Pleased to have John Hall of MetLife with us today. MetLife is among the world's largest providers of life insurance and annuities. It also has a growing protection in international business. John has been Executive Vice President and Chief Financial Officer of MetLife for four years. Prior to joining Met, he was Chief Financial Officer of Arch Capital and CFO of ING Group. John, thanks for joining us today.
Great to be here. Thanks, Jay.
John, 2016 has already been a very busy year for MetLife. To remind everyone, Met has already announced a plan to pursue the separation of its U.S. retail business, which is being rebranded as Brighthouse Financial, and it sold MetLife Premier Client Group to MassMutual. Met also won its appeal in the U.S. District Court in March, which rescinded its SIFI designation, although there is still uncertainty based on FSOC's appeal to the U.S. Circuit Court. In addition, Met recently announced a new $1 billion expense-saving initiative to be achieved by the end of 2019. Before we get into my topics, do you have any opening remarks?
Well, thanks, Jay. All these steps we've taken this year are really to maximize shareholder value. In life insurance, it can take some time to get there, but we think these steps will very much help us maximize shareholder value as we can execute these over time. This is part of our ongoing initiative that we call Accelerating Value, where we're focusing on customers, competitors, and cash, and in particular cash, to have more predictable free cash flow over time from our entities. Third, the steps we're taking this year, we believe, reflect the realization that we are in a tough macroeconomic environment, and that we may be faced with interest rates perhaps lower for longer than we had hoped when I joined four years ago. Every year, the consensus has been going up.
It looked great, then we get to the next year, and it doesn't seem to happen. We, as a management team, are going to control what we can control, and that's by writing good products, allocating our capital to places where we get a good cash return over time, and especially managing our expenses that we just announced.
Let's discuss the separation plan of MetLife's U.S. Retail business. The first question that we often get is: what drove MetLife's decision to separate the U.S. Retail business, which is now being rebranded as Brighthouse Financial?
What we've said, I think, in the initial press release even, when we announced that we were going to pursue the study of the separation back in January, was there are two fundamental reasons, both strategic and regulatory. The strategic side is around the Accelerating Value initiative that we had, where we believe that predictable cash flows over time will have a premium in terms of shareholder value. The business in Brighthouse Financial, although it's a very nice business, and it is a good VA business that works well over time, but it has more volatility in its cash flows. Variable annuity companies, firms that have an amount of variable annuities in their companies tend to have a higher beta or higher volatility in their stocks.
We think Brighthouse will be very successful on its own and be very focused, then investors will have the choice between investing in Brighthouse and the remaining part of MetLife, which is much more predictable, steady cash flows over time, more, say, insurance business, a pure type of insurance business, versus market and insurance in Brighthouse. Today, when you buy a MetLife share, you have to buy all that together. We think it makes sense from a strategic point of view to offer investors the choice between a business that has a potentially higher return, but a higher, say, beta to it, and MetLife RemainCo, we call it, which will have more predictable cash flows over time. That's the strategic sense of it. The other side is regulatory.
Even though we did win our discussion with the government just a short time ago, as you know, they are appealing, There's nothing in the law that says they can't put us through the whole process again. The Dodd-Frank Act allows the agency to put you through the whole process again. Much of the analysis that was in the initial designation by the FSOC dealt with a lot of the businesses that are in Brighthouse. It dealt a lot with the variable annuities business and, say, universal life with lifetime secondary guarantees. These businesses are concentrated in our Brighthouse Financial business. That business, spun out and separated, will be smaller than some other companies or about the same size as some other companies that have not been designated as systemically important. We think that reduces the regulatory risk of MetLife RemainCo being redesignated over time.
Really strategic and regulatory, That same rationale applies today as it did back in January when we first made the announcement.
John, what do you think is the most likely form of separation for Brighthouse, an IPO or a spin-off?
