Lincoln National Corp (LNC) 2006 Q3 法說會逐字稿

Good morning, thank you for joining us for Lincoln Financial Group's third-quarter 2006 earnings conference call. (OPERATOR INSTRUCTIONS). Today's conference is being recorded and later we will announce the opportunity for questions, and instructions will be given at that time. (OPERATOR INSTRUCTIONS).

Before we begin, I have an opportunity to remind you about Lincoln's earnings release. Any comments made regarding future expectations, trends and market conditions, including such comments about premiums, deposits, expenses, purchase accounting, and income from operations, 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 filed with the SEC, 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, Mr. Jim Sjoreen. Mr. Sjoreen, please go ahead, sir.

Thank you. Good morning and welcome to Lincoln's third-quarter earnings call. You just heard the Safe Harbor cautions so I won't repeat them.

We appreciate your participation today and invite you to visit Lincoln's Website, lfg.com, where our statistical supplement and other pertinent information can be found. Before reconciliation of the non-GAAP measures used in the call, including income from operations, and return on equity to the most comparable GAAP measure, is provided in our press release and in the statistical supplement posted on the Website.

Now I would like to turn the call over to Jon Boscia, Lincoln's Chairman and CEO.

Thanks, Jim, and thanks to all of you for joining us this morning. I will be brief in my comments this morning in order to allow Dennis and Fred time to discuss all that happened in the quarter and because we will be meeting with many of you later next week, at our Investor Day conference here in Philadelphia.

What I do want to spend a few minutes on is to share with you what I am seeing as I look at the results and why I'm very excited about the underlying trends in our business.

As we announced last night, we continue to underscore the success we have experienced in integrating the two companies since we closed on the merger in April. The results also highlight the benefits we expected to achieve and are achieving by creating a more balanced, efficient, and more competitive enterprise.

As you review the results, we understand the need to make appropriate references to the two companies but we view the results as nothing less than concrete evidence that our employees and business partners know us as one company.

This is a subtle, but critically important point, particularly this early in the post merger integration. It is the fundamental reason why the integration has not interfered with our ability to grow the businesses. With that, let me share some observations on the quarter.

Our variable annuity business has been a core growth driver for the company for a number of years. We have successfully grabbed market share in a variety of equity markets and competitive conditions, and this quarter was no different. Based on preliminary VARDS data, we exceeded market growth rates for both year-over-year and sequential quarter deposits. Our absolute deposit volume may expand and contract with the market, but to the extent we can outpace market growth rates, and gain share on a routine basis, this is clearly the goal we aim to achieve.

More importantly, we have accomplished market share gains with a product portfolio that has remained true to our goal of aligning markets, product, and distribution while several competitors have sought to grab share through features alone. That speaks directly to several important points.

First, our products are serving the needs of our distributors and their clients. Good design yields a sustainable competitive advantage.

Second, there's no substitute for a high-quality distribution platform that has both scale and a clearly articulated value proposition that attracts and retains talent who meet the needs of the client.

Third, dedicated, high performing employees operating in an efficient and focused environment are key to our success, and the merger has enhanced our workforce at all levels and in all locations.

In our Individual Life business, which represents over a third of our year-to-date operating earnings, the formula for success is the same about the market dynamics are different. The commoditization of universal life has put pressure on returns, and in turn, sales. We have been encouraged by the brief but emerging trend we are seeing in life sales. Life sales are up sequentially over the last three quarters. In addition, this recent sales trend is in advance of what is historically the strongest quarter of the year.

This has been accomplished through a distribution expansion and refocused efforts on how we process the business and serve the client. For example, we have introduced a streamlined underwriting process for our MoneyGuard business that has reduced the time to issue a policy by as much as six weeks. So as I said, an encouraging trend that has me very excited about how the merger is reshaping our Life Insurance business.

Regarding our Employer Markets segment, I spent a fair amount of time last quarter describing the structure, the products and the markets of the business. It has only been six months since we formally established the segment, so we're still in the investment phase of building out distribution, integrating the technology platforms, and creating a strategy around the alignment of products and distribution in this space.

Wes Thompson will go into more detail on this next week at the Investor Day conference and you'll gain an appreciation of the excitement that is building around this business.

The passage of the Pension Protection Act of 2006 underscores our excitement about what we already believed would be one of the largest growth opportunities for the industry and particularly Lincoln. We had good, solid results in the third quarter and look forward to this business gaining momentum in 2007 and beyond.

Our Investment Management business posted another strong quarter of deposits, flows, and earnings. As you know, we have been discussing the situation around the closing of three popular products in order to maintain the investment philosophy and discipline that is needed to deliver on a commitment to the clients. It is a good problem to have, and one that we're transitioning through in a deliberate and patient manner. The international ADR and large cap growth managed account and institutional products accounted for a drop of slightly over $2 billion in net flows from the prior-year quarter so it will take time to replace that level of production.

Now let me turn it over to Dennis to discuss production and other highlights.

Thanks. Let me start with the individual markets annuities section. In the third quarter, we continued strong year-over-year deposit growth in the individual markets annuity segment. Total deposits of $2.7 million were up 23% over the prior quarter, on a combined basis, driven by double-digit increases in all product categories. Total net annuity flows of $304 million were down from the prior quarter, but this is a development specifically attributable to our fixed business, and I will touch on that in just a moment.

