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Manulife Financial (NYSE:MFC)

Q4 2010 Earnings Call

February 10, 2011 2:00 pm ET

Executives

Donald Guloien - Chief Executive Officer, President and Director

Scott Hartz - Executive Vice President of General Account Investments

Beverly Margolian - Chief Risk Officer and Executive Vice President

Warren Thomson - Chief Investment Officer, Senior Executive Vice President and Chairman of MFC Global Investment Management

Michael Bell - Chief Financial Officer and Senior Executive Vice President

Anthony Ostler - Senior Vice President of Investor Relations

Paul Rooney - Senior Executive Vice President, Chief Executive Officer of Financial’s Canadian Division, President of Financial's Canadian Division and General Manager of Canada

Analysts

Joanne Smith - Scotia Capital Inc.

Michael Goldberg - Desjardins Securities Inc.

Doug Young - TD Newcrest Capital Inc.

Tom MacKinnon - Scotia Capital

Mario Mendonca - Canaccord Genuity

Robert Sedran - National Bank Financial

Darko Mihelic - Cormark Securities Inc.

Gabriel Dechaine - Crédit Suisse AG

Steve Theriault - BofA Merrill Lynch

John Aiken - Barclays Capital

Peter Routledge - National Bank Financial, Inc.

Andre-Philippe Hardy - RBC Capital Markets, LLC

Operator

[Operator Instructions] Good afternoon, ladies and gentlemen, and welcome to the Manulife Financial Q4 2010 Financial Results Conference Call for February 10, 2011. Your host for today will be Mr. Anthony Osler. Mr. Osler, please go ahead.

Anthony Ostler

Thank you, and good afternoon. Welcome to Manulife's conference call to discuss our fourth quarter 2010 financial and operating results. Today's call we'll reference our earnings announcement, statistical package and conference call slides, which are available in the Investor Relations section of our website at manulife.com. As in prior quarters, our executives will be making some introductory comments. We will then follow with a question-and-answer session.

Today's speakers may make forward-looking statements within the meaning of securities legislation. Certain material factors or assumptions are applied in making forward-looking statements, and actual results may differ materially from those expressed or implied.

For additional information about the material factors or assumptions applied and about the material factors that may cause actual results to differ, please consult the slide presentation for this conference call and webcast, available on our website, as well as the securities filings referred to in the slide entitled Caution Regarding Forward-Looking Statements.

When we reach the question-and-answer portion of our conference call, we will ask each participant to adhere to a limit of one or two questions. If you have additional questions, please re-queue, as we will do our best to respond to all questions.

With that, I'd like to turn the call over to Donald Guloien, our President and Chief Executive Officer. Donald?

Donald Guloien

Thank you, Anthony. Good afternoon, everyone, and thank you for joining us today. Our fourth quarter and full year 2010 financial results were announced this morning. As you know, we made substantial progress, delivering on our business strategy. This is reflected in significant sales growth, reduced risk profile and strong capital levels. We have record quarterly income of $1.794 million (sic) [$1.794 billion].

I'm joined today on the call -- it's at $1.794 billion, I should say. Joined in the call today by our CFO, Michael Bell; as well as several members of our senior management, including our General Manager in the United States, Jim Boyle; Canadian GM, Paul Rooney; our Asian GM, Bob Cook; Warren Thomson for Investments; and Bev Margolian, our Chief Risk Officer.

I'm pleased to report that we're seeing solid progress on all fronts. Our fourth quarter sales of Insurance products targeted for growth were up 34%. Wealth products targeted for growth were up 28%, Insurance sales in Asia were up 56%, reflecting both the growing diversification of products and the expansion of our distribution channels.

Sales in Canada reflected the value of our diversified franchise. Strong fourth quarter momentum contributed to record sales in individual life and travel insurance, and a number of successes in the Wealth Management businesses.

Our U.S. Division continued at solid progress, repositioning their businesses. John Hancock Mutual Funds achieved record sales levels of U.S. $9.7 billion, 48% higher than the previous year. John Hancock Retirement Plan Services ended the year with full year sales of an additional U.S. $5.1 billion, up 16% over the prior year. Total wealth funds under management in our U.S. business reached a record level of U.S. $188 billion.

Across the company, we saw our funds under management grow at a $475 billion. These are strong operational result that highlight the strength of our franchises and the shift of our business mix.

Now turning to Slide 6. We took advantage of rising equity markets and interest rates to increase our hedging of both equity and interest rate risk. As you know, as at December 31, 2009, we had 35% of our variable annuity guarantee value hedged or reinsured. That number at the end of 2010 was 55%. Beyond that, we have added $5 billion of macro hedges. As a result, through hedging of all types, we have now hedged 50% of our equity sensitivity, up from 25% at the end of third quarter 2010.

Since the end of the quarter, we have witnessed improving equity markets and interest rates in 2011. We have taken further advantage of this opportunity to return to dynamic hedging. In the last few weeks, we have added approximately $8.5 billion towards our dynamic hedging program, and now have 63% of VA guarantee value, hedged or reinsured.

This amount, in combination with the macro hedges, means we now have approximately 55% of our equity market sensitivity hedged. And to be clear, this estimate includes an allowance, a substantial allowance, for hedged inefficiency. Therefore, with the dynamic hedging actions we've taken in the first quarter of 2011, we continue to make substantial advances towards our goal to hedge 60% of our underlying earnings sensitivity to equity markets by the end of 2012 and 75% by the end of 2014.

We also reduced our sensitivity to interest rates. At the end of the year, our sensitivity to a 1% decrease in interest rates have declined to $1.8 billion from $2.2 billion at the end of the previous year. This is a solid movement towards our interest rate to sensitivity goal of $1.65 billion and $1.1 billion by 2012 and 2014, respectively.

Manulife's capital remained strong. We increased our MCCSR [Minimum Continuing Capital and Surplus Requirements] ratio by 15 points to 249%, and this key ratio is now accompanied by a lower risk profile as a result of the aforementioned hedging actions.

This quarter, we reported net earnings attributable to shareholders of $1.8 billion. As I said earlier, that was a record. This equates to a fully diluted earnings per share of $1.

Fourth quarter net income, excluding the direct impacts of equity markets and interest rates, was $933 million. With the $1 billion goodwill impairment and the $2 billion strengthening of reserves, that we undertook in the third quarter, we recorded a full year loss of $391 million. But for these items, we would have recorded a gain of $2.7 billion.

In summary, we have made important progress on reducing our equity and interest rate sensitivities, and will continue to do so. Our capital is strong, our asset quality is superior and we're seeing strong results from our strategy that will position Manulife for future earnings growth and ROE expansion.

So with that, I'll turn it over to Michael Bell, who will highlight our the financial results and then open the call to your questions. Thank you. Michael?

Michael Bell

Thank you, Donald. Hello, everybody. Throughout 2010, we made significant progress, relative to our strategic priorities. We have driven a change in our business mix towards targeted higher return businesses. And as we discussed at our investor day, we expect this mix change to contribute to an increase in our ROE over the next several years.

We also strengthened our capital levels in 2010. Annualized MCCSR at 249% at year end is strong. When combined with the significant progress that we've made in reducing interest rate and equity market sensitivities, this capital level provides a substantial cushion to potentially adverse market conditions.

We also reported record quarterly earnings in the fourth quarter, aided by favorable equity markets and interest rates. The Slide 9 provides a breakdown of the billable items for the quarter. Please note, that the net direct impact of the fourth quarter's higher equity markets and interest rates totaled nearly $900 million after tax, despite the increased cost of the macro equity hedging program.

Other notable items totaled $241 million in the quarter, and included favorable investment in policyholder experience and net gains in our dynamic hedging program. These items were partially offset by an accounting change for our Hong Kong Pension business and small refinements in our actuarial liabilities.

