Lincoln National Corp (LNC) 2005 Q1 法說會逐字稿

Good morning everyone, and thank you for joining us for Lincoln Financial Group's first-quarter 2005 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. (OPERATOR INSTRUCTIONS) This call is being recorded and will be available for replay beginning today through May 10, 2005. A replay can be accessed by dialing 1-888-203-1112. And enter the pass code 9969458. Before we begin I have an important reminder for you about Lincoln's earnings release.

Any comments made regarding future expectations, trends and market conditions including premium, cash flow, pricing and loss cost trends 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 Lincoln's most recent reports, including the form 8-K filed yesterday.

At this time I would like to turn the conference over to the Vice President of Investor Relations, Ms. Priscilla Brown. Ms. Brown, please go ahead, ma'am.

Thank you, operator. Good morning and welcome to Lincoln's first-quarter earnings call. You just heard the Safe Harbor caution and so now we will move right into the call. We appreciate your participation today and we invite you to visit Lincoln's website LFG.com where a statistical supplement and other pertinent information can be found. 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 measure is provided in our press release and in the statistical supplement posted on the LFG.com website.

Now I would like to turn the call over to Jon Boscia, Lincoln's Chairman and CEO and Fred Crawford, Lincoln's Chief Financial Officer. Their brief comments will be followed by a question-and-answer period.

Thanks, Priscilla, and thanks to all of you for joining us this afternoon. Let me first say that I am pleased to welcome Fred Crawford to his first quarterly earnings call as Lincoln Financial Group's Chief Financial Officer. Many of you have met Fred, and I am sure all of you will appreciate the knowledge and perspective that Fred brings to the CFO role and to the management team. Now let me share with you some of the highlights from the quarter.

In the quarter aggregate gross deposits of $8 billion were up about 7% over the prior-year quarter and just shy of the record deposits reported in the fourth quarter of last year. It was another strong quarter for variable product deposits, as well as a record quarter for retail investment deposits. We are extremely pleased with the fact that we exceeded the billion dollar mark through mutual fund sales, especially in a quarter where the equity markets would not be viewed as particularly strong.

Net inflows continued at a strong pace with record retail net inflows contributing to the strongest first quarter on record. For the quarter positive net flows across all domestic businesses were up almost $3.9 billion or were almost $3.9 billion, up 9% over the prior-year quarter and continued to build upon our record of sustainable quarterly flows in both our retail and institutional lines. Let me turn to the segments starting with retirement.

In our retirement segment first-quarter variable deposits achieved record levels, driven by continued strong performance of our American legacy product, together with record deposits in our Alliance program, which is sold in the employer-sponsored market. Total variable deposits for the quarter were over $2.4 billion up 31% over the prior-year quarter. I for life (ph) deposits which have been steadily gaining momentum were a record $177 million in the quarter. When compared to full year I for life deposits of $410 million in 2004, this quarter's result underscores the rapidly growing interest in income focused product solutions. Strong deposits translated into another quarter of strong net flows as first quarter annuity net inflows of $776 million increased 9% over the prior-year quarter.

Now let's turn to the life insurance segment. Retail first-year premiums were $179 million, a decrease of 8% from the prior-year quarter. Life sales were suppressed in three product lines, and I'll spend a few minutes sharing my views on what's happening in the market. Universal Life sales are down by managerial design due to my concerns on a couple of fronts. First, the long-term profitability some competitors are willing to accept that we are unwilling to match and two, the inappropriate use of life insurance as an arbitrage vehicle currently being promoted by some major life producers and certain companies.

We've been saying for several quarters now that the Universal Life marketplace has been particularly competitive and that we will not compromise our target returns to buy market share. This situation has been aggravated by the recent popularity of investor-owned life insurance or IOLI as it’s commonly referred to and the distraction it has caused in key channels as producers look to find carriers willing to underwrite this business. Let me be clear IOLI is not life insurance as any of us thinks of life insurance. It is an investment arbitrage. We sent a memo to producers informing them that Lincoln would not accept IOLI business, reinforcing our position due to the unusually high interest in that product area.

Based on recent public information, I am pleased to learn that some of our competitors in the affluent life insurance marketplace have also taken a similar position, and I am optimistic that life producers will redirect their focus to true needs-based life insurance opportunities. With respect to MoneyGuard, our sales success with this product has been an example of the benefits of product diversity. However, our product innovation has attracted competing product designs, putting pressure on sales and market share in this unique product class. Our product development efforts on the next generation of MoneyGuard are well underway, but it is clear that the success of MoneyGuard has attracted new entrants to the marketplace.

