Friends Life Group (OTC:RSLLF) Q2 2014 Earnings Conference Call August 6, 2014 3:30 AM ET
Andy Briggs – CEO
Tim Tookey – CFO
Gordon Nixon – RBC
Andrew Crean – Autonomous
Alan Turner – Barclays
Oliver Steel – Deutsche Bank
Ravi Kannan – Goldman Sachs
Good morning everybody and welcome to our half year results presentation. I’m conscious it's a very busy day for results today with legal and general’s presentation at 10:30 this morning I believe. So I do promise I will do my very best to get you away from here by say lunch time. Joking aside we will be relatively brief because having clearly set out our strategy back in March and May, today is all about updating against that strategy and how we’re getting in the execution of our strategy and I’m pleased with the progress we have made.
The key messages can be summarized under the two key goals of our financial framework. In terms of cash today, we’re making good progress in building towards our 1.3 times coverage targets. The Lombard disposal and increased share buyback improves our pro forma 2013 dividend coverage ratio. And then our sustainable free surplus in the first half of this year is up 15% and on track from low double-digit percentage growth at the full year. Suffice to say we are confident that in due course we will get to the 1.3 times coverage target.
So my key focus is growing cash tomorrow to support our future progressive dividend. Again our execution in the first half is pleasing. The continued delivery of our program of revenue optimization initiatives will add a further 10 million pounds per annum to expected return from 2015 and there is more to come from future potential initiatives. On corporate benefits we have had strong net fund flows and hence have grown underlying free surplus from £11 million for the full year in 2013 to £14 million already at the half year this year.
And on return on income, our focus has been on further building our customer engagement. I’m particularly pleased with how this has driven good annuity sales both in Q1 and Q2. The superior capability in customer engagement that we are building leaves us well placed for the post budget world. Alongside this we are further developing our market leading platform. Overall our progress in executing on our strategy gives me high confidence in our ability to grow cash going forward.
Before I had over to Tim to cover the results in more detail I do want to mention the Lombard disposal. It was a while in gestation but I’m pleased with the outcome. In particular I’m delighted to announce today that we have received PRA approval given the strength of our balance sheet to return the full initial consideration. Hence we’re increasing the share buyback to £317 million from the £261 million previously announced.
The deal demonstrates our commitment to securing maximum value from each parts of the group and returning cash to shareholders where appropriate. The larger share buyback improves to 2013 pro forma dividend coverage from 1.1 times to 1.7 times and the pro forma capital coverage remains strong. So in terms of agenda today I will be back shortly to update on the execution of our strategy but first I will hand over to Tim to cover our interim 2014 trading update. Tim.
Thanks very much Andy and good morning everybody. So before I get into results I just like to highlight a couple of things on the presentation of our numbers this morning. Firstly following the announcement of the sale of Lombard this business is now treated as discontinued and doesn’t feature in our operating results in either year. Now full reconciliation of the headline measures to those shown before is within the appendix to your presentation day.
Secondly and as plans we completed the transfer of the non-core OLAB business from International to Heritage at the end of last year. We have therefore restated the 2013 results for these divisions to ensure comparability. Now you saw most of the new business restatement effects with our first quarter numbers but you will find everything in the release today including balance sheet EV split. So let’s look at the numbers which we’re presenting today using the financial framework which I set out in March.
While I’m delighted at the continued growth in SFS with a £163 million delivered in the first half of the year. This is supported by good growth in free surplus expected return also shown center top here which has increased by 2%. Our IFRS and MCV results are down marginally last year principally reflecting continued pressure on the international business and the predicted margin compression in retirement income.
This has as expected resulted in lower value of new business contribution in MCV and to reduce new business strain benefit in the IFRS result. I will cover both of these in more detail later. Our capital base remain strong on both an economic and an IGCA basis and in-line with our stated dividend policy we have maintained our interim dividend at £7.05 per share. So let’s get stuck in by looking at sustainable free surplus in more detail.
At a group level SFS has grown significantly, importantly this also reflects a good underlying free surplus performance with expected return growth and lower investment in new business. On development spend, we originally guided to a circa £15 million increase in development spend for this year principally to be invested in retirement income but we have pulled back substantially on our initial proposal for this spend and as you can see here there is £2 million increase at half time.
We no longer expect anything like the originally guided increase although I’m excluding from this comment and from our SFS guidance future cost associated with products and platform development. This will be reported separately and are not expected to exceed £30 million this year.
Looking at the performance at a divisional level it's clear that the group result is underpinned by the Heritage division. On our flags many of the drivers of this performance earlier this year and I will look at the increased expected returns in just a second. Across the other division sustainable free surplus is lower with the UK division result largely reflecting reduced retirement income margins and some adverse protection claims experienced whilst challenging market is continued to impact international.
Our cash returns to ratio being our measure of free surplus generation as a proportion of shareholder net worth has improved than last year. Overall this has continued strong cash generation progress and following the 7% growth in SFS achieved in full year 2013 from £304 million to £325 million, I’m very pleased to confirm that we expect to achieve further low double digit percentage growth in SFS for the full year 2014.
So let’s now discuss the growth in expected returns. Well back in March I shared with you our expectation for the emergence of surplus from our UK and Heritage in-force books with a £39 million uplift expected this year. You can see this in the mini chart on the left hand side of the slide. I’m delighted to be report £23 million of the 39 million uplift has been achieved in the first half and I’m confident of delivery of the remaining element in the second half. The growth has been achieved through initiatives delivered in both divisions with Heritage initiatives including Phase 1 of the with profits annuity reallocation and asset transfers to FLI.
In the UK Division benefiting from last year’s new business growth. We continue to focus on improving surplus generation and we expect further benefits to be delivered through an initiative such as the second phase of the with profit annuity reallocations and the asset recapture work we’re doing to bring further assets onto the FLI and Schroder’s platforms.
