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Principal Financial Group (NYSE:PFG)

Q3 2012 Earnings Call

October 26, 2012 10:00 am ET

Executives

John Egan - Vice President of Investor Relations

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

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

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

James Patrick McCaughan - President of Principal Global Investor

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

Analysts

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

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

Randy Binner - FBR Capital Markets & Co., Research Division

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

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

Sean Dargan - Macquarie Research

Suneet L. Kamath - UBS Investment Bank, Research Division

Ryan Krueger - Dowling & Partners Securities, LLC

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

Operator

Good morning, and welcome to the Principal Financial Group's Third Quarter 2012 Financial Results Conference Call. [Operator Instructions] I would now like to turn the conference call over to John Egan, Vice President of Investor Relations.

John Egan

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

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

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

Now before I turn the call over to Larry, I would like to announce that on November 27, we will have our 2013 revenue drivers and outlook call and give an update on our capital deployment strategy. We'll provide more details as the event gets closer. While we will not provide specific EPS guidance, we will discuss revenue growth rates and revenue margins for each of the businesses. This will provide greater clarity of earnings growth by business unit in 2013.

Larry?

Larry Donald Zimpleman

Thanks, John, and welcome to everyone on the call. As usual, I'll comment on 3 areas. First, I will briefly discuss third quarter results. Next, I'll provide an update on the continued successful execution of our strategy, including comments about our recent announcement of the Cuprum acquisition in Chile, then I'll close with some comments on capital deployment.

As John mentioned, we provided slides related to today's call. Slide 4 outlines the themes for the quarter. As we reported yesterday and estimated at Investor Day, third quarter operating earnings were negatively impacted by $91 million from our actuarial assumption review. As a result of this review, we lowered our long-term interest rate assumption and updated other model assumptions. Terry will discuss these in more detail.

Normalizing for this, third quarter total company operating earnings per share are solid, up 10% compared to the year-ago quarter despite persistent headwinds created by pressure on fees and continued low interest rates.

Net income for the quarter was strong due to a net gain resulting from the merger of Catalyst Health and our sale of the shares we received as a result of the merger, as well as a continuation of improved credit losses. This contributes to continuing financial flexibility in this challenging economy.

Total company assets under management were a record $392 billion, driven by total company year-to-date net cash flows of $25 billion. We continue to see outstanding growth across our businesses, with strong sales and client retention. Our ability to win and retain business is driven by strong investment performance, best-in-class solutions, as well as a distribution model that is a key differentiator for us as we discussed at Investor Day.

Key growth metrics from the quarter include: full service accumulation sales were $2.7 billion, almost double third quarter 2011 sales; net cash flows of $1.6 billion are more than triple from the year-ago quarter; Principal funds had record sales of $4.5 billion and record net cash flows of $2.5 billion; Principal Global Investors had record unaffiliated assets under management of $98 billion and unaffiliated net cash flows were $2.2 billion, nearly double third quarter 2011 net cash flows; Principal International reported record assets under management of $66 billion, up 21% over the year-ago quarter and record net cash flows of $2.7 billion. All of our Principal International operating companies had positive net cash flows in the third quarter with increased momentum in Asia.

In U.S. Insurance Solutions, Individual Life sales of $48 million increased 17% over third quarter 2011, with 53% of sales from the business market. Specialty benefits premium and fees grew 5% to $361 million over the year-ago quarter. The continued strength in the fundamentals of our business is driving this growth, which leads to higher net revenues and ultimately, higher total company operating earnings. We remain confident about the continued momentum in our businesses despite the continuing challenges of the macro environment.

Now let me provide some comments on the ongoing implementation of our strategy. As we discussed at Investor Day, we've been executing our investment management leadership strategy for more than a decade. The company is positioned for long-term growth by capitalizing on opportunities created by global trends such as aging populations, growth of the middle class in emerging markets and financially constrained governments.

We've demonstrated an accelerated ability to execute our strategy since the financial crisis. Earlier this month, we announced the acquisition of Cuprum, the premier mandatory pension provider in Chile, which perfectly complements our existing voluntary savings and payout business in Chile so that we can provide a truly integrated set of solutions to our expanded customer base from hire through retire.

Cuprum's customer base consists primarily of upper middle class consumers, making them more likely to add voluntary solutions to their current mandatory retirement plan. With the mandatory and voluntary markets expected to continue double-digit growth, this strategic acquisition strongly positions us in Chile and, combined with our business in Brazil and Mexico, makes us one of the largest retirement providers in Latin America.

On a pro forma basis, the acquisition will result in Principal International contributing 23% of operating earnings, and 63% of company earnings will be fee-based. Our strong capital position and financial flexibility of our fee-based businesses allowed us to do this immediately accretive strategic acquisition and strengthens our position in emerging markets.

Additionally, the low interest rate environment and the strength of our balance sheet provide us an attractive opportunity to finance this acquisition. As we note on Slide 5, this acquisition is the sixth such transaction since 2010, all done to improve our competitive position in the faster-growing emerging markets and in global investment management.

Additionally, it's important to note that for all of these transactions, we either source the deal ourselves or we were involved in a process with a very small set of possible acquirers. What these transactions signify is that the Principal has become an acquirer of choice within our businesses because of our recognized expertise and our ability to execute. We truly believe this is an effective way to create strategically compelling and accretive opportunities, and we plan to execute similar deals over time.

I'll quickly comment on other examples of execution. In full service accumulation, we continue to focus on key distribution relationships, especially with Allianz partners and third-party administrators. Our combination of proprietary and third-party distribution gives us premier access to the small- to medium-size business market, which has higher net revenue.