The term market continues to experience significant pricing pressure from the larger players in the industry impacting our ability to offer competitive product at targeted returns. However, our new ProTerm product series redefines the term insurance value proposition for clients, and we are excited about this innovative product offering. Variable life premiums, on the other hand, were up 15% in the quarter and were a bright spot in an otherwise difficult market. Again, it is a good example of how best to compete in today's life market with product diversity and product innovation rather than taking on unreasonable risk or competing purely on price.

On the regulatory fronts the recent passage of HR aids by the House of Representatives has reignited the debate on the full repeal of the estate tax and put it squarely on the Senate's agenda. The Administration will be working hard to garner the support for full repeal but the cost estimated at $50 to $60 billion per year will certainly be a factor. Activity has increased in the Senate on trying to negotiate a permanent estate tax reform compromise which would be less costly. But any permanent solution will require bipartisan support. Full repeal would have some impact on life sales, but any permanent solution, repeal or reform would serve to eliminate the uncertainty around estate tax that currently exists today and would potentially have a positive impact.

Turning to investment management, deposits and flows at Delaware continue to build on a positive trend. This is particularly true in retail where as I mentioned earlier, we recorded our first billion dollar quarter in mutual fund deposits exceeding our previous record quarter by 45%. First quarter retail and institutional deposits totaled almost 5.2 billion, up 2% over the prior-year quarter but up 41% if you adjust for the sale of DIAL. Retail deposits posted a strong 38% increase over the prior year quarter, while institutional deposits were down 32% on an unadjusted basis, but up 48% excluding DIAL.

Net inflows for the quarter were $2.8 billion second only to the fourth quarter of last year in terms of record flows. Last month we announced the hiring of a large cap growth equity team led by Jeff Van Harte located in the San Francisco Bay area. We are very pleased to have a team of this caliber join Delaware Investments and to have these individuals complement an already outstanding group of investment professionals in the organization. Jude Driscoll and his management team have worked hard to create a culture that attracts and retains top talent, and this is proof that their efforts are yielding results.

Throughout all our business lines the best people in the business are picking up their phones and saying they want to come to work for us. I intend to continue using this competitive advantage to build long-term value and balancing that positive impact against the immediate period's negative impact. With that, let me turn it over to Fred.

Thanks John. Before I dive into the numbers let me first comment on our approach to earnings guidance. After careful review of the issues including dialogue with the Audit Committee of our Board, we will not be providing specific earnings per share guidance. While there is significant research supporting both sides of the EPS guidance debate, in the end we grew concerned about the long-term impact on economic decision-making at Lincoln. What we are going to do is take more time in discussing our outlook for the business segments. Consistent with the approach we took in this quarter's earnings release and in my comments later in the call.

With that, let's turn to the results. Yesterday Lincoln reported first quarter net income of 178.9 million or $1.01 per diluted share. And income from operations of 172.5 million or $0.98 per diluted share. Return on equity for the quarter was just under 13%. On a consolidated basis earnings were negatively impacted by unfavorable life mortality, higher-than-expected distribution losses and volume-related acquisition costs negatively impacting Delaware's current quarter earnings.

Some other factors played a role both positive and negative, and I will touch on those during my review of the segments, starting with retirement. The retirement segment reported income from operations for the quarter of 98.6 million and overall was a very clean quarter. We saw solid earnings growth in fees related to strong flows combined with the lagging effect from favorable equity markets late in the fourth quarter and its impact on average daily account values. This was partially offset by lower spread earnings in our fixed book which did not benefit from prepayment and make-whole premiums and other investment income at the levels we saw in 2004. The performance of our hedge program was slightly better than expected, that is better than the 1 million net after DAC and after-tax cost we currently expect to see each quarter.

In the life segment earnings of 67.7 million were below expectations with a couple of unexpected items causing most of the shortfall. Unfavorable mortality results including a reported first death on a large survivorship policy combined with a related DAC adjustment hit earnings for $3.1 million. As most of you are aware and will see, we will see periods of fluctuation in mortality and expect results to normalize in future periods. As John alluded to, life sales were below prior year levels, and while this doesn't affect current quarter earnings, it does slow our progress in terms of offsetting the natural lapsation inherent in a large block of in force business.

Turning to investment management, we reported earnings of 7.4 million which were also below our expectations and negatively impacted by the equity markets in the quarter. In addition, incremental acquisition costs are rising from the strong mutual fund and managed account deposits and a reduction in the fees Delaware earns on the Lincoln Life Insurance assets combined to put pressure on earnings. These items were partially offset by the positive impact of net flows and resulting increase in advisory fee income.

