Hi, I'm Mike Kovac, the life insurance analyst. It's our pleasure to welcome Lincoln CEO and President Dennis Glass back to the conference. Lincoln is a $15 billion market cap insurer with life, annuity, group, and retirement businesses. Dennis has been the CEO since 2007. I'm going to turn it over to Dennis for some opening remarks. Then we'll be back to do a fireside chat before opening it up to the audience for some questions as well. With that, Dennis, the floor is yours.
Mike, thank you very much and good morning. I'm delighted to be back here again to talk about Lincoln. If you all take a look at our cautionary language, which is here, I appreciate that. I'll get started. Just a couple of quick slides to ground those of you who may not know Lincoln. As Mike just said, we're in the business of individual life, individual annuities. We have a group protection business, which is group life, long and short-term disability, dental. Then we have 401(k), 403(b), and 457(b) retirement business. We do 100% of our business in the U.S. All of our products are retail-oriented products used by everyday Americans. We're tightly integrated inside of the necessary functions to make that work effectively. Again, we're in those businesses. We pick the high growth segments of those businesses.
One example would be in the retirement business, small group, smaller market businesses, better growth opportunities, better pricing opportunities, mid-large or similar. Distribution is a key to our success. It has been for a decade now. We're one of the few insurance companies where distribution reports directly to the CEO. Not so much that they report to me, that we can attract the kind of talent that can stay away in the distribution and sales organization all the way to the top of the organization. We have great talent in that group. Again, we're retail focused. We have a broad portfolio of products that meet consumers' needs. We're able to pivot as things change. That's worked out well for us. Risk management is strong.
Of course, if you follow us, you know that we continue to allocate our capital very effectively. Our share repurchases have been among the highest in the industry as a percentage of shares outstanding. Let me finish here by saying these are great businesses. It's popular today to be an all U.S. company. We are that. A couple other things in closing. We're not in the crosshairs of dual regulation. We don't have, as I say, businesses overseas. We don't have to worry about macroeconomic or world economic issues or exchange rates. We don't have any problematic closed block business. We don't have any significant transitions going on that would draw management's attention away from growth and opportunities. This slide captures, I think, all of what I've just said in a very meaningful way.
If you look up on the upper right-hand side, you'll see that since 2009, we have compounded our earnings growth annually by 12%, and inside that 12%, we've had the least volatility of earnings of most of our competitors, so it's good growth with little volatility. During that same period of time, we've increased our ROE by almost 300 basis points. This record is outstanding. Again, we buy a lot of shares back, but our capital base has increased dramatically in spite of the fact that we've been buying a lot of shares back, and our RBC ratio is at 500%, among the strongest in the industry. This is outstanding performance. It's the result of the business model that we have, and we're very proud of it. Now, what about going forward? How can we continue to do that?
We share this slide fairly often at meetings like this and at our Investors Day to try to give you a sense of where the earnings come from and how we can get to our long-term goal of 8% and 10% earnings per share growth. Let me touch on a couple of the columns. First, spread compression. Spread compression has been a 2% to 3% drag over the last several years against a target of 8% to 10%. At today's level, that box would be more like 2%, 1.5% to 2% level of interest rates, that's a positive as we look forward. The expense efficiency line, I think we can do a lot better.
One example of how we can do a lot better is we've embarked on a significant digitization program and just very quickly, all companies that manufacture products these days have to have the same level of customer experience that these customers are getting at born digital companies, Uber, Airbnb, and things like that. We're going to invest significantly to elevate our customer experience, but at the same time, digitization provides an opportunity for significant cost reduction. We have something like $1.5 billion in scope in our digitization program, and over a period of three to five years, I think we can take from 6% to 10% out of that $1.5 billion. On the far left, net flows are a little bit soft right now because the annuity business for a lot of different reasons has been softer than we've seen it for the last decade.
