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Executives

Jim Sjoreen - Executive Officer of Investor Relations

Dennis R. Glass - Chief Executive Officer, President, Director, Chairman of Committee On Corporate Action and Member of Executive Committee

Randal J. Freitag - Chief Financial Officer and Executive Vice President

Analysts

Steven D. Schwartz - Raymond James & Associates, Inc., Research Division

Jamminder S. Bhullar - JP Morgan Chase & Co, Research Division

Suneet L. Kamath - UBS Investment Bank, Research Division

Erik James Bass - Citigroup Inc, Research Division

A. Mark Finkelstein - Evercore Partners Inc., Research Division

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

Thomas G. Gallagher - Crédit Suisse AG, Research Division

John M. Nadel - Sterne Agee & Leach Inc., Research Division

Lincoln National (LNC) Q1 2013 Earnings Call May 2, 2013 10:00 AM ET

Operator

Good morning, and thank you for joining Lincoln Financial Group's First Quarter 2013 Earnings Conference Call. [Operator Instructions] At this time, I would like to turn the conference the Senior Vice President of Investor Relations, Jim Sjoreen. Please go ahead, sir.

Jim Sjoreen

Thank you, operator. And good morning, and welcome to Lincoln Financial's First Quarter Earnings Call. Before we begin, I have an important reminder. Any comments made during the call regarding future expectations, trends and market conditions, including comments about liquidity and capital resources, premiums, deposits, expenses and income from operations are forward-looking statements under the Private Securities Litigation Reform Act of 1995. These forward-looking statements involve risks and uncertainties that could cause actual results to differ materially from current expectations. These risks and uncertainties are described in the cautionary statement disclosures in our earnings release issued yesterday and our reports on Forms 8-K, 10-Q and 10-K filed with the SEC.

We appreciate your participation today and invite you to visit Lincoln's website, www.lincolnfinancial.com, where you can find our press release and statistical supplement, which include a full reconciliation of the non-GAAP measures used in the call, including income from operations and return on equity, to their most comparable GAAP measures.

Presenting on today's call are Dennis Glass, President and Chief Executive Officer; and Randy Freitag, Chief Financial Officer. After their prepared remarks, we will move to the question-and-answer portion of the call.

At this time, I would now like to turn the call over to Dennis.

Dennis R. Glass

Thank you, Jim, and good morning, everyone. Operating earnings per share was up over the prior quarter, but operating earnings were down due to high mortality in Group Protection and Individual Life and low alternate investment earnings. These will be covered in more detail in a moment.

Looking through to the drivers of long-term earnings improvement, we had a very strong quarter, including account value growth in every business with total account values at a record $186 billion. Sales results up in every business segment after solid price increases in our Group, Individual Life and Annuity businesses. Expense management producing no increases year-over-year, reflecting actions taken throughout last year and the repurchase of $100 million of our shares. Reflecting these results, we ended the quarter with operating revenue growth of 4% and book value per share growth of 14%.

Let me now share highlights from our underlying segments starting with Individual Life. First quarter sales in Individual Life of $150 million increased 23% from the prior year, as we maintained our pivot toward product solutions that achieved higher returns in a low-rate environment. Guaranteed UL sales were down 26% from a year ago and now represent only 18% of total Life sales. Sales of our Pivot products, which include Variable Universal Life, Indexed Universal Life and term insurance, were up 82% from the same quarter last year. They also now comprise more than half of our total life sales, closing the quarter at 51%. Crossing the 50% threshold is significant for us and serves as an excellent example of our ability to successfully deliver on the Pivot strategy we have discussed with you in the past. We remain focused on improving and expanding our product line as evidenced in the first quarter by the successful launch of our new Treasury Indexed Universal Life product. Launching this offering bolsters our already strong portfolio of solutions and affirms our position as an industry leader focused on bringing innovation to the marketplace. We will keep reshaping and repricing products with changes in the second quarter planned for Guaranteed UL products and MoneyGuard. Underpinning it all remains the depth and proficiency of our distribution teams, which enable us to keep driving the right mix of sales.

Turning to our Annuity business. Strong equity markets and positive net flows advanced ongoing growth in account values that collectively contributed to a very positive result in the first quarter. Annuity sales of $3.2 billion drove positive net flows of $885 million, up from $293 million in net flows a year ago. On the product side, our risk-managed funds strategies remain an effective way to embed volatility management inside client accounts and reduce hedging costs. Of the $2.9 billion in sales of variable annuity, gross profits in the quarter, 78% of the deposits included a guaranteed living benefit rider built on our risk-managed fund strategies. And 9% of the deposits had no living benefit guarantees at all.

In the second quarter, we will expand our risk-managed fund strategies further. Also, we continue to improve VA margins. Importantly, we are reducing income benefits on the bulk of our joint survivorship living benefit riders. These riders comprised roughly half of all the guaranteed living benefit rider elections in the first quarter. This action is likely to flow sales for the balance of the year, though second quarter will be somewhat elevated as product changes are implemented.

