Lincoln National (LNC) Dennis R. Glass on Q2 2016 Results - Earnings Call Transcript

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Lincoln National Corp. (NYSE:LNC)

Q2 2016 Earnings Call

August 04, 2016 10:00 am ET

Executives

Christopher A. Giovanni - Senior Vice President & Head-Investor Relations

Dennis R. Glass - President, Chief Executive Officer & Director

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

Analysts

Suneet L. Kamath - UBS Securities LLC

Ryan Krueger - Keefe, Bruyette & Woods, Inc.

Randy Binner - FBR Capital Markets & Co.

Mike Kovac - Goldman Sachs & Co.

Humphrey Hung Fai Lee - Dowling & Partners Securities LLC

Eric Berg - RBC Capital Markets LLC

Marvin Charles Schwartz - Neuberger Berman Holdings LLC

Operator

Good morning, and thank you for joining Lincoln Financial Group's second quarter 2016 earnings conference call. At this time, all lines are in listen-only mode. Later, we will announce the opportunity for questions and instructions will be given at that time.

Now I would like to turn the conference over to the Senior Vice President of Investor Relations, Chris Giovanni. Please go ahead, sir.

Christopher A. Giovanni - Senior Vice President & Head-Investor Relations

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

We appreciate your participation today and invite you to visit Lincoln's website, www.lincolnfinancial.com, where you can find our press release and statistical supplement, which include a full reconciliation of the non-GAAP measures used in the call, including income from operations and return on equity to the most comparable GAAP measures. So presenting on today's call are Dennis Glass, President and Chief Executive Officer, and Randy Freitag, Chief Financial Officer. After their prepared remarks, we will move to the question-and-answer portion of the call.

I would now like to turn the call over to Dennis.

Dennis R. Glass - President, Chief Executive Officer & Director

Thank you, Chris, and good morning, everyone. As we anticipated, second quarter earnings showed a nice recovery following disappointing first quarter results, as operating earnings per share increased 25% sequentially. Compared to the prior year, earnings per share increased 7% as our diversified mix of businesses and sources of earnings coupled with capital management actions continue to support solid EPS growth.

We covered much of our strategy at the June Investor Day, and I would just like to highlight a few points. First, despite persistently low interest rates, we continue to grow EPS and book value per share, as we said we would. Randy will comment on income statement and balance sheet impacts from low rates in his remarks. I would just note that we are raising prices on certain products as we proactively respond to lower interest rates, consistent with prior years, and we see expense management as a key lever to sustain our targeted EPS growth. Importantly, we have a strong track record of controlling expenses and proved that once again this quarter.

Next, we have a keen focus on allocating capital towards growth opportunities at attractive returns. That said, where external events are affecting sales levels or returns, we are okay with using the capital intended to support sales growth to buy back our undervalued shares. Lincoln's leading distribution organizations combined with our manufacturing capabilities continue to differentiate us from peers. We are driving sales growth right now in our individual Life Insurance and Group Protection businesses, while innovative product solutions across our Annuity and RPS businesses will help sales growth. I'll expand on these in a minute.

Finally, as we have demonstrated for years, we have a quality balance sheet and generate a significant amount of free cash flow. This has allowed us to actively deploy capital to shareholders and it continued in the second quarter as we repurchased $275 million of stock.

Now turning to our business segments, starting with Annuities. A 3% decrease in average account values resulted in annuity earnings declining from the prior year. However, the recent recovery in equity markets led to earnings growth of 8% sequentially and positions us well for subsequent periods. Total annuity sales were $2 billion and net outflows $452 million.

As you have heard from us as well as other asset management companies, market volatility continues to dampen consumer demand for equity-sensitive products. VA sales are certainly in that camp, though I would note, our sales were largely unchanged compared to the first quarter. While sales are lower than we would like, we are still selling volumes that support our distribution value proposition and are not willing to take aggressive near-term actions to stimulate sales. In the interim, we are comfortable reallocating that capital to share buybacks.

We are bringing to market several unique product solutions early next year which capitalize on the growth trends and passive investments and fee-based compensation. These products will meaningfully enhance the value proposition and choice for guaranteed lifetime income, which is an essential solution for retirement savers.

Our Annuity business remains a high-quality source of earnings and we have produced a long track record of success that is different from others. As we have said, this success is because we started the business the right way and have maintained our consistent and disciplined product pricing, end-to-end risk management and industry-leading distribution. We hope you walked away with those take-aways at our Investor Day, as I continue to believe this business is under-appreciated.

Turning to Life Insurance, we generated strong earnings growth versus the prior year. In terms of sales, total individual life insurance sales in the quarter were 164 million, a 6% increase from the prior-year quarter. Two-thirds of our sales came from products without long-term guarantees and our sales are well diversified, with all products representing between 10% and 30% of total life insurance sales. Executive benefits sales, which can be lumpy, contributed 9 million to total life sales this quarter, while the prior year benefited from one large case.

