Everyone, thanks for joining us today. I'm Jay Gelb. I cover the U.S. insurance stocks here at Barclays. We're pleased to have with us Dennis Glass, who is President and CEO of Lincoln Financial. Lincoln benefits from a strong presence in U.S. life insurance, annuities, retirement savings, and group insurance. The company recently completed its acquisition of Liberty Mutual's group benefits business. The format today will be for Dennis to begin with opening remarks, then I'll moderate a Q&A session. With that, I'm pleased to turn it over to Dennis.
Jay, thank you very much. I look forward to the next half hour together with you and the rest of the people in the audience. I do have to make my comment about the cautionary language in our slide presentation, if you'd take a look at that, please. I am going to start off with just a few comments about what I think is important to the business. I like this house chart. It shows sort of the foundation of the business, which is doing the best things for our customers and our employees. If you do those things all the time, you'll have a great company. Strategically, though, these four, six boxes are very important. We only manufacture retail products, that drives a lot of our activities.
For example, if you're only in the retail business, you don't have to drive earnings by taking excess credit risk. That's one of the examples. We focus on the fastest-growing markets, our markets are good, strong markets. We provide financial protection for Americans, life insurance, protected lifetime income, short and long-term disability, retirement products. These are growing products. The demographics are strong underlying them. They really provide important values that are going to be in demand for a long time and aren't interfered with by the ebbs and flows to any great extent by the economics of American growth and GDP and things like that. What distinguishes Lincoln more so than any other company in this industry is we have the most powerful distribution system. We have more wholesale distribution, more individual advisors that sell Lincoln products than any company in our industry.
That allows us to do pivots when pivots are important. For example, if Guaranteed Universal Life Insurance isn't selling either because of consumer preferences or interest rates, this strong force can pivot us to other products. We've done that a couple of times. I'll come back to that in a few minutes with respect to particularly our annuity business. We maintain industry-leading risk management. The rating agents say, as an example, we have the best hedge program in the Variable Annuity business. We've not had any blowups in that program. Good risk management is extremely important in the insurance industry, we do it as well or better than others. Actively direct capital to its best use. We're very interested, obviously, in getting a decent return on our capital.
A big part of our program and earnings per share growth over the last couple of years, actually for quite a while, has been the ability to generate enough excess cash flow on top of our use of about $2 billion a year to support our sales, to buy our shares back. I don't know exactly what the statistics are, but I think in the last four years, we've bought more of our stock back as a percentage of our capital base than any company in the insurance industry that we compete with. Maybe one other company has done as much. We've added to this a little bit around the digital experience for our customers. All of us in America are competing against the born digital companies, and the standard for consumers is no longer just our competitors in the life insurance industry, but it's people like Uber, Amazon.
People are going to expect the same kind of customer service experience, and we're investing heavily to get to that point over time. Fairly simple, straightforward business model. We've been in these same businesses for decades and decades. We've been in business for 100 years. We've gone through ebbs and flows of good times and bad times. We're looking forward to the next couple of years. Our track record is solid, and it's consistent. When I look at this slide, and candidly, I look at our multiple, I can't make the two connect because we've had excellent growth in the top line, excellent growth in the bottom line. Our overall book value per share has grown, and we've increased our ROE fairly substantially. These are excellent results. They don't happen because of third-party influences.
They happen because of those activities or strengths that I just talked about on the first slide and management actions. There's always something that is an opportunity or an impediment to growth, and you have to take action to achieve these kind of results. We have an excellent management team that has demonstrated an ability to get good, solid performance. One of the things that we've been talking about for the last couple of years is getting the right balance of earnings drivers. In the life insurance business, there's only three ways to make money, fees on assets under management, spread business, and mortality and morbidity. We've been a little bit heavy on capital market drivers for a couple of years, for a couple of years, we've been focusing on the idea of using an acquisition to get better balance.