We remain comfortable with our approach to the Annuity business and we will maintain our consistent presence in this space. Our focus remains not on taking market share with low-price offerings, but on selling solutions valuable to our customers that help Lincoln achieve good returns and manageable risks.

In Group Protection, the first quarter sales of $71 million increased 6% from the prior year. We remain focused on voluntary market where we grew sales by 61%. Looking back to 2012 and the most recent market data, we saw consistent market share and rankings year-over-year, and we finished in the top 5 to the life -- Life and Disability product lines by case count. Our field force grew by 13% from the prior year end as we continue to invest in the group business to support the 3,400 brokers who currently sell our products. With this growth and this group of brokers, we expect to grow sales.

In line with what we have shared on the last few calls, we expect nice pricing to firm in the market, particularly in the disability line where we have seen some positive progress over the last few quarters. Given the market-wide focus on profitability in the group space, we will remain diligent in our focus on overall profitability of new sales and renewal actions and our expectation is that all of the steps we are taking in this business will generate profitable growth.

In Retirement Plan Services, it was another excellent quarter for all leading indicators, highlighted by strong total deposits, solid retention and positive net flows. First quarter deposits of $1.7 billion were up 10% from a year ago, driven largely by advances in our mid- to large-market business. Our sales pipeline is strong and continues to grow. The successful completion of our new recordkeeping platform in the mid/large market has directly helped us further penetrate the consultant and advisor communities. In fact, consultant firms who previously did not place business with Lincoln now account for 50% of our active sales pipeline in the mid to large market. This has resulted in significant new sales over the past 2 years.

Net flows for the first quarter were $344 million, up 62% from a year ago. Strong inflows combined with no large terminations contributed to our seventh straight quarter of positive flows. It is clear to us that our investments in RPS are paying off and we will keep investing in this business to increase our competitiveness, market presence and overall growth.

Turning to distribution. As we've said, one of Lincoln's primary strength is the size and scale of its distribution franchise. Collectively, our retail, wholesale and worksite sales teams reach annually more than 65,000 active producers. Producers who sell one of our products. And the number of advisors recommending our solutions in the first quarter increased by approximately 25% from a year ago. This is a tangible example of how strong -- how our strong franchise enables us to move forward key strategies, including: the Pivot in Individual Life, where we had a 52% increase from a year ago and the number of advisors recommending our life Pivot products; the Pivot in Annuities to our risk-managed fund strategies; accelerated growth in sales and net flows in RPS; and a push to stronger voluntary sales in Group Protection.

As I've said in the past, we will continue to build our strategic investments in distribution with an eye on expanding an already deep and powerful resource that includes 8,350 advisors affiliated through LFN, approximately 600 wholesalers in LFD and approximately 550 representatives within our worksite teams.

Spending a minute on investment management. Our net realized gain in our investment portfolio was $8.7 billion or 11.6% of assets. We maintained a strong level of net unrealized gains, the amount reflecting the long duration of our invested assets, which is driven by our disciplined asset liability management practices. With low investment yields persisting, we continue to incrementally invest new money in high-quality and well-diversified asset classes, such as private placements, commercial mortgage loans and middle-market loans.

During the first quarter, we invested more than $700 million in these asset classes with an average yield in excess of 4%, more than a 200-basis-point spread over the average tenure treasury during the quarter. Our private equity book experienced lower-than-expected investment performance this quarter after a very strong 2011 and 2012. We do expect quarterly earnings volatility from our alternatives portfolio. It has, over the last 2 years, generated strong returns and we would expect good results in the future.

Let me close my comments with you today by saying once again that although we experienced fluctuations in the quarter that affected earnings, the underlying drivers of long-term earnings and ROE growth were very strong. Moving forward, we'll keep taking aggressive steps that help us to increase revenue and improve profitability. In 2013, expense management, product repricing to drive new product returns and active capital management are important priorities.

With that, let me now turn things over to Randy.

Randal J. Freitag

Thank you, Dennis. Last night, we reported income from operations of $285 million or $1.02 per share for the first quarter, up 3% from the first quarter of 2012. Overall, it was a solid quarter with earnings negatively impacted by few items of note, including $8 million in expenses that were recorded in the Other Operations segment. Adjusting for these expenses, I put normalized operating EPS at $1.05 per share. In addition, we experienced $19 million of elevated mortality spread across both the Individual and Group Life segments, and $6 million from lower-than-expected income on alternative investments. I've chosen not to characterize the mortality and investment income experience as one-time in nature due to the fact that both of these items will fluctuate from quarter-to-quarter, but felt that the deviation from our long-term expectations were large enough that they should be noted.

Return on equity came in at 10.2% as it was negatively impacted by the earnings negatives I detailed a little earlier, while book value per share, excluding AOCI, increased by 14% to $42 for the year-ago quarter. Operating revenue increased 4% for the quarter and expenses were flat with the prior year. Net income of $239 million came in below operating income primarily due to the nonperformance-risk component associated with our variable annuity GLB reserves. This component moves the credit spreads and is not hedged. Net realized losses, on the other hand, were minimal at just $4 million.