As you know, we have done across-the-board product repricing for the past several years to reflect lower interest rates. As a result, many of our products are meeting targeted returns, even with today's lower interest rates and flatter forward curve. Where we are not achieving acceptable returns, we will reprice. Bottom line, we are committed to maintaining our risk management and product pricing discipline to get appropriate returns on capital. When combined with actions focused on in-force block profitability, we continue to be optimistic about our ability to grow our Life Insurance business.

Turning to Group Protection, we are well on our way to restoring the profitability and long-term growth potential of our Group business. Our non-medical loss ratio continues to improve as we benefit from our repricing efforts and enhancements to claims management functions. Sales momentum continues, as sales increased 15%. This marks another quarter of sales growth as the market disruption from our aggressive renewal repricing strategy has clearly subsided. In addition, as our renewal price increases moderate, we are beginning to see improvement in our renewal persistency. We expect premiums to stabilize in the back half of the year, and premium growth to reemerge in 2017.

I'm pleased to see the encouraging signs of growth while we continue to sustain our pricing and risk management discipline. We have the right strategy, people and processes in place and we are executing extremely well. As we have noted recently, top-line growth will be critically important to drive the next leg of our margin improvement story. I am confident this will be achieved, providing a nice tailwind to earnings and further diversifying Lincoln's sources of earnings mix.

In Retirement Plan Services, earnings were consistent with both the prior year and the prior quarter and in line with expectations. Second quarter deposits of $1.7 billion were down 11% from a year ago, driven by a decline in mid-large market first year sales due to the timing of implementations. We have a strong pipeline and already committed new business scheduled for the second half of the year. This growth can be directly attributed to our focused strategy and investments in our digital and mobile customer experience, which is resonating in the marketplace.

In the small market, first-year sales were up 24% year-over-year, a result of distribution expansion and increased wholesaler productivity. Looking ahead, we expect this momentum to continue, aided by the recent launch of our enhanced small-market Director product. Recurring deposits were also up 3% year-over-year, evidence that our high-touch model continues to differentiate us and drive higher contributions and participation rates. Our overall sales momentum leads us to remain confident that 2016's net flows will exceed 2015 levels.

Shifting to investment results. Disciplined ALM and risk management continue to drive our investment strategy. We put new money to work in the second quarter at an average yield of 3.8%, which was down 20 basis points from the first quarter. The decrease in new money rates was primarily due to a drop in Treasury rates as we invested at 205 basis points over the average ten-year treasury, consistent with recent periods.

The decline in interest rates also increased our net unrealized gain to 8.4 billion pre-tax, up from 5.5 billion in the first quarter. It is also worth noting that our energy portfolio, which has been an area of investor focus this year, swung to a net unrealized gain in the second quarter with values increasing by $600 million from the first quarter. Downgrades have also slowed and, as a result, our below investment-grade exposure decreased to 5.5%, a 10 basis point improvement from the first quarter.

Lastly, the annualized return on our alternative investments was nearly 6% in the second quarter, a significant improvement from the first quarter, however, still below our long-term average and targeted return of 10%. Better results from both our private equity investments and hedge funds helped drive the sequential improvement. We expect further earnings growth over time as we achieve our targeted return, modestly increase our exposure to alternatives and shift the mix towards private equity.

Turning to distribution which, as many of you recognize, truly differentiates Lincoln. Our wholesale, retail and worksite distribution organizations have been instrumental in driving our strategies and delivering on our consistent market presence. The strength and stability of over 90,000 active producers creates opportunities and enables our ability to target the faster-growing segments.

During the quarter, we saw strong producer growth across a number of our products, including MoneyGuard, fixed annuity, term, and RPS. And more advisors are selling multiple products, underscoring the power of our distribution franchise in combination with a diverse product portfolio. We are executing on our diversification strategy. At an enterprise level, no one product accounted for more than 14% of sales during the quarter and non-long term guarantee sales were 73% of our total sales, up from 69% a year ago. As manufacturing and distribution collaborate on existing new product innovations, I am confident that Lincoln will continue to differentiate itself in the marketplace.

On to DOL. There's not much new to discuss since our Investment Day, but it is important to reemphasize that our distribution partners are continuing to work towards using the BIC to serve retirement savers and offer the choice of commissions or fees, whichever is in the client's best interest. This is leading to greater interest in our fee-based annuity product offering by distribution partners and advisors. At Lincoln, we continue to take a leadership role in working with the DOL and our distribution partners to be sure we are prepared for when the first part of the rule goes live in April 2017.