We did that with the Liberty Mutual acquisition. We expended about $1.3 billion last year. Talk a little bit about how that's coming in a little while. Now we really like the balance that we have between spread business earnings Fees and assets under management and more typical insurance profits. In the past, we used to stop just in the discussion of capital market driven earnings and insurance driven earnings. It's an important point to note that our capital market driven earnings are composed of both interest rate spread and equity markets. For example, over the past five years, the equity markets have grown at 13%. Of that, our earnings per share growth has been driven up 5%. At the same time, low interest rates has acted as a drag on our earnings so that we've only get a net benefit of 2%.
I've been concerned that people would think that Lincoln's business, because we have $120 billion of assets under management in our sub-accounts, would think that most of our earnings power has to come from these strong equity markets, and that's just simply not the case. If you look at the next three years, because interest rates are up, most of the drag from lower interest rates and spread compression is going away. To get that same 2% net contribution, we only need to see capital market performance of about 3%. Coming back to the balance of our sources of earnings, going to end up being about a third mortality and morbidity, about a third spread, and about a third equity.
The equity and spread earnings are going to offset each other as interest rates go up over time or come down and vice versa as the equity markets go up or come down. I think it's a very good source of earnings picture, and that'll permit us to get to our earnings growth rates, which we target of 8%-10% every year. Another area that I want to just touch on before we go into the Q&A is annuity sales. Annuity earnings represent about 50% of our earnings for a couple of years, primarily because of the Department of Labor fiduciary rule. Industry sales have gone down, in the marketplace. We established a plan of about 18 months ago to re-energize, refocus on our annuity business. You can see here that we've gone from $8.2 billion to about $11.9 billion of sales.
Most of that comes back to that one slide that you saw about the power of our distribution and the power of our product development. In 2018, 28% of our sales growth is coming from new products and new sources of distribution, not just taking share in existing marketplaces. We've done that time and time again in our different businesses, and I can't express any stronger the powerful nature of our distribution platforms and the products that go along with it. The other thing that we've been trying to do is get a better balance between our long and short term guarantee products. We used to be 70% long term guarantee products. Today, we're 30%, and we think over time, that'll help with the quality of the earnings and the growth opportunities for the company.
Liberty acquisition, again, from a corporate perspective, the reason we did the Liberty deal was to get a better balance of source of earnings, increase our morbidity earnings and mortality and morbidity earnings. That will happen. From the group business itself, we were very strong in the 1,000 under market segment, which is a good growth segment. We weren't as strong in the higher end of the employment segment, 5,000 above. Liberty was. Combining these two platforms was very complementary. When you do deals, you have to worry about both integration savings, but also being able to maintain the top line sales growth that each of the companies had. When you buy a company that's not in the same segment you are, you have much greater opportunity to maintain the top line momentum. The integration is underway. We're doing quite well. First quarter earnings were good.
Our after-tax margin was around 5%. We have to do some repricing of their portfolio, that's underway. Our premium growth is ahead of expectations, we think we have a potential upside to the savings. This is a very critical and important strategic acquisition for us. It fills out what we've been trying to do, as I said a few minutes ago, in terms of source of earnings. As is the case with Lincoln, we have a great history of properly pricing and achieving everything that we had expected to through the integration and the strategic benefits of the transaction. We're very excited about the Liberty deal and where it's taking us. Another one of the things that we're pretty good at and contributes to our ability to get to this 8%-10% earnings growth is expense management.
We're constantly being careful about expenses and managing it. You can see here on this chart that we've gone from 12.5% or so expenses as a percentage of revenues down to 11%. That's just the normal day in and day out of expense management. Anybody who has to put a budget together has to show expenses growing at 2% less than revenues year in and year out. That's how you get that 120 basis points. There's additional opportunities, and here we're showing $90 million-$150 million from the digital program that I talked about. Not only are we elevating our customer experience to the level of the born digital companies, we're also taking out somewhere between $90 million and $150 million on top of our normal expense management, which will drop into earnings over the next couple of years.
