I'm pleased to have Mark Grier joining us. Mark's been with Prudential since 1990, possibilities including overseeing the finance, risk management, investment, investor relations. Mark and his team have taken several steps over the last couple of years to navigate Prudential through a really very difficult macro environment.
Thank you.
I'd like to start on a trend we've seen from the below-the-line volatility, capital volatility. You've taken some actions over the last couple of years. Volatility and some of the capital volatility. I was hoping you could go into some of the actions that Prudential has taken.
Current hot topic. I think we were asked about this in just about every meeting we had this morning. Let me go through four buckets. One applies only several years ago, something that we called FX remeasurement that basically involved marking some non-yen volatility side through the income statement and the asset side directly to the balance sheet, and that created a lot of volatility. This was sometimes in the billions. The inspiration around the effect of that on headline risk and on complexity and on currency led us to focus comprehensively on the volatility issue, also under the theme that it's economic if it affects the share price. It's not just economic if you can trace accounting and money, but things like headline risk matter, things like transparency matter, things like complexity matter.
While we had kind of the inspirational starting point around this FX remeasurement thing, the overall initiative was more comprehensive, and it was in those categories of not just volatility, but transparency and complexity, excuse me, and headline risk. That starting bucket we dealt with. We had to make structural changes in functional currencies, and we've been able to put that FX remeasurement issue behind us. Then moving through subsequent buckets, we restructured our variable annuity business earlier in 2016, which had the impact of dampening volatility, dampening the possibly short-term need to put capital in or take capital out of a specific entity that housed our living benefit. We've made changes in our hedging practices that have reduced volatility, but we've also added, by the way, some more cash components to the way we manage risk.
That's also contributed both to lower cost hedging, but also less volatility because of the derivative marks that go through. There's been a basket of activities around variable annuities that have significantly addressed some of the things that we were wrestling with around both capital volatility and income statement volatility above or below the line. I'd add, by the way, that in the fourth quarter, we did have some below the line volatility. It was for us, though, concentrated in the variable annuity product aspects of what we do, and it reflected real anomalies in the way our accounting for non-performance risk moved relative to the way what we consider to be the non-economic component of the reserve moved. But if you look at the full year, we had net income and operating income just about right on top of each other.
We're feeling like some of the progress that we've made in these areas is showing up in our results. Moving to two other buckets. The third bucket would be the mark of other derivatives outside of variable annuities. The common theme here is duration-related hedges using either swaps or maybe caps or floors. We've been making efforts over several years to add more cash to our balance sheet structure, reducing the need for derivatives to hedge duration. The thing about those marks is that they go straight through to statutory capital. The FX remeasurement pieces and most of what happens in variable annuities is GAAP only and doesn't go through to statutory capital. But you also have volatility in stat capital when you have these other derivative marks that are going through the income statement.
We've also, as I said, increased our focus on using cash, and we've been winding down the use of derivatives in hedging, basically duration risk. The fourth bucket would be the volatility in reserves. Again, some above the line and some below the line, sometimes reflecting assumption updates and sometimes reflecting the more routine adjustments to reserve that reflect either market conditions or experience, maybe on a quarter-to-quarter basis. We've also been, first of all, getting ahead of the game in terms of the assumption updates, so we don't feel like we're chasing assumptions about lapses, for example, or something like that on the client behavior side. And we've also changed some of our methodologies to add corridors or use averages that will make the entries still right but less volatile.
Thinking across four buckets, FX remeasurement, the annuity product world, the derivative world, and the reserve world, we've made significant progress in all four areas. Again, I'd emphasize that this has been an ongoing effort for us over a number of years, including making some structural changes in the way we do business. There's been very little compromise of economics, and we feel like we're on a pretty good track. I'd say the fourth quarter was anomalous in terms of the movement in our spread and some aspects of interest rates. Most of that we think will over time look more like the full year with a pretty healthy convergence between net income and operating earnings.
Just curious on that derivative bucket, moving from derivative to greater cash component. I understand the less volatility there. Is that an area where you're giving up some economics? I would think moving into cash, you'd give up some investment income. Is there any discernible effect on GAAP earnings or stat earnings from that bucket?
There's not an impact that we'd have to talk about.
Maybe moving to ROE, and the ROE guidance you gave on your 2017 outlook call in December. You moved from a 13%-14% ROE that you categorize as through the cycle, I believe the words were, to a 12%-13% intermediate ROE target. Curious what drove that. I'm guessing interest rates were a big part of it. If you think there's a trajectory to getting back to 13%-14% through the cycle.