We have significant new product development. As a matter of fact, we announced just this morning what I'd call a new product category in the business. It's a product that's directed specifically at the RIA market or fee-based advisors. It has very low total costs, 190 basis points, long-term guaranteed lifetime income. The investment engine is fueled by ETFs in our exclusive partnership with BlackRock. That's one of the things that we think is going to help significantly get us back in the growth phase in our individual annuity business. Mike, that's just a quick update and positioning the company. I'd be happy to take questions. Thank you very much.
Great. Well, I wanted to key in, and this is probably a good segue slide to what a lot of people are thinking about in the life insurance space today, which is the pressure of low interest rates for the past several years seeming to dissipate to some degree over the last month. In terms of as you think about the business, and I think it was helpful from an EPS perspective, obviously it's been actually less of an earnings headwind than it has on valuation in other parts of the business as well.
Yeah.
Can you help us think about how the more recent rise in rates is impacting how you're managing the business today?
Yeah. The interesting thing about interest rates, let me start with the fact that there's a lot of dimensions to this, but life insurance is pretty simple. We take premiums in, we invest those premiums, and down the road, we pay claims. The higher interest rates are, the better investment returns we get on those premiums, and the products, therefore, can be lower. There could be better consumer value, or the price of the product will go down as interest rates rise. Fundamentally, the strongest opportunity is just top-line revenue growth because we'll have products that are better priced and available to Americans, and I think people will buy more. That's very helpful. Just the whole notion of some of our products have fixed costs associated with them. In a secularly declining interest rate environment for years, we have seen this compression in interest rates.
That will be relieved at that 2%-3% there as rates continue to rise.
That's helpful. The other key area of focus today is on regulation. Before kind of diving into some of the business dynamics, I wanted to maybe touch on some of your views on regulation, really kind of broad-based. First, maybe on the Department of Labor update to the fiduciary standard, new administration in place. Potentially some reports that the rule may either be delayed, revoked, or watered down in some capacity. Based on conversations that you're having, what is your expectation for that?
First of all, let me back up and say, I think much that came out of the DOL is positive for the American consumer. It's positive for Lincoln. The idea of doing what's in the best interest of the customer is obviously the right starting point. Companies like Lincoln wouldn't have been in business for 110 years if we didn't do that. The idea of transparency, the idea of optionality in terms of how the customer chooses to pay his advisor, commissions or fee-based. Again, when the rule came out, it specifically said that commissions could be the best answer for a customer. Being able to do one or the other is great. Then this whole notion of for products that have the same amount of education requirements and the same similar benefits, they ought to have the same compensation associated with them.
Those three things I think are important. Whatever evolves in terms of this rule, those things ought to be kept. What ought not to be kept is the right of action, which brings enforcement tool or group into play, specifically that being the plaintiffs' bar. That's not good. I'd like to see that changed. To answer your question specifically, I suspect that delay of some amount of time will happen. We're prepared to move forward in April if it doesn't get delayed.
That's very helpful. If we do see some sort of structural change or delay, how does that change maybe the product dynamics that we're seeing in the marketplace today? You mentioned upfront some of the products that you're developing. Sounds like maybe some of those would go in place regardless of what the DOL has in store as we think about annuities specifically.
I think, Mike, the deal, again, it's hard to figure out how much of the slowdown in industry-wide annuity sales are related to the DOL. I would have to say that it's created a power over, sort of a reluctance, if you will, on the part of some advisors to use commissions. Even though when the rule came out specifically on annuities, it reinforced the idea that commissions could be the best option for that particular product type. Set the DOL aside, there are other important trends that we're taking advantage of in the market. There is definitely a shift towards fee-based advisory, financial advisors. A little bit of a shift, but there's this whole group of advisors that want to use fees as the way to get compensated for the products or for their advice, who'd never used annuities.
There's this large group of people that I think now, particularly with this product I mentioned a moment ago, will begin to use annuities in their portfolio for their customers. That's a trend that we're going to take advantage of. The other thing is that everyone has seen that the ETFs and low-cost funds, a lot of money is shifting into that away from managed funds or assets, and we're taking advantage of that. Regulation oftentimes comes in on the heels of trends that are in the marketplace anyway, and we continue to try to develop products that meet those needs of the consumers. Coming back to we have a powerful distribution system, we have great product development capability, and we've demonstrated an ability to pivot to those products throughout all of our businesses that are in most demand.
