Principal Financial Group Inc (PFG) Management Discusses Q2 2013 Results - Earnings Call Transcript

Jul.26.13 | About: Principal Financial (PFG)

Principal Financial Group (NYSE:PFG)

Q2 2013 Earnings Call

July 26, 2013 10:00 am ET

Executives

John Egan - Vice President of Investor Relations

Larry Donald Zimpleman - Chairman, Chief Executive Officer, President, Chairman of Executive Committee, Chairman of Principal Life, Chief Executive Officer of the Principal Life and President of Principal Life

Terrance J. Lillis - Chief Financial Officer, Chief Accounting Officer and Senior Vice President

Luis Valdez - Chairman of Principal International Inc., Chief Executive Officer of Principal International Inc. and President of Principal International Inc.

Daniel J. Houston - President of Retirement, Insurance & Financial Services

James Patrick McCaughan - President of Global Asset Management

Analysts

Seth Weiss - BofA Merrill Lynch, Research Division

Sean Dargan - Macquarie Research

Thomas G. Gallagher - Crédit Suisse AG, Research Division

Joanne A. Smith - Scotiabank Global Banking and Markets, Research Division

Eric N. Berg - RBC Capital Markets, LLC, Research Division

Ryan Krueger - Dowling & Partners Securities, LLC

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

Operator

Good morning and welcome to the Principal Financial Group Second Quarter 2013 Financial Results Conference Call. [Operator Instructions] I would now like to turn the conference call over to John Egan, Vice President of Investor Relations.

John Egan

Thank you, and good morning. Welcome to the Principal Financial Group's Second Quarter Earnings Conference Call. As always our earnings release, financial supplement and slides related to today's call are available on our website at www.principal.com/investor.

Following a reading of the Safe Harbor provision, CEO, Larry Zimpleman; and CFO, Terry Lillis, will deliver some prepared remarks. Then we will open up the call for questions. Others available for the Q&A are Dan Houston, Retirement and Investor Services and U.S. Insurance Solutions; Jim McCaughan, Principal Global Investors; Luis Valdes, Principal International; and Tim Dunbar, our Chief Investment Officer.

Some of the comments made during this conference call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act. The company does not revise or update them to reflect new information, subsequent events or changes in strategy. Risk and uncertainties that could cause actual results to differ materially from those expressed or implied are discussed in the company's most recent annual report on Form 10-K and quarterly report on Form 10-Q filed by the company with the Securities and Exchange Commission.

Before I turn the call over to Larry, I'd like to remind you that our 2013 Investor Day will be on September 13 at the New York Stock Exchange, where we will discuss our investment management strategy and provide an update on our businesses. We'll provide more details in the coming weeks. Larry?

Larry Donald Zimpleman

Thanks, John, and welcome to everyone on the call. As usual, I'll comment on 3 areas. First, I'll discuss second quarter results. Second, I'll provide an update on the continued successful execution of our strategy, including the onboarding of Cuprum; and I'll close with some comments on capital management. As John mentioned, we've again provided slides for today's call. Slide 4 outlines the themes for the quarter.

Second quarter results were strong, especially given the macroeconomic volatility in the quarter, giving us a great first half of 2013. Total company operating earnings for the second quarter were $271 million, a 29% increase over second quarter 2012. This reflects growth in our business, improved U.S. equity markets and continued expense discipline. Net income in the second quarter increased 33% compared to the year-ago quarter, reflecting improvement in our investment portfolio.

Our results again demonstrate that our globally diversified business model is working, and that we continue to execute effectively regardless of macroeconomic conditions in any one country or region. We have now successfully rebuilt operating earnings and net income close to pre-crisis levels and have replaced a significant portion of spread and risk-based earnings with fee-based earnings, giving us more capital flexibility.

Total company assets under management, at $451 billion, remained relatively unchanged from first quarter 2013, reflecting the strengthening U.S. dollar and a rise in interest rates. Some of the growth metrics for the quarter include double-digit growth compared to the year-ago quarter in Full Service Accumulation new sales revenue on $1.8 billion in sales. This reflects our focus on having better sales balance across small, medium and larger plans, which gives us greater ability to grow net revenues. Record sales of $5.8 billion in Principal Funds, an increase of 73% over the year-ago quarter, reflecting success across multiple products and distribution channels. These sales contributed to quarterly net cash flows of $2.3 billion, which outpaced the industry. Principal Funds' total assets under management hit $100 billion in the quarter as well.

Second quarter Full Service payout sales increased 37% over the year-ago quarter to $115 million. We'll continue to be opportunistic with this business. Unaffiliated assets under management of $101 billion for Principal Global Investors, up 10% from the year-ago quarter. Solid inflows of $6.6 billion for the quarter were offset by outflows due in part to a couple of large clients repositioning their portfolios. Net cash flows of $2.2 billion in Principal International led to reported assets under management of $103 billion despite the strengthening in the U.S. dollar. $49 million in Individual Life sales in the quarter, an increase of 12% over second quarter 2012, driven by continued success in the business market. And Specialty Benefits sales of $58 million, up 11% over second quarter 2012 as a result of strong growth in the pipeline. We continue to provide products and service solutions that are in demand in this era of personal responsibility and benefit from our diverse distribution platform.