Variable annuity sales of $2.2 billion increased 18% over the prior quarter, with the wire, independent planner and bank channels all posting healthy gains over the third quarter 2005. Variable annuity net flows also posted strong double-digit growth, coming in at slightly over $1 billion, a 20% increase over the prior-year quarter.

Turning to fixed annuities, third-quarter deposits of $502 million were up sequentially and over the prior-year quarter. The interest rates in the third quarter, although down somewhat from second-quarter levels, remained attractive on a relative basis and we have seen some of that momentum carry over into October. As I just mentioned, total net flows were reduced by fixed annuity outflows, specifically in our multi-year guaranteed products. A large factor driving the high lapse rates that we are seeing is the comparatively low interest rate environment of today. This results in a lower reset option crediting rate compared to the current rate, making the product appear less attractive to the client.

Approximately $1.5 billion net of reinsurance of this business has matured in 2006, including nearly $800 million that matured in third quarter. About $1.5 billion, net of reinsurance, of this business will mature over the next five quarters, including $504 million net of reinsurance in the fourth quarter. Based upon current experience, we would expect to see 60% to 70% of the maturing business lapse.

Mitigating the effect of these outflows is the record sales level achieved during the past quarter. We are selling some low return assets to fund outflows and in general taking appropriate steps to manage the impact of these outflows on our asset and earnings growth.

We continue to have success in expanding our annuity distribution platform with the key addition of Morgan Stanley and Wells Fargo for VAs, during the third quarter, and the addition of the indexed annuity product at Wachovia, scheduled for introduction in the first quarter of '07.

At Morgan Stanley, we saw $30 million of VA deposits in the first seven weeks after introduction, demonstrating the acceptance of our product and effectiveness of our wholesalers. We also launched three additional VA products with specific distribution partners during the quarter.

Let me turn to individual markets. Life in our individual Life Insurance business, total sales of just under $153 million were flat with the year-ago quarter. As Jon mentioned, we have seen an improving trend in life sales with third-quarter sales up almost 15% sequentially over the prior quarter, and second-quarter sales up 10% over the first quarter. This growth is due in large part to increased wholesaling averages in major MGA firms and we are also benefiting from improved operational efficiencies in our new business and underwriting departments. Also, although we're not scheduled to launch our unified life product portfolio until early 2007, we continue to update our existing product suites and focus additional resources on key products.

Progress is also being made in our retail distribution network, Lincoln Financial Network, focusing on combining the pre-merger distribution groups and creating an exciting retail value proposition to grow this distribution. Retail distribution supports the sale of all Lincoln manufactured products.

Expansion of LFD remains a key objective to support all of our individual market businesses. At the end of the third quarter, internal and external wholesalers totaled 463, up 21 since the end of the last quarter. Wholesaler expansion occurred in our MoneyGuard, annuity and investment product lines. Also at quarter end, over 50% of our wholesalers had two or more years with Lincoln and 75% with one or two years of service. We're planning further significant wholesaler expansion to support our individual market business growth.

Let me turn to the Employer Markets division. Deposits in our defined contribution segment of approximately $1.1 billion were up 8% over the prior year and up 6% sequentially, after adjusting for the transfer of the Jefferson Pilot 401(k) plan in the second quarter in the amount of $130 million. Sales and defined contribution segment will typically not follow a smooth trend line, with the first and fourth quarters generally being the strongest due to enrollment cycles, so there will be an element of lumpiness in our sales results.

As mentioned on our call last quarter, we expect Alliance, a mutual fund based product targeting middle to larger healthcare systems and corporations and Director, a small case 401(k) product serving small privately-owned businesses, to be our growth engines for our defined contribution business.

On a sequential basis, the growth in deposits was primarily in these two products. In the third quarter, we benefited from a 13% increase in deposits into our Alliance program, a result of closing several new plans in the quarter. The current successes are a result of the momentum that has been building with the newly organized sales team.

Director sales, again excluding the onetime J.P. deposit, were also slightly higher in the quarter, 2% above the second quarter. We are currently in the process of increasing our wholesaling force to expand our market share in the small case 401(k) market with this product.

In addition to wholesaler expansion, we have rather expanded our presence in the micro to small 401(k) market with the introduction of a new product in the third quarter, the Lincoln American Legacy Retirement product, a multi manager group variable annuity 401(k) product, which successfully launched in September. We have had a team of wholesalers solely dedicated to distributing the product through wire houses, regional broker-dealers, a select group of independent planning firms and banks.

Group Protection, formally identified as Benefit Partners, posted another strong quarter from an earnings perspective, but sales on a year-over-year comparative basis for the quarter were down in disability and dental and essentially flat for life. We continue to see weak industry sales, especially on disability, and that trend is more pronounced in the larger case market. As our disability loss experience has improved, we have moderated some of the pricing actions increases taken last year and are optimistic about resuming profitable sales growth as the overall market recovers.

Moving on to investment management. For the quarter, total deposits in the Investment Management segment were $4.9 billion, with net flows contributing $700 million to assets under management. Earlier in the call, Jon mentioned that we are transitioning through the closing of our popular international AD and large cap growth managed account products, which closed in the first half of the year. Deposits and flows in our retail business have been impacted, but despite these closings, we had ample capacity to gain assets with other equity offerings, including our large cap value, international value equity, and small cap core investment styles. Posting a strong one-year track record, our in-house, international value equity team now offers an alternative to the closed sub-advised international ADR product.

