Christopher A. Giovanni - Lincoln National Corp. Dennis R. Glass - Lincoln National Corp. Randal J. Freitag - Lincoln National Corp..

John M. Nadel - Credit Suisse Securities (USA) LLC (Broker) Jamminder Singh Bhullar - JPMorgan Securities LLC Thomas Gallagher - Evercore ISI Sean Dargan - Wells Fargo Securities LLC Ryan Krueger - Keefe, Bruyette & Woods, Inc. Michael Kovac - Goldman Sachs & Co. Humphrey Hung Fai Lee - Dowling & Partners Securities LLC.

Good morning and thank you for joining Lincoln National Financial Group's Third Quarter 2016 Earnings Conference Call. At this time, all lines are in a 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 Senior Vice President of Investor Relations, Chris Giovanni. Please go ahead, sir..

Thank you, Charlotte. Good morning and welcome to Lincoln Financial's third quarter earnings call. Before we begin, I 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 Financial'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 their most comparable GAAP measures.

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 things over to Dennis..

Thank you, Chris. Good morning, everyone. Third quarter earnings were particularly strong as we reported record operating earnings and earnings per share. Excluding notable items, EPS increased 10% compared to the prior year.

These were high-quality results as all four of our businesses produced solid earnings and our sources of earnings were well-balanced. Our balance sheet and capital position continue to be very strong evidenced by nearly $9 billion of statutory capital and a 10% increase in our book value per share, excluding AOCI, to almost $57.

During the quarter, we also completed our comprehensive annual assumption review which had a modest impact on our financials. Given the strength of our balance sheet and our consistent capital generation, we returned more than $250 million to shareholders in the third quarter.

In addition, we also announced last night that the board of directors approved a 16% increase in our quarterly dividend. As we are all aware, macro headwinds are dampening growth for the life insurance industry and we are certainly not immune to that.

However, I am pleased that across the enterprise, we are successfully responding to these challenges with short-term actions, including disciplined expense management and incremental capital management to sustain our EPS growth.

We also have additional actions underway to position us for the longer term, including pricing changes on both in-force and where-needed new business and enterprise-wide digitization initiative that will significantly enhance our customer experience and provide efficiencies over time and an intense focus on product innovation, particularly in our Annuity business, to meet evolving consumer preferences and marketplace shifts.

This strategy will once again rely on our core strengths, distribution and product development. We will update you on these initiatives as they evolve. But I am excited that each will provide us an opportunity to sustain our strong track record of financial success. Now turning to our business segments, starting with Annuities.

It was another solid earnings quarter for the Annuity business, which highlights the ongoing underlying earnings power of our in-force business, including another year of modest unlocking impacts. Our hedge program also had strong performance. Consistent with past several quarters, new business continues to be affected by various market factors.

As a result, industry sales are down roughly 30% and our sales are down as well. We continue to believe uncertainty in the capital markets is a primary driver. But we see some additional factors including shifting consumer preferences towards passive investments and choice between fee-based and commission-based compensation.

Notably, sales of passive investments and fee-based advice are not currently prevalent in the VA space. Short-term performance of risk-managed funds in V-shaped markets and some impact from the DOL, which is difficult to quantify given similar declines in both the qualified and non-qualified markets.

We have an active plan to boost sales grounded in our successful long-term strategy of both expanding and developing distribution coupled with product evolution. Let me highlight some aspects of this.

First, beginning in the fourth quarter, we are improving our account value growth first value proposition by providing more choice and investment flexibility, which should offer better upside potential. Also, we are leveraging our unique i4LIFE solution which is positioned very well in the non-qualified market to provide better income outcomes.

We expect these refinements to draw new advisors and improve distribution effectiveness. Next, we see the movement towards fee-based products as a significant long-term growth opportunity as it expands our distribution reach into fee-based and registered investment advisors. There is a growing interest in fee-based annuity products.

And we will be refreshing our full suite of products to meet this demand and they will be ready in early 2017. We recently filed a VA product that creates a new product category, which is a no-load and lower-fee passive investment based VA with a simplified guaranteed income story.

We are partnering with one of the leading passive investment managers to capitalize on the movement towards passive investments. We expect a gradual rollout starting in the first quarter and see a long runway for growth. Finally, as it relates to the DOL, we have seen a major distributor narrow its shelf space leaving us in place.

We expect to benefit from this trend if it continues. As a result of these actions, we expect to see momentum in the fourth quarter and further sales gains throughout next year recognizing there could be some disruption in the qualified market around DOL implementation. Ultimately, we expect to return to full-year positive net flows in 2018.

Of note, as we are building sales, we intend to buy back more stock to blunt the EPS impact of lower sales. So as we talked about at Investor Day, our Annuity book has a solid earnings foundation and strong returns because we started this business prudently and smartly from the get-go.

