Right, we're going to get started here. Hi, I'm Mike Kovac, the life insurance analyst at Goldman Sachs, and it's our pleasure to have Dennis Glass, the Chief Executive Officer of Lincoln, with us today for a fireside chat. Lincoln is a retail-focused life insurer with some unique distribution and risk management strategies. I will turn it over to Dennis for some introductory remarks.
Mike, thank you. Let me get the cautionary language out of the way first. Before beginning, I want to point out to you our forward-looking statement and cautionary language, which you can find on our website, as I may make some forward-looking statements. Thank you. Mike, again, we're delighted to be here, and we appreciate being invited. I'll just make a couple of opening comments, then go with the format. Let me start by saying that we're really quite proud of the performance that we've had over the last several years. Just a couple of statistics on that. Operating, for sure, on an annualized basis, have been in the double-digit range. As I talk about double-digit earnings growth, we've also had reasonably predictable earnings and much less volatile than many of our competitors. Good growth and consistency.
We've had a steady improvement in our ROE and our balance sheet metrics, things like risk-based capital, sort of hovered around 500%. Capital itself has continued to grow. The recent performance has been very good, and of course, it has been reflected in our share price. I think this will be the third year, if we're doing the calculation right now, but it'd be the third year in a row that we've outperformed the industry on the previous three-year cycle. It's worked out pretty well. How do we drive those results? I'll just make a couple of comments. Really starts with the combination of one of the biggest distribution platforms in the insurance industry in America, connected to a very profitable and wide array of customer solutions or products. Let me put that in perspective. We sell through independent distribution.
Over the last couple of years, 91,000 independent financial advisors who could choose any company in America to sell their product have chose a Lincoln product. Why is that important? Well, of course, they're choosing the products in the first place on the basis of consumer value. More importantly, that 91,000 group of distributors has many end customers. The different needs of those customers, and the different financial advisors helps us do a couple of things. First and foremost, it helps us target growth markets, which is good. Secondly, it allows us to diversify our product portfolio. Let me give you a couple of examples. We've referred to these diversifications as pivots. One of the biggest pivots was in our life insurance business, where several years ago, almost 65% of the business that we sold was one product, guaranteed universal life.
We pivoted away from that product, again, with the strength of this distribution and product development capability. Today only 30% of our life insurance business is in that product. Moving on to the life annuity business. A couple of years ago, 90% of what we sold had guaranteed living benefits attached to it. Today, only 70% of our sales have a living benefit guarantee. Once again, a little diversification, I think, is healthy. That's one reason why we've achieved these results that I've just mentioned. The second one is pretty good risk managers. Let me give a couple of examples of that. First, our VA hedge program over the last decade has continued to provide very stable results with very little hedge breakage.
Important part if you're going to be a successful player in the variable annuity living benefit business. It's not just me saying that. Outside experts, consultants such as Oliver Wyman, rating agencies continue to say publicly that Lincoln's VA hedge program is one of the most successful and most robust in the industry, and we appreciate those comments. Sticking with risk management, we have a very diversified investment portfolio. Only about 5% of our $80 billion general account is in below investment grade investments. Importantly, particularly in this last three years where we've seen interest rates come down so much, we've always had a very good duration asset liability, duration program.
That's blunted the impact on us of declining interest rates, both from a balance sheet perspective, and although we have seen spread compression, it was better than it would have been if we weren't so disciplined around asset liability duration. The final thing is capital management. First, because of our risk management capabilities, we've had no significant unexpected capital calls, which is a good thing. We consistently generate capital. The business that we sell gets a good return, generates capital. It's positive. We use that excess capital or that capital to do managed buybacks, dividends, and of course, the biggest use of newly generated capital is putting into profitable new business sales. Coming back to, just briefly, the capital management share buybacks. We bought back, since 2011, $3 billion worth of our shares, and we've reduced our share count by 25%.
We expect capital management to continue, as these other two things I've just talked about will continue to be a part of our business as we go forward. I think based on the franchise, and all of the items that I've just mentioned, I expect looking forward that we'll continue to perform well. I've mentioned this a couple of times, just from distractions that other companies might have, we're not in the crosshairs of dual regulation. We don't have that problem. We have a 100% domestic footprint, we're not subject to international turmoil, capital markets, exchange rates, things like that. Finally, we're not distracted by any closed down runoff books of business. That allows us to be very aggressive in our forward planning and our use of capital.