Lastly, as you recently saw, Mark Konen announced his decision to retire. I want to personally thank Mark for his partnership and leadership over the years and wish him the best in retirement. He has recruited a very strong management team, and by having Mark stay on board through the end of February 2017, I am confident there will be a smooth transition.

So in closing, I'm pleased that our earnings returned to levels you have been accustomed to seeing Lincoln produce. While clearly there are economic and regulatory issues, let me reiterate that I remain confident in our ability to generate top and bottom-line growth and actively deploy capital.

I will now turn the call over to Randy.

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

Thank you, Dennis. Last night, we reported income from operations of 373 million, or $1.56 per share for the second quarter, a 7% increase from the prior year. Importantly, most items that negatively impacted our first quarter results, including accelerated amortization of DAC and group, adverse mortality in individual life and weak fee-based earnings, returned to expected levels. It is also worth noting that while alternative investment income improved significantly from the first quarter, returns were still below our expected results by roughly 7 million, or $0.03 per share, with 5 million of the shortfall hitting the life business. As an offset, expenses were favorable by a similar amount in the quarter, primarily in other operations.

Now, shifting to key performance metrics. Book value per share, excluding AOCI, now stands at $54.67, as we continue to consistently compound book value in the high-single digit range. Operating ROE remains strong at 11.7%, unchanged from the prior year. Expense discipline, beyond some of the favorability I noted upfront, resulted in our expense ratio declining by 50 basis points. This reflects our ability to effectively manage G&A in a period of slower revenue growth. We expect expenses to continue to be a good story.

Net flows contributed $0.5 billion to account values, and with end-of-period account values exceeding the quarterly average, we enter the third quarter with a modest tailwind. Finally, our balance sheet strength and capital generation enabled us to repurchase 275 million of stock this quarter, retiring 2.6% of our shares outstanding, the most since the fourth quarter of 2011. Net income results for the quarter included 47 million of realized losses related to investments, while our variable annuity hedge program was effective with minimal breakage in what was a volatile quarter for the capital markets.

Before shifting to segment highlights, I would like to comment on the current interest rate environment. The punchline is that we remain well positioned, even as rates and the forward curve have moved lower. Let's start by talking about the statutory balance sheet because that is what comes up most with investors. Recall at our June Investor Day we noted we had sufficiency in our overall cash flow testing, including stressing the 10-year treasury down to 50 basis points forever.

The one area we pointed to where there could be some temporary reserve strengthening is around certain secondary guarantee universal life subtests. For instance, if the ten-year treasury stayed at 1%, that could require up to $350 million, or 20 percentage points of RBC, a very manageable impact when you think about Lincoln having $8.7 billion of statutory capital and an RBC ratio of 500% at the end of the second quarter.

Now thinking about the other two areas that low rates impact life insurers, that being new business and spread compression, first on the impact on new business returns. Most of our products continue to achieve our targeted returns. But as Dennis noted, we will make changes where necessary to achieve acceptable returns.

Next on spread compression, which has been with us for a while now. We showed at Investor Day that spread compression is abating, even if we assumed new money rates stayed at first quarter levels of 4%. We estimated this would depress EPS growth by 2% to 3%, versus 4% to 5% in prior years, but still enable us to achieve our targeted EPS growth rate of 8% to 10%. Given the decline in interest rates since our June Investor Day, we estimate that we are likely to be at or slightly above the top end of this 2% to 3% range, but expect that other levers, such as capital and expense management, can offset this impact. So bottom line, low rates are manageable and we are hopeful that our peers begin to provide comparable disclosures so you all can better compare companies, as we believe views on Lincoln are misaligned.

Now turning to segment results and starting with Annuities. Reporting earnings for the quarter were $235 million compared to $255 million in the prior-year quarter. Lower fee income from a 3% decline in average account values is the primary driver of the year-over-year decline. Operating revenues declined 1% from the second quarter of 2015. Over the trailing 12 months, net flows totaled nearly $0.5 billion, however, this organic growth was more than offset by negative market performance.

Return metrics continue to be strong, as ROE came in at 21%, consistent with our long-term average, while return on assets decreased 4 basis points versus the prior year, but did increase 3 basis points from the first quarter, stands at 77 basis points. Finally, as I noted up front, our variable annuity hedge program was effective in an extremely volatile quarter, particularly at the end of June, which further demonstrates the high quality of our Annuity business.

In Retirement Plan Services, we reported earnings of $31 million, up $1 million from the prior-year quarter. Second quarter revenue was flat year-over-year, as was average account balances and return on assets. Net flows were modestly positive in the quarter, nonetheless, our growth outlook remains positive for the second half of the year, which positions us well to increase account values.

Spreads excluding variable investment income compressed 9 basis points versus the prior-year quarter, near the low end of our expectation. While retirement earnings will fight the headwinds of low interest rates, continued growth in net flows positions us well for long-term earnings growth.

