Ladies and gentlemen, thank you for standing by, and welcome to the first quarter 2016 quarterly earnings call. At this time, all participants are in a listen-only mode. Later, we will conduct a question-and-answer session. Instructions will be given at that time. If you should require assistance during today's call, please press star then zero. As a reminder, this conference is being recorded. I would now like to turn the conference over to your host, Mr. Mark Finkelstein. Please go ahead.
Thank you, Christy. Good morning, and thank you for joining our call. Representing Prudential on today's call are John Strangfeld, CEO; Mark Grier, Vice Chairman; Charlie Lowrey, Head of International Businesses; Steve Pelletier, Head of Domestic Businesses; Rob Falzon, Chief Financial Officer; and Rob Axel, Controller and Principal Accounting Officer. We will start with prepared comments by John, Mark, and Rob, and then we will answer your questions. Today's presentation may include forward-looking statements. It is possible that actual results may differ materially from the predictions we make today. In addition, this presentation may include references to non-GAAP measures.
For a reconciliation of such measures to the comparable GAAP measures and a discussion of factors that could cause actual results to differ materially from those in the forward-looking statements, please see the section titled "Forward-Looking Statements and Non-GAAP Measure" of our earnings press release, which can be found on our website at www.investor.prudential.com. John, I'll hand it over to you.
Thank you, Mark, and good morning, everyone. Thank you for joining us. While our underlying fundamentals in Q1 remained strong, we were buffeted by market headwinds and our first quarter results trailed our expectations. This quarter's operating earnings per share of $2.26, which excludes market-driven and discrete items, is below the $2.65 we reported in the first quarter of 2015. Our annualized return on equity for the quarter was a little over 12%, or modestly below the 13%-14% that we target across the cycle. This, of course, will fluctuate on a quarterly basis. At an overall level, we produced solid core results. However, the adverse impact of weaker non-coupon investment results, lower average equity markets, and foreign currency headwinds drove the year-over-year decline from the particularly favorable results of a year ago. Mark and Rob will walk through the specifics of our key drivers, results, and financial measures.
I will provide some higher-level observations on our businesses and discuss other matters affecting our operations. Our international business had a solid quarter despite the market challenges I mentioned. We continue to see strong underwriting margins and good core growth at both our Life Planner and Gibraltar businesses. Interest rates in Japan are clearly a challenge, and we have made and will continue to make the necessary product and pricing changes to maintain strong returns. I would highlight that our overall constant dollar sales growth of 12% was driven by U.S. dollar products in Japan, where we have seen an increase in demand. We also completed the acquisition of an indirect ownership interest in AFP Habitat, a leading Chilean retirement administrator. We're excited about the prospects of this business as we expand our international footprint and expect Habitat to produce steady growth and generate stable earnings and cash flows.
It's taken a while to come to fruition, but we believe this investment and relationship is a very good fit for us. Our domestic businesses showed some mixed results, also largely reflecting market factors. At a high level, individual annuities continued to show solid margins, though sales levels have shown some pressure. This reflects our pricing discipline as well as lower variable annuity sales industry-wide. Retirement earnings benefited from another quarter of solid case experience in our pension risk transfer business, which helped mitigate the impact of non-coupon investment returns coming in lower than our average expectation. Let me add that although we did not close any PRT deals in the quarter, we continue to see solid activity in the market. As we've discussed on previous calls, the timing and distribution of PRT transactions can be lumpy.
Asset management earnings were impacted by lower average equity assets under management and lighter earnings from other related revenues, particularly compared with recent trends. We also experienced weakness in third-party unaffiliated net flows, which showed net outflows of about $3 billion for the quarter. To put this in context, however, this follows very strong net flows in 2015 of $22 billion. Our pipeline for new mandates is robust. We remain optimistic on our asset management business and continue to invest in capabilities and distribution, but we're also not immune to some of the industry trends that have impacted active equity management strategies. Life insurance earnings were impacted by adverse underwriting results as compared to our average expectations, which is not unusual for us to see in the first quarter.
This quarter, we experienced both a greater than typical volume of claims as well as a higher level of claims with larger face values. Over time, we've had significant favorable mortality, including since we acquired The Hartford's life business in 2013, which by the way, has proven to be a very good fit. Mortality can vary on a quarterly basis. We continue to show solid sales results, which has benefited from product and distribution actions while maintaining underwriting discipline. Finally, our group insurance business continues to show the benefits to earnings of our multi-year underwriting efforts. We also saw an increase in sales levels following several years of weakness as we benefited from several large case wins in the quarter. Let me also briefly address a few other topics of interest.
In April, we recaptured the variable annuity living benefit riders that were managed in a captive insurer and now house all of our product risk together in our statutory insurance entities. This is a very important initiative that will meaningfully reduce the volatility in our business and increase transparency while not having adverse consequences on our capital flexibility. We will provide more details on this initiative with our second quarter results. The decision in favor of MetLife and their challenge to the FSOC designation as systemically important is a significant development with respect to group supervision and capital standards. We will determine an appropriate path for Prudential as this issue develops, considering other aspects of groups regulation as well. With respect to the FSOC designation, we have options as we go through our annual redesignation process.
