Good morning, everybody. I'm Yaron Pinar, Deutsche Bank's North America life insurance analyst. With us today, we have Randy Freitag, the Chief Financial Officer of Lincoln Financial Group. Lincoln is a long-time leader in the U.S. life insurance and retirement space. Randy, thank you for joining us today. It's a pleasure to have you here. Just to give you a sense of the format, we'll have a fireside chat, open up the last few minutes for questions from the audience. Randy, before we begin the Q&A session, is there anything you'd like to share with the audience as to how you think about Lincoln and how it's positioned today, how it's positioned going forward, and what are you viewing as the opportunities and challenges of the company today?
Sure. Before I start that, I want everybody to read this. When you guys are done reading this in 15 minutes, I'll answer that question. There we go. This is the cautionary language. We're through with that. Okay. Opportunities and challenges for Lincoln. Let me start with the industry. I think that's a good place to start. I think it is, Yaron, a very favorable environment for the insurance industry over the coming years for a number of reasons. I think if you look at the economic environment, what headwinds has moved to tailwinds, right? You have growth returning across the globe, which should hopefully drive equity markets. Interest rates, they're going to bounce around, but more likely than not, they will trend up over time. You've got this economic environment that is favorable for our industry.
Inside of that, you also have a very strong demographic trend in terms of people who are coming into the years when they would be very attracted to the products we sell as an industry. You have strong consumer demand for the products that we sell. You have balance sheets across the industry that are in very good shape. You have product portfolios that have been repriced into this particular environment that exists today. You have strong returns for the products the industry is selling. In terms of the industry, I think that the next 5, 10 years presents some great opportunities to succeed for the industry. When you come into Lincoln then, and you think about what we are, we're positioned in four businesses. In all four of those businesses, we have what I think you need to be successful.
We have distribution strength across our businesses. We have product breadth across all of our businesses. We have great risk management. We have an extremely strong balance sheet. We have all of the underlying fundamentals to be successful in the four businesses, retirement, group, life, and annuity, that I think you need to be successful. We're well-positioned in the businesses we're in. We do have two explicit strategies that we're focused on as we look forward. We have two things we're trying to do. One, we're trying to bring down the percentage of our sales that come from products with longer duration guarantees. We were about 50/50 if you go back five years in terms of products that we sold that had longer duration guarantees. That's variable annuities with living benefits. That's guaranteed life products. We've come from 50/50 to last year, we were at 65/35.
We're well on our way to getting to the 70/30 mix we ultimately desire. The other thing we're trying to focus on is changing our mix of earnings a little bit. If you look at last year, we made 38% of our earnings from interest spread, 25% of our earnings from mortality and morbidity, 32% of our earnings from fees on assets under management, and then 5% of our earnings from the guarantees on living benefits. Over time, we would like that mortality and morbidity component to move up from the 25 to the 33. Those are the two things we're focused on. Great environment for the industry. I think we're well-positioned inside of that industry. We have a couple of things we need to work on.
In terms of challenges, I think that the primary challenge that I see today right now is sort of on the regulatory front, and I don't think it's an immediate threat, but just uncertainty in the regulatory environment. We'll see how that shakes out.
Okay. Maybe a question on regulation then specifically. At the NAIC and the state specific level, there appears to be an ongoing debate over captives, PBR, more broadly how to regulate the XXX or AXXX reserves.
Can you give us your thoughts on how we got to where we are today and what the potential solutions may be, how you're positioning yourself for those solutions?
Sure. Well, you named really the main issues at the state level that the industry is focused on and working with regulators on. You've got PBR, principles-based reserves, captives, and stuff that's going on in New York in terms of AG 38. The way we have solved these things or worked on these things in the past as an industry is by working very closely with regulators. We did that on a broad AG 38 solution with all 50 states. We have one state in New York that decided that they weren't supportive of that overall agreement, they pulled out. I think that was the wrong choice by New York in that particular instance. Our response to that was that we stopped selling that particular product in New York. I don't think that was a good outcome for consumers.
That was unfortunate, but that's just one state out of the 50. With the other states, we have the broad agreement that the industry reached with them on the other two items, principles-based reserves and captives. Lincoln is a leader in working with the regulatory community. We'll continue to be. That's been the industry's approach, is to work with the regulatory community to come up with reasonable outcomes. It's worked in the past. I think it will work again. That doesn't mean we won't have some ups and downs. You won't have some states that from time to time express some disappointment. I think by working with the regulators, we'll reach solutions that work for both the regulatory community and work for the industry.
