I'm pleased to introduce Dennis Glass. Dennis is President and CEO of Lincoln Financial Group. He's been CEO of Lincoln since 2007. Prior to his affiliation with Lincoln, Dennis was CEO of Jefferson-Pilot Corp., which merged with Lincoln in 2006. Lincoln is a diversified U.S. life insurance company offering life products, annuities, retirement, and group insurance. In 2013, Lincoln was the best performing life insurance stock among the S&P 500 life names, almost doubling in price. Needless to say, 2013 was a strong year for both the company and the stock. With that, I'll turn it over to Dennis for a few opening comments, and then we'll get into our Q&A.
Thank you, Seth, good afternoon, everybody. Appreciate your interest. Those of you who are shareholders, I greatly appreciate that as well. I just have a couple of slides here that I want to share with you if I can get past the forward-looking statements. The first is just sort of delivering on the fundamentals, Seth has already said that our share price performance was good in 2013. It's a result of the fundamentals being strong since 2009. You can see here earnings per share have been compounding at 12%. We've moved the ROE up from 8.5% to 8.4% to 12%. Our balance sheet is as strong as ever, 500% RBC, $1.2 billion. Actually net, we'll make a debt payment this year, $700 million, but very strong. We're buying a lot of shares back.
I think in terms of our competitors over the last three years, we've bought more of our percentage of our capital returned to our shareholders in the form of share buybacks than anybody else in the industry. The share price has done well. I'm really positive looking forward, I break it into two buckets. One is the environment, you'll see more of why this first point is good for Lincoln and the industry. Most of the people I talk to still think that we've got a pretty good shot at continued world economic recovery, that's going to cause rising equity markets and increasing interest rates. For the insurance industry in general, those two are very important drivers for the earnings mix. From our perspective, we sell guaranteed products. Consumer demand is still focused on certainties after what happened in 2008, so that's good.
This next point is really very interesting. We have increased pricing, both Lincoln and the industry, quite substantially, in some instances of 15%-20% over the last 24 months. The industry and Lincoln is selling more product. I don't think you find yourself in an environment very often where you can raise prices and sell more product. Overall, the environment's quite good. At Lincoln specifically, we are exclusively in retail businesses. That's where we want to be. We don't do any wholesale businesses. We think we create a franchise that is hard to compete with because it's doing everything along the continuum of product development to distribution and the connection of all of that in a retail product environment. In order to be successful, you have to do all those things well. Our franchise is very strong.
We have, by most accounts, the best distribution in our space. That's both wholesale distribution and retail distribution. Our wholesale distribution last year resulted in some 66,000 independent advisors choosing a Lincoln product. 66,000, that would be much larger in terms of a distribution organization than even the largest life insurance companies that we compete with. Product breadth, we've demonstrated an ability as markets have changed and consumer demand has changed, to use a combination of product breadth and distribution strength to shift and pivot more important. The rating agencies, particularly on annuity risk management, variable annuity risk management, rate us the best in the industry. As you saw a moment ago, we have a very strong balance sheet.
We have a very strong franchise in the right growth markets inside of what I think is going to be a pretty powerful environment for the industry in general. There are a couple of things that I want to do over the next period of time. The two of them are reduce the sales of long-duration guarantee products. In 2013, 36% of what we sold was long-duration guarantee. I want to move that down to 30%. I'll come back to the why for that in a second. Earnings by source, I want to move our mortality and morbidity earnings from 22% to 33%. These two objectives are based on my watching the stock and the competitors and having a lot of analysis done over the last four or five years.
We have a pretty high beta, I think that beta is driven because we have had too many long-duration guarantee sales or guarantees as part of our overall business and too much in the way of capital market margin business. That minor shift, the top part of the chart, the sales, we can get that done organically over the next 24 months. On the bottom chart there, where we're trying to increase mortality and morbidity, that's a little bit longer in its time horizon. I think both of those things will contribute over time to a lower beta and a higher multiple. Finally, I think the industry and Lincoln in particular, sometimes the analysts miss out on what's driving our earnings. If you look at this, and you saw it on the previous slide, mortality and morbidity, 22%.