Next, I'll comment on our success in further implementing our strategy in the second quarter. We've been successfully expanding our fee-based businesses and global investment management footprint for more than a decade. Because of the financial crisis, we've had the opportunity to accelerate that transition. Since 2010, we've successfully completed 7 strategic acquisitions, adding fee-based businesses and expanding our global footprint. We continue to believe this will create long-term value for shareholders. Despite recent volatility in certain emerging markets, the need for retirement and long-term savings in these markets continues to grow rapidly due to the exceptional growth in the middle and upper middle income segments. Having been in these markets longer than many of our competitors, we've established The Principal as a global retirement expert and are well positioned for continued success with a good brand and strong local distribution. We know there will be ebbs and flows in any market, but our broad global footprint allows us to weather cycles of volatility in the U.S. and abroad.

Moving now to an update on Cuprum, the pension company we recently acquired in Chile. The onboarding continues to go extremely well. In fact, during this onboarding process, the pension regulator in Chile once again gave Cuprum the best customer service rating among the 6 AFP providers. Cuprum has now received this distinction a remarkable 18 out of the last 22 quarters. Net cash flows and operating earnings from Cuprum continue to exceed our acquisition plan. In addition, when Standard & Poor's recently affirmed our ratings and changed the outlook to stable from negative, they referenced our success in building out our operations in fast-growing international retirement markets.

Achieving financial security in retirement is a campaign talking point for candidates in the upcoming Chilean elections. We see the discussion of possible changes to the Chilean retirement system as a positive to our businesses there as the goal is to further increase retirement savings for all income segments. In Full Service Accumulation, all of the fundamental elements remain strong, and along with solid equity market returns, contributed to revenue growth in the quarter.

Second quarter 2013 recurring deposits were up 17% over the year-ago quarter and were essentially flat with first quarter 2013, which is typically the largest quarter for recurring deposits. Additionally, the number of participants making a deferral and the number of participants receiving an employer match were both up 8% over the prior year quarter. While down from record levels in 2012, retention rates remain strong across the segments in the first half of 2013.

Our focus on growing sales in the small to medium-sized market to create more balance across plan sizes, along with equity market growth and our continued expense management, contributed to an increase in Full Service Accumulation margins in the second quarter. Principal Funds continued its string of successful quarters. Record quarter end account values as a result of positive net cash flows for 14 consecutive quarters and higher equity markets helped drive a 40% increase in operating earnings over the prior year quarter. Principal Funds continues to provide outcome-based products across asset classes that retail customers seek.

As shown on Slide 5, investment performance remains competitive and is a positive leading indicator of future net cash flows for the organization. We continue to benefit from our well diversified, multi-boutique strategy in Principal Global Investors. On May 1, we closed on our acquisition of Liongate, a London-based investment boutique that specializes in global alternative investments and managing portfolios of hedge funds, adding to our multi-asset class capabilities. We believe these multi-asset class solutions will remain popular, as institutional and retail investors move to outcome-based products. As investor appetite swings to equities and alternative investments, we remain in excellent position to retain and attract clients to our broad investment options and expertise across multiple platforms. Despite negative net cash flows in the quarter for Principal Global Investors, overall revenues increased 9% on a sequential basis, and pretax margins increased to 29%, reflecting performance fees and continuing to gain scale.

Next, a quick update on Principal Bank. As we announced in June, we signed a strategic agreement with Bank of the Internet Federal Bank to transfer substantially all of Principal Bank's individual checking and non-IRA accounts while retaining the products that complement our U.S. retirement and asset accumulation businesses. This action will have minimal financial impact to the company and furthers our progress to deregister as a savings and loan holding company. We still expect to complete the process by year end.

I'll close with some comments on capital management. As announced last night, we will pay a $0.26 per share common stock dividend in the third quarter, which is a 13% increase over the previous dividend. This reinforces our commitment to return capital to shareholders by increasing the dividend payout ratio over time. It also demonstrates confidence in our ability to deliver future earnings growth. So far, we've allocated $405 million of the $400 million to $600 million of capital we targeted for the full year. Looking to the second half of 2013, we'll continue to look at combination of common stock dividends and opportunistic acquisitions and share repurchases. As always, we continue to look for the best and most accretive ways to deploy capital and increase long-term value for shareholders.

Before I turn it over to Terry, I want to mention that IDG's Computerworld recently named The Principal Financial Group as one of the 2013 Best Places to Work in IT, our 12th consecutive year on the list. Our ability to attract and retain world-class IT talent is critical to our success, so we take great pride in being consistently recognized for providing a great environment for IT professionals.

In closing, we're pleased with our team's ability to grow our businesses above industry growth rates while maintaining expense discipline, resulting in a very strong first half of 2013. Despite volatility that will likely continue in the second half, I'm confident that our business model and proven ability to execute will continue our momentum through the remainder of the year. Terry?

Terrance J. Lillis

Thanks, Larry. The second quarter was a continuation of the strong start to the year. Our fundamentals remained strong and margins have improved. This morning I'll focus my comments on 3 items: operating earnings for the quarter; net income, including performance in the investment portfolio; and the strength of our capital position and balance sheet.

Total company operating earnings of $271 million were up 29% over second quarter 2012. This reflects a full quarter of Cuprum. Even without Cuprum, earnings were up 16% over the prior year quarter. On a reported basis, second quarter 2013 earnings per share were $0.91, up 30% over the year ago quarter. This reflects organic growth from our domestic business, strong results from Cuprum, favorable equity markets, expense discipline and a lower share count.

Looking at Slide 6, you'll see that second quarter 2013 earnings were impacted by 2 items. First, Principal Global Investors' quarterly earnings benefited by $4 million from a performance fee that typically occurs on a 3-year cycle. Although performance fees are a positive impact, infrequent fees, such as this one, do impact comparability between quarters. Second, Principal International earnings were negatively impacted this quarter by $7 million due to lower-than-expected returns on a mandatory investment known as encaje. Local regulations in Chile and Mexico require that mandatory pension operations hold a small investment in the underlying funds offered to customers. We report the change in value of the encaje investment through net investment income. This could create some volatility on a quarterly basis. The volatility this quarter was due to a spike of 150 basis points in interest rates in Mexico.