I do want to spend some time going through each of the individual sort of segments and the trends that you see there, but maybe kind of rounding out the conversation on regulation upfront. The other key element that remains topical is tax reform.
I wanted to get your thoughts on how you see potential shifts in the corporate tax reform impacting Lincoln, as you mentioned upfront, obviously domestically focused companies, a beneficiary there to some degree of a lower corporate tax rate. Maybe starting there.
Our tax rate is not as high as some because of the dividend received deduction. Bottom line on this, I think there will be corporate tax reform. I think corporations will be benefited by that. I think Lincoln will be benefited by that. How much exactly? I don't know. I don't think it's going to be a big driver when you look at this chart. I don't think it's going to be a big driver of any one of those bars. It'll be net positive, is my guess. On the individual side, whether or not the estate tax is removed or there's other individual income tax adjustments, my guess it's not going to affect our business that much.
I think the power of lower interest rates, better pricing, the value proposition of guaranteed lifetime income, the value proposition of life insurance, these are all products that are important consumer products, and we're well-positioned to serve those markets.
You mentioned a couple other ones that do come up that are maybe more life insurance specific for more people generally looking at the space like the DRD as something that maybe isn't impacting every company in the U.S. What are your sort of thoughts on that staying in place? I know it's come up in past administrations as well, not just today.
There's a very fundamental, logical reason for the dividend received deduction, double taxation of income. I think there's a strong argument to be made by the industry in some form for that to be preserved. To the extent that is preserved in some amount, and you get corporate tax rates of 20% or 15%, that would help Lincoln more than if the DRD was eliminated. I think there's a strong fundamental reason that the dividend received deduction is in place to begin with. I think you hear coming out of some parts of the administration, the idea of double taxation being a bad idea of earnings. I'm somewhat optimistic.
Sort of shifting to some more Lincoln specific thoughts here. One of the things you mentioned upfront as well is very strong capital deployment over a number of years here today, and still in place today when we think about where your capital ratios are. Given the reset higher in valuations, how are you thinking about uses of that capital today in terms of buybacks, dividends, or potentially adding other elements like M&A?
Mm-hmm. We talk about the capital available for some other use than just reinvesting in the business. The biggest capital investment we make every year is in selling our products. That's $1 billion plus. Of course, that will continue. On top of that, our profitability permits us to send up, I think we say 50%-55% of our GAAP earnings in the form of cash up to the holding company. We build our sort of $600 million cash buyback and dividend buyback off of that number. That will continue to drive us. In terms of dividend versus share repurchases, we manage our cash flow at the holding company to be absolutely certain that the dividend, even in the most severe stress situation, doesn't have to be reduced.
That drives the increase in the dividend, having coverage of that with cash flow at the holding company. It's a board decision. I continue to see a little bit better growth in the dividend than growth in earnings for a year or two, and then we'll have to see. Share buybacks, we don't have any hesitation if we have excess capital each year to continue to buying our shares back. In a life insurance business, if you have excess capital, even with interest rates going up, you're only going to be making after-tax 3% or 4%, even with a higher share price. I'd rather buy the shares back because I think there's more opportunity to earn more on that capital by buying shares back than leaving it idly sit in investments. In terms of other uses, M&A, we built the company with M&A.
We know how to price M&A. We know how to integrate transactions. The limitation or the base against which we compare the returns on M&A has always been what we could do by buying our shares back. That's a little bit closer. There might be some bolt-on acquisitions, but I don't see M&A as a significant use of capital in the near term. Having been in the business for 20 or 30 years, the M&A markets themselves can go cold, and they get hot very quickly. Back to regulation. The Dodd-Frank Act, of course, created the idea of non-bank SIFIs. I think that was a mistake. I don't think life insurance companies ought to be designated SIFIs, and certainly FSOC ought to be more clear about what makes an insurance company a SIFI. MetLife's been successful in the court system.