Looking at distribution within corporate and other, the combined loss for LFA and LFD in the first quarter totaled 13.6 million compared to 13.3 million in 2004's first quarter. The first quarter is traditionally the least profitable quarter of the year, and there are a couple of factors that suppressed a year-over-year improvement in the distribution loss. The first is our investment in wholesaling. In 2004 LFD started the year with 287 wholesalers, both internal and external combined. This year LFD's wholesaler count at the beginning of the year was 362, a 26% increase. While there are exceptions, as a general rule it takes two years for a new wholesaler to reach acceptable productivity levels and is at the heart of why we view LFD losses in part a sign of the firm's opportunity.

Turning to LFA we are in the middle of executing on our new affiliation model and while planner attrition appears normal, there is no question a level of distraction in the system resulted in a soft quarter for production. Notably in the sale of non-affiliated products. Lincoln UK's operating earnings in the quarter of 10 million were slightly above expectations due to a higher-than-expected exchange rate. Lincoln UK also benefited from favorable equity markets and improved persistency.

In corporate, excluding distribution, results were in line with what we communicated to you last quarter. We did have a pickup in earnings of 5.8 million associated with a reduction in the deferred tax asset valuation allowance in our Barbados Insurance Company. Future adjustments to the allowance will be dependent upon the amount and timing of taxable income that is generated in the Barbados Company.

Related to capital and risk management issues, we repurchased $35 million of stock at an average share price of just under $46 a share. Our previous guidance on repurchase remains the same. We expect repurchase activity in 2005 to be in the $100 to $200 million range. We are taking an arguably conservative approach to managing our capital, and that has certainly contributed to a reduction in our ROE for the period, coming in again at roughly 12.9%.

Regulatory capital uncertainty surrounding AG38 on Universal Life and C3 Phase II on variable annuities require careful monitoring of risk-based capital conditions in our life company. We posted a strong 338% RBC at year end, and while first-quarter numbers are not yet available, we do not expect the material change in our life risk-based capital.

Before moving to Q&A and consistent with my opening comments on guidance, I want to spend a few minutes on the earnings outlook and factors that will influence earnings over the next three quarters. First, we expect to continue our track record on positive flows in both our retirement and investment management businesses. These results fueled by continued investment in distribution, product development and strong investment performance at Delaware. Throughout 2004 our outlook for the life segment was understandably guarded for all of the reasons noted in John's comments earlier in the call. As we have discussed in the past, mortality will move around and while hard to predict we would not expect a repeat of the first quarter experience throughout 2005.

We do see early and modest signs of improvement in the life business as the markets rationalize and as we launch the next generation of MoneyGuard and term products. Lincoln expects first-year premium to rebound, gradually returning to the levels at or modestly greater than 2004 levels. Adjusted for about 3 million in variances related primarily to mortality mentioned earlier, we would expect earnings to build off first quarter levels. Our estimates are dependent upon the growth in life insurance in force and the mix of both new sales and lapsed policies recognizing the relative profitability of permanent insurance over term.

With respect to retirement, this quarter's operating earnings were generally in line with our expectations but did include about $1 million of favorable investment income. Since a large part of the earnings is driven by average daily account values, the growth in the second quarter earnings will depend a great deal on the equity markets performance in May and June, and of course net flows. As you've heard, some of our peers say increased volatility in the equity markets could impact the effectiveness of the hedge program Lincoln and the industry have in place for their respective guaranteed minimum withdrawal benefit riders and related living benefit designs. We would expect continued growth in quarterly earnings before adjusting for our published guidance on the impact of the equity markets.

Looking at investment management, the earnings in the quarter are indicative of current expectations excluding the impact of increased retail deposits in the equity markets. However, they need to be adjusted for onetime and ongoing expenses we will incur related to the new, large cap growth team hired last month. In the second quarter we expect earnings to be reduced by about 3.5 to 4.5 million and approximately 1 million per quarter in the latter half of the year.

Turning to our combined results for LFA and LFD our expectation for the year remains largely unchanged. That is we expect modest improvement over last year's combined loss, although continued weakness in life sales could hamper that goal. It is fair to say there is risk in this outlook largely surrounding the implementation of LFA's new affiliation model effective January 1 of this year. While we're very pleased with the response from the planners, we believe that it will take a full year to gauge the success of the change. Bob Dineen and his management team continue to build out the stages of converting a localized delivery of planning services to a true national platform.

With respect to prepay and make-whole premiums we recorded 2.6 million after DACs and tax in the quarter. This is down from the quarterly average of nearly 8 million in 2004. And as we have said in the past while we have no way of knowing what to expect, results in the first quarter are likely more representative of prepay and make-whole premiums going forward.