We can extend these relationships to employees of these businesses to provide additional products they need through retirement. Investment performance, which is the best leading indicator for growth of our retirement and investment management businesses, remains strong as noted on Slide 6. Demand continues to grow for our full suite of investment solutions that help clients solve for needs.

As further demonstration of our expanding global footprint and position as a global investment management leader, Principal Global Investors was awarded $150 million of QFII capacity in China in the third quarter. Additionally, Principal International announced last week the launch of a wholly-owned subsidiary in India named Principal Retirement Advisors. This launch positions us as the retirement expert in this emerging market.

Our strategy is to develop relationships with financial advisors to help the growing middle class establish their own retirement and long-term savings solutions. As these examples show, we are in the right markets at the right time with the right solutions and the right distribution model.

Now I'll close with some comments on capital management. Following the announcement of the Cuprum acquisition, so far, in 2012, we have committed more than $2.1 billion of capital on common stock dividends, strategic acquisitions and opportunistic share repurchase. The increasing amounts of deployable capital provided by our fee-based business model allows us to return greater amounts of capital to shareholders by increasing our dividend payout ratio over time.

In the third quarter, we announced and paid a $0.21 common stock dividend, up from $0.18 in the second quarter. Additionally, as we announced last night, we will pay a $0.21 common stock dividend in the fourth quarter. This brings our full year common stock dividend to $0.78, up 11% over 2011, demonstrating our commitment to providing long-term value to shareholders and our confidence in the strength of our businesses going forward.

We'll also continue to invest in business growth through strategic acquisitions. While we don't anticipate a near-term deal similar in size to Cuprum, there is an active pipeline of strategic opportunities that we'll continue to explore.

Of the $300-million total share repurchase authorizations announced in 2012, we have $42 million remaining at the end of the third quarter. Year-to-date, we reduced our share count 6%. This will provide a nice tailwind to our ability to grow earnings per share heading into 2013. We will continue to consider opportunistic share repurchase as one part of our capital deployment plan going forward.

In closing, I believe we have the most strategically aligned set of businesses of anyone in the financial services industry. And our investment management plus model with strong ongoing execution continues to position us as a global investment manager focused on building long-term value for shareholders.

Terry?

Terrance J. Lillis

Thanks, Larry. As Larry mentioned, normalized third quarter earnings were solid. This morning, I'll focus my comments on: operating earnings and the impact of our actuarial assumption review; net income, including continued solid performance in the investment portfolio; and the strength of our capital position and balance sheet.

Looking at Slide 7, you'll see the impact of our actuarial assumption review had on our third quarter operating earnings. In addition to lowering our long-term interest rate assumption by 50 basis points, we updated assumptions around lapses and deposits and made other model enhancements. Combined, these changes reduced total company operating earnings by $91 million or approximately $0.30 per share. This was slightly higher than our estimated range communicated at Investor Day, primarily due to finalization of our Individual Life and Principal International reviews. On an adjusted basis, third quarter 2012 earnings per share were up 10% over the year-ago quarter, reflecting strong execution.

Additionally, adjusted return on equity excluding other comprehensive income was 10.2%. Looking forward, we expect 50 to 80 basis points of annual return on equity accretion. In addition, we should benefit from Cuprum once it is fully integrated.

Now I'll discuss business unit results. Slide 8 is the same shown in Investor Days. It summarizes the revenue metrics we use for each of our businesses. And as John mentioned, these will provide greater clarity for earnings growth by business unit going forward.

Turning to Slide 9 on Retirement and Investor Services, our accumulation businesses had net revenue growth of 9%. On an adjusted basis, operating earnings grew 11% in third quarter 2012 compared to the year-ago quarter.

Strong growth in account values was driven by positive net cash flows and asset appreciation. This helped grow net revenues but was partially offset by continued pressure on fees.

For full year 2012, we expect Retirement Investor Service accumulation businesses' net revenue to grow between 4% and 6%. Full service accumulation adjusted operating earnings of $75 million were up 8% over the year-ago quarter on 6% growth in net revenue.

Pretax return on net revenue is 29% on a trailing 12-month basis. The underlying fundamentals within full service accumulation continue to be strong. The sales pipeline continues to build, and close ratios continue to improve. In addition, recurring deposits are up 9% year-to-date, reflecting growth in eligible participants due to strong sales and retention, as well as success of our worksite counselors in increasing participation and deferral rates.

Year-to-date 2012 full service accumulation sales at $8.2 billion were up 58% over 2011. Because 2011 sales were more back-end loaded, we now expect full year 2012 sales to be up more than 30% over 2011.

Given the robust sales growth in 2012, we expect future sales growth to be less than our historical averages. However, we expect to drive higher net revenue growth as we put greater focus on the small- to medium-size business market, which drives a higher percentage of proprietary asset management.

Operating earnings for Principal Funds at $13 million were up 7% from the year-ago quarter on 13% increase in revenue, reflecting current-period sales expenses. Results included record sales of $4.5 billion and record net cash flows of $2.5 billion, reflecting strong investment performance and high demand across multiple strategies, including global diversified income fund, preferred securities, MidCap Blend Funds, high yield and our target-risk funds.

Slide 10 covers the guaranteed businesses within Retirement and Investor Services. Guaranteed net revenue and operating earnings were flat in the third quarter as we continue to approach this business opportunistically.

For example, in the third quarter, the $500-million pension closeout sale announced on the second quarter earnings call, funded. Our financial strength and reputation as a proven provider has enabled us to compete for this business, which generates attractive returns.

Turning to Principal Global Investors, Slide 11 shows earnings and revenues grew 8% over the year-ago quarter, reflecting our investment for growth. Investment performance remains competitive. This drove strong unaffiliated net cash flows of $2.2 billion into a variety of asset classes including preferred, high yield, currency, stable value and equities, leading to a record unaffiliated assets under management of $98 billion.