Turning to our Life Insurance segment. Earnings of $120 million increased 14% from last year, as mortality returns to normal levels following elevated severity in the prior-year quarter. As I noted up front, alternative investment income was $5 million below our expected results for the Life business.

A full recovery in alternative income would have put our Life earnings right in line with the $125 million quarterly run rate I mentioned on last quarter's conference call. Spreads, excluding variable investment income, compressed 5 basis points versus the prior year, at the low end of our expectation.

Quickly on Life earnings drivers. Average account values increased 3%, with total in-force face amount up 4%, consistent with recent performance in our mid-single digit organic growth expectations. So second quarter results saw mortality recover from the prior year and typical first quarter seasonality. While earnings are facing some spread compression, drivers continue to support long-term earnings growth.

Group Protection earnings of 15 million were below the 19 million reported in the prior-year quarter, but well above the 5 million reported in the first quarter, as DAC amortization returned to more normal levels, as expected. The decline in earnings versus the prior year is due to lower premiums and investment income.

Loss ratios continue to benefit from our pricing and claims management actions. Our non-medical loss ratio improved to 72.5% this quarter from 73.6% in prior-year quarter. The year-over-year improvement was driven by favorable loss ratios in all product lines: life, disability and dental.

Non-medical earned premiums declined by 11% year-over-year. Lower renewal persistency in sales owing to our repricing initiatives have clearly provided a headwind to growth. However, as Dennis mentioned, we expect premium growth to reemerge next year, given positive leading indicators. Notably, sales increased 15% in the second quarter, marking our second straight quarter of sales growth, while renewal persistency increased to 76%, a nearly 20-percentage point improvement from the first quarter. As a result, we are confident top-line growth will provide the next lever for margin improvement.

Before moving to Q&A, let me comment on a few other items of note. Our capital position remains very strong and our business model continues to generate capital, allowing us to allocate a significant amount of capital to shareholders. This quarter we repurchased $275 million of Lincoln shares as we took advantage of our strong balance sheet and shares trading well below book value. We expect to remain active allocators of capital.

As I briefly noted up front, statutory surplus stands at 8.7 billion and our RBC at ratio will end the quarter at approximately 500%, both very strong numbers and up from the first quarter, due to the reinsurance transaction we executed in April. Holding company cash ended the quarter above our target of $500 million.

So to conclude, we saw our earnings power recover to more normal levels following depressed first quarter results, which lead to 7% EPS growth compared to the prior year. Lower for longer interest rates are manageable, even as the spot rate and the forward curve have moved lower. We are effectively managing G&A in a period of slower revenue growth to drive margin improvement and we remain disciplined yet opportunistic around share buybacks. And given our balance sheet strength, we expect to remain very active.

With that, let me turn the call back over to Chris.

Christopher A. Giovanni - Senior Vice President & Head-Investor Relations

Thank you, Dennis and Randy. We now have approximately 30 minutes for Q&A. As a reminder, we ask you to please limit yourself to one question and only one follow-up, then re-queue for additional questions.

With that, let me turn it over to Vince to start Q&A.

Question-and-Answer Session

Operator

Thank you, sir. Our first question is from Suneet Kamath of UBS. Your line is open.

Suneet L. Kamath - UBS Securities LLC

Thanks. Good morning. Dennis, I wanted to start with the VA new business. Obviously, flat quarter to quarter, even with the market recovery. I guess my question is, do we need to see some real significant product innovation there in terms of guarantees perhaps being a little bit more generous in order to get a rebound in sales here?

Dennis R. Glass - President, Chief Executive Officer & Director

Suneet, as I said, we attribute the decline in VA sales to the volatility in equity markets. You see the same type of decline in sales volume for mutual funds. And so there's this outside volatility that is affecting our sales levels.

The response to that that I also mentioned in my remarks is that we do want to create some innovative products, not products that necessarily have richer benefits. I think the whole industry would be reluctant to do that right now because low interest rates really limit your flexibility on that. But we see real growth opportunities in expanding our products that are sold with fees. We see real opportunities – that's a consumer and an advisor preference.

We also see opportunities to improve our offerings of passive investment options. We also see the opportunity to use digitization in making the sales process more easy and intuitive, products simpler. And so those are the kind of actions that we're taking and we think that they will have a significant impact on sales as we get into 2017. Trying to do all of that stuff takes time. And as we get into 2017, we think we'll have an impact through those actions.

Suneet L. Kamath - UBS Securities LLC

Okay. And then just similar question on the Life Insurance side. Are you already starting to reprice the business, given the decline in the rates, or is that something you are considering at this point, but you haven't actually started the process?

Dennis R. Glass - President, Chief Executive Officer & Director

Suneet, we've been changing pricing on products in reaction to declining interest rates for years now. I'm not quite sure what the product launch is time-wise, but I can promise you that if something is not achieving its return, it's being repriced as we speak and will be launched when we can get the repricing done and get it up on our systems.