Excluding notable items, adjusted earnings from operations in the fourth quarter totaled $692 million. We view this as a particularly positive result, since it includes $34 million in expected after-tax hedging cost for the macro equity hedges, added late in the fourth quarter.

Slide 10 provides another breakdown of our full year 2010 results. In total, we reported a net loss of $391 million for the full year. Excluding the combined impact of approximately $3 billion of actuarial reserve strengthening and the Canadian GAAP goodwill impairment charge, our earnings totaled approximately $2.7 billion. And I would note that those underlying earnings were relatively well-balanced across our three major operating divisions, which we view as a strength.

As can be seen on Slide 11, we've continued to reduce our exposures on variable annuity guarantees. At year end, 55% of the gross guarantee value was dynamically hedged or reinsured. This compares to 35% at the end of 2009. Subsequent to year end 2010, we further expanded our dynamic VA hedging and these actions have raised this to approximately 63%.

Slide 12 describes additional actions that we took in the last four months to further reduce earning sensitivity to equity markets. During the fourth quarter, we took advantage of the equity market rally to initiate our macro hedging program. And in the last six weeks of the quarter, we shorted approximately $5 billion of equity futures contracts. As a result, the total amount of our short equity futures position more than doubled in the quarter, and our sensitivity to equity markets declined substantially.

The after-tax impact related to the macro equity hedges in the fourth quarter was $82 million, including the impact of the favorable markets. We expect that 2011 cost to be approximately $400 million after tax for the full year, based upon our current macro hedged position and our long-term equity market assumptions.

In addition, the recent increase in our dynamic hedging program is expected to reduce annual earnings by an additional amount of approximately $55 million after tax in 2011. Our high-level estimate described at our investor day of $400 million after tax is the incremental cost of hedging in 2015, remains appropriate, as we expect future equity market appreciation will ultimately allow us to reduce our macro hedging position.

As you can see on Slide 13, we've reduced our equity sensitivity. As of December 31, our earnings sensitivity to a 10% equity market decline was reduced by 43% to $740 million, as compared to the end of the third quarter. As a result of the additional hedging implemented in the fourth quarter, 50% of our underlying equity sensitivity was hedged at year end, up from 24% from the previous quarter. And the progress we made in the last several months, puts us ahead of our original timetable for risk reduction.

Relative to annualized MCCSR of 249%, we feel that we have significant cushion in the event of potential adverse equity market conditions. And this reduced sensitivity to capital has helped create a lower risk profile going forward.

Slide 14 details the beneficial impact of the equity market rally on our results for the fourth quarter. We estimate that the positive equity market performance resulted in a net positive benefit of nearly $450 million after-tax, which included the benefit from favorable experience of the dynamically hedged VA business.

The macro hedge cost more in the quarter due to strong equity markets. And I'd remind you that an additional $34 million is included in adjusted earnings from operations, as the expected cost of macro hedging for the portion of the quarter it was in effect. So in summary, the actions we've taken to reduce earnings sensitivity to equity market movements is expected to reduce the volatility of reported earnings in the future.

On Slide 15, you'll see that we've also made significant progress against interest rate sensitivity. In the fourth quarter, the Bond portfolio duration was lengthened in some of the most interest-sensitive liability segments. Since the third quarter, we've reduced our sensitivity by 18%. And we're now relatively close to our year end 2012 target of a 25% reduction in sensitivity, relative to the September 30, 2010, levels.

On Slide 16, we provide updated sensitivities around the changes in corporate and swap spreads. Now while there is no simple formula that will estimate the results accurately, an increase in corporate spreads would be expected to provide us with a benefit to that income, and an increase in swap spreads will result in a negative impact.

Currently, the predominant influence on our interest rate exposure relates to interest rates in the U.S., but other geographies impact our results as well. These estimated impacts on earnings are based on the year end 2010 starting point and the business mix as of that date. Changes to various factors and management actions may change the sensitivities.

Now move to Slide 17, the interest rate impact on earnings in the fourth quarter. During the quarter, treasury rates and swap spreads increased, while corporate spreads tightened. This combination of spread changes and management actions during the quarter, reduced the beneficial tailwind of the uptick in treasury rates in the U.S. Overall, we estimate that the net impact of interest rate changes was approximately $600 million, including the impact for the Variable Annuity business that is dynamically hedged.

I'll now turn to our source of earnings on Slide 18. Expected profit on in-force was up across most of our businesses due to higher assets under management, which more than offset the increased cost of dynamic VA hedging. New business strain increased primarily due to distribution investments in Asia; and lower interest rates and updated valuation assumptions also contributed to this result. And this was partially offset by significant improvements in new business strain year-over-year in the U.S. due to price increases and lower sales of no lapse guarantee Life Insurance products.

The net experience gain, primarily reflected higher equity markets and interest rates. Management actions and basis changes of $140 million pretax, mainly relates to the expected impact of macro hedges and refinements to the actuarial methods and assumptions. Earnings on surplus improved over the prior year due to higher AFS equity gains and lower OTTI provisions.

Slide 19 summarizes our results by division, excluding the impact of the equity markets' interest rates and investment results. The Asia Division results were lower due to the DAC adjustment in Hong Kong and higher new business strain. In Canada, underlying earnings were in line with the prior year, as positive earnings growth in the Wealth Management businesses, including the Manulife Bank was offset by higher new business strain from strong sales and lower interest rates.

Our U.S. Division demonstrated the most improvement in underlying earnings, as price increases and lower volumes in U.S. Insurance drove a substantial improvement in new business strain. Improved policyholder experience contributed as well. So overall, we're pleased with the underlying trends in the divisional results and the continued balance of contribution by the major businesses.

Slide 20 summarizes our regulatory capital position for MLI. MLI reported an MCCSR ratio of 249% at year end, a sequential increase of 15 points. Combined with the actions we've taken to reduce our market exposures, our MCCSR represents an increased buffer, relative to market performance risks.

On conversion to IFRS, we faced a modest decline in our MCCSR. And in the first quarter of 2011, we expect the impact to amount to approximately four points, growing to eight points by the end of 2012, when the phase-in provision expires.

Now as illustrated on Slide 21, we continue to offer our clients a diverse product portfolio. The products indicated in green, represent the products we continue to strategically target for growth, since we expect them to have favorable long-term returns and lower risk profiles. And we view this product breadth as a strength.

On Slide 22, you can see the strong Insurance sales results. For the full year, Insurance sales of products targeted for growth grew by 20% over 2009 on a constant currency basis. We generated strong growth across a wide variety of our businesses. Our Asia Division delivered strong sales growth. With full year sales up 43% while reaching a record $1 billion in 2010 and record sales in Indonesia, the Philippines, China, Vietnam and Malaysia.

In Canada, individual Insurance sales were up 4%. In the U.S., good progress is being made on product repositioning efforts, as evidenced by the fact that the Life Insurance sales, excluding the no lapse guarantee universal Life product, grew by 16% over the fourth quarter of 2009. And I'd also note that we had number 1 market share for most of the year in variable universal life sales in the U.S.

Turning to Slide 23. Our total Wealth sales for the full year grew by 23% over 2009, excluding variable annuities and the book value fixed for the annuity product. Asia Division experienced impressive growth of 27%, benefiting from new wealth products and the acquisition of Manulife-TEDA in China.

Canada experienced excellent progress, as part of our broader sales growth and diversification strategy, as evidenced by record mutual fund sales and strong growth in our Manulife Bank. We're also very pleased with the result of our U.S. Wealth Management businesses. Sales of John Hancock Mutual Funds reached their highest level ever and Retirement Plan Services also ended the year with record asset levels. These results are very positive signs that our repositioning efforts in the U.S. are working.

