Dennis Glass, President and Chief Executive Officer of Lincoln National Corporation. Dennis has been CEO since 2007, and prior to his role at Lincoln, Dennis was the President and Chief Executive Officer of Jefferson-Pilot Corporation, which merged with Lincoln in 2006. Under Dennis’ leadership, Lincoln has delivered stable double-digit ROEs for the last 5 years, and over the last 3 years has returned over $3 billion of capital for about two-thirds of operating earnings to shareholders. I’m going to give the podium to Dennis for some brief introductory remarks, then we’ll move into our Q&A.
Thank you, Seth, and good morning, everybody. As Seth mentioned, I’ll just make a few remarks, and then we’ll go to Q&A. As always, before I begin, let me remind you that my comments could include forward-looking statements and would point you to our website and regulatory filings for all necessary disclosures. 2016 was a good year for Lincoln. Earnings per share up 9%, record levels in our 110-year history, and a 12% ROE. I have one slide that you can see, which is a powerful slide in the context of what we’ve accomplished in the absolute over the last seven years and what we’ve accomplished relative to our peers in the last seven years. The slide speaks for itself, I don’t think I’ll go into the numbers. Let me go ahead with the rest of my remarks.
As you know, we lead with distribution and product breadth, and this strategy produced solid results in 2016 and continues to work throughout cycles. This year, individual life insurance sales increased 7%, group protection sales were up 17%, and RPS had record deposits. 2016 was a challenging year for sales growth in the annuity business, and I’ll touch on this in a minute. Lastly, on capital return to our shareholders, we continue to generate a lot of capital, and we returned $1.1 billion to our shareholders in 2016. Over the last 6 years, we have bought back $4 billion of stock, and notably, our current share price is 92% above our average repurchase price. That’s been an excellent investment. At the business level, our segments are performing well. Life, in our life business, our earnings showed sequential improvement in earnings each quarter.
This year, as I noted, our sales were outstanding, driven by our diversified product portfolio, combined with our strong distribution. Group, great recovery story, and continue to see a positive trajectory in our growth and profitability trends within the business. We’re pleased with the strong rebound in sales and improvement in our persistency rates. As a result, we expect premium growth in 2017 and further margin expansion. RPS, we’ve seen very consistent earnings, record deposits during the year of $7.7 billion, combined with a 25% increase in our net flows, positions us well for future bottom-line growth. Lastly, on annuities, we have a differentiated and high-quality annuity book. I think it’s recognized as the most solid in-force book in the industry. That help us overcome some of the sales challenges here in terms of producing net earnings. We expect that strength of that portfolio to continue.
Now let me shift to some notable actions we're undertaking to sustain our top-line and bottom-line growth. Let me start by addressing actions we are taking to rebuild sales momentum in our annuity business. There is some adjusting taking place in the market, driven by shifts in consumer preferences, but importantly, many of the trends are ones we can address and we are addressing. Let me just touch on these briefly. Four primary actions. The first, the economic environment is a little better today, which is permitting us to create a better consumer value proposition in our core products, will help sales. We're responding to a shift towards fee-based advice by refreshing all of our fee-based products, which will enable us to expand distribution by reaching new advisors, particularly in the RIA channel, which is a big opportunity.
We will introduce new products that we're seeing sell well in the current market. Four, as we've talked about, we created an entirely new product category through a collaboration with BlackRock, which will help us capture some of the shift towards passive investments and lower fees in total. We expect all these actions to contribute to our sales recovery and build on this track record of growth and profitability in our annuity business and our total business. Lastly, I would note that this year we are launching another dimension of strategy, and that is to accelerate our utilization of digitization to improve customer service. The born-digital companies, Uber, Amazon, people that you interact with, are elevating the expectations for all manufacturers in terms of customer services, and we're moving forward to meet this expectation.
