All right. We're going to kick it off. Great to have Lincoln Financial back with us again at the conference. Appreciate your continued support. Up with me, we have Randal Freitag, who is the CFO and also the head of Lincoln's individual life business. Also want to acknowledge Chris Giovanni and Jesse Brackett from Investor Relations in the front. Wanted to start with group protection. You had a strong second quarter. You indicated that the Liberty acquisition is exceeding expectations so far. I was hoping you could walk through what you're seeing with the deal in the early stages.
Yeah. I'd say that so far everything has gone as we thought it would or better than planned, that's a good thing. You think about when you do an acquisition, you make a set of assumptions. What are some of those key assumptions, and are you able to validate those when you actually get in and are the actual owner? What's the size of the business you're going to get? In that regard, the premiums, which is really how you think about sizing a group business, are bigger than we thought they would be because Liberty had had very good persistency and had a strong sales year. That's a good thing. There's always a key assumption around synergies. We made an assumption on expense saves as we've gotten in and started to do the real work.
We've been able to validate our expense saves and actually believe we can go a little above. The key assumptions that really drove the value that we paid for the business, we've been able to validate or do a little better than, that's a good thing. Separate from that, you've got how is the profitability of this business going to emerge? When we originally provided input to investors back at the time of the announcement, we had estimated that we could take this combined business and get to a 5.5% margin or so in 2020. We currently think we can do a little better than that. I'm not getting specific, but we think we can do a little better than that. That's in an environment of higher loss ratios.
Currently in the group business, it's just a tremendous time, and we've seen really good loss experience over the last two, three years. In that environment, we'd even do a little better than that. Yes, it's going very good and we're very excited that we've bought a great new addition to our group business.
Just wanted to expand on that a little bit. You mentioned the 5.5% original target by 2020. I think in the first quarter you had Liberty, you basically already did 5.5%, pretty close. You're just starting on the cost saves. You tied pretty early on the repricing of the Liberty block as well. I guess when you take those two things into account, have your expectations changed and improved for where you think you can get the margin over time?
I think similar to what I said before, we think we can do, if you target that 2020 number of 5.5%, we think we can, all else being equal, do a little better than that because we've been able to identify synergies, little expense synergies over and above what we thought we could get originally. We currently think we can do better than that. Now, completely separate from that, there's the environment, the loss ratio environment for group insurance right now, which is just very, very strong and healthy right now. Going back to that guidance again, 5.5% in 2020, we thought would be around 3.5% this year. We came in at 5.3% in our most recent quarter.
That's really just a reflection of that loss ratio experience I talked about where I'd say loss ratios are running a couple points better than we would think they would over an extended period of time. If we stay in that very healthy environment for loss ratios, we would obviously do better than we originally thought. All else being equal, we think we can perform better than we originally thought on this transaction.
I want to, I guess, shift a little bit to expenses. G&A expenses were down in most of your businesses in the first half of this year, and particularly life insurance.
You saw a pretty good decline in G&A costs. Can you talk a little bit about what you're doing to drive efficiencies on the expense side, and then also where you stand at this point relative to the expense save targets that you had laid out a year or two ago?
Yeah. I think there's two things that are driving what was very good expense experience in the first half of the year. The first is just our normal budgeting process. The normal budgeting process we operate on really defines that there will be efficiency driven into our business over time. How do we do that? Expense guidance budgets are linked to revenue growth. Expenses are expected to grow at a fraction less than one of revenue, which drives margin improvement into the business over time. That goes on every single year. Separate from that, as you alluded to, we have a savings initiative in place, really driven by digital technologies, the digitization of many of the things we do at Lincoln. You're really seeing the first set of efficiencies coming through the financial statements.
If you go back to the original guidance that we gave on that, we expected $30 million-$40 million of expense savings this year. I'd say, once again, we're right in line with that original guidance. We'll have to continue that work to continue to see that grow. Ultimately, we would expect $90 million-$150 million of savings. Right now, we're right on track. Why are we able to actually achieve that and see it in our financial statements? Once again, I think it goes back to that budgeting philosophy we have at Lincoln where one, meeting your budget guidance is part of your incentive compensation, so there's a strong incentive. Inside of those budget targets, we embedded those $30 million-$40 million of savings.