On top of that, as I said, we'll get another $100 million of savings from our synergies on the group acquisition, actually expecting to do a little better than that. Just finally, in addition to being good markets, executing well, having a good source of earnings, good balance between long- and short-duration liabilities, our capital position remains strong. If we look at the balance sheet, our below investment grade exposure is down to 4.1%. You hear people being concerned about entering a credit cycle, well, at some point, this growth period will end. I'm not sure how quickly it will. We've got a great RBC ratio, very strong. We're generating a lot of cash flow, buying a lot of shares back. We're going to deploy $2.2 billion of capital in 2018.
As I pointed out, we reduced our shares outstanding by 31% since 2011. Overall, the basic business, the consumers that we serve, the needs that they have are strong and growing. Excellent distribution and product development, strong risk management, good balance of earnings in all different economic environments, strong capital base. I couldn't be more optimistic about Lincoln's prospects over the next several years. With that, Jay, why don't we start our Q&A?
That'd be great. Thanks, Dennis. That was a really helpful overview. I think to start off, why don't we start big picture. As you've talked about, Lincoln's results have been very strong year to date. Where are you most encouraged, and where do you still feel Lincoln has some work to do?
I'm most encouraged by the recovery in annuity sales, and I'm not going to allocate percentages, but the overall environment is much better. Mostly because of the DOL being vacated. Nothing wrong with doing what's in the best interest of the consumer. When you have the regulators being the plaintiff bar, that's not a good situation. We're happy with the improvement in the environment. That bleeds down into the compliance departments of broker-dealers and makes it much easier to get annuity sales through for financial advisors. I'm very positive of that. Again, back to this combination of distribution strength and product breadth. That is demonstrated again by the 28% that I talked about in terms of increase in our sales, 28% coming from new products and new distribution. We're very excited about that. Over the years, our retail-based business model worked quite successfully.
Even during the 2007-2009 period, no single business ever had negative cash flows. The idea of the annuity business having negative cash flows for the last 18 months is something that we just wouldn't stand for. By making good product decisions, good distribution decisions, I don't know if we'll be break even in the third quarter, but we'll be pretty close. Hopefully in the fourth quarter, we'll be positive cash flow. We've got that under control. Again, under control in a very positive way. We're not lowering price on our products to gain market share. We're improving the value propositions, entering more segments, adding more distribution. We're going to add a distribution partner. We'll announce it in the next couple of weeks. That has the potential all by itself to increase our annuity sales in the neighborhood of 5% on an annual basis.
It's those kinds of relationships that are important. You don't get those relationships unless you have good wholesalers, you have good products, and you deliver for the customer. They don't want just any old company in their distribution system selling products without good support. That's what I'm excited about. The RPS business is doing very good. That's working well. Positive net flows for eight quarters in a row. Good returns. Good earnings development we haven't seen for quite a while. The life insurance business is equally doing well. I'd like to see a little more diversification of sales. We used to sell 65% GUL and 35% other things. We got more diversified, because we've had such good results with one or two products, we're a little bit concentrated now. We want to increase the sale of our Term Life Insurance products.
We want to increase the sale of our indexed universal life product. We have a smaller share there than we should have. I'd like to see that going well. By and large, we've put these excellent results on the paper really for the last 7 or 8 years. Again, not because of any one factor. It's not just equity market growth and fees on assets under management. The power of our distribution and our products, expense management, smart capital management. Good risk management. Those things are going to continue. I'm pretty optimistic about our 8%-10% growth targets over the next several years, and hopefully some expansion of ROE as well.
Great. Well, on that topic of ROE, it's already running in the 12%-13% range, which is certainly well above your cost of capital. That's occurring despite some challenging macro factors, including a flat yield curve. To what extent do you think that ROE profile could be maintained or potentially even increased?
We sell products at a level. Well, let me say that differently. We're achieving better than 12%-13% on new product sales in most instances. Over time, that could pull up our ROE on an aggregate basis. I expect it would be. ROEs are very difficult to make meaningful progress on. I think incremental progress on that is what I'd like to see occur.
Okay. On the macro environment, low rates have been a drag on insurers' net investment income, that headwind has begun to fade. How much upside could there be to Lincoln's earnings power if rates rise further?