There's more background information on the encaje investment on Slide 7 and on our website, along with publicly available information on how to track the encaje performance throughout the quarter. A normalized result for the second quarter is $0.92 earnings per share. This normalized earnings per share should not be considered a run rate on which to base future quarters. Seasonality of earnings, investments in our businesses and macroeconomic factors particularly in Latin America, should be considered. We continue to stay focused on what we can control, executing on our strategy.

Now I'll discuss the business unit results, starting with the accumulation lines of businesses within Retirement and Investor Services. Reported operating earnings increased 22% to $144 million. As shown on Slide 8, net revenue was up 17% over second quarter 2012. Growth in the underlying businesses, driven by more than $30 billion of sales over the past 12 months, equity market performance and improved spread, were the main catalysts for the increase. Trailing 12-month pretax return on net revenue stabilized at 30% for the sixth straight quarter. Assuming an equity market total return of 2% per quarter for the second half of the year, we anticipate 2013 full year net revenue growth to exceed our long-term range. We also expect pretax return on net revenue to be above the 27% to 29% range communicated for Retirement and Investor Services accumulation for the year. Quarterly operating earnings for Full Service Accumulation, at $90 million, were up 25% from the year ago quarter. This reflects a 16% increase in net revenue due to strong growth in businesses and equity market performance.

Account value growth due to market performance is more beneficial in the short term than growth from net cash flows as there is no cost associated with acquiring the revenue. The net cash flow over the trailing 12 months of $4.1 billion also has more positive impact in recent years as we shift to a more balanced mix of business. The revenue growth, coupled with expense discipline, resulted in a pretax return on net revenue of 34% for the quarter. While fee pressure continues to exist in the marketplace, we're working closely with advisors and plan sponsors to adjust our service model to align with our clients' needs.

Net cash flows for Full Service Accumulation were approximately $300 million for the quarter. And as communicated last quarter, we expect full year 2013 net cash flow for Full Service Accumulation to be 1% to 3% of the beginning of the year account value. This metric has dampened in time periods with large equity market returns. That's because sales and recurring deposits do not directly correlate with the market in a similar fashion as withdrawals.

Full Service Accumulation sales, at $1.8 billion for the quarter, were down $500 million from the year ago quarter. However, due to our sales focus in the smaller end of the market, new sales generated a higher amount of annualized net revenue on a lower account value base. As expected and mentioned last quarter, Full Service Accumulation withdrawal rates are returning to more normal levels, with the dollar amount of the withdrawals increasing due to growth in assets under management. However, we are replacing some lapses with higher revenue business as we focus on profitable growth.

Principal Funds operating earnings were $17 million for the quarter, a 40% increase from the year-ago quarter. On a trailing 12-month basis, revenue was up 22% and operating margins continued to improve due to the scale-based nature of the business. Although the sales costs are expensed in the quarter in which they occur, strong fundamentals over the last several quarters should continue to drive increased bottom line earnings. For the quarter, sales were a record $5.8 billion, driving $2.3 billion of net cash flow. Individual Annuities operating earnings were $29 million for the quarter. This is an increase of 17% from the year ago quarter due to improving equity markets and more favorable expense experience in the current quarter.

Slide 9 covers the guaranteed businesses within Retirement and Investor Services. Second quarter operating earnings of $28 million were up 18% over the year ago quarter. On a trailing 12 month basis, pretax return on net revenue improved to 80% due to improved spreads. We continue to approach this business opportunistically, and we'll issue investment-only and full service payout business when market conditions generate attractive returns. Principal Global Investors operating earnings were $29 million, up 59% from the year ago quarter. Earnings benefited by $4 million from a once-in-3-year performance fees on one of our real estate funds.

Slide 10 shows second quarter revenues grew 19% over the prior year quarter, driven largely by higher average assets under management. On a trailing 12-month basis, pretax margin improved over 500 basis points from the same period a year ago to 25%, an exceptional result as Principal Global Investors continues to build scale.

Regarding Principal Global Investors' portfolio, even though approximately 1/2 of the overall assets under management are categorized as fixed income, 2 factors helped minimize our exposure to interest rate movement. First, 1/3 of the fixed income portfolio is in the general account, where fees are billed on a book value basis. Second, a sizable portion of the remainder is invested in high-yield, stable value and liability matched strategies, which do not directly correlate to the change in treasury yields. Unaffiliated assets under management ended the quarter at $101 billion. The unaffiliated net cash flow for the quarter was a negative $1.8 billion. Lapses this quarter were primarily due to a couple of large mandates that transitioned out of our stable value and currency investment options. These assets had lower revenue and margins, so the impact on earnings from these lapses was minimal.

Slide 11 shows Principal International operating earnings of $58 million for the quarter. As I mentioned earlier, quarterly earnings were negatively impacted by $7 million due to the lower-than-expected return on the encaje investment as a result of local interest rate spikes. Most of the loss this quarter was due to the encaje in our Mexican AFORE business, as Cuprum's results are reported on a 1-month lag. The encaje return will cause some quarterly noise, but should benefit earnings over the long run. Quarterly net cash flows for this segment were $2.2 billion. Principal International ended the quarter with $103 billion of assets under management, despite the strengthening U.S. dollar. On an adjusted trailing 12-month basis, combined pretax return on net revenue was 56%, in line with expectations even with macroeconomic pressures.