Let’s go through the businesses in a bit more detail starting with Heritage. Well the drivers of the 7% increase in Heritage expect to return as shown on the right hand side of the slide and are in-line with my March presentation. But I do want to briefly comment on the impact of the transfer of the OLAB business into Heritage. The table on the bottom left shows the impact of this transfer on the Heritage result and as you can see there has been no net impact on the trend in expected return.
However the OLAB transfer has reduced the cost of investments in new business this year. OLAB new business was seized barring increments at the end of Q3, 2013 and has driven £15 million of the £17 million reduction in Heritage I&B this half.
Overall this is a strong performance from Heritage, now let’s look at ISF based business corporate benefits. How would I sum up the overall corporate benefits performance? Well I have to say I think it's terrific. The growth in the business has driven income up to £60 million equivalent to 60 basis points on opening assets. While outgoings have been held flat £47 million. This in turn equates to 47 basis points of outgoings which is a six basis points improvement on last year. This is a clear improvement in operating leverage and this drives the increase in underlying free surplus generation which is at £14 million for the half against the total of £11 million the whole of last year.
Growth in the business has fueled another good period of net fund inflows of north £0.4 billion, and investment performance has moved from negative Q1 to an overall plus north £0.3 billion for the half.
New member growth to auto enrollment remains a principal driver of growth with a second quarter of the year expected to represent a clear peak in new scheme enrollment. The first half of the year has shown strong growth on this front with 648 new schemes enrolled. In total the group has added a net 108,000 new employees to its membership bringing the total to 1.25 million. With this supporting the APE and regular premium growth OF 30% and 4% respectively.
All in all terrific progress, moving now to the open insurance business starting with protection. While protection business had delivered a strong start to the year with volume growth up 21% with value of new business close to flat on last year of £31 million and the underlying free surplus generation is flat at minus £7 million.
Growth in this business has been driven by the individual protection proposition although some of this growth reflects the comparative market weakness at the beginning of 2013. Across the protection business as a whole however there has been some tightening of margins with more competitive pricing in the individual protection market in contributory factors as well as a shift of mix in group protection business to the lower margin group life product.
Financial discipline continues to be key in this price driven market, the cost of writing new business remains an important factor and we have worked hard to manage the cash strained dynamics.
As a result the cost of investing in new business has increased by just 5% and thus at a much lower rate than new business volumes. So overall my scorecard type view of protection would be strong sales progress but only a satisfactory cash performance.
Next retirement income, while the market is still adjusting to the changes announced in the Chancellor’s budget. Andy will talk in a minute about the products and platform and other activities that we’re undertaking to win in this new world.
The business contribution from underlying free surplus shown on the left at a £6 million loss it's a continuation of the trend that we saw in the second half of last year and is much more about conscious increases and the competitiveness on the product than impacts of the Chancellor’s budget. This is also the case in VNB and margin trends shown top right.
We have some excellent annuity products and are committed to maintaining a competitive product suite although we would hope that any further margin compression from here would be modest.
Notwithstanding all this volumes are close to flat in the first half showing little budget impact although we do expect annuity sales to fall overtime as we have previously said. Importantly, first half sales reflect a high proportion of GAO related business which is 53% of first half volumes.
But they are also testament to our successful customer engagement model. This performance compares well to a general trend of individuals to defer their time of decisions even before the budget announcement.
In the international division cash generation is clearly disappointing although this does reflect the trends that we have reported recently.
The underlying free surplus contribution has reduced to plus £14 million in the period with a reduction in expected return only partially offset by reduction in the cost of investment in new business.
The business has continued to suffer from market disruption and local market reviews particularly in Hong Kong where the market has shrunk as we discussed at Q1. In addition we’re also facing continued competitive pressures in Singapore and the Middle-East but we’re maintaining our focus on financial discipline.
The delivery of free surplus and importantly the ability to grow free surplus is a key part of the business being able to deliver its dividend targets. The difficult trading environment has impacted sales and thus SFS. But this effect is being compounded by adverse exchange rate movements and a likely shift to the Hong Kong capital regime becoming the biting capital constrained for the company. To mean that the interim dividend has been passed and the final dividend will be kept under review.
We’re very focused on addressing the recent poor performance and have a number of initiatives underway some of which have led to Q2 sales being marginally better than Q1 and July looks encouraging. In addition the business is investing heavily in its capabilities with platform development continuing to progress well and is expected to be ready to accept new business on the platform at the end of the third quarter.
The in-force book will be transferred in 2015 leaving this business better able to compete in its chosen markets. Let’s move on to the IFRS result. Well operating profit on IFRS basis is down 7% on last year. At a group level the drivers principally reflect a slight reduction in in-force surplus and that is largely driven by lower positive mortality experience in 2014.
This has however being more than offset by higher returns on shareholder assets which are in-line with guidance. Development cost have also being tightly managed as I set out when we discussed SFS earlier.
We have made some modest one-off modeling changes but otherwise the results are in-line with the first half of 2013.
At a divisional level the period on period performance is similar to that in SFS with the Heritage division delivering increased returns through reduced new business strain in the recently transferred OLAB business and improved economic factors driving higher in-force surplus and returns on shareholder assets.
In UK we have experienced a low result because of our decisions to improve the annuity pricing.
Looking at the IFRS result as a water fall I have set out here the key components of the period on period change. Starting here on the left and finishing on the right, with the removal of the half year 2013 and 2014 principal reserving changes. Across the middle here in the dotted box I have split new business strain into two with this highlighting the benefit of reduced non-core OLABs sales offset by the consciously reduced margins in retirement income.
The next box here highlights the drivers of in-force surplus generation with this reflecting the additional surplus delivered by the first phase of with profits annuity reallocation offset by the lack of positive protection mortality experience that I referred to just a moment to go.
Finally and as I mentioned on the previous slide you can see it a benefit of probably expect to raise a return on shareholder assets.
Moving on to MCV briefly. I want to spend a great deal of time here as the key drivers of the same as those that we talked through already on SFS and IFRS. At the headline level, MCV result is marginally lower 5% down on last year. Last year results of a lower contribution from new business mainly from retirement income of course and international.