Again, looking forward, I think our business model will permit us to grow earnings per share in the 8%-10% range. That comes from organic growth, modest capital market headwinds, and of course, capital management. You may have seen we've produced this slide a couple of different times, how we get to 8%-10%. There's a series of drivers that permit us to do that. Again, that slide is in our IR materials. 8%-10%, I think is a good long-term growth rate for our business as it's presently conducted. Of course, at any time, world events or capital market changes could cause us to be a little bit below that or possibly even somewhat higher than that. 8%-10%, again, I think our franchise in the businesses that we're in can develop that kind of earnings growth.
With that, I'll just turn it back to you.
That's great. Yeah, some great introductory comments there, and I think we'll touch on some of those topics over the next half hour or so here. Wanted to start with maybe your biggest product on the annuity side. As you think about the competitive landscape in variable fixed and indexed annuities in 2016 and beyond, and we mentioned some of the current macro headwinds that might be facing some of those products today, can you describe how Lincoln views the competitive landscape today?
In the VA business or in the annuity business?
In each of the sort of separately within the different annuity businesses.
Okay. Let's take the individual annuity business first. As I said, we have been on a path to diversify. Diversify is a good word, but maybe better tilt away from just being so much focused on guaranteed living benefits. We've gone from, as I mentioned already, 90% of our business to 70%. We continue to offer new products into the marketplace that will further diversify that business while maintaining good return on equity. That business is pretty good. The VA business has had historically, and now I'm going back to pre-crisis, you've had what was referred to as feature wars. The people who got out of the business really got out of the business for two reasons. One, their benefits were too rich. One of the benefits of the VA living benefit is the annual roll-up.
People were going up to 6% or 7%, payouts were high, they didn't manage their hedge program or didn't have a hedge program, or didn't have a comprehensive hedge program. That's really behind us. Since the crisis, the people who remain in the living benefit variable annuity market are rational people, good companies, good management teams. I'm going to say this across all of our business. It's a pretty competitive environment, but it's not crazy the way it was before the crisis. The individual annuity business is a good business. Again, we're diversifying in that business. We have such a strong distribution organization that it's going to permit us to move as market circumstances, consumer preferences change. In terms of ROEs, we've always gotten 20% or have over the last seven or 10 years gotten 20% ROEs.
It's very difficult to identify a specific cost of capital for a specific product. We've done a lot of work trying to get the math, looking at the math on this. My guts tell me, my 40 years in the business tell me that the spread between cost of capital and return on capital from new sales is wider in the variable annuity business, living benefit business, than any other insurance product sold in the U.S. I think there's a good value proposition there. As we diversify, we have good fixed products. We have good indexed annuity products. We have good Long-term care riders. It's just a big, strong business, again, the combination of distribution and product development hedge programs. I'm very comfortable about that business. The other place where we have annuities as the core chassis for the business is in the retirement business.
We focus on the retirement business either with group variable annuity contracts or a mutual fund chassis in some cases. Our business is small case to mid to large. We've been investing both in technology and in expansion of our distribution in order to make that a more successful business. I think that'll continue to pay off with pretty good results. Let me come back to distribution. Merrill Lynch put us, 24 months ago, on their platform, us being our small case 401 product. Defined contribution product. The last thing Goldman Sachs needed was another 401 product on their distribution platform. They had very good ones, some of our competitors. The reason they asked us in is because they wanted to cross-sell from other product lines, individual annuities, and hopefully increase the pie for them of their retirement product sales. That worked out quite well.
I think in Merrill Lynch, about 40% of what we sell in the small market retirement product is the direct result, 30%, I guess is the number. 30%, in that neighborhood, is the direct result of our wholesalers in their system cross-selling from the variable annuity product into the retirement product. Again, just another example of the power of distribution and the opportunities it gives a company like Lincoln to partner with other organizations to sell what we sell. Those are the annuity businesses. I'm happy to talk about the life business and the group business as well.
Yeah, just following up on the annuity side. One of the places that Lincoln's been innovative on this side is reinsuring some of the risks associated with the variable annuity side of it. To what extent do you see appetite to continue to de-risk the variable annuity offerings that you have through both reinsurance, through de-risked products?
Yeah.
Do you feel like we're sort of there today from products that you'd like to pivot into, or are there future opportunities?