In addition, in September, we hired an emerging markets team, which will also provide room for future growth. Finally, fixed-income opportunities are positive as well, with several final proposal opportunities underway.

Asset class diversity is a key to maintaining our strong momentum. We continue to see a good balance of new institutional fundings across both equity and fixed income styles. So far this year, we have had 66 new institutional mandates across 14 asset styles. Investment performance, a key to keeping client assets, remained strong. For the one, three and five-year periods, at least 70% of Delaware's mutual funds were in the top half of their Lipper category. In addition, institutional investment performance continued to perform at strong levels, consistent with prior quarters.

This briefly covers the major points related to our Investment Management, employer and individual market businesses, and distribution efforts and initiatives. The integration activities are running in parallel, are getting done effectively, and importantly, as Jon has said, are not interfering with our progress and focus on profitably growing the businesses.

Let me now turn it over to Fred to discuss our earnings in the period.

Thanks, Dennis. Yesterday, Lincoln reported third-quarter net income of $364.1 million or up for $1.29 per diluted share. And income from operations of $371.1 million, or $1.31 per diluted share. Operating return on equity for the quarter was 13%.

Stepping back from the quarter and excluding special items, earnings continued to build and the formula continues to be the same - -robust asset gathering, steady life production, and expense management. We are seeing margin improvement in our businesses driven by operating leverage and productivity gains across our distribution platforms. Recognizing the impact the merger has had on financial results, I will focus my earnings commentary on sequential trends from the second quarter of 2006, with a few year-over-year observations.

Let me start by giving a little color on some of the larger special items we detailed in this quarter's press release. I will get more specific as to their financial impact in my segment comments.

Starting with favorable items, this quarter's results include a tax benefit related to our dividends received deduction. This is the result of truing up our 2005 tax liability and 2006 effective tax rate to recognize the deduction. The true-up comes as a result of more detailed year-end information supplied by the funds underlying our separate account products, as we prepared our 2005 tax returns. The majority of this benefit was reported in the individual annuities segment with a more modest impact in our defined contribution businesses.

The quarter also included the insurance recovery we previously disclosed related to past mis-selling claims in our UK operation, and was recorded in other operations. Finally, we experienced another quarter of better than expected loss ratios in our Group Protection business.

These positive items were offset by the net negative impact from our third-quarter prospective DAC assumption review. The prospective unlocking exercise is the result of updating our product experience studies and our best estimate assumptions used in the amortization of deferred acquisition costs or DAC under FAS 97. Major assumptions influencing our estimated future gross profits include persistency, mortality, expenses, default assumptions, equity market returns, and interest rates. The most significant and negative impact from the unlocking took place in our Life Insurance business, where we adjusted our long-term interest rate assumption.

Individual annuities and Employer Markets had largely offsetting adjustments with overall prospective retrospective unlocking having little impact to earnings for these segments.

In the quarter, we also experienced a loss in our hedge fund portfolio attributed to an investment in the AmRamp Partners hedge fund and recorded in our individual life segment. We have less than 1% of our general account in alternative investments, which can the volatile at times. These investments have paid off handsomely in the past and we expect they will continue to do so in the future.

There were a number of more modest and largely offsetting items in the quarter. Concentrations include better than expected investment income and VA hedge results, offset by increases in incentive compensation accruals, the result of strong earnings and sales results through the third quarter.

Before moving into the segments, I want to highlight a merger related change that this quarter to harmonize the Lincoln and Jefferson Pilot default charge methodology. During the third quarter and somewhat coupled with our unlocking exercise, we harmonized our default charge assumptions and methodology. Specific to the methodology, Jefferson Pilot incorporated an inter-company charge whereby the insurance businesses paid a default charge to corporate in exchange for corporate absorbing actual default experience in a given reporting period.

In the third quarter, we adopted Lincoln's historical approach and adjusted the former J.P. product lines accordingly. This change has essentially no impact on overall earnings, but from a reporting standpoint, results in an increase in investment income realized by the business units, offset by a light reduction in income reported in other operations. This change also has an impact on spreads, which I will point out during my segment overview.

Let me share with you more detail on these items and our earnings drivers, starting with individual annuities. Third quarter income from operations for the individual annuities segment was $129.4 million versus $89 million for the second quarter. The quarter included a $27 million positive tax benefit from truing up the DRD and a $2 million favorable impact from our variable annuity hedge program. Excess investment income in the period was largely offset by a true-up of incentive compensation accruals.

Focusing on key earnings drivers, I will start with account value growth. Variable annuity account values grew 25% over the previous year's balances, driving a 28% increase in expense assessment revenue. Sequentially, expense assessment revenue grew 4% over the second quarter's results, fueled by over $2 billion in variable account value growth in the quarter. This is the result of positive flows and favorable markets.

The hedge program performed very well with results coming in above our expectations, contributing approximately $2 million to earnings, after-tax and DAC in the quarter.

We reported spreads on our fixed annuity business of 211 basis points for the quarter. The adoption of our new default charge methodology had a 9 basis point positive impact on spreads, and a $2 million positive impact on the segment's results, now part of ongoing earnings.