This is partially offset by 15% increase in the expected existing business contribution which as I reported at year end is benefited from improved opening rates of return. Elsewhere the results are broadly in-line with last year with the capitalization of lower investment expenses and increase in the recognition of deferred tax assets shown in the line called operating assumption changes.
Let me finish by looking at capital, and as you would expect not much has changed really. The group has continued to maintain strong economic and IDCA capital basis. Available shareholder assets also remain strong and we have further enhanced the returns achievable on these assets with more than 2/3rds of the £200 million syndicated loan mandate already invested at the end of June this year.
In line with our stated dividend policy we have maintained our interim dividend. In addition and supported by our capital strength like Andy, I’m delighted that we have received PRA approval to increase our proposed share buyback to the full £317 million consideration from the Lombard sale.
The share buyback will commence when the sale has been completed and proceeds received. I expect you will be getting your calculators out shortly to do the maths on when we might start a progressive dividend.
But when I look at it I also remember that the average share price of which share buyback will be done is unknown and of course a key part of our annual SFS is expected return where one January economic factors are key and cannot be predicted in advance. So there are a number of factors to take into account.
And with that I will hand you back to Handy so we can get stuck in the progress that we have made on executing against our strategy.
So as Tim has covered we are making good progress to our cash delay target of 1.3 times dividend coverage and I therefore want to focus on growing cash tomorrow by updating on how we’re executing against that strategy and leveraging the strong market positions we have to drive growing cash and hence support our future progressive dividend. You will recognize this chart, recapping the strategy we previously set out.
I want to focus on three key areas where there is significant market change on where we’re investing. That is not to diminish the importance of other areas such as protection and FPI and but just -- there is less change in these markets and Nigel would never forgive me if I didn’t keep you till lunch time.
Three areas are, firstly our revenue optimization initiatives, secondly, corporate benefits and thirdly retirement income. So I will talk about our execution and delivery in the first half in each of these three growth areas and our goal is to grow cash to more than offset the run-off of the in-force book which we covered back in March as roughly £30 million per annum in the shorter term and £10 million per annum in the longer term.
Firstly revenue optimization initiatives, primarily focused in our Heritage division. There are two areas, UFCs with profit funds totaling £4.3 billion which we’re looking to move into the shareholder fund and also asset migration, with total potential assets of £66 billion. Last year we announced 2 billion of annuities from the with-profit fund and 17 billion of asset migration to Friends Life Investments and combined these have improved expected return by 16 million per annum starting this year. This is an important driver of the growth and expected return that Tim has just covered.
Our focus in the first half of this year has been on the further north 0.8 billion of annuities in the with-profit fund together with the 14 billion of assets from F&C that we’re moving primarily to Schroders as part of our new strategic partnership.
We expect the combined benefits of these to be £10 million per annum from 2015, so this isn't included in the expected return numbers in the current year.
And as you can see from the pie charts that takes us roughly half way through to potential revenue optimization initiatives that we can undertake. Jonathan Moss and his team have established a strong track record so while it isn't certain that we can complete the remaining initiatives I’m confident that if it can be done profitably we have the team to do it.
The revenue optimization initiatives is reducing the speed per in-force run-off in the shorter term so the £10 million here will reduce the £30 million run-off at the in-force booking 2015 down to just £20 million. With the other growth areas them leading to more than offset this residual £20 million run-off.
Moving onto our second area, corporate benefits, the market growth there is very strong with assets in corporate benefit market expected to triple over the next decade. And the strength of our market position is clearly highlighted on the left hand side of the slide. Across corporate benefits and Heritage pensions we have over 2 million pension customers, that’s 1 in 7 DC savers in the UK.
Our customers have 48 billion of assets under management and pays up in in-force regular premium of over £1 billion per annum. All in all we’re a scaled player in this markets.
In terms of our delivery in the first half in corporate benefit, the key focus has been auto enrollments where we auto enrolled over 600 schemes having a total over 100,000 net new members in the first half of this year. In addition we have launched our new master trust [ph] and have developed a different offer transfer proposition to attract new asset for long side and UCE.
Here the take up rate is a very impressive 37% with average funds of values of £28,000. These initiatives have been key drivers of the excellent net fund flows in the first half of north £0.4 million. As you know asset base businesses are allow about leveraging operational gearing. Gross assets and income and whole costs, that’s what we’re delivering and hence we made excellent progress in our underlying free surface generation. To having grown significantly in 2013 from 2012 we have now done more in the first half of 2014 than we did in the whole of 2013.
I recognized this is only 18 months of track record and you all want to see this for longer. For the growth in this market will largely happen in the existing schemes which we already have. Indeed there was a 80% of our new business comes from existing scheme and if we continue the performance we have been corporate benefits alone will go a long way to cover the residual run-off that we had from the previous slide.
Moving on to our third area of the quarter, retirement income, we covered it before, we have 1 in 9 maturing pensions in the UK in a market that we expect to triple in size over the next decade. Let me take a moment to set out the size of the price, remembering this is also all about growth from our existing customer base.
The chart on the left here shows our existing 48 billion of corporate benefits and Heritage pension asset which I just covered by age of customer. Quite simply there is a wall of money coming at us. And of course this is just a current assets under management, this will grow to asset growth, the in-force premiums for existing customers and the addition of new customers.
The chart on the right shows that the distribution of our existing pension assets by pot size. It also covers our target market recognizing that larger pots may seek IFA advice and small pots may well be cashed in. Although even cashing in a £20,000 pot will need a big income tax bill and paying higher rate tax in many cases which could be significantly reduced by drawing income overtime.
Summary, the vast majority of our existing customers are mass affluent, do not have an existing IFA relationship and are unlikely to pay fees for IFA advice. Given the retirement income market is a one subject that most changed post the budget. I want to spend a bit more time setting out what we have been doing to drive value from our significant scale here.