Additionally, through the increased use of tools like robotics and others, we intend to lower our cost. This requires some investment, and we're trying to strike the right balance in terms of protecting near-term results while also capitalizing on efficiency opportunities. Two years, the project will be self-funding, and by 4-5 years out, we'll see significant cost saves as well as potential revenue enhancements. As we enter 2017, we have a lot of positive momentum, and I like the fact that we continue to be on the offensive as key drivers of financial success remain well within our controls. With that, I'll sit down and take Q&A with Seth.
Great. Thanks, Dennis. Thanks for those opening remarks. Before I get into segment questions and specific questions, I guess one broad one for Lincoln, the stock has been a lot more volatile than the business has been. It's been relatively stable ROEs. I think a lot of this relates to balance in the business and balance to sales. I was hoping you could tackle that theme, as it relates to both the segments you're in and also how you've been shifting sales and pivoting sales, given challenging market and interest rate conditions.
That's a difficult question. I think actually there's probably people who follow multiples and valuation in the audience better than I do you for sure. I can only talk about what we try to do to produce consistent earnings.
We'll focus on the consistent results.
Yeah, on the consistent results. We display our earnings by line of business, which I think is sort of less informative for investors than by source of earnings. When you look at our earnings by source of earnings, we talk about those earnings that are driven by equity markets, earnings that are driven by interest rates, and then earnings that are driven by mortality and morbidity. What we've said is that we're trying to increase the amount of earnings that are driven by mortality and morbidity. We're not in any urgent hurry to accomplish that, but over time, I think that segment produces about 26%, 23%, we want to get it up to about 30%. Some of that will be achieved with the growth that we're seeing in the group business, but some of it will have to be achieved in a non-organic way.
I think in terms of consistency of valuations, as we achieve that, perhaps from a portfolio perspective, that will improve. The second thing that I think drives the volatility is just the impression that interest rates have a bigger effect on Lincoln than they do on other companies. That probably comes from two views. One, again, the spread that we have on cost of liabilities versus investment results. That is, I forget, about 30% of our earnings, maybe a little bit more. It's in the materials that we have. As interest rates rise, that issue will improve, I think, if the tenure goes up 70 basis points, the 2% hold back on our 8%-10% earnings growth that occurs with interest rates at the current levels will go away. I think over time, we'll see interest rates rise.
That is a dimension of interest rates. I think the other dimension of interest rates is because we have long-term liabilities. People think that as you would guess, with the change in interest rates, the present value of these long-term liabilities go up and down more dramatically than short-term liabilities. We're attempting to address that issue by increasing the amount of non-guaranteed business that we sell. If you look at our sales mix today, in aggregate, we're trying to get to 70% non-guaranteed sales and 30% guaranteed sales, which is a shift from what we've done over time. That actually, we've achieved that organically. I think those are dimensions of the question. How much of the volatility is attributed to either one of those factors is hard to know. I think it'll come out as we move forward.
Again, if you look at this slide, there is no reason to have the volatility that you're talking about when our results are so much more consistent than the competition.
Maybe transitioning now into the segments, if we could start with your biggest segment of annuities.
Yep.
There's been some pressure on VA flows for the last 5 years, and that seemed to accelerate in 2016. I think with Lincoln, we saw pressure on VA sales, particularly in the back half of the year. Curious your view on what attributed to that pressure and how we stand going into 2017.
Seth, let's put that in perspective. We have, as long as I've been the CEO, and longer than that, we've had positive net flows in the annuity business. We're talking about one year out of the last 10 where we've had negative flows. Things like that will happen from time to time. In terms of the specific issues that have caused both industry pressure on sales as well as pressure on Lincoln sales I would talk about a couple of things. First, the DOL is an issue, and it both affected the qualified market and the non-qualified market in the sense that there was a sort of focus on aggregate fees and without as much of a look-through of the fee to the benefit provided.
