Ladies and gentlemen, thank you for standing by, and welcome to the Prudential Financial 2017 Financial Outlook. At this time, all lines are in a listen-only mode. Later, we will conduct a question-and-answer session. Instructions will be given to you at that time. If you need assistance during the call today, you may press star and then zero, and an operator will assist you offline. As a reminder, today's conference call is being recorded. I would now like to turn the conference over to Mark Finkelstein. Please go ahead.
Thank you, Cynthia. Good morning, and thank you for joining our 2017 Financial Outlook conference call. Please find our presentation for today's call on our website at www.investor.prudential.com. Representing Prudential on today's call are John Strangfeld, CEO; Mark Grier, Vice Chairman; Charles Lowrey, Head of International Businesses; Stephen Pelletier, Head of Domestic Businesses; Robert Falzon, Chief Financial Officer; and Rob Axel, Principal Accounting Officer. We will start with prepared comments, and then we will answer your questions. Today's presentation includes forward-looking statements. It is possible that actual results may differ materially from the predictions we make today. In addition, this presentation includes references to a non-GAAP measure. The slide deck includes a reconciliation of such measure to the comparable GAAP measure and a discussion of factors that could cause actual results to differ materially from those in the forward-looking statements. With that, I will hand it over to John.
Thank you, Mark, and good morning, everyone. I'd like to welcome you to our 2017 Financial Outlook presentation. Before Robert Falzon takes you through the specifics, I want to provide some higher-level observations, and I'll begin on slide two. The key message is that while there are market and regulatory uncertainties and interest rates are still a challenge, we remain positive on our near and longer-term prospects and our ability to produce a differentiated return on equity and strong cash flows. We benefit from our complementary mix of high-quality protection, retirement, and asset management businesses. Our business mix provides a good diversity in earning sources, which helps us weather the normal variability in business results or fluctuations in market conditions while offering solid growth opportunities.
At the same time, we have a strong capital position and generate a significant amount of free cash flow in our businesses, which we estimate at about 60% of earnings over time. This allows us to execute a balanced approach towards capital deployment between dividends, buybacks, and investments in our businesses, including M&A when we identify opportunities that represent a good strategic fit. As Rob will describe in more detail, we're pleased that the board approved a $1.25 billion share repurchase authorization for 2017. Since 2011, we have returned over $10 billion to shareholders in the form of dividends and buybacks. We're also investing in our businesses. This includes investments in distribution, products, data and digital, and technology. Several of these investments have already started paying dividends, such as in our asset management business. Other initiative spending will position us to capture opportunities and succeed over longer time horizons.
Much of this incremental spend is financed through efficiency gains we have achieved in our businesses. We believe these investments, combined with our track record of innovation and execution, will drive future growth at attractive returns. Overall, we feel very good about the positioning of our businesses and prospects and our ability to deliver strong value to our shareholders. Turning to slide three. This slide shows our historical return on equity since 2010. Recall that back in 2011, we established a long-term ROE objective of 13%-14% and then exceeded the top end of that range in 2013, 2014, and 2015. Those years clearly benefited from market tailwinds, including the impact of strong equity markets on many of our fee-based products and favorable non-coupon investment income.
We also executed very well across our businesses, successfully integrated key acquisitions, benefited from innovative jumbo risk transfer transactions, and returned substantial sums of capital to our shareholders. As we look out over the next several years, many of the underlying factors that drove much of the ROE success in 2013-2015 remain intact, including strong business execution and effective capital deployment. We're not immune to the multi-year impact of very low interest rates in our two primary markets, the U.S. and Japan. While we don't consider ourselves to have higher interest rate sensitivity than our peers, the low rate environment does adversely affect the returns we expect to achieve on new product sales, as well as the return on our in-force business.
In addition, though to a lesser extent, our multi-year strategic investment spending in our businesses that I referred to earlier also has a negative impact on our returns over the shorter time frames. As a consequence, we have moderated our ROE expectations to a 12%-13% ROE range over the near to intermediate term. If interest rates were to gravitate back towards more typical historic levels, we would fully expect to return to the 13%-14% ROE level over time because of our business mix and our execution track record. Before turning the floor over to Rob to discuss guidance
I know there has been a lot of attention on Wells Fargo's distribution of our MyTerm life insurance product, so I'd like to ask Stephen Pelletier to spend a minute on it first. Steve, over to you.