As shown on Slide 12, Individual Life operating earnings were $22 million for the quarter, a decrease of $6 million from the prior year quarter, primarily due to the continued low interest rate environment. We continue to expect a quarterly earnings run rate for this business of $25 million to $27 million with volatility from quarter-to-quarter. On a trailing 12-month basis, adjusted pretax operating margin was 14%, just below the range of 15% to 17% communicated for 2013. Although claims improved in the second quarter, higher claims for the first half of the year could put us slightly below the range for the full year. Specialty Benefits operating earnings of $26 million were up 14% over the same quarter a year ago, reflecting improved claims experience and growth in the business. The loss ratio continues to perform well at 67% for the quarter.

Slide 13 highlights Specialty Benefits premium and fee growth of 3% over the year ago quarter. On a trailing 12-month basis, premium and fee growth was 4% relative to our 6% to 8% target, reflecting our focus on profitable growth. Trailing 12-month pretax operating margin of 10% was in line with our expectations. The Corporate segment reported an operating loss for the quarter of $35 million, within our expected range of $35 million to $40 million of operating losses. For the quarter, total company net income was up 33% to $222 million. Realized capital losses for the quarter were $48 million and credit-related losses remained in line with expectations, down 11% from the year ago quarter.

Our unrealized gains at the end of the quarter were $1.8 billion, down from $3.1 billion at the end of the first quarter, predominantly due to the rising interest rate environment. As a reminder, because of our strong asset and liability management, changes in net unrealized gain or loss due to interest rate movement do not result in an economic impact and in periods of stress do not force us to sell assets. Additionally as I mentioned in the past, our fee-based business model limits our exposure to the interest rate environment. However, our diversified business model provides some benefit over time from an improving rate environment.

Looking now at capital adequacy, we estimate our second quarter risk-based capital ratio to be 417%. Relative to a 350% RBC ratio, we have approximately $920 million of excess capital. Book value per share, excluding AOCI, at $29.81 increased 7% over the prior year quarter. Our reported return on equity was 10.4%, a 70-basis-point increase from a year ago. This result was negatively impacted by approximately 90 basis points due to the third quarter 2012 actuarial assumption review. We expect ROE at the end of the year to grow 50 to 80 basis points from the normalized year end 2012 result.

Regarding capital management, as outlined on Slide 14, we've allocated $405 million of our expected $400 million to $600 million of capital to be deployed for the year. Last night, we announced our third quarter 2013 common stock dividend of $0.26, a 13% increase from the second quarter. We continue to focus on increasing our dividend payout ratio on a growing net income base. In the second half of the year, we will continue to evaluate all of our opportunities to deploy capital and will manage capital in the best interest of our shareholders. In closing, we're extremely pleased with the continued momentum of our businesses and feel that our business model is well positioned for future growth.

This concludes our prepared remarks. Operator, please open the call for questions

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from the line of Seth Weiss with Bank of America.

Seth Weiss - BofA Merrill Lynch, Research Division

You mentioned that you think the political pressure out of Chile or the political reforms out of Chile will be beneficial for the pension system. The Chilean public pension providers have declined in market cap since those reports came out last month. Maybe you could just help us think about the pressure on fees versus what you see as an expanding pie of pension assets.

Larry Donald Zimpleman

Sure. This is Larry, Seth. I'll comment, and I know Luis will want to add some comments as well. Let me just make a few comments. Luis and I spent considerable time down there about a month ago and had an opportunity to meet with many of the regulators, in particular, who have been very involved in this. First, I'd say a few things. First of all, the AFP system is very, very well accepted as an important element of the Chilean economy. It's been around over 30 years, and I've not seen any indication, there's any intent in any way, to sort of unwind the AFP system. Now the problems that they're trying to solve, I would say are twofold. One is that the contribution rate that is currently being made into the AFPs is too low. If you look at the replacement ratio that's produced by those contributions, it's about half of what it needs to be in order to provide a full replacement of preretirement income. The second problem they have is a problem that exists all over the world, which is trying to get the lower middle income and those who have a more in-and-out employment record into the system, so that they're going to end up with some amount of retirement savings. So the discussion -- the reason I say all that, Seth, is because the discussion is really about improving the system, whether it's higher contribution rates or other ways to get the lower income in. It's not about in any way, shape, or form sort of rewinding the system. Last thing I'll say before asking Luis to comment is, I think as it relates to many of the other AFPs, part of the reason that you're maybe seeing some decline there is because at the end of the day, I think if you're going to be a leader in this Chilean retirement system, not just the AFP, but also the voluntary system, you've got to have a very sort of coordinated and integrated platform that you can use, not only for the AFP side, the mandatory side, but a mutual fund platform and other products that you can capitalize on for the voluntary side. And as you know, Cuprum, as well as Principal prior to the acquisition have been the leaders in the voluntary portion. And that's where you're going to see most of the growth in the Chilean contributions going forward. The growth -- there's going to be some growth in the AFP, but most of it's going to come in the voluntary. And given our leadership position there, I think we're going to be in the strongest position to benefit as these changes may take place. But Luis, additional comments?