The fiduciary standard rule issued by the U.S. Department of Labor addressed some of the concerns expressed by the industry participants regarding the proposed rule and includes several positive changes. We continue to evaluate the new regulation and potential impacts on our business, which also needs to include consideration of how our distribution partners will respond. The final rule gives us a path forward to implement certain changes to our processes and businesses, including in individual annuities, retirement, asset management, and our in-house distribution arm, Prudential Advisors. While there will be challenges with the new rule, we have a history of adapting to change and will continue to support our customers with innovative solutions to meet their retirement needs.
In terms of capital deployment, we returned roughly $700 million to shareholders through dividends and share repurchases in the quarter and funded approximately $530 million for our Chilean investment, all while maintaining strong capital flexibility. To sum it up, while this quarter's results were a little light than we would normally expect, due mainly to market factors, the fundamentals in our business remain sound, and we continue to benefit from a strong balance sheet and capital position that enables us to return substantial amounts of capital to shareholders while continuing to support organic and inorganic growth opportunities. With that, I'll turn it over to Mark.
Thank you, John. Good morning, good afternoon, or good evening, and thank you all for joining our call today. I'll take you through our results, and then I'll turn it over to Rob Falzon, who will cover liquidity, leverage, and capital highlights. I'll start on slide two. After-tax adjusted operating income amounted to $2.18 per share for the quarter, compared to $2.79 a year ago. After adjusting for market-driven and discrete items, EPS was down $0.39 from a year ago. While underlying business performance was solid, the decrease reflected a less favorable macro environment and negative fluctuations in some inherently variable items. Non-coupon investment returns were about $90 million below our average expectations in the quarter. In contrast to a year ago, when we called out a contribution about $60 million above expectations.
Earnings from asset-based fees in our U.S. businesses were about $50 million below the year-ago level, largely reflecting the 5% decline in equity market averages. The contribution from other related revenues in our asset management business, which is largely driven by changes in market values and timing of transactions, was $25 million below the year-ago quarter. We estimate that these three items, together with less favorable currency exchange rates, had a negative impact of roughly $0.40 per share on the comparison of results to a year ago. Now moving on to slide three. Returns on non-coupon investments fluctuate over a cycle by their nature. As we mentioned in our earnings guidance call in December, our long-term expected returns on these investments are 6% to 7%, with our expectation for 2016 slightly below the long-term average.
In our case, included in non-coupon or alternative investments are private equities, hedge funds, real estate, and a $3.6 billion public equity portfolio held mainly in Japan, which includes stocks, mutual funds, and J-REITs. These assets total about $8.8 billion as of March 31st. While these investments diversify our exposure and are a good fit with some of our longer-term liabilities, especially in retirement, the pattern of returns introduces some variability into our results. We've called out significant variances from our average expectations, which provided a fairly strong tailwind in 2013 and 2014. However, returns are below the long-term expected average in the current quarter.
We would estimate that current quarter variances in comparison to our long-term average expectations from returns on non-coupon investments, mortality in individual life and international insurance, pension risk transfer case experience, together with the benefit of favorable revenue seasonality in our International Life Planner business, had a net negative impact on earnings per share of about $0.10. After adjusting for market-driven and discrete items, our EPS of $2.26 for the quarter implies an annualized ROE of 12%. On a GAAP basis, including amounts categorized as realized investment gains or losses and results from divested businesses, we reported net income of $1.3 billion for the current quarter. This compares to just over $2 billion a year ago, which included substantial mark-to-market gains from derivatives and hedging activities. Turning to slide four.
For the current quarter, market-driven and discrete items consist only of our quarterly market and experience unlocking in the annuities business, driven mainly by performance of equities in our customers' accounts, which resulted in a net charge of $0.08 per share. Now moving to slide five. Our GAAP net income of $1.3 billion in the current quarter includes amounts characterized as net realized investment gains of $338 million and divested business results and other items outside of adjusted operating income amounting to net pretax gains of $44 million. Of note, product-related embedded derivatives and hedging had a positive impact of $282 million in the quarter, driven by the impact of applying credit spreads to our gross GAAP liability balance for variable annuity living benefits, which increased due to the decline in interest rates in the quarter.
The gain from other risk management derivatives also came mainly from the decline in interest rates. Impairments and credit losses of $106 million included $85 million from the energy sector, primarily on bonds. Moving to our business results and starting on slide six. I will discuss the comparative results excluding the market-driven and discrete items that I mentioned. Annuities earnings were $381 million for the quarter, down by $42 million from a year ago. The earnings decrease was mainly driven by a 7% decline in policy charges and fees, reflecting a similar decline in average account values, which was largely driven by equity market levels. Higher expenses and lower non-coupon investment returns, which were modestly below our average expectations, also contributed to the earnings decline and to the decrease in return on assets, or ROA, which has fluctuated in the low 100 basis point range. Slide seven presents our annuity sales.
Our sales mix continues to reflect our product diversification strategy, which we enhanced in April of last year with an agreement to reinsure about half of the living benefit guarantees on new business related to our Highest Daily or HD product. This agreement extends through this year. We have also grown sales of our fixed income-based PDI product with some recent small adjustments to enhance product attractiveness. As a result, only about one-third of our sales for the current quarter come with retained exposure to equity market-linked living benefit guarantees. Turning to slide eight. Retirement earnings were $219 million for the quarter, down by $65 million from a year ago. The decrease included a $36 million lower contribution from net investment results. Returns from non-coupon investments were about $40 million below our average expectations in the current quarter versus about $15 million above average expectations a year ago.