People need to hit those targets to hit their incentive compensation targets, which is usually a strong driver of behavior.
In terms of that $90 million-$150 million ultimate target, one thing I've gotten some questions about is how that When you gave that target, it included group, and now you have this separate expense savings target for group. Can you help us think about how to put those two together?
Yeah. You add them up and you get to $200 million-$250 million of savings. If you think about them, the $90 million-$150 million, that should appear in the bottom line incremental to what we're doing today. The group expense savings target of what started out to be $100 million has moved up a little bit. That was driven by the fact that the business that we bought, a great business from the markets it operated in, its position in those markets. The reality is it was underperforming from an earnings standpoint, and it needed to realize some expense efficiencies to get up to those margin targets we talked about earlier. That $100 million will appear in our financials, but it was really required and something we priced into the transaction.
We need to get those to realize the returns we expected overall on the $1.4 billion-$1.5 billion of capital we invested in that acquisition.
Really just it's additive.
Yeah.
There's no double. Okay. On spreads and interest rates, in the past, you've talked about a 2%-3% annual headwind to earnings growth from spread compression and low interest rates. We've had interest rates rise. How are you thinking about the impact now, given where new money rates are?
I'm very happy that interest rates have risen. That's a good thing. If you look at our most recent quarter, we invested money at about 4.3%. That's about 35 basis points or so below our portfolio. If you go back a year where we were investing money, we were about 65 basis points below our portfolio. There's a lot less compression. In terms of the 2-3, I'd say we're definitely at the lower end of that range. In terms of what we expect when we look forward, once again, investing at these sort of rates, 4.3%. The 4.3% that we did in the second quarter. From this point through 2019, I think we'd expect a little more spread compression, but once again at the lower end. It's really when you get into 2020 where the math really starts turning around. That's all the math.
The assets that we expect to run off the portfolio versus where we're investing today. Spread compression becomes really a non-issue, which will be a very happy event if and when that occurs.
Really, 2019 you'll still have a little bit more, but once we get beyond that, if things stay as they are, you expect spread compression to basically go away.
Yeah. If you think about the environment in 2009, that was the financial crisis. Spreads were very wide on the assets we were investing in that year. The yield that's running off the portfolio in 2019, because we do a lot of 10-year investing is a little elevated relative to what it'll be in 2020.
Got it. On, I guess, this is related, but you've talked about an 8%-10% annual EPS growth target.
That included two negatives, which were spread compression.
Weaker annuity growth. You've talked about spread compression starting to go away in the next couple of years, your annuity flows have gotten much better.
Does that change how you view the target?
No, I still think 8%-10% is reasonable. Starting with the last part of your question on the annuity flows. We gave input to investors a year ago that we thought that by the end of 2018, we could exit this year having gotten back to positive flows in the annuity business. Nobody believed us at the time, but we seem to be well on our way. We just had a very strong second quarter and got pretty close to closing that gap completely in the second quarter. I think embedded in our 8%-10% view as we look forward was already the thought that we would start to get annuities back to positive flows. In terms of the other contribution items that you talked about, spread compression which has been, over the last five years, a 2%-3% headwind.
Over that five-year period, we've grown our earnings 12%, so we've actually exceeded. We've exceeded, I would say, because we've been able to go over and above the contribution we would expect on a normal basis from share buybacks. It's been more like 4%-5% when we'd really expect 2%-3% on an ongoing basis. The spread compression component for the last few years has been 2%-3%. On the other hand, we've come through a period where the equity markets have grown 12% a year for those five years, and so that's been a strong contributor to growth. The sum of equities and interest rates over the last five years has been about 1%.
If you look out over the next three years embedded in that 8%-10%, the fact, as we said earlier, is that spread compression will not be as big a deal. Turning around in 2020 to actually start to be a positive contributor. The spread compression will be less. The upside of that is we don't need that same level of equity market growth that we've experienced over the last five years to get back to that 8%-10% expected EPS growth, which has been our target for some time now.
You mentioned the improved annuity sales. Can you talk a little bit about what's driven that, secondly, how's the environment for new business returns in the annuity business right now and how does it compare variable versus fixed?