Thanks, John. Good morning, everyone. First, let me begin by saying that all of us at Prudential are squarely focused on doing what's right for our customers. We stand behind our MyTerm product and the value that it's provided since we launched it in 2007. Prudential has acted responsibly since we initiated our distribution relationship of MyTerm with Wells Fargo in June 2014. Before the issues at Wells Fargo became public, we surveyed Wells Fargo customers about their experience with MyTerm, including reasons why some of them let their policies lapse. Since that time, we've expanded our review into how the product was distributed at Wells Fargo bank branches and on the bank's website. As we announced on Monday, we made the decision to suspend sales of the product through Wells Fargo until we've completed our review.
I want to emphasize, we do not gauge the importance of this matter in financial terms, but for purposes of this call, it's probably useful to put some financial parameters around it. MyTerm sales through Wells Fargo, based on annualized new business premiums, were approximately $4 million from the beginning of the relationship through the third quarter of 2016. If any Wells Fargo MyTerm customers have concerns about the way in which the product was purchased, even if it has since lapsed, we will reimburse the full amount of the premiums they paid and cancel the policy if it hasn't been canceled already. We're in discussions with our regulators and other constituents, and we'll respond to their inquiries and requests for information. Because our review is ongoing and there's litigation related to the matter, we're unable to provide any additional information regarding this specific topic.
With that, let me turn the call over to Rob to discuss our financial guidance.
Thanks, Steve. Picking back up on the presentation, Slides four and five set out some key considerations and sensitivities at the business unit level that affect how we think about 2017 results. As many of you are aware, we don't provide guidance at the segment level or specific outlooks for sales or flows, which can vary from one period to another. While I don't plan to go into detail on the potential impact of the items we've shown, we thought these points might be helpful as you think about your own models in the context of our guidance. I won't cover each of the points, but let me give you some of the highlights. In international insurance, our focus on death protection products with returns largely driven by mortality and expense margins helps mitigate exposure of results to interest rates.
We've taken steps to reprice or in some cases suspend sales of products that are most affected by low and negative rates in Japan, essentially yen-based products with higher cash value structures. We have a less favorable hedged exchange rate for 2017 yen earnings relevant to 2016. Using results for the nine months ended September 30th, 2016 as a proxy, segment earnings would have been about 2% lower. Due to our significant sales of non-yen products, we expect the impact on future results from a less favorable currency exchange rate to be modest. We are continuing to target low single-digit growth of our Life Planner counts in Japan and modest growth for Life Consultants at Gibraltar. In addition, we continue to build out third-party distribution.
In individual life, we expect to continue our diversified product strategy, targeting sales of roughly one-third Guaranteed Universal Life, one-third term, and one-third other products, including Variable Life. In group insurance, we are benefiting from our multi-year underwriting efforts, especially in disability, and we are expanding our market segment focus to include mid-market clients. We continue to target an 87%-91% benefit ratio for the combined group life and disability business. We expect to build on the revenue growth we've begun to achieve in 2016 while maintaining pricing discipline going forward. In retirement, we continue to see a strong opportunity to expand our pension risk transfer business, although growth will not be linear given the episodic nature of larger cases. We feel that spread compression and fee compression we've been experiencing in our full-service business are manageable headwinds.
In asset management, we are continuing to build out our multi-manager model, and we expect positive net flows and a stable fee yield. While we are continuing to invest in the business, we are starting to see payback in the form of increased net flows. In the annuities business, the completion of our recapture of living benefit risks from our reinsurance captive and the changes we've made to our risk management strategy have contributed to higher free cash flows and improved stability while also providing an ongoing benefit to results that we would estimate at about five basis points in return on assets, or ROA.
While there is some remaining uncertainty relevant to sales and flows as we work through our distributors on implementation of the DOL fiduciary rule, we are benefiting from the success of our product diversification strategy with our fixed income-based PDI product contributing nearly half of our recent annuity sales. We expect to continue to improve our risk profile and meet a broad range of client needs through ongoing product innovation. Turning to Slide six. Here are some of the key assumptions and considerations that underpin our guidance. Our guidance assumes that the S&P 500 ends 2017 at 2310. This is based on a 6% growth from an average of recent market levels rather than a single point, which we believe is appropriate in light of market volatility.