The decrease in non-coupon returns was partly offset by the impact of growth of the investment base over the past year. Contribution from case experience was about $20 million below the year-ago quarter, but roughly $20 million above our average quarterly expectation. The remainder of the earnings decline came mainly from lower fees in our full service business and higher expenses. The sequential quarter in earnings and retirement mainly reflects lower expenses compared to the elevated level of the fourth quarter and a greater contribution from case experience than in the fourth quarter. Turning to slide nine. Total retirement gross deposits and sales were $8.7 billion for the current quarter compared to $7.3 billion a year ago.
Standalone institutional gross sales were about $2 billion for the quarter, largely driven by stable value wrap products, compared to sales of roughly $1 billion a year ago, which included about $660 million for a funded PRT case. Full service sales were roughly in line with a year ago. Total retirement account value amounted to $372 billion at the end of the quarter, up by about $7 billion from a year earlier, reflecting net flows of about $5 billion from our full service business and about $2 billion from our institutional standalone business. Turning to slide 10. Asset management earnings were $165 million for the quarter, compared to $205 million a year ago.
While most of the segment's results come from asset management fees, the decrease from a year ago was mainly driven by a $25 million lower contribution from other related revenues, reflecting strong strategic investing results and incentive fees in the year-ago quarter. The remainder of the earnings decline came mainly from lower asset management fees, driven by a 12% decline in average equity assets under management, which reflected both outflows and negative market impact. Higher fees from management of fixed income assets, with a 5% increase in average assets under management, partly offset the equity-driven decline. After $22 billion of net positive third-party flows in 2015, we experienced outflows of $3 billion in the current quarter, nearly all driven by equity strategies. As John indicated, we are seeing the impact of industry trends, including movement to passive strategies as well as some client rebalancing. Turning now to slide 11.
Individual life earnings were $120 million for the quarter, compared to $125 million a year ago. The decrease in earnings was driven by higher expenses, including costs supporting business growth. The net contribution from claims experience was essentially unchanged from a year ago, but about $35 million below our average expectations. Excuse me. Historically, the first quarter has tended to reflect a lower contribution for mortality than the average for the year. The contribution from net investment results was essentially unchanged from a year ago. Lower returns on non-coupon investments, which were about $10 million below our average expectations, were offset by the benefits from a larger investment base. Turning to slide 12. Individual life sales, based on annualized new business premiums, were up $21 million or 17% from a year ago.
Guaranteed universal life sales contributed about half of the increase, mainly from greater sales in selected age bands, where we repriced last year to bring our rates more in line with the market. We continually monitor expected returns and competitor action, and in February, we implemented modest price increases. The remainder of the increase in sales came mainly from variable life, where sales tend to be driven by large cases and are lumpy. Moving now to slide 13. Group insurance earnings were $26 million for the quarter compared to $30 million a year ago. A lower contribution from investment results with non-coupon returns about $10 million below our average expectations, together with higher expenses, more than offset more favorable underwriting results driven by group life. The current quarter total benefits ratio was more favorable than a year ago and within our targeted range of 87%-91%.
Turning to slide 14. Group insurance sales, based on annualized new business premiums, were $311 million for the quarter, nearly double the level of a year ago. Most sales occur in the first quarter, based on calendar year inception. Following the substantial completion of underwriting and repricing actions we've taken over the last few years, we did see an increase in sales of both group life and group disability, including more larger cases. Moving now to international insurance and turning to slide 15. Earnings of our Life Planner business were $410 million for the quarter, compared to $439 million a year ago. Excluding a $30 million negative impact of foreign currency exchange rates, earnings are essentially unchanged from a year ago.
The benefit to earnings from continued business growth was offset by less favorable mortality experience, higher expenses, including nonlinear items such as legal and business development costs, and a lower contribution from investment results, including non-coupon investment returns about $5 million below our average expectations. Mortality experience in the current quarter was essentially consistent with our average expectations, but about $15 million less favorable than a year ago. A concentration of annual mode premium revenues in our Life Planner business results in an earnings pattern that favors the first quarter. We estimate that this benefited current quarter results by about $30 million in relation to a quarterly average. Turning to slide 16. Gibraltar Life earnings were $369 million for the quarter, compared to $395 million a year ago.
Excluding a negative impact of $28 million on the comparison from foreign currency exchange rates, earnings are essentially unchanged from a year ago. Looking at some key components, the benefits to earnings from business growth, including the initial contribution of our investment in AFP Habitat in Chile and more favorable mortality experience in the current quarter, were offset by a lower contribution from investment results of about $40 million. Business growth drove an increase in earnings of about $20 million, with about half from Chile, including above average wise known as the encaje. The contribution to earnings from mortality experience, which was about $5 million more favorable than our average expectations, exceeded the year-ago quarter by about $15 million. Net investment results included returns on non-coupon investments about $20 million below our average expectations in the current quarter, compared to about $40 million above expectations a year ago.
