All right. Good afternoon, everyone. I'm Jay Gelb. It's a real pleasure here to have Dennis Glass, who's the Chief Executive Officer of Lincoln Financial Group. Lincoln has a particularly strong presence in four key areas: life insurance, annuities, retirement savings, and group insurance. We're going to continue the fireside chat format we've been using today. Dennis, why don't we start off with, what's the top of your mind?
Jay, first, thank you for having us here. We greatly appreciate it, and I appreciate the attendance and people who are listening in. I'm pretty optimistic about the opportunities for the insurance industry over the next decade. I'll sort of narrow it down to Lincoln, specifically. We serve employer markets and particular segments of the employer markets in our retirement businesses and in our group ancillary businesses. That segment of the market, this is important, is the smaller employee base companies, so 1,000 and under. McKinsey work shows that that segment, the smaller employer, growth opportunities are double what they are in the overall market for employer products in the retirement system and in the group protection business. Where you participate, what segment of the market you participate in is a very important piece.
If I go over to our individual markets, there we have the power of very significant demographic movements. We sell income guarantee products. There's a lot more people because of the baby boom that are retiring. That group is particularly wealthy. The dynamics in that marketplace are pretty strong as well. When I look at, specifically from Lincoln's perspective, but when I look at the markets that we serve, the buying preferences inside of those markets, I'm pretty optimistic. When I drill down to Lincoln in particular, I just want to draw everybody's attention to the fact that over the last five years, we've completely recovered in terms of earnings power, earnings per share power, absolute operating earnings, and ROE. As I compare that to the banking industry, the banking industry over that same period is up 2%.
The life insurance industry is down 9%. We've outperformed our peers over that period. More importantly, it's not the outperformance, it's just the strength of the company has returned to pre-2007 levels or the earnings of the company and ROEs and so forth. Same point on the balance sheet. Today, the balance sheet is stronger than it's ever been. One key metric there is we carry about two years of debt service at the holding company, whereas in pre-2007, Lincoln and a lot of other companies ran a negative cash balance because capital markets were always open, and of course, that changed during 2009. We had $700 million at the holding company level. Our RBC ratio is near 500%, 490, in that area.
It's very solid, very strong, gives us the opportunity to have flexibility, whether it be share buybacks or whatever we might want to do, invest in the businesses. Another example. When I look into 2013, we have this great market opportunity. The company is as sound as it's ever been. When I look at the emphasis for 2013, we're in four businesses you mentioned, and we're continuing to invest in all those businesses. I think they're good businesses. We're going to over-invest in the Group Protection and retirement businesses. We think there's better opportunity there for ROE and growth, again, on the segments that we participate in. Put pressure on all the business units to increase pricing across the board, continue our emphasis on strong risk management and effective risk management, continue pretty active capital management with more share buybacks.
We've had nine quarters of meeting or beating street estimates. I've been saying for the last six months, I don't ordinarily talk about price-to-book regression analysis, but because our price was about $9 below where it should be on that line, I've argued that it'll move up more quickly. We've outperformed the industry for the last 15 or 18 months, or at least all but one or two companies. I think there's still $4 or $5 of just sort of getting back to where the industry is in terms of valuation, and then hopefully the whole industry will rise. I'm optimistic. Strong company, strong markets that we serve, and a low valuation.
Let's start with a broad question about the life industry, Dennis. As you think about the operating environment for the life insurers, what do you see as the major opportunities and challenges this year, and then the next few years beyond?
Pretty much what I've been talking about. I mean, the demographics are pretty strong. The products that we provide Americans are products that are always in demand. Each company has to compete in getting those products effectively and priced right to American consumers. I think as compared to the last decade where maybe the banks had an advantage and the mutual fund companies had an advantage, post-crisis guarantees, focus on safety. The insurance industry is in the best position to meet those concerns and the needs of the American consumer. I think that's all very positive. Not only is Lincoln well-capitalized, but the industry is well-capitalized by and large. Those are positives. Obviously, if you're in capital intensive businesses, life insurance or annuities, low interest rates mean that you're getting a lower return on the capital that you have to put behind your products.