And I look to do this considering each of the three areas of the customer value chain, mainly customer engagement, platform and products and asset management. In each of these three areas I will share some of the headlines from the expensive customer research that we have done over the last few months and then cover the actions we’re already taking as a result.
Starting first with customer engagement, even before the budget this was a key area focus and since then we have redoubled our efforts because there is no doubt in my mind that the winners going forward will be those that engage best with their customers. So this is the critical area.
Headlines from our research, most customers want help but won't pay more than £500 for advice which rules out most good IFAs. And there is a huge opportunity to help customers optimize their tax position.
Another fact, in both the U.S. and Australia the significant majority of customers decumuli with their accumulation provider. In other words the evidence for the market is look after your customers, offer competitive products and most will choose to stay.
We have three key channels of engagement with our customers, telephony, direct mail and online. In terms of telephony, our retirement engagement themes [ph] compete over 2000 customer calls per month both outbound and inbound playing a vital role in supporting them. We’re open for business when it suits our customers providing weekend and evening appointment.
We offer a dedicated retirement specialist to each customer enabling our people to understand each customers priorities in order to help them understand their retirement choices. In terms of direct mail we contacted approximately 50,000 customers so far this year offering them support and guidance in this period of uncertainty and change immediately following the budget.
By the end of the year we will have contacted a further 100,000 customers by reaching a critical point in their retirement journey. Those customers wishing to discuss their options in more detail will be offered one of our dedicated retirement specialist to speak to.
In terms of online, our new retirement planning hub is now live on our customer website. The customer website hits increased in the month following the budget by 232% compared to the previous month.
And as part of our platform development, our extended customer interface will offer a single view of Friends Life holdings and importantly tax guidance which customers will find hugely valuable.
So, lots of action underway, is it working? What’s happening today is that the annuity market is declining the red line on the charts here and it will have fallen even further since the year end. This is because more and more customers are deferring their retirement.
Another fact for you, 80% of our customers that were due to retire in 2012 that choose to defer have still not retired now. The deferral option is good for us as we keep earning our annual management charge. The alternative to deferring is to buy retirement income products and prebudget the mass affluent customers thanks to annuity.
Our annuity sales in the first half of this year have been excellent and far superior to the majority of our main stream peers. In other words for those of our customers who choose to retire using the annuity rather the deferral far more buying that annuity from us. I believe the reason for this quite simply is that we’re building a distinctive capability in engaging with our customers at retirement.
Yes, a product needs to be competitive and our annuity margins are lower as Tim covered but they are still very profitable and better than most of our peers historically. And of course guaranteed annuity options continue to be attractive to our customers and remain about half of our annuity sales.
In terms of the independent government guidance we said very early on that this should be provided by independent bodies and I’m pleased that the Chancellor agrees. He will be brief and will not provide specific recommendations so we will be there when our customers want help in understanding their options and deciding which one to take.
To summarize on customer engagement, strong delivery in the first half as evidenced by excellence in annuity sales leaving us very well placed for the post-budget world.
What I believe that customer engagement will be the key differentiator, it's also important to have a good competitive platform and product range. In terms of the research here my favorite is that three quarters of customers want a fixed income for life but only a quarter in terms of buy annuity. But this actually says quite a lot, they want simple competitive products. So alongside our annuity product range we need a competitive platform based flexible income proposition.
We are therefore investing to further build and already market leading corporate rep platform by adding an individual version which we expect to go live by April of next year. The key point I want to make here is that this platform already exists into many of your senior outside on as you were coming in and it's already offering our customers pensions on side by side with a broad range of funds as well as the cash savings account, online share trading and so on.
It's already market leading in the corporate market, the largest employee benefit consultant in this market is MRSA [ph] their client offer is MRSA work place savings where we want three partners and the benefits of this partnership have been a key driver of our 30% sales growth in corporate benefits in the first half that Tim just covered.
This is fundamentally down to the strength of our corporate platform. So while there is work to do to separate the corporate layer further build the D2C interface and integrate to our existing products. It's a strong base on which the build our flexible income proposition.
We’re also planning further product delivery here including more flexible annuities, late life income products and number of other ideas.
All these would ensure that we have a competitive range of products to fulfill behind our strong customer engagement. The other point I would like to draw our here is the strong complimentary benefits of our business model particularly between Heritage and the open businesses. Going forward as I’ve just said retirement income would involve both annuities and the platform based flexible income which we’re basing on our existing corporate rep platform.
Given we have pension customers in both Heritage and corporate benefits, we leverage much greater value having Heritage, corporate benefits and retirement income altogether.
And finally on the retirement income I would like to touch on asset management where I believe our best of breed model is a competitive advantage. The research tells us customers rarely know where they are invested. Once a safe choice and already choose high alpha funds.
The pie chart shows the asset mix on our corporate benefits book which is typically mass affluent customers. Over a third is passive whereas scale and buying power gets us extremely competitive rates. And even the active [ph] is still a low level of basis points.
In terms of key actions we are working with Schroders to develop a new range of fund options and we have our excellent range of Friends Life default funds where we manage the asset allocation of underlying passive components. Nearly half of our auto enrollment schemes have taken the Friends Life default fund.
The key point to make is that pay away is very large, so in my opinion an in-house multi-asset manager is not necessary for us to capture value and succeed. In summary for retirement income overall customer engagement will be the key differentiator. We have performed strongly here in the first half along with a competitive product, platform product range and asset management model I believe we’re well placed to secure the wall full of money as it comes through into retirement.
So to conclude we have been getting our heads down in the first half and getting on with the execution of our strategy. In terms of cash today, the Lombard disposal and increased share buyback improves at 2013 pro forma cash coverage of the dividend. On the strong performance in sustainable free surplus in the first half of this year gives us confidence in building towards our 1.3 times coverage target. Therefore my focus is much more on growing cash tomorrow to support our future progressive dividend.