Finally fixed spreads on both Universal Life and annuities benefited during 2004 from prepay and make-whole premiums, contingent interest and interest received on securities in default. In the first quarter of this year retirement spreads contracted about 5 basis points due primarily to a reduction in these favorable pickups while life saw little compression in the quarter. Our prior guidance of 4 to 5 basis points of spread compression per quarter is still current in light of where interest rates are, but as has been the case actual results will depend on a variety of factors. We do, however, expect spread compression in the life business to be marginally better than our estimate for retirement.

With that, I'll hand it back over to John.

Thanks, Fred. Our reported results for the first quarter highlight several themes that have been a part of the Lincoln story for the last several years. Our focus on building strong product, brand and distribution strength to drive new business and long-term shareholder value has been clear and consistent and everything in the first quarter's results supports that focus and reinforces our strategic commitment. We continue to be very pleased with the strong deposits and flows and more importantly the performance in our products that is driving the growth.

I will now turn it back over to Priscilla for the question-and-answer period.

Thank you, John. We would like to now open the call for your questions. In order to provide an opportunity for as many callers as possible we will take one question and one follow-up from each caller.

(OPERATOR INSTRUCTIONS) Colin Devine with Smith Barney.

John I think Priscilla gave you the question last night so maybe we can just go right to it and that is the problem I have in looking at Lincoln today is we're seeing spectacular sales, spectacular net flows, across-the-board and yet that doesn't translate into earnings. And I guess we've heard time and time again building up the distribution costs, but at some point when does LFD start making money? If I look at the business lines, the life insurance earnings frankly have been flat for -- this will probably make it about the sixth year in a row. Retirement is doing somewhat better. When does this hit the bottom line?

Colin, I will talk a little about LFD here and when does it turn profitable. Fred is then going to talk about the individual characteristics of how it flows through. But from an LFD perspective what we've been saying for a number of years is that I shouldn't say for a number of years -- for a couple of years -- that it is our intent to continue to manage wholesaler additions into LFD in balance with the production that those wholesalers get against the cost of the wholesalers. And I do not yet believe that LFD's wholesaler base, as we indicated closing in on 400 is still at the level that a company with the product capability that Lincoln has available to it should be. So we will continue to add wholesalers and with this breakeven period of roughly two years on average, we're not going to see LFD breaking even let alone making money in the foreseeable future.

But the other part of the question then really is how do the new business flows translate into profitability? And Fred is going to spend a little bit more time on that.

I mean really you've got to look at it with respect to the differences in the booking of the revenues and so forth from retirement and life insurance flows versus investment management and the investment management flows. The primary difference being in the expensing of acquisition costs on the investment management side. Let's talk first about retirement. We have what we believe to be a good kind of a problem in that when you look at the retirement earnings we are suffering somewhat from the results of strong positive deposits on a trailing 12 month basis roughly $8.6 billion worth of deposits in variable annuities alone, and the resulting DAC and DAC asset build up and DAC amortization associated with those new flows.

What you're starting to see at Lincoln after several quarters now of strong positive flows is little change in the makeup of how our assets or return on assets translates into earnings. We are seeing gradually that some of the older business is starting to become a smaller percentage of our total block of variable annuity business. That newer business put on more recently carrying a higher DAC balance and higher DAC amortization associated with it. I would say also from a return on assets standpoint you did see a pickup year-over-year in some of the operating and administrative overhead expenses. Obviously we have plans underway to better manage those costs but much of that is the result of the combination of risk management and controls related investments over the past year.

Turning to investment management you really have a different kind of an animal going on, but still the result of again a good kind of problem that is strong flows. Retail investment management flows largely mutual funds and managed accounts are unique in that you expense the acquisition costs in the period incurred, and so you end up with a situation where for example, we will on average generate about 60 basis points annualized on the sale of a mutual fund product. Or said another way, 15 basis points in the quarter. Meanwhile we pay away roughly 50 basis points of acquisition costs in the period in which we acquire the new deposits. When you think in terms of the growth and more particularly the accelerated growth within the retail products reaching $1 billion, as John mentioned, that up over an average retail mutual fund flow of about a $0.5 billion a quarter during 2004, it is difficult for the lagging effect of investment revenues off 2004 positive flows to catch up with the accelerated expensing of acquisition costs on the first period billion dollar record for mutual funds. And so we would expect over time to climb out of this situation as we build scale and as these positive flows start to contribute and overwhelm the new business expensing of acquisition costs.