Slide 24 shows the growth in new business embedded value for our targeted growth products. New business embedded value for the Insurance businesses where we're targeting to grow, increased by 17% in 2010, reflecting a more favorable product mix and strong growth in Asia and Canada.

New business embedded value on wealth products, excluding variable annuities and the U.S. book value fixed deferred annuities, increased 10% over 2009. And this reflects our successful repositioning efforts, as well as our strong franchise in the John Hancock brand.

Full year new business embedded value for Insurance and wealth on products that we're not targeting for growth declined in 2010, due primarily to lower volumes, but increased in the fourth quarter as we took actions to improve the profitability.

Slide 25 provides a summary of our annual update for the in-force embedded value. This analysis will be detailed in our upcoming annual report. In aggregate, our year end 2010 embedded value declined modestly relative to year end 2009. And while there are a number of moving parts to the calculation, the main business factors that impacted the change in embedded value are the same ones that drove the third quarter 2010 actuarial basis change, particularly the higher morbidity assumption in long-term care.

In addition, our substantial increase in variable annuity hedging decreased embedded value for year end 2010. And I would note that our year end 2010 in-force embedded value continues to be higher than our current market cap. Now more detail will be included in our annual report.

As shown on Slide 26, total funds under management at year end 2010, was nearly $0.50 trillion representing an increase of $35 billion over last year, and we view this as strong growth.

Slide 27 demonstrates that our portfolio continues to be high-quality and well-diversified. 95% of our bonds are investment grade and our invested assets are highly diversified by geography and sector, with limited exposure to the high-risk areas noted on the slide.

So by way of summary, we're pleased with our performance last quarter, and overall for the full year. We made substantial progress delivering upon our business strategy. We are ahead of our original timetable in reducing sensitivity to equity markets and interest rates. Our capital levels are strong, with MLI's MCCSR up 249%. And when combined with the risk reduction actions, we believe our capital levels offer a significant buffer against potential future market declines.

We reported record quarterly net income in the fourth quarter, which was supported by favorable markets. And overall, our business operations are well-positioned for future growth as we continue to execute on our business plan.

As similar to past quarters, I think it's important to address key questions that you're likely to have regarding these results. And the first is, what is the expected impact of IFRS in 2011? Well next quarter, we will begin reporting IFRS, with corresponding comparative IFRS financial information for 2010.

As previously disclosed, with the exception of the additional goodwill impairment, we don't expect the initial adoption of IFRS to have a significant impact on our financial statements. Our disclosures have provided a reconciliation of the January 1, 2010, opening shareholder equity. And known events in 2010, such as the judicial goodwill impairment under IFRS.

The capital impact from IFRS is expected to be approximately a 4-point decrement in MCCSR in the first quarter of 2011 and an 8-point decrement by year end 2012.

And the last comment that are reinforced here, is that there continues to be significant uncertainty around the future impact of IFRS Phase II, since it's not clear what the final standard will ultimately be.

The second topic is what is the expected incremental cost of the recent expansion in our equity hedging for 2011? Now I'd remind you that our reserves and expected profit on in-force, assume a long-term equity total return of approximately 10% per year. We initiated $5 billion in macro hedges in November and December of 2010. And as a result, we're trading the equity market performance for the short-term risk-free rate, which today is currently close to zero.

So when you multiply our macro hedge position by 10%, you get approximately $500 million of pretax expected hedging costs, or approximately $400 million of incremental after tax impact per year. Now to repeat, this is based on our current macro hedge position and our long-term equity market assumptions and actual results, of course, will vary.

In addition, the recent increase in our dynamic hedging program is expected to reduce annual earnings by an additional $55 million after-tax in 2011. And please, also remember, these estimated incremental costs of the hedging will likely change in the future, as changes to various factors and additional management actions can have significant impact on reported results in the future.

The third topic is the status of the long-term care in-force rate increases. Overall, although it is very early in the process, we feel positive about our progress so far with the states. And their review and approval process of our in-force rate increases for long-term care.

As of today, five states have approved substantial rate increases, including a handful of key states. We've also had constructive discussions with several additional insurance departments in other states. And we currently feel comfortable with our estimates and timetable that we developed, as we calculated the reserve strengthening in the third quarter of 2010. Again, it's early in the process and we expect to provide additional updates in the future.

This point, this now concludes our prepared remarks. And operator, we'll now open the call to Q&A.

Question-and-Answer Session

Operator

[Operator Instructions] The first question is from Doug Young from TD Newcrest.

Doug Young - TD Newcrest Capital Inc.

My first question is related to the hedging cost. Michael, obviously it's $400 million plus $55 million. What's the level at which you think that peaks out? And is that in a year's time and then starts to flow down into the $400 million that you're expecting by 2015?

Michael Bell

Doug, the short answer is that it depends upon a number of factors. But I would expect that it will likely be higher in the near term and then gradually decline to the $400 million. But it really depends upon a number of different factors, including how equity markets perform. The better equity markets perform in the near term, the faster we will get to our year end 2014 target and the faster that we can begin to unwind those macro equity hedge positions, which are costly. So at the end of the day, if we literally modeled out where the market is today, we assume precisely 10% equity market total returns per year, from here over the next several years. The equity cost in 2015 would likely be lower than the $400 million placeholder that we have out there. But again, it's too early. There's still too many factors. And the point is that $400 million represents a reasonable placeholder for us, although again, potentially conservative if the equity markets continue to perform well.

Doug Young - TD Newcrest Capital Inc.

Just a follow-up on that, I mean, within that model that you just described, does it get to $500 million in 2012 before it starts to decline?

Michael Bell

Doug, the short answer is it depends. It depends, for example, on our own management actions. I mean, if we went out tomorrow, I'm not suggesting we're going to do this, if we went out tomorrow and said, "By God, we're going to get to our year-end 2014 hedging targets right away by the end of February." Then the annual cost would be higher in the near term. Again, so it's based on a number of different factors. I think assuming a gradual implementation to get to those year-end 2014 targets, it's likely to be the pattern that I described earlier. But again, there are a lot of different factors. And I think the most relevant is that we're significantly reducing our equity market sensitivity for a reasonable cost to near term earnings and we're on a glide path to either meet or even potentially modestly exceed the earnings target in 2015, if everything works swimmingly according to plan. But we'll stick with the long term targets that we gave at the investor day at this point.

Doug Young - TD Newcrest Capital Inc.

And this is my second question on lapse rates. Obviously, it looks like lapse experiences is favorable in the U.S. but negative in Japan. Just wondering if you can give us a little more details around what products this relates to and what's driving it?

Donald Guloien

I just want to add something to what Mike said. And that is, he's perfectly described the question you asked which is the detriment. But I think you also have to keep aware that if equity markets go up, which was what would lead us to hedge more faster again, that's going to have a salutary impact on many, many other parts of our operation. When you've got $475 billion roughly under administration, fees are going to go up. A whole bunch of other things are going to be incredibly positive. So the next thing is, yes, there are scenarios that could cause the hedging costs to go up a bit more but there will be a lot of other good news for our company across the entire enterprise, not the least of which is sales of some of those mutual fund, 401(k) and other type of products.

Michael Bell

So, Doug, on your question on the lapse rates, relative to a year ago, we have seen a pretty significant improvement in the lapse experience for the U.S. Life Insurance business. Our speculation is that a fair amount of that may be economy driven. You may recall that a year ago, we cited the weak economy as one of the reasons we were seeing early duration lapses in the U.S. as the economy has modestly strengthened. Thankfully, that is proven to be a temporary phenomenon now of what program it went in. So that's driven the year-over-year improvement in the U.S. In terms of the lapse rates in Japan, there was one particular product, which we updated the lapse rates on recently. It wasn't a huge impact, but it was enough to take a product that had new business gains at issue of a small magnitude to now some new business strain at issue. Again, not material, but we're serious about keeping on top of our valuation assumptions, obviously.

