We're going to get started with the next presentation here. We're pleased to have Dennis Glass, President and CEO of Lincoln here today. Dennis has served as the CEO since July of 2007, after previously serving as the COO, as well as the CEO of a predecessor. Year to date, Lincoln shares have nearly doubled and are up 166% since the end of 2011. With that, I'll turn things over to Dennis for some opening comments, then we'll kick it off with Q&A. As always, feel free to raise your hand and jump in with any questions.
Yeah. Chris, thank you. Certainly, we're pleased on behalf of our shareholders to have those kind of equity increases. I know we're all looking forward, let me make a few comments about what I think the future holds, both for the industry as well as Lincoln. I would say that the industry is probably as well positioned in 2013 for growth as it has been for a long time. I say that for a couple reasons. First, a lot of the industry earnings come from equity assessments. As equity markets rise, our earnings go up, and I expect that to be continuing at some pace. A lot of the industry earnings come from interest margins, and I expect interest rates to be going up. That'll push earnings. Consumer demand, going from capital markets to consumers.
The demographics are in favor of our industry, particularly the baby boomers, and the baby boomers' preferences for guarantees, which is what our industry provides, long-term guarantees, is increasing. There's increasing demand. Probably the most telling and most interesting recent market development is that the industry has repriced its products, increasing across the board on variable annuity products, long-term guarantee, universal life. Just about every product in the portfolio has been repriced with a higher price, and in fact, across the industry, we're selling more product. Demographics are favorable, capital market trends are favorable, and people are paying more for our products. That's a pretty good situation. When I look at Lincoln particularly, I start with the fact that in the context of these broad demographic and market movements, we focus on the fastest-selling segments in the businesses that we're in.
An example of that would be in the group business, where we're concentrating on employers with 1,000 or fewer employees. The growth rate in that market is probably 7% or 8%, versus the overall growth rate in the group market, which would be half of that. Similar situation in the retirement business. Yes, we participate broadly in the markets that most of our competitors compete in as well, but we pick specific segments. You get good macroeconomic conditions. We're focused on specific segments with faster growth. We have a very strong franchise, and I'll lead with the fact that we have the best distribution platform, I think, in the industry. 70,000 different independent financial advisors each year choose to sell a Lincoln product, and that's a pretty big sales force as compared to what everyone else has. Distribution strength is part of the franchise.
We have a broad portfolio of solution sets. As you saw over the last couple of years, as consumer demands changed and as the dynamics in the marketplace caused us to have to pivot to new products, we both had the distribution to do that, as well as we had the products with which to do that. The rating agencies continue, broadly speaking, to say that we have the best risk management or one of the top risk management programs in the industry. When you narrow that down to variable annuity risk management, we're generally, by the rating agencies and other third-party observers, said to have the best performing hedge program and capability. Finally, we have a strong balance sheet. Completely strategically have redesigned the balance sheet, carry a lot of cash at the holding company. Our RBC is very strong.
Again, to repeat myself, macroeconomic conditions, demographic conditions, consumer buying habits, all very good. Within that context, I think we have one of the best franchises in the businesses that we participate in. There's two things that we're trying to do. As I've studied our performance over the last four or five years, a little bit too much beta, and I think that's associated with, to some extent, the proportion of capital interest margins that are driven by capital market factors, again, equity assessments and interest rates. We're trying to move our mix of source of earnings more towards mortality, which will dampen, I think, the volatility in earnings a little bit in periods of time where you have big swings in the capital market. I'm in not any big hurry to do that, but over time, we'd like to do that.
Finally, again, in the context of the basic framework, I think the other reason our beta's a little high is we have proportion a little bit more in terms of long-term guaranteed business on our books. We're changing the mix of that as we go forward, so we'll diversify the risk of our product portfolio down a little bit as we go forward. We like the guarantee income business. We're good at it, both in the VA and the guaranteed UL space. We get good returns today. I think it's a pretty positive outlook, Chris, and I hope to be able to continue to provide those kind of returns to our shareholders.
Okay. Maybe I'll get started with one and, like I said, anyone with questions, feel free to raise your hand. Maybe starting in the annuity space. First on the VA side, there's been increased sentiment in terms of capital market participants coming into the space. At first, it was more on the legacy runoff for closed block businesses, but you guys last quarter announced the reinsurance transaction. Wondering your updated thoughts around these financial buyers. Are some of them starting to be more strategic? Is the market for new business starting to open up a bit more, or is that just a one-off transaction with Wells Fargo?