Our international insurance JPY and KRW earnings are fully hedged for 2017 at JPY 112 per dollar and KRW 1,130 per dollar. Our interest rate assumptions are based on an average of recent forward yield curves, a methodology that we believe is appropriate given market changes post the election. As a benchmark, we assume a 10-year treasury rate of 2.5% at the end of 2017. We are assuming continued investments in business initiatives for product distribution, data and digital innovation, as well as for systems and technology, including items that will have a longer-term payback period. We're expecting an effective tax rate of approximately 25%, which does not give effect to possible impacts of post-election tax reform in the U.S., given the uncertainties of these. Our board has approved a share repurchase authorization for 2017 of $1.25 billion, as mentioned by John.
In thinking about the authorization in relation to 2016, keep in mind that repurchases in 2016 included the redeployment of $500 million of the proceeds of capital released from our annuities recapture, as well as the redeployment of proceeds from our JPY equity hedge. Our 2017 authorization reflects our expectation that about 60% of our after-tax adjusted operating income will become available for deployment over time. As we had mentioned in our last earnings call, we expect to move the evaluation of our dividend level to the first quarter of 2017 to align better with our capital planning cycle. We intend to continue to operate at double A financial strength standards, and we expect our leverage ratios to be within our targets. Turning now to slide seven.
To level set, this slide starts with the results for the trailing 12 months ended September 30th, 2016, and removes the impact of market-driven and discrete items and net unfavorable variances from our average expectations in the key areas we call out each quarter, such as mortality. We've also adjusted the earliest quarter included, the fourth quarter of 2015, for the change in currency plan rates as we moved into 2016, so that the entire baseline gives effect to the 2016 plan rate. This leads to a pro forma baseline of about $9.40 per share. While this should not be viewed as a projection of our full year 2016 results, we believe it provides a useful frame of reference for discussing our 2017 guidance.
Starting from this baseline, we take into account market factors, which include a negative impact of about $0.05 per share from the change in foreign exchange rates, including the hedged rate for the JPY going from 106 to 112. We estimate for 2017 there is a further negative impact of $0.25 to $0.30 per share from the continued low interest rate environment, mainly driven by reinvestment rates on portfolio turnover and by lower investment yields on recurring premiums, net of the benefits from interest crediting rate adjustments. These negative market factors are essentially offset by the impact of our assumed appreciation in the equity markets. We expect continued core growth in our businesses with key considerations I reviewed earlier. We expect to balance our capital deployment between investment in our businesses based on market opportunities and returns to shareholders, including repurchases and dividends.
Putting all this together, our 2017 earnings guidance range for baseline adjusted operating income is $10.15 to $10.65 per share. On slide eight, you can see the estimated impact of our earnings per share from a ±10% movement in the equity markets and a ±100 basis point change in interest rates. In each case, these shocks are viewed in isolation and applied at the beginning of 2017 on top of our existing market assumptions. As shown, a 10% move in the equity markets translates to about $0.20 to $0.25 per share, and a 100 basis point change in interest rates, defined as a parallel shift in the yield curve, translates to about $0.15 to $0.20 per share. We also provided a GAAP balance sheet sensitivity to an immediate decline in our long-term benchmark rate.
If we assumed an immediate reduction of our long-term benchmark interest rate assumptions from 4% to 2.5% in the U.S. and from 1.9% to 1% in Japan, it would result in an estimated day one decrease of approximately 3% in book value based on GAAP, excluding AOCI and foreign currency remeasurement. I would like to caution that these sensitivities are not necessarily linear nor entirely symmetrical and should not be extrapolated over more severe shock levels in either direction. That said, we believe they, along with the business-level sensitivities that we showed earlier, provide a useful frame of reference for some of the key assumptions that affect our results. In conclusion, we believe that our business mix and solid fundamentals will continue to produce attractive financial results, driving solid earnings per share growth, strong cash flows, and attractive returns to our shareholders. Now I'll turn it back over to John.