I'd describe the environment as healthy. It's definitely not irrational, but it's competitive. If you look at what we've been able to do on product benefits and price over the last year or so, we've been able to improve the value proposition for the consumers by improving benefits driven by increases in interest rates. Interest rates are the main contributor to the cost of hedging. As interest rates have increased, we've been able to do things like ease up on investment restrictions as an option for the consumer. They're not going to get as strong a payout benefit, but they can get a product without investment restrictions, which is really something you couldn't get if you go back a couple of years. We've been able to improve benefits, the benefits we offer, and we've seen the competition respond in a like fashion.
I wouldn't say we've seen the competition respond in an irrational way. In terms of the returns, I think, like I said, it's a healthy environment, we're getting returns in line with our expectations, which in the case of variable annuities is mid to maybe a little above mid-teens. For the fixed annuity business, it is more 10%-12%, somewhere in there.
Got it. On annuity profitability overall, your ROA has kind of been in the 80 basis points range. You've been generating GAAP ROEs in the low 20% range. When you think about new business returns and cost save potential and the in-force, do you think this is kind of a sustainable level of profitability, or what are your expectations as we move forward?
Look, it's a level of profitability that we've sustained for as long as I can remember. We've been right in that 20%-20+%, a little over 20% ROE and an ROA in the 75-80 basis point range, 75-85 basis point range. We've been in that range for some time, and all the time we've been issuing business at the sort of returns I just described. I think that's reflective of some of the other things we talked about earlier, expense saving initiatives and other items really allowing us to maintain that very strong return profile in the business. Looking forward, I'd expect us over the next few years to be able to maintain those sorts of returns. I don't expect the ROA to grow.
Yeah.
I also don't really expect it to shrink in the annuity business.
Okay.
They're very healthy returns. They're definitely top of the industry when it comes to returns. We are extremely proud of our annuity business. Not only the returns you talked about most recently, but the fact that for a long, long time, we've been able to churn out those sort of results every single quarter. In a business that most investors think of as very volatile, Lincoln has differentiated itself really into a class of one when it comes to how we operate that business. I think it's something that investors dramatically underappreciate and undervalue about the way we operate that business. At the end of the day, it's just an asset management business with a guarantee overlay.
Yeah.
We've proven our ability to manage that guarantee overlay. Investors will do what they do, but I'm going to contend that that business is one that is very undervalued by investors, and I think that value will be realized over time.
In the life side, you mentioned that you expected an improvement in sales in the second half of the year and that you had some new product rollouts coming out. Can you expand on that a little?
One, it's seasonal. It always happens. The sales go up in the second half of the year. There are a couple things that drive that. One, in the executive benefits business, oftentimes those are larger cases that get worked all year, and people race to close them by the end of the year. You also see that in the retail space. The fourth quarter is always our-
Yeah
has always been our largest quarter, and we'd expect that to be the same. On the product side, as I mentioned on the call, we have rolled out some new products. In the indexed universal life space, which is one of the fastest-growing, is the fastest-growing space in the life insurance business. It's a really good time right now for returns in the life business. It's actually a very logical time for returns in the life business in that the areas of the life business with the least amount of competition are experiencing the strongest returns. The areas of the life business that have the most competition have a little lower returns, but all those returns are very healthy right now. In our case, in VUL, which is a space that doesn't have as many competitors, it's a complex business.
It's a business that takes a lot of pieces to really operate appropriately. In our case, the hybrid business where you don't have as much competition, are getting very, very strong returns well above our 12%-15% expectation for the life insurance business. Then in the other spaces, term insurance, indexed universal life, you're down more towards the lower end of that. When you wrap it all together, we're getting returns actually above our 12%-15% targets. I'd expect that to come back in line over time. I think if you think logically, there is no reason in the life business to get returns in new business too far in excess of 12%-15%.
In terms of one thing we've seen some of is reinsurers trying to raise rates on business they underpriced in 15, 20 years ago. You did a transaction with Swiss Re a few years ago where you.
I didn't say that. You said that.
All right. Are you seeing any more of this activity at this point that is occurring with any of your reinsurance partners?
It's been going on for four years.
Okay.