Two years ago, I set a challenge for the company to drop the VA living benefit sales from 90% to 70% of total sales. That wasn't just a number that I pulled out of the air. That was a number that was predicated on potential earnings growth, balance sheet risk of the annuity business, return on equity. All of those things, and 70/30 turned out to be about the right amount of guaranteed versus non-guaranteed VA business. At that time, we knew that we could do two things. One, we could just shift the incentives of our distribution force and make some progress, but we also knew that we'd need to introduce a new product that was more asset accumulation focused than living benefit focused. About the same time, a reinsurer got into the business and offered to partner with us.
Never happened before, at least since the crisis. A very reputable organization wanted to partner with us on a reinsurance basis, and they took all of the risk of the living benefit feature. That helped us, very quickly, get from the 90% down, actually below 70% of sales being, at least from Lincoln's perspective, without guaranteed living benefit risk. Right now, we've increased the size of that a couple of times, but I don't think we need any more of that. Mike, there's not a big market for it in the first place, but I always wanted to get to the right risk profile in the VA business based on organic sales, not having to rely on a reinsurance opportunity.
In part, now of course, we use reinsurance a lot across the organization, but in the VA business, this particular opportunity, it's not a deep reinsurance market, so you can't build a business plan around there being one reinsurer of living benefits in America. We really don't need that reinsurance anymore. We might do a little bit more if we needed to.
Makes sense. Shifting gears to life insurance side of it, results have been volatile, not just for Lincoln but for the industry over the course of the year. We saw some elevated mortality trends in the first and second quarter, and then maybe more normalized levels in the back half of the year. Can you discuss the current dynamics that you see there? Do you feel like pricing is adequate today, or are there trends that make you a little more concerned today?
Yeah. Let's go back to 1992. Let me just use an example. These numbers are just pulled out of the air. Let's say you were selling a block of life business and you expected the claims to be $10 or let's say $100 a year. At that point in time, the reinsurers were coming in and expecting claims to be, let's say, $80 a year. Again, this is directional. This is not precise. What the industry did, and what Lincoln did, was to lock that profit in by reinsurance, reinsuring quite a bit of what we were selling in those days. Importantly, on the business that wasn't reinsured, we weren't using the $80 expectation. We were using the $100 expectation because that's what we thought it would be.
When you look at experience in the industry, and you separate it out from the primary writers and the reinsurers, you've got that $80 that they were thinking, but we always thought it was going to be $100. The life industry itself, the primary writers I don't think have had quite as bad of experience as the reinsurers have had. Having said that, you're right. In the first quarter of this year, across the industry, the incidents increased, so there was more claims than you would have expected. Severity, I guess, was in line. The second quarter, you had higher than expected mortality results. In the second quarter, you have what we refer to as a one in 100 year experience, where incidents return back to normal levels.
We had one, two, three, or four large cases that related to homicides and some other events sort of outside the normal expectation. In the third quarter, we got back to normal. My view is, and we turn these analyses inside out and upside down. We look at issue year, we look at age, we look at sex, we look at preferred, we look at non-preferred. All of our analysis suggests that our expectations and our experience will continue to be at our expectations.
Building on the Life insurance product here, you've used reserve financing transactions in the past to free capital out of the Life insurance business. Do you see future opportunities for that into the end of the year, maybe in 2016 and beyond?
I think Randy said that we would probably do $200 million in 2016. You have some really positive dynamics in the life insurance industry that will reduce the need for captive financings. One of them is principle-based reserving. That in the regulatory environment, you have to have 72% or 75% of premiums. The states that represent 75% of the premiums agree to the new regulation, and we think we'll hit that. We and the states think we'll hit that in June of next year, so that starting in 2017, principle-based reserving will be in place. Huge result in terms of PBR, particularly on term insurance. Almost eliminates the difference between economic reserves and statutory reserves. There's still a thin layer of cushion above economics. That's a big deal. That should be in place in the first part of the year.
Principle-based reserving doesn't do quite as much for guaranteed universal life. Back specifically to Lincoln, because we're not selling as much as we used to, we won't need to do as many captive financings. I think on the regulatory front, from the state perspective, I had a couple conversations about that this morning with investors. It's really been a very positive outcome. Now we're working. We have one more big issue from a captive standpoint, that's the VA captives.