Thank you, Rob. Thank you very much. We'd like to open it up for questions.
Thank you. Ladies and gentlemen, if you wish to ask a question, please press star followed by one on your touchtone phone. You will hear a tone indicating that you have been placed in queue. You may remove yourself from queue by pressing the pound key. If you are using a speakerphone, please pick up your handset before pressing the numbers. Once again, for any questions or comments, press star and then one. Our first question will come from the line of Erik Bass. Your line is open.
Hi, thank you. Question on your expectations for pension risk transfer activity, do you think that the rise in interest rates is going to have a material impact on expected demand in the market?
Erik, it's Stephen. Thanks for your question. The uptick in interest rates definitely improves funding levels, planned funding levels overall. That's helpful. Actually, we feel that the pipeline is strong, but it's continue to be driven by more fundamental considerations. By that, I mean plan sponsor awareness of longevity risk and desire to manage it and increasing PBGC premiums. We really see those as continuing drivers. We do see right now a trend in the marketplace of a strong desire by plan sponsors to transfer liabilities that are comprised of large numbers of retirees, but each with a relatively small individual benefit. That type of liability is particularly useful to transfer as it mitigates the impact of that portion of PBGC premiums that are assessed on a per capita basis.
We're very pleased to have been supporting United Technologies and being at the vanguard of this trend, with the transaction we've recently announced with them, we see very strong appetite for this type of strategy on the part of plan sponsors. Honestly, we feel ourselves very well qualified to help on that type of strategy because of our service capabilities. The strength and scalability of our service platforms enable us to give the right type of quality of service level to all retirees, even those with small benefits, the type of service that they deserve and that plan sponsors expect us to provide them.
Great. Thank you. I realize that you don't give segment guidance, I don't know if you could help at all talk about the geography of the investment expenses you've discussed and how we should think about those affecting segment earnings.
Erik, it's Robert Falzon. That spending is actually running across our platforms. Actually what you'll find is that there is spending that we've budgeted at the enterprise level for those things that sort of apply jointly across platforms, particularly opportunities that we have to take advantage of the platforms working with each other in the marketplace. Then we have initiative spending that occurs at each of the business levels. We're not going to provide more detail in terms of how it is allocated between each of the individual businesses. I would say that it's to date been focused primarily, or not primarily, the majority of it has been focused within our U.S. businesses, particularly driven by the opportunities we're seeing in the marketplace for those U.S. businesses. We also are making investments in systems across all the enterprises which include our international enterprises.
Okay. Thank you.
Thank you. Our next question comes from the line of Tom Gallagher. Your line is open.
Good morning. First question is just on how to think about longer term impact if the yen continues to weaken. You have the capital hedge, which you should get continued gains from. Would you still expect, if we saw a big move weaker in the yen, let's say toward the JPY 130 to JPY 150 range, that the negative earnings impact should largely be offset by capital that gets released and share repurchase, or is there only a partial offset? That's my first question.
Tom, it's Rob. The yen equity hedge is designed to protect us from further depreciation in the yen. It would do so even to the more extreme levels that you've described. It's a complete hedge, not a partial hedge in response to your question. What I would caveat that with is that obviously we have to harvest the gains on that equity hedge, and then upon harvesting them, we have to redeploy them. We do that in a variety of ways, including stock buybacks, as you mentioned, but also when we have opportunities to do so, in reinvestment in super organic or inorganic growth opportunities. There could be some delay in terms of when we book those gains and when we're able to then harvest and redeploy them.
Over time, you should expect that we're able to protect the returns that we're generating from our Japan business through that equity hedge.
Just a related question, Rob, do you have an update on where that gain stands today overall?
Tom, I can't provide you that number, but let me give you a couple benchmarks that may be helpful to you. If you recall that at the end of September 30th, it was actually in a negative position of around $800 million, and that's when the yen was trading at about 101. The break even at that point in time as of September 30th was 108. When and as the yen appreciated to 108 based on where we were as of September 30th, that $800 million would have become a neutral, and so that any depreciation in the yen beyond 108 then puts that into a gain position.
That's helpful. Last question is how do we think about your current SIFI designation post-election? Should we be considering that you might actively pursue being de-designated? If that's the case, should we think about what process or procedures are available to you if you are going to pursue a de-designation?