Okay. When you talk about the situation in New York, I think last year you strengthened reserves by about $90 million.
That was step 1, if I remember correctly. Can you maybe give us a little bit of an update as to where things stand, what else one should expect?
Yeah. That was going to be a five-year grade in of the minimum reserves. We put $90 million up last year. We put this year's $90 million up in the first quarter, so we're $180 million into that. We still had a very strong quarter from a statutory standpoint in the first quarter. We did put up that $90 million in the first quarter. New York, my understanding is, if you think about those two products, there's term insurance and there's guaranteed universal life, which are generally thought to have these redundant reserves. On term insurance, New York actually came up with their own approach, which is going to lower term reserves. My understanding is that will go into effect the beginning of 2015 for product sales going forward. I hear they're working on some stuff on the guaranteed universal life side also.
We'll see where that ends up. We'll give them input if they ask for it. That's where they are in working on those products.
Okay. Also on the regulatory front, I'm wondering if this may actually be an opportunity for a company like Lincoln, where clearly two of the large competitors are, either one is already designated a non-bank SIFI, the other seems to be a very short distance from being designated as such. Does that present an opportunity for those companies who are not designated, or do you see the whole industry maybe facing more enhanced capital requirements, whether de facto or any alternatives?
Yeah, I don't think that we're going to be successful or not as a company based upon whatever regulatory regime some of our peer companies are in. We're going to be successful or not because we're in good businesses, and we're executing inside of those businesses. At the end of the day, that's why we're going to be successful as a company. We're very supportive of, you're talking about Met and Pru, and AIG. We're very supportive of them developing capital standards that are more reflective of the insurance industry. We believe over time that will become the best outcome for the federal regulatory system. We were part of an industry group that sent in a letter the other day very supportive of that goal that Met and Pru are working very hard on. We'll be continued to be supportive.
I don't think at the end of the day that whatever capital regime they are subjected to at the federal level will necessarily move over to the rest of the industry. I think the ultimate gatekeeper on what the capital requirements are for the industry has been and will continue to be the rating agencies. We are a rating-dependent industry. It's very important that we have strong ratings to sell in the markets we do. If the rating agencies change their capital models in response to something, we would probably need to respond to that. I haven't heard anything from the rating agencies that would indicate that they're not very happy with their existing capital models. I don't expect any response from the rating agencies, but we'll see.
Moving on to a different subject topic. Management in the past has opined that Lincoln should or could be viewed as an asset manager of sorts. With that in mind, I think it raises a few questions. First, what proportion of the in-force business does have these long-term guarantees today? Two, how do you value those guarantees if you take a view of an asset manager here?
I said the numbers earlier, but I'll repeat them again. I think the best way to look at this is how we make our money and what are the sources of the earnings that ultimately we report to shareholders. Using 2013 data, we made 38% of our earnings last year from interest spreads. We made 25% of our earnings last year from mortality and morbidity charges. We made 32% of our earnings last year from fees on assets under management. We made 5% of our earnings from the guarantees that we sell on living benefits. I'm not going to tell investors how to value that 5% piece. They can reach whatever conclusion they want. I will point out, though, that we have managed those guarantees at Lincoln through any number of market environments, right?
I mean, go back to 2008 and 2009, the equity markets went down in excess of 50%. We've seen interest rates drop to as low as 1.5% on the 10-year Treasury. We have managed that risk using our hedge program at Lincoln. To a great deal of success, right? We have always had assets in excess of the economically driven liability that exists for those guarantees. Very comfortable in our ability to manage the guarantees that we sell to consumers. We've demonstrated that in some of the harshest environments. We've demonstrated that in the very good environment that exists today. Very comfortable with that, investors can think about that particular valuation however they want. In terms of how they should value the rest of the company, let's focus on that 32% piece that is really fees on assets under management.
I don't know how you can see that as anything other than just an asset management business. I mean, it's no different than what any other asset manager does. We have $100 and some billion of these assets, and we collect a base fee of 1.5% or so for managing those assets and providing the platform that investors use to get to those investments. That's how we think about it, and we'll continue to work with investors on that story.
Okay. This is a question I actually asked in the previous session as well. As Lincoln moves away from the long-term guarantees, and I think it's something that's true for the industry as a whole.
How do the products remain competitive relative to the alternative that a consumer may have? All of a sudden, doesn't that part of that offering that a bank has or an asset manager, don't those become more relatively attractive at that point without the guarantee?