One or the other. I get a lot of questions on this, obviously, We've been doing a great deal of work on this. We've said that we will make an announcement and file something with the SEC after our board meeting at the end of this month, Obviously, we have to discuss this with our board. It's an interesting decision, though. It's not a clear-cut decision because there's pros and cons on both sides. Why don't I just say those in terms you can think of what we've been weighing. Traditionally, I think people have thought is when you separate a business, you would typically file what's called an S1, that's the form at the SEC you file, That would be to do an IPO first to sell equity securities. Why do firms like to do that when you separate off a subsidiary?
Well, you get to have new investors in the stock and who know the new story of that standalone company, that can create demand or help with demand when you spin off the latter part later. To do a tax-free separation, you can IPO up to 19.9% of the company. You can do it through new shares or through selling the ownership by MetLife. After a period of time, usually about six months, the underwriters allow you to spin off the remaining shares to the shareholders. If you already have an IPO base of shareholders who own 99, that can sometimes help take up the stock as it flows back and forth from some MetLife investors who may not want the 80.1% that's distributed with it. That's been the traditional way of doing it.
Recently, though, we've seen a lot of industrial companies that have been separating. There's been quite a lot of activity in this area. They've generally been doing what's called a Form 10 file to the SEC, which is a spin first. They may spin 80.1% and retain 99, or actually 100% have been some of them. Why do you want to do that? It is kind of an interesting flow for the first few days as people settle down to get the price, but it does settle down within usually a week of trading. It settles down to an okay price, sometimes much faster. The holder, the MetLife holding the shares of Brighthouse, we wait a period of time, maybe the six-month same period. We could sell the period then. Maybe it'll be more settled.
You may not have such a large IPO discount when you distribute, when you do that later on. Importantly, the distribution is not dependent upon market timing and how well the market's doing. Had we planned this a year ago and were scheduled for the first quarter this year, it would've been very tough to do an IPO first, but a spin can generally happen even if the IPO markets are a bit choppy. You see there's pros and cons to each of those, and we're evaluating both of those and have to have a discussion with our board, and we'll let everybody in on the excitement and secret when we file with the SEC. We're looking forward to sharing this with you.
We think the Brighthouse story is going to be a great story, and we can't tell you any details ahead of time when we're about to file a securities offering. That would be front-running a securities offering, and that's not a good thing to do. We've been wanting to tell you this story for some time, and we're really looking forward to the end of this month when we can finally share it with you.
We're looking forward to seeing it too. From a technical standpoint, whether the separation is filed as an S1 or a Form 10, there is the ability to change the direction of that, correct?
Yes.
It doesn't just depend on initial filing?
Absolutely. The process is you file the form, whichever registration form it is with the SEC. The staff looks at it. It takes some time, three or four months to review. They give you comments back. You can ask the staff to switch over between one form or the other. If you can keep the same reviewer, it can be generally done pretty quickly. There's always the risk they may give it to another reviewer because if you change it. Generally, firms have done this because they've switched. They've been planning sometimes to do the S1, the IPO, and then the market's not very well, and they decide to switch and do a distribution first. There is the ability to, depending upon market conditions or what the company thinks, to make the switch. We'll have to just see how the market goes through the next year.
When would you anticipate full separation of Brighthouse to be completed by?
As I said, it depends a bit on the timing. If you assume that we file with the SEC right after our board meeting, shortly after our board meeting, and there's a normal review time, in the first quarter of next year, you could be ready to do an IPO. It will take us a little longer to do a full separation, doing the full 80.1%. We need some state regulatory approvals to get that done. That would tend to be more toward the end of the first quarter. Then you could sell down your 99 if you did that. It depends on how well the stock goes. Often firms are doing it about six months later, typically the holding period. If you do the IPO first, six months later, you can typically do the full distribution.
On the other hand, there are some firms that do a separation and keep the 99. They keep it for a period of time, and they let it season more. There could be a remaining stub held for longer than that. The full separation, in other words, with the 80.1% being separated, can happen in 2017.
Another significant transaction for MetLife this year was the sale of its MetLife Premier Client Group to MassMutual. What drove that decision, and what are the benefits for MetLife?