Prepayment income added about 7 basis points to spreads in addition to other favorable investment income. Spreads also benefited from expiring high crediting rate annuities rolling off our books. Normalizing for excess income, spreads came in at about 200 basis points and are representative of what we would expect to see in the coming quarters.

As Dennis noted during his comments, we're diligently managing our fixed annuity negative flows. From an earnings perspective, we have been defending our margins through a combination of investment strategies and careful management of cash flows. As we finish out the year and move into 2007, we expect a modest reduction in spread margin, the result of a drop in fixed annuity values partially offset by wider spreads on the remaining block.

General and administrative expenses were up in the quarter, the result of a true-up of incentive compensation accruals and hitting distribution bonus breakpoints on production, given the strength of our results.

Our outlook for this business remains unchanged. We would expect continued, uninterrupted performance in VA deposit and flows, supporting continued expense assessment growth, while fixed annuity net outflows will apply pressure to any fixed investment margin growth. We expect expenses to improve as we move into the fourth quarter.

Individual Life Insurance income from operations was $122.8 million in the quarter, compared to $147 million in the second quarter of 2006. The third quarter was negatively impacted by our prospective DAC assumption review. The prospective unlocking resulted in an $18 million reduction in earnings. However, this was partially offset by approximately $5 million of positive retrospective unlocking in the quarter.

As noted, we realized a loss of about $8 million from our investment in AmRamp Partners hedge fund. Partially offsetting the hedge fund loss in the quarter was favorable prepayment and make-whole income of about $4 million. Other miscellaneous income items in the quarter were largely offset by expense true-up's. Of note, the second quarter included approximately $10 million of favorable items, related to investments and positive unlocking.

In terms of earnings drivers in our life segment, the face amount continued its steady growth increasing about 5% and account values grew 6% as compared to the pro forma combined levels in the 2005 third quarter.

Our mortality margin was down modestly as compared to the second quarter, due to weak mortality results on select larger policies.

Reported spreads in the life business were 157 basis points. The hedge fund loss impacted spreads by 22 basis points, partially offset by better than expected prepayment income of approximately 11 basis points. The change in default methodology contributed approximately 10 basis points to spreads, and $3 million to the segment's earnings, this change now part of our ongoing earnings.

We would expect spreads to return to their normal levels in the mid to high 160 basis point range as we look ahead to the fourth quarter.

General and administrative expenses were up, a similar story to our annuities segment, the result of truing up incentive compensation accruals and production bonuses flowing back from LFD.

Our outlook for this segment remains stable with face amount in force and account value growing in the mid single digits, spreads stable, and expenses benefiting from integration initiatives.

Turning to our Employer Markets division, I will start with the defined contribution business. Third-quarter income from operations was $52.5 million, this down from $54 million in the second quarter, which benefited from positive investment results. The third quarter included a number of offsetting items that when totaled had an approximate net $4 million positive impact, the primary contributor being the DRD adjustment. As we pointed out in the press release, we have steady year-over-year growth in earnings when adjusting last year's results for a positive $12 million after-tax DAC unlocking.

Turning to key earnings drivers, expense assessments increased 4% in the quarter over the same period in 2005, the result of year-over-year increase in variable account value of roughly $1 million. Fixed investment margin and expense management also contributed to the year-over-year growth in earnings.

Spreads in our fixed business came in around 252 basis points after adjusting for excess investment income. The reported spreads included about 10 basis points of excess investment yields. We would expect to increase crediting rates in the fourth quarter by 10 basis points on our largest fixed block, resulting in roughly a 4 to 5 basis point spread compression in future quarters.

The Executive Benefits subsegment, our pension, COLI and BOLI business, reported income from operations of $12.1 million, down from $16 million reported in the second quarter. As with Employer Markets overall, this is a new subsegment of reporting for the company post-merger. Our COLI and BOLI businesses are stable but the second-quarter results in our pension runoff line included approximately $3 million of favorable mortality. We would expect this segment to generate earnings more in line with our third-quarter results going forward.

For the third quarter, our Group Protection business reported income from operations of $28.8 million, down from $37 million reported in the second quarter. Our Group Protection business experienced another quarter of favorable non-medical loss ratios, although not as favorable as the second quarter. The consolidated non-medical loss ratio of 68.4% included favorable results across all major product lines. Long-term disability, in particular, loss ratios benefited from continued positive incidents, and claim termination experience and favorable Social Security offset activity. We estimate the better than expected loss ratios translated into about $5 million positive to earnings. We would not expect these several loss ratios to be sustainable and are holding to our guidance in the low 70% range.

Investment Management reported income from operations of $13.4 million for the quarter, compared to $12 million for the second quarter. There were a number of small offsetting items in the quarter that resulted in a net $1 million negative impact to earnings. Sequential improvement in the quarter's earnings was the result of over $3 billion of third-party account value growth, driving growth in fee revenue, while operating expenses were up more modestly. Account value and revenue growth are the result of positive flows in the quarter, and favorable markets.

Based on our internal forecast, we expect Delaware earnings for the fourth quarter to be in the $14 to $15 million range, absent a material change in the market.

Turning to Lincoln UK, operating earnings in the quarter of $8.3 million were slightly below expectations, the result of net negative prospective unlocking having a $3 million impact on the quarter's results. For the fourth quarter, our forecast is for income from operations in the $10 million range.