That's a bit of a headwind. The industry is not simply a victim to that. You can lower your crediting rates, you can cut your cost, you can improve product pricing. You don't just wait around to be affected by it. You try to take positive actions to deal with the environment. At Lincoln, we've done that pretty effectively. Although it gets harder every year, some of the tools get used and aren't available anymore, such as reducing crediting rates. There's other things that we can do to blunt the impact of low interest rates.
Turning to the variable annuities business, this is a business that's garnered a lot of attention due to industry product changes as well as for some companies in the industry, sizable charges to earnings, and even some recent merger and acquisition activity. Lincoln has maintained a steady presence, although sales in the fourth quarter were higher in variable annuities on a relative basis. How do you view the current state of the VA business specific to Lincoln, and how do you think about it going forward?
Yeah. I think a well-managed variable annuity business is a very good business. It has risks associated with it, but it's priced at middle teens. We've been showing 18%, 19% ROEs, and we need 18% or 19% ROEs because there's certain risks in the business. When I step back and I look at the last five or six years, definitely what's happened is the pricing has hardened up. The products that are in the market today are still good consumer products. The dynamics of return on equity taking less risk, having less risk features, is a clear pattern over the last couple of years. The competitive marketplace, at least from a pricing standpoint, the features is as good as it's ever been. There's a couple of people, as you've said, who've left the business.
I think most of the time you'll find that they stumbled pretty badly at one point and probably underpriced the product and have ended up with a big book of business and sort of hard to get out from under that business. When you look at the players that remain in the market, smart cautious people, the MetLife, the Prudentials, Lincoln and others. We've got good competition. The fact that the seats have changed a little bit is from my perspective, actually a positive because the players that remain, I think make better decisions, have made better decisions over the years that they've been in the business. It's a better environment for the product.
From a long-term perspective, do you see VAs maintaining that level of importance within the advice channel?
Oh, absolutely. Yeah. Then 2008, 2009 came along, There's very definitely a shift in consumer attitudes towards, for some portion of their portfolio wanting more certainty. Income guarantee benefits provides that for the consumer. So that would just be one example of changing consumer attitudes and how it fits well with the annuity business in particular. I think more generally, this whole concept of peace of mind and financial security is provided by the life insurance industry. That's sort of the mindset of more people today than pre-crisis.
From Lincoln's individual perspective, have you been able to keep the returns on equity at such an attractive level? Can that be sustained going forward?
On the VA business?
Right.
I guess 18% is what we've averaged over the last five years, 17% or 18%. Of course, that's because we price the product to get those kind of returns. With Lincoln, you have to start with our value proposition, which is that we sell account value growth first and guarantees second. We've never competed on the basis of the most rich guarantee, the highest roll-up rate, the highest payout rate when you get to the distribution period. An example of that would be we're very careful about the funds inside of our mix of mutual fund advisers. We have more four and five Morningstar rated investment managers than any of our competitors. Just one example of account value growth first. We're constantly in the market. We're consistently in the market.
The average American consumer makes 2% less than the S&P 500 over time because they buy high and they sell low. I think a lot of our competitors found themselves in the same position. The markets began to get wobbly, and they withdrew from the marketplace. 2008 and 2009 again, being examples of that. Whereas we've been in the market when the market's been low, we've been in the market when the market's been high. That consistency of the marketplace is good for your returns. As I've said already, we don't put a product or a feature into the marketplace that's not hedged. That protects us quite a bit. Consistency in the marketplace of products that aren't as rich as some of the products are in the industry, comprehensive hedge program, all contribute to. Again, I got to come back to distribution.
We've been fifth for the last five years in terms of market share. Whereas the top four are all different names, and the next five are all different names. In part, it's because we have such good shelf space. Every major commercial bank, every major wirehouse, every major regional wire, every independent distribution company, we have shelf space at and we have an army of some 600 wholesalers that deliver our product message and value proposition. They can sell product even when you don't have the cheapest product.
Okay. Why don't we switch gears to the retirement plans business?
Yep.
You've made a lot of progress in retirement plans since taking a more focused direction a few years ago. Where do you see this business over the intermediate term, and how would you measure success in this unit going forward?