VA.
I think that could turn out very good for the industry and for the regulators. Let me just very quickly say, the way the regulations stand right now, the companies have to make a choice. You either hedge to build assets to pay future claims, or you hedge to avoid temporary capital calls because of statutory accounting. These temporary statutory calls occur in periods, tail risk type periods. We have, and I believe the regulators agree that it's kind of goofy to have to have a regulated company choose between two risks. This all comes down to, very simply, economics is roughly market value, and statutory is book value. I think we can come together on that issue and eliminate this choice of having to do one or the other, but leaving yourself exposed. That could be a good development.
I don't think we'll get all the way there. I think we'll get pretty far.
Yeah. How do you think that plays out in terms of how Lincoln would manage its business, and if the rules sort of pass as the conversations are going from a VA standpoint?
It takes a risk off the balance sheet that we now have with this problem of tail risk and statutory calls. That would go away, but it really wouldn't fundamentally change the risk management and the diversity of the individual annuity business in a material way.
This just takes a risk off the balance sheet. Did I say something wrong? Reserve financing 2015 We did a reserve financing. You will do one. 2015? That's right. I'm getting my years mixed up. 2015. Yeah. It's 2014 now. Okay. I'm sorry. We'll do a reserve financing first quarter of next year.
Fourth quarter of this year.
Fourth quarter of this year. Okay.
Just sort of closing the loop on that, would it change your use of captives? Is that how you're imagining the VA would play itself out? In that sense, you wouldn't necessarily need to use captives in that scenario. Would there still be a role for captives?
Yeah. The VA captive is a very different animal than the life insurance captive.
Right.
A life insurance captive goes live on the day you move the business. There's actually a shifting of the risk from the company to the captive assets and everything else. That actually happens. In a VA, it just sort of sits around waiting for this tail risk to occur, and you don't really do much with it at all. It just lies dormant. You have to have it in place. For us, it may not be true for everybody else, it just lies dormant, and you only need it in the case of this tail risk. Let me hasten to say, to my recollection, we've never used it for VA risk. Yeah.
Shifting to the retirement business, you mentioned this a little bit in some of the opening remarks. How does Lincoln see its role within the retirement space today? Is this a core business for you going forward? You were in the asset management business at points in time with Delaware Investments. Out of that business today, do you continue to expect retirement to be a core business for Lincoln?
Yeah, Mike, we don't have any hobbies.
Yeah.
The businesses that we're in, we're in, and we're investing in, we expect to grow, and that's the case with the retirement business. I'll say that one of the challenges we have in that business that we don't have in any of our other businesses, is that we're competing against non-life insurance companies.
Right.
We're competing against the asset managers. Makes it a little bit more difficult. Again, when I say that we're in a business, we're not in a business all the time across the spectrum of opportunities. We pick the very spot or segment of the larger opportunity that fits with our capabilities, and gives us an edge. Again, we don't have hobbies. We've had four businesses. We've been in that business for a long time. I will say, and I say this all the time, our job is maximizing shareholder value. If something comes along different, not particularly in the RPS business, but in any of our businesses, where our organic game plan can, over the long term, be enhanced by doing something slightly different than we're doing right now, we do it.
Makes sense. We talked a little bit about changes in regulatory environment. One big one that comes up across the asset management and life spectrum is the Department of Labor update.
Yeah
fiduciary standards. Any updated thoughts there in terms of conversations that you've been having, either with regulators, with industry participants, or even on the distribution side in terms of how people are preparing?
What Lincoln's path has been on the whole fiduciary, DOL fiduciary program, which is 800 pages of regulation, is to focus on that piece which affects us most significantly, and that piece happens to be the ability to easily pay commissions on living benefit variable annuities that go into IRAs. Lincoln has put 100% of its effort, 98% of its effort on that single issue. I've put a coalition of other variable annuity companies. Just about every major variable annuity company in America is in our coalition. What are we trying to achieve? First, there's no argument, none of us could be in business. Life insurance companies, Lincoln's 110 years old. I think New York Life is 150 years old. Northwestern Mutual is maybe 160 years old.