Suneet L. Kamath - UBS Securities LLC

All right. Thanks, Dennis.

Operator

Thank you. Our next question is from Ryan Krueger of KBW. Your line is open, sir.

Ryan Krueger - Keefe, Bruyette & Woods, Inc.

Thanks. Good morning. I had a question on the RBC ratio. You've been hovering generally in the high 490%s, up to 500% after the reinsurance transaction. I was just hoping to get some perspective on where you would like to run that going forward and if you have the ability to bring it down a little bit to take advantage of buyback opportunities.

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

Ryan, we've been running, as you noted, in the high 400%s for some time now, four or five years. And I think traveling in and around that area is an area we're very comfortable with. As I've noted a number of times, our expectation is as you move forward and we distribute capital that that RBC ratio would trend down over time, ultimately maybe declining to that 450% range or so. But it's something I think that is best if it happens over time.

How that relates to, I think, ultimately where your question is going is what do we think about share buybacks. I'd make this comment or this note. I think about share buybacks, I think it's best to start from the beginning. And what have we said all along here is that we would expect on an annual basis to distribute 50% to 55% of our operating earnings back to shareholders. That translates, if you do the math and you back out the fact that our dividends run about $250 million a year, to roughly 125 million to 150 million a quarter.

In addition, as we've talked about, sales have come down a little bit and that gives us a little bit of flexibility to boost that number up. And then we can use the strength in our balance sheet to go even a little above that. You saw that this quarter with 275 million for the quarter. And I would expect that we'd continue to take that same sort of view as we look forward.

Ryan Krueger - Keefe, Bruyette & Woods, Inc.

Okay. Thanks. And then the follow-up, I guess this is more of a philosophical question. But have you contemplated having a higher mix of dividends versus buybacks in your capital deployment as a way to differentiate yourself and demonstrate the stability in your capital position that you've been highlighting?

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

You know, Ryan, I think when you look at what we've done over the last five years, we've increased our dividend dramatically. This year we're running at $0.25 a quarter, or $1 for the year. And that's up substantially and I think that demonstrates the fact that we have a great deal of confidence in our ability to generate annual cash flows. I don't think anybody out there can put forth a record of generating capital and distributing that capital like we have over the last five to six years.

So we've done just what you would suggest. We've increased our dividend significantly, reflective of our confidence. I would expect, obviously it's a decision of the board, but that we would continue to increase that dividend. But the reality is right now, Ryan, that we believe that allocating capital to share buybacks is a very good use of capital. We believe it's a high-return opportunity and we will likely continue to do that.

Ryan Krueger - Keefe, Bruyette & Woods, Inc.

Okay. Thanks, Randy.

Operator

Thank you. Our next question is from Randy Binner of FBR. Your line is open.

Randy Binner - FBR Capital Markets & Co.

Yeah, I'll try this one with Randy. I think you mentioned in your comments that you felt that peer disclosure was not comparable to Lincoln. So in light of some trading effect on your stock I think today from a large life insurer taking a charge, I'd be interested if you'd feel comfortable expanding on that and helping us understand a little bit better how your disclosure might be more useful or different than peers.

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

Randy, thanks for the question. Part of this, you have to give as speculation. But if you asked me what do I think the number one overhang on our stock is today, it is low interest rates and investors' perception of how low interest rates impact Lincoln, primarily around the balance sheet. And that's why we have focused so intently on trying to get the message out to investors how exactly we are impacted by low interest rates on our balance sheet. I reiterated it in my discussion today and we had a very fulsome discussion at our most recent Investor Day about the impacts. I think there's a perception among investors that the impacts are larger than we've shown and so we continue to try to get that message out there.

I think that message would be enhanced if other companies were to have similar disclosures so that there was a more fulsome understanding among investors across the industry. I think any time you're out there doing something on your own, some investors will have a tough time moving that way or agreeing with just one company's view of the world. So I think it's always helpful if you can have more companies and that's why I say that. I think you will continue to see that as interest rates stay low for a longer period of time. I think you'll continue to see companies expand the disclosures around this area and I think it'll be beneficial.

Dennis R. Glass - President, Chief Executive Officer & Director

I would add to that that along with line of business earning, we happen to think it's very important from an investor perspective to see the source of earnings, capital market-driven earnings, interest rate-driven earnings, mortality and morbidity earnings. But that's a different view and I think an important view from an investor's standpoint to understand the prospects of the company.

Randy Binner - FBR Capital Markets & Co.

And I guess just to summarize where you're standing, because we'll have an actuarial review in the third quarter, is that while some lines may be more interest rate-exposed, you've pivoted away from the most exposed products. And if you look at the impact over the total base of your statutory reserves, you feel that you're going to have more than adequate buffer across the board and that's the nature of the actuarial review that you'll do in the third quarter.