Turning to segment results and starting with Annuities. Reported earnings for the quarter were $159 million, while ROE came in at 21%. Operating revenues increased 6% from the first quarter of 2012, primarily on higher fees driven by an 11% increase in average account values. Interest spreads remain steady as we continue to be in a position to manage in-force annuity spreads. Results specific to our VA guaranteed riders reflect both the quality of our book of business and hedge programs, as the net amount of risk associated with our living and death benefits continued to decline to $450 million, in the case of living benefits, and $1.1 billion for death benefits, both measures right around 1% of associated account value; while the hedge program had another good quarter with breakeven hedge performance and hedge assets $840 million in excess of guarantee liabilities.

Across all metrics, this was another very strong quarter for the Annuity segment. Of note, account values exceeded $100 billion at the end of the quarter, a record level for this important measure.

In Retirement Plan Services, we reported earnings of $35 million, which included $2 million of excess investment income. Quarter-over-quarter revenue growth of 3% benefited from an 8% increase in insurance fees, the result of an 11% increase in average account values. Market appreciation, strong deposits and net flows again contributed to the growth in assets under management, which ended the quarter at $46 billion, an all-time record level for this key driver of growth. Interest spread of 1.98% was down 19 basis points from the first quarter of 2012, roughly in line with our expectations for 20 to 25 basis points of annual spread compression for the Retirement business. Normalized ROA remained at 29 basis points on a sequential basis, in line with our expectations for 20 to -- 20 -- 25 to 30 basis points.

Turning to our Life Insurance segment, earnings of $112 million were down as a result of the fluctuations in mortality and alternative investment income. These 2 items reduced Life earnings by $20 million for the quarter, with $12 million of the impact coming from mortality. The quarter's mortality experience was driven by a few large claims, primarily in our term insurance book of business. To provide some context, our actual-to-expected mortality experience for 2010, 2011 and 2012 was 79%, 79% and 78%, respectively, while this quarter came in at 86%. While we will have outlier mortality quarters, both good and bad, I expect that when viewed in the context of a longer period, such as a calendar year, that we will return to levels more in line with that experience in the last 3 years.

Turning quickly to the Life earnings drivers. Average account balances were up 6% and Life Insurance in force up 2%, consistent with recent performance. Reported interest spreads were down on the weakness of the alternative investment portfolio. On a normalized basis, spreads came in around 185 basis points, down 13 basis points from the prior year and in line with our expectations for 10 to 15 points of annual spread compression.

Group Protection earned $14 million in the first quarter, with mortality negatively impacting the quarter's results by roughly $7 million. The mortality results for the quarter, which are similar to what we experienced in the first quarter of 2012, were driven by seasonality and fluctuations that will occur from time to time. As I mentioned with the Life segment, when viewed over a longer period, we expect a return to more normal experience.

Loss ratios in the disability business recovered nicely on improved recovery rates and stable incidents. It's premature to extrapolate these results to the rest of the year as incidents can trend higher and recoveries moderate. However, both metrics show well against the respective 5-year averages, which is a positive development.

Investments in distribution continue to drive stronger premium growth, which came in at 10% for the first quarter. We did reduce the discount rate on new claim incurrals by 50 basis points to 3.75%, which decreased earnings by $1.4 million, and increased the nonmedical loss ratio by approximately 0.5 percentage points.

Before moving to Q&A, let me comment on a few items of note. We continued with our disciplined capital management strategy during the first quarter repurchasing 3.4 million shares at a cost of $100 million. Cash at the holding company came in at $647 million and statutory capital ended the quarter in excess of $7.5 billion, so RBC was approximately 480, both measures down slightly from their year-end levels. While Guaranteed UL sales were relatively modest in the quarter, it did generate some capital strain driven by the new reserving requirement that went into effect at the beginning of the year. We expect that we will be able to largely reverse this strain with the reserve financing transactions later in the year.

While as I noted, earnings were negatively impacted by a few items this quarter, we are very encouraged by the continuing strong performance that we see in key growth and operating metrics, including: strong earnings driver growth, with both average account values and group premiums up 10%; good expense management with G&A flat year-over-year; excellent sales and deposit growth, as noted by Dennis; continuing price increases across the portfolio; and a strong capital position that allows for continuing share repurchases.

With that, let me turn the call over to the operator for questions.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question is from Steven Schwartz of Raymond James & Associates.

Steven D. Schwartz - Raymond James & Associates, Inc., Research Division

A couple of questions, guys. First on the mortality, which I guess we'll probably get a lot. The term was just a few -- on the term side, it was just a few large claims. On the group side, did -- was there any commonality between what was going on types of accounts, distributors, anything like that, that might indicate something else than just a random fluctuation?