We don't have that kind of longevity unless every day you're doing what's in the best interest of your customer. Who argues with the overall agenda and objective that the DOL has? No one would, because that's what we all do on a daily basis. You get into the details of the 800 pages, and the way it's written right now, it's very difficult, if not impossible, for distribution organizations to permit the sale of VAs on a commission basis into IRAs. We've worked directly with Secretary Perez in meetings. We've worked directly with his staff in meetings, and we've proposed to them our number 1 solution would be to put the VA product back into 8424, where all the other insurance products are. I think the likelihood of that is small.
We're as happy to get inside of the Best Interest Contract Exemption and insurance-focused BIC. We call it the IBIC. I think we're cautiously optimistic that would happen, and if that does happen, there'll be some disruption, but not significant disruption. That's what we're doing on the DOL front and our efforts. The second issue is an important question, which is because the DOL affects mostly the distribution companies, not the manufacturers in this particular instance. We've seen a couple of examples where one or two smaller distribution partners of ours have sort of thrown in the towel on thinking that anything good's going to come out of this next iteration of DOL, which I don't agree with, by the way. Have suggested to their financial advisors that they shift their business from commission to fee-based.
There's a little bit of that, but there's not any overwhelming rush that way at this point. When the rules are published, hopefully they'll be clear enough that all distribution organizations will have the same reaction, but we'll have to see. I've said this a couple of times, but our distribution strength, our product development capability, even in the worst case, will permit us to get important products into the hands of customers who need them on a cost-effective basis and with a decent Return on Equity. If the rules came out the way they are today, it may take a couple of years to do that, and our sales could drop off. If that worst case happened, the capital that we wouldn't be putting into new sales would be put into share buybacks.
Over a three-year period, the earnings per share impact of that sales disruption would be de minimis because we just used that capital and buy our shares back. I've done that before. We've done that before. In 2013, when interest rates dropped, or 2009 when interest rates dropped, our Guaranteed Universal Life business went from a return on capital of 12% to 8%. We cut back by 20% or 30%, generated hundreds of millions of dollars of capital, and bought our stock back when it was $25 bucks. It worked out quite well for us. We're good at capital management. Let me also hasten to say we're running out of time here. There's only so much contraction you can do in a business before the fundamentals of the franchise start to break apart.
You can't take a program of $600 million of sales in the Life Insurance business and take it to zero. You'd lose your underwriters. You'd lose all your value propositions. But at the margin, particularly in the VA business, we can do what it takes.
Any questions from the audience? We'll move, shifting gears here in the little time that we have left. Want to focus a little bit on capital management, which has been a strong part of the Lincoln story for the past several years, really. Demonstrated a preference for buybacks over dividends, though I'd note that you did increase your dividend most recently in the third quarter by 25% year-over-year. How do you think about uses of excess capital in terms of buybacks, increasing the dividend, or potentially looking to M&A transactions in terms of what businesses you'd be interested in?
Let me start with the third one first, because it's an easy answer. If returns on buying add-on businesses were reasonable, our first choice would be the group business. They're not high enough. People are buying group businesses at 8% or 9% IRRs. When we can sell business between 12% and 14%, it would be silly to allocate any significant amount of capital to M&A right now. That'll change. Right now, we're not actively in the market trying to do a deal because people are buying these properties at such low returns. The Japanese have had an influence on that because they've come in with their lower cost of capital and bought three insurance companies. I think the M&A market for add-on deals for Lincoln is not a high priority right now.
That could change tomorrow if the dynamics in the business return on investment changed. If it did change, group would be our biggest business. We've said for a couple of years now, we'd like to move our source of earnings from mortality and morbidity, which now are around 23%. We'd like to move it up to 30%. It'd be very hard to do organically, we'd like to do a deal. That leaves us with the question of our choice between share buybacks and dividends. We're not quite at the dividend level on a payout ratio, where I would say that our increases would be consistent with growth and earnings. We may have above-average increases. May. Let me hasten to say, this is not my decision. It has to be approved by the board. I'm not suggesting anything.
The dividend payout ratio, when you look across our industry, we're a little on the lower side. We have very strict metrics around the amount of free cash flow that's generated into the holding company and coverage ratios on dividends. We have a very mathematically oriented decision point, and we won't drift away from that. I would guess that on a go-forward basis, we'd continue to proportionately have more share buybacks with our free cash flow than dividends. Again, I'm not predicting anything about dividend increases next year or the year after. I can't make that decision. The board can make it.
Great. Looks like we are right out of time here. Please join me in thanking Dennis and Lincoln-