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

As we noted at Investor Day, our buffer as defined by reserve adequacy and cash flow testing has increased from $8 billion to $11 billion over the last three years. And we expect it to continue to increase, providing additional cushion. So we are very confident in our cash flow testing results. We've talked about the subtests and the potential impact and our ability to manage that in the context of the strength of our balance sheet. So, yes, we remain very confident in the cash flow testing process and the significant strength of our balance sheet.

The results around cash flow testing and these other areas I think ultimately, Randy, are very company-specific. And the reality is the products we sell yield this result. We have some products in there that are impacted by low interest rates, there's no doubt. Secondary guarantee UL, being the biggest example, but that is manageable in the context of a company with the diversified business mix that we have.

Randy Binner - FBR Capital Markets & Co.

All right. Thank you.

Dennis R. Glass - President, Chief Executive Officer & Director

You bet.

Operator

Thank you. Our next question is from Mike Kovac of Goldman Sachs. Your line is open.

Mike Kovac - Goldman Sachs & Co.

Great. Thanks for taking the question. Wanted to follow-up on a couple of questions regarding the upcoming assumption reviews in the third quarter. Is there anything that Lincoln is conducting in terms of either new systems or deep dives or changes in terms of what you're looking at for utilization, whether it's your own information versus industry data that we should be thinking about as we head into the back half of the year?

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

Mike, it sounds like your question is focused in on annuities, but I'll just give you some broad thoughts on the upcoming assumption review. And let me preface this by saying I'm not going to front-run the process. There are lots of people at Lincoln working very hard on this process as we speak.

I think the results that come out of an unlocking are, once again, same thing I said for the last question. But they're very company-specific. I think the primary drivers of the results that come out of these unlocking processes, there are a number of them, but if you had to ask me to pick a couple, I would say this. It has to do with the riskiness of the optionality of the products you have on your balance sheet and it has to do with the point at which you start from an assumption standpoint.

When you look at Lincoln, so let's talk about the facts now. When you look at Lincoln over the last decade, but I'll focus on the last four years because that's when we've made a number of assumption changes. And now I'm focusing in on the Annuity side. What you see is a very solid result.

In fact, if you look at unlocking over the last four years in the Annuity business, the net unlocking impact has been a positive, a number in excess of $100 million. It had a low one year of negative $7 million and another year of $60 million. Very consistent results. And then if you look inside of that result, you would see there are a number of large assumption changes. We changed lapses significantly, we changed utilization significantly. But each and every year, there's been a consistent result. No big negatives along the way.

That has to do, once again, I think with the fact that our products are designed very well and the people who design these products were very thoughtful when they were putting together the assumptions they were going to use inside those products. They were not right on every assumption, but in the totality of assumption setting, they did a great job. And you see that in the results. So that's how we've done. That's just the reality of the facts.

Now let's look forward. I believe it was Will had a good piece of his presentation where he focused on if you look at the key assumptions in the Annuity business again and you look at what we would expect if you had to take rather dramatic changes in those assumptions, what would the impact be. Let's take lapse rates. We have a very low lapse rate embedded in our models, 3.8%. Look, if we had to cut that number in half, the impact that we showed was $50 million. Once again, very small. The reality is I think we have an expectation of 3.8% in our model, right now experience has been running at 3.4%. So right in line with where we are.

The other big assumption, utilization. If we needed to change our model to 100% effective utilization, complete and total effective utilization, that would be $160 million. Once again, a relatively small number. Utilization, by the way, has been running spot on with what's in our model. And the third item is mortality. If mortality was to improve significantly, 20% I think is the number that we showed that would have a net impact of $90 million. Morality in and of itself is running right in line with our expectations. So we've had great results in the Annuity business. We don't have any expectation of big negatives going forward based on where we are today. That's the Annuity story. I don't think the story would be any different if you went across our other businesses.

For instance in the Life business. If you look at the unlocking results over the past four years, six years, ten years, what you're going to see is a pattern of consistency. The Life business over the last four years, I'll use that same period again, I think the sum total of the results has been about a negative $100 million. And that was all last year when we unlocked, when we lowered our long-term J-curve assumption.

So, Mike, I think we've had a great history of results. We fully expect to have good results going forward. I go into any unlocking process assuming that we're in a good place because that's been our history. But we'll see. Once again, there are lots of people doing lots of work out there. But I have no reason to have any bad expectation coming into any of this regardless of what other companies may be experiencing because it is very fact-specific to each and every company.

Mike Kovac - Goldman Sachs & Co.