Yeah. Maybe a little context. We put out the public objective of 13%-14% ROE back in 2011. We thought it was important at that time to express the earnings power of the company, given normal capitalization and given normal markets. We qualified it a bit, as you point out, we said through the cycle, we think this is the center of gravity of our earnings power. We outperformed sometimes when we had tailwinds. We had the low end of that range when we had headwinds. We put a stake in the ground at a time when the phrase in the market was, "What's the new normal?" We tried to tell the market what we thought the new normal would be for us, again, with normal capitalization and normal markets.
The erosion of investment income as a result of chronically severe low interest rates is the main reason that we've now decided that at least for an intermediate term earnings power range, we should be thinking about more like 12%-13% and less in the 14%-15% range. I also mentioned on the earnings call that there's a consideration in there for some tactical initiative spending on systems and on products and on distribution. We've talked over the last couple of years about the impact of initiative spending on earnings. We've carved out roughly $0.15 per share last year and $0.15 per share this year as a sort of level of run rate initiative spending that we've also factored in as we've thought about the intermediate term target for our return on assets, I mean, return on equity. There'll be fluctuations.
Tailwinds come up in returns on alternatives. Tailwinds come up in mortality. We expect that in the intermediate term, that's a reasonable expression of earnings power and the center of gravity for ROE. Your interpretation about the effect of low rates is right. Now, it was a slow grind on the way down, and it's likely to be a slow grind on the way up. The impact of rates on us is over time, as we have kind of a concept of the macro spread on Prudential, in that macro spread world, over time, assets reprice a little more quickly than liabilities reprice, and we have things like equity that doesn't reprice. We grind a little lower as we reinvest at lower rates, and we'll grind a little higher as we reinvest at higher rates.
In the U.S., we need about 75 basis points more with no change in spreads to break even in terms of the runoff rate on the portfolio versus the new investment rate. We're not quite there yet. We'll continue to see some of that grinding downward in terms of the macro spread. Again, if rates turn around and go up and we have that 75 basis points or more, we'll have that gradual grinding back up in the ROE.
Shifting over to regulatory. Interest rates were one of the pieces that was a pressure on earnings growth. I think regulatory has been a sentimental pressure on the stock, especially before the election. Trump campaigned on dismantling and replacing Dodd-Frank, but I don't think anyone knows exactly what that means or what form it would take. Curious your viewpoint on what the range of outcomes could be, specifically as it relates to non-bank systemically important financial institutions.
Well, I'd say, first of all, the tone of things in Washington has changed dramatically, and the themes around examining regulatory burden and the themes around examining unintended consequences are important themes for us as it relates both to our SIFI status and open questions about the Department of Labor fiduciary standards. I think you said it well when you said that from at least a sentimental aspect, there's probably been a drag on valuation from the regulatory issues and particularly what SIFI status might mean. I know from meeting with investors that there has occasionally been concern raised about the tail risk in regulation, meaning what would happen if things started to go bad? I've sat across from people who have said, "You might have to eliminate your dividend. You might have to stop buying back stock. You might have to issue dilutive equity.
You might have to get out of certain businesses." There's this whole litany of what-ifs or maybes in that tail. I think at least on the sentiment side, that notion of the tail risk has been significantly dampened by this tone around regulatory burden and around unintended consequences. More specifically for us, numerous members of the Trump team at various levels and in various roles have said that they don't think there should be non-bank SIFIs. Now, obviously, that's right in our sweet spot. The idea of getting rid of non-bank SIFIs would mean that we would no longer be designated, and we would no longer be under that Federal Reserve supervisory regulatory umbrella. The Hensarling bill, which is an amendment to Dodd-Frank in the House, also eliminates the category of non-bank SIFIs and basically says only banks can be designated.
There's a path for us through the Hensarling amendment and changes to Dodd-Frank that would eliminate non-bank SIFI status. There's a path to us through action taken by FSOC to vote to de-designate us. Remember, our designation comes up annually. We're in front of them once a year, and they have the opportunity to basically decide not to maintain our designation. That's a path. We have a legal path to go down the route that Met pursued going to court, and there's even an open issue about whether or not it would even be challenged by the administration. There are a number of different ways that this might happen.
I would say at this point, we don't know how or when, but directionally, it seems that the idea of perpetuating the non-bank SIFI status is at least out of favor if there's not a concrete game plan at this point to get there.
On your outlook call, you commented that even if SIFI goes away, there's still likely to be some form of group supervision or supervision at the group level as opposed to the statutory level. Curious if you could go into more depth on that as who you would see being your group supervisor and what form that would take.