I appreciate the response but Ken (ph) and I am not sure you really answered the question. I am not really focused on what Delaware is doing; I certainly appreciate how acquisition costs are expensed upfront and I can understand that one. Nobody addressed what is going on in the life insurance business, why earnings (technical difficulty) flat now on a multiyear basis. And even if we look at the annuity business -- retirement business -- whatever you want to call it, I hear you but earnings aren't going up despite the sales.

Let me talk about the life insurance; I took your question to be more along the lines of how do the new deposits and flows activity translate into earnings. Turning to the life segment you have different conditions at play there. You're right, our past recent experience on life earnings as well as our outlook remains somewhat muted, and that is largely the result of we believe, a cautious approach to putting on business that meets with our risk management initiatives. And as a result there are several things at play. John mentioned MoneyGuard experiencing some competitive pressure and certainly we hope some of the retooling on MoneyGuard will help to gain back some share and advantage in the marketplace.

We are also experiencing pricing pressure on the term side, which again we retooled the term product and hope to gain back a little bit of momentum there as well. But and then on UL it has been more risk management. All of these things have conspired in really holding down some of the sales progress and therefore growth in net amount at risk and some of the earnings drivers such as mortality margin and the like. I would also say past periods both in life and retirement enjoyed the benefits of very strong prepayment in make-whole and other investment related onetime type of benefits for the period and this quarter did not experience any of those pickups.

I am not sure we are getting anywhere with this -- but if I look at the end of 2000, the account values in the life business were 10.8 billion. Today we are roughly 40% above that, and yet earnings are flat. That's the question I am trying to get answered. Despite the great sales in life returns. A similar situation really exists in retirement; it seems for every marginal dollar Lincoln is spending in distribution costs -- generating distribution revenues it is spending away in distribution costs. And that is what seems to be the disconnect here. At what price are these sales coming?

Clearly we're trying to buildout some of the distribution leverage on the life side as well. Examples would be carrying MoneyGuard product to alternative distribution channels. And also pulling Universal Life more into the wire broker-dealer channel. It has predominantly been sold into the financial planning and MGA channel, as you know. So there is, indeed, some investing going on in building out some of the diversity of the distribution on the life side.

I would also say you are seeing higher DAC amortization in the life area, as well. This largely the result of our prospective on locking in the third quarter last year which brought down some of our estimated gross profits on the product, largely adjusting our long-term interest rate assumptions, as well as some of the lapse assumptions on COLI product. This certainly has contributed to a period over period change in DAC amortization and somewhat muted the growth in earnings on the life side.

Andrew Kligerman with UBS.

Just shifting over to the capital position, could you give us a sense of what that is? I know you talked about having 1 to 200 million of share repurchased, but what do you have at this stage? Where do you plan to deploy it during the course of the year and then I will follow-up.

You are right that we have dialed (ph) in roughly 100 to 200 million dollars of share repurchase for 2005 and I would argue that is certainly a conservative position to take, particularly given our earnings track record year here the last several periods and our views of earnings going forward. We are being cautious as we watch both AG38 the Universal Life regulatory reserving.

Where are you on excess capital?

We are running 338% risk-based capital on the life company and I would equate that to roughly a couple hundred million dollars of excess capital down the life company. At the holding company our leverage is down around 21, 22%, and I would equate that to roughly $300 million of excess capital at the holding company. So I think historically we have talked about 3 to $500 million of excess capital, and that remains to be our position.

Right.

Vanessa Wilson with Deutsche Bank.

On the AG38 question it appears to me that you're taking a very conservative posture towards that, and I applaud you. You put up more reserves in your statutory results in 2004 and it is being reflected in your sales at this point, and my question really is what is it about the regulation that is causing you to react to it today when we are hearing other companies saying it's fine, its not going to be retroactive, we are just going to continue to sell along until it actually comes to pass?

I mean really anytime there's uncertainty around the regulatory regime on for Lincoln what is the very large block of business we think it is prudent to be cautious. It is difficult for me to get very specific on what elements of the ideas being put forth give us concern. There's lots of discussion as to things like prospective versus retrospective adoption and these sorts of matters. The bigger issue to me is the wide range of views that are being put forth at the NAIC level and various other related governance bodies and that causes me to want to hold the line on doing anything too dramatic with respect to our statutory capital until we have a little firmer footing on the direction it is going to go. Again, I would agree with you Vanessa, I do believe it to be a relatively conservative position versus perhaps some of our other competitors. But again we think it is prudent -- it is a prudent position to take. It is one that we’ve discussed at length with the rating agencies, for example. I would expect as we get more clarity and more confidence in the direction that the regulatory regime will go we will be looking for opportunities to free up and more efficiently manage our capital.