I have outlined the three key areas here and our delivery in the first half of this year has been strong with a significant majority of the growth focused on existing customer base given it's scale which in my view makes the growth all the more attractive. Overall I’m pleased with our execution on the first half and I’m confident we can drive growing cash going forward.
And with that we will move on to questions.
I have got three questions please. Firstly on the 1.1 billion in-force premium number you give to the corporate business. I wonder if you have the number where that (Technical Difficulty) number is going to reach one you reach the full contributions for its auto enrollments, that’s the first question. Second question on FPI, how confident are you? You’ve got enough scale in this business because I realize you move on to new platform but it does seem to be struggling in terms of returns and the third question on the capital in terms of PRA. Is it too much to conclude because you have been able to give back all of the proceeds from Lombard and the (indiscernible) rules aren’t yet finalized. So actually that implies you have got some underlying excess capital in those positions.
So I will take the second of those and let Tim do the first and third. FPI scale I mean very, very much a scale business. Our assets under management are just under £7 billion so significantly greater than many of our UK listed peers in that marketplace so comfortable got the scale. The embedded value is about £500 million so it's a decent size and scale of business. Tim?
Thank you. Yes John on the first point about auto enrollments, there is no doubt auto enrollment an existing scheme to be in the key driver behind the fund inflows. We have seen a larger number than we would have expected of employers go with the minimum 1 plus 1 contributions. So simply through the passage of time we retain those schemes and we see new members come on board as we would hope to on both then that 1 plus 1 would rise to a total of 8% when auto enrollment is completed in end of 2017.
So what I particularly like is that we’re writing this business profitably now eve on the modest level of employee and employer contributions and that bodes very well for the efficiency and therefore the operating leverage that we should get from the business as those contributors rise in-line with the legislative step changes in the future.
Did you have the feel for the numbers? It’s sort of 2 billion or 2.5 billion into the step up--
No, I can’t give you that because that would depend on understanding the distinct averages of how many are 1 plus 1 are, what we have seen is average contributions that we’re receiving from employees are down quite a bit, this is the effect of auto enrollment and company is averaging down to low contributions overall. But clearly it's -- I am particularly pleased with the performance and that’s why it was described as terrific. If you can write it profitably in greater operating leverage when contributions are modest and that bodes well for the future. I think it absolutely vindicates the decisions taken probably 18 months ago to focus on auto enrolling our existing customers. What you have incurred or the infrastructure cost you have got a setup, you have the funds designed, you have got the electronics straight through processing with the HR departments of the employers.
So your overheads are relatively fixed and you can just put the additional volume coming through that’s why we’re still writing business profitability even the finer margin that you get on auto-enrollment so it's stokes the boiler [ph] well for the future there. In terms of your last point John on capital, I mean we were particularly pleased to get the PRAs approval to the larger buyback. So initially we announced just the upfront cash consideration from say Lombard so £261 million what we have now agreed is that the full initial considerations so effectively distributing our share buyback, the financial element which is the vendor loan note which actually we won't receive for some eight years down the track. I mean that’s a strong indication about our [ph], so the Board’s confidence in the strength of the balance sheet and our capital position and financial prospects but I think it's also clear that the regulator has taken a similar view in forming their position on it.
I don’t think you can necessarily leap to a position that says there must therefore be an excess because the industry is still working through insolvency too, still waiting to see that land and as I said back in March. I said that then we didn’t see material distributions of capital from organic activities until Solvency II is in and calibrated and I still stand by that. But we went into this year in finalizing Solvency II over the very strong economic capital position. Not saying that’s the same as Solvency II, but clearly the two -- because they formed on an economic base. I think it's a very strong statement about out capital position.
Gordon Nixon – RBC
Gordon Nixon from RBC. So we heard yesterday that the corporate pension suffices necessarily auto enrolling but the price is mock up the employers, what a very messy pensions arrangement and several schemes within each employer. Do you agree with this? And can you maybe give us an indication for what proportion of the 1350 will you have relationships, some pension relationships and are you well placed to pick up these sort of consolidated mandates? That’s first question. Second on annuities, bulks, you talked about perhaps you can enter and have a look at this market and just give us an update on that and third on the guaranteed annuity option if you can just tell us what the shape of that book is please.
So I will take the first two, I mean the headline for me in corporate benefits is that assets will triple over the next decade and it's all about allowing your income to go up in-line with assets and then largely holding costs and that’s the operation gearing, that’s what we’re delivering in our business at the moment and there is a range of sources of where that growth will come from but the reality is the vast majority will come from the existing schemes already in place. There is a number two player in the market, no big surprise we’re the number two player in terms of the schemes and our focus is very much the mid to larger employers within the marketplace. So I think there will be a range of sources I think it is quite likely that customers will consolidate more of their assets together in a platform based world and elsewhere I’m particularly pleased as I said in my prepared comments that we have been working with the new schemes we are bringing on with a direct offer transfer. The take up rates have been 37% I mean if you do direct offer marketing 1% is a take up rate you might expect in many areas. We have got 37% of customers are taking that up with an average transfer value coming in at £28,000 and that’s one of the important drivers of the strong net fund flows.
So I think there is a whole host of drivers in corporate benefits, the key is disciplined financial management, scale of existing book, the growth will happen in the exiting schemes controlled in the cost as that growth comes through and we’re very comfortable well placed for that to be a key driver of growth for us.
In terms of I will do bulk annuities and then let Tim do the (multiple speaker). Yes, so on bulk annuities the work we’re doing there continues, I mean so far this year we have probably seen about 30 billion of derisking activity from the bulk annuity longevity swap market but that’s only an uphold of over trillion of DB assets. So and that trillion of DB assets generally Finance Directors don’t want that on their balance sheet and would like to derisk. So although it's grown a lot 30 billion so far this year it's still 20% of the available market size if you like.