Wells Fargo transaction was the first of its kind, the most innovative of its kind in the last 10 years. The reason it worked is because the economics for Wells Fargo were good, the economics for Lincoln were good, and Wells Fargo picked Lincoln for the reasons I was talking about a minute ago, because generally, outside observers would say we run the annuity business as well as anyone else. Chris, this particular transaction, I would say there's a fairly thin market, but I expect more people at the moment, it's a thin market, but I expect more people to come into that type of reinsurance transaction. I think the trend would be positive there. When I step back and I look at the dynamics, broadly speaking, of the insurance business, the returns on new business are good.
Again, I've said a couple times this morning that the macroeconomic conditions are good. That should, broadly speaking, bring more capital into the life insurance business.
Are any of the regulatory things that cropped up primarily with N.Y., but is that distracting at all in terms of maybe additional capital looking to get into the space?
Yes and no. What are the two big regulatory issues in the industry right now? One of them is behind us, and that was how the regulators wanted to change the reserving for long term, for guaranteed universal life. AG 38 in N.Y. is still a little more aggressive on that than the other 49 states. I would say that's behind us with both Lincoln and the industry without any serious consequences. We're looking forward, broadly speaking, to Principle-Based Reserving, which should right-size reserves. Doesn't mean that all reserves are going to go down with Principle-Based Reserving, but it's a much more sophisticated way at trying to right-size the reserve for a variety of economic conditions. I think that's a good outcome. Hold that thought for a second.
The second big issue in the industry is the use of affiliated captives to help finance the redundant reserves that were created by AG 38 and Triple X in the first place. There's been some noise around that, and the industry's looking at it. Let me say, what we do at Lincoln is essentially set up an affiliated captive. The RBC in that captive generally runs from 400%-500%. We put real or traditional insurance assets, bonds, and mortgages behind what we think the economic reserves are. Then the contingent liability, which is this redundancy, is matched with a long-term contingent asset, which is a letter of credit. I think Lincoln's captive structure is going to survive any changes in the industry from the regulatory standpoint. I think the large number of captives in the industry are economically substantive.
I think it's a useful and effective tool to lower the costs of carrying redundant reserves. There's going to be some changes, but I'm hopeful it won't be a big impact. Of course, as Principle-Based Reserving is it will take three or four years just to get through the state legislative process. That should reduce the need for captives. I think the other issue that, and it's not so much for Lincoln, but the other regulatory issue is not directly an issue for Lincoln, but is what changes to the holding company requirements are going to come from SIFI designations or international regulations that seep into the United States. There again, it could be a bit of a challenge, broadly speaking, but I don't sense it's going to be a serious problem.
Are you preparing for those unknowns on the regulatory side to work their way down to a company of your size, or would you expect those to be contained within those SIFIs or G-SIIs?
I think in the immediate future, as far as I can see, there's no reason to think that the standards that might be applied to Prudential because of its SIFI designation will leak into the marketplace and affect the rest of us. One data point on that is one of the gatekeepers, of course, on that question are the rating agencies. I've sat down and I've talked with every one of the rating agencies, I asked them this question: Does any additional capital requirements for Pru because of SIFI going to change the way you analyze Lincoln? The answer has been universally no. At this moment in time, I don't see the indirect issue that you hear people talk about.
Certainly, if Pru holds a little more capital, I hate to use Pru, but I think John Strangfeld and his team is a great team, and that is one of the great franchises in America. I'm not picking on them in any way other than they happen to be subject to this. I just don't see the indirect leakage into the rest of the industry in the foreseeable future.
Can I ask a very broad question, please? That is, how should I think about what proportion of your total profit is free cash flow or dividendable profit? What can you do to increase the upstreaming from the operating units to produce more dividendable cash?
I'm just going to repeat the question just for the webcast. The question is the operating earnings, what portion of those is free cash flow dividendable to the holding company, what can you do to increase the level of that ratio?
Our products are capital intensive, as a realistic issue, as we sell more business, some of the strain on capital comes from having to hold more capital for new business. Now, having said that, let me move to the holding company. I think over the last 36 months, we've returned more cash to our shareholders through share buybacks and dividends than any of our competitors. Even though we have more capital intensive businesses, we're throwing off enough cash and we have strong enough RBC to be very aggressive on the capital management side.