The actions I just described will allow us to navigate the changing dynamics in the marketplace and build on our successful track record. Turning to Life Insurance. Our earnings were robust and included mortality results that were in line with our third quarter expectations.

Total Life Insurance sales in the quarter were $193 million, a 12% increase from the prior year quarter as nearly all of our product lines generated solid growth. Included in our sales results are several noteworthy stories.

Term sales at $31 million were a post-merger record and increased 55% as we continued to benefit from several product and process enhancements over the past year. The UL sales increased 11% as our strong pipeline began to convert to sales following a slow start to the year.

Index Universal Life sales increased 10% as regulations that began last September required many competitors to make significant reductions in maximum illustration rates, resulting in an improvement in our competitive position. Lastly, MoneyGuard sales increased 8% as we are benefiting from continued market demand for linked-benefit products.

Our focus on sales is not just to grow but to grow profitably with a diversified mix of products and a tilt away from long-term guarantees.

This quarter, we once again achieved these objectives with expected new business returns within our target range of 12% to 15% and all individual life products representing between 10% and 30% of total Life Insurance sales. Also, 65% of our sales did not have long-term guarantees.

Overall, our Life Insurance franchise continues to be strong as growth in key business drivers combined with pricing actions leave us optimistic about our ability to grow our Life business. Turning to Group Protection. This quarter reflects our continuing progress in improving profitability and the long-term growth potential of our Group business.

Consistent with recent quarters, we continue to benefit from a favorable non-medical loss ratio primarily attributable to our repricing efforts and enhancements to our claims management function. Although loss ratio results can fluctuate from one quarter to the next, we believe that our underlying experience trends are solid.

As we have noted recently, top-line growth will be critically important to drive the next leg of our margin improvement story. And we are clearly seeing signs of success as our premiums grew sequentially for the first time since 2014. We'll build on this growth moving forward and expect year-over-year premium growth to reemerge in 2017.

Driving our encouraging top-line momentum are improvements in sales and persistency. For the full year, our sales growth is solid, up 16% off a low sales result in 2015, while our pricing remains sound. Just as important, renewal persistency has been improving as needed price increases have moderated throughout 2016.

Bottom line, I am pleased to see signs of growth reemerge while we continue to sustain our pricing and risk management discipline. In Retirement Plan Services, earnings were consistent with recent quarters. Third quarter deposits of $1.8 billion were down 5% from a year ago due to timing of first-year sales in the mid-large market.

That said, we have pointed to a strong sales pipeline which we are seeing convert to new sales. As a result, first-year sales increased 41% sequentially. With several recent wins scheduled for fourth quarter implementation, we expect 2016's net flows to exceed 2015 levels.

This quarter generated nearly $100 million of positive flows and have had positive flows in six of the past seven quarters.

Our strong results and optimistic growth outlook are being driven by several positive factors, including distribution expansion and increased wholesaler productivity in the small market, the launch of our enhanced small-market Director product which is level fee and DOL-ready, and lastly, investments in our digital and mobile customer experience that is resonating in the marketplace.

To this point, since launching our new Click-to-Contribute functionality in June, we have seen 12,000 participants take action to increase their contribution rates.

These tangible outcomes, combined with our alignment to the fastest growing markets and an ability to distinguish ourselves in these markets through our high-touch service model, give us a lot of positive momentum.

Shifting to investment results, our alternative investments had a solid quarter with a 12% annualized return, above our long-term average and targeted return of 10%. Better results from both our private equity investments and hedge funds helped drive the increase over the prior quarter.

We expect to further increase our alternatives' earnings over time as we continue to grow the portfolio to our long-term target of 1.5% of invested assets and further shift the mix towards private equity. In the third quarter, we put new money to work at an average yield of 3.6%, down 20 basis points from the second quarter.

The decrease in new money rates was consistent with the drop in Treasury rates as we invested approximately 200 basis points over the average 10-year Treasury. Lastly, the investment portfolio remains high quality, with below investment grade assets representing just 5.4% of our fixed income portfolio.

Before wrapping up, let me provide a few comments on the DOL as there have been a fair number of developments over the past few months.

First, as we have noted, most of our distribution partners are continuing to work towards using the best interest contract exemption to serve retirement savers and will offer the choice of commissions or fees, whichever is in the client's best interest. This is the decision we made with LFN and shared with our advisors early on.

While some distributors have publicly announced their intentions, many have been slower to formally communicate their decisions. That said, if you listen to recent earnings calls, you would have heard a number of the large wirehouses imply that choice has always been fundamental to their firm's practice and they do not expect that to change.