I raise this in the context of terms of deregulation. That's one thing that might help the industry, is if we get off the SIFI list. Being on the SIFI list, back to M&A, is an impediment to doing larger transactions because you don't want to do a large transaction and then become subject to SIFI requirements and the extra capital. That could be a positive if we, as an industry, get off the SIFI designation list, which I think should happen. Should, I don't know if it will. That would free up more opportunity for M&A transactions.
That's very helpful. To be clear, Lincoln's not a non-bank SIFI today. As you think about the rules that are potentially going to be in place down the road, one of the things that we heard was the potential for there to be some sort of trickle-down into companies that are large but not designated non-bank SIFIs. Does that go away to some degree in terms of sort of harmonizing of regulation?
Really, you can see I'm laughing at that. The only people in America who think that SIFI rules are going to trickle down to non-SIFI companies are the SIFI companies who'd like to see that happen. That's the only people in America who think that's going to happen. If people want to be big or if they want to have bank holding companies, want to have S&Ls, and invite secondary regulation, that's a business model that they choose. If they choose it, they bring along that extra regulation. We're not in the business of having an S&L or a bank holding company. Again, if you elevated our size a little bit, we might be subject to SIFI. There is no trickle-down. That's created by the SIFI companies because they'd like to see it happen.
Okay. As we think in your underlying businesses today, annuities, obviously, the largest business that Lincoln is in. We talked about some of the new product development. I wanted to maybe talk as well about what you're seeing as the returns on business today versus maybe earlier in the year.
I want to think about that kind of in two contexts. One, in terms of your own incentive to grow today, and two, to make a product that's potentially more attractive to the policyholders if rates are somewhat higher, which I think you alluded to early on.
With the 10-year treasury at 30-year at 3%, we're hitting our target returns, which is middle double digits on the annuity business. That's very positive as compared to where we were before this recent run-up in rates. We have a variety of products that we're looking at. Actually going back to some of the basics, we're looking at that as well. What do I mean by that? Our i4LIFE product, which is a rider that provides guaranteed living benefits, dominates in the non-qualified market. We can spend more time with our wholesalers on that product. We're adding a couple of other riders.
Part of the reason that the annuity sales industry wide are off, and at Lincoln are off, is because the value proposition that we have probably more so than the industry, and that has helped create the fact that our book of business is economically better positioned than anybody else in the industry, is that we started with the day that we got into the business, account value growth matters, and we provided low guarantees. Then you got a pay raise as the account value grew, and that worked into an increase in the payout stream on the guaranteed living benefit. That has been hurt a little bit for us because risk managed funds and equity market volatility has made a little bit of the growth less. The risk managed funds and uncertainty around fund assets under management, the account value growth.
We're going to continue to do that. We did come out recently with a product where the investment engine does not require risk managed funds. There's three pieces. The investment engine, the roll-up guarantee, and then the payout guarantee. If you tinker with the investment engine, you've got to tinker with the roll-up and with the payout. We have a product in the market that goes back to, without risk managed funds, closer to our value proposition of account value growth. This new product that I mentioned this morning is not a new product, it's a whole new product category. The individual annuity business is almost 100% commission-based historically, and 100% actively managed funds based. To create a product that is fee-based oriented, and the investment engine is passive investments, is a big deal. It's a big deal, and we expect good results from that.
How do you think about the returns of that business to the manufacturers like Lincoln versus the traditional actively managed commission-based product?
Two dimensions. The ROEs might be even a little bit higher on this product that I'm talking about than on our traditional living benefit products. There's less capital up front, there's no commission actually embedded in the product. The ROAs go down a little bit. That's because we're not using the capital in the VA business. What capital that's not used can then be used for buying shares back or some other product or business use. It's a good product, higher IRRs, lower capital strain. It's a good deal.