Our guidance, as I look forward the next couple of years, is the amount of money that we move up from the subsidiaries to the holding company. Then you subtract debt interest expense and other holding company expenses, the cash available for dividends and for share buybacks, somewhere in the neighborhood of $600 million annually. As our earnings grow, that $600 million will grow over time. Our guidance right now, I think our dividend dollars out of that $600 million are in the $150 million range or so. We'll hopefully continue to grow our dividend at some pace in the coming years. Net, we still plan on using $400 million a year or more for share buybacks.
Yeah, the return on that might not be quite as great as it was when we were buying stock at $0.50 when we were at 60% of book. I think this is still a good buy, and I can talk about that. If anybody wants to talk about that. The guidance is still the same, $400 million. Over time, that number, which is $600 in total with dividends, will get bigger.
What can you do that is going to increase this upstream?
Well, that fundamentally can happen two ways. One is the redesign of our products that call for less capital. In my opening remarks, I said that we were shifting a little bit away from longer term guaranteed business. The products that'll replace that in our sales mix have a little bit less capital call associated with them. That's one thing that will happen. Most importantly, though, in 2008 and 2009, the industry and Lincoln was selling life insurance in the 10% ROE range, and today we're selling it in the 12%-15% ROE range. It's the additional profits associated with new business that will help drive earnings and will help drive more cash flow from the subsidiaries up to the holding company. Okay.
Thanks. Amanda Lynam, Goldman Sachs. You had alluded to the rating agencies in your opening remarks and their favorable view of your risk management.
Yes.
How are you thinking about other rating agency metrics such as leverage, interest coverage? Some of your peers have suggested to us that they're focused on lowering interest expense, for example. Is any sort of liability management on your radar, or do you feel pretty comfortable with your current metrics and ratings as they stand now?
Yeah, I feel pretty comfortable. What was the comment by our competitors?
I was wondering if that was something that you were interested in doing.
Yes, we've been pretty clear that we want to reduce leverage over time, and part of the drive of that is just what you said. I think particularly from Moody's perspective of the interest coverage ratio. We're fine with it. Just even from my perspective, I'd like to see that go up a little bit. Again, it's not anything that's a big problem. There's nothing urgent about it. Over time, I think to get that number up would be a little bit helpful. The rating agencies are important. They have their capital models. They're different from RBC, so you have to pay attention to them. You also have to just sit back and ask yourself, what's the right amount of capital in the company to get good returns and provide a good, strong, healthy company from a balance sheet perspective.
What drives us more today is our stress testing. We look at RBC, and we look at the rating agencies. At Lincoln, it starts with stress testing to see under broad and difficult circumstances where the problems might arise. That's how we manage capital. Again, it's easy to communicate in the context of using RBC, we talk about it that way because, again, it's an easy communication tool. Stress testing under adverse economic conditions is how we manage our capital and the amount of capital that we want to hold.
Well, I know it's a little early in this, with the health exchanges and obviously some of the changing of behaviors that might happen with people that are forced to buy off the exchanges, I'm wondering if you have any insights or comments looking at your small group businesses and how that might change the buying and the perceptions of people who have to go off and the different types of transactions they have to do.
Yeah. We think there might be, at the margin, some impact. When I say at the margin, we distribute through brokers, and how the brokers react to the exchanges and how they change their business model could affect us and the way we sell our products today. At the margin, I don't think fundamentally. We don't sell health insurance per se, so that big block is not something that affects Lincoln. We're making a shift from True Group, which is employer-paid benefits, to voluntary benefits, which are employee-paid benefits. Those voluntary benefits, accident insurance, life insurance, long and short-term disability insurance, those are not part of the exchange and the healthcare issue. We have to be careful. We have to watch. I think it's predominantly, to repeat myself, a distribution issue.
Right now, in the direction that we're taking the business, we don't see any significant disruption. More to come as the Affordable Care Act evolves over time. Right now, we're pretty comfortable with our business model and its interaction with healthcare. I guess dental is an area. We don't make a lot of money in dental, but that would be an exchange product. We'll watch that as well.
It's one thing, I guess, that's been interesting in the industry, and I think the same holds true for you at Lincoln, is the changing of the product features and pricing that you've talked about that's been kind of across the board. You've seen a lot more of that make its way to the bottom line on your individual products and the individual products across the industry, where the institutional side, the retirement, even the group, the profitability, despite the recovery and kind of incident rates from disability, still seems to be lagging. Is there something that's taking place across the industry that's enabling you guys to get more of those, maybe revenue drivers to the bottom line on the individual side, where it's just not as sticky on the institutional side of things?