Let me provide some specifics on what we expect. Of our 10 largest VA partners, we believe nine will use the best interest contract exemption for commissions. Also of note, 85% to 90% of the sales from our top 25 VA partners will also allow commissions.

As I mentioned earlier, we're also seeing significant interest in fee-based annuity product offerings. With fee-based annuity currently representing a small portion of industry sales, we see this as a big distribution growth opportunity. As I already mentioned, we're seeing some distribution partners narrow manufacturers and product offerings.

We expect to benefit from this given our leading wholesaler force, the breadth of our customer solutions and our consistent market presence. In fact, we are already seeing early signs of this as a leading distributor announced that effective January 1, they will be paring down the number of products and manufacturers they offer.

Proudly, we have more products retained on their shelf than any other manufacturer. Once again, proof that we will be well-positioned in a post-DOL world. So in closing, I'm pleased with our record results which include underlying EPS growth of 10%, consistent with the EPS growth targets we have provided.

While clearly there are economic and regulatory issues, we are taking both short and long-term actions to manage them. Also, when I look around the industry, I continue to believe we have a clear and straightforward story. We are not in the crosshairs of dual regulation. We are not undertaking uncertain transformational changes.

We are not distracted by precarious run-off businesses while our 100% domestic footprint better protects us from global macro uncertainty. Our business model is simple. Manufacture only retail products, lead with distribution and product prep, target the fastest growing segments of the broader U.S.

market, maintain industry-leading risk management and actively direct capital to the highest and best usage. Most importantly, our business model has a track record of financial success and stability. And we see opportunities to respond to market headwinds to drive further shareholder value. I will now turn the call over to Randy..

Thank you, Dennis. Last night, we reported income from operations of $441 million or $1.89 per share for the third quarter. Excluding notable items, EPS increased 10% year-over-year. First, let me touch on this year's annual review of DAC and reserve assumptions.

Following last year's lowering of our long-term earned rate assumption by 50 basis points, this year's annual review had a series of pluses and minuses that netted to a modest positive impact to operating earnings of $5 million or $0.02 per share. A few comments on this year's review process.

Favorable items this year included variable annuity policyholder behavior and expenses. These items more than offset the impact of lower interest rates and a 30 basis point decrease in our separate account return assumption which now stands at 7.3%.

It is also worth noting that we did not unlock a reversion to the mean corridor, which still provides a cushion against weak equity markets. So the bottom line related to our annual review is that when viewed in total, the assumptions underlined in our balance sheet continue to be sound.

Outside of the annual assumption review, other notable items included a $0.02 benefit in Group Protection from a balance sheet review that I will discuss later and another $0.02 in Other Operations largely from tax adjustments.

One other item of note before shifting to key performance metrics and that is variable investment income was strong this quarter. Results ran $18 million after tax and DAC or $0.08 per share ahead of our 5-year average for prepayment-related income and our 10% return assumption on alternatives. Moving to the performance of key financial metrics.

Book value per share, excluding AOCI, now stands at $56.65, up 10% as we continue to consistently compound book value. Operating ROE was outstanding at 13.7% while our ROE through the first nine months stands just shy of 12%.

Expense discipline contributed to G&A expenses, net of amounts capitalized, declining by more than 2% in line with our full-year results. We continue to be pleased with our ability to effectively manage G&A in a period of slower growth for the life insurance industry. Consolidated net flows were positive.

And with end-of-period account values exceeding the quarterly average, we enter the fourth quarter with a slight tailwind. Our balance sheet and capital generation remain important sources of strength and it enabled us to repurchase $200 million of stock this quarter.

Lastly, net income for the quarter was $2 per share, exceeding operating EPS, driven by very strong performance from our variable annuity hedge program which reported $82 million of realized gains. Net income results also included $28 million of realized losses related to investment. Now to business results and starting with Annuities.

Reported earnings for the quarter were $240 million, down 2% from last year when excluding notable items in both periods.

Net unfavorable items this quarter totaled $10 million, primarily related to lowering our separate account return assumption as policyholder behavior assumptions, which have resulted in significant charges for many of our competitors, were once again favorable.

Equity markets' strength over the past year has more than offset the negative net flows that Dennis mentioned. As a result, end-of-period account balances increased 6%, which further improved our risk profile as our guaranteed living benefit, net amount at risk, as a percentage of account value is less than 1%. Return metrics remained strong.

Our ROA of 77 basis points is consistent with recent periods while ROE came in at 21%, again, an outstanding result. So the financial impact of changes to assumptions was minimal, another testament to our established and strong foundation in the Annuity business. Earnings continue to be high quality. The business is well-managed.

And we expect to build on our success in the future. Turning to our Life Insurance segment. Earnings of $167 million included net favorable items of $17 million related to our annual review. Excluding notable items, earnings were consistent with the prior year period.