The industry has about an 11 multiple on those kind of earnings. Investment spread, credited rates versus what you get on your assets, that drives 34% of our earnings. That has an 11 multiple. What I think people miss a lot is that essentially we get 37% of our earnings on fees on assets under management . It's the same source of earnings that asset management companies get, I think we ought to get a 16 multiple on that. The offset to that is we do have guarantees, but our VA riders, which is what pays for the guarantees we actually get a profit on. For this slide, I just said, well, let's assume we get a zero multiple on those earnings.
If you look at it from the source of earnings and compare it to what other industries get as multiples, I think we should be up in the 12 range versus the current nine. To summarize, great industry outlook, strong franchise, some movements to lower the beta, and opportunity for multiple expansion. I think is a pretty good story for Lincoln and for our shareholders over the next 2 to 5 years. Seth, with that, we'll open up for questions.
That's great. Thanks, Dennis, for those comments. You mentioned the shift to about a 70/30 mix, in terms of ultimate sales, we've talked about this in the past in terms of the pivot strategies. Maybe first you could update us on the progress of that program.
Yeah. The program started initially with just trying to lower our guaranteed universal life sales were a large part of our individual life sales. Because that was a long-duration guarantee, as interest rates dropped, you couldn't reprice the product. We shifted to other products, in the course of two years, I think we went from 75% on universal life as a percentage of total sales down to about 18%. That was a very big shift. Right now I'm more focused on the broader points that I've just made here, which is getting the sales mix to 70/30, 70% non-guaranteed, 30% guaranteed. I think we can do that organically over the next 24 months, and we'll continue to report on that.
Moving the mortality to a third or more of earnings is probably going to have to be done through an acquisition if we're going to do it in any reasonable period of time. If I was to choose an acquisition opportunity, it would probably be in the group space or maybe even in the life space. When I look at each of the business lines, just take this kind of pivot idea a little bit further. In the life industry, we did pivot away from long-term guarantee UL to different products. That's essentially done. In the annuity line, we're making good progress on getting to 70/30.
We did one of the most innovative reinsurance deal, in the history of the industry last year, where we got the subsidiary of Wells Fargo for a very good cost and return for them to pick up the living benefit guarantees on $4 billion worth of sales. Next year, actually, in the life, in the annuity business, we'll be further along on our targets there, guaranteed versus non-guaranteed because of that deal. Over time, by adding new products that are more oriented for asset accumulation and shifting wholesalers' incentives, we'll get to the proportions that we need there. When I look at the group business, where we've had a little trouble this past quarter and really not great results for the year, we're moving the business from employer-paid, which is a more difficult environment, to employee-paid, that's another pivot.
In retirement business, there's not really too much of a pivot going on, but we're expanding substantially in our small case, 401 and 403 business. I would say that the pivots are guaranteed versus non-guaranteed and the source of earnings. Within the lines, it's more emphasis these days. It's pretty much job done. It really comes back to having product breadth and significant distribution capability to make those things happen.
In terms of measuring success, you opened up talking about the high beta that Lincoln had and the group had entering the year. How would you measure success in terms of lowering market sensitivity beyond just sales numbers? I guess beta is one obvious way that you can measure this, but that's going to be very much dependent on the market and what the market chooses to put on, if it's fair or not. Are there other internal measures that you look at other than sort of the external beta in terms of measuring success of this pivot strategy?
It's just the achievement of these objectives that I set forth, Seth, I think that will translate over time into a lower beta. I'm reasonably confident of that. Yes, we'll continue to report on source of earnings. I think that's a much more important and easier concept to understand than line of business earnings, because line of business earnings really, many of them overlap in the source of earnings. What's really driving the earnings is important from a source perspective. How you raise your liabilities is important as well. Individual annuities, you raise it one way and that liability has different characteristics from what you do in the retirement business, getting to those objectives over time.
Maybe if we could switch over to that top-line earnings numbers and think about ROE trends. Your ROEs in retirement and annuities have grown nicely in 2013. Individual life and group have lagged a little bit in the single digits, and that's brought the total ROE a little bit down.
Right.
Thinking about those two other businesses, what are the objectives to bring those ROEs up, which should drive ROE improvement in the group?