This $60 million variance was partly offset by benefits to spread results, including higher prepayment income and growth in the base of invested assets. Turning to slide 17. International insurance sales on a constant dollar basis were $781 million for the current quarter, up by $86 million or 12% from a year ago. The increase was driven by our Life Planners in Japan and by Gibraltar's bank channel and Life Consultant. About 45% of our current quarter sales in Japan were U.S. dollar products, compared to roughly 1/3 of sales a year ago. Life Planner sales in Japan were up by 15% from a year ago, reflecting a 6% increase in agent count, together with higher productivity and higher average premium size. Gibraltar sales were also up by 15% from a year ago.
Sales from the bank channel increased by 27%, largely driven by a recurring premium U.S. dollar retirement income product and by debt protection products. Life Consultant sales increased by 10%, benefiting from a recently introduced U.S. dollar whole life product that has been popular among clients seeking maximum death protection in early contract years. Turning to slide 18. The corporate and other loss was $312 million for the current quarter, compared to a $253 million loss a year ago. The main drivers of the increased loss are lower investment income, reflecting a benefit in the year-ago quarter from returns on assets from our closed block restructuring that were subsequently deployed in our businesses, and higher expenses, including items such as legal costs which can fluctuate, and lower income from our pension plan following our assumption update at year-end. Now I'll turn it over to Rob.
Thank you, Mark. I'm going to give an update on key balance sheet items, financial measures, and other related areas of interest, starting on slide 19. As of year-end, Prudential Insurance reported an RBC ratio of 484%, with total adjusted capital, or TAC, of $15 billion. While we don't perform a quarterly bottoms-up RBC calculation, we estimate that our RBC ratio as of the end of the first quarter is well above our 400% target. In Japan, Prudential of Japan and Gibraltar Life reported strong solvency margins of 877% and 929%, respectively, as of their most recent reporting date, December 31st, 2015. We expect these ratios to be above our targets as of their fiscal year-end on March 31st. Looking at liquidity, leverage, and capital deployment highlights on Slide 20. Our cash and liquid assets at the parent company amounted to $4.1 billion at the end of the quarter.
The decline of about $1 billion from year-end was driven primarily by our shareholder distributions, debt reduction, and acquisition funding. The excess over our targeted $1.3 billion liquidity cushion is available to repay maturing operating debt, to fund operating needs, and to deploy over time for strategic and capital management purposes. Our financial leverage and total leverage ratios as of March 31st remained within our targets. During the first quarter, we returned roughly $700 million to shareholders, including $375 million of share repurchases under the $1.5 billion authorization for the year. In March, we funded the purchase of our stake in AFP Habitat in Chile with a purchase price of about $530 million. As John noted, we maintained our capital capacity at a level not meaningfully different than what we reported at year-end. Let me provide an update on a few other noteworthy items.
The fair value of our yen equity hedge was about $760 million at the end of the quarter, compared to $1.7 billion at year-end. The decline in fair value is as expected in response to the 7% strengthening of the yen in relation to the U.S. dollar during the quarter and corresponds to an increase in the U.S. dollar equivalent of yen earnings in Japan over time. Expected cash flows from the yen hedge in 2016 reflect scheduled settlements that are essentially unaffected by the change in fair value. While the fair value of our equity hedge declined sequentially, it continued to operate as designed to protect the value of our businesses and the overall return profile against currency moves in our largest overseas operation.
On our energy holdings, our net unrealized loss on the energy sector fixed maturities, excluding the closed block, at the end of the quarter was about $200 million, essentially unchanged from year-end. 83% of fixed maturities were investment grade. To update you on the variable annuity recapture, on April 1st, we recaptured the moving the rider risks into our statutory insurance companies to be managed together with the base contracts. This marks a major milestone in our initiative, which is on track for completion over the course of the year. I'll turn it back over to John.
Thank you, Rob. Thank you, Mark. We'd like to open it up to questions.
Thank you. Ladies and gentlemen, if you'd like to ask a question, please press star then one. If you're using a speakerphone, please pick up the handset before pressing the numbers. Once again, for any questions or comments, it is star one at this time. We will go directly to the line of Erik Bass with Citigroup. Please go ahead.
Hi, thank you. Just wanted to start with a question on Japan, I was hoping you could provide some more color on the sales growth this quarter. For POJ, talk about what's driving the increase in productivity and whether you think sales can continue outpacing Life Planner growth.
Sure. In terms of sales on the Life Planner side, and then if you want, I can do Gibraltar, but sales were up about 15%, and that's half, as indicated before, due to the Life Planner growth of about 6% and then some due to the productivity. The Life Planner growth has really come from the sales manager growth, which is really up 7%. We've talked about that for about the past year, where we've increased the number of sales managers, and that has a lag effect, but then goes to the increase in Life Planners. The real answer is it really is both the productivity and the number of Life Planners that has led to the growth. There's a little increase in premium, but not really that much. It's mainly the Life Planner growth and the solid growth there.
Got it. Are you seeing more competition in non-yen-denominated products given the drop in JGB yields?
We're seeing some increase in competition, but we have such a range of non-yen products, and it's retirement income, it's whole life, it's fixed annuities that we enjoyed a great deal of increase in the sales of the past quarter were in non-yen products. There may be more competition, but we're still seeing significant growth in that area.
Thanks. John, if I could just ask one more. I was just hoping that you could expand on your comment that you have options to challenge your SIFI designation or pursue a SIFI off-ramp. I was just wondering if you could comment on what are the different mechanisms available to you.
Yeah, I think Mark is best to speak to that. Mark?