Also included in the current quarter's results was $9 million of the favorable variable investment income I noted upfront and strong mortality experience, which largely reflected typical third quarter seasonality. Spreads, excluding variable investment income, came in at 131 basis points.

Year-to-date, spreads have compressed 7 basis points compared to last year, the midpoint of our 5 to 10 basis point expectation. Lastly, total in-force space amount increased 5% with average account values up 4%. But both these measures are in line with recent performance and support our mid single-digit organic growth expectation.

Group Protection earnings of $28 million marked the highest quarterly earnings since 2009. Included in this quarter's result were net favorable items of $5 million from a review of disability reserves and DAC assumptions. Excluding this adjustment, our earnings increased 35% and our operating margin was 4.7%.

Our non-medical loss ratio, excluding the disability reserve refinements, improved to 70.2% from 74.5% in the prior year quarter. This 400 basis point improvement was driven by better loss experience in all product lines, Life, Disability and Dental. As Dennis noted, top-line growth is expected to drive the next leg of our margin improvement story.

And we are encouraged that non-medical premiums grew compared to the second quarter. This marked the first sequential increase in premiums in two years. Given these successes, we expect our positive momentum to continue. In Retirement Plan Services, we reported earnings of $32 million, compared to $42 million in the prior year quarter.

This quarter's earnings were negatively impacted by $2 million from our annual assumption review while the prior year period benefited by $2 million. Spreads, excluding variable investment income, were 148 basis points. Year-to-date, spreads have compressed 12 basis points compared to last year, the midpoint of our 10 to 15 basis point expectation.

For the quarter, our ROA was 23 basis points, consistent with our year-to-date result. Account values have benefited from several quarters of positive net flows. When combined with positive changes in the equity markets over the past year, end-of-period account values increased 8% to $57 billion.

As our outlook for net flows remains positive, we are positioned well to further increase account values and earnings in the Retirement business. Before moving to Q&A, let me comment on a few other items of note.

As I noted upfront, our capital position remains very strong and our business model continues to generate capital, allowing us to remain one of the best capital return stories in the life insurance space. This quarter, we repurchased $200 million of Lincoln shares.

And year-to-date, we have deployed 76% of our operating earnings towards buybacks and dividends, above our annual target of 50% to 55%. We expect to remain active allocators of capital. An example of this can be seen by our announced 16% increase in our shareholder dividend.

As we have noted in the past, we anticipate growing and maintaining a competitive dividend. Our statutory surplus stands at $8.8 billion, up over $500 million from the prior year period even after sending a little over $1 billion to the holding company. We also estimate our RBC ratio will end the quarter at approximately 500%.

Lastly, our holding company cash ended the quarter at $546 million. So to conclude, we reported record operating earnings and EPS. Net income was also a record and exceeded operating income as the hedge program had an excellent quarter. We grew book value per share by 10% and our ROE approached 14%.

This year's annual review had a modest positive impact on our operating earnings and enterprise expense discipline continues. At the business level, Annuities continues to report strong returns. Earnings in our Life business reflected strong mortality experience. RPS results were consistent with recent quarters.

And Group Protection posted its best earnings quarter in 7 years. These solid results have drove consistently strong capital generation. And when you combine that with the strength of our balance sheet, it allows me to conclude my comments by stating that we expect to continue actively returning capital to shareholders.

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

Thank you, Dennis and Randy. We will now begin the Q&A session. We have about 30 minutes. And as a reminder, we ask that you please limit yourself to one question and only one follow-up, then re-queue if you have additional questions. With that, let me turn it over to Charlotte to begin..

Thank you. Our first question comes from the line of John Nadel from Credit Suisse. Your line is now open..

Hey. Good morning, everybody. The first question I have is around risk-based capital and just capital supporting the variable annuity business.

We've, I guess, heard on the first two calls this morning, both MET and PRU, that they may be taking or at least articulating a slightly different approach to the way they think about risk-based capital and capital supporting the VA blocks and really thinking about the targeted risk-based capital ratio of 400% for everything ex variable annuities and then thinking about variable annuity capital relative to a CTE-97 or 98 kind of level.

If we thought the same way or in a similar fashion for Lincoln, what kind of impact does that have? I think given the captive, your risk-based capital at about 500% is still something we can think about relative to that 400% longer term.

Is that reasonable?.

Hey, John. Thanks for the question. That's a very broad question, so let me come at it this way. When I think about how we develop capital that's appropriate for all of our businesses, I don't think about it as any different business to business. Ultimately, we're looking at the stresses that can impact each and every business.

And that should ultimately drive the amount of capital that we've put behind each of those businesses. In the case of the variable annuity business, we express that with a CTE measure. And we talk about capitalizing that business to a CTE-98 measure..

Yeah..