Let me give you the history on the life ROE. The ROE got set at 11% in 2006 when we did the transaction, the merger between Jefferson-Pilot and Lincoln. You have to put the business on a book at a certain return, and we put the business on the book at 11%. Since that time, we've lost 100 basis points to spread compression, and we've lost 100 basis points to increased capital requirements because of regulatory changes. That's how we've gone from 11 to 9. How are we going to move the 9 up? Most importantly, I think I said it already, we have the best returns on new business that we've had in the last decade, and we're selling more.
That takes a little bit of time to work its way in because so much of the earnings are from the in-force business that have that lower return on it, but that will help. The second thing is spread compression in the life business and in our PS business has been getting less as interest rates have risen. It'll get less again this year, but spread compression is still a reality in the life insurance business and in our PS business. We need a kick of about 75 basis points on the 10-year and 75 basis points on the 30-year to get out of spread compression and convert spread compression into spread expansion in order to get the life ROE up. It's spread expansion and new business returns as it works its way into the in-force numbers.
On the group business, it's a matter of repricing the business that we underpriced for the last couple of years. We underpriced it. It's employer-paid life and LTD business. It's always interesting. I've been in this business a long time, and you watch volatility around a trend, and you have to decide when the volatility around the trend is just volatility or it's actually changed the trend line. Back in 2006, I felt the volatility around the trend line had changed the trend line, so I increased pricing. We lost 20% market share, and the trend line came back to what it looked like. This year, we waited too long. I think the trend line actually went up on loss ratios, particularly in LTD, and we didn't increase pricing quick enough to recognize that.
In the group business, it's repricing our employer-paid business, which will occur and work its way into the revenue line over the next 24 months. Then it's a return to a more normalized, a slightly better loss ratio than what we saw in the fourth quarter. Those two things. Then a little bit of a shift from employer to employee-paid, where that second segment has more margin in it than the first segment. It'll take us probably 24 months to work our way out of these lower ROE numbers that we had in 2013.
If we think about the margins on employee- versus employer-paid, could you help us quantify sort of how much better that is on the voluntary side?
We don't split it out. The reason we don't split it out is because even when things are going well on the employer-paid side, it really is a package sale. A large part of our voluntary sales is, let's say, all of us in the room probably have it, our employers provide a certain amount of life insurance free, maybe one time salary. Then they give the provider, in this case, Lincoln, the opportunity to sell buy ups so that you can buy, as an individual, more life insurance. So the two are negotiated at the same time.
The more you can drive, you do get better margins on the employee-paid, in part because there's a little better underwriting because once you get out of the group itself or sort of the risks are homogenous and you go into individuals buying their own insurance, more like individual purchases. You have a little bit of underwriting. We need just to move up the employer paid a little bit, not the employee side. Again, it's a package sale. Then we have a lot of worksite products that are being developed, term, critical illness, accident, and health. Those are sort of separate from the employee, employer-paid through group sale.
Maybe if we could transition to the annuity segment.
Yep.
You mentioned in your opening remarks how pricing in the competitive environment has generally been improving. One of the products that you've been emphasizing has been non-guaranteed.
Yep
I think that's up to about a fifth of total VA sales right now as of the fourth quarter. Thinking about that as a simpler product, I would think that would be a more competitive, maybe more price elastic product. Could you talk a little bit about what the competitive environment you're seeing on non-guaranteed VA is and what differentiates Lincoln in a product that may be a little bit more commoditized?
Well, let me give everybody a base. Industry-wide in the variable annuity business, you'd have about 88% over the last five years or so, or maybe more, that have been sold with living benefit or death benefit guarantees, and you have 12% that is non-guaranteed. The industry statistics are about the same as we had before this year's emphasis on non-guaranteed sales. I think in the fourth quarter, we took the 12 up to 18%, then we knew 18% non-guaranteed sales. We did that merely by taking this powerful distribution force that we had and changing the math around the compensation to emphasize non-guaranteed sales. That was a big move in a short time. Probably can't go much faster on that, much more than that, without introducing a new product, and the new product would have more of an accumulation emphasis to it.
For example, in the variable annuity product, the subaccounts are limited to, I think, 10 or 12, then you have a wrapper around that. For income purposes, it takes the top 20% of account value growth and presumably protects you for 20% downturns. It's not a good accumulation product. We introduced a good accumulation product. Just like everything else, it's a combination of a competitive product, then driving it with distribution. I think we'll do quite well on it. There's only two competitors that are taking this route. Probably more will follow. The space for sort of the old-fashioned mutual fund for guarantee annuity wrap, there's not a lot of competition right now.