You're absolutely right. We did take a more focused approach. The first thing that we had to do was get a new administrative system, which may sound like a detail at a meeting like this. Fundamentally, whereas the variable annuity product or a life insurance product or even a group insurance product, the value proposition can be defined more in the context of the product. In the retirement business, the value proposition is defined more in the context of the customer experience, the plan participant experience. Can they get on the internet at 1:00 A.M. and get their balances? Can they get fast movements of their money from one account to another account? The system that you have in place and the interfaces that you have in place are important. We started that program about 24 months ago.
All of our new plans are going onto the new platform and all of our in-force plans. I think the majority of the large cases moved on to that, and now the small case is moving on to that. That's very positive. We have also invested in expanding distribution, and particularly, like the small market cases I said earlier in my comments, best growth opportunity. Pricing in there is a little bit easier to get to because the person that's being sold the product, the CEO or the CFO of a smaller company, they're more concerned about the full value proposition and their customers having a good experience with their savings vehicle than they are getting the last $0.25 per participant cost of record keeping.
Then you have to have a very large and comprehensive footprint in terms of shelf space and wholesalers in order to sell the products in the small case market. Again, we have that, so the expansion of distribution. We're getting good returns there. We also are in the mid to large case market, which is a little more price competitive. A few more players in that space. Distribution is through consultants, and so sharper pencils on the other side of the table. If we pick our businesses and pick the size of plans that we want to be in, which again, is slightly smaller, we'll do okay. There's more pricing pressure there. The nature of the business is such that you have short duration assets, so we've seen a little spread compression.
I think long term with the investment that we're making, we continue to see positive net flows. A couple of headwinds on earnings, particular interest rate compression, but a good business for us long term.
To what extent would the benefit of record level equity markets offset that interest rate impact within the retirement business?
I'll probably be wrong about this, but I think our source of earnings on the retirement business is the interest margin, and the equity fees are probably pretty close. Yes, if equity markets are going up, that's helpful to offset a little bit of the interest rate compression. In-force business by itself won't do that, so we have to have large dollar amounts of new business.
Okay. What are the trends looking like?
Good
in that area?
We've had, I forget exactly last year, but I think 20% or 30% increase in deposits overall. Positive net flows around $1 billion. That's a business where a year ago we were having net outflows in a couple of quarters. It's very positive. Back to the strength of Lincoln. I think it's another important note to say that from a net flow perspective, we've never had a year where we haven't had positive net flows right through the middle of the crisis.
Yeah.
Which is another example of the power of distribution and the power of having a good solution set that you can pivot to, either because if the company wants to pivot to it Because consumers have changed their buying behavior and want to pivot to a different solution. I don't think there's many companies that can talk about positive net flows from all their businesses collectively through the crisis.
Fair point. Keeping with the theme of making progress, you've also been investing in the group protection operation.
Yep.
The results there have been hurt by elevated loss ratios.
Right.
Correct?
Right.
What's happening in the group business, and what should we expect as we look out over the next few years?
Probably at Lincoln, there's more change going on in the group business than in any of our businesses individually, except maybe the retirement business. We're investing heavily. I think we've talked about numbers in the neighborhood of $150 million over the next three years, and we're shifting the target market from what's called True Group, which is employer-paid ancillary benefits, long and short-term disability, dental, and life insurance, are our four biggest products, to voluntary. Which means the employee pays for those products and other products, critical illness products, accident and health products. We're making a very significant change in the mix of business. I expect, maybe not next year, but sort of at the end of 2014 and into 2015, that investment will create a fairly significant rise in earnings if we execute well.
In the meantime, we have to be a little cautious about loss ratios. Last year, we saw our mortality loss ratios climb a little bit. We think that was just normal fluctuations that will happen from time to time. We've also seen something that I haven't seen as much in the decade that I've been, decade or more, that I've been watching this business, and that's an increase in severity, which means larger dollar amount of claims per claim, and it's coming from higher wage bands. You always see in an economic downturn, you see lower wage earners go on a disability, short-term disability, more so than when their job prospects are better. I'm not suggesting that they're doing something that's not right. It's just that happens to be the fact.
I've not seen in a decade or more where you have an unusual spike in higher wage bands, $56,000 and higher. I don't know if that's a change coming out of the crises and the prolonged economic and unemployment downturn, or if that's just a fluctuation that'll correct itself. We're watching loss ratios on LTD, STD more closely. It may take some pricing changes too if in fact there's a systemic issue there as opposed to just a normal fluctuation.
