Last week, someone came into my office and dropped off a copy of Best's Review. It's a periodical. It's one of the many periodicals that I read. It's fascinating. The headline was Words of Wisdom, and there were photos of seven different business leaders on the cover. I glanced over to see who I would recognize, and I saw Dennis Glass. I was kind of nervous that this article was going to contain all the words of wisdom that Dennis was going to share with us at the conference. I think it was literally one quote, so it wasn't much.
It was a good one, though.
It was a good quote. Thank you for not sharing everything before the conference.
Yeah.
Dennis is President and CEO of Lincoln National. He's been CEO since 2007. Prior to his role there, he was President and Chief Executive of Jefferson-Pilot, which merged with Lincoln in 2006. Under Dennis's leadership, Lincoln has delivered stable double-digit ROEs for the last five years with a significant return of capital to shareholders. Dennis, thank you for being with us.
Delighted to be here, Jay. Thank you for having us.
What I want to do, again, I've started the other panels this way, other sessions this way, is just give you a chance to have some kind of opening comments, if you will, to talk about how you viewed 2018 and some of your priorities for 2019.
Great. Well, you all have seen the numbers of 2018 in terms of operating earnings per share was a record year, we're pleased to see that on behalf of our shareholders. It's also a year in which we saw the fruition of some of the management actions that we've been talking about for a little while. For example, we've been talking about increasing the scale of our group protection business. You just heard from one of our best competitors, Unum. Closed that transaction this past year. What was the purpose of the transaction? To increase the portion of our earnings or the source of our earnings that came from mortality and morbidity. We've had a strategy of getting to about a third on that, we're pretty close with the Liberty acquisition.
It's fun to see something that you've been working on for three or four years actually happen. We were patient. Another strategy that we had that developed very well in the fourth quarter was that we had run into annuity net outflows. About two years ago, we developed a strategy that broadened our view of what businesses or what products were going to participate in the annuity segment. We went from negative flows to very positive flows in the fourth quarter. That was another management action that thought about, conceived, and executed on. We were proud for that to have happened. Another one that we talked about a little bit is about two years ago, we decided a couple of things. The background on the decision, the decision was to invest more heavily in digital technology.
The background on that was we thought that the customer experience that people would want was not going to be defined by the insurance industry, but it was going to be defined by the born digital companies, Uber, Amazon, and the like. The second thing is, as we saw spread compression occurring, we thought through the use of digital, that we could replace the lost earnings from spread compression with expense reductions of about the same amount. This year, we're right on track to see that savings, which is about $125 million, develop in 2020 and 2021. Another management action that's very important to driving future shareholder value. We had another financial engineering event, which worked out very well. We had talked about the possibility of selling a block of business and buying our shares back.
Facts and circumstances turned out such that in the fourth quarter, the buyer's appetite was at a price that we thought made sense. Coincidentally, our share price had drifted down along with the rest of the share prices, as you know, in December. That financial engineering transaction is going to be very helpful to our accretion over the next couple of years. Management actions producing good results and achieving strategic objectives is what characterized 2018 and made me proud of the company and management's execution capabilities and vision. As we go into 2019, continuing work on the integration of the Liberty transaction, continuing work on expanding our portfolios.
The life business, I think we can take the same approach on that we did with the annuity business, which is to participate in segments where we can distribute effectively, get a good return, but we're not now in any significant way. Indexed universal life is the best example of that. 2019 has been characterized by execution of our core strategies, which have been working quite well for quite a period of time.
On the annuity sales, luckily my predecessors left me with a great earnings model, so I can go back and look and see how does this compare with the past? I think it was the best net flows in about five years. I think the perception, to some extent, is, well, everyone's seeing better flows. The industry is. Clearly, you guys are taking action to drive sales. Can you talk about some of the specific things you've done over the past several years that have now resulted in this good sales growth?
Yeah. Generally, I pointed out that it was broadening our strategic view of where we would participate in the individual annuity market in the U.S. Before we changed our strategy, we had focused predominantly on guaranteed lifetime income sales, variable annuities with guaranteed lifetime income riders. Early, I think about three years ago, we started getting more of that business because some participants in the market dropped out than we really wanted. We switched to increasing our sales of variable annuities without the long-term guarantee rider, and very quickly got to instead of 92% guaranteed down to 70% guaranteed. As the Department of Labor rule came out, and other new products were being introduced to the markets that were being accepted by consumers, we decided to broaden our approach, specifically in the fixed annuity business, which we always did.