Yeah, this is Mark. Let me start with our process issues. Just to remind you that we come up for consideration of re-designation every year, every year as part of that process, we have the same
option to pursue this in court that we had when we were originally designated. As we've said, right now, at that process level, we're waiting to see what happens with MetLife's case. We'll learn from the outcome there, and we'll learn from the opinion, and we'll consider the right path for us, again, in the context of that part of the process, as things develop over the next six months or so. I would add that every year when consideration of our redesignation comes up, we repeat our case that we don't believe that we satisfy the criteria for being designated as systemically important. Our case is familiar and being heard. Beyond that, in terms of the current context for regulation, I guess there are a few moving parts. One is Dodd-Frank and SIFI designation.
On that front, I think the macro point that we may see reconsideration of the burden of regulation on the economy and the burden of regulation on individual companies is something that we're going to be paying very close attention to. The consideration as it relates to specific issues like SIFI designation and managing systemic risk or Department of Labor standards, will also be important. The way in which this shakes out is highly uncertain. We could see legislative changes that impact Dodd-Frank dramatically. We could see legislative changes that impact Dodd-Frank more narrowly, but one thing that's out there is the consideration of the elimination of such a thing as a non-bank SIFI.
We also could see changes in implementation as it relates to either FSOC generally or the Secretary of Treasury's role as the leader of FSOC, and possibly ultimately as well, changes in implementation with respect to Federal Reserve supervision and regulation. There's a wide range of the way in which things can develop that would impact us as it relates to designation as a SIFI and regulation and supervision that goes along with it. Maybe I'll ask Steve to comment on Department of Labor while we're on this general regulatory topic, but my summary on SIFI is that we have our process level in the works, which we've talked about before, and possibly some other things to consider as we see developments over the next six months or so.
Thanks, Mark. Tom, I'd just add that we're well aware of discussions about the Department of Labor fiduciary rule. Perhaps some anticipation in the marketplace of the possibility of a delay in the implementation of that rule. We'll see how that plays out. I just want to emphasize that we are ready for April 1 implementation of the rule. I'd also comment that most of our spend in preparing for that rule has been around certain types of data gathering infrastructure, data reporting infrastructure, and we believe, honestly, that that's a spend that will serve us in good stead no matter what the actual regulatory outcome is. Again, to close where I started, we're ready for April 1 implementation.
That's really helpful, guys. Mark, if I could just ask a follow-up to something you said. I think this is a very big question for you, certainly for AIG. If there is an elimination of non-bank SIFI, kind of broadly here, what would that mean for you? I think in the past you've said you're not necessarily holding an explicit capital buffer, clearly your expenses would probably go down. What do you think that would mean for you if that comes to pass?
Let me make a comment, and then I'll also ask Robert Falzon to comment on it. It wouldn't mean anything with respect to capital. We've said before that we believe that we're very well managed with respect to aligning capital and risk. We're extraordinarily strong in terms of our loss absorption capacity, as well as the various metrics related to measuring either GAAP or statutory capital, or more importantly for us, maybe economic capital as well. With respect to expenses, group supervision is an evolving theme in other arenas besides SIFI and the Fed. We have New Jersey as group supervisor and evolving work on group supervision at the state level in the U.S. We also have evolving international work on various aspects of supervision, now including designation as globally systemically important and also internationally active.
Within the various dimensions of things going on internationally is work on supervision, kind of highlighted by ComFrame and the Supervisory College approach. Aspects of work now going on internationally on resolution and recovery, and continuing work going on internationally on capital standards. There are four or five things happening on the international front that we also have to consider. This is kind of a long way of saying that SIFI or no, there is a group supervisory environment in which we're going to be operating going forward. I'll ask Rob to comment on expenses, but I want to make sure that we're not thinking that if SIFI goes away, the whole world changes tomorrow morning. We've got other moving parts around the regulatory and supervisory environment for us.
Tom, with regard to the more narrow question on the expenses, we disclosed that our enhanced supervision-related expenses last year were $100 million. That same number through September 30th of this year was $100 million on a year-to-date basis. I would only repeat what Mark said, which is that some component of that is really related to the activities and systems around consolidated supervision or group level supervision, and that not all of that goes away, which should, under some circumstances, cease to be Fed-regulated because it would need to support group supervision as it would come from other places.