As the economy hits a steady pace of recovery, would you expect that to be a benefit to loss ratios going forward?
Well, it's certainly a benefit to the top line. We've seen this already in 2012. We had 9% premium growth last year. Half of that premium growth came from our in-force business. Of the half percent, 5% increase in premium, 4.5% increase in net premiums, a part of that came from more employees at our customers' employment or more employees employed by our customers. It came from wage increases, then it came from product pricing, excuse me, renewal pricing. At least half comes for those reasons. As the economy continues to improve, people get paid more, we have a slight recovery on the back of an improving economy.
Right. Okay. All right. Let's talk about probably the major macro issue, which is the sustained low interest rate environment. If rates were to remain at low levels for the foreseeable future, what's the impact on Lincoln and the industry more broadly?
Yeah. Of course, the biggest issue is a drag on earnings growth. The reason that happens is because interest rates have been falling for the last 20 years. Universal life players in particular, which was the dominant product during those two decades, had minimum guarantees, crediting rate guarantees. As interest rates kept coming down, you kept lowering the guarantees, and now the industry is probably at the floor there. You'll see some spread compression as portfolios turn over, and you can't lower your crediting rates. That's an issue. Another issue is, this is just sort of a round figure, but when you're looking at the profitability of an insurance product, maybe 20% of the profits come from a return on your capital.
When your capital is earning 6% or 7%, that's a bigger number than when it's earning 3% or 4%. Those are the two issues. The insurance industry, and certainly Lincoln, is not a victim to this. I mean, you have to take action. Just as an example, when rates dropped down to 2%, there were two concerns that people had about Lincoln. One, what was the earnings impact? I'll talk about that in a second. Second, what was the balance sheet impact? The simple thought process, I don't mean it was simple people, but the simple thought process was, well, you receive a claim. Excuse me. You receive a premium, and you pay a claim 20 years down the road.
If instead of getting 6% return on that premium, you're only getting a 3% return on that premium, doesn't that mean that you have to put more reserves up to be able to meet your obligations? It's a very simple thought. What was missed in that analysis is that every time you put a liability on the books, you invest assets for the term of that liability. Looking at Lincoln, as an example, our unrealized loss, excuse me, our unrealized gain on our investment portfolio is $9 billion. That's the $9 billion that even though interest rates are low, that's going to pay those claims off over time. We are properly asset liability matched.
There is no, what we've been saying, there is no cliff event on the balance sheet, either statutory or GAAP of Lincoln in the near term, and we've put some numbers out, about $500 million sometime in the second half of the next decade from a statutory requirement. That $500 million compares to $700 or $800 million a year that we make in statutory earnings. It's a manageable number. There's no balance sheet impact, and we've been saying that, and I think the market is beginning to believe it. There is the issue of earnings drag, and yes, I think we have numbers in the market right now that it's about $35 million a year in earnings drag.
35 this year, 100
100 next year. That's certainly a drag on earnings. We're not sitting still. We still have levers improving the pricing on our products. I said at my outset, we're going to do that across the board. We still can take more cost out of the company. We are expecting to grow earnings. By the way, just about all the spread compression is easily offset just by our share repurchase program at the $400 million level that we've been talking about. It's an issue on slowing the growth of earnings. I expect that our earnings will grow over the next several years, subject to a lot of inputs, a reasonable stock market, rates not dropping much lower than they are now, things like that. A lot of our competitors are talking about flat earnings, and I'm expecting growth.
Okay. Staying on the issue of life insurance, it's an important product line for Lincoln, but it appears you're willing to shift your focus as conditions warrant. Are we seeing a permanent shift in Lincoln's business with the decline in sales of universal life with secondary guarantees?
No. Although we did see a decline last year. That was an easy decision to make because, particularly with respect to Single Premium Guaranteed Universal Life and short pay guaranteed universal life. By that short pay, I mean there's premium patterns, right? You sell a policy for $1 million, you can take one premium, and the customer doesn't have to make any more payments, or you can have periodic payments, and they'll make payments over 30 years. Well, the short pay stuff, no one was repricing, and you couldn't achieve an internal rate of return of more than 5% or 6% on that. We're pretty disciplined about putting capital out at or above our average cost of capital. We priced ourselves out of the short pay guaranteed universal life market intentionally because there was no returns.