We got much more creative with product. We got much more creative with adding distribution. That'd be one good example. There's a couple of products that we didn't have in the variable annuity space. An important one, indexed variable annuity, which is kind of a product value proposition that's between a variable annuity and a fixed annuity, and grew to a market size of about $12 billion. That was the best product launch we've had in the history of the company. Actually, in the fourth quarter, it represented 25% of sales. I can also say that we launched a product a couple of years ago that we sold two policies, we don't always get it right. In this case, we got it right in spades. We've added on the fixed annuity side in terms of distribution, more banks.
We've added a couple of independent marketing organizations with proprietary product. Again, this is all in the annuity business. It's our standard playbook of product breadth and powerful distribution and shelf space. In terms of distribution shelf space, we also were very pleased to be awarded the opportunity to sell our annuities through the Allstate system, and we think that in of itself has the potential. We had a very good year in VA sales last year, excuse me, in individual annuity sales. We think that relationship alone has potential to increase sales by 5%. Just to give you an example, if you hit the right distribution opportunity and have good products, which gives you the access to the right distribution opportunities, it can be very powerful.
You say the Allstate relationship would help by 5%?
Yep.
That's pretty significant then.
Yep.
Does that happen in one year or over several years?
Well, you have to build up your wholesalers team, and I think we're going to put 15 wholesalers behind that channel. The wholesalers have to develop the relationship to people who sell the products. That'll take some time. I think that 5% will be at a run rate toward the end of this year, going into the next year.
Wanted to just ask your view of the competitive environment in annuities, how it has changed, and do you expect it to get tougher in 2019?
This is a very interesting time in the annuity business. I would say that the management that's in place of our competitors are sound people who have a very high respect for not taking excess risk and get a decent return on capital. Let's just compare and contrast. During what's referred to as the feature wars, which I guess occurred in 2005 and 2006, you had roll-ups on variable annuities of 7%-10%. The basis points cost for the guaranteed lifetime income rider was 70 basis points. That was not sound pricing. A lot of it was being driven at the time by a greater focus on the parent companies on top-line sales rather than on return on capital. The companies that were doing that got out of the business, and the companies that remain are very focused.
The riders, the roll-up features today are 5%-6%. The fees for the riders are 135, almost twice what they were before. There's restrictions on the amount in a particular account, how much bond. You have to have some bond and some equity. The overall business is a much sounder return on capital, and the products are much less risky.
I guess, do you see that changing? I mean, you're always aware of the potential for it.
That comes back to my comment about who's running the businesses these days, the businesses are being run by people who have a very keen sense of return on capital and risk. In the life insurance industry, the CEOs, a lot of them today have come up on the finance side or in the investment side. Their teams are, for example, I came up on the investment side Randy's an actuary, our Chief Financial Officer. Lots of the people who run the businesses are finance-like actuary people. We've got good distribution people as well. I think that our skill sets are similar to what we have at our principal competitors. I think it's a much sounder and better-run business today.
Yeah.
As good as it's ever been, I think.
Rational competition. You obviously have newer products, newer distribution.
Yeah.
I guess the biggest risk would be just macro at this point, equity market downturn, recession.
Yeah. Jay, that's come back to our strategic decision to increase the source of earnings coming from morbidity and mortality earnings. That's something that's not affected, obviously, by the capital markets. Our other two sources of earnings, spread compression-- excuse me, interest spread, and fees on assets under management, are affected by the capital markets. Now, if not unlike the asset management business. In our case, I don't want to stop by saying capital markets is bad, capital markets is good. For the last, what, eight or nine years, equity market's been growing at 9%, so we've had some lift in our earnings coming from that. Some of that lift's been offset by interest rates going down low. Well, things will turn around. Interest rates will come back up, so the source of earnings attributable to our spread businesses will grow.
The growth rate in the equity markets with rising interest rates will be a little bit slower, that'll compress a little bit. That all is cooked into our business model, and we call it the all-weather business model. This balance between fees on assets under management and interest spread should typically, in cycles, offset each other. There's the possibility that both interest rates will fall and equity markets will fall. That's not a good environment for any insurance company. Over the long term, we like where we are with our business mix and source of earnings.
You sort of alluded to the morbidity business. Let's talk about group benefits. Do you see the growth there as sustainable over the next several years?