Do you see more coming on the horizon?
I would guess that there's going to be a bigger appetite for the traditional VA product without a guarantee. I think in April, when we all do our taxes, we're going to have a little bit of sticker shock because there's so many deductions that burn off. I think, and the incremental taxes associated with some of the federal programs that kick in. I think there's going to be more demand for tax-deferred products, because of the change in the marginal tax rates as another sort of market push.
Maybe if we could shift over to the regulatory environment.
Yep.
There's been a push towards principle-based reserving. New York State has been outspoken that standards aren't stringent enough. Maybe you could give us a comment sort of on the move to PBR, and the impact on Lincoln's business and with New York's recent comments.
Yeah, let me just step back. With just about any product, one of the big drivers of what the reserve amount is the premium that you charge. As you've gone from fixed premium products, which were the style in the 1950s and 1960s and the 1970s, to products like Universal Life that have variable pay capability of the sort of historical 150-year-old system of having a fixed formula to set reserves and to try to measure what the real revenue generation is going to be. It just doesn't work. You have to have something that's more dynamic, and that's principle-based reserving. The U.S. insurance industry is following the lead of the Europeans in having a principle-based approach. Now, inside of that, for a variety of reasons, there's a floor reserve. Principle-based reserving is about right-sizing reserves and doing a better job of that.
It's not about lowering reserves necessarily. It's about right-sizing them based on the capacity that you have today to run complex problems through computers, and you didn't have that 150 years ago. New York is a little uncomfortable with principle-based reserving. They're one out of 50 states that hold that respect, with the other 49 believe that principle-based reserving is the right thing to do. The NAIC, despite New York's objections, are pushing forward. A little bit of good news out of New York is that they have, kind of interesting, they all of a sudden made public their view that the reserves for term insurance and for SGUL are probably too high.
They're proposing some sort of negotiation to reduce reserve, particularly on term insurance. Because on those two products, it sort of confirms what the industry has been saying all along, is that you've got these tremendously redundant reserves that have to be financed. I think it's progress from New York's perspective on the dialogue. To have formulas for those two products instead of principle-based reserving, I still think it's generally believed to be the wrong direction.
Maybe on the federal side, Lincoln's not big enough to be designated SIFI. Is there any shadow impact or trickle-down impact that could come to Lincoln, be it the state regulators, or more likely, the rating agencies?
What's happening is sort of the worst outcome for the life insurance business, which is having two regulators rather than one. For my whole career, we've been advocating for an optional federal charter, but not both a state and a federal charter. We are where we are. The crisis occurred. You've got SIFI designations, you've got international standards, and then you have the Treasury or the Fed regulating insurance companies that have thrift or bank holding companies. Let's put the state system and then everything else. The state system is very solid. The RBC framework and the solvency framework has been tested time and time again. It's very solid, and I don't think that'll change significantly. There's some issues like principle-based reserving or the use of captives that the industry is working on. I'm pretty familiar with what the big issues are.
There's no talk right now of tremendous change in capital requirements or reserve requirements. It's all PBR and captives. Let me say, just from a states' right and federalism perspective, the states will always be the primary regulator of life insurance. That's not going to change as far as I can tell. You have the question, well, let's say Pru or Met has a higher capital requirement because of these other regulators. Will that in some way affect a Lincoln or other companies that don't have those regulators? The gatekeeper on that, first and foremost, is the rating agencies. If the rating agencies were to up the requirements for capital because of these other capital requirements imposed on certain companies, then that would affect us. I've talked to them all, and at this point, they're not changing their capital standards.
I think in the foreseeable future, we'll work with the companies that are subject to the second set of regulations to try to get the best outcome for the industry. I don't think it's to Lincoln's advantage in the long run to try to take advantage of a dual-based regulatory system and capital standards. I think it's best for the industry if we end up with the right capital standards for the industry. That's where we're going to put our energy. There may be a short period of time where maybe we get an advantage. We're not market share people. We got to get the business we want on the terms that we want.