We shifted our emphasis to products that still met consumer needs but had a higher return profile. Really easily, we all could follow this math. Every $1 of life insurance sales uses a $1 worth of capital. If I reduce sales, if our sales, because of pricing changes, were reduced by 20%, it's about $200 million. Why would you spend $200 million selling new product that's only earning 5% or 6% when you can take that $200 million and buy your stock back and get a 15% or 16% return on that? That's what happened last year. Actually, by the end of the year, our Guaranteed Universal Life sales were a very small proportion of our total sales, but total sales had gotten back to the same level in the fourth quarter that they were in 2011.
Again, coming back to having powerful distribution that can tell the story, alternative solutions in your product set that sort of meet the same needs as what you had been selling, but on a basis that's profitable to the company.
Okay. Once rates revert back to some more normal level, let's say above 10% on the 2-year, which we've been dealing with for so long, what would you anticipate the outlook for life products would be?
Well, I think life products, the products we're selling right now, which are higher face term, Indexed Universal Life, Variable Universal Life, and we put our MoneyGuard product in that same category of life insurance sales are getting acceptable returns. We've repriced all those products several times, and they're getting good returns. On a new business basis as interest rates rise, if history is repeated, you're not going to get an enormous increase in the return on your capital because people will reprice. We'll be back in the 12%-13% range on life insurance products. That would be a good thing.
Let's turn now to capital management.
Yep.
Lincoln's been an active repurchaser of its own shares.
Yep.
I believe over the past nine quarters, it's repurchased roughly $1 billion.
Yep.
Over the next year or so, do you think any differently about the allocation of deployable capital, whether that's share buybacks, dividend increases, de-levering, or perhaps even acquisitions?
Mm-hmm. Well, first of all, I think everybody in the room can figure out if you're selling a 50% or 60% book, which we were at different times in the past 12 months, buying your shares back is an incredibly good idea. We were very aggressive and bought, as a percentage of our market capitalization, more shares back than any of our competition did. We were in a position to do that because of the strength of the balance sheet. I was happy to do that. We have about $400 million of free cash flow at the holding company each year. $800 million coming out of the subsidiaries in one form or the other, $400 million of debt service and dividends at the holding company, netting out to $400 million.
With the stock trading where it's at, my expectation is that we continue to use most of that $400 million for share repurchases. We have a strong RBC. We could probably do a little bit more of that, but we'll start the year thinking about free cash flow as the limit on share buybacks. I spoke earlier about the overall strength of the firm, some of the capital that we have is not fungible with excess capital, is not fungible with share repurchases. The rating agencies have limits. Even though our RBC is very high, I couldn't take $1 billion and buy our shares back. There's money that is available for M&A that wouldn't be available for share repurchases. Because the company is so strong, we have an excellent track record. My management team has done, I think, $15 or $17 billion worth of acquisitions.
They all have been accretive. We've gotten all the cost saves out of them that we ever intended. Given the strength of the balance sheet, the quality of the underlying businesses, and a management team that knows how to price and integrate deals, all of those things would make me more ambitious around M&A than I've been for a little while here, especially during the crisis, obviously during the crisis. Let me caveat that again by saying that if we're talking about dollars for M&A that might otherwise be used for share repurchases, that's always the litmus test for the minimum hurdle rate that I would expect out of an acquisition. It being what I expect to get out of a share repurchase. That would blunt the otherwise enthusiastic level that I have for M&A.
Fully understanding that, what areas might you look to expand in from an acquisition standpoint?
We've said the group protection business and the retirement business. We'd like to see those grow as a percentage of our overall capital allocation and earnings. Now, having said that doesn't mean I'm going to slow the growth in the life insurance business or slow the growth in the annuity business. I want to keep those on the same patterns they've been on, but we're over-investing capital into the group protection business, into the retirement business to accelerate the rate of earnings growth there. From an M&A or non-organic basis, those would be the first priorities. Let me hasten to say, we build our financial plan and our growth in earnings around organic growth. If we can accelerate our strategic objectives on an organic growth basis through an acquisition, we'll do that, but we don't look to acquisitions as a source of earnings growth.
Makes sense.
By and of itself.
Let's open it up to the audience. Any questions?