We're primarily talking in the annuity space, today. I think you're primarily talking about the annuity space. Historically, about if you go back three years, 90% of our sales were on variable annuities with living benefit guarantees. 10% were on non-guaranteed variable annuities. Last year, we changed some of the incentives for our wholesaling force, we upped that 10% to, I think it was about 18% last year. Ultimately, we would like to get to 30% of our overall sales coming from VAs that don't feature a living benefit guarantee. To make that happen, we're rolling out a product this year, more of an investment driven, tax deferral driven product. That'll come out in the middle of this year. Some of our competitors have had some pretty good success on that product.
I think it makes sense that that product should be competitive against other options for the same reasons it's always been somewhat competitive. There is a tax deferral advantage that exists inside of a variable annuity relative to other products, and there will always be some portion of investors out there who have another place that they can go to with some tax-deferred money. I think there will always be the capacity out there for these products. I think when you wrap in sort of some of the interesting investments that we and others are putting into these products, it makes them just very attractive place for investors to go. I think that our competitors have proven that there's some demand out there. I think that the underlying reason for that to exist isn't changing. Tax rates are going up. The tax deferral story just gets stronger.
We hope to be successful. We'll get the product out in the middle of this year, and we'll see how it goes.
Okay. If we move on to another favorite subject of mine, interest rates.
I tend to agree with the comment you made earlier that by and large, we should expect interest rates to rise over the course of the next few years. Nonetheless, year to date, I think the interest rate environment has been a little disappointing. With that in mind, and you look at Lincoln, which may be as interest rate sensitive.
A, do you agree with that, or would you disabuse those investors of that concept? B, can you maybe give us a little bit of a sense of what the impact of maybe rates staying flat from here for the next maybe 18 months, what would that impact be on earnings and on the balance sheet?
In terms of the interest sensitivity of Lincoln, I think once again, keep quoting these numbers, but 38% of our earnings came from interest spread last year. There aren't many competitors who report their earnings in that way. By the way, I think this is the way to report earnings that gives investors some of the best flavor of what's going on. I have a suspicion, not supported. I haven't went out and sort of tried to break down everybody's earnings. That 38% isn't too different from what your typical insurance company has in terms of how it makes its money.
I have a suspicion that the interest sensitivity of Lincoln relative to its peers is exaggerated somewhat. There are three aspects that I can think of about interest rates that are important to think about. The first is, what sort of headwind does it create against earnings growth? We've done numerous sensitivities for investors all the way down to when 10-year Treasury was at 1.5%. If you go back to the first quarter, we invested our money at 460 overall, which was about 50 basis points below our portfolio. That is down from roughly 150 basis points below the portfolio yield at the depths of interest rates. There's a lot less spread compression today than there was a couple of years ago.
We have shown the ability of the company, really as an industry, to manage spread compression even when it was at a much wider level. While I don't like having spread compression, it is a little bit of a headwind. We have been managing this particular phenomenon for a number of years, and I feel very comfortable that we'll have the ability to manage it going forward. There's earnings growth headwind that's created by low interest rates. The second is the balance sheet. Once again, we have done numerous stress tests as low as 1.5% on the 10-year Treasury that demonstrate that the balance sheet is not at risk because interest rates are low.
Because of the significant amount of work we've done around asset liability management, we have a very strong balance sheet, even at very low levels of interest rates for an extended period of time. 10-year Treasury of 2.5%, feel very comfortable that the balance sheet is in great shape. The third aspect is, does it impact the returns you're getting on the new business you sell? In that regard, I think that the products, we've said this a number of times, we've really repriced our entire portfolio into this low interest rate environment. The returns that we're getting on new business are definitely not as impacted as they were before we had done all that significant repricing. Earnings headwind, we have been managing that. It's down significantly from where it was. We'll continue to manage that.
No balance sheet products have been repriced into this low interest rate environment. Look, I'd prefer that rates went up just like everybody else a little bit, but we'll manage with interest rates at this level.
On that last point about the repricing, I think on the last earnings call, management said that repricing is pretty much complete. Since then, rates have come down a little bit more. Do you see another round of repricing should rates remain flat?
I think it's doubtful that you would see repricing in the real near term. If you go out three, four, or five years, is it conceivable that you'd have another round? Possibly. I think that for the near term, most products have been repriced into this low interest rate environment. I don't think you have that extensive amount of repricing going on. If you go business by business, life has been repriced. Returns are in excess of 12% across all life products. Variable annuities, the returns are in excess of 20% in those products. You've got your retirement business, which continues to be a 13%-15% business. The group business, which is similar. Really the only business that remains at the lower end of acceptable range is the fixed annuity business.