Yeah, Chris, let me try to parse out the terminology here. Let me start by saying Lincoln only manufactures and distributes retail products that are used by individual Americans. We think that strategy, which requires good product development connected to our distribution and then even connected to financial advisors and how they sell the product, we think that holistic view is a very hard total business strategy to duplicate. Just the whole idea of retail product development and distribution, I think sets us aside from some of our competitors. Let me, on that point, make a contrast. If you're in the wholesale liability business, say, for example, GICS, all that really happens is you get someone on the phone who calls a smart CFO or a smart consultant, and you set a price, and then the only other dimension is duration risk and asset risk.
If I'm coming across, that business model, anybody can do that. Anybody can make a call, get some cheap capital, and then try to outperform the rest of us by taking more credit risk or duration risk. Lincoln doesn't do that. We're never going to do that. We're most comfortable in the space of retail distribution. Again, it's holistic and complete. It has to be all done in a connected way. That's one dimension, I think, of what you're talking about. Another dimension might be who is the person that you're negotiating with across the table? In 95% of the cases, it's just individual Americans or these 70,000 people that sell our product. There's one or two situations where we actually are working with consultants. It's a small amount of our business, but that is in the RPS mid to large market.
In fact, our returns in that business are a little bit lower than they are in the rest of our businesses, and that gets back to that issue of you're just dealing with a very sophisticated player representing big companies, and we try to stay away from that. With the exception of mid to large market, we're pretty much getting our returns. Let me come back to group for a minute. Our group profits aren't following our growth in net premiums as quickly as I'd like to see it. In part, that's related to the significant investment that we're making to move from employer-paid benefits to employee-paid benefits. There's hundreds of millions of dollars of investment that's running through the income statement and lowering our net margin.
Candidly, the other thing that we haven't done as well as I'd like to see us have done it is get better price increases. Now we've gotten good price increases, and we're getting better price increases. I think we could've done that a little bit faster than we did. I expect this to be a good business. I expect margins to improve. I expect the growth rate to be very strong. We've got some more investment to make. We've got to reprice the portfolio again, which takes a little bit of time. It's a great business over the long term for us.
Can I just ask a slightly broader question following up on that then? Across your product suite, what are the more profitable products and what are the ones that are still fairly competitive?
Just again, the question is products that are most profitable and then those that are maybe a bit more competitive.
Yeah. We're talking about new sales as opposed to in-force business. Let me just go across the board real quickly. The best returns are on our variable annuity business, where we're getting, at this moment in time, well north of 20%, mid-20s. Moving to individual life, we've gone from 10% and 11%, or even maybe south of 10% in 2009 and 2010, and now on new business, we're in the sort of 11%-14%, maybe even 12%-15% range. As I mentioned before, that represented significant price increases for the customers. We did it two years ago. Our sales went from 700 to 500, and this year our sales will be back up to 700. That's that point I keep coming back to. We've repriced the products, and we're selling more now than we did, or about the same level as we did before.
The life insurance business is good. As I mentioned a couple of times, we've got one more product, the big product, the MoneyGuard business, which is being repriced for the first quarter of 2014, That'll be up in that same 12% range.
Which product is that?
12% range.
Which product?
MoneyGuard.
Okay.
If you go into the group business, we should be in that 11%-13% on new business going forward. It may take us a little while to get there, but we're seeing good price increases there. In the retirement business, I'll come back to this point, there's two channels. One is the small market channel, which is where we have wholesalers, and the business is sold by financial advisors to their customers, who may be small business owners. That would be an example. That's still a 12%-13% ROE business. In the mid to large size cases in retirement, we're still around 10% to sort of in the 10% range. The reason for that, I think, is because instead of it just being an insurance company marketplace, it's both insurance, the 401, 403 type business. It's both an asset management.
Asset management companies sell the product and the insurance companies sell the product, so there's just more players. I think that'll resolve itself over time.
You mentioned the returns on the VA space and how attractive those are today, a lot of that has to do with the pricing actions, feature changes that you guys have done.
Yeah.
If we fast-forward and rates increase 200 basis points, the attractiveness of that product to the consumer starts to deteriorate. Maybe some competing products start to come on the shelves of distribution. How do you guys react to that change in the rate environment from that product standpoint? Do you think the industry kind of needs to then re-risk the product again, or is it just a shift to fixed annuities? Is that the answer?