Randal J. Freitag

Now, Steven, this is Randy. We've looked across the entire book. And it was, I'd say, of the excess mortality, about 1/3 of it was probably seasonality. We typically see a little higher claims in the first quarter, and the other 2/3 is really spread across the entire book. Once again, to provide a little context around group mortality, if you look over the last 3 calendar years, the mortality rate is incredibly stable, it varies less than 1% year-to-year. Looking at the first quarter, we're roughly 10% above that level with about 1/3 about attributable to seasonality, like I said. So I fully expect that if you look forward and you look over a longer period, like a calendar year, that will return to the type of experience that we've had year after year after year.

Steven D. Schwartz - Raymond James & Associates, Inc., Research Division

Okay. And then just on the corporate side, you noted $8 million of after tax expense there that you thought was nonrecurring. That would drive, if you were to take a look at that, that would drive that commission other expense line to certainly lows over the last 5 quarters, maybe even longer. Would that be a sustainable run rate going forward, Randy?

Randal J. Freitag

I think that we had very good expense management across the company. Now, typically, when you look at expenses historically, you'll see they trend up somewhat over the course of the year as projects get rolling and production typically moves up over the course of the year. But I'd note that I fully expect that account values, and premiums and face amount in force also grow over the course of the year to cover that sort of the expense growth. So I think it just reflects very solid expense management. I wouldn't be surprised to see expenses trend up a little bit over the course of the year. But I expect revenues will continue to grow also.

Operator

Our next question is from Jimmy Bhullar of JPMorgan.

Jamminder S. Bhullar - JP Morgan Chase & Co, Research Division

First question just on -- you mentioned limiting sales of secondary guarantee UL, just how comfortable are you with the business that you have sold over the past couple of years given the rate environment and just given the reserving requirements? And then secondly, on the dental business, the loss ratio seemed high even x seasonality. So wondering if you could actually just discuss what drove that?

Dennis R. Glass

Let me speak to the first question about how comfortable we are with the guaranteed universal life sales that we've had over the past year. Each quarter, we have been reporting that the expected new business returns on those products were in the 9%, maybe the 10% collective when you add all sales up together. And that those have been 1% or 2% lower targets. But the fact of the matter is, it's a very difficult environment. We continue to increase our pricing, as I've mentioned. We're going to do it again pretty significantly in the first -- in the second quarter. So the answer is, we're getting 10% on new business sales, our surplus is earning 3% or 4%. We continue to improve pricing. So yes, we're pretty comfortable with the sales that we've made. But we're going to continue to improve the pricing and be very careful about the mix of sales as we go forward. I can't be more proud of the execution around this Pivot strategy that we have mentioned this quarter and before. Randy, do you have something on the dental?

Randal J. Freitag

Yes. Jimmy, you typically see seasonality in the dental loss ratio. It's a calendar year benefit and so you see the loss ratio is a little higher at the beginning of the year as people use up their benefit and it trends down as people run out of benefit later in the year. I don't think there was anything in the dental loss ratio outside of that typical seasonality.

Jamminder S. Bhullar - JP Morgan Chase & Co, Research Division

But it seems like it was been higher than it's been typically in the first quarter, that's the reason I was asking. So normally it does pick up, but it picked up a little bit more?

Randal J. Freitag

Yes, Jimmy. I think it was well within our expectations for the first quarter.

Jamminder S. Bhullar - JP Morgan Chase & Co, Research Division

And then maybe I'll ask another one on share buybacks. Last year, you bought back a lot more in the first half than you did in the second half. Should we assume a similar pattern this year on -- because the buybacks were at least a little bit lower than what we had assumed?

Randal J. Freitag

Jimmy, as always, we guide to roughly $400 million of capital management in the course of the year. I fully expect that we're on track to do that again. As I say every time that I give this answer, we always strive to overachieve and I don't expect any different this year. We're going to be working hard to get things like reserve financings done. I mentioned that we'll reverse the strain we experienced on the Guaranteed UL in the first quarter, I believe, with financing transactions. So I'm very comfortable with the way we're using our capital to do things like share buybacks, and I think we'll continue as the opportunity arises.

Operator

Our next question is from Suneet Kamath of UBS.

Suneet L. Kamath - UBS Investment Bank, Research Division

Randy, I just wanted to follow up on Jimmy's last question on the share repurchase. Interested in your comment about wanting to overachieve again this year, like I think what you did last year. If you did do more than the $400 million, should we be thinking about higher level of reserve financings being the primary driver there? Or is there something else that you're thinking about that could influence the pace of buyback?

Randal J. Freitag

Yes, I think if you look back to the last couple of years, it's been a combination of strong reserve financing, a couple of years ago. And then last year, just leveraging a bit of our strong capital position. We remain very well-capitalized, a very strong capital position. So I think it's going to be a combination of all of those things if we're able to. Once again, my guidance is for $400 million. We're always trying to overachieve on everything we do.

Suneet L. Kamath - UBS Investment Bank, Research Division

Right. And then, can you just talk a little bit about the reserve financing market? I mean, you said that you're going to trying to reverse some of the strain that you experienced in the first quarter and, I guess, how likely is it? And then from a timing perspective, when would you expect to pull the trigger on something?

