Good morning, everyone. I'm Jay Gelb from Barclays. I'm the Senior U.S. Insurance Analyst. I'm very pleased to have with us today Dennis Glass from Lincoln Financial. Dennis is President and CEO of the company. Lincoln benefits from a strong presence in U.S. life insurance, annuities, retirement savings, and group insurance. The company's been able to effectively manage the sustained low interest rate environment. Dennis, thanks for joining us today.
Jay, thank you very much. I appreciate being here and the invitation. I'm happy to speak to the people in the audience.
Lincoln's results have been strong year-to-date. What are you most encouraged about? Where do you still think Lincoln might have some work to do?
Yeah. Well, results have been excellent this year. I think in the last three quarters or three of the last four quarters, we've had record earnings. It's been pretty good. That's on the heels of 13% earnings per share growth since 2009. That's a very good track record, probably not bettered by many in the industry, if any. We've had a long track record, and the last couple of quarters are particularly good. Yeah, we're pretty exciting. The reason for that is we've been sticking to what we do well. We have primarily a retail franchise. We don't manufacture wholesale products. We have excellent distribution, broad product breadth, good risk management, and as you all know, we return a lot of capital to shareholders, both through share buybacks and a good dividend level. That's the story that supports the success.
More recently, each of the businesses this year is doing very well. We've seen good sales growth in all of our businesses but one, although that's the annuity business, and I'll come back to that in a second. We've seen good revenue growth and good earnings growth in each of the businesses. They're all performing where we want them to be. A couple of highlights, the group protection business has recovered completely from some of the earlier years, the last couple of years where earnings weren't as good because of some pricing issues. That business has recovered. Retirement business is generating net cash flows that are positive. Life business is in good shape. Overall, the portfolio of businesses is doing well. Again, it all comes back to this fundamental issue of strong distribution, good product solutions, good risk management, and good capital management.
The one area that we need to put more work into, and it's a big area because it represents some 50% of our earnings, is getting our individual annuity business back to double-digit cash flows, excuse me, to positive net flows. We think we can accomplish that in 2018. We have a variety of programs to get there. Good, solid businesses that are performing well and a very good track record of earnings per share growth since 2009. By the way, associated with that earnings per share growth is among the lowest volatility of earnings in the industry. We think that we're a little bit undervalued given the statistics that I just mentioned. Hopefully with continued performance, that valuation will move up.
Thanks for that overview, Dennis. There's a bunch of things I'd like to circle back on there. First, do you feel Lincoln can maintain or possibly improve its 12%-13% return on equity profile despite challenging macro factors, including the impact of sustained low interest rates?
Yeah. We've really been able to overcome low interest rates over the last four or five years, and there's a lot of explanations for that. I guess I would start with the fact that, as I was just speaking, that we pay very much attention to return on capital deployed. Over the last three or four years, we have repriced the entire portfolio. All of the products that we're selling in each of our businesses are achieving middle teen or better type results. I guess there's a couple that do 12%. As new products get into the market with higher ROEs than what we're currently achieving on our current returns, that will elevate the ROEs longer term. Yeah, I think we can get there. There's other things that we're doing when I think about managing the business.
There's so many different levers a company, specifically Lincoln, has to improve earnings, expense management, and as I mentioned, repricing the product portfolio. Again, that range that we've achieved this year of 12%-13%, 13% if you include all of the earnings, 12% if you normalize a little bit. We hope to be able to do better than that over time.
Great. At the same time, low rates have been a drag on net investment income and spread income. What's Lincoln doing to address that headwind?
When we talk about our potential earnings growth for our collection of businesses, we speak in terms of 8%-10%. The headwind at the moment against that 8%-10% is low interest rate levels. That headwind is about 3%. We have to look to other areas to improve earnings in order to overcome that 3% headwind. If I look specifically at the investment portfolio, we've done a couple of things. One, we've increased our production of less liquid assets, such as mortgage loans. We've modestly increased our alternatives portfolio. We've had success. We have all of our money managed outside, which is unique in the insurance industry. The reason I do that is because I'd rather our internal resources focus on strategic issues, and we'll let the external money managers, JP Morgan, as an example, BlackRock, Goldman Sachs, pick the individual investments.
We've had pretty significant reduction in the fees for managing our general account, which has helped as well. At the margin, we've improved net investment income with those investment actions. I'd step back, Jay, and say that we run a very specific, or let me say that differently. We don't depend on excess risk coming out of the investment portfolio to make money. You have to do that if you're in the business of selling wholesale liabilities, funding agreements, and things like that. Anybody can get on the phone and raise funding agreement liabilities. There's no distinction there. The only way you can distinguish yourself is by taking investment risk and duration risk. We have a retail model, we spread the risk around. We have a huge commitment to distribution in other areas. We don't take a lot of investment risk.