There's a little bit of an issue around aggregate fees and actually broker-dealer by broker-dealer, how they wanted to deal with that. I think that's a temporary perception issue that will change. The other issue is more specifically around fee versus commissions, and different distribution systems have addressed that differently, and I think that will harmonize over time. I think there's a couple of what I expect to be temporary effects on annuity sales, sort of related to DOL, but in general related to trends in the marketplace around compensation, aggregate fees, and things like that. Let me step back and say about the Department of Labor. The Department of Labor Fiduciary Rule is about doing what's in the best interest of the customer.
I travel around with our wholesalers and talk to financial advisors, and I talk to financial advisors in the context of what are they telling their customers. I can promise you, when you talk about doing what's in the best interest of your customer for a wide swath of American retirees or close to retirement who have a good nest egg, but not a huge nest egg for retirement, guaranteed lifetime income should be a part of what's in the best interest of the client. I think that value proposition is just going to gain momentum. Again, I think there's been some cloud around that as people try to understand what the Department of Labor's intent is or whether or not it's even going to continue.
I think long term, the value proposition that comes from the variable annuity business with guaranteed lifetime income is going to be foundational to the financial planning for a lot of Americans who have money to invest. What happens when you listen to advisors, they talk about if a customer has a certain amount of aggregate net worth and they have what they call the burn rate, which is dollars that they need to live on. Well, if you're going through cycles and you don't have a segment of guaranteed lifetime income, and the equity markets go down or the bond markets go down, all of a sudden, instead of taking 5% of your nest egg for your basic living, if your whole portfolio value goes down 50%, now all of a sudden, the burn rate is 10%.
A lot of the advisors are talking about some level of guaranteed lifetime income as being very important for a big segment of America in their retirement planning. I think that's just going to continue to gain momentum. By the way, in the DOL final rule, in the preamble, it came out and specifically said that guaranteed lifetime income is an important benefit for America. It also said that in specific instances, commissions versus fees, that commissions can oftentimes be in the best interest of the consumer. We're positive about the importance of that product to Americans in retirement or building toward retirement over time.
A couple of weeks ago, it sounds like Lincoln is well-positioned for the spirit of what the DOL was trying to accomplish. A couple weeks ago, President Trump came out with a memorandum that the Department of Labor should review the rule. It's now up in the air. April 10th is fast approaching. In terms of the changes Lincoln has made, both on the product and distribution to comply with the DOL rule, where do those stand and how are you managing your business towards this uncertainty around that April 10th applicability date?
Let me answer the question. Is the DOL rule going to be put into place as it currently exists?
Thanks for asking, I didn't have to ask you that question.
On April 5th. Nobody knows the answer to this. I think many of President Trump's advisors have talked about their dislike for the rule. Procedurally, where we are in terms of, we being they, the administration, in order to delay it, there are certain procedural steps that have to take place. The most important one, it has to go back to the Office of Management and Budget. I think if it's delayed, and my guess it's more likely than not that it will be delayed, it'll be an 11th-hour thing because of just the procedural thing. I don't think we'll see that. We'll know for sure until we get closer to that April 17th date. Again, I think it's more likely than not that it'll be delayed. Who knows?
Whether it's delayed or it's not, Lincoln will be prepared to implement the rule as it currently stands. Even if it is delayed, there's dimensions of the rule that we think are positive for the consumer, and they, specifically transparency of cost for the consumer. It's actually crazy to think that consumers don't understand costs today because there's so many tools that you could use as a financial advisor to compare product to product. Transparency, first thing, it's the right thing to do for your customer, and second thing, if you don't think they can find out on their own, you're not thinking right. The second issue is we talk about the idea that there is a commission or a fee option choice. As I mentioned a moment ago, we're introducing throughout our portfolios that are affected by the DOL, the option of commissions or fees.
We're going to continue to pursue that, whether or not the DOL goes forward. This third part of the DOL that is, I think, healthy and positive for the American consumer, and that is for products that require the same time and effort on the part of the financial advisor and have the same rough benefits for the consumer. I don't think there should be compensation differences such that an agent would get more compensation for providing essentially the same effort and product to a consumer than, again, if the thing is, if the products are the same as I described. The first two absolutely we'll implement, pretty much do that anyway. The third one we're prepared to implement. If the DOL rule is delayed, we'll probably be more cautious about the implementation of that because we'll have to see what the competition does over time.