Looking at Principal International on Slide 12, third quarter 2012 operating earnings of $29.5 million were dampened by $11.5 million due to the actuarial assumption review this quarter. In our Mexican AFORE product, lapse rates are down noticeably from recent history, but we expect near-term lapse rates to be higher than previously assumed. More importantly, we continue to gain market share, particularly in the more desirable high-amount and high-contributing accounts.

Combined net revenue growth was flat compared to the year-ago quarter, though it's up 18% on a constant currency basis. Foreign currency headwinds are masking double-digit growth in the member companies on a local level. We continue to expect long-term operating earnings growth of 15% to 20% in Principal International.

Turning to Individual Life, Slide 13 illustrates third quarter 2012 adjusted premium and fees are down 2% compared to 2011 due to a targeted decrease in single premium sales. Third quarter 2012 operating earnings were down $66 million, of which $63 million was due to lowering our long-term interest rate assumption by 50 basis points and model enhancements.

Additionally, operating earnings were down $3 million from the year-ago quarter, reflecting continued impact of the low interest rate environment. On a trailing 12-month basis, adjusted pretax operating margin at 18% is in our targeted long-term range of 16% to 21%. We expect to be at the low end of this range as long as the low interest rate environment persists.

Slide 14 highlights Specialty Benefits' premium and fee growth of 5%, a solid result given continued pressure on employment levels. Third quarter 2012 adjusted operating earnings at $18 million were down $3 million from the third quarter 2011. This was primarily driven by the higher group disability claims in the quarter, which we consider to be normal quarterly volatility. Overall loss ratios for the year continued to be in our targeted range. On a trailing 12-month basis, pretax operating margins of 9% is in line with our long-term expectations of 8% to 12%.

The corporate segment reported an operating loss of $31 million, right in line with our expected quarterly results of $30 million to $35 million.

For the quarter, total company net income was $180 million. Third quarter benefited from a net gain resulting from the merger of Catalyst Health and our sale of the shares we received as a result of the merger. After tax credit-related losses remain steady at $38 million.

Our investment-related losses continue to be in line or better than our loss projections and better than market expectations, reflecting sustainable recovery in commercial real estate.

Slide 15 explains near-term impacts we experienced on our earnings growth. As long as pressure on fees and the low interest rate environment persists, we expect normalized total company operating earnings to grow 6% to 8%. With a lower share count in 2012, we expect normalized earnings per share growth to remain in our expected 11% to 13% range.

Looking now at capital adequacy, we estimate our third quarter risk-based capital ratio to be 440%. Relative to a 350 RBC ratio, we have approximately $2.2 billion of total excess capital, up from $1.5 billion in second quarter, primarily due to our September $600-million debt issuance. The $1.5-billion purchase price for Cuprum will be met by using $1 billion of current excess capital in addition to approximately $500 million of assumed and yet-to-be-issued debt. Cuprum is expected to close in first quarter 2013.

As Larry noted, the evolution of our business model means that we now have 60% to 65% of earnings coming from less capital intensive fee-based businesses that have limited or no guarantees associated with them. This will allow us to continue a pattern of increasing our dividend payout ratio year-over-year.

As outlined on Slide 16, so far in 2012 we've allocated $2.1 billion of capital for common stock dividends, strategic acquisitions and opportunistic share repurchase. We announced our fourth quarter common stock dividend of $0.21 payable on December 28.

Additionally, year-to-date, we have repurchased 9.9 million shares worth approximately $260 million. Looking ahead to 2013, we again expect to deploy capital with a commitment to increasing long-term value for shareholders.

In closing, we're very pleased with the continued growth and momentum of our businesses. This concludes our prepared remarks. Operator, please open the call for questions.

Question-and-Answer Session

Operator

[Operator Instructions] And your first question comes from the line of Chris Giovanni from Goldman Sachs.

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

I guess, first question for you, just in terms of the guidance and I guess the decision to kind of poll the EPS guidance, and I'm just curious why the decision. Because I think, historically, you guys had a pretty strong track record of kind of landing almost right in the middle of kind of the guidance range that you guys have provided.

Larry Donald Zimpleman

Chris, this is Larry. I appreciate your comment. Actually, a couple of things about that. First of all, of course we've continued -- as we did on Investor Day, we continue to reiterate, if you will, our guidance, but our view that our EPS growth over the long term should remain at 11% to 13% range. So I would sort of start with that. Second thing I would say is that we actually believe that what we are planning to do and sort of have been doing but plan to do in our call on November 27 with providing you better insight on revenue growth and margin expectations, is actually going to allow you to do a better job of sort of forecasting what the earnings and growth rate in earnings is going to be for each of the businesses. So I'd argue it's actually more valuable to sort of get slightly more granular and get down to the business level, rather than just having us throw sort of one macro number out there that would be an overall company EPS, because I think it's really more important and helpful to understand the trends within each business. And so that's why we've gone to this approach.

Christopher Giovanni - Goldman Sachs Group Inc., Research Division

Okay. Understood. That's helpful. And then Terry, you had mentioned the pension closeout transaction and talked about targeted returns there being attractive. Could you maybe quantify what the return target is there? And then we've seen a number of big pension kind of risk transfer deals out there. I'm curious on your capacity to do those and how big of a player you're willing to be in that space.