Randal J. Freitag

The reserve financing marketplace from the suppliers is as strong as it's ever been. It's as if -- I think the only caution I put out there is that we continue to work with the NAIC captives. I believe that at the end of the day, we'll end up with capital solution -- captive solution that is in alignment with how we have historically used captives, but that's the one caution I'll note there, I'd say.

Suneet L. Kamath - UBS Investment Bank, Research Division

Got it. And then just another one on the Group Protection business. I think in your prepared comments, you talked about the voluntary business being up. At Unum's last call, called the last hour, they talked about some pricing challenges in that business, perhaps some competition, some impact from health insurance reform, health care reform. So I guess I'm just curious in terms of what's driving your growth? Is it new plans that you're adding, or increased business with existing accounts? It seems like you're seeing a little bit of a different trend than, perhaps, they were guiding to in terms of the first quarter.

Dennis R. Glass

That's a good question. I think Unum is -- well, I shouldn't say I think Unum -- Unum dominates the market and they have a very large market share. I think the dynamics for them are a little bit different than they are for us because we have a smaller share, and so our percentage increases don't require as many dollars of new sales, frankly. But it's a combination of a couple of things. One, as you heard me say, our sales force is up 13%, I didn't mention it again this year, but -- this quarter, but last quarter, we talked about that sales force being able to reach a lot of new brokers. And so it's driven in part by the increase in our sales force. Also, it just so happens this quarter that we had 1 or 2 larger cases than we'd typically get on the voluntary side. And so that helped with the increase. Insofar as pricing is concerned, at least relative to True Group, we continue to get better ROEs on our voluntary business. So that's better business for us from a profitability standpoint. So we're going to continue to try. I -- the 61% increase that we saw in voluntary, I don't expect that percentage increase to continue through the course of the year, but it was a good year -- a good first quarter. I'm proud of it. It's good business.

Suneet L. Kamath - UBS Investment Bank, Research Division

Got it. And then just one last one on the mortality, just so I understand the messaging, Randy. So when you said the 1/3, 2/3, was that just for the group insurance business or did that include the individual life? And then, I guess, as we think about getting back to that -- those mortality -- actually the expected numbers that you were talking about, should we assume that you'd probably get the back the 1/3 from the seasonality maybe as soon as the second quarter, but that the other 2/3 might take a couple of quarters before that comes back? Or just wondering, how that's going to trend as we move forward through the year?

Randal J. Freitag

Yes. I mean, seasonality and mortality are a little higher. Mortality in the first quarter is pretty typical across -- we've seen is pretty typical across all of our businesses. And specifically, I spiked out the third in the group business. It's is a little more volatile in the individual business, I'd say. Now as for the timing of getting back, that I don't know. I think, once again, on the life side, at the end the day, our A to E is incredibly steady year after year after year on a calendar basis. There's nothing in the mortality that leads me to expect that we should expect any different going forward. As to the timing of when it comes back, I can't talk about that.

Operator

Our next question is from Erik Bass of Citigroup.

Erik James Bass - Citigroup Inc, Research Division

Just had a question and VAs. I just wanted to get your perspective. I guess, the pricing has gone up significantly over the past years and features have become less generous, but still seems like we're seeing strong consumer demand for the product. Just wondering if you have any sense from your discussions with customers or through your distribution as to kind of how much more the industry can reduce feature generosity before customers kind of won't buy the product? I'd just be interested on your thoughts on that.

Dennis R. Glass

That's a great question. We give it a lot of thought around here. What I look at the Lincoln fact situation, we've increased pricing pretty significantly either through reducing the benefit levels or from actually increasing the charge on our riders. Collectively, we've done that over the last couple of years. We've -- sort of separate from the consumer, we've decreased commissions, we've also recently restricted add-on payments. So there's quite a bit that we've done. And I think, as you've pointed out, others have done the same thing, yet we continue to see good demand from consumers. So I don't think we've yet reached the point where the price changes the industry has been making is at a the point where consumers don't think VA is still a good product for them for part of their portfolio. How much further we can do, we can go, I think we'll just have to see. It's a combination of not just VA, but what other alternative investment opportunities are available to consumer. But so far so good. And again, at Lincoln, we're producing 20% ROEs on a consistent basis. You heard Randy talk about the hedge fund performance, and Standard & Poor's and Moody's both publicly say that Lincoln's hedge performance -- excuse me, hedge strategy and risk management is singularly the best in the industry. So we'll make adjustments as we can. It's good business and, in the right amount, we're quite happy with it.

Erik James Bass - Citigroup Inc, Research Division

Got you. And to follow up on that last point, when you say the right amount, how do you think about that? And I guess, if we are in a scenario where pricing alone is not kind of enough to dictate demand, then would you consider actions on the kind of the distribution side that, I don't know, if need be, to kind of manage the sales volume?