As we looked and we did our work on Accelerating Value, we looked at the products that our career corps sells and how much capital they consume and how fast you get that back. Selling more traditional life products uses a lot of capital upfront and takes a while to pay it back. Annuities are a faster payback, and they had a mix of sales. By selling this business to MassMutual, who have perhaps a longer timetable for payback, being a mutual, and certainly not as demanding as some of our shareholders, I think, we decided that this made sense from a strategic point of view to sell it. It also has a regulatory aspect as well because of the pending DOL rule.
We believe that the interpretation of DOL, if you're manufacturing for your own product and in your own sales force, may be challenging to try to prove the independence. Brighthouse will be a true third-party distributor. It'll be able to work better, we believe, within the new DOL framework. We haven't seen exactly how that's going to work. The big distributors are still working on that, but we think it's actually an advantage for Brighthouse to be doing that. Also, Brighthouse has the ability as we now have a relationship with MassMutual. We've actually over doubled the amount of agents that we have access to in terms of selling annuity products to them going forward. We think this is a great win-win across the board.
We did post a gain, by the way, of almost $300 million when we sold it. We'll save about $250 million a year split between both Brighthouse and RemainCo. I know MassMutual is very pleased with our sales force, and they've almost doubled their sales force, which was one of their key strategic goals. We think, again, it's a great transaction, and everyone's very pleased all around.
Let's change gears in terms of thinking about MetLife's appeal of its SIFI designation. What are MetLife's arguments that it should not be a SIFI?
Well, we had many. If you read our first designation, we actually had what we called 10 counts, but you can group these into a series of arguments. The judge that ruled on our first filing, Judge Collyer, found against one of our arguments but agreed with three of them. Upon appeal, we can bring back those three, but we can also bring up some of the ones that haven't been brought forth before. We've actually brought up in our filing, we have a total of six reasons why we believe the FSOC erred in designating us systemically important. I wanted to sort of run down some of those to get a feel for it. The first three, Judge Collyer ruled in our favor. The first one, that every federal agency tends to publish guidance, rules, and guidance.
When an act is created, like the Dodd-Frank Act, the agency publishes a set of rules for how they plan to operate within that law. FSOC published a final rule on interpretive guidance, they did not follow that when they did our designation. They said very clearly they would assess the vulnerability of a non-bank financial company to financial distress, they did not do that. We said they weren't following their rules. That was when she found in our favor they did not follow their own rules. The second point is that they didn't really follow their final rule interpretive guidance and the principle of reasoned decision making in showing that we posed a material financial stress to the U.S. financial system.
Judge Collyer really didn't rule, and I'm a finance person, so I'm not an attorney, I'm giving you my interpretation on all this. Judge Collyer said they did not prove and show that we truly were systemic, that the analysis and the numbers didn't really get through that. The third reason that she ruled in our favor was that the government, FSOC, refused to consider the effects of the designation on MetLife. This is often called the cost-benefit argument, but it really isn't a cost-benefit analysis. It's that our argument is that FSOC or the government must consider the consequences of the actions to know whether the designation will achieve its regulatory objectives. We say FSOC did not do that. We brought forth three more arguments to the appeal that Judge Collyer did not rule on.
She ruled on those three and said, "That's enough, I don't have to rule on the other ones." To the appellate court, we have brought forth three more. The first one is that FSOC did not consider reasonable alternatives to designating MetLife. We believe an agency must consider alternatives. There is another alternative. It's what's called the activities-based approach. As opposed to designating an institution, you look at the activities that might cause systemic risk and think through how to regulate those. In fact, FSOC is approaching the asset management industry this way but did not agree, even though we brought it up, to rule on our case using an activities-based approach. Second, the designation on FSOC on us violated due process and the separation of powers.
We repeatedly asked for the administrative record and to understand the standards by which we will be judged, we were never given that. That's due process. The other, the separation of powers, the same people who vote you and analyze you, also you appeal to. Most federal agencies have a separation, even within the agency, between these different set of powers. This violates the separation of powers, which is a constitutional right. Those are the three arguments that will be heard in addition to the other three that the appellate court will rule on.