Okay, thanks guys.
Thank you. Our next question comes from the line of Ryan Krueger. Your line is open.
Hey, thanks. Good morning. I guess while we're on the topic of the election impact, do you have any pro forma tax rate sensitivities you could provide us if the base rate is reduced to 20% or 25% or something in that magnitude?
Ryan, it's Rob. I'm not sure I entirely understand what you're asking. Let me take a shot at it, and if I don't answer it appropriately, come back at me again. First of all, we're not providing sensitivity analysis around it because there are just far too many moving pieces, and far too much uncertainty around what, if anything, is going to occur there. Our effective tax rate for the upcoming year is at 25%. That's one data point. Recognize that that's a combination of our effective tax rates outside the U.S., which is almost half our business, and then within the U.S. for the remainder half of our business. Within that, it's not just a matter of the marginal tax rate, but all the other pieces that go around that.
Our effective tax rate in the U.S. is a function of DRD and tax advantage investing we do, and a number of other items as well. You have to pay attention to the full landscape of things that could change. What I would point out to you is if you look at our balance sheet, what you'll see is that there's a tax liability, including a DTL in there, deferred tax liability. To the extent that taxes are lower from a balance sheet standpoint on an effective basis, once you run through all of that math, think about it as that would be from a balance sheet standpoint, a positive thing. I don't want to get carried away with that because we'd have to think through income and product implications of tax reform as well.
Okay. Yeah, understood. I know it's a moving target. I guess second question was on share repurchase. The $1.25 billion is a little bit below the kind of original pace you came into 2016 with, before you did the captive redomestication. I was just wondering if you could provide any color on why this reduction.
Yeah, Ryan. Going back to some of my opening remarks, what I'd point out to you is that the amount we came into, which I think you're referring to is the billion and a half that was authorized for 2016, which was before we increased it by a half a billion dollars for some portion of the proceeds coming out of our annuities recapture. That billion and a half was an increase from $1 billion the year before. That half a billion dollar increase was really driven by two items. One, it was an increase in our expected cash flow that we had indicated was going from 50% to 60%, so more distributable earnings coming out of our AOI.
Secondly also, that we had a significant amount of gains that we had harvested from our yen equity hedge, and that in order to protect the returns coming out of Japan, we were going to need to redeploy that. That half a billion dollar increase off what we had done in 2015 was a reflection of both those. What we've articulated to you in the billion and a quarter this year is just the one component of that. That is the amount of buybacks that we think is supportable in conjunction with our dividends coming just out of the 60% of our free cash flow. We will continue to look during the course of the year at opportunities for redeployment of capital capacity we have, both from yen equity hedge harvesting to the extent we have that, and from our ongoing balance sheet strength.
Got it. Thank you very much.
Thank you. Our next question will come from the line of Jimmy Bhullar. Your line is open.
Hi. Good morning. I realize your equity market assumptions, it seems like it's fairly conservative given where the S&P is right now, but can you give us some color on what you're assuming for non-coupon investment income, either directionally versus this year or magnitude-wise, how much higher or lower are you assuming that it'll be, versus what it's been in the past few quarters?
Jimmy, what we assume in our forecast is that our alternatives portfolio will produce its expected long-term rate of return. As you'll recall, on an AOI GAAP basis, that's about a 5% return on that portfolio. That works out to be somewhere between $100 million and $120 million a quarter that you would expect on a normalized basis, given the portfolio as it was constructed as of September 30th. Recognize that we're constantly adding and subtracting from that portfolio, that number could change a little bit, but the forecast includes an expectation of producing long-term returns.
On the individual life, it seems like the benefits ratio has gone up in the past couple of years. Not sure how much of that is just mix of business versus maybe poor results. Have you changed your assumption for just margins in that business? I realize you've made some pricing changes, though.
Jimmy, you're talking about the individual life benefit ratio?
Yes. Exactly.
Going up, did you say?
Going up, yeah.