Larry Donald Zimpleman

Yes. Christ, this is Larry. I'll turn it over to Terry for the return comment. I just want to make a quick comment on sort of how we think about that from an overall capacity and capital usage, et cetera. First of all, we've been in this business for 70 years. So this is a business that we know extremely well. Of course it's a business that has been fairly dormant up until lately because it tends to be inversely correlated to interest rates. So when interest rates are low, there tends to be not a lot of that business written. We may be in a period of that starting to change a little bit. Our focus for the business is, for the most part, going to be on smaller placements where we can get the kind of returns that Terry is going to talk about in a second. I would say the third quarter sale, $525 million, was a little bit unusual for us, and you probably wouldn't see us write much more than about $1 billion a year of that kind of business. So I hope that kind of helps frame it, and I'll let Terry talk about returns.

Terrance J. Lillis

Thanks, Chris. This is Terry. As you look at that business, it's -- not only will it be reported on our full service payout line, but it will also get some benefit in our global asset management as well. So we have to look at the return on both basis. However, what you'll see in the earnings will show up in full service payout predominantly. Long term, we're not expecting this to be dilutive to our long-term ROE. This business will probably put on in that -- mid-teen range is what we're looking at. It will vary by the size of the business, and we don't think that it's a drag on the business. We do see that this is a very good diversifier of earnings for us as well. So we're real pleased with this type of business.

Operator

And your next question comes from the line of Joanne Smith from Scotia Capital.

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

I was wondering if maybe Dan could talk a little bit about the various segments of the market for the full service accumulation business and just talk about -- because I've noticed that recurring deposits were up nicely in the quarter, and I'm just wondering where are you seeing the best recovery there and what you think you're going to see going forward.

Larry Donald Zimpleman

Okay. Dan, go ahead.

Daniel J. Houston

So a couple of comments. The good news about the third quarter is the sales were actually split very nicely across what we think of is the emerging market, which is less than $5 million. And then we have what we call dynamic, which is kind of that $5 million to $50 million. And then what we call institutional is greater than $50 million. We really have had and enjoyed good traction and growth in all 3 of those segments, which is a very deliberate strategy for a variety of different reasons. It certainly helps us improve some of the return on asset metrics. It also helps drive our net revenue, growth rates, which you saw expressed in the third quarter results. On the smaller-sized plans, we generally can get a larger percentage of the assets and proprietary investment options. And with Jim's investment performance as of late, we've been able to drive more of those assets into our proprietary options. And the good news there is it's not just the fixed income options, it's equities, it's asset allocation. So it's across the board. TRS continues to be the best solution that we have out there. It still captures about 60% of the business. The TPA strategy, and we've talked about it on this call on many occasions, continues to grow, administering a lot of those smaller plans. And again, we've reiterated, I've reiterated again today, we think the TPA business is just as profitable as the others. So hopefully that helps give you a flavor for the market today.

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

Dan, I was really looking to see where you're seeing the best recovery in recurring deposits. Because that has been weak off -- pretty much since the financial crisis, and that's kind of key to the overall assets under management growth going forward. So where are we seeing it? Are you seeing it in the smallest plans? The largest plans?

Daniel J. Houston

It's across the board. So that 9% increase that was thrown out during the prepared comments is across all of those segments, small, medium as well as large. There's still plenty of growth for improving on deferral percentages and improving in participation and certainly, contributions through increased salary deferrals and bonuses. And frankly, if you're trying to calibrate it, we're probably half way back from the high-water mark of '07 in terms of those recurring deposits.

Larry Donald Zimpleman

I would just add a couple of comments, Joanne. I think this was now the 10th straight quarter we've seen an increase in the salary deferral rate. So we're now seeing salary deferrals that are getting into the very, very high 6%, almost 7% range. So that's going to be key. One of the real opportunities, I think, for us going forward is sort of the activity that we call retirement readiness, where I really think that the American workers now recognize, if they didn't understand it before, they recognize that it's on their shoulders to make sure that they're doing the right things to save for retirement. So for somebody that's as big a player as we are on 401(k) and has the local footprint to actually be in the worksite driving higher deferrals, driving higher participation, this is going to be a big advantage for us. So hopefully, what you're going to see is you're going to see that recurring deposit number continue to build. And a lot of that again is going to be based on the reality that I think people now understand they've got to secure their own retirement.

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

And Larry or Dan, whoever wants to take this follow-up question, with respect to that, if you're getting an improvement in the recurring deposits and deferral rates, then should we not see over time some counterbalance to the pressure on fees? Because obviously, those assets are kind of -- come with no cost, so to speak.

Daniel J. Houston

Yes. So just breaking down cost for just a second. Think about it being in 3 buckets. And again, some of those are account value-based. So commissions are based on account value, and so commission costs generally rise at the same rate as your account values. The asset management fees also follow that similar pattern, and so you have some higher cost there. The third bucket, which is comp and other, and that's where we've been quite careful in managing those expenses. And that's where we're going to get some of that additional margin expansion hopefully as we grow these assets. But you're right, Joanne, in the assumption that whether it's a profit [ph] contribution, increase in deferrals, increase in participation, a lot of that does fall to the bottom line. And we look forward to having that return.

Operator

And your next question comes from the line of Randy Binner from FBR.

Randy Binner - FBR Capital Markets & Co., Research Division

In regards to capital management, kind of a 2-part question there. One, your commitment to capital as you covered on the call is $2.1 billion in 2012. That's well ahead of kind of the initial target. And so kind of looking for the updated thought on that, maybe ahead of this November 27 call, you seem comfortable managing capital. And then the other angle I'd like you to cover, if you could, was savings and loan holding company status. It seems like you've been pretty comfortable there. It's been kind of a "getting to know you" period so far with the fed, but some other insurers have kind of exited that status. And so wondering how you're thinking about that and if that's going to have a relation with what you're going to plan for next year.