It's very important to get good investment returns. When you're trying to get 12% and 13% returns, and you have to overcome 3%-4% return on the capital backing those businesses, it takes a little bit of effort. Again, we've repriced the entire portfolio, and we're getting good returns on our products.
Let's turn to the annuities business. As you mentioned, it accounts for about half of Lincoln's earnings. What gives you confidence that Lincoln's variable annuity business can return to net inflows in 2018?
Yeah.
There's a lot of headwinds in the industry.
Yeah, there are a lot of headwinds in the industry. Let me say, we're not going to do it by underpricing the product. We're going to do it in a couple of different ways. First of all, it's the regular playbook, which is powerful distribution, good shelf space across the industry, and even better shelf space since the introduction of some of the DOL rules, because we've been left on the platforms of some of our competitors because the distributors are narrowing the platform of manufacturers have been left out. That's one dimension of it, getting strong distribution. Come back again to the other piece of what we do, and we do so well, is product development. Historically, we focused primarily on guaranteed lifetime income.
About three years ago, we added a product called Investor Advantage, which was your more typical product that didn't have guarantees associated with it, longer term guarantees, but just was sort of mutual funds, the old variable annuity business mutual funds wrapped in a tax-deferred package. We've seen very strong sales from that. What else we've noticed is that there are products that are actually selling very well in the market, designs that we did not have. Rather than try to create new markets, I think it's easier to go into markets that are already there and consumers are using the products.
We just introduced recently, or about to introduce, a product that's been sold by a couple of our competitors, which has a higher roll-up rate and a higher guarantee coming out of the front end of the product, or the front end of the life cycle of the product. But if the account value drops to zero, the guaranteed income goes from six to three. That actually turns out to have very good economics if you do sort of an analysis from the investor's perspective and an analysis from our perspective. It has really good outcomes over a variety of scenarios for both the customer and Lincoln.
Particularly for Lincoln, in the tail risk scenarios, dropping that guarantee from six to three gives us a lot less risk in the tail, and that's allowed us to do what the market is more interested in, is take risk-managed funds, which I think can be good, but everybody doesn't like them. That product doesn't have risk-managed funds associated with it. Again, it's because of the spectrum of risk in the tail that's not quite as big. That's a big market. We've introduced that product, and we have some pretty good results so far. Another product that we'll be coming out with, I think in January, is a product that requires us to register our life insurance company. It's taking us a little while to do that. Kind of a fixed index product on a variable annuity chassis.
There's a lot of volume of that product being sold in the marketplace. We'll introduce that next year. We have a unique payout rider, which is called i4LIFE. I think it's unique in the industry, but we have a letter from Treasury that permits, as you're making payouts, that the first payouts come out of capital and the last payouts come out of investment income. The result of which is that you don't pay taxes on the early distributions. From an investor standpoint, it's very positive. You can attach that to any of our products, we're putting a lot of emphasis on the i4LIFE rider.
Step number 1 is take advantage of our core products, and we freshen them up a little bit, build new products in markets that are ready or where there's a lot of consumer demand already. The third leg of that stool is continue to build products that sort of are on the next horizon of sales. Those products would be similar to what we've talked about in the past, our Core Income Product. The Core Income Product is differentiated from our other products because it's a fee-based product, and because the investment interest engine is ETFs provided by BlackRock. That product has lower costs to the consumer, and it's sold by a different segment of the financial advisors population, and we think that'll continue to catch on.
Freshen our core products, rely on our heavy or our extensive distribution, build new products that are selling in the marketplace, then begin to develop other products that'll catch fire later down the road.
Thank you for that. You mentioned the Department of Labor Fiduciary Standard Rule.
Yep.
I know this is a fluid issue on the regulatory front. What are your latest thoughts on kind of the landing spot around that now? It came out initially as a pretty major concern for many in the industry. What does it mean currently?
The DOL rule has a lot of detractors and supporters. I think what we're seeing is those two groups come closer together. I have to be careful how I say this, because every time I say doing what's in the best interest of the client, Elizabeth Warren and others pick that up and then publish me saying that, and they forget that I say, but I think we can make improvements into the rule to achieve that objective even more so than what's in the current rule. There's some things that we like about the rule. I think the best thing for individual consumers is transparency around cost. A lot more transparency, I think, would be helpful. We believe that if you're providing the same service amount and the same benefits to a consumer, there shouldn't be price differentials from one carrier to the next.