Earnings per share grew at 12% over the last five years. Pretty good 12% earnings per share growth. That would have been 15% if we didn't have spread compression that held that growth back by 3%. That 3% headwind will go away over the next three years. I'm not saying that we're going to get to 15% earnings per share growth because there's going to be other factors that play into the equation. The 12% would've been 15%. That 3% drag goes away. I come back to our long-term goals of 8%-10% being pretty achievable, specifically because of the elimination over the next three years if the 10-year stays at 3%.
Let's turn to the annuity business, which as you said, accounts for about half of earnings. What level of return on equity do you think should be achieved in this business, in the annuity business?
We're reporting on our GAAP statements, and we think this is an accurate reflection of the earning power of the business, 20%. I think 20% in any insurance product is on the high end of what you can expect over time. The reason we've gotten to 20% is because we've been consistently in the marketplace. As competitors have gotten in and out, and we've been in consistently with good pricing, we're getting this 20% return on equity. We're pricing the different Guaranteed Lifetime Income products sort of in the middle teen range. I think that's fair enough for that product line. Fixed Annuities, sort of at the lower end of the double-digit returns.
Interestingly enough, when we look, we don't break out ROEs on our Fixed Annuity business, they are also middle teens because we have better development of earnings than what we had priced for on that business at the time.
Right. fixed index annuities and buffered annuities have become a pretty interesting growth area for the industry.
Yep.
Can you talk a little bit about what Lincoln's doing there?
Yes. We just launched what you referred to as a Buffered Index Variable Annuity. We call it an Index Variable Annuity. It's kind of a blend between a pure Variable Annuity where you have unlimited upside and unlimited downside because your account value goes up and down with the performance of the underlying investments. A Fixed Annuity, which gives you some upside. Index Annuity gives you some upside relative to equity market performance, but you have a guaranteed flat. You can't lose your initial deposit. This is somewhere in between.
For a consumer that would like to take a little bit less risk than the Variable Annuity has in it and a little more risk from a preservation of capital perspective than what a Fixed Annuity provides, it's in between those two things. It's actually the best product launch we've had ever at Lincoln in terms of immediate sales growth. It's a good product, well-priced, good consumer value.
Excellent. On the regulatory front, I was hoping you could give us your latest thoughts on the fiduciary rule. The DOL has vacated their process on that, but now it lies with the SEC and perhaps some of the major state regulators. What are your thoughts there?
Yeah, generally, I think the SEC has it right. Many of the proposals that they have on the table are ones that we had been advocating for all along. Simple things like transparency of cost. I think consumers want to know what the cost is in the products and the costs as they relate to the benefits of the products. The same pricing for products that provide similar benefits. There's no reason why a U.S. small cap mutual fund should have a commission of 6% and the same A small cap mutual fund sold by somebody else ought to have 3%, and it's the same thing. It takes the same amount of effort. Sort of a consistency of pricing among different products we think makes a lot of sense. Transparency is all important for us, and that's the general direction that the SEC is going in.
Again, these are things that we've been advocating all along to the Department of Labor. I think my sense is the Department of Labor is going to pretty much follow what comes out of the SEC. The states, New York has got some thoughts of their own, but the other 49 states, I think, will fall in line with the SEC. Again, all of us in the industry trying to do the best thing for Americans. Consistency of regulation, making sure that Americans buy products that are right for them at the right time. They know what they cost. They know what the benefits are. Those are all very positive things for Americans and our insurance and the general wealth management industry as we move forward.
Great. Okay. Let's turn to the life insurance business. Near or short and long term, do you view life as a growth opportunity for Lincoln?
The life insurance industry, our metrics are it grows 4%-5%. Premium growth is 4%-5%. Assets under management grow at 4%-5%. It's in that ballpark. To do better than that, you need to have good expense management. You need to have better sales growth than the industry average. Again, I come back to these are strengths that we have. Distribution strength, product development strength, allocation of capital, expense management. It's never going to be what's the term in the Silicon Valley? There's an expression, breakout velocity. When are you going to get to breakout velocity? I don't think the life insurance industry is going to get to Silicon Valley like breakout velocity. I think it can be a strong business. Fits well into our 8%-10% returns over time. And it's a good business. Good business for Americans.