I think that'll become commonplace in the market. That is the same aggregate fees to the advisor for products that require time and effort and provide similar benefits. The thing that I've been very public about in the DOL is that the DOL does not have an enforcement arm the way FINRA has an enforcement arm or the SEC has an enforcement arm. The way they got to enforcement is by the right of action, which essentially makes the plaintiff bar the enforcement arm for the Department of Labor Fiduciary Rule. That's just wrong. Inviting litigation into the marketplace is not good for the American consumer. It's not good for financial institutions. If it's delayed, I'm hopeful that we'll keep some of the positives in the new rule, but that goes away.
Second, the most important other issue is we can't have one set of best interest standards for qualified plans and another set of best interest standards for non-qualified plans. We can't have FINRA with one set of best interest standards in the SEC. That all needs to be harmonized. As it's harmonized across all of these different groups, the American consumer will be better off.
That's tremendously helpful. If I could transition from something that's so uncertain, the DOL, to something that we have a lot more visibility on, tax reform. Obviously, we have no visibility on tax reform. It's a big question mark here. Lincoln is not a full taxpayer, mid-20s% range. A big benefit is on the dividends-received deduction. Just curious what chatter you're hearing on the dividends-received deductions specifically as it relates to tax reform.
Let me answer that question, answer a different one or expand on it. The dividends-received deduction has been in place for a long time. The dividends-received deduction is available to every corporation in America. The idea of it not being available to the insurance industry and the separate account business just to me doesn't make any sense at all. All the assets are on our balance sheets, so if we get a dividends-received deduction in our general account, the idea of not getting it in our separate accounts makes no sense to me whatsoever. I'm a strong advocate that it's a logical tax issue. Let's set that aside.
The two issues that most of us are focused on with respect to tax reform in the insurance industry, outside the insurance industry, are the dividends-received deductions, which as I said, there's a logical basis for preserving. The second issue is the Border Adjustment Tax that President Trump and Chairman Ryan are talking about. That's simple in its concept. It's just simply if you buy goods from overseas or services, you don't get a tax deduction. If you sell products overseas or services, you don't get taxed. It's a very simple concept. The way it's supposed to work, because it increases the cost particularly for retailers in the U.S. The reason it's supposed to work is because the dollar would strengthen by 20%, according to the economists.
That's an important part of the blueprint, because in order to reduce taxes, corporate or individual, you need two components. You need the Border Adjustment Tax component, and you need dynamic scoring. That's the background on that. At Lincoln, let's just assume that everything else stays the same. You drop the 35% corporate tax rate to 20%, we eliminate the DRD, and based on our analysis of the cost, worst case to us of Border Adjustment Tax, we still come out 2% or 3% better on a net tax basis than we are today. If you add back the DRD, we have a significant benefit from the changes. We'll have to see how it works out. I think if, again, everything else stays the same, 35% to 20%, even if DRD goes away, we're better off. Even if Border Adjustment Tax goes into effect, we're better off.
If one of the two of those doesn't, we're way better off.
Where does Border Adjustment Tax come into play?
Worst case analysis is that a lot of insurers reinsure with U.S.-based companies that are subsidiaries of parents that are domiciled overseas. Theoretically, our reinsurance premiums would lose their tax deductibility in the worst case. Now, let me hasten to say, all of the work is done in the U.S., and it's more of a capital allocation between the U.S. subsidiary and the foreign owner. That may not get swept up in Border Adjustment Tax, but I wanted to take the worst-case analysis when I was talking about this, that it did get swept up. The other place that it could affect Lincoln and the insurance industry, if you have partners that you're doing business with that have offshore. If you have a technology partnership and some of the work is done offshore and you're paying for that offshore work, then you lose that deductibility.