Luis Valdez

Yes. The main issue here is that actually, the system and its replacement ratio is going kind of well below expectations. But mainly about what Larry said, did you -- a 10% contribution rate, which is kind of low and insufficient in order to get this kind of 75%, 85% replacement ratio. So that 10% contribution rate is coming from 1982 when the system was designed. And since then, what the Chileans have seen is a dramatic improvement in their longevity and also a very important drop in their interest rates. So that is essentially 2 factors that are driving this kind of low replacement ratios right now. And we think that there's a great opportunity in order to really, really improve the system going forward. The pressure on fees is not exactly the point here because it's a little bit confusing for the Chilean system. Fees are being charged on flows, not over AUMs. And if everyone is making a kind of very simple math in order to calculate how much you're charging over AUMs, the Chilean system is a very efficient one and has a very, very, very, I would say, very appropriate changes on -- over AUMs for the entire system.

Larry Donald Zimpleman

Does that help, Seth?

Seth Weiss - BofA Merrill Lynch, Research Division

That's helpful.

Operator

Our next question comes from the line of Sean Dargan with Macquarie.

Sean Dargan - Macquarie Research

As I look at the encaje slide that you provided, I was just wondering if you could tell us about the composition of the assets in Mexico and Chile, I guess the relative proportion of fixed income versus equity in there?

Larry Donald Zimpleman

Yes, that's -- this is Larry. Sean, that's a very good question and perhaps something that as we go forward, we can provide you a little bit more insight on in general. In general, what I would say is that the Mexican encaje is predominantly a fixed income investment. So sort of think 80%, 85%, 90% fixed income. So that's why you saw the negative impact as interest rates in Mexico rose about 150 basis points, pretty much right at the end of the quarter. Again, that's a positive in the long term, but it's a negative in the very, very short term, which is why you see that adjustment. The Chilean encaje is a broader basket. It's a broader basket of fixed income and equity. And even within the equity component, it has some element of, if you will, non-Chilean or more global equities as well as Chilean equities. So think more balanced fund when it comes to the Chilean encaje. But we'll try to perhaps get you more information as to what that makeup is, Sean.

Sean Dargan - Macquarie Research

Okay, great. And just one additional question. As we think of how we're modeling margins going forward, was there any change in transfer pricing between FSA and PGI?

Larry Donald Zimpleman

The answer is no.

Operator

Our next question comes from the line of Tom Gallagher with Crédit Suisse.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

First question, Larry, I just want to make sure I understood your comment correctly on the onboarding of Cuprum. I think you mentioned net cash flows exceeded estimates. Just looking at the disclosure that you guys had, it looked like $200 million of net flows compared to $40 billion of AUM. That would be an annualized growth rate of around 2%. Is that exceeding expectations? And is that kind of a normalized level that we should expect?

Larry Donald Zimpleman

Yes. This is Larry, Tom. It's, again, a good question. I would say when we talked about exceeding our plan, what we're talking about there, of course, is exceeding our acquisition plan. So one of the big unknowns, and again you can well understand this, one of the big unknowns anytime you make an acquisition is what's going to happen with some of the existing contributors, in this case, of Cuprum. And while we think and believe that the Principal acquisition of Cuprum really now supports Cuprum with a strong global player, we recognize that in the local market, in the local market, you're going to have other AFPs all taking their shot at you during this kind of transition period. So from an acquisition plan perspective, you always want to be a little bit conservative in modeling those flows. What I would say is, I think we've essentially, through the good work of the local team there, we've essentially blunted all of that. So we essentially have not seen any of that potential for outflow that may come just from the sheer announcement of the acquisition. So the kind of 2% that you referenced of net cash flow is probably in the reasonable range for Cuprum on the AFP side. Again, the real opportunity here in the long term is going to be building that more integrated platform between Cuprum and Principal. And the growth, the larger net cash flow is going to come on the voluntary side as compared to the AFP side. Luis, anything you want to comment?

Luis Valdez

Yes. As probably is also is interesting to comment that Cuprum, in particular, is a pretty mature company. So part of our inflows and outflows are very much more determined because we have, every single month, we have customers that are getting their retirement income products. So Cuprum also pays a lot of benefits. Close to 30,000 clients are receiving their monthly income from Cuprum. So that is part of our natural kind of outflows. Also, other clients are choosing other kind of retirement income products like annuities. And we have an annuity company there. So it isn't in their normal process and pace. I should say that $200 million that we already have.

Thomas G. Gallagher - Crédit Suisse AG, Research Division

Okay, that's helpful. And then just one follow-up on the U.S. Full Service 401(k) business. The margins were quite good this quarter. And I know that you guys have talked about the mix shift should be helpful. And that looks like it's coming through. Any -- I guess my question is, should we assume that this higher level is sustainable? Or do you think we'll get some slippage? And then just a specific question, the -- shall I presume the fact that sales and transfer deposits were lower this quarter, had a positive impact on the margin? Is there any way to quantify that?

Larry Donald Zimpleman

Okay. There's a quite a lot packed in there so -- and I know Dan will want to comment. I would say on the question about the sustainability of the margins, Tom, I think that really, really, really comes down to what any persons or analysts or investors view is of the future kind of economic conditions. I mean, if we continue to see the strong fundamentals that we saw in second quarter, and by strong fundamentals I mean we saw compensation increases -- we, although modest. We saw payroll -- I mean, we saw growth in employment, albeit modest. And we saw a very positive equity market return. So the upshot of that is that the incremental account value coming through is some of the more profitable account value. And I think Terry commented on that during his comments. If you think that's going to continue, if you think that represents the economy that we're going to have in the United States going forward over the next few quarters, then I think you would tend to believe that those margins are more sustainable. If, however, you believe that we may see payroll growth rollover, we may see comp growth rollover, we may see equity markets rollover, then I think you would tend to want to model something where there would be -- you'd see those margins kind of decline. So it's really going to vary based on I think your outlook for the economy in the markets going forward. And I'll let Dan comment and then also handle your second one on sales.