Larry Donald Zimpleman

Okay, Randy, this is Larry. I'll make a few comments on that. Obviously, the $2.1 billion that we've deployed or we've [ph] spoken for in 2012, we of course hadn't planned necessarily on having Cuprum, which is essentially $1.5 billion of that. And as you know, we plan to use about $400 million of excess capital in order to help finance that acquisition. So I think that our capital budget, if you will, is pretty well sort of spent when you take account of the announcement we made last night around the $0.21 share dividend. And I think it's important to sort of reiterate that $0.21 share because again, I believe that board decisions and management decisions around common stock dividends is the best single indicator you have about the strength of the businesses going forward. So going into 2013, again, I think that we need to slightly rebuild our excess capital levels, given that we'll use about $400 million for Cuprum. So we'll need to sort of build that back, which again we're roughly thinking is going to take us probably 2 quarters. So that's why we're sort of thinking, and we'll provide more insight at the November 27 call, we're probably thinking about being an opportunity to have greater amounts of capital to deploy to shareholders, probably in the back half in the continuation of the common stock dividend, and maybe a little bit of share repurchase to offset dilution. On savings and loan holding company, again, I would reiterate that -- as we have said before, I think our conversations continue to be constructive. If you think about the stress test that we all hear about and read about, if you think about the new supposed requirements, which are still very much in proposed stage, those are really things, Randy, that are going to be 2014 and 2015 events. So it's not going to have -- none of that should have a significant impact on our capital management strategy for 2013. Obviously, moving into 2013, one of the most important priorities we're going to have is to ultimately figure out a reconciliation for the savings on holding company and the fed and what impact, if any, it's going to have on our capital deployment strategy. So you'll hear us say more about that I think as we get into 2013. But again, at this point, it's really had no impact on us. And so we're actually very pleased with the relationship, and we're going to continue on work on that going forward.

Randy Binner - FBR Capital Markets & Co., Research Division

I appreciate all that. One quick follow-up on the stress test. Is your expectation that it can be an RBC-based approach rather than a more bank-centric Tier 1 approach?

Larry Donald Zimpleman

Well, as it was in the proposed stage, Randy, and again I know you're very familiar with this, but as it was in the proposed stage, I would say there were 2 things in there that were, I would say, question marks. I wouldn't say they were problematic. I just say they're question marks. One had to do with how they treat AOCI, accumulated other comprehensive income, and how they look at that from a standpoint of capital as AOCI goes up and down. The other one, which I think again reflects sort of bank-centric versus insurance-centric, has to do with separate accounts and the extent to which there are requirements for capital in separate accounts. In the insurance world, for the most part, separate accounts or fee-based businesses wouldn't require much, if any, capital against them. And that's certainly true for essentially all, not 100%, but for most of our separate accounts. So assuming we can get some reasonable resolution in those 2 areas, then I think they will have a set of requirements that could work for more insurance-centric organizations like Principal.

Operator

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

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

First, I want to concentrate on the disability issue in the quarter, maybe a deeper dive there. Maybe you could offer -- I realize we're only 3 weeks into the year, but maybe -- or into the quarter, excuse me, but maybe what's going on there so far through October?

Larry Donald Zimpleman

Okay. We'll have Dan talk to that, Steve.

Daniel J. Houston

Overall is -- again, kind of just focused on the group disability line for just a second, we do think it's a bit of an anomaly and not a trend here. We did see an elevation in both incidents as well as severity. Loss ratio, roughly 80% -- 85.5%. Trailing 12 months would be closer to the 75%. And ideally, we'd like to see this number closer to 70%. So we did do a deep dive on this business and looked hard at occupation, diagnosis, plan types. And what we think we have here is just a situation of just normal volatility and would anticipate it straightens out. Also, remember that disability represents only about 20% of our overall SBD line of business as measured by operating earnings. And that when we kind of look at what's happened so far in the fourth quarter, we're maybe trending back towards a more normal run rate for loss ratios. Does that help?

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

Yes, it does, thank you. And then just -- that's really what I wanted to ask. But just one off, Larry, obviously you've felt it important to mention the new operation in India. Obviously a very, very big market. What does it do for you that your current operation in India will not?

Larry Donald Zimpleman

Yes, Steve. What I would say is that the mutual fund industry in India -- with all due respect to Indian regulators, the mutual fund industry in India has been upside down for about 2 years now because the regulators, roughly 2 years ago, said that there would -- they would not allow any sort of front-end commissions in the mutual fund industry. And so the mutual fund sales, surprise, went down by about 90% overnight. So I think that the industry has been sort of searching for, if you will, an alternate strategy for how to drive mutual fund sales. And so we've done a lot of research, actual field research, that would seem to indicate that there is a subsegment of employers in India who sort of get it, that their employees are not going to be adequately prepared for retirement. There really is no particular system over there. There's no private system. There's really no public system. And so this is going to be an emerging area of concern, I think, for employers in India and employees in India. So our approach is to use the branding that we have as a global retirement leader to dialogue both with advisors as well as with some of the more global employers in India to try to educate them and ultimately convince them that by putting in place a sort of payroll deduction mutual fund platform, they can provide a valuable service to their employees and sort of help them begin to accumulate assets for retirement. So we're not sitting around anymore, kind of waiting for the regulators to ultimately put in place a more rational system. We think that the demand is already there, as evidenced through our research, and so we're going to go after it. And actually, we're pretty optimistic. It's going to take a while. It's not going to contribute a lot in the next year or 1.5 years, but it could make us a leader in a very big market over time.

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

Oh, that's very interesting. Is there a -- just as a follow-up, is there some type of tax advantage or tax deferral for retirement savings in India?

Larry Donald Zimpleman

Well, it's just whatever the normal tax advantages would be relative to mutual funds. So mutual funds do enjoy some tax advantages, but there's nothing special, Steven, related to this particular platform. Again, think about it more like payroll deduct mutual funds.