Doug Young - TD Newcrest Capital Inc.

In U.S., is it variable annuities or is this like term life?

Michael Bell

In the U.S., the primary -- and I'll ask Jim Boyle, if he wants to add. The primary improvement that we're seeing is around the universal life product.

James Boyle

Yes Doug, Jim Boyle. In our insurance lines, both long-term care and life insurance, we saw favorable improvement in lapses. So on the wealth side, the story's a bit different. Obviously, lapse is a bit of a different concept but we have positive net sales in both mutual funds and our 401(k) business. So our lapse experience generally across the board has been consistent with our pricing and our expectations, and our policyholders have been behaving effectively as we had assumed they would.

Operator

The next question is from Tom MacKinnon from BMO Capital Markets.

Tom MacKinnon - Scotia Capital

Just a follow-up on this hedging cost discussion here. When you had your investor day, the way I understood, it was from September 30, 2010, through the end of 2014, the aggregate spend would be $400 million in terms of equity market hedging costs, and that was sort of on, we'll call it a dollar cost kind of average formula throughout that time period. And assuming markets went up annually 8%, plus another 2% for dividends. That's correct, right?

Michael Bell

Tom, the only piece I would adjust in what you said is we never talked about an aggregate cost to hedging. What we said was that by the time we got to 2015, we had a placeholder in there for calendar year 2015 of a $400 million after-tax hedging cost. We didn't explicitly try to give out a schedule. I would also say we didn't explicitly say dollar cost averaging. What we said was we would expect to get to our targets by year-end 2014.

Tom MacKinnon - Scotia Capital

If you did everything right at the very beginning of that projection, if you did all the hedging at the very beginning of the projection and you spent $400 million then and the markets behaved exactly as you would have expected, would we anticipate under that scenario that some of that would come back into earnings.

Donald Guloien

Tom, it's hard to speculate. Because at that time, if you recall the time we did Investor Day in November, the markets were lower. So if we'd hedged at that point, the actual cost would have been greater than what would otherwise be hedging when we did. It's very hard to -- that's why Mike is, he's not trying to be evasive. It just depends on when you do it. If we'd hedged in the summer, in August, you can only imagine what this might have cost us. That's why our strategy was to have a very, very robust capital base to withstand the vagaries of the market and wait to hedge until markets reward us with higher levels, which is what we've done. And now we're being rewarded by higher equity market levels and higher interest rates, which enables us to go back to dynamic hedging. So the cost will be much lower than they would otherwise have been.

Michael Bell

Tom, Donald's got it exactly right. And I would add, if you're really asking the question, "Do we expect our overall cost of hedging to decline over time?" The answer is yes, probably. And I say probably because as long as equity markets appreciate, we would expect, once we've hit that long-term target on equity market sensitivities, to be able to begin to take off the macro hedge position. As we take off the macro hedge position, the cost of hedging would decline. I'd also say just for completeness, I would not expect short-term risk-free rates to be zero forever. So again, I'd also expect the macro hedging costs over time to shrink as short-term rates rise but the first point is the primary point.

Tom MacKinnon - Scotia Capital

So obviously, it looks like the glide path towards that 2014, '15, projection you talked about is going to be heard initially as a result of hedging faster but then benefited more later as a result of hedging earlier? Assuming everything else works out as they are.

Michael Bell

There are a lot of assumptions, obviously, in your statement. I mean, I think that your point is a fair one, Tom. I would also add, though, a couple of very important points. Number 1, let's keep in mind, we took advantage of the markets rallying to put these hedges on. So that means that the all-in economic cost over time is lower to do it when the markets are high than when the markets are low. Second, let's also remember, we felt significantly reduced are equity market sensitivity. To have more stable results quarter-to-quarter, we view as a very good thing.

Tom MacKinnon - Scotia Capital

What would you suggest, given that you've significantly de-risked the downside? Any kind of view on what a target MCCSR might be?

Michael Bell

Tom, that's an important question. I mean, so I'm not going to give you a specific number at this point because there's just too many different factors. Obviously, at this point, we're a lot more comfortable with our capital position, in fact, I think it's fair to say, we're more comfortable with our capital position than any time in several years certainly since the financial crisis. We're now several billion dollars over a 200% level and several billions over that over 150% kind of level. But I still think at the end of the day, the capital requirements are still uncertain and therefore, I wouldn't try to put a number on the MCCSR at this point in time.

Operator

The next question is from Robert Sedran from CIBC World Markets.

Robert Sedran - National Bank Financial

Is it fair to assume here that until you get to the level at which you are satisfied that you are at your target level of hedging, that you're not going to be paying down or covering any of these macro hedges? In other words, future hedging from here will hopefully be dynamic and until you get to the point where you can start replacing the macro with dynamic, you're not going to be doing it?

Michael Bell

Robert, I'll start and see if Bev wants to add. I would not make any absolute statements at this point in time. I mean, we're obviously very serious about our year-end 2012 and year-end 2014 targets. And barring a calamity, we would certainly expect to meet those targets. Having said that, we think that if there's good balance between the dynamic VA hedging that locks in the long-term swap rate and is therefore built right into the reserve process and the macro hedging, which is really a short-term vehicle, not built into the reserve process because it's not tied to a specific product or a specific block of business, and therefore is a floating short-term cost to reduce near-term sensitivity. We think that balance makes a lot of sense. And so the short answer is it will depend upon what market conditions are and what else is going on in the world. Let me see if Bev wants to add.

Beverly Margolian

I think that as we do add more dynamic hedging, I think that there will be a point at which we take off some macro hedges. It's not necessarily one for one. We're just looking at all of the market conditions and we'll be balanced with the positions between our macro and dynamic.

Robert Sedran - National Bank Financial

I know the earnings on surplus tends to bounce around quite a little bit. If I was to look at the annual $430 million that you did in 2010, is that a number that will be considered a normal on an annual basis or would it be higher or lower than you would expect?

Michael Bell

Robert, as you said, there's so many different things that impact that. Again, a lot of it obviously will depend upon where our interest rates go in the future and where we end up placing those dollars. We also, remember, harvested a significant amount of equity market gains, a significant amount of AFS equity gains here in 2010. I mean, if you really made me pick higher or lower, I would probably say modestly lower. But again, there's so many different factors, I wouldn't probably be overly precise. Let me see if Warren, our Chief Investment Officer, wants to add.

Warren Thomson

One point I think should be highlighted is the fact that in Q3, we did in fact lengthen the duration of our surplus significantly. And that was to take advantage of the statements of the yield curve, as well as provide a bit of a natural hedge to our interest rate sensitivity and our Liability segments. So in fact because of that [indiscernible], we would expect to actually pick up some incremental run rate in our surplus earnings. But the second piece as well, it give us the flexibility to realize AFS gains or losses to us at some of the sensitivity that we'll see in the Liability segments. But we think, overall, surplus asset mix is fairly stable with the exception of that lengthening of the duration that we did in Q3 and there's a little bit more in Q4 as well.

Donald Guloien

I'd like to add one more thing. Over the last couple of years, we took some appraisal marks on our commercial real estate portfolios. And the real estate market is looking pretty robust. I attribute that to a couple of business publications asking whether it was the end of the commercial real estate market and of course that's the best predictor of a raging bull.

Warren Thomson

And the final point, actually, our AFS equity gains as well. Those should be fairly stable. The levels we realized in 2010, we feel very comfortable. It could be repeated in 2011.

Operator

The next question is from Gabriel Dechaine from Crédit Suisse.