Lincoln Financial Media income from operations was $14.6 million in the third quarter, compared to $11.9 million in the second quarter. Adjusting for purchase accounting and option expensing, earnings were up 9% as compared to last year's third quarter as reported by Jefferson Pilot.

While broadcast cash flow remained stable, we continued to experience weakness in our auto industry, national and local advertising revenue, and political ad revenue has not been as robust as we expected in our major locations.

For the fourth quarter, our forecast is for income from operations in the 14 to $15 million range.

Other operations recorded an operating loss for the third quarter of $11.5 million versus an operating loss of $26 million in the second quarter. The third quarter's results included income of $17 million from the UK insurance recovery, offset by $4 million of expense related compensation accruals. The segment's results were negatively impacted by approximately $8 million from harmonizing the default charge methodology, now part of this segment's ongoing earnings. Again, the default methodology, having no impact on enterprise earnings in the period.

We recognized $13 million of pretax restructuring charges and other merger-related expenses, having a $9 million after-tax impact on operating earnings. This was modestly lower than what we expected and due to simple timing issues. For the fourth quarter 2006, we expect the combination of restructuring and other merger expenses to be in the range of $20 million pretax.

We continue to make good progress towards our goal of $180 million in pretax run rate savings by the third anniversary of our merger. A review of integration savings in the third quarter and our merger to date realized savings tells us we're comfortably on track to achieve our year one run rate savings of $90 million. I will be discussing expense trends in our businesses briefly at our investor conference.

On an adjusted basis, that is adjusting for growth and extraordinary expense items, we are seeing positive trends in expense ratios across the Company.

Turning to capital management, we repurchased 6.3 million shares in the quarter, the combination of closing out our second-quarter ASR and delivery of 5.5 million shares under a $350 million accelerated stock repurchase program executed upon in the third quarter.

We closed out this ASR during the month of October and took delivery of another 181,000 shares.

Looking at the remainder of 2006, we expect to conduct another $150 million stock repurchase process, executing another ASR in the next few weeks. This will conclude our repurchase plans for 2006, having repurchased $500 million in common stock over and above the $500 million repurchase executed at the time of closing our merger.

Our plans for 2007 have not changed. Absent other more compelling opportunities for excess capital, we would expect to repurchase approximately $500 million of stock next year.

After-tax interest expense for the period was $44 million, in line with the post-merger guidance we provided last quarter.

With that, I will turn the call over to our operator for Q&A.

(OPERATOR INSTRUCTIONS). Eric Berg, Lehman Brothers.

I will of course limit myself to two questions as you have asked. First, in the Life Insurance area, while I certainly heard and am aware of and am enthusiastic about the sequential quarter improvement in sales, you seem to be gathering momentum. The revenue line seems sort of stuck. I guess my question is if you're selling insurance, maybe not as much as last year, but more than in the June quarter, if the in-force is growing, why don't we see some improvement in revenues?

And then on the Employer Markets area, I would like to return to a question and ask it again to what -- or to whomever it would be appropriate. While I understand that your sales -- your deposits are strong, I think we can agree that this business is not about deposits but about what you keep, the net flows, and my question is, as it was in the June quarter, what would be a reasonable time table to start seeing meaningful net flows and by meaningful I mean meaningful relative to your existing roughly $30 billion asset base? Thank you.

I think on the revenue side, while we have continued some sales momentum, and we are seeing some modest growth in our in-force and our net amount at risk and account value, on a sequential basis, we have not moved revenue up quite as aggressively. And I think that is largely the result of some modest increase in crediting rates on some of the business that is having a little bit of a squeeze on account margins. But I think sequential comparisons are a little bit difficult given the overall size of our in-force block. I think as we look at the business going forward and if we can continue on these kinds of sales patterns, we should see a little better lift on the revenue side going forward. But your observation is correct. Right now we're not seeing very bullish growth on the revenue side.

You also have, I might add, some impact related to some of the DAC unlocking, in that you'll have some of that impacting expense assessment line items as well. You're seeing a little bit of that come through and I think going forward we will see a little bit of improvement.

That helps. And on the Employer Markets side.

This is Dennis. As you have heard us say in both the first -- the second quarter and third quarter, we have refocused in this business segment the defined contribution business. As I just said a couple of minutes ago, we've introduced a new product. We're expanding our wholesaler activity, and that is producing improved results.

My guess is that we will see significantly better results developing in the first half of next year, but the amount of that is yet to be seen. We're very confident that this will be a growth business. We're very confident that the products associated with Lincoln American legacy, the product that I mentioned, the system improvements that we're making, distribution improvements that we're making, will add up to strong growth, particularly in the market that we're focusing on.

Thanks very much for both of those helpful answers.

Andrew Kligerman, UBS.

A question around the individual life area per the stat supplement. You have roughly an ROE of 8, 8.5 in the past two quarters. I assume the unusuals put it at 6.8 this quarter. You are looking at a run rate around 8.5. The question is -- you mentioned tough competition. What ROE is that allowing for? And then in terms of getting the expense improvement, what is the interplay between expense improvement, the competitions allowing you to get what ROE on a product stand-alone basis and where does the ROE settle out? The follow-up question is just simply the capacity constraint, does that also include the large cap growth business in the United States?

I'm trying to pick out the questions in that (multiple speakers). Let me start with the --

Sure.