So if you look at your life sales, how would you sort of separate the two issues out? Your conservatism on AG38 and your conservatism on the investor-owned life products?

They are related in the sense that they both surround the Universal Life marketplace. I would say -- I wouldn't pull them together so much with respect to new sales. Our concern over AG38 is more related to the way in which we manage our RBC. Our concern on investor-owned life insurance has more to do with a direct impact on sales activities where we've been proactive in putting out the message that we will not participate in these kinds of new sales designs.

Vanessa, I might add a little bit onto what Fred is saying there. There are some pretty good indications in the marketplace that some companies that were aggressively taking the investor-owned life insurance on their books may not have known they were taking investor-owned life insurance on their books. Because some of the companies that have posted very strong first-quarter results in terms of sales growth have subsequently shut down the investor-owned life insurance. It perhaps could be their view although each company will certainly differ, that they were just taking a more proactive approach on a secondary lapse protection rider types of products out there. And it may be a little bit of rationalization as to market conditions on their part.

We started underwriting very early in the process, specifically for IOLI to be able to help identify it and shut it down, and I think we have pretty good indications that we were effective in doing that early on while other companies just thought that they were taking LPR type products. So there is a little bit of a connect there in the way that people are identifying them.

Nigel Dally with Morgan Stanley.

First with hedging, Fred, you mentioned increased volatility to the impact of the effectiveness of your program. Can you just provide some color behind that given that I saw your three Greek hedging program hedged against volatility changes then I've got a follow-up.

It does Nigel and I want to be clear that as we sit here today we are not seeing any negative effects from volatility on the market. We simply put that out there as a caution as we provide an outlook on the retirement business. Our three Greek program is working as planned. We are a little bit better than we thought the expenses would be on the program but the effectiveness is solid, and we continue to be comfortable with it. It is important to note that we are attempting to find the right mix of options and futures positions both on interest rates and equity markets to marry off against the liability that has some natural basis risk in it. And so as volatility picks up both up and down it makes it gradually more difficult to dial in the absolute right level of offset, but nevertheless we continue to see good performance in the hedge program.

And just as a follow-up with C3 Phase II I know it is a moving target but if you can also provide us an update on whether you expect any impact on your excess capital after C3, Phase II, in particular whether you expect to get credit for your hedging activities?

The impact on our capital is really one of remaining cautious as a result of it being uncertain, and that is we don't really have any commentary relative to where we see it coming out. And again the ideas being put forth are varied, and so we are not yet at a point to be able to really pinpoint an exact impact to it. And as a result we again want to err on the side of conservatism holding a little bit of excess capital recognizing that there could be changing approaches to that C3 Phase II.

Jimmy Bhullar with J.P. Morgan.

Last quarter you had some very good comments on the acquisition environment or the M&A activity in the life insurance business. I want to see if you just could give us your views on Lincoln's positioning currently and where you see yourself in a consolidating market?

Jimmy there's really no change from anything in the fourth quarter comments; what I had indicated back then was that I think in coming years we will see increased consolidation in the marketplace taking place, and I still continue to say that will be the case.

And do you view yourself as more of an acquirer or an acquiree or?

We really don't comment on where we may find ourselves in that position at all. We continue to believe that our underlying operating results are very strong and solid, and we have not seen our size as a handicap.

Steven Schwartz with Raymond James Associates.

John, you mentioned an affiliation program at LSA. That was a little bit new news, I was wondering if you could talk about that -- what you're doing there.

Yes, actually Bob Dineen talked about this at the investors conference last year in November. Basically what we were trying to do is if you think of an interesting parallel is to think of a distribution -- retail distribution system that is similar to a healthcare entity -- and what we mean by that is if you are entering into a healthcare system, your particular care, Steven, shouldn't be in an ideal situation dependent upon the location of that healthcare facility. The doctors that make up that healthcare system should have the same practice protocol, the same approach to diagnostics and treatments that any other physician there should have.

Pulling that over into the LFA system, we believe that an LFA planner and her client in Salt Lake City, Utah and an LFA planner and his client in Orlando, Florida should have access to the same expertise and therefore be able to deliver a consistent, high-quality program and solution to their client base. LFA was previously -- you could think of it as 40 individual companies out there with the client experience being highly dependent upon which of the 40 local companies that client experience entered into. What Bob and his management team have been working on for the last better part of two years is transitioning Lincoln Financial Advisers to a single, national planning firm away from 40 individual, regional types of firms.