The demographics are good for that business, actually, for all of our business, and the value propositions.
Okay. The MoneyGuard product, I often get questions from investors around the long-term care component-
of that product, and I realize it's not a legacy long-term care component. It doesn't nearly have the type of risks associated with the other life companies that have large legacy blocks around that. I was hoping you could shed a bit more light on that topic.
Well, for the benefit of the audience, the product's a pretty simple product. Give us $100,000. This is the old product we've improved. You can do it in multiple premiums and things like that. Just fundamentally, give us $100,000. If you die, we give you $200,000. If you go into a long-term care situation, we'll give you $400,000. If you don't want the two or the four, we'll give you the $100,000 back. The nature of that product is so different from long-term care because of policy behavior opportunities, as one example. Someone who is sort of wanting to preserve the death benefit for their children may not take advantage to the extent that they could of the long-term care. The optionality in the benefits can work to the benefit of the family, and it could work to the benefit of the insurance company.
Because if you're in a long-term care situation, the right economic behavior is to maximize that long-term care benefit, take every advantage that you can. In our product, not necessarily because you may have inheritance or other things that are higher on your list of important things than just long-term care. That's one example of why a multi-benefit product is much different than long-term care. I want to make two comments about why sometimes companies end up with much better books of business than other companies do, and it's the way they get into the business. Let me go back to annuities. We have, by all metrics, the highest quality, lowest risk book of Guaranteed Lifetime Income in the industry. Nobody argues with that. There may be somebody as good as us, but we set the standard.
The reason for that is because when we got into the business 12 years ago, we actually got in with American Funds, and they wholesaled the product, and their value proposition to the customer was account value growth matters, and oh, by the way, you've got a guarantee. We never got into this feature war about giving the best guarantee because we weren't selling the product on the basis of the guarantee. The American Funds portion of our book still represents 40%, we really got in on a very smart basis. The other thing that we did at the outset was we hedged all the Greeks, and that was a very smart thing to do.
It's not by chance that we have the highest quality in force book of Variable Annuity businesses because of decisions that were made in how we got into the marketplace. We started to manufacture the MoneyGuard product 15 years ago as well, and sort of the same group of people that were smart enough to do the Variable Annuity business were smart enough to make good policyholder assumptions in the design of the product. For example, a lot of the long-term care companies assumed that there would be morbidity improvement and priced that into the product. We assume no morbidity improvement, that's not an assumption that we have. There again, we got into the product on a smart basis.
I'm sure that there's products that we got into over the years, not on a smart basis, but some of our biggest and most profitable products were started out very thoughtfully. Coming back to the VA business, policyholder behavior assumptions, again, were fairly thoughtful, and we haven't had the kind of explosions on the balance sheet that some of the competitors did who weren't as thoughtful about their policyholder behavior assumptions. We have a company history of getting into businesses in the right way, risk management, good assumptions around behavior, and MoneyGuard is just an example. Just to finish on MoneyGuard, we provided a stress test on our current reserves, which I guess are about $10 billion, and we stressed the three most serious. If you didn't get these assumptions right, you'd need an increase in reserves.
The worst-stress test on all three didn't add up to a need to increase our reserves. I can pretty confidently say that no one's going to see an increase in our long-term care reserve, in our MoneyGuard reserves in the foreseeable future because it's just not going to happen.
That's good for people to know. Okay.
I suppose I should qualify that a little bit. To the best of my knowledge, it's not going to happen.
All right. While you're making projections, what should investors expect coming out of third quarter actuarial review in life insurance?
I think Randy, our Chief Financial Officer, who's always rated one of the top three CFOs in both the P&C and life industry, and we're very proud for him of that, says it the best when he answers that question, which is, I don't want to run ahead of the numbers because the numbers aren't complete. He is not aware of anything that would, I think that's what we said in the last earning call, that would create any consternation. Doesn't mean that there won't be some back adjustments, plus or minus, but we'll see when we get there. We're not aware of anything.