Great. Thanks. That's helpful. Helpful answer. In terms of one other item that I heard mentioned by Dennis in the opening remarks, expense management obviously a key lever and a strong track record for Lincoln on that. I wanted to dig in a little bit deeper into that. Is there anything specifically new that you're looking at from the expense side from here on out, given changes in maybe either sales or the outlook for the macro?

Dennis R. Glass - President, Chief Executive Officer & Director

Let me start with our overarching expense management tactic or starting point. And that is we're very disciplined during the budgeting process that our expense growth in a budget is 1% to 2% less than that year's revenue growth. And some of that reduction can come from volume, but sometimes it has to come from core operating expenses. So we start off by saying you can't have a budget that doesn't show an improvement in your expense ratio. That's an important ongoing management discipline.

Now in addition to that, we are looking very hard at digital strategies to further drive down our core expenses. We're on the front end of that. I think there is meaningful opportunity with process improvement and digitization. And, again, we're on the front end of this and it will take time to size and execute.

We're also looking at partnerships where others can do things more economically than we can. I think there's opportunity there as well. What I've been saying internally, if you sort of look at two big issues, one is that the foreign digital companies are setting the standard for the relationship between companies and consumers' expectations about ease of doing business. We weren't born digital, but we're taking very decisive steps to improve our customer experience. Along with that will come expense saving.

The second big issue, as we all know and we've been spending time on it this morning, is that low interest rates hurt margins. And so you are compelled to have a very aggressive reaction to that and find ways to overcome it. So looking at expenses again, start with our core strength of expenses aren't going to grow at a faster rate than revenues, and then we're looking at additional things, digitization, partners who can do it less expensively and those things to achieve earnings per share growth. Pretty excited about it actually.

Mike Kovac - Goldman Sachs & Co.

That's great. Thanks.

Operator

Thank you. Our next question is from Humphrey Lee of Dowling & Partners. Your line is open.

Humphrey Hung Fai Lee - Dowling & Partners Securities LLC

Good morning and thank you for taking my questions. Looking at Group Protection, I hear Dennis and Randy's remarks talk about the improvement in margin will hinge on the premium growth or getting new sales of new business. But looking at your sales growth and also some of the market commentary related to pricing being a little bit more aggressive right now, can you talk about what you're seeing in the marketplace and how your current pricing of the new business relative to your assumptions?

Dennis R. Glass - President, Chief Executive Officer & Director

Yeah, let me first respond to the competition in the marketplace. We don't see any significant change in that. I know other companies may have referred to some increased competition. But in the markets that we serve, we are not seeing a significant difference in competitiveness from the first quarter or actually from last year.

And, remember, most of our sales are in the 1,000-employee and below category and also 30% to 40%, I forget the number, are in the employee voluntary space. So I start with the premise from what we can see there's not been a significant change in the competitive or pricing in the marketplace. It could be different for other companies that have different segments than we do.

Randy, do you want to take the second half of that question?

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

And, Humphrey, reiterate the second half outside of competition, just in genera are you talking about premium growth?

Humphrey Hung Fai Lee - Dowling & Partners Securities LLC

Yes.

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

I think, Humphrey, when you look at where we are today, sales growth for the last two quarters, persistency – and this is really I think the key element – returning to more normal levels. If you remember in the first quarter we had persistency of 57%. It's tough to grow premiums if your persistency is only 57%. You can do the math.

This quarter we saw significant recovery to 76%. I think that's reflective of the fact that the significant pricing actions that the group team has taken over the last few years have – we're a little removed from them, we're out of the significant price increases and you're starting to see that in broker behavior. So persistency up significantly. And we'd expect it to continue to trend up from where we are today.

So when you factor in sales starting to grow again, persistency getting back to normal levels, the math just works where the premium level we experienced this quarter should be right around the trough. And then you level out for a little bit. And then as you move into 2017, we'd expect that you'd start to see premiums grow little bit. Ultimately, we'd like to get premium growth back to that mid-single digit area.

Humphrey Hung Fai Lee - Dowling & Partners Securities LLC

Okay. Thank you for the color. And then shifting gears to Retirement Plan Services. I think in Dennis' remarks, talked about expecting the pipeline in the second half to be strong and then expecting full-year net flows to be exceeding 2015 level. But I was just wondering can you maybe give a little bit more color in terms of what you're specifically seeing in the pipeline and in terms of opportunities out there?

Dennis R. Glass - President, Chief Executive Officer & Director

I think that we don't typically get into pipeline numbers. The bottom line is that with the pipeline and with already committed sales, we expect to see positive flows in the second half and full year 2016 going above the net flows that we saw in 2015.

Humphrey Hung Fai Lee - Dowling & Partners Securities LLC

Okay. Got it. Thanks.

Operator

Thanks. Our next question is from Eric Berg of RBC Capital Markets. Your line is open.