Thanks for that very complete answer. If Met were redesignated a SIFI, what actions could the company take?
It would depend on how we are redesignated. If we lose the appeal, we can appeal again and try to apply to the Supreme Court. If they refuse to hear it, there's an annual review done every year. By the time that one annual review comes up, we expect to be a different company. We would have Brighthouse separated. We would reapply our logic that we do not pose a systemic risk and can have the right to go through the whole court process again. We believe that being a SIFI is a material risk for our shareholders over time, and we will do everything in our power to not be a SIFI.
John, let's get an update on the SIFI designation appeal process, which you alluded to just before. What's the timeline of the appeal process?
The oral hearings have now been set for October 24th. It's a three-judge panel drawn at random from the D.C. District. That's done about 30 days in advance of that date. It's a weekend, so I don't know whether it'll be the Friday or the Monday after when it would be announced. The government has just filed their final response to our response to their initial appeal, and that was just filed late last week. All the key responses are in before the court now. They'll consider them, and we have oral hearing on the 24th. It's always unclear how long they'll consider it after that. There's a range of timing on these things. It is a bit hard to predict.
Okay. Are there public disclosures that will occur around the judge selection?
It'll just be announced, I think, about 30 days prior to the 24th. It'll just be announced who the judges are. All the other pieces are out. It's almost all public. It's all filed already.
All right. Let's turn to the announcement of MetLife's expense saving initiatives. The company has announced a new $1 billion expense savings program to be achieved by the end of 2019. Can you help us a little more in terms of what the source of those savings would be?
Certainly. Just to put this into perspective, this is about 11% of our running operating costs, so it's quite a significant savings. We took out about $1 billion gross, $600 million net over the last four years, and we did that through moving people around the United States and consolidating, investing a lot in technology, and so we've seen the benefits of that. We think we have to do more. We think to be ready for a potentially lower for longer interest rate environment, we have to become more efficient. An example of this is we just announced we're outsourcing some of our closed block administration to CSC, Computer Sciences Corporation. Almost 7 million policies, about 1,000 MetLife employees will become employees of CSC, and they'll be converting these old policies on older systems.
They'll be converting them over to a new system, and we'll pay them per unit. That'll be split between Brighthouse and us, and we've negotiated that the economics will be the same between the two of them. That's just one example. We believe this will take an investment to get to this $1 billion. The plan is to have this $1 billion be there by the end of 2019, so run rate end of 2019, so fully there in 2020. It's going to take an investment in technology. It'll be thinking about how we do work and where we do work around the world. We think we have to do this. We think we will be faced most likely with lower for longer, and we have to take costs out of our system.
Makes sense. How much of that $1 billion expense saves would you expect to drop to the bottom line?
Almost all of it getting to the bottom line. Whenever you do a separation of a pretty large piece of your business, you have what's called stranded overhead. That's overhead costs that used to be allocated to that business. Once you take those brains away, you're stuck with this stranded overhead. Approximately run rate about $200 million of that $1 billion is what would be stranded overhead. If you think net net of what we used to be, it's kind of $800 million flowing down.
That's helpful. Okay, turning to investments and interest rates, what's MetLife's current outlook on variable investment income?
Well, we've had a pretty rough year in hedge funds, as you can see from our earnings, and we've actually taken down our hedge funds to be now well below $1 billion by next year. When you think about the returns we've been able to achieve compared to the capital we have to put against it really just doesn't hold its weight anymore. We've been doing better in private equity, but they've still been a little weaker than historical. We still like our private equity group, and we've lowered our outlook. We had about $1.2 billion-$1.5 billion was our range for VII for the year, and we've announced on our last call that we will be below that this year. We still like private equity. We think it is a good return, although we're lowering our assumption down a little bit long-term from that.
Just reflect generally a lower return environment in general.
Okay. Has the earnings impact on MetLife from low rates been consistent with your expectations?