Operator

Your next question comes from the line of Jimmy Bhullar from JPMorgan.

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

First, I had a question just on the pipeline for the FSA business. I think in -- Larry, in your remarks you said that the comps are difficult and the sales will grow. But I was wondering what you -- like, would you still grow off of this base? Or is there a chance that the deposits will actually shrink next year? And then given how strong the market has been, I'm assuming that in the PGI business, you'll have performance fees in the fourth quarter. If you could talk about that as well?

Larry Donald Zimpleman

Okay, I'll have Dan comment on the first one. Jim can take the second one.

Daniel J. Houston

So pipeline still remains quite strong for the fourth quarter and for 2013. In the prepared comments, we mentioned a 30% growth for -- a projection for all of 2012, which I think you would agree is very strong. As we look at 2013, we would probably see something more in the lines of a single-digit growth rate, mid-single digit and a mix of that business being different. We're going to put more time and energy and resources across the small- to medium-sized market segment and again, manage that accordingly. But we feel very good about the pipeline, feel very good about 2013.

James Patrick McCaughan

On the incentive fees likely in the fourth quarter, Jimmy, it's true that the equity markets have been quite strong. But our incentive fees are on a number of areas, including currency funds, including some long/short emerging market debt funds. So we have a diversified portfolio of business that has performance-related fees. If we -- it's obviously very difficult to say what this will be at the year end since we're more than 2 months away from the year end. But if you were to draw the line around now, you'd have an increment to earnings somewhere north of $5 million in the fourth quarter, in the range of $5 million to $10 million incremental earnings from the performance fees. And that would place the operating earnings on the Principal Global Investors line in the upper half of the twenties for the fourth quarter, meaning that the whole year would have a significant increment over last year. Now I would caution though that, that really does depend on how we do in the fourth quarter and that nothing is baked yet. But the seasonality of PGI's earnings towards the fourth quarter continues to be quite marked.

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

And then just one last one for Larry, just thinking about your long-term earnings growth guidance of 10% to 12%. In the near term, you're expecting growth to be about 4 percentage points below that, 6% to 8%, and I think the 2 main things you've mentioned are low interest rates and pressure on fees. And obviously, rates could go in either direction. But the fee pressure, I'd assume, is probably -- it's been compounding over the last few years, so it's not going to reverse. Maybe it stabilizes. So what gives you the comfort that, over the next 1, 2, 3 years, you can get to 10% to 12% rate? Is it growth in the International? Is it something else? Or what do you really need? Rates to be a lot higher? And are you assuming that the fee pressure completely goes away before you return to that rate?

Larry Donald Zimpleman

Yes, those are -- there's a lot baked into there, Jimmy, so I'll try to do my best. But the first thing I would say, of course, is that that 6% to 8% doesn't really -- which again is an OE growth rate, not an EPS growth rate. Again, I know -- I think you were clear on that. So the 6% to 8% OE growth rate doesn't really take account of the Cuprum acquisition. Okay? So that was -- we mentioned the 6% to 8% at Investor Day, which was prior to when we had announced the Cuprum acquisition. So what's actually going to happen, assuming again we get a close sometime in the first quarter, is that we are going to get a bump. We're going to get a bump in OE, we're going to get a bump in ROE, and we're going to get a bump in EPS from Cuprum. So I think what the reality is, is that we'll have to kind of reset everything for all of you once we get sort of -- we get that deal closed, we get that deal integrated. We'll kind of have to reset all of it. I do think that your comments, generally speaking, about where is the delta for the 4%, the difference between 6% to 8% and 10% to 12%, where is that delta coming from, it is coming more from interest rates than it is coming from fee pressure. And we're not necessarily assuming the fee pressure goes away. I think, as you indicated, it's probably more reasonable to assume that it stays at about the level it is today. But as Dan commented earlier, really, our focus is going to be to try to drive -- change kind of the mix of business. So volume of sales will be the same. It'll grow. But the mix of business will be a little bit more towards the smaller and medium size. Or quite frankly, we can drive more proprietary assets. So again, interest rates are going to continue to be a headwind. Cuprum is going to help us. And I think by the time we get done -- we remain very confident in that 11% to 13% EPS as a growth rate over time. And maybe in the near term, it's going to come a little bit more from OE growth, a little less from share repurchase. And then when we get into the back half of '13 and '14, it'll be more normal -- a combination of OE growth and share repurchase. That's probably more than you wanted, but I hope that helps.

Operator

Your next question comes from the line of Sean Dargan from Macquarie.

Sean Dargan - Macquarie Research

Following up on Jimmy's question about the interest rate pressure, what segments should we expect to see that? I assume Individual Life. But should we look at where the charges were taken in the third quarter as kind of a blueprint for where the interest rate pressure will show up the most?

Larry Donald Zimpleman

Yes, I'll have Terry make some comments, Sean. This is Larry. First, good to hear from you. I think this might be the first time that you've gotten in the queue. So thanks for that, I appreciate your work. Yes, the short answer is that Individual Life and fixed deferred annuity are going to be the primary areas. If you look at fixed deferred annuities, for example, we write -- we have been writing business since '09 with a 1% guaranteed minimum interest rate. But there is still old business at a 3% rate, and that's about half the block today. The other half, which is at the 1% rate, still has about 40 basis points of cushion left in it. So that would also be an area where there will be an impact of lower interest rates beyond Individual Life. But Terry, anything you want to add?