Daniel J. Houston

Yes, Tom. Just a couple quick comments relative to the growth and some of this was covered in the script. We just can't forget about the fact that the first quarter of '13 enjoyed a 10% rise in the S&P 500, 2.9% for the second quarter of '13. But as you know, we get compensated on the average daily balance, which was up 6%. So we really had some really nice tailwinds relative to revenues for the first -- for the second quarter. We have really good expense management throughout the quarter, very deliberate. And then something that we haven't had a chance to talk about a lot is these reoccurring deposits. As mentioned in the script, it was up 17%. These are strengthening the matching contributions, the profit-sharing contributions. There's increased salary deferrals and increased participation. During this period of time, we just kind of looked at the last trailing 12 months. Net new contracts, they're up 7% or 2,200 contracts. And we've added 215,000 participants during the last 12 months. So you're seeing the inertia of that in-force block business starting to add a lot to our success. You mentioned in your second question around sales and what the positioning is there. We, frankly, have oriented the sales force to more focus on new sales revenue. It was up more than double digit. Again, as opposed to assets, at the same time, our alliance sales continue to be about 61% of our sales. TRS is 45%. And our TPA business that we've talked about on this call for years now is up over 68%. And again, that's a very efficient way for us to administer these programs. The shortfall in sales isn't small to mid. It's on the large side compared this quarter versus the year-ago quarter. We're down about $831 billion in terms of sales. And that speaks in large part to the shortfall. So we like the mix. We like the current fundamentals of the business and feel good about working towards, and continue to maintain those 5-year benchmarks that we had set out relative to margins in net revenue growth. Hopefully that helps.

Operator

Our next question comes from the line of Joanne Smith with Scotia Capital.

Joanne A. Smith - Scotiabank Global Banking and Markets, Research Division

Just a couple of questions. Just as a follow-up to Tom's question on the FSA business and the strong recurring deposits that Dan mentioned. When we look at the second quarter recurring deposits, how much of that can we look at as being sustainable, recognizing obviously the first quarter is the strongest period for recurring deposits? And then the second quarter, I would expect, would be more on a normalized basis for the remainder of the year?

Larry Donald Zimpleman

Yes, go ahead.

Daniel J. Houston

Yes, Joanne, I think you got that dialed in exactly right. I think that's the kind of the expectation that we would have. There's always that benefit after the 1st of the year where you see people do financial planning. And they make their initiation to participate in a plan or increase their deferral or even possibly change their investment mix. But I would anticipate the balance, latter half of the year looks more like the second quarter.

Larry Donald Zimpleman

Joanne, this Larry. I just want to jump in with one more general comment, if you'd allow me. And then I think you have another question. But the 401(k) system has taken a lot of criticism over the last few years by some people who I think would have different ideas about how he would construct a healthy retirement system in this country. But I find it very interesting, and as part of this question on recurring deposits, I think we've seen increases in the average deferral rate now. So the deferral rate is the amount the employee is contributing out of their own payroll. And we've seen that average deferral rate increase for something like 8 to 10 to 12 quarters since the financial crisis. So I think there's a strong indication that employees get it relative to the fact that they need to get their deferral rates up to a much higher level. So today, you're talking about an average deferral rate that's kind of in that low 8% range, the 8.2%. And that's up very significantly from what it was, say, before the financial crisis. So I want to get a plug-in here for the fact that I think both employers and plan providers like Principal are doing a much better job of getting people to save up near the levels that they're going to need to be if they're going to have adequate retirement income. And so that's part of what you're seeing in this growth in recurring deposit.

Joanne A. Smith - Scotiabank Global Banking and Markets, Research Division

I would also expect, Larry, that it would be a function of people feeling a little bit better about their own financial position given the fact that we've had relatively low economic growth, but at least it's stable. Would you agree with that?

Larry Donald Zimpleman

Right. I would agree with that. I would agree with that. And I think the residential mortgage piece, Joanne, I think also plays in that because that's kind of that wealth effect. I think when people feel like the value in their home is at least stable and now is starting to increase, I think again they're more willing to kind of dig in their pocket a little bit deeper for a little increase in that deferral. And the final thing would be we've been using this kind of step-up concept for several years now. And so we're now getting to a point where those step-up contributions, the increase is now coming through because we're 2 and 3 years down the road. So again, what we find is once people commit to the higher level, they commit in advance, they don't go back on that. They actually follow through. And that's another reason you're seeing these deferral rates increase.

Joanne A. Smith - Scotiabank Global Banking and Markets, Research Division

Okay, great. And then just a question for Jim on PGI. Are there any other mandates that could be at risk at this point in time or you think you're pretty much through that?

James Patrick McCaughan

I think the way to really think about this, Joanne, is that there are always in the institutional market going to be mandates flowing in and out. Some of this is a function of changing allocations by institutions. And what you've seen is an allocation away from active core mandates and towards, in our case, active specialties. That means that we're not necessarily going to be seeing positive cash flows every quarter, as the last quarter described. But we are going to be seeing consistent growth of the revenues because those active specialties are on significantly higher fees. So the answer is there could be. And those will tend to be the kind of active core mandates even where performance is good, that institutions are turning away from. But in our case, we believe that the revenue will continue to grow because we are very strong in areas like high-yield, emerging market, debt and equity, real estate, including something that's very active at the moment, which is origination of commercial mortgages. So all of those areas, we think, will lead to a better revenue picture than necessarily you see from the asset flows.

Operator

Our next question comes from the line of Eric Berg with RBC Capital Markets.