We gave a disclosure on our 10-K, compared to our plan, where a year ago, we used consensus rates to think about the next year, and rates were going up, I think, by the end of this year. The 10-year treasury, according to consensus, was supposed to be 3% almost.
That was really wrong.
With all those analysts on Wall Street.
Exactly.
We give a sensitivity. It was about 1.5%. If the 10-year treasury this year was 1.5% for the whole year versus where we had it would be about $65 million reduction in earnings in this year and just over $200 million next year. I think the 10-year treasury's been averaging about 1.75% so far this year, not quite the 1.5%. Generally, we've seen the earnings impact about what was in our 10-K disclosure. That still makes sense to look at when you think about our business.
Okay. Has MetLife lowered its assumptions based on the year-to-date decline in rate, looking from year-end 2015 to now?
We did make an adjustment when we did our actual assumption review in the second quarter, we lowered our very long-term assumption, which was 4.5% 10-year Treasury out 11 years from now. How do we come up with that, and why do we have that number, I get asked a lot. U.S. GAAP requires us, the finance and actuaries, to have a best estimate, and you have to create a best estimate assumption for the very long term. We have liabilities that can go out 100 years. You have to create an assumption that will last for a very long period of time. We come up and have historically had 4.5 because we assume the Fed target of 2% inflation. A real return in the U.S. economy of two and a half. That's how we came up with four and a half.
A year ago, we actually pushed out how fast it would take us to get to that four and a half out to about 11 years, so in 2026. At our second quarter assumption update for variable annuities, we also adjusted that down to four and a quarter now, and it's still out 11 years from now. Starting it from today's interest rates, how we do our GAAP financials, we start today and slowly go up to that number way out 11 years from now. That's not how we price. We price our products based on level rates, what we can achieve today. U.S. GAAP requires us to make this assumption for all the financials that we have to produce. That's why we also give you sensitivities on our earnings. We try to share with you what it means.
Also remember on statutory in the United States, you take last year's year-end interest rates, whatever they are at year-end, and you have to say your reserves meet those or even a shock down.
The capital, the statutory piece, is on a different basis from how U.S. GAAP works. I don't know where interest rates are going to be 11 years from now. I hope the U.S. economy does recover, we're running our company that even if rates take a long while to get there, that we can still give good shareholder returns. It's why we're taking the cost out. It's why we're allocating cash and capital to products that have a good return, even a faster payback. We're really paying attention to that throughout the whole company.
That's helpful. Let's talk about the investment yields that MetLife is able to deliver currently and relative to the overall portfolio. What's MetLife's new money yield as it stands today?
In the second quarter, we're able to invest at approximately just a little over 3%, 3.07% to be exact. That was new money, but our core yield is around four and a half. You can see, obviously, if this keeps going forward, if rates stay, the 10-year treasury on average, was about 1.75 in the second quarter. You can see how that will have an effect on you over time. It takes a long time for our portfolio to turn over. We have an average duration between seven and eight, so it only flows off a certain amount every year. We also have derivatives that we bought some time ago. They're still giving us good earnings power, and will even give us $hundreds of millions into the next decade, into 2020 plus.
Nevertheless, as this slowly wears off over time, it comes back to why we have to become more efficient each and every year to make up for this potential change in our margins.
Can you talk a little bit about the derivatives portfolio and how that protects against low rates?
Some time ago, we had a derivative portfolio we bought, and we get about $700 million a year in terms of earnings from that. That will slowly go down over time, as I said. We actually had a graph on this, I think, in one of our year-end outlook calls. It might've been the last one that you can actually see the graph and see how it goes down over time. I wish it could stay for longer. I wish we could have bought even longer ones, it would stay there for even a longer time. You can't have everything, so that's why we're adjusting our portfolio. We have time to take those new cash flows, reinvest them wisely, and you just do this year after year, we can help mitigate the impact of that over time.
That's helpful. Which of Met's businesses are most impacted by low rates in terms of the earnings impact or the balance sheet strength?