There are quite significant barriers to entry in terms of that market place but equally I think we’re over the significant majority of them. So you need a strong longevity understanding which we clearly have for our existing annuity business, you need strong relationship, the employee benefit consultants and large employers where we have that as a number two player in the corporate benefit markets. You also need to be out of transition assets but remember when we did the 2 billion with profit annuity reallocation last year, the majority of the assets that we brought across from with-profit fund to the shareholder fund were Gilts and within three month we managed to restructure those assets into the format -- largely into the format that we wanted them. So we have got the core capabilities that represent those significant barriers to entry and therefore is an area where we’re considering to actively consider.
On your GAO question Gordon, we see for the next 3, 4, 5 years an average of £250 million per annum of GAO business, that’s what we said back in Q1. That was on the basis of expecting a circuit only about a 20% decline in take up of annuities from GAO related product. That itself is the cause. It's a dynamic that is driven by two things mainly firstly obviously is interest rate and secondly that the average uplift that we’re seeing last year, I don’t have a stat in my head for the first half of this year. So the uplift from the fund value to purchase the annuity that is embedded in the guarantee was well north of 40%.
So these product still represent significant value for customers which is why we think in that sort of medium term time frame in the market for those will shrink much less than for general annuities. Probably more to that shrinkage will probably happen in the very small fund sizes as well where people might well just take advances, the expenditure -- the reality.
Andrew Crean – Autonomous
It's Andrew Crean at Autonomous. Three questions, when I look at your sensitivities on your capital ratios both economic and IGD to the economic I think you test for 40% fall in properties and risk free falling through the floor and credit spreads is expanding. I mean you’re still very financial strong. What is the PRA? What is beyond that which we can’t see tap [ph]?
Secondly could you talk a bit on the corporate benefit side, I think the government has capped a 75 basis point but it says it will keep returning to the level of the cap from 2017 on. To what extent are you concern that the massive tripling in the asset buildup which will be delivered by auto enrollment, will be consistently offset by further margin or revenue cut by the government and the thirdly can you explain a little bit more about the amount that you’re spending on platforms and new products? I think you said 30 million this year. Could you give us the targeted spend across 2014, 2015 and how does that row into the SFS, because you said you’re going to have it as a broken out line. Would that be part of the sustainable free surplus or below it?
So first one I’m not sure what the PRA war is about and here I can’t suggest you asking because they wouldn’t tell you either but I would agree with you that we have a very strong balance sheet. I would argue with you that the sensitivity is a clearly manageable within out capital base. I think that we won't as an industry see material returns of capital except for in organic activity like we have demonstrated. I think my confidence in the balance sheet position and if I’m allowed to interrupt that is the regulators confidence but I can’t confirm it obviously, that’s for their own view.
In fact that we have been allowed to distribute an amount of surplus “capital” equivalent to the vendor loan note, there won't actually be received for eight years. I think it's just clear a testament that I can give that we’re confident in the strength of our capital positions as we go into Solvency II. I think the whole industry needs to wait until solvency dwells [ph] in and the regulator is calibrated it. So therefore I don’t think we certainly will know the answer on 1/1/16 or 31/12/16. But we clearly go into this from a very strong position. So I’m very comfortable in our capital position.
In terms of the platform costs, you’re absolutely right, we are -- I am carving that out from sustainable free surplus and therefore sustainable free surplus guidance. I think you will be fairly safe to assume that the Board would also set aside when looking at dividend policy and alike and the reason I say that Andrew is because the Chancellor in his own words describe this as a biggest change in pensions and taxation of pensions since 1921. So I think if I ever have got something that I could regard as a non-recurring type item. This is probably it, but generally speaking platform product development is what we pay with the development spend line and so it is only the platform of product related cost associated with the stuff that Andy was showing on targeting that he is only those costs that I think it will be appropriate to call out as a separate item outside of the SFS guidance, outside of dividend policy. Don’t expect to spend more than 30 million this year. I haven't put a number on it for next but I think you could read into that that if I was particularly worried I would have said something on the future.
Andrew Crean – Autonomous
And should you see the development cost coming down as you make this spend elsewhere?
No I said we would expect to see materially less than the 15 million pound growth in development spend that we described with year-end results because the majority of that was targeted against retirement income. So obviously what we did post budget which was literally the day after we gave the guidance on that debt spend it was reviewed those programs. Most of them are being scaled back in order to create intellectual capacity within the business to put our experts and platform and IT capability, get the experts working on what should now be the shape of the proposition and platform for working in the post-April 2015.
So the corporate benefit, so as you likely said hat qualifying things under auto enrollment is captured at 75 basis points. What we said back in and you see in our results today it's a non-operating impact on MCV a £50 million is a result of that. We also expect that the commission going forward means effectively the cash in IFRS impacts will be negligible. If you look at our corporate benefit book overall the 60 basis points is we have covered here today and you have seen from our asset management slide roughly 10 basis points, so that is asset management. People choose to go passive and effectively 3-4 funds in the cap – you kind of raise a significant majority of that.
And then roughly 10 basis points because the 60 would be commissioned in today’s world which obviously wouldn’t stand that’s historical commission if you like or historical product that wouldn’t then because covered by the charge gap. So then ultimately it depends where the government goes to on this in due course if indeed they do go further but we’re already operating on a sort of people based non-commission basis in corporate benefits significantly below 60 basis points. I mean the other point probably worth drawing out is the 50 million pounds that we have covered is actually, it looks pretty modest compared to the numbers I have seen from some others as well. So it will be modern than the new compared to some.
Alan Turner – Barclays
Thanks. Alan Turner from Barclays. Couple of questions, first in FDI, (indiscernible) and second is the platform spend you’re making, will that have any financial benefits when this is done or you just to make the platform competitive in the market and then finally in the dividend, you have given your assets they are still positive, they are still cash generative is that more to do with the capital requirements moving to Hong Kong?
And then the final question on the impact of interest rates, couple of years you said interest rates would be 50 million headwind to SFS, if interest rates do move up in the second half of the year, how quickly can we see that coming back into SFS? Thanks.