And to make the best intellectual capital available in LFA to any planner in LFA, not just the planners that happen to be located close by. And I think as I said, they are better part of two years into this process. As Fred indicated we are cautiously optimistic with where we stand today. We made major changes effective the first part of this year, and we just want to continue to see how things go through the remainder of this year.

Is it back office issues that might be causing a bit of the softness?

I am not quite sure what you mean by softness, what we have going on, Steven, is on the front office side the planner himself or herself -- we are giving them the opportunity to decide first what type of affiliation do they want with us. Do they want a high payout affiliation or do they want a payout affiliation that covers such things as real estate benefits, 401(k) plan participation. If you ask most planners -- if you ask most people they will say I want the high payout plus I want all the other stuff, too. And obviously you can't do that so for the first time we are giving our planners the choice as to what they want.

Then on the home office side what we are having to do is to take, as an example, the best advanced design people that may exist in perhaps Birmingham, Alabama and how do we make them available to somebody in Denver, Colorado? And there's a lot of work that has gone on this past couple of years to make sure that we have the right business flow and processes and compensation for people.

Bob Glasspiegel with Langen McAlleney.

I sort of share Colin's confusion a little bit on how the numbers work together on sales and distribution costs, but I guess I do trust that you guys really have thought this out and have a thoughtful approach to this. My confusion sort of in how the numbers play out is John, your opening speech indicated you couldn't have been happier with retail production companywide, retail deposits up 27% and domestic deposits up 7%. So you give an impression that you are hitting the ball out of the park on sales and when you get to Delaware, you clearly mention the great sales are a negative, but then when you get to LFD you say you're coming in a little bit below expectations because of weaker sales. And I appreciate there is perhaps a mix shift going on and you are spending money on development, but I guess if we could have some better sense on what you're investing, and sort of what sort of sales is good for LFD that would be helpful in thinking about how you're monitoring, how you're doing.

Bob in general for both LFD and LFA, the highest revenue producing sale for those legal entities as just looking at their own results themselves, are life insurance sales. They have the highest amount of revenue that comes through, and both of those operations LFD and LFA had a lag in life insurance sales. It was soft for both of them this period. We made a conscious decision that we were not going to chase the life insurance marketplace as we had indicated earlier. There was a lot of IOLI business that was up for grabs in the first quarter, and there was a fair amount of I'll say traditional Universal Life that was up for grabs if we wanted to alter our either risk bearing capacity or else our profit target levels. We could've done that, posted very strong life sales for the first quarter which I believe would have translated into a much better P&L picture for both LFD and LFA, but we decided that we weren't going to do that. And a dollar of mutual fund sales and a dollar of variable annuity sales does not provide as much revenue to either distribution company as that same dollar premium of life insurance held up.

Is it two or three to one, or what is the ratio just how should we think about it?

At the top of my head, have the answer to that. But it certainly is a multiple.

I think just some more disclosure on how much money you're investing, how much that’s hurting the P&L and sort of what the road map is over several year period would be helpful for us to get from Colin's position of confusion to sort of my position of trust.

We are very much in the process of putting that information together, Bob, so that we can see what it is, figure out the best ways of being able to communicate it. Another point that I would make when Fred noted the increase in the number of wholesalers that we have in kind of that lag period, a mutual fund sale can literally take place tomorrow if you are hired today. A life insurance sale isn't going to take place for months and months after the day that you're hired. And Fred indicated that we have gone a long way in hiring wholesalers and have been putting those wholesalers into channels where on the life insurance side, where they have not been previously placed before. So not only do you have an even bigger lag period because of the timing of life insurance versus investment products, but you have a bigger mismatch then between how much money you have to pay this wholesaler for their salary, their expenses, etc. with not just inadequate revenue coming in in that initial period, but in all likelihood zero revenue coming in.

One of the things we don't give a great deal of detail out on either in the call or in the form of say a statistical supplement is the kind of penetration success we are having within our key accounts. That would go I think a long way also to in addition to the numbers, speaking to the value of what we're trying to invest in, building out your marketshare within key distribution partners like Salomon Smith Barney and UBS, Merrill Lynch, A. G. Edwards, etc. Year-over-year progress on that front both measured by the number of products we sell in those distribution channels, the number of financial advisers we're now facing off against, the number of those financial advisers who sell multiple products are all metrics that we look at to make sure we're getting an appropriate return on the investment in LFD just beyond what you see in the pure segment results coming through corporate and other.