Yeah. The group business in the U.S. has been a middle single-digit growth industry for a long time. The value proposition for the employers is only getting greater by providing ancillary products to their employees. They want to hold onto their employees, that's one benefit that they can provide them. The markets that we're in, of course, we're now with the acquisition of Liberty, we're in all size employers. We used to be only in employers with 1,000 or less, mostly 1,000 or less employees. Today, we go all the way up to 50,000 or 60,000 companies with 50,000 or 60,000 employees. The characteristics of those two business are slightly different. Large scale customers are a little more customized. You have a longer duration relationship because you're working with them on a more customized basis than in a small market where it's more of a transactional sale.
Yeah, I think 5%-7% growth in sales and premiums with a 5%-7% margin, it's a pretty solid business.
Yeah. relatively stable-
Yep
too.
Yeah. The bigger you are and the more customers you have, the more likely that your expense ratios and loss ratios will be less volatile than if you're smaller.
How would you evaluate the acquisition of Liberty's Benefits business to date, and what has surprised you about it, both positively and negatively?
We built Lincoln on, I don't know, 10 or 15 acquisitions. When we get into a due diligence process, we have a lot of history about how to do it, what information to gather, what questions to ask, what models to run. If you do that effectively, there should not be any surprises when you get to the day you close and move forward. I would say by and large, that's what happened in the Liberty transaction. Very thorough due diligence. When we communicate a transaction, again, this has been part of my history for 25 years, we don't give the most aggressive expectations. I know the old saw that you'd rather do better than what you said you did. I forget what that old saw is exactly.
We thought out a solid set of margin expectations, integration savings expectations, and timeframe sales expectations, retention expectations, premium growth. We're ahead on every one of those metrics except sales on the large case side was a little bit slower than we had in our models. Whenever there's a deal, again I've seen a lot of them, there's always a little bit of hesitancy on a broker to bring a company that's going into an integration into play for a customer because they're a little bit worried that the integration will cause servicing or other problems. I think that's behind us. We are seeing a more robust pipeline of opportunity as we move into 2019 on the large group case side.
Well, I assume you have some sense. From my understanding, a lot of that business gets done early in the year. Do you have any insight into how sales looked in January?
Actually, a lot of the sales, in large cases, are written in December, I think. Yes, we are seeing in January some good traction.
One topic that comes up quite a bit is the kind of investments in digital capabilities.
Yep.
You guys, I think, have been as vocal as anyone about the need and your efforts to do that. Can you describe some of the projects that are going on? I know you've talked about this before, but how it affects both revenues and expenses.
We've talked about the ultimate run rate of savings coming from digitization of $95 million-$150 million, I think we've sort of settled in on a target of $125 million, leaving 2021 sort of run rate around $125 million. The digitization is using tools, robotics, optical character recognition, chatbots all of which reduce the amount of staffing that you need to achieve your service levels. The old staffing models, let's say that you wanted 98% of your incoming customer calls answered within 30 seconds. If you wanted to change that to 99% in 25 seconds, you'd have to increase the number of people. That's why it was always hard to get improving customer service always meant increasing the number of people you had in your service-
Right
in your call centers. With the tools that I'm talking about, chatbot, for example. I mean, you reduce the number of people. You get a better customer experience. You're available around the clock. It's a combination of tools like that. There's a lot of process reengineering that needs to be done. I mean, you don't just sometimes you can come in and add robotics if the process is already at its maximum efficiency. Most of the times you have to relook at the processes, that in itself saves money. On top of that, some of these digital tools can help save money.
The other thing that we're discovering is that as we put digital in place in some of our customer service areas, and we take down headcount, what we're also finding out is that we can experience much larger volumes without having to raise headcounts because the robots can do as much as they can do. Not only are we reducing our costs, but we're putting a cap on further cost increases that we actually hadn't anticipated as much.
The-
By the way, when we throw out a number like $125 million, those numbers are in our financial projections, and some person is responsible for achieving them. It's not a matter of just saying, "Well, we think we can get." We know exactly where it's going to come from. Now we may miss one or two of the projects, but it's not just a number that I throw out loosely.
With some of these investments, can you create a sustainable competitive advantage or is it these are just table stakes? Everyone has to do this to compete, but you won't really have a sustainable advantage. How do you view that?
It's another interesting question. When I decided to push it at the company as sort of a top-down strategy, we were doing a lot of it anyway. One of the business units, the RPS business unit, it was already table stakes in the defined contribution business capabilities such as Click to Contribute, where you can look at your Apple Watch, see what your current account balance is, and if you increase by 2% the amount of paycheck contributions how much more will you have when you retirement. You can do that right on your phone. I mean, people expect that kind of ease of doing business.