Yeah. Recognize that what we've called out in each quarter is that we've had mortality that we think was outside of what would be our normal expected mortality experience. We've called that out for you in each quarter, and I think, if you look at our benefit ratios adjusted for that adverse experience, then you would find that they would be more normal and consistent with our expectations. We've had a couple of quarters of adverse mortality, but we think that there's nothing systemic there, and that it is not indicative of any long-term change to our expected mortality experience.
Okay. Just lastly, is it fair to assume that as of right now, you don't have any reserves for any potential settlements or charges or fines that you might incur related to the Wells Fargo issue?
The Wells Fargo issue broke in this quarter, Jimmy, prior to this, we would not have anticipated that event and therefore would not have reserved anything.
Okay. Thank you.
Thank you. Our next question comes from the line of Michael Kovac. Your line is open.
Great. Thanks. Taking the question. Wanted to quickly go through what you'd provided on slide eight related to the potentially lower interest rate environment. Is that on a GAAP basis? And if you have any numbers on the statutory basis as well.
It's Rob. Yes, the answer to I'm sorry. First of all, let me make sure I'm clear on what you're asking. You're referring to the book value impact on the lower part of that slide, or you're referring to the plus or minus 100 basis points?
The book value impact.
Okay, that is on a GAAP basis. If you looked at that on a statutory basis, there would not be a significant difference in terms of expected outcomes. Remember, from a statutory standpoint, that the interest rate sensitivity is largely already captured in our AAT testing, and therefore, to the extent that there are incremental or residual adjustments we would have to make on a statutory basis as a result of lower interest rate expectations, we'd fully be able to absorb that within our existing capital capacity. We're not looking at anything in the way of a material outcome that would result from that assumption of reversion rates applied to our statutory books.
That's helpful. One as it relates to the annuity business more broadly and the DOL. We've heard others talk about product innovation over the course of the last several months. I'm wondering if you have any thoughts on detailed on new product rollouts either in anticipation of the rule or more broadly, shifts in the annuity marketplace?
Michael, it's Steve. I'll address your question. We definitely have plans in the course of the year to continue our strategy of product diversification that we've been pursuing over the past couple of years. As Rob mentioned, PDI, introduced a couple of years ago, now represents fully half our sales, and that actually is kind of very much in the lead of a move towards products where the benefits are simpler to communicate and somewhat lower cost in terms of the price point as well. We'll continue that effort in the course of 2017. We have plans to introduce product in that context and in continued pursuit of that diversification strategy. We also have plans to continue to kind of refine the fee-based product that we already have in place, and to make it more fully effective in the marketplace.
Like I say, we've been at the diversification path for a couple of years, and we see it as something that is very much where customers want to go, and we want to provide solutions in that context. We really see this trend, in our mind, as largely independent of Department of Labor considerations. We see this as a way to provide a wider range of solutions in a way that we're providing more solutions to clients and helping to diversify our own risk.
Thanks. That's helpful.
Thank you. Our next question will come from the line of Humphrey Lee. Your line is open.
Thank you. Good morning, and thank you for taking my questions. My first question is related to the investment expenses that you are planning to incur. You mentioned that some of those will have a longer payback period versus some of your typical kind of expense investments. How should we think about what portion would have a longer payback period versus those who have a more typical payback period?
Humphrey, I don't think I can give you a breakdown in sort of the duration of the investments and the payback periods on those. What I would say is that we've been at this for a couple of years. When we first articulated this increased level of spending, we said that it would be sort of a three to five-year horizon that we would expect that spending to continue, and that over that period and subsequent to that, we would expect the payback on that, and then for that level of spending to begin to return to a more normal level of investments. The payback actually varies fairly dramatically by business. A number of the things that we've been doing within our investment management business have actually resulted in rather fast paybacks.
We've also undertaken certain initiatives across our businesses for which we've gotten paybacks, and in fact, those paybacks have been how we've been able to finance many of the initiatives in a way that we've continued to be able to show growth in our earnings. So what you see is a fairly attractive earnings growth rate trajectory going from 2016 to 2017 per our guidance. That's despite the fact that we continue this level of investment spending, and that's coming as a result of certain businesses like investment management beginning to realize some of those benefits, and because some of that spending has resulted in reduced expenses across the platform that have allowed us to support the initiatives.