I want to compete against the Mets and the Prus and the other quality companies in the industry on the basis of good product, good distribution, good service, good risk management not some regulatory arbitrage.
We have a question here in the middle, on the right-hand side.
Actually, I have two questions. The first is, in terms of your assets under management, you're using the 16 PE. Would your returns on equity and profitability be compare, or would they be better or worse than the other people that are selling at 16 times?
The majority of those earnings are driven by our annuity business. We're earning 22%-23% on that business right now.
The second question is, obviously distribution is key for you. Would you talk a bit about whether you are expanding distribution? Distributors pushing back to get greater share of profits? Is there competition, more or less than is normal for piloting good distributors?
Let me just talk about sort of, and answer that question, because some of the questions inside the question are most specific to our Lincoln Financial Distributors organization, which is 600 wholesalers strong and sells through all the major wirehouses, all the major banks, all the major independent companies. Let's first go how much we're paying for shelf space. First of all, we have all the shelf space there is in the U.S. For the products that we sell, there's not any organization that distributes the product that we're not on their shelf already. There's not a lot of pressure these days. There's pretty much we got to continue to work with the companies to share the cost of access Advisors and their clients. Let me give you an example of what goes on.
Merrill Lynch is either the number 1 or number 2 provider of small case 401 business in the U.S., and we had never been on their shelf. That was the one shelf that we weren't on, so we didn't have access to that large group of financial advisors that sold small case 401. I would say the last thing that Merrill Lynch needed was another 401 provider because the product itself is not different. Because we had such massive distribution and we ourselves could help Merrill Lynch improve the sales of their small case 401 business because we're selling to their financial advisors that are selling annuities. We can cross-sell, we can run joint programs and everything. It was really a win-win for Merrill Lynch and for Lincoln.
Sort of the ability to generate more business for both organizations was a driver rather than us having to pay $50,000 or $60,000 to get on the shelf. I think these days it's more about productivity and joint efforts to sell more business for both distribution organizations than it is just worrying about the fees. That's our experience. Other companies may have different experience. Good. Yep.
We have a couple minutes left. Maybe we could just close on your thoughts on capital distribution, especially with the share price rising now at maybe a little bit above book value. Capital distribution's been pretty strong the last couple of years. How have your priorities changed as the stock price goes up?
Well, as I said, we have been very active in capital management. Again, I think it's accurate to say in the last three years, as a percentage of market cap, we've bought back more shares than anyone else has. Now, in part that was because we were selling at a secret discount to book than everybody else was. It was a good decision to buy that stock. We really even made, Seth as you know, we jumped pricing in our individual life business, took a 20% decline in sales. Every $1 reduction in sales gave us a $1 more to buy our shares back.
Why would you ever not, if you're selling life insurance products or any product at 9% and 10%, why don't you channel back a little bit those sales if you can turn around and use capital that would be deployed for new business to buy back your shares at 15%-20%? We did that. Now the equities between return on new business and getting return on our shares is a little more in balance. Now I would tell you that for the reasons I started, I think the prospects for share price growth for Lincoln are still pretty strong. We developed $700 million of free cash flow that's available for dividends and share buybacks annually. You're not just going to let that sit there.
As we've done in the past, we provide guidance this year, which is sort of $500 million to $550 million of share buybacks, which is 30% higher than what we guided to last year. We're going to be active in buying our shares back, and as our earnings rise, our free cash flow should rise. Absent some surprises in capital and things like that, I'm pretty optimistic about staying in the market. We have something like $1.9 billion. That's just our annual free cash flow that we can put to work. We have $1.9 billion of excess capital represented by the difference of 400% RBC, where we think over the next five to seven years, we'll become more the norm than 450%.
Between that and having a couple of hundred million on the cash at the holding company, more than we need, that adds up to about $1.9 billion. All of that's not available for share buybacks because you can't take $1.9 billion of capital outside the company. If you invest in a new acquisition, a larger amount of that money is available for acquisition. We'd like to do an acquisition again in the group space. I don't want to do anything so big that it tampers with the ability to continue a good share buyback program, as long as I think it's a good price and I hope that's always. I always think it's going to be a rising price.
Great. Thank you. I think we'll have to leave it there.
Thank you very much.