Gabriel Dechaine - Crédit Suisse AG

Just to go back to the MCCSR, and I don't consider that you've got like real excess capital, but you are very comfortable. So what are the prospects so that at some point within the next year or so assuming things go well, you are able to move some of that back to a holding company and delever a little bit given that Aussie seems pretty intent on evaluating, holding company capital regulation Basel III type concepts on two insurers, et cetera?

Warren Thomson

I think, Gabriel, you've got it right. I mean, there's a lack of clarity around where the ultimate capital regulations are going here in Canada. And I think that's going to be uncertain for a while. Internationally, you got solvency too out there and what they call regulatory modernization in the United States. There's a lot of uncertainty about what levels of capital. So anybody who tells you that they know exactly what precision, how much excess capital to have in insurance industry, is probably not aware of what's really going on. Having said that, we have a very robust level of capital, a fortress level of capital. I mean, a policyholder of Manulife has not a thing to be concerned about. If you look at where Manulife bond spreads have come, it's come down 70 basis points in the last little while. I mean, we've made huge strides in hedging as reflected in the decreased sensitivity both equity markets and interest rates, plus have that very robust level indicated by the 249%. I mean, I can't think of another time when we have been more robustly positioned in terms of the amount of protection that we have at all levels. In the base reserves being stronger than they've been before and then the level of capital that we hold in addition to the reserves and in terms of the risk profile of the company going forward, all three have moved in an incredibly positive direction. And I sleep very easy at night with the level of fortress capital that we now enjoy.

Michael Bell

It's Mike. I would add on your question on the leverage. We recognize that our leverage is higher than our long-term targets currently with the IFRS pro forma adjustment. Our financial leverage is approximately 33% company-wide. We do have approximately $950 million of debt maturing throughout 2011, including over half of that maturing here as a normal redemption later in February. So we would look at it as an opportunity to reduce our leverage over the course of the year. Again, it will take several years to get back to that 25% long-term target. But your question is right when you say will we look at this an opportunity to start to bring that leverage ratio down. I do expect to do that.

Gabriel Dechaine - Crédit Suisse AG

So is that eminent, that repayment? I thought it was at the MLI, not MSC...

Michael Bell

I just meant, in terms of our consolidated leverage company-wide, it obviously counts.

Gabriel Dechaine - Crédit Suisse AG

And then just on the asset, the investment side and this duration extension. You've increased your exposure to U.S. government debt by about $11 billion over the past year. My understanding is your long-term goal is to rotate into more corporate and enjoy some higher yields. When that takes place, if and when it does, how will that be expected to impact your earnings? I'm trying to get a sense for, is that already implied in your five-year target or is that something positive that could still take place?

Michael Bell

It's Mike. I'll start and see if Warren and Scott want to add. Yes, we are, at this point, given our efforts to extend the duration of our assets backing the liabilities. We have significantly increased our holdings of 30-year U.S. treasuries in particular. We do view that as an opportunity going forward over time to move out of treasuries and into long corporates. That would, in fact, be an incremental increase. It would show up as a trading gain in our results as we swapped it out because, again, the 30-year treasuries will be what's embedded in the valuation assumptions today. The issue really is going to be managing our strong credit underwriting discipline and also looking at what supply is out there. We benefited significantly in 2009 and 2010 from the Build America bonds program. Obviously, that was great while it lasted. What the supply looks like going forward is an open question. We view this as an opportunity but I certainly wouldn't try to put a number on it.

Scott Hartz

I think that's just right. This is Scott. I would view it as an opportunity, but not something we planned on at all. As Mike mentioned, when you're making 30-year corporate loans, you need to be careful about your credit discipline and we clearly have done that through the cycle and we'll continue to do that. But I would just view it as an opportunity.

Gabriel Dechaine - Crédit Suisse AG

The underlying VA sensitivity, if I look year-over-year, I don't recall seeing that disclosure. It went up to $1.3 billion from $1.2 billion last year. Why did that number go up? Is that because it's closer to ultimate withdrawal dates? And is that going to keep going up and we should not bump up your hedging requirements to keep it at 50% to 60% hedge ratio?

Michael Bell

That's pretty detailed question. I'm just going to say why don't you let us take it offline with you and we'll go through that.

Operator

The next question is from Mario Mendonca from Canaccord Genuity.

Mario Mendonca - Canaccord Genuity

Heading into the quarter with rates moving the way they did, would have expected that the higher interest rates would have some positive effects on this company's longer-term sustainable earnings, ignoring anything to do with the gains and any particular quarter from higher interest rates. And Michael, you referred to it when you were discussing earnings on surplus suggesting that higher interest rates would improve your earnings on surplus. Why is it that from Investor Day to today, with everything on top of markets and interest rates, that you would only characterize your 2015 objective as being attainable and appropriate? Why wouldn't they be essentially a give me at this point?

Michael Bell

First, your point is a fair one. I would certainly agree that with interest rates now being higher and equity markets being higher, that overall helps the outlook for 2015, all things equal. I mean, to call it a give me, I mean, boy, there are a lot of things that are going to happen in the world over the next four years. But you're absolutely right. If from this point forward, interest rates stayed at the level, if equity markets appreciated from this point forward at a 10% total return per year, that would be very helpful in terms of the 2015 outlook. Again, I still wouldn't get to the give me stage, but it would be helpful. I just think, Mario, as well, I don't know that updating the 2015 outlook on quarterly calls based on fluctuations is necessarily a productive exercise, that would probably be more false precision. But I think it's fair to conclude that if we saw a material sea [ph] change in our outlook positive or negative, we would talk about it. But your underlying point is a fair one that as good as we felt at the Investor Day, we feel better here 69 days later.

Mario Mendonca - Canaccord Genuity

And from a more specific perspective now, how do higher interest rates manifest themselves in higher sustainable earnings, on your surplus earnings. Is it fair to say that it results in lower earning strain and higher earnings on surplus gradually over time as the bonds mature?

Michael Bell

Yes, those are both fair points. I would also add that I think, in general, it would help our sales levels. If interest rates were higher, again, long-term guaranteed life insurance products are very expensive to consumers when interest rates are low. When interest rates are more reasonable, those products are more reasonably priced and therefore we would tend to get more sales. I'd also expect it to have longer term a positive impact on our ultimate reinvestment rate if that changed. And also, Mario, just think generally, there'll be a sign of a healthier economy site. I mean, there are all sorts of reasons to feel bullish if interest rates were today's levels or 100 basis points higher levels for the next few years. That's obviously not what we built into the Investor Day but there are a lot of reasons that we'd feel better.

Mario Mendonca - Canaccord Genuity

So finally, with that said, taking into account higher interest rates, Don Guloien said a moment ago about real estate values improving. They're very strong equity markets. Why would you suggest then that earnings on surplus in 2011 could be potentially lower than they were in 2010?

Michael Bell

Well, I just think, Mario, that importantly, there was a lot of bounciness in our results in IOS in 2010. And as an example, I appreciated one's comments that there should be more equity gains to be reaped in 2011. Again, that depends upon the market performance. We've also lowered our overall proportion in the surplus segment of public equities. So we've got -- you need more appreciation to get the same level of realized capital gains. I look at the fourth quarter number of $78 million pretax. It's on the SOE on Slide 18. And if I multiply that by four, would I be far off? And so an answer to Robert's question, if I had to take higher or lower, I'd probably say modestly lower. but I'm not trying to give you precision. I'm just trying to answer Robert's question.

Operator

The next question is from John Aiken from Barclays Capital.

John Aiken - Barclays Capital

Taking to discussion the MCCSR ratio, the next logical step further. Don, what would be your top preferences in terms of allocation of capital into various regions or products going forward as you become more comfortable and we get more information from the regulators?