Eric N. Berg - RBC Capital Markets, LLC, Research Division

My questions actually follow directly from Joanne's. Jim, if AUM cannot be expected to grow consistently, what would you consider to be a reasonable level over an extended period of annual revenue growth from your business? And the second question is perhaps more important than the first. Why are we seeing now such a large increase in the profit margins in your business? And where can those margins head?

James Patrick McCaughan

Yes. Thanks, Eric. I think the long-term trend in AUM and revenues will obviously depend somewhat on the market change. And that has been a tailwind certainly for the last 6 months. But it doesn't solely depend on that because flows and the change of mix will continue to help us. Just to illustrate that, the quarter we're currently reporting on saw a 14% increase in average AUM across PGI. The revenue is up 19%. I think that's the kind of trend that feels right for the long term. Now obviously, if you didn't see the strength in the equity market, the numbers might've been both down by 3%, 4%, 5%. But remember, we are not so dependent on the equity market given that we have significant alternatives, including real estate, a lot of different fixed-income options, many of which are not really linked into purely the treasury market. So I think that trend is really a decent indicator of the long-term trend. And it's very much in line with what we said last year to our Investor Day in terms of our 5-year expectations. In terms of the margins, sure, the 29% pretax margin in the second quarter is a bit above long-term trend simply because it included $4 million arising from a performance fee. But in all other respect, I think it basically is in line with long-term trend. And what we said last year at Investor Day was we were on a 5-year view as we gain scale and we grow into the expenses we've made, we've got a significant all-expensed investment in growth in Principal Global Investors. As we grow into that and as our new offices and new capabilities generate assets, we will be able to increase profitability towards, we believe, that 30% pretax margin. The fact we almost got there in this quarter is incidental and not sustainable. But on a 3-year view, I do believe that, that 30% will prove to be sustainable as we develop our scale and our higher added value products. Hope that helps, Eric.

Larry Donald Zimpleman

Eric, this is Larry. I just want to make one comment on this kind of in defense and support of Jim and PGI. I think when you do compare PGI against margins from other asset managers, you do need to take account of the fact that today, about 60% of PGI's assets are basically transfer-priced to other businesses of the Principal. So whereas when you look at other asset managers, my guess is probably 80% to 100% of their assets are unaffiliated clients. So when you think about the fact that we're sort of working towards 50% unaffiliated, 50% affiliated, and we're still pushing sort of leading-edge margins in PGI, I think they're doing a really nice job of managing expenses along the way.

Operator

Our next question comes from the line of Ryan Krueger with Dowling & Partners.

Ryan Krueger - Dowling & Partners Securities, LLC

You mentioned that the $0.92 normalized result shouldn't necessarily be viewed as a base going forward given some potential timing of expenses. I was hoping you could give us some sense for what type and magnitude of additional expenses you may incur in the second half of this year?

Larry Donald Zimpleman

Yes. This is Larry, Ryan. And I'll have – I'll ask Terry to comment as well. I mean, again, I think whether you view $0.92, I mean this is what I was sort of commenting on earlier, I really think whether you view $0.92 as the jumping off point for Q3 or Q4 or whether you discount that to some degree for Q3 or Q4, again, I think really depends in large measure on your view of the economy and your view of the market. I mean, I think you could go in and sort of financially dissect this or that, and you could try to figure out, was DAC amortization this time a little higher or a little lower or whatever, whatever. And maybe that leads you to a conclusion. Although I think sometimes it's a bit of paralysis by analysis. I mean, my personal view is, again, as long as the economy continues to normalize and the markets continue to heal and interest rates don't necessarily spike up, but that they continue to increase as a result of economic growth, then I view the $0.92 as a kind of reasonable neighborhood from which we launch into third quarter and fourth quarter. But if on the other hand, you believe the market's overvalued, the economy is going to roll over, then I would be cautious about just forecasting $0.92 into the rest of the year. So Terry, you want to comment?

Terrance J. Lillis

Yes. Ryan, this is Terry. It's a great question. And as you -- when we talk about the $0.92 in the current environment. And we think that that's a good, normalized number for this quarter. However, there are some things that are going to affect the future. We've had seasonality in all of our businesses. And that'll continue. Some of it will be somewhat favorable into the future. You talk about dental claims, for example. We've talked about the impact on security -- excuse me, the Specialty Benefits business. We also talk about the macroeconomic conditions in Latin America. Right now, the -- you're seeing some impact because of the 1-month lag on Cuprum's earnings. And what happened in Mexico could have an impact on us in the third quarter. That is yet to be played out. You also look at the exchange rate. The spot rate at the end of the quarter was lower than the impact or the average for the quarter. And so that could have some impact. And it will once again play out. Expenses could be larger in the second half of the year, and you'd expect that. Sales could be larger. We expect them to be larger in the second half of the year. And depending on the mix of that, we may have to expense all that cost in the current period and not have an opportunity to defer it. We also are going to continue to investing in our businesses. And so to some extent in the first half of the year, we may not have included as much of expenses as we have in the past. Once again, it's somewhat spotty. And then the other item, the last item that I'll comment on, is the effective tax rate. You do expect -- we do expect the tax rate to go up. We benefited in the first half of the year because of a true-up on the dividend received deduction. And so that held our effective tax rate down a little bit lower than what you normally would have expected. In the second half of the year, with the higher earnings and those having a smaller impact on it, you could see a higher effective tax rate as well. So all of those things need to be taken into consideration, modeled, looked at and analyzed. And that's why we don't say you just simply can go just jump off as this is the normalized run rate. I hope that helps.