You get away from what's the consumer value, and you start incenting the financial advisor. We try to take that out of the equation. We do think that setting aside those two positives, we think that the best outcome for Americans, if you will, is a harmonized Fiduciary Standard Rule across the SEC, the Department of Labor, and the states, and if they'd all have a similar standard, then their enforcement arms, which exist, could be the way it's monitored in the marketplace. That's a much better enforcement mechanism than what we have in the DOL rule today, which is the plaintiff's bar. That comes about from the right of action.
I think we have to keep what's good about the rule, but most importantly, eliminate that right of action and get professional enforcement people if there needs to be enforcement done, and from time to time, there does. Specifically, coming back to the impact on Lincoln, the issue early on with the DOL was even though in the latest and last rule, the preamble to the DOL said how important guaranteed lifetime income is to Americans, and it also said that commissions can be in the best interest of the consumer. Those two things are very important to be in the preamble. Unfortunately, the regulation itself gives more benefit to fee forms of compensation or makes it easier to do fee compensation than it does commission compensation. That's what concerned us most because the annuity business is 98% historically a commission-based product.
By the way, why does that make sense? Because on long-term products, the cycle of advice is all upfront so that you put a lot of energy, the financial advisor puts a lot of energy into explaining to the consumer on the front end all the benefits of a long-term product. It's not that after that goes away, it's put to bed in terms of the financial advisor and the consumer, but they ought to get more money up front where the effort is expended. Than a financial advisor who is on a quarterly basis advising on the mix of some customer's portfolio, which would lend itself to ongoing effort and therefore ongoing compensation. What happened on June 9th was very positive. A large majority of our distribution partners came out with both fee and commission-based products for Excuse me, fee and commission-based compensation for qualified products.
That was good again because commissions have been historically the preferred way for compensation. They narrowed the number of manufacturers that they were going to use, and we retained all of our shelf space. That's been helpful. Nonetheless, there's still, with all the tug and pull going on, I saw some articles today about the states supporting aspects of the DOL rule. There's still a little bit of We have to have a little more momentum to deal with that rule. We're positive that it's going to turn out. I'm hopeful. I met with a handful of people with Alexander Acosta a couple of days ago, and I think he and the Trump administration are in favor of making the improvements to better achieve the objective of doing what's in the best interest of the customer.
Okay. The administration seems to be lining up generally with the industry, so that's good.
Well, I wouldn't say lining up with the industry. That raise all sorts of bells. They're working with the industry to improve the rule for the benefit of Americans.
Including areas like the private right of action?
Yeah. I can't speak for the Trump administration or Alexander Acosta, but I think most people sort of have a question mark in their mind as to why you'd want enforcement to be done by the plaintiff's bar. That just sort of seems like an ongoing distraction and difficulty for distribution partners. It has forced some of our partners to take the other view, which is they're not offering qualified products on a commission basis, one or two big distributors.
The Best Interest Contract Exemption was also a potential area of concern for the industry at the outset. Where are we with regard to that issue currently?
Yeah. The best interest contract, the BIC exemption, as it's referred to, I didn't use that term, but that's the right of action and commissions, and you have to get certain exemptions in order to go through more hoops in order to use a commission-based product, and that's where the right of action comes in. Again, if you eliminated or if you had a standard across SEC, FINRA, and the states and permitted the states, each of those to use their own enforcement groups, then the right of action goes away.
Okay.
If that doesn't happen, I think annuities ought to go back into a section called 84-24, where they've been for four years, that treats them differently than other financial services products, mutual funds, most importantly. I think that's a possibility as well.
Okay. Last question on annuities before we move on. Can you discuss Lincoln's recently announced reinsurance partnership with Athene?
Yeah, that's pretty cool. Athene has some advantages that Lincoln doesn't have, particularly, they're domiciled someplace where they don't pay income tax.
Bermuda.
Bermuda. That gives them a leg up in terms of pricing a product because we all price our products on an after-tax basis. Athene has a different view on investment composition than we do, and so they're a little bit more aggressive. Our transaction reinsurance agreement with them, in the trust agreement that backs the reinsurance, we had to bring our credit and concentration perspective, and sort of the two organizations had to come together. What really was cool about the deal is we sort of for every $1 of product sold, we can actually achieve the following. We can give the consumer a slightly better crediting rate than what Lincoln could do on its own.