Fixed annuity business has been a 10% return business since dinosaurs roamed the Earth, I imagine it always will be a 10% return business.
All right. Talking about the pivot strategy and connecting that to cash flows. You're four or five years into the pivot strategy. The cash flow, I think cash generally at the holdco level is about $700 million per year. Where do you see that ultimately go to as you move further away from the pivot strategy and more of the earnings come from, say, less capital-intensive businesses? How long would it take to get there?
Well, let's start with what we have done. It all starts inside of the life insurance companies because that's where the source of the holding company cash flows ultimately comes from. If you look at the last couple of years, go back two years, 2012, we had about $800 million of statutory operating earnings. We did a $200 million reserve financing that gave us $1 billion of capacity in the insurance companies. Last year, we had about $750 million of statutory operating earnings, we did $450 million of reserve financings. That gave us about $1.2 billion of capacity in the life companies. First quarter of this year, we had a very strong statutory operating quarter, about $350 million. I said it was somewhat anomalous. What I said is I'm very comfortable that we can continue in that billion-dollar range in the life insurance company.
With that level of earnings, what have we been able to do at the holding company? We've been sending roughly $700, $800 million a year up to the holding company, which is enough to allow us to do what we've done from a deployment standpoint at the holding company. Once again, using the last few years, we have done $1.7 billion of share buybacks over the last three years. We've averaged roughly $125 million a quarter or so. We have built a cash position at the holding company of about $600 million at the end of the first quarter. Over those three years, we've also been able to grow our statutory capital from $7.1 billion to $8.2 billion. We've grown statutory capital by $1.1 billion. We've also done a few hundred million of de-levering.
At the same time, we've taken our annual shareholder dividends from, at the depths, about $12 million of actual outflow to this year, it'll be about $170 million of shareholder dividends that we'll spend. We've increased dividends, we've maintained a strong level of share buybacks, we've grown capital in the life company, we've maintained a strong cash position at the holding company, and we've done a little bit of de-levering. We've done that over an extended period of time, three years, I feel very comfortable that we'll continue to be able to do that going forward.
All right. You had mentioned in your earlier comments the desire to move the mortality and morbidity business to a greater portion of overall earnings, 33%. Do you envision using M&A as one tool to get there? If so, maybe you can talk about where you see opportunities specifically within those businesses. Those aren't really businesses that we've seen a lot of activity in the industry recently, certainly not in the U.S. Is there a pipeline there? Maybe you can give us a little more color as to what you're seeing or what you're interested in.
Yeah. What we've said is that we were at 25% last year for mortality and morbidity. We'd like to go to 33%. To make that happen will really take inorganic growth. If you just look at the way the different pieces of our earnings are growing, to really change the 25 to something significantly higher would take something inorganic, like M&A. We don't comment specifically on M&A, M&A is episodic. We have a group of people at Lincoln who, probably just like every other company, who spend their day looking at what's available out there in the world, and we'll continue to do that. You never know when something's going to come up on the M&A front. It pops up, you look at it, and you move forward. In terms of a focus standpoint of that group, we will focus that group on mortality, morbidity-driven earnings.
We would likely look at something that might come up in the retirement space if something came up in the retirement space. That's where our focus would be as we look forward. You never know when it's going to happen, if it comes up, we'll take a look at it. We're very well positioned from a capacity standpoint to be active in that marketplace should something come up.
On the variable annuity book, clearly, the book has had an outstanding year, driven also by market or markets. As we've seen some stabilization in the markets, what do you see as a reasonable kind of run rate for top line, for margins, as you maybe see a little less of benefit from AUM growth due to market appreciation, maybe less of a K-factor impact on margins? How do you see that develop? Assuming you do see some stabilization in the variable annuity book, what are the main drivers for earnings growth besides variable annuities?
Well, I don't see much impact from the K-factor going forward. The main drivers of earnings at Lincoln are going to be the four businesses we're in. If you look at those four businesses and what are their growth potentials, and does that get us to where we want to get to as a company? You've got the life business, which is a 3%-5% sort of business. We'll probably grow at the upper end of that range, given our scale and our capacity in the life insurance business. You've got a mid-single-digit grower in the life insurance business. You've got the retirement and the group business that are higher single-digit growers. Then you have the annuity business, which I would probably put in that higher single-digit space also.