That's a couple of %. It's not a big deal.
Capital management has been a real strength of Lincoln, the last few years especially. 2017, I think you commented on the fourth quarter call, should be another above-trend year as you're able to take advantage of some of your balance sheet strength.
Yep.
How could we think about what your excess balance sheet capacity is? If there's a way you could help us frame that above and beyond your free cash flow generation.
Seth, we don't talk about using the excess balance sheet capacity. We've done, as I said, $4 billion of share buybacks, and our RBC ratio has hovered around 500% that whole period of time. We have $500 million of liquid investments at the holding company, $530 million. We're very strong on our balance sheet. It's as strong as it's ever been. Yes, would we have some capacity to use the balance sheet for incremental share repurchases? Yes, that's not the way we think about it. We think about ongoing generation of capital. Randy talks in terms of historically, we think that we have 50%, 55% of our GAAP operating earnings available for share repurchases and dividends. This year he's given the guidance that it'll be 60%-65%.
I think the powerful point, though, is that the biggest use of capital is supporting our new sales. We spend a lot more capital year in and year out on supporting new sales than we do on share buybacks. The fact that we can support the kind of growth that we've had, which costs more than $1 billion a year in capital to support the sales growth, and then a couple of hundred million dollars on top of that to invest in the business specifically, I mentioned another one of those investments being the digitization. Which if companies aren't doing digitization, they're going to fall behind very quickly. It's not as important today, but three years from now, if you're not on the digital path you're going to fall way behind. We have to do that.
I think the more interesting issue is how much capital we generate to finance growth and then still have $700 or $800 million a year for share buybacks and dividend increases. Yes, we could do a little bit more because balance sheet is stronger than we think it needs to be over time.
I want to see if we have questions from the audience. If not, I want to touch on the digitization initiative. You commented on it in your prepared remarks and introduced it on the last earnings call. I think you quantified the expense at somewhere around $0.10 of earnings a year, if my memory serves me right. Could we talk about what the benefits will be if we look beyond the next two to three years, and if we should think about it as benefits to more so the top line or on the expense margins?
The math that Randy described was a run rate of pre-tax investment of about $10 million a quarter or $40 million a year. I guess that is about $0.10 a share in 2017 and 2018. That investment and the returns on that investment, the cash savings on those investments will finance the future additional investment. What we've said is that three or four years out after the program that is planned right now, that we would expect savings on the amount of, I forget how we characterize it, but a billion and a half dollars is what we're trying to get the expense savings off of in our total G&A. We expect to get, I think 5% to 7% of a billion and a half dollars, which will emerge three or four years out.
some of that will start coming in earlier and offset the investment.
And on the-
In scope, 5%-10%, 6%-10%. The in-scope G&A that we're looking for efficiencies from is $1.5 billion, and we're saying 6%-10% expectation three or four years out. That includes no revenue enhancements because of the improvements in service, the improvements of efficiency of our distribution organization. That's just the cost. At Lincoln, we base our investments on things that we can actually see and put a circle around, and then we expect more. It's hard to say what an improved service effect will be on sales. I'm just talking about cost saves, pure and simple, when I say 6%-10% of $1.5 billion.
One last one just on the group business. Improvement in group will be one of the ways you get to that goal of increasing your share to protection-oriented businesses.
I think you're still a couple points below that 5%-7% margin target. What's the trajectory there?
I think we're talking about late 2018 now. We thought it would occur a little bit earlier. Because of all of the turmoil, our sales went down and our persistency went down a little bit more than what we had initially anticipated. Sales are now back on plan. Persistency is coming back, the next leg of margin improvement comes from an increase in net premiums over time.
Late 2018, think of it as a 2019 measured margin. Is that right?
I think you'll begin to see it emerge in 2018.
Great. Dennis, thank you so much as always.
Seth, thank you for inviting us, and thank you for all the contributions you make to the industry in your role.
Thank you.
Appreciate it very much. Thank you.