We have had arrangements with different reinsurers that have involved different outcomes going back to 4 years ago when we did a large recapture, which a very strong reinsurance partner paid us to do.
Yeah.
That was a very healthy relationship for both sides. We had some things that they needed. We had some things that they want us to do, and we're able to strike a great transaction for both sides. We've done other arrangements over the past 4 years with other reinsurers that have been a mixture of recapturing business. Sometimes we've accepted higher rates on term insurance. Sometimes we've went to arbitration with varying outcomes. It's hard to size exactly where we are. I think we're probably in the sixth or seventh inning of this whole process. We've been managing it for some time now. It's been a headwind.
Yeah.
It's been a headwind we've managed to deal with.
Below investment grade exposure has been declining at Lincoln. How do you feel about the portfolio at this point? Do you feel like you have capacity on the margin to add some higher yielding assets or a more cautious based on where we are in the cycle?
I think we do just based upon the numbers. Our below investment grade, which we target 4%-6% of our time, we're at the very low end of that. I think we're at 4.1%.
Yeah
or so last quarter. We're at the very low end of that. I think that's reflective of a healthy economy and a very strong credit environment. I don't think we're probably alone in seeing that sort of trend. I think the fact that the below investment grade percentages went from nine during the heat of the crisis down to the low fours today isn't reflective of us taking any view on credit. We're following our normal credit process. I wouldn't say we've changed anything about our investment philosophy. It's just been a result of what is a very healthy environment. Also the other thing is that we did do some trading.
If you remember when energy prices got very low, I think one of the things that we saw was that our energy holdings were a little bigger than we wanted relative to the size of our portfolio. We did some trimming of some below investment grade energy holdings. You're seeing the benefits of that in where we are today. Yeah, there's capacity to take on more risk, but we haven't changed our investment philosophy in how we invest.
On the alternative portfolio, the performance was a little bit lower than it's been in the past in the first half of the year. It seems like you guys were pretty confident in the outlook for the second half. I don't know if you have, based on the way some of the investments are reported I guess on a lag basis, do you already have insight to some extent into the second half of the year?
I don't say we have. We don't have any hard data when we make those sort of statements, but we do have insights.
Yeah.
Private equity, which is 90% of our alternative investment portfolio reports on a one quarter lag, hedge funds, which are the other 10% report on a one month lag. Insights would mean when you look at what the equity markets have done, there's some linkage between private equity returns and equity market returns.
Yeah.
All else being equal, you would expect to have pretty good returns in your alternative portfolio as you look into the last half of 2018. All that being said, you can always get one-offs. We all own a variety of these alternative investments. You can get one-offs both ways.
Yeah.
Pluses and minuses. The underlying environment for strong returns in the alternative portfolios is definitely there based upon what the capital markets have done.
Moving to capital. Can you talk about how you feel about Lincoln's capital position following the Liberty deal? You have upcoming changes to the RBC formula in terms of tax reform and C1 charges. When you roll all that up, how do you feel about the capital position?
Feel really good. Why do I feel really good? We had traveled with an RBC ratio in the high 400s for some time. All along, we had said that we were carrying some excess capital that we could use in the context of M&A. I'd sized it at $500 million-$750 million. We ended up using $600 million to fund part of the Liberty acquisition. We used up that extra capital, and that took our reported RBC down to about 460. Separate from that, you have tax reform, which has a negative impact on reported RBCs, and that's going to take about another 40 points. We'll be at 420. Feel very good about that ratio. That feeling is definitely enhanced by the fact that we took our entire capital plan and strategy to the rating agencies as part of doing the Liberty acquisition.
We actually went for a pre-ratings review process that they have. They have reviewed all of this, and they affirmed our ratings with the capital plan that we just executed on for the Liberty acquisition. I feel really good on my own, and I feel really good that I have some outside validation from my rating agency partners. Yeah, feel very good.
On free cash flow, you've got it to $850 million-$950 million of annual free cash flow. As we move forward, would you expect free cash flow to grow at a similar pace to GAAP operating earnings? Is that how we should think about it?
Yeah, over time, I think you should see that sort of phenomena. Distributable earnings, which are driven by statutory results.
Yes.