Dennis R. Glass

Yes, let me put my comment of the right amount into perspective a little bit. I think because we aggregate fixed annuity earnings with variable annuity earnings that we leave the impression that variable earnings -- maybe we leave the impression that variable annuity earnings are a larger portion of total earnings than they actually are. If you add up business segment earnings, and by that, I mean, if you add up the Group business, the Life Insurance business, the RPS business and the individual Annuity business, variable annuity earnings are about 36%, so a little more than 1/3 of the total of those -- of that aggregate. So it's probably lower than what you all think. I am not uncomfortable with that level as we move forward with our program. Again, we want to see growth, but we're not looking for 15% to 20% growth year-over-year. And how much we will do is a function of earnings mix, it's a function of, frankly, the multiple applied to that by the market over time, and I think that's going to get better rather than worse. We have to look at the potential calls on capital from the size of the book that we have. But right now, we're in very good shape. I think Randy mentioned, just throwing another fact in here, that the living benefit reserves and the mortality reserves are only 1% of our -- not the reserves, but the net amount of risk is 1% of our account values. So 1% of our account values, excellent risk management continue to change pricing. And let me just comment -- and then I'm on running on here a little bit, but in May, we're going to reduce by 50 to 100 basis points the payouts on the benefit on our joint survivorship business, which represented about 50% of the business that we had in the first quarter of 2013. So again in the second half, because of that pretty substantial benefit change, we expect sales to be tempered from what they otherwise might be in the second half.

Randal J. Freitag

Eric, just let me add a little bit to that. I'd say that part of the reason they've come up -- the earnings are about 36%, is because the equity markets have performed so darned well. And I'd definitely put that in the camp of a high quality problem.

Operator

Our next question is from Mark Finkelstein of Evercore Partners.

A. Mark Finkelstein - Evercore Partners Inc., Research Division

Randy, I think you alluded to it a little bit. But -- maybe you or Dennis, can you just give us an update on where we are in the captive discussions? You guys are clearly involved in discussions that we don't see.

Dennis R. Glass

Yes. First of all, the starting point, if I can compare it to AG38, is much different, because the starting point on AG38 was both a prospective and retrospective application of the new -- whatever the new reserving practice or rules would be, and ended up being just mostly a prospective thing, some cash flow testing retrospectively. And I do think in aggregate, the industry really had to change its historical reserves in total by much, if any. With respect to captives, I think we're pretty much starting from prospective that a lot of good captives have been put in place. There might be 1 or 2 things that the regulators are concerned about in some of the structures. But that, by and large, both the industry and the regulators are looking at this more on a prospective basis. And the discussions are ongoing. Lincoln, along with other companies in the industry, are engaging directly with the NAIC leadership. And I expect a similar good outcome on this as to what we saw jointly between the regulators and the industry on AG38. What we're looking for, both of us, in the industry and the regulators, are -- want the captives to be strong. We want -- we have a focus on solvency when we do these things at Lincoln, making sure that they're substantive, they're real, there's risk transfer. And I think the regulators, once they are satisfied with some of the more sound structures and they can get some comparability and some understanding, transparency, that it will work out. But it's in its early stages and it will take a while to work through.

A. Mark Finkelstein - Evercore Partners Inc., Research Division

I guess just on the life changes. You talked about kind of putting through some rate increases in SGUL and, I think, MoneyGuard as well. I mean, how meaningful are the increases that you're making and how do we think about kind of sales levels of those 2 products going forward?

Dennis R. Glass

Yes. Well, first, sometime in the first quarter, we restricted single pay premiums completely -- not completely, but significantly, while we are repricing the products. On single rate product or short pay products, single pay or short pay products, we're looking at some pretty substantial increases and premium, 16% to 30%, so those are big changes. But with the new reserving requirements and the low interest rates, that's what it takes to get these returned. On MoneyGuard, sort of 2 things that we're trying to do. One is move more of the business to flexible pay, which has the better return pattern. And then, we're also increasing the premium requirement on the single pay by 5%. We're eliminating some single pay -- we're eliminating single pay for ages over 70. So we're doing quite a bit, more at the margin. But the 5% is a pretty big increase in the movement to the flexible pay versus single pay is important as well. So it’s pretty significant movement on that. And just as you've been listening to me speak, we're -- last year and this year, we're talking about strong price increases across all of our product lines. You hear us talk about 5% -- excuse me, middle and single digits to upper single digits. In the life side, 15% and 20%. So we're going at it aggressively. And we still, as you saw it, had pretty good sales results across all of our lines. So we're feeling good about it.

Operator

Our next question is from Chris Giovanni of Goldman Sachs.

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

Just a question in terms of the sort of response from the distribution and that's the major point, I mean, guys are putting through aggressive price increases. The industry is doing that broadly. I mean, sort of how are they responding as they look for products to sell?

Dennis R. Glass

Well, let's talk about how this works at Lincoln and then we'll talk about how it might be received by our distribution partners. So at Lincoln, any decision about product changes or price increases is a collaborative decision between our distribution organization and our manufacturing organization. But that's still very important because as you get to the end seller of the product, the financial advisor at Merrill Lynch or the financial advisor at Morgan Stanley, we have to make sure that the changes that we're making, either in the design of the product or the pricing of the product is going to meet with their needs. And so everything we do takes significant input from not only internal distribution people, but discussions with our distribution partners outside. So my answer is that we don't do anything that we don't think is a good balance between what the distribution organizations need -- again, our partners, the 67,000 different individuals that sell our product lines, and what we need to get decent returns for our shareholders.