Yeah. First, with respect to the notion of an off-ramp, that's a pretty vague concept that hasn't really been operationalized yet. I wouldn't be thinking in terms of the options that we might have to reconfigure the company in a way, at this point, that would make an off-ramp a clear option. The reference is primarily to the ongoing designation process, which does involve an annual redesignation, and in the context of the way the annual redesignation works, we retain the ability or the option, if we choose to, following a redesignation decision, to contest that decision and to contest that decision in court. The principal option that's referenced there is the process that we go through every year in redesignation and the fact that options remain open to us as we're redesignated.
Got it. You do have a legal option to challenge a redesignation?
Yes.
Our next question is from the line of Jimmy Bhullar with J.P. Morgan. Please go ahead.
Hi. First on the recapture of the VA captive, are you able to discuss what you expect the capital impact of that to be if there is one?
Jimmy, we expect to be able to cover it more holistically in our second quarter call. I can offer some comments on where we are.
Sure.
We remain on schedule to recapture VA captive, as I mentioned in my introductory remarks. We're doing that in phases, the entire project through 2016. Recall that the first step of that was actually accomplished last quarter when we got the regulatory approval for our statutory framework. The second step is what we've mentioned, which is as of April 1st, we've done the actual recapture of the living benefit rider from the captive back into the seeding companies. We have some remaining steps in front of us. They're around ALM strategy, around some of our hedging strategies, implementation of those, and then operationalizing and reporting around those as well.
I think the important takeaways are that, one, this is part of a broader strategy we have around a priority of reducing volatility in our reported results, and ensuring that the very strong fundamentals that we have in our businesses are being mapped to and visible in our reported financial results. I think in the first quarter, you've seen some of the benefits of that in terms of in our capital numbers in the quarter.
I'm assuming you're not assuming a huge impact. Obviously, you can't give me precise numbers on your capital, otherwise there would have been either a comment on that or maybe a slowdown in buybacks or something else, right?
Well, again, Jimmy, it's a multi-phase, and so simply upon recapture doesn't mean that there's instantaneously the pro forma effect of what we ultimately hope to accomplish with regard to the recapture initiative as opposed to the physical recapture itself. I think what we've said is we can accomplish all of this and we're confident in doing so that there will be no adverse impact to our overall financial resources. In fact, we expect increased financial flexibility as a result of the completion of the initiative.
Okay. Then one for Charlie on Japan. How has the depressed JGB yield environment there caused you to change your strategy for the Japanese business if it has, and the type of products that you're avoiding versus the ones that you're pushing more proactively?
Well, I think it has affected us obviously over time. We've been dealing with low rates for a long period of time. They're obviously lower now than they were before. We have, I think, proactively either eliminated products or lowered crediting rates or commissions, and we've been doing that for some period of time. In the last earnings call, I think I articulated that we stopped selling any single premium life or retirement products in the third-party channels, and we've reduced crediting rates in our other captive channels. We will continue to monitor this very closely. The other way it's affected us, I think, is that we have sold more U.S. dollar products, and we've done that for a couple of reasons. One, as you said, rates are much lower in Japan, so on a relative basis, they're better in the U.S.
Also the appreciation of the yen has led people to think, gosh, with yen, I can buy more dollars, and therefore U.S. dollar products are more attractive. With the suite of a wide range of products that we have in the U.S., I think our product offering is quite attractive. We have, if you will, taken advantage of the lower rates by virtue of the product suite that we offer, and we'll continue to very proactively manage our product mix in order to protect margin.
The JPY-denominated business that's on your books, is that earning your targeted returns or is it a little bit of a drag versus what you had assumed previously?
Well, I think the amount we have on our books is returning what we want. Obviously, we're not immune to negative interest rates, and there's some impact on our margins on the new products we sell. Again, we're looking at those products, and we're lowering crediting rates and commissions, and in fact, eliminating some products that don't meet our hurdle rates.
Okay. Thank you.
Well, this is Mark. Just remember how much of the profitability in Japan is driven by mortality margins and expense margins, not investment returns.
Thank you. Our next question comes from the line of Suneet Kamath with UBS. Please go ahead.
Thanks. Good morning. Rob, I was hoping you could, as you've done in the past, maybe walk us through the capital capacity walk. I think we ended the year at roughly $4 billion. I think you're saying you're kind of still there, but obviously there's kind of pluses and minuses. Can you help us fill in kind of the bridge between the two?
Sure, Suneet. As we've mentioned in the past, our businesses generate a significant amount of capital, and there was no change from that in the first quarter. I think we've provided sort of rules of thumb that are helpful around that, and that's the fact that about 60% of our operating earnings translate into free cash flow. You could think about that while it varies in any given quarter, you could think about that as being a capital-generating capacity in the form of free cash flow. As I said, that's sort of representative of what we would see over a longer term, but also in the first quarter. There were significant capital deployment actions during the course of the quarter. As I mentioned in my introductory remarks, we had about $0.7 billion of shareholder distributions.
That was in the form of both share repurchases, and that's at an elevated level. Recall that we increased our buyback program by about a half a billion dollars at the end of last year for this year. We increased it from a billion dollars to a billion and a half. It was also in dividends. Recall that we also increased that dividend rate by an excess of 20% last year. Those were the distributions. We funded about a half a billion dollars from our Chilean acquisition. That we had already earmarked from our capital capacity that we articulated at the end of the year because it was an imminent transaction. When you think about apples to apples, the Chilean acquisition was already taken out of the capacity number.