Terrance J. Lillis

Yes, I do. Thank, Sean. Sean, you referenced the display that we've provided. For the rest of you on the call, on the website, we have a breakdown of the unlocking that we did this quarter on a line-by-line basis, as well as by line of business basis, which may be helpful to see as well. But as you say, though, the Individual Life line will be the one affected most by the low interest rate environment. Now the fixed annuity -- fixed deferred annuity portion of the individual annuities will also be impacted as well. But other than that, the impact of the low interest rate environment somewhat has an impact on the economy and the size of our clients as much as anything else. So it does affect all of our businesses. But predominantly, those 2.

Sean Dargan - Macquarie Research

And one follow up. The Principal International segment has seen some pretty steady deposit and flow growth. Is that coming primarily from BrazilPrev? Or can you talk about what you're seeing in other markets?

Larry Donald Zimpleman

Yes, the good news -- I'll have Luis make some comments, Sean. The good news was, as we said in the comments at the start of the call, we actually had positive net cash flow in every Principal International operating company. So as a general comment, we've actually seen better sales and flows out of the Asian companies, along with continued strong flows in LatAm. But I'll let Luis give you a little more insight.

Luis Valdez

Sean, yes, you're right. And it used to be essentially BrazilPrev and Brazil a year ago. Right now, we have a much more diversified source of net customer cash flows, as Larry said. The main contributor and the main change that we can see this year is particularly Asia. Asia has been much more dynamic, particularly Southeast Asia. So the $2.7 billion that you could see in our last quarter in net customary cash flows, half of that is coming from Brazil, essentially. And the rest is a combination between Asia and our -- and the other operations in Latin America. But in particular, what Larry said, all our operations are having positive net customer cash flows in the third quarter of 2012.

Larry Donald Zimpleman

Does that help, Sean?

Sean Dargan - Macquarie Research

Yes.

Operator

Your next question comes from the line of Suneet Kamath from UBS.

Suneet L. Kamath - UBS Investment Bank, Research Division

My first question, I wanted to follow-up on Randy's line questioning on the whole thrift regulation. Larry, you mentioned 2 question marks, AOCI and guaranteed separate accounts, and I get those. But I think the bigger issue in my mind was how they were treating some of the regulatory capital, specifically the authorized control level capital and sort of subtracting that from Tier 1 and Tier 2 capital. And I know that this featured in the presentation that your company gave to, I think, the Chicago fed earlier this summer. So can we read from the fact that you didn't mention that as a question mark that you've received some sort of clarity on how they're going to approach that?

Larry Donald Zimpleman

This is Larry, Suneet. I'm not aware of -- well, first of all, we haven't received any feedback on that. And the fact that I commented on AOCI and that I commented on guaranteed separate accounts is because I do think those are the 2 biggest levels. I don't remember exactly, I think that letter, Suneet, was like a 20-some page letter. So obviously, there's other stuff in there besides those 2. But I think those are really the 2 that I wanted to focus on.

Suneet L. Kamath - UBS Investment Bank, Research Division

Okay. I was actually referring to a presentation that you gave, but I can follow up later. My second question is, I kind of look at the quarter and I struggle here because if I go through the key highlights that you have in your press release, I think you used the word record 4 or 5 times. And I think there's very few companies in financials that are using that word in their releases. And then I look at, yes, the stock being down 3.5% today, and I look at companies like Ameriprise where they're not anywhere near records but they traded a much higher multiple on a price-to-book basis anyway. And so I guess what I struggle with, is should there be more of a balance between kind of near-term ROE and long-term ROE? I get a lot of what you're doing is for the long term, but I wonder if there should be maybe more of a focus on the short term? So I don't know if you have any comments on that.

Larry Donald Zimpleman

Sure. Sure, Suneet. This is Larry. So I mean, again, let's think about, if we just look sort of quarter-over-quarter and again stripping out the impact of the DAC, as you can see from our slides, our view is that our EPS is up 10% sort of quarter-over-quarter. Our view of the year, again setting aside for a moment the DAC noise, is that we'll be very much in the range of that 11% to 13% growth in EPS, 2012 over 2011. I would argue, in a year that continues to have all the sort of economic challenges and all the market challenges that we all know are out there, for us to be able to grow our EPS at 11% to 13% over 2011. And 2011 was a very good year for us and would indicate that we do have momentum, we do have strength and we do have growth both in earnings and in EPS for our businesses. There again remain this number of headwinds around FX, around low interest rates and other things and, in the absence of that, of course you would see even stronger performance, both on an OE and EPS basis. Beyond that, what I'd say is we want to balance out -- we're taking a very long term strategic approach here, Suneet. And so what we want to do is we want to balance out, we want to make sure we're meeting our long-term EPS goals. We do not want to disappoint investors. And I would argue, with our 11% to 13% EPS growth rate, we're right on track with everything that we've said to investors. And in addition to that, I think we're making some very important, very significant long term strategic investments that are going to have dividends -- that are going to pay dividends and create value for shareholders over the longer term. I've been -- this is now my 41st year in the organization. I've never seen us do the kind of strategic acquisitions, 6 of them in total, that we've been able to do since the financial crisis. And so as I said earlier, we're definitely going to take advantage of that. And if that means that we come off of OE growth rate a little bit or we come off a share repurchase, because we'd rather invest to buy premium properties like Cuprum or we'd rather buy great, emerging market managers like Origin and Finisterre, this management team and this board believes that's the right thing to do. And we'll see what happens over the next 2, 3, 4 years. But I'm absolutely convinced that companies that create the long-term value are companies that both focus on OE growth but also invest for the future. And so that's what we're going to continue to do.

Operator

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

Ryan Krueger - Dowling & Partners Securities, LLC

Following the Cuprum announcement, Moody's put out a release where they put you on a negative outlook. And within the text, they've suggested they may downgrade your ratings, depending on the amount of debt that you used to fund the deal. So I wanted to know if you still feel comfortable at this point with the original financing plan which includes $500 million of additional debt?