When you wrap all those four businesses together, you get where we need to go when you combine share repurchase, capital management activities. You get that mix of business that can get you to that 10% EPS growth, which is what we strive to get over time. I'm very comfortable that the mix of businesses that we have can get us where we need to get to from a growth standpoint. Of course, we have to manage things like the spread compression we talked about earlier. We have been doing that for a number of years, and we'll continue to do that going forward.
All right. Why don't we open up the floor to questions from the floor? If you could state your name once you get the mic, I'd appreciate that.
Yeah. Good morning. Len Savage from Decade Capital. Randy, can you just talk a little bit more about the new VA product? I'm curious what kind of investments you're putting in there that sort of focus more on the tax deferral. Are you putting alternatives inside the VA, or what kind of funds are you putting in?
Yeah. The underlying investments, there'll be a number of underlying investments, but that will include access to some alternatives, hedge funds, private equity. There'll be a number of different options wrapped into the separate account wrapper that investors have access to. The tax deferral theme has always existed in variable annuities, right? There's always some segment of the population that has additional funds that they have to invest. They're in search of a tax-deferred strategy. Variable annuities have provided that opportunity. Now they can get that tax-deferred strategy along with access to some pretty interesting investment options. It won't be dissimilar from some of the other products that are out there. Jackson National, to their credit, has probably had the most success with this product. I think they sold about $4 billion of it last year.
Can someone choose to be in one fund, or you sort of asset allocate it?
It's not an asset allocate. It's their choice where they want to be, right? This is not a product that has any guarantees wrapped to it. This is a classic access to investment options, and they can choose to go in those options wherever they want. We're not concerned about that because we're not providing a guarantee, right? That's when you're concerned about where they put their money.
Why don't I ask another question? With regards to variable annuities, clearly, there has been some link between high betas and variable annuity portfolios. We've seen, I'd say, different strategies across the industry the last couple of years or maybe a little more than that now with regards to growing or shrinking that portfolio. Lincoln clearly has been very stable in that market. In fact, in some years, maybe even taken market share given that some have pulled back. Ultimately, clearly, there's this pull or push situation between going after very attractive business when a lot of the markets pull back, and trying to maybe lower betas, which I think has been one of the goals as well. How do you think of the two, and how do you balance the two?
Well, I think over time, the beta story is linked to what I talked about, a desire to raise the mortality and morbidity component of earnings over time. We've talked about how that would likely take something inorganic to fundamentally change that. In terms of the beta of Lincoln relative to peers, that's the main thing I'd point out. There's been a perception that we have more exposure to the capital markets driven sources of earnings than others. I think that's one of the reasons we've come out with this look at our earnings by source. Hopefully, others in the industry follow along. I think that'll allow you to get a fair comparison of how different companies make their earnings.
I think in actuality, if you look at sort of the volatility of earnings, I think we've demonstrated over the years an earnings stream that is not much more volatile, if at all, if not less volatile than our peer companies. I'm comfortable with where we are today. We've talked about what we'll try to do to change that going forward. We're very comfortable with the earnings mix we have today and feel it provides a good place for investors to come into.
Any other questions from the audience? Otherwise, I'll take the last question. All right, I'll take the last question. If we shift gears to the group business. Clearly, margins came under a little bit of pressure at the end of last year. I think it's a business that management's been trying to grow in recent years. Rightly or wrongly, I'd say this reminds some investors of instances in the industry's history where there's an attempt to penetrate a business or to take market share in a business. It doesn't always pan out well, and then there's a retraction or retrenchment, I'd say. How do you think of that, or how do you disabuse investors of maybe a more cautious view as to what's going on to group business?
Yeah. I think of what has happened on the Group side, which is, in Lincoln's case, primarily focused in about $1 billion of our core employer paid business, which is roughly 50% of our overall group premiums. It's not so much a price-driven, competition-driven event, but it's more about the experience is rolling out a little different than the assumptions that went into the pricing. Incidence is a little higher, claim severity is a little higher, and you have to respond to that change in experience in your pricing. We're doing that. As I mentioned, it's about $1 billion of premium. About $300 million of that'll be repriced this year, another $500 million next year, with the small amount that remains in 2016.
I don't think of this as much as a competition-driven event, just as much as it is just experience is not rolling out like the assumptions that went into the pricing. We'll respond to that over the next couple of years.
Great. Well, Randy, thank you very much. Looks like we're just about out of time. I appreciate your insights and time with us.
Thank you for hosting the Conference. Love to come up and do it.