The remaining variable was the fact that we reduced our debt by about a quarter of a billion dollars. It was maturing, and we paid that off. As I was thinking about sort of going from year-end to the end of this quarter, that you generated internal capital capacity that was sufficient to fund our shareholder distributions. The M&A activity and strategic investments were taken care of in our prior allocation of capital. You have left the debt reduction, which would be sort of maybe a placeholder for the order of magnitude of change in our total capital capacity from year-end to where we are now.
I guess on the yen hedge, I had thought on prior calls we had talked about some cash payments moving from Japan to the holding company as sort of an additional source of flexibility. But now it seems like you're indicating that there's not a significant change in the timing of those cash flows. I'm just curious why, given the significant strengthening we've seen in the yen, why wouldn't we expect at some point to see maybe cash flowing from the holding company to the Japanese entities?
Good question. Let me sort of bring that up a level and if I can, respond to that a little bit more holistically. First, the hedge is doing exactly what it was designed to do. As and if the yen has depreciated, that has yielded proceeds to us. We've been able to take those proceeds and redeploy them either in the form of share repurchases or in the form of investments in order to restore the ROE that otherwise would have been lost by virtue of the depreciation in the yen. To your point, as the yen appreciates, you get things that could go the other direction. Hedge settlements would go instead of from the Japanese companies to the holding company, they would go the other way. However, the point is that ROE is protected in either direction, and we've actually experienced this in the past.
The higher yen earnings contribute to sustaining our targeted enterprise ROE because what happens is, over time, our yen earnings are higher, it creates greater dividend capacity, and that translates ultimately into greater US dollar dividends coming back to us. When we actually think about that yen hedge, it creates capital capacity when there's a depreciating yen. When there's an appreciating yen, what happens is we have something that I would consider to be more of a liquidity issue, which is we temporarily have to fund the mark on those going down to the Japanese companies. But that ultimately works its way back to us in the form of higher earnings and greater dividends coming back to the holding company.
In terms of that lag, you're not expecting a big liquidity draw on holding company resources until you wait for those higher earnings from Japan to send cash back there? There's a timing issue, but you're not expecting a big change in terms of that holding company liquidity, right?
That would be correct. Two thoughts on that. First, with regard to this year particularly, as I alluded to in my introductory remarks, we actually have locked in our settlements for this year. We have about a half a billion dollars for the entire year of pre-tax gains that are locked in for the year, and in fact, will be coming our way regardless of what happens to the yen rate during the course of this year. That's one. Two, the settlements beyond this year are actually staged out over long periods of time, and that is actually with the intent of trying to match up dividend-paying capacity against settlements that we might otherwise have against those hedges. We're actually very conscious of that in ensuring that it doesn't create a short-term liquidity dislocation.
Thanks, Rob.
I will now go to the line of Ryan Krueger with KBW. Your line is open.
Hi. Thanks. Good morning. I had a follow-up question for Mark on the FSOC potential to legally contest. In terms of your legal right, if you were to contest the redesignation, does that legally only apply to the specific redesignation process, or does it allow you to essentially legally contest the entire designation to begin with?
No, it's the whole designation. Technically, that redesignation is a renewal of the original designation, so we're talking about the same thing.
Okay. Got it. A quick one. Do you have anything you can provide in terms of earnings expectations for the Habitat deal now that it's closed?
I think what we have said is that we closed on March 1st, and that we're very pleased with what we have so far in terms of earnings. Now, one month does not an acquisition make. Those earnings are in part coming from the stable cash flow and the dividends that come up, and part of it is from the encaje. Obviously with the encaje, having invested March 1st, that was a good time to invest given the quarter. We're pleased with the first quarter. It meets our original assumptions and return expectations, and we'll see how it goes from here.
This is Rob. The only thing I'd add to Charlie's comments is that I think as we've communicated, when we made this investment, this investment was accretive to what we viewed to be our hurdle rate ROEs. When you think about the returns that we expect to get on this, you could look at what we've paid for it, think about the ROEs that we expect to generate. That would give you an indication of what would be a sustainable level of ongoing earnings coming out of that investment.
Okay. Got it. Thank you.
Next, we have a question from the line of Sean Dargan with Macquarie Capital. Please go ahead.
Thanks. Good morning. I know the PRT business is lumpy, but can you give us any more color on what you saw there in the first quarter and maybe if anything's changed due to market dislocation year to date?
Sean, this is Steve. I will address your question and thanks for it. We do not see any fundamental changes in PRT market dynamics. We think that the propensity to transact is still very strong. When it comes to interest rates, a big impact on propensity to transact is not just what rates are today, but what is a plan sponsor's expectations about rates in the future. We see increasingly a reduced expectation that rising rates will address the liability. We still see healthy propensity to transact. Obviously, market conditions have, in some cases, impacted funding levels. We have also seen, especially in the large case market that we specialize in, we have seen plan sponsors undertake steps to protect those funding levels through various types of hedging instruments, not with us, but in their investment activities. Like I say, we still see a healthy pipeline.