Donald Guloien

Well, we're doing it right now. We're not being held back by capital. When we raised some equity, it was very painful just over a year ago. But it's enabled us to invest in all the things that we think are appropriate to invest in. We're not capital constrained in our growth in Asia. That's a very, very high margin, high ROE business, as Mike has reminded. You guys, if you look at the results that we've experienced, we're fulfilling our wildest dreams in terms of growth in those markets. Same is true in Canada and United States. So we're not being held back by lack of capital. That's the nice thing. The ship is there. I mean, we've cut back in certain products where we think the long-term expectations aren't as good, on behalf of the shareholders, and allocated this stuff we think the returns in this profile are best for our shareholders. So we've got more enough capital to sustain all the growth. And I could an acquisition opportunity that's complimentary to our businesses. That would obviously be highly attractive. But I think in this kind of market, it's lifting a lot of boats. There's less likely to be the opportunities on sale that we experienced a couple of years ago.

Operator

The next question is from Darko Mihelic from Cormac Securities.

Darko Mihelic - Cormark Securities Inc.

A question for Michael. I guess, one of the things that would help me out understanding the results a bit better is where would the macro cost of hedging show up in the source of earnings?

Michael Bell

Darco, we've included the expected cost of the macro hedging in management actions in the SOE. Since it is a management decision each quarter whether we roll that, whether we increase it, whether we decrease it, so the expected cost is in management actions. And the variance between the actual equity market performance and the long-term assumption of a total return of 10% a year would show up in experienced gains and losses. So that if markets rallied like they did in Q4, there have been experienced loss just on the macro hedge program relative to the 10% long-term assumption. Obviously, that would just be a partial hedge to other equity gains we would expect to have.

Darko Mihelic - Cormark Securities Inc.

Where would the cost of dynamic hedging show up in the SOE?

Michael Bell

The expected cost of the dynamic hedging primarily shows up in expected profit on in-force. And the reason for that is that because the dynamic hedging has been designed to be a long-term program. We've built that right into the reserve process based upon the long-term swap rates. So if you think about it, when we're hedging a certain block of VA business, we go out and we say, "Okay, what's the equity market sensitivity on that VA block?" We short an amount of futures to try to offset that sensitivity. That gives us the short-term risk-free rate. We take that short-term risk-free rate and we swap it into a long-term swap rate and then we say, "Okay, it's in the long-term swap rate 4%". We say, "Well, okay, now the reserves can't look at a 10% annual total equity return. It needs to be based on this 4% that we expect to earn on the swap rate." So we build it right into the reserves and what that means then is a greater proportion of the variable annuity fees have to go to pay for the reserve changes rather than drop to the bottom line. So that's why it shows up as lower expected profit on in-force. And as we've talked about a high-level rule of thumb of that is 50 basis points after-tax per year times the guarantee value. So with $58 billion now of guarantee value hedged through the dynamic VA program, it's a crude estimate, we would say that, that's 50 basis points on that, so $290 million a year, would be the cost relative to zero hedging and that would be showing up as a headwind in the expected profit on in-force.

Darko Mihelic - Cormark Securities Inc.

And where does the breakage show up in the SOE?

Michael Bell

Let's see. We show the breakage in the experience gains and losses.

Darko Mihelic - Cormark Securities Inc.

And what was the reason for the massive amount of breakage this quarter?

Michael Bell

Well, I don't know if I -- just really called it massive. We're obviously pleased to see the benefit. There are number of things that helped us out, then I'll start and ask if she wants to add. First of all, remember that we don't hedge the PfADs in our dynamic hedging program. So in the quarter where you see equity markets do well and interest rates rise, we would expect to get a natural benefit because we'd have a PfAD release that wasn't accounted for in the hedging program. But again I would not get carried away. This is going to bounce around quarter to quarter. It certainly bounce around quarter to quarter in 2010, but to answer your direct question, that was a big driver. Bev, you want to talk about some of the other pieces?

Beverly Margolian

Yes. I think the other major drivers are underlying trends or performed better than the hedge instruments so we got some positive fund tracking if you will.

Darko Mihelic - Cormark Securities Inc.

But it seems to me that it's very far away from what you would expected in terms of breakage. And you could see it in fact in Page 5 of your own press release. We can see sort of what you expect in terms of breakage in an upward sort of moving equity market. So here's the crazy question, is it possible that when equity markets are booming you could think of the hedge as a sort of a natural break and you could sort of ease off on that break when equity markets are moving up and when equity markets are crashing, I guess, sort of slamming that break? Is that a crazy question or...

Donald Guloien

Darko, I think of it in a different way. But you know it's not a crazy question, it's a good question. First of all, we shouldn't be calling this breakage. As Mike explained, you want to hedge against what you think is most likely to happen. Accounting, which gives rise to PfADs is basically residual of solvency accounting. It says, forget your best estimates. Now, let's imagine that we torture the assumptions for conservatives in every dimension. Higher mortality, right, higher lapse rates, higher everything that is negative and lower everything that is negative and you come up with a different answer which is used for accounting. That's a notion of these PfADs. I don't think many people, if they really understood it, would suggest that you should hedge to the patted result. You should hedge to your best estimate. As a result, there will be things that aren't hedge, that will be great residual things. Now, the good news is that it actually works in a positive direction as you've indicated in rising markets that will lead to higher than anticipated earnings. As Mike has indicated earlier, that will lead to more hedging on our part and the higher hedging cost, but that's a really good news story. The obvious, the reverse is true in down markets. We don't hedge these paths. So if we have negative or positive result, that's not necessarily a failure of the hedging program, in fact, it's more likely just as result of fact that let's all acknowledged that we're not hedging the PfADs, you won't expect it. Bev talked also about the difference between fund tracking between what the managers do, and as a general rule of thumb, I find the act of managers tend to outperform a down market and tend to underperform an upmarket. That's not always true and that wasn't true. In this quarter, we ended up with a more positive result than what the index is, but there's going to be movement there. We, to be conservative, when we talk about 55% of our volatility is being hedged now, we already deduct an estimate, a very reasonable estimate, one that we think is conservative for inefficiency or breakage. We also make the assumption that it will always go against us. And when markets are up, we sort of say, okay let's take it off, the positive impact. When markets go down, we take it off the other way and assume it's going to be worst than that. That's not actually what's probably going to happen. Some elements of it, like fund tracking and so on, are going to be more of a random walk. I think the PfADs, the not hedging of the PfADs, that is going to have a directionality to it, but a big chunk of it is more random. It's more like a plus or minus concept rather than when markets are down, it's all going to go against us, and when markets are up, it's always going to go for us, I mean, or against us as well, which is sort of what we assume in the calculation of reduction of earnings sensitivity. So a betting person would say that they would bet the reduction in income sensitivity is actually going to be less than that, that we're depicting, but we have put reasonable estimates in there because no one would want us to fairly assume that there will not be any inefficiency or breakage or tracking here of any type.

Michael Bell

Darko, it's Mike. I'll just add to other factoids here for you to consider. First, we have just very recently looked at our performance from the inception of the dynamic VA hedging program and found that in upmarkets, as Donald and Bev both alluded to, in upmarkets, we've actually outperformed the inefficiency assumption that's built into the sensitivity. So based on historical experience, that would be a conservative. We thought that it made more sense to disaggregate our assumptions and then again track those over time before officially changing those assumptions going forward. But historically, thus far, that's proven to be a case. So your hypothesis would be a fair one, and again for a while, the reason for Donald described as well. I would add just to be balanced, while Manulife didn't have a significant VA hedging program in 2008, other insurance companies did, and you may recall that volatility was, realized volatility was off the charts in 2008 at the same time that markets were down, so there are certainly examples where hedging ineffectiveness could be worse than what's described. All you have to do is look at that period. So again to date, we feel like our assumptions are reasonable based on our experience today, they're conservative. But I just want to be cautionary here in terms of predictive capacity.