Yeah. There's been enabling legislation and as a result of that, a positioning by the state of New Jersey as our group supervisor. We actually, in addition to working with the Fed as group supervisor, work with our regulators in New Jersey as group supervisors. They extend their reach through their cooperation with other regulators. While we have legal entities in New Jersey and Arizona and Connecticut in the U.S., and we also have numerous overseas operations, New Jersey, through its comprehensive view of the group and then also through its cooperative efforts with other domestic regulators, meaning other states, and then also foreign regulators, extends its reach into a broader view of Prudential, either at the group level as a supervisor or across other legal entities as part of what they do with the other states.
That would be the center of gravity for us with respect to group supervision.
That already occurs.
That already occurs, but it's an evolving process. The capability and the way in which we will work are both still developing.
I guess presumably, or is it safe to presume that this would still be under some statutory NAIC framework if this was the evolution and SIFI goes away?
There's an interesting question about that. The NAIC has a project on capital standards, but they very consistently describe this as capital guidelines, not capital rules. The question of where and how capital standards would be developed, formulated, and imposed on us is very much an open issue if we don't have the Fed.
One more on regulation here, the DOL has been a hot topic, obviously. From a practical standpoint, are you moving full steam ahead for that April 10th applicability date? If this rule does get delayed, is there a brake that you could step on here?
Well, we've made the investments and developed the systems to support implementation, so we're ready to go. The practical issue for us will be on the front end. It'll be what our third-party distributors decide to do, and we'll take our lead from them. It's kind of in limbo. It's not clear exactly what the status is of implementation, whether it's delayed, how it will be examined, and what will come out next. We've done what it takes to implement, and again, we'll be following the lead from our distributors.
Broadly on tax reform. You're not a full 35% taxpayer. How are you viewing the ins and outs of potential tax reform, knowing that there's not a lot of clarity yet?
Yeah. The thing to keep in mind for us is that we have the dividend received deduction as an offset to our marginal tax rate. When you say we're not a 35% taxpayer, there's a benefit of several percentage points in there from the dividend received deduction. The way this will, as a practical matter, play out for us will be the trade-off between dividend received deduction and whether it's all there, whether part of it's there, or whether it goes away, and how much marginal tax rates change. I think you said it right. There are some moving parts here, and the outcome is not clear until we get a better idea of how the two most important pieces for us are going to shake out.
You have substantial overseas operations in Japan and Asia. Is there any implications for Prudential if Congress passes a tax holiday on overseas capital?
There's very little. We haven't piled up a lot of capital overseas. We've been pretty routine in using and deploying the capital that we generate. Unlike some of the tech companies that you hear about that have massive amounts of cash offshore, we've stayed on top of this, and it would not be a particularly big issue for us.
Just want to pause and see if we have questions also from the audience. Front up front.
How do you think about the growth outlook both in U.S. retirement businesses, so both 401(k) and in pension risk transfer?
I think the growth opportunity in the U.S. is in retirement. The institutional side, and for us, that means full service retirement as well as pension risk transfer, I think is an exciting opportunity. We've got a good track record in pension risk transfer, and while it's lumpy, we're having a reasonably good experience in full service retirement. Hopefully, higher rates will inspire more activity in pension risk transfer, and that can continue to be a cornerstone of a really significant, immediately accretive business that's had a meaningful impact on our return and on earnings growth and retirement over the past few years. On the retail side, we think of what we do as implementing a secure retirement income strategy. We don't focus on a variable annuity product strategy except under that umbrella. Conceptually, again, in the market, I think there's a compelling growth opportunity in secure retirement income.
We've got to think more expansively about the opportunity in the market that we can drive by simplifying, by improving transparency, by focusing more directly on outcomes, and maybe less directly on the complexity of the products that we sell and the bells and whistles. I think with the right approach to outcomes-oriented solutions under the theme of secure retirement income, that's also a significant growth opportunity. We feel like we're well-positioned in the best parts of U.S. financial services. We've got work to do on product design and execution, but we've had a great experience over the past five years, and I think we're well-positioned to benefit from what should continue to be a good growth opportunity.
In the pension risk transfer market, probably safe to assume that this is a higher leverage business assets to equity compared to the rest of your portfolio. What is it about that business that allows you to take maybe a more levered approach to running it?
Let me answer a fundamental question, then I'll get to an optical point. On the fundamental question, this business is pure corporate finance. There are very few things that are ever in front of us in the business we're in that are as directly driven by risk-return, by leverage, by the shocks, and analyzing the impact of things like a cure for cancer, things like a cure for Alzheimer's disease, things like a credit cycle as it relates to the asset side. The answer to leverage is that we are driven by a very highly disciplined economic view of risk and return, shocking the system, different risk-return combinations of investment strategies, for example, optimizing the risk-return profile of the asset side, matching the liabilities.