I will mention that since the close of the quarter, we have announced a longevity deal in the U.K. with Legal & General of less than $500 million. As I say, we still see a healthy pipeline, and when you consider the increasing awareness of the longevity risk, when you consider the rising PBGC premiums, we still see lots of inclination for plan sponsors to pursue this solution.
Okay. Thank you. If I could just ask one about the non-coupon investment income. Other liability-driven investors are rethinking their allocations to the hedge funds given some of the performance issues and the volatility they introduce. I am just wondering if you can give us some color on what your outlook in the medium term for hedge fund allocation is.
Sean, of our $8.8 billion alternatives portfolio, hedge funds are a little over $1 billion of that, so about $1.1 billion. A little bit more than 10% of the portfolio in hedge funds, so not an overweight allocation to that. Within that portfolio, we have got some 40 different funds. They are diversified by strategy, by asset class, geography. They are sources of the alpha that they generate and the level of hedging that they undertake to do. We are actually quite pleased with the portfolio.
We would look at the first quarter results as being something that would be kind of an outside of a couple standard deviations of expectation that normally within a body of distribution around what would be volatility in the market, we would actually expect our hedge funds to mute volatility as contrasted to what you saw across the entire industry, including in our portfolio in the first quarter. We think we have a very carefully designed portfolio that we're actually quite pleased with, and we remain committed to retaining that as a portion of our alternatives portfolio.
Great. Thank you.
Next, we'll go to the line of Eric Berg with RBC. Please go ahead.
Thank you. I have just one question today about the growing number of market participants, and this was referenced earlier, who are selling dollar-denominated investments, both annuities and life insurance in Japan. It just strikes me as curious, and I guess this is more of a question of a cultural rather than a financial nature, but what is it about Japan and Japanese nationals that lead to the interest in these products?
Exposing the customers to FX risk. I presume that in the typical transaction, the customer is not hedging the customer's foreign exchange risk. It's exposed, therefore, to the possibility that down the road, either when the customer retires or the customer dies, the family will receive less money than the customer thought because of a weakening of the yen. The customer's family receives, or customer in retirement receives dollar investments. What's your sense of why the customers are willing to take this FX risk? I guess I'd wrap up the question by saying, I can't imagine if we sold yen-denominated life insurance in the U.S., it would be nearly as successful as your life insurer dollar-denominated products there.
Well, I think the last comment you made is absolutely correct. I think the issue with Japanese consumers is one of having lived with a low interest rate environment for a long period of time and looking at the interest rate differential with the U.S. Yes, you are right, they do take the FX risks. Over time, what they believe and what their experience frankly has been, is that the FX risk is not as great as the interest rate differential, and therefore they're willing to do that. You've seen it with the U.S. dollar product, and you've seen it with the Aussie dollar product. They're very savvy because they'll go back and forth from time to time. Now, most of the product we sell, as Mark suggested, is life insurance based. It's protection based. They buy it for different reasons.
It's not savings products per se. They do look at the interest rate differential and then make decisions accordingly. They have for a long period of time because they've been living in an environment where those differentials in interest rates between Japan and then the U.S. and Australia have been there for a long period of time.
Very clear. Thank you.
Eric and Mark.
Were you going to say something else? Go ahead, I'm sorry.
Also keep in mind that retail investors in Japan don't take a lot of other risks. They're very conservative in saving in the mattress as opposed to buying stocks, for example. This is one place where they just may choose to take risk instead of other places.
Thank you, Mark.
Next, we'll go to the line of Steven Schwartz with Raymond James. Your line is open.
Hi. Good morning, everybody. First, a question on the alternatives. Mark, I think you said that your expected return on your non-coupon investment portfolio is 6%-7%. Is that pre-tax or after-tax?
Pre-tax.
Pre-tax.
Okay. That strikes me as awfully low compared at least to how other companies talk about the expected returns on their alternative investment portfolios. I was hoping maybe you could touch on that. Maybe it's mixed or something like that. Maybe it's Japanese equities. I don't know.
Steven, it's Rob. I'd say a couple things in response to that. One is, those are our actuarial expected returns as opposed to what our portfolio managers would expect. I would think our portfolio managers would concur with you. Their expectation is actually to produce a higher return. When we build in our returns for budgeting and forecasting purposes and for purposes of communicating to you, we think about level of conservatism in that, those are the numbers that we express. That would be one. Two, yes, if you look at the overall composition of our portfolio, you would say that it's got a conservative tilt to it. As I mentioned before, with respect to the hedge funds, our expectation with the hedge funds is to mute volatility as opposed to produced outsized returns.
Similarly, with respect to what we've got in our private equity allocation, which is about a quarter of the total alternatives budget, we look at that as we don't take what you would consider to be sort of venture capital risk in our private equity, but rather more traditional private equity, which would be further in on the risk spectrum.
Okay. Thanks for that. Moving on to asset management. I was interested, of the $166 billion, I think it was, of AUM that you have in equities, could you discuss maybe the split between what may be considered beta products as opposed to alpha products?
Steven, this is Steph Pelletier. I'll address your question. I would say that if you look at our equity business overall, it is a business of active management. I would characterize it in two buckets. First is our quantitative management. That's an area that we've been building out significantly over the past several years. We look to continue to do so. The other bucket is our fundamental equity management business, in particular U.S. large cap growth. Increasingly over the past couple of years, we've been seeking to diversify that fundamental equity management business, also including areas such as international and global. We don't look to intend to get straight into the passive space.