So we've got to do I think a better job of connecting the dots on that so you see how the money flows through. If you adjust 2004 retirement for example just speaking to their earnings for a second, for the level of prepays, make-wholes, investment partnership earnings, earnings on defaulted securities, a whole series of contingent interest in the first quarter this past year was another item. We had a series of investment related positives that if you iron out and come to a run rate you will see steady progress on run rate earnings and retirement, the result of adding significant flows in the expense assessments off those flows. So there is a marginal decline in return on assets, the result of having booked a lot of business and generating more DAC amortization. But progress on the core earnings of the Company continues to move very well in retirement.

Investment management you've got to work your way through dramatic flows on a relatively small base, and that is the big difference there. You're not building off a very large base of retail assets under management at Delaware; they stand at about 34 billion roughly in combine managed accounts and mutual funds. So you've got a couple of things at work there, you've got dramatic deposits built off of a small base, and you clearly have a scale issue where we are looking to build scale to try to push that EBITDA margin up. You also have scale at LFD where as you buildout new wholesalers we are not running enough product through those wholesalers. But again, we still think it is the appropriate investment given the buildup of the story. We will start doing a better job of connecting the dots for you so you will see the return on the investments we are making.

Eric Berg with Lehman Brothers.

I will apologize in advance. I lost the connection before, and I hope I don't ask a question that has already been asked if that is the case just tell me and we will move on to the next question and I'll ask my question privately. But it is just a quick couple ones. First, I still don't fully understand why in the retirement area, the addition of new assets should penalize earning. My question is really for Fred. I am thinking that you immediately begin booking the mortality and expense revenues. You defer the cost of getting the business and immediately begin amortizing the capitalized cost into earnings as an expense. That GAAP sort of takes care of everything, and that earnings should not be depressed by the addition of new assets. So maybe Fred, could you sort of elaborate on your answer to Colin?

Our absolute earnings are improving on a run rate basis that is when you pull out any unusual items from previous quarters. So they are improving. Example, for example year-over-year expense assessments are up from roughly 137 million in the quarter to 164 million in the quarter. DAC amortization is up, as I have mentioned, and up marginally more against those expense assessments than we've seen historically. For example, the DAC amortization was running, I think roughly 29% or so of expense assessments a year ago. That now up closer to 35%, and that accounts for the increase to DAC amortization or so-called K-factor that I am mentioning, but it doesn't mean that you're not building core earnings on an absolute basis. It means that the ROA is being compressed and frankly compressed in the sense of finding its way back to more traditional industry ROA levels.

Lincoln has enjoyed a greater return on assets than many of our competitors in the industry, the result of having an aged block of business where the DAC has been fully amortized. As we start to pour on new deposits and our ratio of new business to old business starts to shift, you will see that return on assets start to compress to more industry norms. That doesn't mean again that you have lost the buildup of earnings that come through additional assets under management.

Okay, I followed that and I thank you; that was helpful supplement. And I guess my second and final question would be why in the LFA would the choice that John referenced you're giving to your planners, the kind of employee with the associated benefits 401(k), pay for your real estate versus be more of an independent contractor -- why is that hurting sales of third-party products, which is what I think you referenced?

Overall, Eric, this first quarter is when we gave the planners the detailed information to help them decide what model makes most sense for them, and we also gave them information to show them how they would be compensated under the current model and how they would have been compensated last year. A truing up in some cases and in other cases a truing down. Any time you take an individual, a planner whose compensation is effectively 100% variable and you start giving them choices, they will spend a lot of time looking at what they should do. They will build their own models to decide what model makes most sense for the type of practice that they have. All the time that they are spending on an introspective basis, looking at their own business practice is time that is taken away from their new business activities. And we are fortunate in one sense from a Lincoln perspective that it hasn't hampered Lincoln sales that much or Lincoln product sales that much. It has hampered more nonaffiliated product sales, whether it is somebody else's mutual fund or whatever it might be.

Now from an LFG perspective as it looks at our product manufacturing whether it's Delaware products or Lincoln Life and retirement products, we are okay because our sales aren't necessarily being impacted. From an LFA perspective, however, as a broker-dealer everything that is being sold is running through the broker-dealer books, and if it's not being sold that is revenue that would have been there in a situation or in a time period that wouldn't have had this type of choice that's not there. And if you look at the general infrastructure that LFA has, that means some of that infrastructure isn't going to be covered the way that it would have been through that nonaffiliated share of GDC that would've been coming to them. Does that answer it?

This does conclude our question-and-answer session, and with that Ms. Brown I will turn the conference back over to you for any closing remarks.

Thank you all of you for your engaging questions both last evening and today. As always we will take your questions on our IR line at 800-237-2920 immediately following this call. Thank you, and have a great day.

And ladies and gentlemen this does conclude our conference call for today. We do appreciate your participation and you may disconnect at this time.