Now the stresses are going to be different in a Life business, for instance, where you're primarily talking about credit stress, or an annuity business where once again you're talking about credit stress.

So while these stresses or the potential impacts may be different, the fundamental underlying approach for how we develop our capital is consistent across all of the businesses. We then convey those approaches, typically, through an expression of an RBC percentage. As I mentioned, we were at 500% at the end of the quarter.

As I've said in the past, we have a very strong balance sheet. But I wouldn't anticipate taking some piece of that balance sheet and doing an outsized share buyback, for instance, in a particular quarter.

I think we do have excess capital on our balance sheet if we wanted to do something like some M&A probably in the range of $500 million to $750 million. But I don't think that when you take everything like ratings into account, that we would take a similar amount of capital and suddenly put that into buybacks.

That being said, we continue to do a strong amount of buybacks each and every year. And I'd point out that our shares went down nearly 8% year-over-year, indicating the strong capital return story that we have been.

So, John, that's how I would think about capital that we use to support the business and how we ultimately express that as an RBC percentage..

Yeah. No, I appreciate that, Randy. That's very helpful. And my second question unrelated to the first is, if we think about mortality results in the Life Insurance segment, seasonally, 3Q tends to be more favorable than the other three quarters of the year.

And just reflecting upon that relative to a typical seasonal strong 3Q, how would you characterize this quarter's results? And could you remind us how to think about the contribution in 3Q relative to the rest of the year?.

Sure. I think the third Q was the better twin of the first quarter, certainly with a little different numbers in terms of the mix. If you remember in the first quarter, I talked about $30 million of negative mortality experience with roughly two-thirds of that being expected seasonality and then the other one-third being over and above that.

This quarter we had roughly, in total, what I would say is about $15 million of favorable mortality over a full year's average quarter, with about two-thirds being normal seasonality and the other third being experience better than that.

But if you try to break that down into percentages, the actual expected for the quarter, John, came in about 95%, 96%, I believe it was. So a good quarter all around, a quarter that wasn't unexpected as we do talk about favorable seasonality in the quarter. But, nonetheless, a very good quarter..

Perfect. Thank you, Randy..

You bet..

Thank you. Our next question comes from the line of Jimmy Bhullar from JPMorgan. Your line is now open..

Hi. Just had a question first on alternative investment income. It was pretty strong this quarter. So I don't think you highlighted the number that you see as sort of maybe above your expected long-term run rate. But if you could do that and then also just talk a little bit about which asset classes did well and contributed the most to that.

And then I have a couple other questions..

Hey, Jimmy. In terms of the impact, I mentioned $0.08 between prepayment income and alternatives. About one quarter or $0.02 of that was from the alternative portfolio. You know we have a long-term expectation of a 10% return in the portfolio. I think we actually came in at 12.4% for the quarter. So it was a good strong quarter.

But I think it was consistent with movements in the equity markets that we've seen in prior quarters..

If I could just follow up. About 90% of that overall number came from private equities, balanced hedge funds, but both categories performed nicely..

Okay. And then you reported pretty strong margins both in Group insurance where you've been repricing and individual life. Individual life especially has been weak the last few quarters.

So does this represent more of a run rate that you can improve off of or do you consider the margins in both of those businesses abnormally good this quarter?.

Well, you asked about two businesses. And I just addressed the Life question. We had a good mortality quarter which benefited us by roughly $15 million. And I also mentioned that additionally we had about half of that $18 million of variable investment income, or $9 million, was located in the Life line.

So overall, it was a strong quarter that featured good mortality. I would also note that when we think about seasonality, we think about it being negative in the first quarter and then getting it back in the third and fourth quarter.

So our base expectation as we go into the fourth quarter is that mortality in terms of, once again, an average quarter would be a little better than that full year's average quarter. In terms of the Group business, $28 million of earnings; I noted that $5 million of earnings came from the review of reserves and DAC.

So if you took that out, you'd be at $23 million or a 4.7% margin. At the end of the day, Jimmy, it was a good quarter.

If you go business by business and look at the loss ratios that we reported and if you adjusted those loss ratios for the reserve review, you would see that every line, Life, Disability and Dental, improved from the prior year and improved from the preceding quarter.

So it was undoubtedly a quarter consistent with what we've talked about, which is the repricing of this business has been done and is largely behind us. And you're starting to see that feed through into the results. When you look business by business, I would say that our strongest quarter would have been in the Life business.

And when you look forward, I would – I think if you look in the stat supp, Jimmy, the loss ratio in the Life business was 66%. I'd expect that to trend up a little over time. And the adjusted loss ratio for the Disability business would have been 74%. I'd expect that to trend down a little bit over time.