Even though we're splitting every dollar sold 50/50, we actually make as much money on the $0.50 that we keep with the reinsurance as we would make on the dollar that we would sell if we didn't have the reinsurance. Let me try to say that again. I wouldn't be inclined to use our distribution system and do a reinsurance deal if we had to split every dollar of sales and all Lincoln got was half of the dollars of earnings because we've given away half of the business to a reinsurance basis. Because Athene's tax break and their willingness to pay us for our distribution, it turned out that, again, even though we're only retaining $0.50 on every dollar sold, we're making as much dollars of earnings as if we kept the whole dollar. It really works out quite well.
This is on a fixed index annuity product?
Yeah.
Okay.
Yep.
Okay. Turning to the life insurance business, is this a growth opportunity for Lincoln?
Yeah, I think it is. Life insurance, obviously, has been around forever. The consumer needs for life insurance remain the same. It's either protecting against early death of the income provider in a family and making sure there's money that the family can continue their lives with. There's some estate tax planning, and I don't think that's going to change significantly. Even if they eliminate the estate tax. My sense is, if the estate tax was eliminated, it would be better for the life insurance industry, because most estates in the U.S. are $10 million and under. Because of the $10 million individual exclusion, estate taxes are not paid on the majority of the net worth in America anyway. It's just for the estates of $10 million or more.
The way the rule works is if you eliminate the estate tax, of course, there's no $10 million exclusion. The rule, the way it's written right now, you have to pay the income tax on the step-up. Whereas before you'd pay no income taxes on $10 million of estate, today you'd have to pay income on the step-up. If you had a farm that was worth $1 million, and now it's grown, worth $10 million with the current estate tax rules, you don't pay any estate taxes when you pass it to your heirs. In the new environment, the $1 million would grow to $10 million. There'd be no estate taxes, but you'd have to pay income taxes on the difference between one and 10. No matter which way the estate tax goes, I think the industry will come out well.
Lincoln's account value growth is about 3%-5%. Our in-force grows around 3%-5% every year based on our sales and runoff of the book. You start with 3%-5%, which is not a bad growth rate in the financial services business. Of course, what's hurting us right now is that 3% headwind, a lot of that occurs right inside of life insurance, in our life insurance business. The growth that could be 3%-5% has been more in the 1%-2% range. I think as that headwind from interest rates burns off, and it's going to burn off in the next five years, whether or not interest rates go any higher than they are today, because the portfolio rate is going to come down to the new money rate, compression goes away.
That's good. Then inside the life insurance business I talked about, protecting families for the early death of the income provider, estate taxes. Another very popular product has been growing at double digits are these hybrid products, and we have one of the best in the market, where you're not only providing the option for life insurance, but you're providing the option to use those same proceeds to buy long-term care. That's what a hybrid product is. We've shifted the payout to both be for death claim payments, and you can use on certain products, the claim payment for long-term care purposes. That product, industry-wide, is selling at double-digit levels. That's on a life insurance chassis. Hybrid products will add an additional spurt of growth.
When spread compression goes away, it's going to be a good business. The other thing I'll tell you that most of you guys know I've been around for a while, and I've been watching a secular decline in interest rate over the last 40 years. As the industry priced products based on the current interest rate environment, we've chased the yield curve down. Well, I think the yield curve is down as far as it's going to go. We're pricing. Actually, I think we repriced the life portfolio when the tenure was at 150.
Our assumptions, although there's some upswing in our expectations for interest rate and our assumptions, I think over the next 20 years, we're going to be beating our interest rate assumption that we have in pricing rather than not beating it the way we have over the last 20 years. I think as I look forward, I think the life insurance business can be a very good outcome.
Great. One thing that often comes up when discussing the industry with executives is the potential for bolt-on or perhaps larger acquisitions.
What are Lincoln's views on this?
Jay, start off with the proposition that we're going to achieve our shareholder objectives through organic growth. We haven't done a major acquisition, I think for three or four years. Not been an opportunity to do that. We start with the proposition that organic growth or basic fundamental strategy can achieve shareholders' objectives. To the extent that a deal comes along that can accelerate those objectives, we'd be interested in doing that to accelerate already in-place strategies, not just to do a deal. Let me give you a very specific example of that. About three or four years ago, we came up with two strategies.
One was to change the mix of our new sales, which I think was 70% guaranteed and 30% non-guaranteed, and flip that on its back and sell new business where there's only 30% of the business that has guarantees and 70% doesn't have guarantees. We've already achieved that organically. A second longer-term objective was to increase our source of earnings from non-capital market drivers, which would mean mortality and morbidity. Our mortality and morbidity earnings are about 25% today, and we'd like to get that up to 30 or 32 or 33%. The ideal business to help achieve that goal, better mix of source of earnings, is the group business. If something came along that was complementary to our existing group business, we'd be interested in doing that. Now, having said that, let me make a couple of quick cautions. Come back to my point.