Ending in the third quarter, you mentioned flows potentially challenged in 2017, then seeing positive flows in the annuity business as we headed out in a further period of time, 2018. Is that contemplating this new launch or in the DOL? How are you thinking about the flow dynamic over the next couple of years?
Yeah. We have several product and distribution initiatives underway, all focused on achieving the goal that we've made public and set for ourselves, which is full year 2018 positive net flows in the individual annuity business. It's the two products I've already talked about. This intermediate product that doesn't have risk managed funds, but it's a full commission product. Again, the new product category that I talked about. We have a focus on i4LIFE and the non-qualified market. That's important. We're redesigning every one of our products that have compensation inside the product to be friendlier to the fee-based advisor that wants to use it. A very active product development being responsive to the trends that we see occurring in the marketplace.
shift from active to passive, an increased opportunity in the fee-based advisory market for the products that we have, or this new product, and these other things that I've mentioned. A lot going on, and we're pretty excited about it.
Yeah. One of the other parts in terms of managing your capital within the annuity business on the regulatory front, at least for the insurance company specifically, is the NAIC and Oliver Wyman working on some work on VA reserves.
Yep.
I wanted to get your thoughts as to how Lincoln's managing its business as a result as it relates to that. Any changes in the go forward, and maybe thoughts now several months after their initial proposals have come out as to your thoughts of the impact on Lincoln.
Yeah. I'm on the executive committee of the ACLI, the committees that I chair have been fundamentally focused on the key big money issues for the life insurance industry. AG 38 reserves, the use of captives for life insurance, and now the discussion of captives around the variable annuity business. The outcome in every one of those regulatory issues has come out favorable for the regulators, has come out favorably for the industry and the companies in the industry. AG 38 worked out fine. The life insurance captives worked out fine. We've just introduced, or the NAIC has just introduced principle-based reserving that, particularly on Secondary Guaranteed Universal Life, pretty dramatically lowers our reserves on new business. All these things have been worked out in a very positive way, good for the regulators, good for the industry, and good for consumers.
My expectation is that the variable annuity regulatory look and the use of captives is going to turn out fine, again, for all of the right constituencies, the regulators, the consumer, and the industry. The Oliver Wyman study specifically had 14 or 15 points, some of which actually surprised us a little bit. The idea of having a regulation which exists today where companies have to choose between hedging for economics, market-based hedging or statutory hedging. Picking one or the other is goofy, and the regulators know that. Goofy is not the right word in the sense that it was their intention to have it that way.
Now when you recognize after a couple of years that companies have to pick one or the other and they can't protect themselves on both, the regulators and the industry are driving towards an outcome that is more market-based, and you don't have to choose one or the other. I think that'll happen.
Wanted to shift gears to one of your other large businesses in the individual life side. You also discussed one of the big regulatory elements there starting in 2017, move towards Principle-based rules rolling out next year. How do you see that playing out for Lincoln? How is that developing, changing, potentially the products that you're selling, if at all?
Principle-based reserves?
Yes.
Yeah.
For the individual life side.
The reserve reduction requirement is the largest on term policies, 10-year term or fixed price policies. By and large, the new reserving requirement ought to almost eliminate the need for captive secondary reserve, excuse me, for captive type of financings. That'll take 50 or 75 basis points out of the mix of the cost of that product, which for term, is a pretty big deal. It has less impact, I mentioned it helped on Secondary Guaranteed Universal Life, but it has less impact on SGUL. Some impact, some positive impact. Again, it would reduce the amount of reserve financings that we've had to do, so generally positive.
Wanted to sort of quickly touch on some of the other businesses as well. The group business has been a pretty good story over the last couple of years as you've repriced from lower margins. Where are we in that today? Specifically, as you think about heading into year-end renewals, what do you see as the forward outlook there as well?