Well, from earnings, it's the retail business, and to an extent, CBF, it takes longer.
CBF?
CBF over time. That's a mix of businesses, both with some short-term funding as well as with very locked in, the potential closeout business.
The Corporate Benefit Funding.
Funding Corporate Benefit Funding. The corporate other that has some of our excess capital in it, where we have a lot of II that can be impacted by it. From a balance sheet perspective, it's primarily retail has the largest potential impact from very low rates for a long period of time.
Right. That being U.S. Life.
U.S. Life, yeah.
Okay, why don't we switch over to the audience response system? The first question is for investors, if you currently don't own shares of Met or are underweight, what would cause you to change your mind? We can start the clock. A couple seconds left here to check in. The responses here are 53% saying higher interest rates and a steeper yield curve, clearly kind of macro-focused, and both at around 20% saying increased clarity of the separation of Brighthouse Financial, as well as a favorable outcome of the non-bank SIFI litigation. Only 3% said reduced uncertainty around Department of Labor fiduciary standard rules or mentioned valuation. Is that consistent with what you would have thought, John?
Sure. Number 1 I have less control over, clearly. I'm glad to see that 2 and 3, that we have a chance to influence, is almost up to number 1. We think as we continue to demonstrate that we can produce cash over time, even in lower rates, I think that can help mitigate a bit the number 1 point.
Next question, please. My return on equity expectation for MetLife, not including Brighthouse, over the next several years is? Keep in mind that MetLife's return on equity target in 2016 was approximately 11%, and this is obviously for both Met inclusive of Brighthouse. We can start the clock here. Investors are saying that 50% saying between 9%-10%, 24%, 11%-12%, and 16% below 9%. Actually, a similar amount, well, not quite, a lesser amount, 11% saying above 12%. Any views on that?
I guess I would have to ask everyone who pressed those buttons, what is your outlook for the 10-year treasury? I think an ROE target is always relative to what the risk-free rate is. To think you can get dramatically above the risk-free rate in a life business over time, you're probably taking too much risk, and you'll pay for it later. There's an important element, I think, is what is the expectation for 10-year treasury, and there's a wide range if you just listen to the news every day as to what's going to happen to rates. I think how we think of this is relative to the risk-free rate, how much value can we add for shareholders versus the other alternatives? That's really how we're thinking of it.
I think that's maybe where the conversation has to get to more over time, we think, because it's just uncertain where rates will get to.
Cost of capital should come down.
Should come down over time. It takes a while, but it should come down.
Okay. Next question, please. My view of Met's plan to separate its U.S. retail, that's the U.S. Life and annuity business, the outlook for that. Let me start the clock. Investors here are calling it mostly favorable, around two-thirds favorable or highly favorable. Clearly, your message is resonating.
We haven't been able to share with you the details. It's hard to have an opinion, actually. We have an opinion. We believe it will add shareholder value, clearly, we have to demonstrate it to you, that's what we owe you in this. Hopefully, we'll move number three and number four grouping over more to the left after you get a chance to actually see what we plan to do with Brighthouse.
Are there any more ARS questions there? Nope. This is probably the last one. Will MetLife ultimately avoid being designated a non-bank SIFI? Don't answer not sure. I put it up there. Don't answer not sure. All right. The outcome, 61% saying yes.
I think I can take those odds too.
Good odds. 29% saying no, 10% saying not sure. Well, we wish you the best of luck with that, John.
Thank you. As I said from the beginning, we think it's important to our shareholders to do what we can to not be a SIFI. We also think it's very important that we continue our Accelerating Value initiative and completing the separation. Lastly, taking costs out over time. That $1 billion is all for RemainCo. That's important. That's only for the remaining business. We think these three areas of focus that we have will pay off for shareholders over time.
That's great. Any final thoughts, John, before we close it out?
No. We're looking forward to a very exciting fall with the filing of the registration statement and the result from the court over time. It's going to be quite fascinating.
That's great. Please join me in thanking John Hall from MetLife. Thanks, John. Well done.
Good. Thank you.