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

Okay. And then the product changes that you're making on the VA, Randy, can you comment maybe just how much you're boosting, sort of, ROEs or IRRs are you getting on the new product versus the similar old product or comparable old product?

Randal J. Freitag

Could you ask that again, please?

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

Yes, just in terms of the ROEs or IRRs that you guys are measuring for the product that you're going to be focusing on now in terms of the VA sales changes, the changes you're making versus what you sold maybe just a quarter or 2 ago?

Randal J. Freitag

The change in the ROEs?

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

Yes, please.

Randal J. Freitag

Yes. Generally, we're going up 1% to 2% on the internal rates of return across the board. That's sort of what the objective is on some of the different products.

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

Okay. And then just following up, Dennis, on the last call, you made the comment around smart money kind of, looking into the VA space. Curious if you can provide any more thoughts or insight in terms of what you're hearing or seeing on that front over the past 3 months or so?

Dennis R. Glass

Yes, there was the flurry of activities that was -- that were done by the private equity firms, I guess, predominantly Apollo and Guggenheim. Everything we hear is that there is -- because they've been so successful and the profitability on what they have done has been high, that there's other product private equity firms that are out looking for similar opportunities. So I think private equity in the fixed and variable annuity business will be a growing phenomenon over time, and hopefully a positive impact on the business in general.

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

Okay. And just -- would that be your view? I mean, I guess, you sit on a lot of boards and represented the industry, I mean, I think, there are some concerns that people have on increased risk on the asset side, maybe putting companies or the industry at risk. I mean, is that something that you would be focused or worried on, or not as much at this point in time?

Dennis R. Glass

That's a question that I think we have to see how it evolves. Anecdotally, what we've seen is that the private equity firms are barbelling, and so that in their portfolio, they're putting more private equity in which would be a higher risk, more volatile asset. But they're compensating for that by limiting the rest of the portfolio, at least in the cases I've seen, to more like NAIC 1-type investments. And in some instances, the actual C3 risk, or the call for capital, in the portfolios they structure is less than what maybe a typical insurer would do. So that would lead you to believe that there is no more risk in what they're doing and what the average annuity portfolio is doing. Having said that, that's anecdotal, and we'll have to continue to watch as more private equity firms get into the market to see if there's a change in posture that would change my view on it.

Operator

Our next question is from Tom Gallagher of Credit Suisse.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

First, a follow-up question on the universal life product changes. The single-pay and short-pay SGUL that you referenced you were changing pricing on, what percent of sales would those represent, let's say, in 1Q or the quarter before that? Is that meaningful as a percent of overall sales?

Dennis R. Glass

Not since we've introduced the limits of the amount of single pay business that we let flow through the system. But we want to get out into the marketplace and have single and short pay that's profitable business. We want to have a complete portfolio of business. And so it still would represent a small portion of what we do, is my expectation, but we'd have a product that meets our total returns.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

Dennis, I guess, my question -- I just wanted to try and get the context of that change. If you're not selling much of it, by changing pricing, presumably, it'll go close to 0. I just want to understand what's going on behind the scenes? Why flag this if it's not really moving the needle in terms of sales volumes to begin with?

Dennis R. Glass

AG38 came out -- and again, I'm just going to repeat what I said. It's important for us, for our distribution partners, to have a complete suite of products. And right now, our old single-pay, short-pay product is way underpriced for the type of returns that we want to achieve. So as a stopgap measure, and something that we don't like to do, we've essentially limited the amount of business that come in on that basis. So the next step is to get back into the market even though it's a small piece of what we'll be selling, but we'll have a product that's a good product for the consumer, it's -- it has acceptable returns, even with the new AG38 reserving requirements. And again, we'll build out the product suite. And that's important, because people don't come to us for a single product, they come to us for a suite of products. And so we want that full suite of products that strengthens the relationship with our distributors or our end distributors.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

Understood. So the reason the sales volume is low is because you're just limiting the amount. But you don't like the profitability as per new AG38 requirements, so you had to get it to acceptable levels even on even on that limited amount. That's the way I should be thinking about it?

Dennis R. Glass

Yes. I think, that's a good summary.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

Okay. The -- and Randy, just to go back to the actual to expected, I just want to understand that I fully get the message here. The 78% to 79% a year seems like a very good result. And this quarter's 86% was worse, but still, certainly, doesn't sound bad in the grand scheme of things. So you'd said 2 things. One was, that if you looked at it versus a year ago in the 1Q '12, it was fairly similar. I think I got that right, that's what you said. I just want to make sure that's what you said. And then I want to understand, should we take these numbers to mean, even if they do drift up to the mid-80s actual to expected, that would still be pretty favorable relative to reserving levels, even if the absolute earnings we're going to see is going to be low? Sorry for the long-winded question, but I just want to try and get -- better understand this.