Yeah. Actually, the fact that we've corrected mistakes that we've made over the last 24 months, I'm very proud of. Not so proud of the fact that we made mistakes that got us into trouble in the first place. All the remediation of that business, which had to do with claims management and selling products with too low of a price in the marketplace for an 18-month period, are behind us. The business is in great shape. It's a good business. Again, the segments that we're in are the smaller end of the market, under 1,000 lives. By that I mean employers with 1,000 or less employees. That's a very good market. We're dipping our toe in the 1,000 to 5,000 employee size corporations. That will be good. It's a good business. The pricing across the competitive landscape is, I would say, positive. No one's doing crazy things.
We're very optimistic about that business and driving towards our margin expectations of 5% to 7% over the next 12 to 24 months.
Wanted to leave a couple minutes here. If you have any questions, raise your hand. We have a microphone in the back. We'll be walking around if you have it. If not, I will sort of continue here. One of the other parts I wanted to think on and touch on, the investment portfolio, which, if we think back over the year, that was still a long time ago, but at the beginning of the year, we were concerned, more broadly, the market was concerned about energy and credit risk, potential for downgrades on investment portfolios. Are you seeing any trouble spots in the investment portfolio today broadly? Then, as you think about if rates do rise from here, are there places of concern that you could see, maybe for Lincoln specifically or more broadly, for where life insurance companies are invested today?
You're right. When the price of oil and commodity prices in general dropped so dramatically, there was concern about over-concentration in energy investments and mining and mineral companies. I think most of that has gone away in terms of a spiked expectation around credit defaults. We've very significantly moved concentration in our general account away from energy. We've done that over the last 18 or 24 months. When I look out, and we sit around on the investment committee, we've upgraded a little bit the credit quality that we're buying. Pre-election, the expectations were that there might be a small credit cycle out in 2019 or 2020, we slightly increased the quality of the investments that we were buying. I don't think there's nothing that we see right now, even with higher interest rates, that creates a concentrated risk issue from my perspective.
Let me come back to our value proposition. There's some of our competitors who sort of try to make money off the back of taking credit risk and duration risk because that's their business model. That is not our business model. We sell everyday retail products to Americans. Obviously, we have an $80 billion general account portfolio, and we have to get a good return on those assets, our value proposition is not dependent on taking outside duration bets or outside credit risk bets. We think that's a good way to run the business.
Question up here in the front. Dennis, when you look up at the chart, there seems to be a drop. Talk about that a little bit.
Yeah. The 0%-1% is predicated on our year in and year out discipline of having expense growth 2% less than revenue growth. When you work that through, that's where you get to 0%-1%. I think we can do significantly better than that. We just renegotiated some of our outsourcing of our investment management, picked up $20 or $40 million in expense savings. This digitization program that I'm talking about has the potential for 6%-11% of that $1.5 billion number. That would come in over time and require some upfront investment. I honestly think that 0%-1% has the potential to be higher, and we're working very hard to make that happen. We are also, with some of our other partners, looking at our technology contracts. I think we can pretty significantly reduce the cost of some of our partners' fees.
It's a bigger number than the 0%-1%.
If there's no further questions, I'm going to follow up and end on one last one. We have a panel coming later this afternoon on insurance disruption and ideas of where there might be some innovation in the market going forward. Distribution has obviously been an advantage for Lincoln over a long period of time. Maybe in closing, give us your sense of where the industry is headed from a technology standpoint and from a distribution standpoint over the next three to five years.
Yeah. I think most of the disruptors in Fintech have been people that are our partners. Robo-advisors can help gather information and help our financial advisors in planning. They're not going to replace them. The idea of online distribution of insurance products surely will grab a bigger share of distribution over time. We're planning to be in a position to, again, with this digitization initiative that's underway, and actually things that we already have in place, that if that's a pivot in the way our customers want to be served, that we'll be in a position to do that. Our whole strategy around distribution is to be in every channel that's meaningful for the products that we develop. Even have some greenfield distribution capabilities so if something pops up that's not traditional, that we're in a position to take advantage of it.
Distribution is king at Lincoln because we sell retail products. We're in every major distribution channel for the products that we have today, we're planning to be in any major distribution channel as things shift.
Great. Please join me in thanking Dennis and Lincoln.