Yeah.
We think that's a space very well spoken for.
Hey, Steve?
Yes.
If I can interrupt because I may have put the question wrong. I guess what I really wanted to know is how much of that business do you think is at risk of moving to a beta strategy?
Well, we have seen the pressure especially on actively managed equities. Like I say, we don't intend to address that challenge by going head-on into pure passive products, we look to diversify our active management capabilities, both on the quantitative side and on the fundamental side.
Okay.
We're investing in the business to achieve that.
Okay. I appreciate that. Thanks, guys.
Sure.
Thank you. We'll now go to Randy Binner with FBR Capital. Please go ahead.
Hey, thanks. I guess I'm going to ask the DOL question. It hasn't come up yet. We've had calls with some other folks this morning, and the basic concept that I think we're all trying to get to is if you are primarily a manufacturer of variable annuities, which is the case, and you look forward to when you're going to be selling these VAs post-implementation of the DOL rule, that would be under the best interest contract. It's kind of a two-part question. One, do you think that the distributor, rather than manufacturer, would be the one who is a party to the legal risk of the best interest contract? If that is the case, can you characterize your conversations with your distribution thus far and kind of how constructive they are so far on being able to sell VAs under the BIC?
Randy, it's Steve again. I'll address your question. I'm not going to get into an apportionment of legal liability. I'm sure you understand that. I would point out that manufacturers will have a responsibility to perform certain processes and provide certain information to distributors so that they can fulfill their obligations under the contract. We are making the necessary preparations to do exactly that. I think if I could, just to address some other questions that I know have come up on other calls regarding the DOL, just to make some broader comments. The final rule does contain some meaningful improvements. We still think it creates significant challenges and changes in the industry as a whole. It can increase compliance costs, although I would say that that's not an overly consequential matter for a company of our size.
It can also contain, as you were pointing out, increased exposure to legal claims. We think it's more important than ever to really avoid those unintended consequences that we spoke about last summer on Investor Day and ensure continued access to education, advice, and product solutions. That's the position we've taken consistently, and we'll continue to do so. If you look at our three businesses most impacted on Prudential Advisors, and here I'm more talking about differences between the original regulation and the final one. If you look at Prudential Advisors, the final rule did make the process for obtaining the required contract under the BIC exemption less onerous than it originally was, and it also permits us to deal with, on a negative consent basis, with clients who had accounts established prior to the beginning of 2018. That's helpful.
The final rule also clarified how proprietary products can be sold to IRA owners, providing we address some significant new requirements. Again, that's useful. For Prudential Advisors, compliance and business processes will change, and we'll be ready for those changes. We fully expect that unit to continue to play an important role in our distribution strategy. For annuities, and you touched upon this in your question, Randy, the DOL did attempt to clarify the circumstances under which higher compensation for the sale of more complex products requiring more upfront time by the advisor is permissible, so long as that compensation is reasonable, and what that means will play out over time. The final rule did not include an exemption that would have favored lower cost products such as index funds over higher cost, higher value products.
While these changes could help mitigate adverse impact on VA sales, we do want to emphasize, we think it's really still premature to offer any predictions as to what that impact will be. That's going to play out over multiple years through the lens of advisor behavior and firm behavior. We'll see what that proves out to be. For Prudential Retirement, the third business I'd mentioned, the final regulation does contain meaningfully clearer delineation between investment advice and investment education, and we think that delineation will allow us to continue to offer our asset allocation services to DC plans. It's come up on other calls about the sales exception for plans with 100 and more participants. In the original rule, that was changed to a $50 million or above in assets exemption or threshold.
The bulk of our business focus is in the larger case market, we expect the vast preponderance of our business to continue to qualify for either exemption threshold.
Thank you. That was really comprehensive. I just wanted to clarify, though, as the manufacturer, while you have a lot of responsibilities as you laid out, you are not the signatory, if you will, to the BIC. That rests with the distribution of the financial institution.
They're the signatory to the BIC, but as I say, manufacturers will be expected to do certain things and provide types of information to support the distributor in fulfilling those obligations.
All right. Thank you very much.
Christy, we have time for one more question?
Yes, we do. We'll go to the line of Humphrey Lee with Dowling & Partners. Please go ahead.
Good afternoon. Thank you for taking my question. Just one follow-up question related to the other related revenue in asset management. I understand that that line item could fluctuate from time to time. At least my understanding is, in the first quarter, at least one of your peers kind of talked about there's a slowdown in commercial mortgage loan origination activities, and that hurts their kind of similar type of fee revenue for the quarter. Do you see something similar in this quarter? If so, how's the second quarter to date kind of trending in terms of commercial mortgage loan activities?
Humphrey, this is Steve again. That really wasn't a factor in our ORR results, our other related revenue results. The year-on-year decline that Mark cited in his review was really driven by performance and incentive fees, which were impacted by market turbulence, and by strategic investing, which was also impacted by market turbulence.
Got it. Then, in terms of kind of thinking about it on a normalized basis, again, I understand you don't provide us explicit guidance for this line of items, but what would be a more kind of trendable or kind of more sustainable level, at least for modeling purposes?
Humphrey, I would just describe the recent trend, the recent quarterly trend in this category has been about $30 million.
Okay. Got it. Thank you.
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