When you wrap it altogether, we had an adjusted loss ratio of 70.2%. I'd put that on the good side of an expected quarter for this business. And I think – if you went back to the first quarter, I talked about a 1% to 2% sort of margin around an expected mean. And I think that this quarter was on the good side of that expected mean..

And then you mentioned you being – you're done with your repricing initiatives. As you're looking at year-end renewal season, how is the pricing in the market? Because we've heard from some other companies that it's starting to get a little bit more competitive now.

But how is the pricing in the group benefits market?.

Jimmy, it's Dennis. We're not seeing across any of our businesses any outliers. And all of our businesses, they have good, strong, tough competition.

Interestingly, in some of the business lines, take for example, RPS, it's a little bit less on price and a little bit more on technology and how that technology can help both the provider and the participant. But in general, we don't see any extreme pricing, either people coming in and underpricing or anything in that arena..

Okay, thank you..

Thank you. Our next question comes from the line of Tom Gallagher, from Evercore ISI. Your line is now open..

Dennis, I wanted to follow up on some of your DOL comments as it relates to the variable annuity business. And you talked about by 2018, you expect net flows to become positive.

Can you provide a little color on how you see this playing out for yourself, for the industry a little more broadly in this context? So is your expectation that you're going to see a pretty meaningful product pivot and commission structure pivot here as it relates to a move into passives on the product side and a move to level fee sales versus the frontload commission structure that has existed historically? Or do you not see something that dramatic happening here?.

That's a good question. And I think a lot of that answer remains to be seen.

What we know now and what I said during our remarks, which I know you've heard, but I'll repeat them, is that there's a big group of advisors that haven't been doing the VA business because the VA business – they've had more commission-based financial advisors than fee-based advisors. We think that's an opportunity for growth.

We think there's a very significant population of financial advisors if the industry and Lincoln provides better fee-based product structures that they'll participate. So that's one direction.

Is there going to be a significant shift from commissions in the traditional marketplace where it has been commissions? Is there going to be a significant shift from commission compensation to fee-based compensation? Again, I think we have to wait and see if that's going to take place.

We're focused on and I think all of our distribution partners are focused on what is in the best interest of their clients in terms of the type of fees or the type of compensation that they charge.

And as we have talked about on numerous occasions; for insurance contracts where the advice cycle is mostly upfront, it seems like commissions make most sense both for the advisor who's providing the advice upfront.

And it's less expensive oftentimes for the client because there's not this ongoing management fee that's really, in long-dated insurance contracts, not as necessary it is, say, for example, with an advisor who's helping with asset mix on a daily or quarterly basis.

So in the industry in general, the movement to passive investments has been pretty significant. Whether or not that continues, we'll have to see. But we want to be in a position to meet that need as well. So we'll have to see. But we think we're well-positioned no matter what direction the overall marketplace takes..

Thanks for that, Dennis. And then if I could shift to a question on the NAIC proposal to change variable annuity capital and reserving framework.

Randy, any initial thoughts on this as it relates to your views on ultimately how much capital is going to be needed for this business? Do you feel well-positioned based on the way this is trending? Would you expect that maybe this could consume more capital? And any initial thoughts?.

Tom, there hasn't been a lot of change since the last time we talked about this. Yes, we do feel well-positioned. In general, I think we're typically going to be supportive of changes that we see as improvement to how we account for our product.

Then undoubtedly, what the NAIC in conjunction with Oliver Wyman is working on is an improvement in how variable annuities are accounted for both from a reserve and a capital standpoint. It's an improvement because it's moving from what I would describe as more of a book value approach to what I would describe as more of an economic value approach.

And that is a good change because that's how we hedge the products and when we think about that risk. So we are supportive of what Oliver Wyman is doing. We believe we are well-positioned.

If you go piece by piece through the proposal, you're going to find some that are positives and some of that are negatives relative to the current approach to reserving that the NAIC has. For instance, I think linking the returns to the risk-free rates would probably be a negative.

But on the other hand, hedge accounting for derivative assets is a definitive positive. When you add them all together, we continue to believe we're well-positioned. I think one other thing that leaves me feeling very good about how we're positioned for any changes that might come about is what you see with our policyholder behavior.

As I mentioned in my script, you've seen very large charges across the industry from companies who've had to bring their policyholder behavior assumptions more in line with experience. You haven't seen that at Lincoln.

In fact, if you look over the last 5 years, the sum total of impacts from unlocking our policyholder behavior assumptions is a positive. It's been a positive pretty much each and every year.

So I think the fact that our assumptions are well-linked to our actual experience and always have been puts us in a very good position when you think about what the NAIC is working on..

That's helpful, Randy. And just one final one. This 7.3% separate account return assumption, that moved from 7.6% a year ago.

So did you take that down 30 basis points?.