Operator

The next question is from Steve Theriault from Bank of America Merrill Lynch.

Steve Theriault - BofA Merrill Lynch

First question, I wanted to talk a bit about the dividend, what the MCCSR now hiring above 250 and your sensitivity is down significantly. Are you starting to give any consideration to a dividend increase? I think I know the answer for the very near term, but further out, what's sort of criteria does it need to be met to consider an increase to the common share dividend? It looks to me, like, within few quarters you'll be back to sort of a payout ratio in the 30% range.

Michael Bell

What we'd have to look to is sustainable earnings, growth and sustainable earnings. You're absolutely right that everything is moving in the right direction for that. And the second thing is clarity around the capital rules. And again, that's not just a Canadian concern, that's an international one, lack of clarity there. But that they will come. You phrase it exactly right, it's probably not a short-term consideration. Of course, it's a matter for the board but that day will come and I look forward to that day. We'll probably a little bit more conservative. It's so painful taking the dividend down and, as we all know in Canada, financial institutions, people think it's a one-directional thing. So I think our board will be very conservative in approaching that. But certainly, I'm comfortable that, that day will come.

Steve Theriault - BofA Merrill Lynch

And then, maybe another one for you, Don, if I might. We've talked about equity hedging, but want to talk about rate hedging. Historically, you have pushed back from the idea of crystalizing losses on some of the legacy non-cash interest rate charges and I appreciate fully it's a balancing act. Can you talk a little bit about the process you went through to get comfortable to the point where in pretty short order, you've gone most of the way to your 2012 sensitivity targets pretty much two years ahead of schedule, so why not be a little bit more measured?

Donald Guloien

Well, the big thing is we always had sort of economic hedge and that is our surplus assets. For some very unusual reasons, that have nothing to do with us, the accounting and regulatory posture is that the mark-to-market -- everything we have is mark-to-market except for the surplus, interest rate gains, and those weren't taken into account. Now some of that is we've embarked on a philosophy that says, if rates go down, we take gains, surplus and recognize them. And therefore, through that process, it gets recognized for capital purposes and displayed in our interest sensitivity. But we always have that flexibility. Those people look at economic sensitivity, and you can see that phenomena demonstrated. So some of that flat and the other is yield curve changed substantially its shape. Warren touched on it earlier. It got a lot of steeper and terming out reduced some of that sensitivity but also give us a lift in the running yield, and we thought that was a very sensible trade off to make. A lot of these guys were worried when we talked about doing that in the prior quarter about how much will we give up, but because the steepest in the yield curve to give is not anywhere near what, it might be and would've been at different points when the yield curve weren't so steep. So you got that steep yield curve that we're taking advantage of. I have an obligation to make sure that the downside is limited. When we did our reevaluation of the long-term care business and the additional liabilities that emerge out of that and also, the VA business, that gave rise to a lot more interest sensitivity that we had before. And I can't let that run regardless of what my be view of interest rates are, I can't let that run beyond reasonable expectation. So we took all the appropriate action to bring it back on site, otherwise, it would have grown. It would have grown a lot. So we basically tried to stem the growth and take it a little bit more than that. As a result, with the improvement in interest rates now, we're going through to the end of the year and where they've gone subsequent, the risk profile associated with interest rate exposure is significantly attenuated. A lot of it coming from just the market movement frankly not over actions that we've taken, but we are in a good position now to lock some of that in for various instruments, and we look at -- we were very hesitant to do so before not only because of the earnings give if markets went up, but also because collateral demands and so on that would be created by hedging too early from a risk-management posture. It would not had been good thing to do. Now, we're in a happy position of figuring out exactly how much we want to hedge it to these rates that looked pretty good.

Steve Theriault - BofA Merrill Lynch

So you put on $5 billion of macro hedges over the last several months. So with the sharp rise in equity markets, I would imagine the underlying futures position have gotten fairly costly. So if I think of it in these terms, what has been, I guess, the cash outlay you've had to make on the marks on the futures and how is that funded?

Donald Guloien

Steve, I'll start, and then Bev can add. I mean, which all you need to do there is take the $5 billion times the equity market appreciation and that's been the net cash payout. Again, we're exchanging the total equity return for the short-term risk free rate, which is approximately zero. So any equity market appreciation means cash out the door. Now again, in the grand scheme of things, that's rounding in our liquidity position but that has been the cash payout and, obviously, that's been reflected in the first quarter P&L.

Steve Theriault - BofA Merrill Lynch

You mentioned the -- you mentioned it's early, but what's the size of the hedge inefficiency allowance?

Donald Guloien

It's detailed in the public disclosures. Steve, it assumes it gets worse as the markets are more volatile. And as Bev and Donald pointed out earlier, again, it's proven to be conservative because it assumes its negative in both directions and that's not been our history to date.

Operator

The next question is from Andre Hardy from RBC Capital Markets.

Andre-Philippe Hardy - RBC Capital Markets, LLC

First, on Slide 9, on the other notable items. There's always going to be positives and negatives. I realize that. But do you feel like you have a better than an average quarter or below average quarter in terms of the positive contribution of other notable items? The second thing is back to earnings on surplus. If we go back to the 2004 to 2007 period, the company generally had returns between 4% to 5% of equity, so if you take earnings of surplus over equity, it tended to be between 4% and 5%. And this year was 1.6%. So can you talk about whether it's down as a result of a change in interest rates and mix? Or is it more of the disappearance of gains or some gains that have turned into losses, and how might that reverse in upcoming years? Is it a matter of rates rising or losses disappearing or gains reappearing?

Michael Bell

Andre, it's Mike. First, on your question on notable items. I would characterize the $241 million of favorable notable items as better a than average quarter. On your question on the IOS. There are 2 main factors driving the stronger IOS that we had historically versus what we've had more recently. The first very importantly is the cost of the debt leverage that we've put on between the preps and the literal debt that we've added over the last several years to boost our capital position. That has created, in fact, a significant negative drag that we didn't have before to impact a negative cost to carry on those particular proceeds. And the other would be the disappearance of the gains. So, I mean, we were harvesting significant gains during that period, which weren't really a sustainable run rate. Now, I was at the company, I believe that, that was described that at period of time that some of those gains were not run rateable, but those would be at the main items.

Operator

The next question is from Michael Gordon Burke Goldberg from Desjardins Securities.

Michael Goldberg - Desjardins Securities Inc.

I have a couple of number questions also, and the first one relates to Page 38 of the set. So what I'd like to know is of the $45 billion of pad and excess margin on seg funds at the end of the year, what would be the amount of tax item included in adjustments that would go against just tax?

Beverly Margolian

It would be tax effective. I actually think it's in the closure. If understand the question correctly, Michael, you say that the taxes are $13 billion and while there's [indiscernible] $4.9 billion of additional falsely [ph] margins, you could pretty much pro-rate the $13 billion by the sum of the $45 billion and the $4.9 billion.

Michael Goldberg - Desjardins Securities Inc.

My other question is, of your total amount of 14 to 17 experience gains in the quarter, how much would be experience gains have been excluding equity and the interest rate, in other words, excluding investment experience on a pretax basis?

Donald Guloien

Michael, let me circle back you on that offline. I'll give you the conceptual answer and then we could give you the specific number offline. If you take that pretax number and you convert on Slide 9, the direct impact of the buyer equity markets and interest rates number of 861, that's an after-tax but you're deemed to convert that to pretax. Do the same thing with the 184 on the gains on the VA hedging program and the other investment experience. You could then back into the remainder. I just don't -- again, we got an after-tax and pretax. It's kind of apples and oranges. But why don't you let us -- I'll catch you offline on the specifics.