Fair enough. All right. Last question before we.
We're not done with the work. To be clear, we're not done with the work.
My last question before we go to the audience response system is, can you talk about the potential for future bolt-on or perhaps larger acquisitions following Lincoln's acquisition of Liberty's Group Benefits business?
Yeah. We've built Lincoln over the years through M&A mergers. All the time, what drove the need for a non-organic event was an otherwise strategic objective that we couldn't get to organically. Having completed the Liberty acquisition, there is no strategic objective that we have that requires an acquisition. At this red hot moment, there's nothing that I have in mind that needs to be done on the M&A front. All this $800 million of free cash flow will then remain available for dividend growth and for share buybacks. Just on the M&A front, there's nothing that Lincoln needs at this point that we can't get organically. Jay, somebody could walk into my office tomorrow with a good idea, and maybe we do something, but I doubt it because I'm comfortable that we can get to where we need to be just with organic actions.
That's helpful. Thanks, Dennis. Let's go to the audience response questions. First question is, if you don't currently own shares of Lincoln or happen to be underweight, what would cause you to change your mind? Let me start the clock. We'll have the answer here in a couple of seconds. The audience is saying overwhelmingly 71%, higher interest rates and a steeper yield curve. You can do that, right, Dennis?
Well, let me respond to that. What's number three is? Yeah. I agree with number three.
Around 24% saying higher sales of Variable Annuities and Fixed Annuities.
Yeah. Not much higher. If we do $12 billion, 10% or 15% growth off of that, we'll be fine. If we do $12 billion this year. The steeper yield curve, I don't get that as much. I mean, yes, the steeper the yield curve, if you're investing out further on the yield curve, you're better off. We price our products for interest rate that's available in the marketplace. Whether the yield curve is steep or not doesn't make that much difference. We don't do funding agreements and other short liabilities versus long duration assets. It's not as big of a deal for us. Higher interest rates helps us most because we could improve product pricing. The higher interest rates go, we get some benefit, ongoing benefit from higher spread income.
Most of the benefit will come from improving the value to the consumer because higher interest rates allow you to do that.
All right. Great point. Next question, please.
My confidence that Lincoln's return on equity, around 13% in the first half of this year, will be 13% or higher in 2019 is? Answers ranging from, we can start the clock, very high, medium, low, very low. The confidence among investors, it's a nice bell curve. Around 50% saying medium, one third saying high.
We don't give long-term forecasts of earnings, which would imply.
Refer to your Barclays model on that.
Right.
Okay. Next one, please.
What should Lincoln pursue more of? We can start the clock. Organic growth, bolt-on deals, large-scale acquisitions, share buybacks, or dividend increases. View from the audience here is greatest responses being organic growth at 31% and share buybacks at 35%.
Dividend increase.
Consistently your views, right?
On number five, we've been increasing our dividend for the last couple years in the middle teens or higher. At some point, that growth rate will slow to our more customary earnings per share growth rate, which has been 12%, not that much different. Share buybacks, we continue to think is a important part of our overall program, particularly today when the industry is so surprisingly and weirdly undervalued. Organic growth is always the way to build a business.
Absolutely. I believe we have one more for ARS. My level of concern regarding the life insurance industry, this isn't really a Lincoln question, this is more about the life insurance industry's exposure to legacy long-term care insurance is between low, moderate, and high.
Okay. Around two thirds pointing to either high or very high if I add up those two. No one said very low. Not really surprised.
Let me just reiterate it. There's no explanation for that answer. That we've demonstrated the mechanics of the problem of the product relative to long-term care and talked about the assumptions which are more conservative than the legacy blocks of business. I'm sorry, gang, but that's a misplaced concern.
Yeah. I think this might be more around for the overall life industry, not necessarily-
Oh, for the overall life industry?
Yeah.
I don't know about that.
I thought you've been very clear it's not an issue for Lincoln. Okay. With that, please join me in thanking Dennis Glass and Lincoln.