Eric Berg - RBC Capital Markets LLC

Thanks. Randy, my one question relates to the mechanics, the operation of this subtest. And I'm interested in this issue because, of course, it goes to the question that all investors have, which is whether these low rates are an income statement issue or in fact a balance sheet issue.

And my question regarding this subtest is this. If the subtest essentially requires you to move capital within the Life Insurance company, but doesn't require you to increase capital in the Life Insurance company – and maybe my problem is that I don't fully understand or have an accurate understanding of how the subtest works, but if it is simply an intra-Life Insurance company capital allocation issue, why should it really matter to people looking at your financials?

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

Eric, I think as with any potential allocation of capital, it has to do with the potential size of that allocation and your capacity to deal with that particular item. As I mentioned, for us, in the case of these subtests, you're talking about $350 million with the ten-year treasury at 1%. That compares to a balance sheet that has a total capacity of 8.7 billion of capital, 500% RBC ratio.

Now, if the potential size of that impact was much bigger and the amount of capacity on your balance sheet to manage that impact was smaller, then you would have to think about where is that capital going to come from to maintain all of the other things I want to do with the company, the ratings, et cetera. So it's about the size of the potential impact compared to your capacity to manage that impact.

What I have said, I have given you the potential size of the impacts and I've stated that our balance sheet is very strong and we feel very comfortable saying that we have the capacity to manage those potential impacts of those subtests. Specifically, what are these subtests? They have the generic names, 8C and 8D. They are tests of particular books of business.

For us, the one subtest that becomes the item that generates the potential reserves is 8D. 8D is a test where the earned rate that you use as part of the calculation is defined. It is defined by an index, an index that is established between July 1 and June 30 of the year preceding the end of the calendar year. So for the end of 2016, the rate has already been defined. It was finalized on June 30. Very confident and comfortable that that index level, we are fine in 2016.

As you move into 2017, you're in the middle of setting that, or you just started setting that index right now. On July 1, you'd be using that index. You'll develop the average index rate over the following 12 months, and that's the rate that we'll use at the end of 2017. So that's mechanically how these things are calculated.

I've given you the potential size of the impacts, very comfortable saying we can manage them. But I can't tell you what those facts are for some other company. I don't know what their potential impacts are and I can't speak to their capacity to manage those impacts. But for Lincoln, that is how it works and that is the story.

Eric Berg - RBC Capital Markets LLC

Thank you.

Dennis R. Glass - President, Chief Executive Officer & Director

Eric, I heard a different question. You can have the kind of redundancy in our reserves in total that Randy mentioned. This is a separate test that even though you have a big cushion, in total this is a separate test that you'd have to meet anyway. If that's helpful.

Eric Berg - RBC Capital Markets LLC

That's a helpful clarification and it definitely complements Randy's response. So thank you, Dennis. Thank you so much.

Operator

Thank you. Our next question is from Marvin Schwartz of Neuberger Berman. Your line is open.

Marvin Charles Schwartz - Neuberger Berman Holdings LLC

Gentlemen, I congratulate you not only on an excellent quarter, but on an excellent call. Okay. I can't tell you how impressed I am with all of the things that you are doing to intelligently and conservatively manage and grow your earnings.

The question is, on the share buyback program that you have, I appreciate that in the second quarter, you bought back more stock from any single quarter than for many years going back to 2011. What I would suggest you consider, and you've never done this before, is doing an accelerated share repurchase program where you call your investment banker, whoever it is that's representing you on the buyback, and you have idea in your mind how much stock you might like to buy back for the third quarter. Do it right up front while the stock is at this price and get it done really fast and then you have options if you want to go back in addition to that with a continuation of your daily program. But in my opinion, buying back the stock on an accelerated basis makes a lot of sense. Thank you.

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

Marvin, I appreciate the input. We have actually used ASRs in the past. Most recently we used one a couple quarters for about half of that quarter's buy back. So it's something we definitely have used in the past and will definitely think about moving forward, but appreciate the comments.

Dennis R. Glass - President, Chief Executive Officer & Director

And, Marvin, I really appreciate the predicate to the question. Thank you for those compliments.

Marvin Charles Schwartz - Neuberger Berman Holdings LLC

Thank you.

Operator

Ladies and gentlemen, that does conclude Q&A for today. We will be able to follow-up with those with any other questions later this afternoon. At this time, I'd like to turn the call back over to Chris Giovanni.

Christopher A. Giovanni - Senior Vice President & Head-Investor Relations

Thank you. And we are at the top of the hour, so we want to be cognizant of another call about to take place. As always, we're around to take questions on our Investor Relations line at 800-237-2920 or via email at investorrelations@lfg.com. Thank you and have a good day.

Operator

Ladies and gentlemen, thank you for your participation in today's conference. This concludes the program. You may now disconnect. Speakers, please stand by.

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