You can get some period-to-period volatility because sales generate strain, and fewer sales create less strain. You can get some period-to-period noise in statutory. Over time, I expect our free cash flow to grow in line with our reported results. Yeah, absolutely.
Since we were talking a little bit about GAAP, FASB has approved the new framework for long duration insurance contracts for 2021. I know you've made some past comments where you had some issues with some of the things they were doing. Can you talk about your view of this new framework and how you see it impacting the industry and Lincoln?
I'm going to start to sound old. I never like to sound old. I've worked with U.S. GAAP for a long time, and in many different roles, all the way from when I was a young pup actuarial assistant wherever I started, to where I am today. I have long, based on my experience, held the belief that U.S. GAAP was the best system for accounting for insurance type products in the world. It's based both on my experiences with U.S. GAAP and lesser experiences, but some experience looking at other forms of accounting across the world. That's just been my fundamental belief. I also have a belief that things can and should be improved over time. I've always been a strong supporter of improvements to U.S. GAAP, and I felt there were some areas where U.S. GAAP could be improved.
For instance, we unlock assumptions on FAS 97 or interest-sensitive products, but historically, companies have never unlocked their assumptions on FAS 60 products. It was always illogical to me, and it seemed like a logical thing to do to bring FAS 60 in with FAS 97. I felt that there were some improvements that fit into what FASB's goal was, which was to make targeted improvements to U.S. GAAP. In the end, I think they went beyond that. I think a bar, a threshold for making changes is that you should be improving something. I don't think that when I look at the changes they've announced that in total, they've improved U.S. GAAP, I worry that that will not stop a trend that I've seen, which is a trend towards investors using alternative forms of accounting when thinking about our business.
I think that investors should be able to look at U.S. GAAP when they think about whether or not to make an investment in Lincoln. I don't think that they've enhanced that math with what they've done. I've been very public. I'm not a supporter. I think we'll deal with it, and we'll incorporate it into our results, and we'll make sure that we communicate with investors and disclose to investors the things that help them understand our results. In total, I just don't think it's an improvement to how we do things today.
Are there any questions in the audience? Maybe just following up on this, what are other couple specific examples you can give that are things you opposed that were part of the FASB change?
Sure. If you look at living benefit guarantees, there's been a weakness in the industry for a long time in that companies who sold a certain type of living benefit guarantee, GMIBs, were trapped into a form of accounting which didn't reflect the economics of the products. All the other companies who were issuing GMWBs, we had the capability to institute accounting that reflected the economics, which is what we had done at Lincoln. I think a very reasonable change would've been to go to the IB players and said, "Look, we're eliminating that box that has stuck you over here in insurance-type accounting for these products which have capital market risks." Instead, they've sort of made every company change.
Yeah.
I think they've just caused more disruption in that regard. That's one. Two, I'm personally a believer that for guaranteed minimum death benefits, which is a non-elective benefit in one of the most well-understood areas, which is mortality for the insurance industry, I think that particular type of benefit is best accounted for with insurance type accounting. They've changed that to become fair value. Those are two on the what are called market risk benefit side of the house. On the other one, and this is not a universally held belief, this is Randy's belief, and based upon a survey we did about the belief of about 50% of investors. I'm not a fan of straight lining the amortization of deferred acquisition costs. I think to me, it's ridiculous to de-link expenses from revenues in this type of business. It borders on lunacy to do that.
While, as I've said before, it is true that my 12-year-old will be able to tell you, or 13-year-old now, will be able to tell you what our amortization is going to be in the next year because it's just a straight line. The downside of that is financial statements that don't make as much sense as they did before. To me, that's just a bad trade-off. My 13-year-old versus statements that make sense. I'll take statements that make sense. Those are three.
All right. Well
I tried hard, too. Rob Falzon and I from PRU made a trip up to Norwalk. I made trips up to Norwalk with Chris. I did a lot. In the end, they're smart people, and they made a different decision. Like I said, we'll adopt it, and we'll move forward, and we'll help investors understand what the impacts are.
Well, I can only say that I'm also not looking forward to the new accounting. I think we are out of time, so thanks a lot, Randy. Much appreciated.
Thanks for having me.
Yeah.
Thanks to everybody for spending your morning with us.
All right. Thanks.