Let me start with the last one, which is in our investment businesses. We touched on a couple of the fund closings but let me come back specifically to where we have opportunities. We have room to grow in our large cap value international equity and small cap core products. And in total, those have $29 billion in remaining capacity. So very good opportunities for growth there. We did say that we have replaced the international ADR product with a new team and that team now offers an alternative ADR product so we could see -- resume growth there. And again, we mentioned the hiring of the portfolio manager to build -- that we did last quarter -- to build an emerging market equity team to add depth. I will also say that we're refocusing our wholesaler efforts; we have added a few wholesalers, but we are refocusing on the specific products that are performing well and have adequate capacity.

Could you restate your question --?

I might take it a little bit just on the ROE's. A couple of things to obviously point out about the life business is that the combination of really historical Lincoln results that is pre-merger results, as well as of course related to the merger, we added a significant amount of allocated goodwill to the life segment in general and so that serves to depress those returns in general by better than a couple of 100 basis points, if not approaching more than that, upwards of 300 to as much as 400 basis points. It is a significant amount of goodwill allocation to that line, which depresses the overall returns.

Beyond that, your question was also a little bit about what returns you would expect to achieve in the business and we have been saying for quite some time that it is realistic to be achieving returns in that, sort of that 12, 13% range, right in that territory. North of cost of capital, which is certainly favorable, not quite as high as what you would find in certainly some of our other variable businesses.

And as it relates to expense assessment, and frankly the merger and integration, that is really the key to dialing in the achievement of better returns. And that is the degree to which we can be successful on the integration and continue to make progress on taking expenses out of our platform, much of which relates to the life business as you can imagine given the two large life companies. That is a piece of the puzzle to driving better returns.

Just lastly, just the competitive dynamic, what was it that you were citing earlier that is really putting pressure on sales right now? Is it IOLI? Is it something else? What is the dynamic there?

It is Dennis. The IOLI/SOLI product group was an industry issue last year. Both old Lincoln and old JP had sales in that product category or in that market segment. Both organizations and now Lincoln is not accepting that business. In a sense, we have taken a product that contributed last year significantly to the sales results, out of the mix, and despite that, we are seeing good growth in the business on a sequential basis and again, replacing that product sales last year were on a -- about flat.

The competitive pressures are consistent in this business. There's a lot of players in the business. The distribution is difficult because of the nature of what is selling mostly in the marketplace today, which is the secondary guaranteed product. But I wouldn't say that the pressure is any more significant this quarter than it was the prior quarter. And coming back to what Fred said, we're pricing the product appropriately. We're generally inside of our allowables, so achieving our expectations. And we have good hope for this or expectations out of the life business.

That new manager on the international ADR -- without them having the actual track record themselves, do you think that significant funds are going to flow into that or is it going to take a few years for them to individually get recognized?

This is Jon. On our international ADR product, we do have a very good one-year track record. That is going to help us on the institutional flows and new business opportunities, because institutional responds more quickly as we have said throughout the last couple of years than retail. But what we are seeing across all of our mutual funds, as an example, if I look at July, August, September and October, we have month-over-month sequential sales growth gains in each of those months. We really seeing that traction in our broader mutual fund portfolio offerings taken hold now.

Colin Devine, Citigroup.

I guess I really have two. The first one, just if you could expand a little bit on the new American Legacy retirement product in terms of describing what the product is and then who you are marketing to. And then you really get to the guts of my second question.

Jon, if I take your 13% ROE target for the fourth quarter of next year, my calculations get Lincoln pretty close to about a $6 a share run rate. To get that means Dennis has to come through clearly on the expense saves and a lot of the back office integration. If I look back at Lincoln's acquisitions from the past, I don't think it is unfair to say that off the Cigna and Aetna deals, while you certainly achieved the top-line growth, the fact that Lincoln is still running 16 different policy administration systems would tell me that the back office was never really put together.

How is it going to be different this time, because it certainly seems to me that some of the restructuring we are seeing now really has little to do with JP. is stuff really from before. And how are you also with that adjusting the compensation goals, or programs, if you like, for people such as Wes Thompson, for Terry Mullen, to get the focus a little less on the top line in sales, and really now starting to drive the bottom line so you can get Lincoln's policy admin expense ratios -- its policy -- processing ratios -- down to the very superior levels that Jefferson Pilot enjoyed?

Let me take a couple of those here, Colin. First the American Legacy -- or the Lincoln American Legacy Retirement product is a 401(k) product that features all of the American Funds AFIS funds as the core product offering, fund offering, inside of it, supplemented by Delaware Funds and other sub advised funds out there. We believe, and early indications support this, that it is going to be received very well in the marketplace because it will be or is the only 401(k) product out there that has all of American Funds' funds embedded in it rather than just some select ones. We know how the marketplace feels about American Funds. We will be taking this eventually through all of our channels. Initial concentrations will be in the wire regional, but we intend on expanding it to the independent planner as well as the bank channel as we go through time.

The questions about the integration efforts, you're right, Dennis has to deliver on it. I'm 100% confident that Dennis will deliver on the savings.

In terms of some of the things that we're looking at right now, whenever you have an integration and you have multiple investment platforms, I'm sorry -- multiple administrative platforms -- you always have to look at the trade-offs between what are the expenses of shutting one down, moving into the other, against your run rate going forward there.