Interestingly, Click to Contribute added $900 million of incremental deposits in the first 12 months, which is good from the perspective of Lincoln and profitability. How powerful is that in terms of helping with this huge savings problem that we're going to see develop already, but more so over the next couple of years? That's what's good about the life insurance industry. It has such important social value, and we make money. Those types of things are what is making a difference.
Yeah. Especially for younger people. They're more likely to do that on the watch.
Yeah
They're the ones that need to save as well.
To finish my story the other three lines of business, two years ago, were sort of shaking their head and saying, "It's really not a competitive issue for us." In this last strategic planning session, well, in this year's strategic planning, every business unit needs to have a better level of customer service driven by digital capabilities in order to your point, to be in the business. I mean, it's not just a nice to have. You've got to have it across our businesses. Just a small anecdotal example. I was talking to one of our financial advisors, and a year ago he was saying they sat down at the kitchen table to sell a life insurance product, took the application, and he built a relationship with people, and that's the way he was going to conduct business. 12 months later, he said, "You were right, Dennis.
I was wrong. People don't want to sit around the kitchen table for two hours with me anymore. They want to be able to fill out the underwriting thing on their computers and get it processed right away and get their policy issued." That's an anecdotal example, but those are the kind of things that are going on in the industry in order to remain competitive.
You were right. I was wrong." I don't hear that very much. That's a nice thing to hear.
I hear it around the other way a lot.
I wanted to just touch on some of the accounting/regulatory/capital changes that are going on. Maybe first, your thoughts on the NAIC analysis regarding VA reserving standards. How is Lincoln positioned for these changes that are occurring?
I've been pretty active with the regulatory community for a decade or so. This is one of the best examples of both companies, industry, and regulators understanding that the regulation that was in place was not as good as it could be, wasn't actually helping the regulators, and it was making difficult choices for the industry. We've worked together, the industry and regulators, and this is going to be a positive outcome for the large majority of insurance companies in the States, and it's going to be a good outcome for the regulators because they're getting what they wanted. In terms of Lincoln, we've known from the get-go that it would have very little impact on us. I see it as a net positive for the industry.
It was good for the industry, it's good for Lincoln, specifically for Lincoln, it doesn't have any real effect on us.
I guess from an accounting standpoint, I just learned life insurance accounting, now they're going to change it. Chris, you're going to have to explain some of these changes to me, probably. As far as the accounting changes from FASB, what's your view on that? There too, I know you've had an opinion.
My opinion is it's a bad rule. It's going to cause more confusion. This is accounting for long-dated contracts. It's going to create more confusion. This is not anything new coming from Lincoln. We've sent any number of letters and have visited with the members of FASB. It's not economic, all it is going to do is create more volatility in the income statements, maybe in the balance sheet, and not any additional information for investors. Again, we're against it. It's probably going to cause some new measure that's non-GAAP to help people understand what's going on. Moving away from GAAP to some other kind of a criteria because GAAP confuses the picture more than it clarifies the picture. It's not a good idea. In terms of what it means to Lincoln, again, it's not economic.
It doesn't affect statutory capital, which is of course important, or statutory profits. It could create some volatility in our statements that isn't helpful. We'll know, and we'll manage around it.
Any questions out there for Dennis? One towards the back. Just hang on. We'll get a mic to you in a second.
Thank you. I wanted to just ask, in terms of your EPS growth, on the call you mentioned coming in at a high or above the target range for 2020. I wanted to just understand what's driving your confidence and visibility on that.
We talk about 8% to 10% as our target earnings per share growth rate. At our investor days, we go through a lot of detail on how you get to 8% to 10%. It's a combination of equity market growth, interest rate levels, new business developed, share buybacks, and it all adds up to 8% to 10% over time. Sometimes the components of what gets you to 8% to 10% changes. When we talk on the analyst call about seeing perhaps higher than 8% to 10% out in 2020 and 2021, it all relates to the cost saves coming from the Liberty transaction and the digital program. In our forecast, there's assumptions regarding equity market growth, the level of interest rates, the amount of sales.
Holding everything sort of equal to the way we would do our financial planning, and overlaying some $250 million of incremental saves in the out years is how we get to that comment.
Any other questions? All right. Why don't we end it here? Dennis, a great session. Thank you so much for sharing-
Thank you, Jay.
some time with us.
Okay. Thanks.