Yeah. This is a great question, and I think it's really an interesting dynamic in the variable annuity marketplace. Let me be precise about one thing. I think the players that took too much risk left the marketplace, and by and large, the players that remain are thoughtful and understand risk. I don't see anyone going to a feature war again. I just don't. Well, I say again. I don't see it in the immediate future. I think it's going to remain a very good business from an economic return to our shareholders. That's number one. Number two, you're right, Chris, that if you think about it in the way you described it. Let's say that the long-term treasury is what people wanted to use for that portion of their portfolio, where they were looking for guaranteed returns.
Let's say that got up to 5%. Well, that would match the income guarantee benefit of the VA space, right? Because we roll up at around 5%, then we start taking income on the rolled-up amount. We pay out 5%. That would be similar to the bond. There's a couple of differences, though. One is that in the VA business, unlike the bond, you have the potential upside of the equity markets. Let's just use this year. If you had a bond, even if it was paying 5%, and that was theoretically the roll-up, well, the roll-up that occurred on the variable annuity product was 20%, right?
You got the equity. It's never going to just be when you compare it to a bond, the bond can't get equity upside.
Yeah.
That's a big differentiation. Put on top of that, the bond doesn't give you death benefits either that are growing, at least with the high water mark in our case. We don't have a roll-up on that. I think it's more of an equity potential return on the living benefit than a bond return, and it's never going to be 100% of anybody's portfolio, but I think it'll remain a significant part of a lot of people's portfolio. That's the answer on the dynamics from a consumer's perspective. I still think there's going to be a lot of demand for it. The other cool thing that's going on in the market is it's back to basics, and I talk about us moving a little bit away from guaranteed living benefits.
By the way, I say guaranteed living benefits, but Lincoln's consistently been in the marketplace, and the value proposition has always been account value growth. As we've reduced the flexibility for the customer to invest in equities versus bonds, and even within the equities, we've inserted overlays. The expectation for growth of account balance is not as good as it would be if you didn't have any of those limitations, but you need those limitations to be able to provide good income guarantee. The new trend, and one I'm really excited about, and I say back to basics, is tax rates are going up, and the old concept of an annuity being simply a mutual fund in a tax deferred wrapper is becoming a bigger selling opportunity. We're redesigning products to have much more asset opportunity flexibility within them.
I think that's going to be a big part of the industry going forward. Returns on that will still be good. The VA market, just like every other market, has to adjust for the circumstances of demand and the buying preferences of consumers.
Okay. We're running a little short on time. Maybe just close with where we opened. The stock's up a lot.
Yep.
Help us frame thinking about upside from here.
Yeah.
You mentioned how you're thinking about your buyback.
Yeah.
Just help paint the picture for our investors.
Yeah. I think there's, again, if I'm right, the equity markets are going to continue to gradually rise. If I'm right, the interest rates are going to continue to gradually rise. Well, I am right about the demographics. I am right about the substance of our franchise and the strength of our franchise. Just from those dynamics alone, I would expect good growth in earnings and assuming multiples for this moment stay the same, an increase in share price. People ask me about, well, if interest rates rise, equity markets are going to go down, isn't that a problem? Now let me give you the math on that. If interest rates from this point were to rise, the 10-year was to rise 50 basis points over the next three years, we would generate an increase in our annual earnings of, let's say, $48 million.
50 basis point increase in the treasury rate, we'll get an extra $48 million. If that 50 basis point increase in interest rates was to cause a 1% decline in the growth rate of the equity markets, we would lose about $8 million a year. Over 3 years, $24 million. The trade-off of 50 basis points up on treasury rates against a 1% decline in the growth rate of the stock market, we're net ahead. That's a good thing. That's the answer to what happens if equity markets slowly because of rising interest rates. The other thing I would say, and I think smart people can debate this a little bit, but Lincoln used to have a multiple of 14 or 15 on its earnings, and today it has 9. Why would I think that 14 or 15 was rational?
I come back to the fact that 34% of our earnings come from equity assessments in businesses that we get 20% returns on. That's just the same kind of returns that an asset management company gets. If asset management companies get an 18 or 15 or 18 multiple on the same returns and the same dynamics of the business, which is equity markets going up that we do, we should get that. If you take the margins that we get on more traditional insurance and the, excuse me, the multiples we get on more of our traditional margins from insurance, then you do a sum of the parts by getting much more multiple on the equity assessment earnings. There's 2, 3, 4 points of multiple expansion, theoretically, that could happen.
I think good growth overall from a macroeconomic perspective, a very strong franchise, and multiple expansion seems warranted to me.
Okay.
Multiple expansion is your deal, though. I don't worry about that so much. I just try to run a good business.
All right. Well, thank you very much, Dennis.
Okay, thanks.