We have at Lincoln, after the Cigna and Aetna integrations, we had outsourced some of those administrative -- the administration of some of those systems. When you're outsourcing it, it doesn't make a lot of sense necessarily to go and shut them down and go through that expense of moving them in because you've got good expense ratios coming out of those outsourcing arrangements. Unlike the Aetna and Cigna transactions, Jefferson Pilot presents us with an opportunity to have best-in-breed administration. It changes the dynamic of what we would be looking at and how we would be undergoing that consolidation.

We have, to your point on incentive compensation, we have in the business lines specific targets associated with expense saves. Those expense saves are largely driven by technology and the facilitation of it. And each of the business lines have their own unique objectives that they will be measured against and compensated accordingly.

People like Terry Mullen in the LFD organization, I prefer to keep them heavily focused on the top line. And in the business manufacturing areas, in the shared services, keep them focused on profitability and integration expense saves and that is the way our current plans have been designed.

Tom Gallagher, Credit Suisse.

First question is on -- basically I guess the revenue shifts that were done between the other ops and the business lines based on the change in default methodology. Fred, I just want to understand I have the numbers right. When I look at apples-to-apples fixed annuity spreads, you said that changed -- added 9 basis points to your spreads?

That is correct.

Does that imply then X the change, your spreads still went up about 20 basis points sequentially?

(multiple speakers) annuities?

Yes. I think I can walk you through it if it's helpful. We announced adjusted spreads last quarter. That is normalized for unusual items of about 183 basis points. On top of that is the 9 basis point change from the default methodology, which would bring you to around 193 or so basis points.

In addition to that, though, we are seeing some widening in the spreads related to the run-off, if you will, of the high crediting rate fixed annuities. As that high crediting rate -- some of the crediting rates on these multiyear fixed annuities are in the low 5% range, just to give you an idea of how high we're talking about. So as those roll off, you do have a natural widening of your spreads, which is contributing to that. That is where in general I come down to thinking in terms of around 200 basis points going forward.

The actual after-tax earnings that are getting shifted out of other ops to the segment, did you say that was $8 million after-tax?

Yes. Essentially the way to think about it is you've got a reduction of revenue in the corporate and other line of about $8 million and you've got a pick-up in the insurance businesses and I think it was roughly $3 million give or take pick-up in both the annuities and life area. There are other insurance businesses that were impacted, but on an after-tax basis, not really worth diving into in terms of affecting their results.

So the $8 million, most of that is going to go, be split between individual annuities and Life Insurance?

That is correct. I point it out there because that is where it has a more meaningful impact on how you think about spreads. And it is a bigger enough number to have that incorporated in your future run rate under expectations.

Last question is -- I guess just overall about the universal life market, we heard from a competitor, Genworth, that they are in the process of completing their AXXX securitization. Just curious if we should expect to see something similar from you by let's say early '07 and whether you think this will result in possibly further price declines in the market or how you think that is going to effect the market competitively?

I think capital management on the life side, which includes how you go about the business of financing redundant reserves, will indeed play into the competitive landscape, just as it has played into a bit of the term life landscape in past years. Our plan is fairly straightforward and I'm going to cover it in some more detail during our investor conference next week. But we wanted to first and foremost wait until after we heard the interim solution make its way through the process, which has an impact on what really you're talking about in sizing the redundancy. Once seeing that, make it through the process and having an improved effect, if you will, on the level of redundant reserves, we're now in a better position to dial in longer-term solutions. Currently we finance much of this through letters of credit. We also, frankly, hold a fair amount of redundant reserves on the balance sheet.

Long-term strategies we're reviewing include long dated letters of credit, which are sort of synthetic letters of credit that are a bit more expensive but also go out beyond 10 years. And we're also looking at full-scale securitization along the lines of what was announced from one of our competitors.

Those activities are underway. And I would expect that we would indeed execute on a longer-term solution in 2007. Difficult for me to pin down precisely the quarter and the time, but we are working on it actively as we speak.

Jimmy Bhullar, JP Morgan.

I just have a question on your group benefits business. I think sales this quarter were down about 13%. If you can just discuss the trends within each of the specific products, disability, life and dental, and then what your outlook is for sales and why your sales have been weak, and I think you mentioned -- Dennis mentioned that you were lowering rates on disability. I just wanted to make sure that I heard that right.

Let me talk about the general sales trend, which is down. The protection business, about four quarters ago, was experiencing some pretty high loss ratios, particularly in the LTD business, both large case and small case.

So some fairly aggressive pricing actions were taken at the time. We, in the last six months or so, as our loss experience, again, particularly in LTD, both small and large cases, improved, we were able to relax somewhat some of those price increases. We think that is part of the change that will help us with the resumption of top-line growth.

Were sales down this time across all products or was there one product that actually drove the overall decline?

I don't have that in front of me. Paul, do you have the answer to that please?

Yes. The sales were down principally in disability and dental. Life was relatively flat on a year-over-year basis. You have to look to JP's comparable quarters because there is lumpiness in Group Protection sales throughout the year.

Darin Arita, Deutsche Bank.

I was hoping that you could give us an update on your ROE goals for the individual annuities segment. Similar to the individual life segment, it seems like it has been impacted by intangibles. Where do you think that could go over time?

Talking about individual annuity returns -- obviously returns in that business, as you have pointed out, while impacted to some degree by some allocation of goodwill, are -- tend to be more in the midteens. That in general is what we expect when we are pricing out our products.