Yes, we did. If you remember last year, we went from 8.2% to 7.6%. And this year we went from 7.6% to 7.3% and that was primarily by doing some work on the underlying returns that go into the separate accounts. This year, it happened to be primarily on the fixed income side..

And I presume then that you had one maybe semi-sizable adjustment negatively.

Was that then offset by favorable policyholder behavior?.

Yeah. In fact, the Annuity business, as we mentioned, the total was $10 million of negative results from the unlocking. That was comprised of $25 million from changing capital markets assumptions and that was primarily the reduction in the separate account return. That was offset by $15 million of positive primarily from policyholder behavior.

So then that netted to the $10 million that we talked about..

Okay, so pretty small. Thank you..

Yeah..

Thank you. Our next question comes from the line of Sean Dargan from Wells Fargo. Your line is now open..

Hi, thanks. I'd like to follow up on Tom's question around DOL and Annuity sales in another way. Dennis and Randy, for the last couple of years, you've been saying that if Annuity sales fell because of changes in how the products sold due to DOL, you would use the capital that was backing those annuities and buy back more stock.

We're kind of essentially there now at least in order of magnitude. Versus what I was thinking, it came a little earlier. I was thinking the fall would come in 2017. So I'm just wondering, Randy, if the stats surplus in RBC that you referenced earlier, if that's benefited at all from the lower capital strain from lower Annuity sales..

Sean, I think we've pretty much done what we said we would do. So if you look at what we've done year-to-date, we have returned 76% of operating earnings to shareholders through buybacks and dividends. That compares to a guidance of 50% to 55%.

If you use the central point of that guidance and you develop how much additional buybacks over our guidance that would be, what you will see is that there's probably about $75 million in there related to lower variable annuity sales. And I would expect that to continue, should Annuity sales remain below our longer-term expectations.

As Dennis mentioned, we will be working aggressively to get back to a positive flow situation. But we have been and we will continue to do what we've said which is put that capital to work through share buybacks..

Okay, thanks.

And can you help us think if you do get to positive flows and the vehicle that gets you there is a fee-based annuity chassis, is the capital strain lower on selling new products with that type of product versus the commission-based chassis that you've used in the past?.

Yeah, absolutely. You have less investment upfront. So what you will typically see is that, from a return standpoint, your ROEs are a little higher and your ROAs are a little lower because of the fact that you don't have as much investment and you have less capital strain..

All right, thank you..

You bet..

Thank you. Our next question comes from the line of Ryan Krueger from KBW. Your line is now open..

Hi, thanks. Good morning. I wanted to follow up on the no-load passive VA that you're going to roll out.

I guess, one, is that an investment-only product or does it have an income guarantee? And then secondly, are there many other passive-only VAs in the market or is yours the first or one of the first to roll out?.

Yeah. I refer to this, Ryan, as a new product category, not that elements of it aren't in the market. And we're not going to go into too much detail because it is a competitive opportunity, I think. But it's the combination of passive investment income, a simplified guaranteed living benefit and a no-load product.

And again, I'm not aware of any competitive products that include all of those features. And importantly, sort of back to the question that I was asked about, what's the direction of commissions versus fees.

I think the most important answer is what's in the best interest of the customer; what's the customer's investment ideas, coming back to – or preferences, I should say – coming back to passive. At the moment, a lot of active investment moving to passive. We're just trying all the time to be responsive to major trends in the industry.

I think this particular product is exciting. It has a lot of technology associated with it that makes it easier for the customer to understand the product and where it might fit into the customer's overall portfolio of investments. So we're very excited about it and we've got a great partner.

And again, because it's so technology-heavy, it will take a few months to get it into the market and then connect with our different distribution partners' systems..

Thanks. And then for Randy, it seems that a lot of your peers have disclosed their long-term interest rate assumptions on a risk-free basis. I think your 5.25% is an earned rate assumption. I was just hoping you could tell us what that kind of translates into for a risk-free rate for comparison purposes..

Yeah, I think most people generally have talked about the 10-year risk-free rate and how that translates into a longer-term earned rate. For us, the underlying 10-year Treasury assumption is 3.75%.

When I look around, and I do have access to some surveys and other information on the industry, I would say that that number is, in general, at the lower end of industry assumptions. I would say that the industry average is probably about 50 basis points higher than that.

On the other hand, our grading period of 5 years is probably a little shorter than the average industry grading period. I think those two items, from an economic standpoint, probably offset each other.

I would prefer, or we would prefer right now, to be in a situation with the lower ultimate rate assumption because I think most evidence indicates that over the longer term, we should expect rates to be a little lower than they have historically.

And we also happen to think that whatever the ultimate resolution on rates is going to be, it's going to be known inside of 5 years. We will understand that rates are going to move higher or in the next 5 years we will understand that we should lower the assumption again..