Got it. Another question. I understand the investigation with the Wells Fargo relationship still an ongoing investigation, and there's probably not much you can really share at this moment. How should we think about the potential outcome of that investigation? Would that affect your kind of existing variable annuity reinsurance relationship with them in any formal way?
Humphrey, it's Steve. I'd just address your question on a broader basis regarding kind of the full context, the broad context of our Wells Fargo relationship. As you'd expect, like a number of insurance companies, we've done business with Wells Fargo in a variety of different institutional and retail capacities across our company over a multi-year period. To put this in context, if you consider the full extent of our third-party sales across all product lines, I think you could kind of bring the reinsurance consideration into the context of this, looking at the relationship on a more comprehensive basis. If you look at it through the lens of total third-party sales across all product lines, no single third party represents a disproportionate amount of our sales volumes. As for the reinsurance, I think that's been pretty much a separate and discrete conversation with them.
Okay. Thank you.
Cynthia, we have time for one more question.
Certainly, that will come from the line of John Nadel. Your line is open.
Thanks for getting me in under the wire here. Two questions. Should we be taking away from the dialogue around investment spending that 2017's level of investment spending, at least planned, will be higher than what you've been doing in 2016, at least on a run rate basis?
John, it's Rob. What we've built into guidance is that the level of initiative spending that we've been doing in 2016 would continue into 2017 on a net basis. Again, net basis meaning some of what I described in response to Humphrey's question, that some of our investment spending is being supported by savings that we're already realizing.
Okay. In terms of swing factor on a year-over-year basis, we shouldn't expect that to have an impact.
Correct.
My second question is, recognizing that maybe the timing of the end of October letter, I think that sort of dictates some of the assumptions you need to use for asset adequacy testing, relative to the big move in rates we've seen very recently. Should we expect that there's any significant impact on a statutory basis from sort of additional reserves you have to put up?
You're referring specifically to AAT testing in that question, John?
Yes.
AAT testing has lots of moving pieces to it. Included in those moving pieces are assumptions, our assumptions with regard to the blocks of business that we have, and included in that, obviously, are also interest rates. What I would say is that, one, we did our assumption update in the second quarter of this year. What you saw from a GAAP standpoint on that was that was generally a positive outcome from the assumption update. Directionally, you would expect that that would have the same sort of an outcome with regard to AAT testing. Two, that when we did our AAT testing at the end of last year, the 10-year was at about 2.25, 2.27. Obviously, if interest rates are higher than that, directionally, that would also correlate with a lower AAT.
There are a lot of moving parts, and I would not want to get ahead of my actuaries with respect to how this is gonna turn out at the end of the year.
Okay. Just somewhat relatedly, and maybe it's a little bit of a tangent, but as things have progressed on the NAIC Oliver Wyman study, and I guess it's moving to sort of another phase here, any updates on your views or expectations there?
No, John, I think we would reiterate that which we said in the third quarter call, which is that what came out of the Oliver Wyman study was entirely consistent with the way in which we implemented our recapture. We don't see anything in that would otherwise give us pause with respect to how we've done that and the way in which we've done that with our New Jersey, Arizona, and Connecticut regulators. I would say that the industry has concerns around some of the details that were in that Oliver Wyman study, not all of which were necessarily proposals for changes, and we are engaged with the industry in trying to get to some of the more granular points around how that may ultimately be implemented by the NAIC.
Going back to my original point, we don't see anything there that causes us any sense of alarm.
Rob, we've had a few companies talk about the sort of capital differential, or maybe it's a reserve differential between the CTE 95 level, which I think is more of a rating agency type level versus the CTE 98. Have you guys quantified that? If not, could you?
Recall, John, that we hold to CTE 97 over adverse market or moderately adverse market circumstances. For the way in which we're holding capital effectively, if the ruling comes out that ultimately the CTE 98 is where the NAIC lands, consistent with what's bracketed in the Oliver Wyman study, we don't think that that presents any particular challenge given that while we're at CTE 97, it's sort of a forward look under somewhat stressful conditions such that we would continue to hold CTE 97 under those moderately adverse circumstances. I don't have a quantification for you other than to say that we're well above the CTE 95 and would not have an issue with complying with CTE 98.
That's helpful. Thank you so much.
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