FDI with own standalone platform that will work with Asian time zones, languages and currencies and yes we do expect a significant benefits from that ultimately will be at both platform that works better with Asian time zone, languages and currencies and more modern platform and ultimately we don’t -- investments we didn’t think there will be benefit to shareholders on it.
So continuing on FDI in relation to its dividend position, yes positive SFS from FDI to the half year, not as positive as we would have liked to be quite clearly. I think it's important to differentiate between an international dividend and SFS. I mean I know another company is reporting today apparently and that cash measure has UK based plus dividends received from overseas, our SFS measure reflects the sustainable free service generation of all over businesses. So a dividend payable from international to group would not show in our sustainable free surplus, that would simply be a transfer of free surplus from one end to another whereas our SFS measure is a generation of free surplus across the group. How that impacts with capital? So we have seen a number of factors affecting the capital position in the first half partly trading so it's generating less than we had desired to.
Secondly, currency movements have probably cost £4 million or £5 million in terms of balance sheet surplus capital and the impacted ratios. On this Hong Kong binding capital -- if we just stepping back and thinking about how the rules work here. So in the Isle of Man regulations you have a relatively -- you have a completely mechanistic approach to that provides to your capital base to form the funds under management of your business and it's fairly crude and it doesn’t take a great deal of impact associated with the profile of the business you’re writing.
Whereas the Hong Kong rules, is a division of the group applies to the whole of that bill much more like the UK rules that look at your reserves and look at the kind of business you write and apply different factors to different types of business. So there is nothing that’s changing in the Hong Kong capital rules, it is simply that the mix of business we’re writing recently seen more protection sold in that bill. So under the Isle of Man rule that doesn’t make a great difference, the way the Hong Kong rules main it's actually increasing the regulatory capital requirements. So I think if sales mix continues in the certain pattern then it is possible in the second half we will see the Hong Kong rules becoming the biting constraint rather than the Isle of Man rules that they are today, that could further impact on full year dividend capacity all over things being equal.
So that’s why we have decided it's prudent to pass on it to the half year and get ourselves two type of capital position, which is never a clever thing to do.
And we will keep it under review for the second half. It's not a shift in the rules, it's more shift in the profile for the business you have a different rule sets apply for the balance sheet. So I apologize the long answer, that puts more color on it for everybody. Does that answer your question on that?
Yes. I mean if long term rates only rise in line with curve, then no it wouldn’t make a difference, in the short hand yes if we saw a rise in short term rates when we reach that thing to the start of the year then that would be beneficial to our capital and available shareholder cash figure except for the element that we have already expected to accelerated that return by investing some indicated length. So I guess beneficial but not quite the scale that I would have given you two years ago.
Oliver Steel – Deutsche Bank
Oliver Steel, Deutsche Bank. The year-end you seem to have imply that you were thinking about M&A acquisitions. I wonder if you could just update us on your thoughts about acquisitions.
Our view is yes we definitely still see, in fact many thing I would say that post the budget the consolidation in the UK life sector is more likely because ultimately more of the business is going to be asset base, asset base is more about scale and therefore consolidation is more likely and it's fairly widely held around the market. We would remain interested in participating within that ultimately we think we have demonstrated a distinctive capability in fact in driving value for shareholders from inorganic activity but remain of the view that we don’t need to -- we have a strong healthy organic future as a group given the scale of the customer base and the range of things that we have already talked about this morning. So we remain interested in considering that. In due course if it would drive incremental value on top of the already attractive organic future that we have as a group.
Two questions, firstly you talked about your retirement specialist advice team. Could you go into a bit more detail about what these people are actually doing? How far are they going with the advice and how that -- process is going to come in? And secondly on the platform I think it was talked about and then dismissed in the past by this group and it will be under the management team. I see why you’re doing it there but can you talk a little about how you expect the economics of the platform to put on the assumption of most of the assets go through third party assets management, what’s in it for you in terms of revenue and the gross margin please?
Taking the first one first, the thing with retirement specialist have a number of QCF level 4 qualified individuals so effectively that’s the IFH standard of financial qualification. Today we’re not giving advice to customers so we’re giving education information guidance, we’re not giving advice today. What we envisioned this of holding it at overtime is I mean ideally and we’re working with the FCA [ph] on this along with the other members of the ABI to try and create a guidance regime that fits somewhere between education information and if you like full advice.
So ideally we would get in to that space. We haven't ruled out giving advice but we haven't made the decision to do it either at this stage. I do think that most mass affluent customers actually the income tax position is going to be one of the most important questions I need to ask. I need to basically understand their options, understand the different elements of their options and therefore I think just helping them understand those and what the options might look like will be the key and to optimize their tax position as part of it.
In terms of how it fits with the government guidance, as I said in my prepared words we were always of the view that that should be provided by an independent body and we were one of the first that to come out and say and I’m pleased with the Chancellor agrees with that. It's going to be -- we will see how it develops but my expectation is it will be 15 to 30 minute conversation where the customer will start to get an understanding of broadly what their options might look like but at the end of it they are going to have a whole series of questions and ultimately we want to be there for our customers to help them think through those questions and think through their options and then help them decide what is that they want to do.
In terms of the platform the economics, the again as I said sort of touched on what I said earlier on, mass affluent customers don’t buy high alpha funds. They basically go typically for the passive or the (indiscernible) based funds and therefore the level of asset management, if I look at corporate benefits in sort of a moment ago the 60 basis points there is around 10 basis points of that is the asset management fees, we’re seeing virtually half of our auto enrollment client, selection our own people fund where effectively we’re doing the asset allocation on top of asset components given our scales we get most asset components really very low level of basis points indeed. So my view is the pay away for mass affluent customers is very low and you don’t need an in-house multi-asset manager to be able to secure value and compete successfully and profitably in that marketplace.