In the guts of it, at the end of the day, the real leverage depends on the real economics and volatility, the fact is that these are fairly low-risk businesses. As we match assets and liabilities and don't take much interest rate risk, it's a fairly low and well-understood risk profile. In terms of optics, remember that when you're looking at the GAAP financial statements, we can't recognize a gain at issue, to use the phrase, when we do a profitable insurance transaction. If there is a gain at issue, it's buried in the reserve. It's the total moral equivalent of equity, but it's not showing up on the equity line.
When we do a deal, maybe the year we did General Motors and Verizon, we booked a couple of billion dollars of gains in the reserve that didn't go through the income statement and result in an increase in equity. It's a little bit misleading to look at asset leverage on these deals just as book equity compared to the balance sheet, because buried in the reserve may be a substantial component of equity, and that's realized over time. Again, it's the exact moral equivalent of equity. It looks just like it. The description of the accounting standard describes it that way, but it's not going through the income statement. It's probably not as levered as it looks optically. Again, at the end of the day, it's driven by the pure economic discipline around risk and return.
A question on annuities, you talked before about the VA recapture. I think a lot of that was in the context also of this Oliver Wyman proposal out there regarding NAIC reserving standards for variable annuities. I'm curious if I could get your view on how you expect that to progress, timing, implementation, and then how Prudential is positioned for those potential rules.
All right. Let me work backwards. We're very well positioned for those potential rules. The things that we've done, I guess, allow us in a way to characterize ourselves as early adopters of the new approach to variable annuities that's coming through the NAIC, but reflecting work that's been done by Oliver Wyman. This means our characterization of the liability and our approach to hedging are in sync with the things that are happening in that world of rethinking variable annuities. I think there may be a few issues around the fringe related to some of the capital markets assumptions, we've got some cushions out there to allow for maybe some different outcomes around the edges. The core of that is very much in line with what we've done, we're very comfortable moving forward on that path. I'm not quite sure what the timetable is.
As I said, there are some loose ends around some of the aspects of assumptions that are driving some of the testing and what CTE98 or 97 really means. That's work in process, and I don't know when it's going to be settled, but from a Prudential standpoint, I'd say we're very comfortable. We're encouraged by the fact that the work that we've been doing ourselves has come out in a manner that's very consistent with the external work, and we're feeling pretty good about where we are.
I'm going to just pause one more time to see if there's questions from the audience. If not, I'll conclude with a couple questions on international. Big franchise in Japan. How are you positioned for what is ultra-low interest rates there? And how has that impacted your business?
Well, we've been very much on top of the rate environment. We've been active in repricing products over a long period of time, but particularly as the decline in rates accelerated. We've eliminated some products, particularly single premium yen-denominated products, and we repriced many others. We also have built up, not in the past six months, but over many years, a strong capability to sell U.S. dollar or other currency-denominated products in Japan. Our history over the last several years has been 30%-40% of our sales have been in non-yen denominated products, and this reflects an intrinsic capability of our distribution system, primarily captive, that allows us to make sure suitability issues are in order and compliance issues are in order, and make us very comfortable selling the non-yen products in that market.
We have a competitive advantage, and as a result of that, our emphasis on dollar products and the market's interest in dollar products, dollar-denominated products have recently made up more than 60% of our sales in Japan. As you see, our total sales have kept right on going. Mix is changing, but it's changing in a way that's an extension of what we've been doing, not something new. It's enhanced our performance in a difficult market. We're preserving returns. We're producing a very highly productive sales force using the products that we make available and continue to do very well. So it's been a combination of an active response to repricing in yen products and the capability that we have to sell non-yen products, which is a particular asset in this market.
Just one final one on international. Japan is not the only international market you're in. Can you talk about some of the other markets that you're in or you've entered and the growth prospects there?
Yeah. I think in order to keep the answer short, there's one market I'll talk about, which is Brazil. We've been building a Life Planner business. The Life Planner designation for us refers to a differentiated distribution system that's better educated, providing high-quality advice and driving protection-oriented insurance sales. We've been building a Life Planner model in Brazil that has been very successful. The productivity metrics are sometimes even stronger than we see in Japan. The product mix is very attractive in terms of profitability. However, U.S. investors don't see it yet because profitability emerges very slowly through the build of the in-force book in the Life Planner business. Again, these are long-term protection products, not short-term investment products. We are optimistic about the trajectory there.
The vital signs are very positive and the leading indicators of what's possible, meaning productivity and product mix, are suggesting to us that there will be a good story there over the next few years as earnings emerge and we get a chance to talk about it more.
That's great. Well, Mark, thank you very much. Appreciate your time and insight, especially so late in the afternoon.
Yeah. As you can tell, my voice is going. We saw a lot of people today. Thank you all for sitting and listening.