We don't chase deals and give up the return on capital concept. If we're going to do a transaction, it's going to be subject to our typical return on investment requirements. The second thing is that I don't have an appetite to do a transaction that would take us out of the share repurchase program that we've been in for any length of time. I could stomach a couple of quarters maybe, but not much more than that. If we do a deal, it's going to be priced right, and it's going to be accretive, and it's not going to interfere with our share repurchase program to any great extent.
That's helpful. Let's go to the audience response system. Everyone has a remote in front of them. This is the time for audience participation. I'll just give you a quick recap of the question, and then feel free to key in your answer. The first question is: If you currently don't own shares of Lincoln or are underweight, what would cause you to change your mind? We should get the instant response here. Okay, just over half saying higher interest rates. The majority of the other responses essentially saying higher sales of variable and fixed annuities, as well as a lower valuation.
A lower valuation? Ours is already too low.
Where do you think it should be?
If you have one of the highest ROEs in the business, you have better earnings per share growth, and less volatility than competitors. It certainly should be at the industry average, which I think is 9.5, and we're around eight. I would think there'd be a 1.5 upside. We have the highest earnings in the 110-year history of the company, and we sell 10% or 15% below the highest share price. There's a valuation change that's occurred that ought to come back into the share price.
Okay. Next question, please. The effect of the Department of Labor Fiduciary Standard Rule on the annuity market will be? Got a couple options here. We can start the countdown. Further implementation delays will remain an overhang on annuity sales. Option 2, the Department of Labor impact is already reflected in the annuity market, and sales will slowly improve. Or 3, the Department of Labor impact on the annuity market will get worse before it gets better. Let's see what the audience thinks. The response here is almost 80% people saying Department of Labor impact is already reflected in the annuity market and sales will slowly improve.
I think that's the most likely outcome.
Let's hope so. Next question, please. My confidence that Lincoln's return on equity, which was 13% in the first half of 2017, will be 12% or higher in 2018 is? Just getting to the end of the key in here. Okay. 40% each saying high confidence or medium confidence.
Yep. At 13%. Very high.
Okay. Next one, please. This question is on which should Lincoln pursue more of? We can start the countdown. Organic growth, bolt-on acquisitions, large-scale acquisitions, share buybacks, or dividend increases Investors are saying somewhat evenly split here, around a third saying to focus on organic growth. Around 20% each saying bolt-on acquisitions and dividend increases. Interestingly, just under 10% saying share buybacks. Does that surprise you at all?
I just see organic growth. I agree with bolt-on acquisitions of the kind that I mentioned is fine. Large scale acquisitions, I'd caution people on that one because although I think insurance companies, after they've relaxed Dodd-Frank a little bit, will not be designated SIFIs. The fact that right now we could be designated a SIFI chills large deals because I don't want to be a SIFI company, but I think that'll change. Yeah, pretty good.
Fewer investors having a preference for share buybacks. I would figure at a low valuation, that's a good use of deployable capital.
I sort of read that the amount that we're doing rather than.
Correct. Yes.
Increasing the amount.
Magnitude.
The magnitude that we're doing is about right.
Okay. Excellent. We have a minute or so left for any questions from the audience. There are any? Chad?
Sure.
Sorry, let's just wait for Mike.
Hi, Dennis. Just a quick question on MoneyGuard. Can you just briefly describe how that long-term care rider is structured and how it compares to the industry? That part of the deal.
Yeah. Let me go back maybe 24 months. The product used to be a real easy sell. I mean, it still is an easy sell, if you gave up to $100,000, depending on your age, you might get 200% of the $100,000 as a death benefit. You might get 400% of the $100,000 as a long-term care benefit. If you didn't want it for either purpose, you could give it back, or you could ask for the $100,000 back. That's changed slightly now because we have surrender charges, you can't get your $100,000 back for six or seven years. You still have the interplay of death benefit and long-term care, and that gives some risk mitigation because you have those two risks as opposed just to a single risk.
I think if your question is what do we pay for, there's a variety of specific uses of the benefit all around long-term care, and I can't tell you exactly what those are. I would say the important point, as contrasted to long-term care products or long-term disability products in the past where there was no cap on the benefit, we have a very specific cap on the benefit. It's a limited risk product as compared to what the individual disability products were in the past and have created such problems.
Excellent. Well, with that, please join me in thanking Dennis Glass.