I think the key point here is the customer segmentation, so an awful lot of comment around the budget is all about high worth individuals, the sorts of people that will pay the 150 basis points on their platform the high alpha funds and everything else. Mass affluent customers aren’t like that, they are different, so I think it's really important to understand the segmentation of the market. There is an opportunity in that high net worth which is what we’re targeting to target customers with high alpha funds with very high margins on and the point is we choose to do that I’m sure we will do very well. In the mass affluent space customers don’t go for those high alpha funds.
Ravi Kannan – Goldman Sachs
Ravi Kannan from Goldman Sachs. Just two questions please, the first one was on auto enrollment, and forgive me if you’ve already kind of answered this but just trying to get some clarity on going forward the smaller schemes that come through under our auto enrollment, do they, my reading of it is that perhaps they aren’t meeting the hurdle rates in terms of profitability. Is that a fair assumption given your emphasis on enrolling existing schemes and can you perhaps talk a little bit about the profitability of those schemes going forward and second one is just on Solvency II, and you laid out from slide 21, the various measures or capacity for extracting cash from the Heritage but I’m just wondering are any of those at all Solvency II contingent, ODC, clearly Solvency II still developing, do you opportunities there for further extraction cash from the back as a result of that?
I will let Tim take the second one. In terms of the first one historically, our view is the most profitable segment for the market has been the medium to large employers to the super large employers tend to get completed for that’s sort of trophy schemes get completed at a very low levels of basic points and historically the smaller employers tend to be more advice on our IFA commission basis. So we will see how that smaller end of the market plays out in due course in terms of the profitability (indiscernible) there will be difference and we’re doing more work in that segment of the market than we have done historically but our core focus is on that mid to larger employer segment where we have our scale.
And at the end of the day corporate benefit, it's a scale game, if you have got the scale you can drive the operating leverage and you can drive strong year-on-year growth in cash generation. If you don’t have the scale it's a much, much tougher just to get to that breakeven point.
So Ravi there are two types of issues [ph] on that slides there are the asset restructuring potential migrations. Those will work either way because they are simply it could be cash benefit or recurring cash benefit that comes from being able to restructure those but one of the most important considerations we have in those is actually making sure that we’re giving our customers the best chance of having a superior investment return. That’s right at the core of what we do. We can do that and achieve a benefit for the shareholders at the same time and certainly that’s primarily to a cash. As for the with-profit annuity the allocations which is the other part of slide 21 and we’re already looking at those on an economic capital return basis as well. So I’m quite comfortable that although we haven't seen finally calibrated Solvency II but we’re looking and we didn’t the first and the second but we’re looking through all those lenses and in Andy’s prepared words he said, I’m won't try and quote you but, basically if anybody can write these things profitability we got the team to do. That assessment will include looking at on an economic basis not just for the [ph].
Ravi Kannan – Goldman Sachs
In the statement there is quite a strange comment that during the transition to Solvency II the group will need to hold its capital in a different way and what we had just did perfectly. I wonder what you mean by that.
Probably a reference to the fact that we said back a year-end but we intend to apply for entire model approval in the middle of 2016 and might get approved by the end of ’16. So technically we will be reporting under a standard formally during 2016 but I don’t expect whatever that shows for us to reap any kind of benefit if there is one because we will already be looking through it at the last stage and what we think our internal models will be. But I think it's probably referring to that. But if that doesn’t match when you look back at it -- can’t find the answers.
Andrew Crean – Autonomous
Just going back on your capital optimization, cash optimization for 2015 onwards and you didn’t give any sense as to what kind of benefit you would get? We look at the credit loss -- assets cautiously, is that a ’15 thing or it's quite lot of the asset trends likely to be aimed summarizing --
We have not given specific guidance going forward on the remaining elements, in terms of the with-profit annuity side of it we look at each funds on its merit and ultimately you can kind of see the pace at which we’re doing those funds by transfer, already to give you a sense of timing going forward. In terms of the asset migration side those are the assets that are currently with asset investment managers and I said before the nature of the agreement there means that the break fee involved in that have in the second half of next year. Now obviously we haven't any decisions around what we may or may not do with that but that will be the logical time to think about whether it's appropriate to restructure those arrangements in anyway.
Alan Turner – Barclays
Just one question on your retirement portal, is that going to be portable? We heard standard IFC [ph] talk about corporate benefits platform moving portable and they can build a direct model by themselves and you’re getting one of the IFA channel to work with either. So can you use this platform to go direct to consumers?
It will lead direct to consumers, so the people who use the platform today are employees or pension schemes they are on their using it. They are putting money into their (indiscernible), they are reorganizing their funds between their pensions and ISA and choosing multitude of the fund options within their, they are doing their share trading online today on that platform. So it already is a consumer platform and employee platform. What we’re basically going to do is to expand out that consumer interface. So at the moment you got to be a member of the corporate pension scheme to be able to use it but it's the employees that use it. So we’re going to basically build that front interface for all of our customers whether they are pension scheme or not to be able to use it and link in to the underlying products that we have. So if you’re a customer in Heritage you can go in for that front end and you can see your Heritage products from that front end.
What’s likely a retirement it seems to me and we will see how it develops in due course and what’s likely is that Heritage customer may well say actually, you know what I want to move across on to the platform itself so I have got my pension and ISA side by side. So when they take their tax recash if they are not using it to pay down debt then put it in the ISA on the platform, keep it invested as you choose to. So we do see some movements between the different books of business as we bring it together which is why I made the point about the complimentary benefits of the different parts of the group. So for the existing platform it's already there, employee is already using it in our corporate benefit business. It's one of the key drivers of the 30% sales growth we have covered earlier on and hence the financial performance there.
Alan Turner – Barclays
But if an employee leaves and the employee changes his job, could he still use the -- see this vehicle?
Yes and other 1.25 million corporate pension customers that we covered earlier on probably about a third have left their employer and they are effectively are direct customers.
Thanks so much indeed for coming along this morning and as ever don’t hesitate to bring any follow on questions that you’ve either to Tim and I or to Yana in the IR team. Thanks so much for coming along. See you soon.
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