet and make sure that our assumptions are reflective of the future. We have a long-term expectation for the 10-year treasury of roughly 375. To the extent rates are lower, we'll have to have a thoughtful discussion about whether that's appropriate at this point in time, and that's part of the third quarter unlocking process. That'll be done in the context of all of the assumptions. At this point, we have no idea what the answer will be. We'll add everything up, we'll have a thoughtful discussion around interest rates. We have to think about are there any impacts on our statutory balance sheet. I talked about those impacts and how we would manage any of those impacts we might have.
The reality is at the level of interest rates today, we don't see a big impact on our statutory balance sheet. We'll have to think about what do we look like in the stress test? How does our balance sheet hold up in the stress test? We'll do all the things we've always done. I don't want to, in any way, shape, or form, indicate that I'd like low interest rates, I think our ability to respond has been demonstrated in the past. I think the responses we have to do today aren't quite as severe as they were a number of years ago.
Any other questions in the audience?
Thank you. Thanks, Randy. Tim Morgan, KBW, London. I guess the magic question when we talk about being more evolutionary as we get used to lower rates is.
Whether there is a step change required if we go to negative rates, at least for U.S. Treasury, that's just joining.
The rest of the world that way.
I think the step change would be naturally occurring as any products that were impacted by that were repriced or the benefits we were able to offer to the consumers were negatively impacted. One would expect that would have an impact on demand. I think the natural response to lower interest rates, which is an input into the price and benefits we can offer, is that to the extent the price goes up or the benefits go down, I would expect to see demand for those products fall. We as a company would have to decide, okay, we're not allocating as much capital to those products. What do we want to do with that capital? Do we want to return it to shareholders? Are there other product categories that we can move into that aren't as impacted by the level of interest rates?
I think that discussion, which you can expect is going on at Lincoln, is one we would have as interest rates change over time.
Just one last question from me was, you've taken some de-risking actions in the investment portfolio. Can you review what you did, and do you envision doing anything additional at this point?
I think we're very happy with the position of the portfolio today. It's a day-to-day ongoing thing that Ellen and her team are involved with. If you look at some of the major statistics, below investment grade holdings, which historically have been 4%-6% of our portfolio, are at the very low end of that. We're at 4% today. BBB holdings in total are down 1.5%, down about a billion and a half dollars of our $100 billion general account. Inside of BBBs, the BBB- component has shrunk, and Ellen showed that at the investor day. We've done things inside of classes to move to the higher end. At a high level, you've seen us lower our holdings of more cyclical industries. Our energy holdings have come down quite substantially over the last four to five years as a percentage of the portfolio.
Consumer cyclicals have come down pretty substantially, you've seen a shift into less cyclical investments like commercial mortgage loans, infrastructure, municipals, those sorts of investments. We're happy with where we are today, every single day, Ellen and her team are deciding what small adjustments should be made.
All right. We're going to wrap it up there. Thank you very much.
Right on time.
Right on time.
Thank you for having us and coming today.