All right, great. Thank you..

You bet..

Thank you. Our next question comes from the line of Michael Kovac from Goldman Sachs. Your line is now open..

Great, thanks.

For Randy here, I was wondering if you could share any initial thoughts, as we are in the fourth quarter, about statutory testing and lower rate utilization; anything you learned this quarter that you could share with us?.

Hey, Michael. Thanks for the question. I think, as we have done in the past, our overall cash flow testing has yielded a growing efficiency over time as we add some more new business and more profitable new business than runs off our books.

In terms of the things that can be variable from year to year, you're generally talking about the subtests, what are called 8C and 8D, the highly descriptive tests – 8C and 8D. The rates for those – for the 8D test was locked in back at June 30. It's well-known and we don't anticipate any stress from either of those tests this year.

So we feel very good about how we're positioned for cash flow testing and would not expect any additional reserves this year end..

And Mike, I'll just then, for everybody's benefit, just add a comment that if you go to our investor presentations there is a lot of sensitivity around this question and the consequences of interest rates at different levels. If you go into the policyholder assumptions sensitivities, you can see very little – you can see what the impacts are on us.

And in all cases, I think we feel like we're in a good shape..

Thanks, that's helpful. And then one for Dennis here. Appreciate all the additional color on the Department of Labor and the uncertainty that maybe still exists to some degree.

I was wondering if you could give us an update in terms of any either upfront expenses or ongoing expenses that you believe you will incur as we head into April and then sort of on the go-forward..

Yeah, Michael, let me bucket that for you. The most significant investment is on the distributor's part, not on the manufacturer's part. And so, yes, in our RPS business and in our Annuity business, there's some incremental investment, but it's not significant.

In our own broker-dealer, which is not a large contributor to earnings, there's probably a little bit more in terms of its expenses, a little bit higher for the implementation. But I'm not aware of any significant expense item with Lincoln primarily because we're the manufacturer of related DOL..

Nothing outside of what I would describe as manageable expenses, sort of expenses that come up all the time..

That's helpful..

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

Good morning and thank you for my questions. I have a question regarding the new products that you're launching, not the passive one, but the other one that you're enhancing the investment's flexibility.

For those enhanced flexibility, would you still have the volatility control features in those fund options? Or if not, would that still have any kind of living benefits associated with that product?.

Yeah, Humphrey, that's a good question. And let me talk about the design of products generally. And let me put it into three categories. One, if you will, you have the investment engine and that means that you have asset allocation funds or do you have risk-managed funds or individual securities or individual mutual funds.

So we make adjustments on all of the engines, if you will, that drives outcomes. The next block that you have is how does the roll-up feature work for guaranteed living benefits. And as you know, almost everyone on the phone knows, oftentimes in the market it's about 5% roll-up for income purposes.

And then on the backend, you have the third important piece which is what's the identified payout, how can that identified payout be adjusted. So when looking at your questions, I can tell you that in terms of the risk-managed funds, we did build a product that doesn't rely on them.

But we've also had to look carefully at those other two buckets so that when you step back and ask, is it a good consumer value and does it fit into our risk tolerances, the answer is yes on both..

So basically, it will be – you kind of broadened the investment choices without the kind of the built-in volatility control in those options. But then you kind of manage it from the roll-up perspective and the payout perspective..

I think if I heard you correctly, that's correct..

Okay. And then maybe shifting gears a little bit.

In terms of the Life Insurance sales kind of like running being pretty decent, how should we think about when would you get into the capacity that you can do some reserve financing again? And on top of it, with the upcoming principal-based reserving, how will that change your need for reserve financing going forward?.

I think with the level of Term sales we've have had this year – as Dennis noted, Term sales were up quite nicely year-over-year. I would expect that we would likely have the amount of Term business where we would look to do one next year. Don't know the exact timing on when it would be next year.

But it's likely that we would have the capacity to do one next year..

I would just add in that principal-based reserving has had a very positive effect on the reduction of the required reserves on that product. And so it, longer term, will have less need for reserve financing on Term business..

Yeah, Dennis is absolutely right. As we look at PBR rolling out, principals-based reserve, excuse me – rolling out next year, you would see much less strain on Term insurance sales, so much less need to do reserve financings..

Okay. Thank you for the color..

Thank you. And I'm not showing any other further questions and would like to turn the call back over to Chris Giovanni for closing remarks..

Thank you, Charlotte, and thank you all for joining us this morning. As always, we're available to take your questions on our Investor Relations line at 800-237-2920 or via e-mail at investorrelations@lfg.com. Thank you all and have a good day..

Ladies and gentlemen, thank you for participating in today's conference. This does conclude the program and you may all disconnect. Everyone have a great day..