Could you comment on the difference between operating income and GAAP income and where you think that you might see differences in the future? You've been closer than your competition in the past couple quarters, but there had been quarters earlier in the crisis where you had a significant GAAP. The cumulative GAAP is still large, and I'm just trying to reconcile your comments on earnings power recovering, where we'd like to see GAAP income so that book value grows.
Yeah. I think our book value growth has, again, been at the top of the industry. Pretty close, certainly upper quartile, which means that over the last 24 months, our net income has tracked pretty well with operating income. The things that can separate the two would be asset losses, a write-down of your goodwill, and/or a write-down. There's been a lot of write-downs of intangibles in the VA blocks these last couple of quarters because of policyholder behavior drifting from pricing. We haven't had any of that in the last two years. I mean, the asset losses or your hedge program not working the way it should, those types of things. I don't see any big diversions between operating income and net income.
If you were to have hedge losses, because we understand we've had other presentations today that have told us when the GAAP income differs from new reserve release on a hedge loss, how would you think about that recovery process going forward, and how the two would close the gap?
Well, there's two buckets. Let's talk about them separately. There's the policyholder behavior bucket, where if you have a negative drift between your pricing assumption and actual experience, and that's what a couple of our competitors had in the third quarter, I guess. You can have some pretty big numbers. We haven't had any of that in the last 24 months. Net, we haven't had any of that because some of our experience has been more positive in pricing. Some of our experience has been as positive as pricing. Net, it's not been a big number. When you start talking about the second bucket, which is what's called hedge breakage, which does the hedge target that you have change proportionately with your hedge asset that goes to the quality of your hedge program. We've done a pretty good job on that as well.
How does that drift apart? Most of the time, it drifts apart because most of us use the S&P 500. We buy the S&P 500 as a hedge against equity movements in the underlying policyholder accounts. The underlying policyholder accounts have a different mix of investments than what's in the S&P 500. Sometimes the S&P 500 does better than the subaccounts. Sometimes it does worse. Over time, it seems to be pretty close together. I just looked at some numbers on that. I don't have them on the tip of my tongue, but the hedge breakage has not been cumulatively severe. In each of the last 5 years, while we were producing 18% ROE, our hedged target has always been lower than the assets that we have to meet those claim payments, which is what a hedge target is.
You mentioned on the policyholder behavior, one of the things we've seen most occur is a difference in the lapse assumption when the client is in the money from what the company had originally expected. Are there any trends you're seeing in either of the 2 major parts of policyholder behavior under utilization or lapse?
For the industry, lapse assumptions have been higher than lapsation. Over the last 3 years, we've had some of that at Lincoln as well. It's not an easy calculation. Let me give an example of what I mean by that. For older age policyholders that are deeply in the money, the surrender rate assumption might be as low as 1%, versus a younger age policyholder who's not in the money on their account, and that might be 5% or 6%. I mean, there's a whole series of different assumptions as to what the lapse rates should be. Having said that, we've drifted modestly apart. I think we've got it all corrected now based on the assumptions and experience.
On utilization, which means how much of the income guarantee do people use and when do they start using it, our experience has been the opposite, which is people aren't using it as much as we expected, and they're taking it later than we expected it. When you add those 2 policy behavior actions together, we haven't had significant net increases in the liability because of policyholder behavior. Although, again, we have had, like everybody else in the industry, a little bit of hurt related to surrenders being higher, even with our dynamic models, higher than what we've seen. It's very interesting. I'll just tell you a little story. We run about 100 million scenarios a night to reposition the hedge portfolio the next day for what's gone on in the capital markets or what's gone on with the hedge, with the underlying assets.
It used to take us seven hours because we'd do it through a series of PCs. Then we switched the operating system to the operating system that all our kids use to run their video games. It went from seven hours to seven minutes. That's been an improvement in our ability to manage the hedge position. That gets to scale, and throughout Lincoln, we're pretty much at scale in all our businesses, which means we have low manufacturing costs. We can attract the right talent to run the businesses. We have a distribution presence that's significant in every product line. If somebody wants to sell the product, they come and talk to us for sure. We're in pretty good shape from a scale business. The one part of the business that's not as big as I'd like it is the retirement business.
We're $40 billion in assets. It should be somewhat bigger than that to be at scale.