Ryan Krueger - Dowling & Partners Securities, LLC

Understood. And maybe just along the same lines, so the FSA margin was about 34% in the quarter. In the past, over a pretty long period of time, I think it's hovered closer to 30%. So I guess maybe I'm just trying to get a sense for, I think, Larry, you said that if we tend to continue in the same environment that we're in, you don't necessarily see any big changes. But at the same time, that margin's actually quite a bit above what you tended to do. So that was kind of my question in regards to the expenses, if maybe there was just some timing considerations for the quarter that wouldn't necessarily lead you to believe that, that 34% margin would be sustainable even in a good macro environment.

Larry Donald Zimpleman

Yes. I mean, we've commented many, many, many times that you always want to be careful about taking one quarter and prognosticating that for the future. So I think if you wanted to sort of look at a better estimate of what it might be, you always want to work with trailing 12-month periods rather than work with current quarter periods because there's just naturally going to be some ebb and flow. But I think even if you look at trailing 12 months, you're still getting a number that is in that 30%, 31% kind of range that really does represent best in class. I mean, the bottom line here that I would say, I think, investors and analysts should focus on relative to FSA is not the level of margin in any one place. I think the key message here, and what you should focus on, is the fact that this business model is not broken. This business model has faced a lot of headwinds in the period of time since the financial crisis. But a lot of reports have said, has something happened? Is the model broken? Can it get back to where it was in 2004, '05, '06? And I believe firmly the answer to that is when the economic conditions normalize, when the market conditions normalize, it absolutely can get back to that same sort of growth trend we saw back in those days. And this quarter happens to be a 3-month period where the economy and the markets performed more in line with what was happening in those periods. And you saw very nice returns and you saw very nice margins. And so, again, I would just comment that I think the key thing here is not the kind of current margin level and prognostication. The point is the model works. The growth in earnings is there when the macroeconomic and market conditions allow it to come through.

Operator

Our next question comes from the line of Steven Schwartz with Raymond James.

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

After that public service announcement, Larry, I'm now going to completely ignore it and go back to the FSA margin. Is that okay?

Larry Donald Zimpleman

You bet.

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

Okay. Two questions, and I think one of Tom's myriad of questions wasn't answered. Did -- but Terry may have touched on it a little bit later, did the low sales or the low transfer deposits in the quarter benefit margin? Because there was a lack of expenses that maybe would not have been DAC-able under the new rules.

Larry Donald Zimpleman

I think short answer would be yes. But in terms of quantification of that, Steven, it'd be awfully hard to do. I don't know, Dan, you want to comment?

Daniel J. Houston

No, you're right. It's -- obviously, if we had lower sales and the split of sales was roughly 50-50 between our group annuity contract and our 40 Act funds. And so if you just think about 40 Act funds as having to be 100% expensed, that's where you would see this expense that would've been deferred. So we reach our full year sales goal which we said was roughly flat with the year ago, about $11 billion. We would anticipate we'd have higher sales-related expenses in the second half of the year than we did in the first half.

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

Okay. Okay, good. I'm glad I asked that. And then to look at these -- couple of more follow-ups. To look at the PGI outflow that Jim talked about from the 2 accounts, my understanding is that one of the accounts was Nationwide pulling funds from Morley, which was always going to happen anyway. Jim, do you happen to know that number?

James Patrick McCaughan

Yes. It's approximately $1 billion. Whether it was always going to happen anyway or not, I wouldn't want to make a judgment on. But the account had performed pretty well, but they decided to take it back to one of their own teams. And that's always a hazard with sub-advisory mandates.

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

Okay. And then one more on Chile. I think one of the other proposals with regards to the pension system there, I think the guy who's leading so far in the polls is a socialist. And he is also proposing that the government set up one of these AFOREs. Is that possible? Is that an issue? Would it really concern you if that did happen?

Larry Donald Zimpleman

Well, we happen to have, Steven, the best Chilean political commentator with us today. And there actually have been some sort of late-breaking developments relative to candidates there in Chile. So maybe I'll just have Luis comment on it.

Luis Valdez

Okay. As Larry mentioned before, one of the main issues that we're facing and the Chilean system is facing there is the coverage in order to go deeper into the middle and low-income segment. And probably, and this is one particular idea, probably one way in order to try to better cover that particular segment, it could be the creation of kind of state-owned AFP or a pension company in order to try to go into that particular segment. But this is still a kind of idea. And the truth is the Chilean government, they have to really better figure out how they can build a much more stronger first pillar. And we don't know yet if within that kind of design and a state-owned AFP is going to be the right solution. But as those comments and the initiatives are going into that particular way to go and to try to tap that unattended market, which is particular is not our market. So we're right far away from that particular market. Cuprum is a premier provider, and is having on average, the highest average salary in the pension system in Chile. So we're kind of away from that problem. And even if that AFP is coming, we think that we're going to be pretty much more isolated from that particular effect.

Operator

We have reached the end of our Q&A. Mr. Zimpleman, closing remarks, please?

Larry Donald Zimpleman

Well, thanks again to everybody for joining us for our call today. We're really proud of our second quarter. And we continue to believe our transition to a global retirement and asset management leader with a well-diversified global footprint will produce a significant increase in shareholder value over time. As John commented, we're having our Investor Day in New York City on September 13 at the New York Stock Exchange. And we hope that many of you are going to be able to join us there. So thanks, and have a great day.

Operator

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Principal Financial (PFG): Q2 EPS of $0.91 beats by $0.09. Revenue of $2.31B misses by $0.08B. (PR)