We have seen though margin expansion in individual annuities and it is really the result of a number of things. Certainly you're seeing some of the productivity improvements coming through the strength in VA sales come back in through now allocating distribution expenses back into the business units so that has been a lift.

You're also seeing that as our gross profitability improves, with increased revenues from the new riders that we attach to product, plus also underlying performance and the separate accounts that back our variable annuities, as these expected gross profits improve, you also have a regular retrospective unlocking that is taking place. Markets certainly help that as well. And overall that improves what is known as your k-factor, and, therefore, your DAC amortization patterns going forward come down and start to expand your margin.

You also have the DRD impact, which we have talked about, which has an ongoing impact because we've adjusted our estimates for that deduction going forward too.

So you've got the combination of scale, that is as we continue to grow assets under management we are obviously building operating leverage. You've got distribution productivity benefits coming through, and then you've got more technical, I would characterize it, as accounting benefits related to DAC amortization but they are real. They are the result of expansion of gross profits. So all those things are trending positively for returns in the business. We don't give specific ROE guidance or projections on the business but we certainly remain positive about the direction of our returns in that segment.

Great. Turning to your thoughts on acquisitions, could you remind us what your philosophy is there and in particular for the Investment Management business?

On the acquisition front, what we strive to do through any acquisition is to put us in a position where it will help take the growth trajectory curve that we have to a more favorable situation. As we look at the businesses that we're in right now, and again, I'm sure this will come up in more detail next week on our Investor Day, but as I look at the businesses that we're in right now, we feel very good about our scale, either in business in-force or our distribution capabilities, and everything with two exceptions.

One is clearly our retail investment management business, would like to have that be a larger scale business than we have right now. And we would also like to be able to take the defined contribution business to a higher level. Those would be two areas that would have appeal to us.

Investment Management is not the easiest of businesses to integrate for reasons you all know every bit as much as I do. But it still would remain an area that we would have interest.

Saul Martinez, Bear Stearns.

Good afternoon now. A couple of questions? Could we drill down a little bit more on the update on the integration efforts. It sounds like the wholesale retention has been good but can you give us a little bit more color on where you are on systems consolidation and if you can give us the specific number for where you are in terms of merger to date cost saves. Second question is a related question -- very specific timing of integration costs. Fred, do we still expect those costs to be over with by 2008?

Why don't I hit your expense questions first. This is Fred. We do, as you know, track very, very carefully, very specifically on a line item by line item basis where we are achieving and what we are achieving in the way of expense saves across all our major businesses. We track it on a realized basis and a run rate basis. Looking at the second quarter, we continued the positive trend of realized savings in the quarter of a bit north of $20 million realized in the quarter, which converted to a run rate savings trajectory of just shy of $90 million. My comments were that we're on track and we continue to be confident in hitting our first anniversary run rate savings and it is those realized tracking tools that give me that confidence.

But aren't you pretty much running two quarters ahead of it if you are at $90 million now of $180 million?

No, I'm really isolating the second quarter and applying an annualized rate to that. The -- on the merger costs, I suggested that we will do about $20 million pre-tax in the fourth quarter. There isn't an adjustment in terms of really concluding the majority of our costs as we close out 2007 and go into 2008. It is still the case that in that first year, I would expect to have roughly 40% of those costs embedded. And then in the second year, which will trickle into the first quarter technically of 2008, we would then take on more the lion's share of it. I think as you get beyond two years, you're talking about maybe in the range of 10% of the costs now.

Something to keep in mind as you think about this trajectory, I'm going to go forward trying to give you near quarter guidance and what I see coming through in the way of expenses. That can be subject to timing issues, which can be difficult to pin down. Obviously, you also have other issues like assessing what is capitalizable and what is not and we will make those adjustments for you when we give you our guidance.

But I do want to warn you that this is going to be a rolling effort on our part and it is really a bubbling up of watching the compression on the integration front. I think the reason why you're seeing saves come in a little bit earlier, and expenses come in a little bit earlier is really a testimony to the fact that we're making good progress and we're making it really on plan, if not ahead of plan.

This is Dennis. I will just add a little bit more color to what Fred said. If you think in terms of the source of integration savings, we acknowledged at the outset that we would probably eliminate some 900 overlapping positions. Early in the process, a lot of that occurred because you have two managers running a service unit; you only need one manager to run that. A lot of the $90 million -- that run rate that Fred is talking about -- is numbers that you can get at through fairly quick decisions. When you start looking for the balance of the savings, it does come from the integration of systems and some other activities that have a longer planning horizon and execution horizon, such as taking 16 administrative systems down to two. Having said that, broadly speaking, I would just like to repeat what Fred said, is we are on plan to achieve both the amount and the timing of the integration savings that we identified when we announced the merger.

Ladies and gentlemen, we do apologize. However, due to time constraints, this will conclude our question and answer period. Mr. Sjoreen, I will turn the conference back over to you for any closing remarks.

Thank you, Rufus, and thanks to all of you for joining us this morning. As always, we will be able to take your questions on our Investor Relations line at 800-237-2920 or via email at InvestorRelations@LNC.com. Thank you again for your participation this morning.

Ladies and gentlemen, this does conclude today's Lincoln Financial Group's third-quarter 2006 earnings conference call. We do appreciate your participation, and you may disconnect at this time.