Operator

The next question is from Peter Routledge from National Bank Financial.

Peter Routledge - National Bank Financial, Inc.

Just a couple of quick questions on the MCCSR. Total capital required drop somewhat significantly. What were the drivers behind that? And I know the equity market hedging doesn't do anything, but does the desensitizing actions for interest rates impact that? That's the first question. Second question is, the adjustments to tier 1 and tier 2 capital, the other adjustments, sort of improved significantly. What were some of the movements in that, that caused that? And last one is it looked like you put about $1 billion up from MLI to the holdco [holding company], if I got that right, and is that enough for the whole year?

Donald Guloien

Peter, I'll start -- ask Cindy if she wants to add. On the improvement in the required capital, a couple of major factors there. Obviously, we benefited from a required capital standpoint on the improvement in the interest rates and equity markets in the quarter and that has a second order impact on the required capital. Currency has also helped us as the U.S. dollar has continued to weaken when that gets converted over to Canadian dollars for the required capital calculation, that has helped us. And in the case of the MLI to MFC, that was really normal course of business. We see that essentially every year as MFC needs the funds for the fixed commitments that MFC has. So there was nothing interesting there. We continue to hold our excess capital at the MLI subsidiary level. We do not have a material excess capital at the holding company level. We think again it makes a lot more sense to hold it at MLI.

Peter Routledge - National Bank Financial, Inc.

I asked just because last year, I think, it looked to me the dividend was a lot bigger. Is that just your cash outflows, the holdco this year are lower?

Donald Guloien

I honestly don't remember the 2009 transaction. This transaction really was the full year 2010 fixed commitments that MFC had and in effect, moving the money up to cover those commitments in 2010. So it was truly a matter of course. It was not an idea of holding excess capital at holdco at all.

Peter Routledge - National Bank Financial, Inc.

And then just on the adjustments?

Beverly Margolian

Well, looking at the page, there was a change Q-over-Q. There's really nothing exceptional that happened in terms of the adjustments. So I think that it's something to do with small changes. So if you'd like to take it offline, I can.

Operator

The next question is from Joanne Smith from Scotia Capital.

Joanne Smith - Scotia Capital Inc.

The first is given everything that's taken place with respect to the derisking and the progress that you've made on your target to get through this level of equity market sensitivity and interest rate sensitivity, have you had any more favorable conversations with the rating agencies? And when you are having discussions with the rating agencies, what are some of the conditions that they're setting, I mean, is it a combination of operating fundamental improvement on say, like, in the U.S., is it deleveraging? Is it derisking? Is it a combination of all? I'm just trying to get the flavor of what we should be looking for going forward.

Michael Bell

So, Joanne, it's Mike. Yes, we have ongoing discussions with the rating agencies. As you can imagine, after a quarter like this one where we significantly reduced our equity market and interest rate sensitivities, we substantially strengthened our capital position and, again, had progress really on each of the key operational areas, that was a more positive set of discussions than we've had in a while. In terms of the major items that would lead us to a stronger position and ideally would lead us to an upgrade at some point further down the line, probably not likely in the next couple of quarters but further down the line, I think it'd be combination of all the factors that you described. But, mainly, number one, the rating agencies would like to see us have less volatility in our results so less bouncing around quarter-to-quarter. Second, less equity market sensitivity, interest rates sensitivity relative to our capital cushion and obviously, we made a big progress there in the last 90 days. Successful execution of our business strategy particularly the repositioning in the U.S., again, that has really been a successful area for us over more than 6 months with record sales in 401(k) and also the mutual funds and the derisking of the insurance and MBA of fronts [ph]. And as you said, the reduction in the leverage. So really, I feel reasonably positive on each of those areas, but it will take some time.

Joanne Smith - Scotia Capital Inc.

I'd like to follow-up on the earnings and surplus question, because the way that I think of it and putting the debt aside just for a minute, we can revisit that, but I'm thinking about higher earnings, higher sustainable earnings, I'm thinking about lower new business strains, with the exception of some temporary items that impacted the recent quarter in Asia and also in Canada. I'm thinking about a lower risk profile so therefore, there's going to be less capital that needs to be backing the existing business and the new business going forward. I'm thinking about rising equity market. I'm thinking about higher interest rates. Where am I going wrong with expecting that earnings on surplus is going to go up and not down?

Michael Bell

Well, first of all, I think you've identified a number of very important positive trends for our company and why we're bullish on the future. The only specific headwind to earnings that you didn't mention was the cost of hedging. I mean, the equity hedging is not a free lunch. The dynamic hedging program as well as the macro hedging program, both of those reduced our ongoing earnings run rates so that's obviously a negative, and the rifle shot point on the interest on surplus is there are a number of different factors there that we've talked about throughout this call. And so again, I just wouldn't go gangbusters on those. We're not going to be reducing the debt by leaps and bounds anytime real soon. Again, we'll get some AFS equity gains going forward. We'll see how that works out. So again, we're bullish on all the factors. I just wouldn't go hog wild on the IOS.

Joanne Smith - Scotia Capital Inc.

In that thinking about the cost of hedging, I'm thinking about the cost of carrying additional capital to support a riskier book of business, what's the economic difference there?

Michael Bell

Well, obviously, we think that over time, the economics are favorable to reduce our volatility. But again, the long-term answer to that question will be dependent upon how much hedge credit we ultimately get in the capital requirements, and the capital requirements at this point are still uncertain. Not just for us but for other geographies as well.

Donald Guloien

Joanne, I want to go back to your question about the credit rating agencies, and we really don't know when they'll get it but the bond markets certainly has. If you look at our spread, they've come in from 236 basis points to 155. That's a reduction of approximately 1/3 in the last couple of months. So they'll get it. Give it a 6 months or a year, maybe the rating agencies start to notice that Manulife has substantially derisk from where it was before.

Joanne Smith - Scotia Capital Inc.

Well, Don, I guess the issue that I'm having right now is the progress that you've made. And I understand the concern regarding the upfront cost associated with that. But knowing that earnings are going to be less volatile in the future and the amount of progress that you've made towards your goal of achieving less marketing sensitivity, I would think that the rating agencies would start to come around.

Donald Guloien

You got it, Joanne, but anyway...

Paul Rooney

Joanne, it's Paul Rooney in here. I think which you described might be considered an excellent thesis as to why our stock is undervalued.

Operator

The next question is from [indiscernible] from ABN Amro.

Unidentified Analyst

Looking at the progress you've made with your hedging and the fact you're ahead of your original timetable, do you prefer to accelerate your hedging level if you had the choice or reduce the cost of hedging?

Donald Guloien

I guess, the ideal is we'd like markets to grow up so we can hedge more at prices that we'll have in pages. The higher the equity markets, in fact, the lower the cost of our hedging. But as you correctly identified, the pace of which we had higher equity markets enabled us to hedge more, so while the unit cost, if you will, is lower, the volume is greater. We are enormously pleased by the direction of markets. I mean, I can't think of a more favorable scenario than what we experienced in the last couple of months. It's enabled us to get way ahead of the hedging program. Some people are trying to get their arms around the cost of hedging but believe me, this is something that shareholders should be very, very pleased with, that we're able to stabilize our earnings at a fraction of the cost that would've cost us at any other time in the cycle.

Operator

Thank you. There are no further questions. I'd like to turn the meeting back over to Mr. Ostler.

Anthony Ostler

Thank you, operator. We will be available after the call if there are any follow-up questions. Have a good afternoon, everyone.

Operator

Thank you. The conference has now ended. Please disconnect your lines at this time, and thank you for your participation.

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