Larry Donald Zimpleman

Ryan, this is Larry. I think the short answer to that is yes. But just to be sort of clear -- I was having actually a little bit of trouble hearing you, and so just to see if -- make sure that I'm clear here, what -- first of all, I'd say the rating agencies all responded in exactly the fashion that we would have expected as it relates to the Cuprum transaction. And so you would expect that they would go to a negative outlook pending the -- being able to see in 4 or 6 or 8 quarters kind of how the integration and the earnings flow from the Cuprum business. So I think they reacted in an absolutely proper way. We had great conversations with them. I think they get it strategically. And now it's a question of we'll have to demonstrate the earnings growth coming out of that. So again, I would expect that, that negative outlook will get reversed. In terms of the financing plan, the market remains very open, certainly open for companies like Principal that are perceived as very solid companies with a good balance sheet. And when we did our $600-million debt offering, we had -- that was oversubscribed by a significant amount, let's say 8X to 10X. So there is a lot of interest and appetite in our name. And so I don't think -- we don't expect at this point, we don't expect any issues in completing the financing here in the very near future.

Ryan Krueger - Dowling & Partners Securities, LLC

Okay. So there's really no pushback from the rating agencies on the actual financing plan itself?

Larry Donald Zimpleman

No. They're well aware of our plan, and we're proceeding right down the path and having -- continuing good conversations. Don't expect any issues there.

Ryan Krueger - Dowling & Partners Securities, LLC

Okay. And a follow-up on your comment on 2013 capital management. You said -- I think what you said was that there may be a little bit of share repurchase in the back half of 2013 to offset dilution? What dilution are you referring to? Just the issuance of employee stock?

Larry Donald Zimpleman

Yes. The issuance of employee stock, which typically happens for us in March of each year, Ryan.

Operator

And your next question comes from the line of Eric Berg from RBC Capital.

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

My question is for Dan. And I continue to be -- it has to do with the profitability issue that to me, at least, continues to loom large over your business. My question is this: Principal -- it's my sense that Principal moved away from the smaller and mid-sized market in the last 2 years precisely because it was -- sort of the secret was out, it was getting more competitive, there were more players in the business. So I have a 2-part question. By going back to the -- by refocusing on the smaller market now, what has happened? Is it that profitability has been restored in that market? And secondly, what other things do you plan? What are the other elements of your plan to try to improve or stop this margin squeeze in what is still Principal's largest business, representing 30% of earnings, 401(k)?

Larry Donald Zimpleman

Eric, good to hear from you. I'll let Dan take those questions.

Daniel J. Houston

Yes, good to hear from you, Eric. I think we would have to be careful and frank with the words I choose from time to time, because I've tried to stress that we balance it across the board, small, medium and large. And if you looked at large year-to-date, those over $50 million, it's about half those flows. And maybe it ought to be 60%, 40%. 60% on small to mid and 40% on large. So it's not in anyway trying to pull back but to effectively make a bigger investment, especially now that we have our TPA solution in place. It's working for us well. We have good, solid proprietary investment options. So I would say it's reinvigorating our focus on small- to mid-sized plans, also recognizing we added that ESOP capability. And it works really well. But as you know, it's very dilutive to the ROE measures. So we think the best way to go about rewarding shareholders is to see if we can't grow the return on net revenue and grow those net revenue fees for the small- to medium-size business. In terms of how -- what else are we doing here, Eric, it's around deploying our technology. We've got some pretty exciting stuff. We're using our presentations to advisors on the iPad. We are doing a lot online with our -- both our planned sponsors as well as our planned participants, and we'll look for continued efficiencies. But we've never abandoned that market. We think it's a great market. The one that you probably are -- the one I get concerned about is the, say, under 20 employees. Lots of turnover in that group. And again, that's very expensive business to have on the books for a short period of time and have it lapse. Hopefully that helps.

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

It does. Here is my one and only follow-up. You indicated a couple of times in this call that one of the reasons you like the smaller market is that you're able to use more principal funds in it, at least that's what I think I heard. I'm surprised. I would think that given the fact that mutual funds and mutual fund investing have become so much a part of life today in our country -- I mean, everybody in it seems to know about mutual funds. I mean, the paper everyday -- just given the public's broad knowledge of mutual funds and personal finance and all that, I would think that the demand for open architecture would be just as great in smaller companies as it is in larger companies. So how is it that you're able to get more principal funds into these smaller plans than in the larger ones?

Daniel J. Houston

So a good question to end on, Eric. In large part, it's because we've built that retirement investment services capability that allows us to go out and hire complementary managers to what we're doing at PGI, something we refer to as the foundation option. Small- to medium-size businesses advisors in many instances have the resources to do a good evaluation of the performance of managers. So our ability to combine that management capability among multi-manager, multi-style, multi-asset class yields a higher benefit to small- to medium-size employers than it might to the very largest employers where they could very well outsource that to a third party.

Operator

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

Larry Donald Zimpleman

Well, thanks again to everybody for joining us for the call. Let me just close by reminding you of what John mentioned in the opening, which is our November 27 call where we'll discuss our outlook for our main business drivers going into 2013. Despite the headwinds, we continue to see strong momentum across our businesses, and our fundamentals remain solid. And our focus will be to stay with our investment management strategy and grow those fee-based businesses that gives us greater financial flexibility and the ability to create long-term value for shareholders through capital deployment. So thanks again to everybody for listening. Hope you have a great day.

Operator

Thank you for participating in today's conference call. This call will be available for replay beginning at approximately 8:00 p.m. Eastern Time until end of day, November 2, 2012. 29872826 is the access code for replay. The number to dial for the replay is (855) 859-2056 for American and Canadian callers, or (404) 537-3406 for international callers.

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