Randal J. Freitag

Sure. On the first part, I think you were mixing the 2 businesses. I think, I said group was similar to last year and the percentages you were referring to were the numbers I gave for the individual business. So on the individual side, we were higher than we were last year on a -- from a mortality standpoint. As to the second part, the mortality that we assume in our GAAP models and in our recipe reserves, that is -- reflects our experience as a company. And I don't see any threat to those assumptions inside of those models as we sit here today. So I have no reason to expect that the assumptions we are using in our models need to change at all because we had one quarter of bad experience. As to our -- your -- just the theme of your -- that your last question, about mortality drifting up to 85%, that just is not something I would ever expect to happen. I mean, 99.9% of the people that were with us for the last 3 years are the same people that are part of our mortality experience today, and those people haven't suddenly decided to die at a 10% faster rate. I mean, experience is going to be what it has been in mortality and it doesn't change at a very fast rate.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

And then, Randy, just following up on that. In 3Q of this past year, you did make some, I think, it was assumptions to your DAC model, which released some of the conservatism on the mortality side, I believe. Is that too small to move the needle or is that -- is it possible we're starting to see some of that flow through?

Randal J. Freitag

Yes, I don't expect that we experience this quarter will have really any impact on the assumptions in our model, so I don't really see a threat from what happened this quarter.

Operator

Our next question comes from John Nadel of Sterne Agee.

John M. Nadel - Sterne Agee & Leach Inc., Research Division

I had a question on alternatives. Just because I'm so curious by the results this quarter. I mean, I think Lincoln is the first and the only company that I've seen so far this quarter across, frankly, all of insurance that is seeing alternatives investment income coming below expectations. Is there something specific, a specific fund or something like that, that might have driven that?

Dennis R. Glass

That is a great question. We're -- you expect the performance of at least the private equity to follow the stock market in some fashion. Let me just give you some statistics that might help to put this into perspective. Our total vaults [ph] -- total portfolio is $841 million at the end of 2012. We're taking that up to $1.1 billion by the end of 2013. And during -- in 2012, that portfolio earned $125 million. In 2011, it earned $90 million. But when I look back over the last 24 months -- I'll just pick out some points for you. In December, we had negative $2 million, in December of '11. In March, we had positive $42.5 million. So year-over-year, we've had pretty consistent total earnings. But in any one quarter, we've seen swings as high as $45 million quarter-to-quarter. So my guess is this is just one of those quarters where you just have a bad result and there's no systemic reason for it.

John M. Nadel - Sterne Agee & Leach Inc., Research Division

Okay. And so this -- it's helpful. I was going to ask you, so you already sort of answered with how much you expect to take this portfolio size up through this year. So we should expect as the size of the portfolio grows, I suspect your return expectations will be similar, is that a fair to assume? So a normal level of alternatives investment income should grow with the size of the portfolio?

Dennis R. Glass

Yes. The only caution I would give you there is the same J-curve concept in private equity, which is -- particularly on brand new investments, it takes 2 years, 3 years or 4 years before you begin to see earnings developments. And so we try to balance sort of the richness of -- or the age of the portfolio and not overload it with too much new stuff because that would drive down in the short run the earnings.

John M. Nadel - Sterne Agee & Leach Inc., Research Division

Understood. And then Dennis, I got a question for you just on the variable Annuity business and market share. I think you've said in the past that Lincoln has been very steadily over some lengthy period of time about the #7 player in the VA market. But in short term periods of time, I suppose, that can move higher or lower. My guess is it's moved higher here recently with your 35% year-over-year VA sales growth much faster than what we've seen from at least the publicly traded peer group. So I guess my question is this long-winded way of asking it, but what level of market position are you comfortable with? Are you comfortable with moving into the top 5? If more of those who are currently there continue to pull back as much as they seem to be doing?

Dennis R. Glass

If I might just correct the market position, I don't know, maybe you put more people into that bucket than we do. But we have been fifth for 5 years. And we're putting the IRB slides together and we have a very powerful slide in there that in terms of quarterly fluctuations in sales that over the last 5 years -- and when you see this, you'll see that our quarterly fluctuations have been extremely modest relative to the industry and that's because we've never chased market share by having a low-priced product. So again, the way we run the business, we're comfortable. We'd rather tamp down sales. Again, we're not looking for 30%, 35% sales increases this year. We can't turn on $0.10 because we don't like to take product off the shelf, we don't think that's a good strategy, vis-a-vis, our partners, our distribution partners. And so we have to do with pricing changes. And sometimes it just takes a little longer for us to get a pricing change. I mean, it takes 3, 4, 5 months to properly redesign and get the product approved. But this May change that we're making is consistent with our strategy. We've see our volumes get a little bit higher than we'd like them to see. We have opportunity to improve returns even above already high returns that we're getting, and expect sales to slow over the second half of the year.

Operator

Ladies and gentlemen, this does conclude today's conference. Thank you for your participation and have a wonderful day.

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