美國信安金融集團 (PFG) 2003 Q1 法說會逐字稿

Good morning and welcome to the Principal Financial Group Q3 conference call. There will be a question-and-answer period after the speakers have completed their remarks. If you would like to ask a question at that time, simply press star and the number one on your telephone key pad. I would now like to turn the conference over to Tom Graf, Senior Vice President of investor relations.

Thank you. Good morning and welcome to The Principal Financial Group's first quarter conference call. If you don't already have a copy, our earnings release and financial supplement can be found on the investor relations section of our website at www.principal.com/investor.

Please note in the earnings release and during this call we discuss certain non-GAAP financial members that management believes are important in evaluating the company's normal ongoing business operations. These non-GAAP measures are not meant as a substitute for GAAP measures. Therefore we also posted on the investor relations section of our website a reconciliation of each non-GAAP measure used to the comparable GAAP measure. Following a reading of the safe harbor provision, Chairman, President, and CEO, Barry Griswell, and Executive Vice President and CFO, Michael Gersie, will deliver some prepared remarks. Then we will open up for questions. Others available for the Q&A are Executive Vice-President, John Aschenbrenner, responsible for the life and health insurance and mortgage banking segments; Mike Daley, responsible for marketing and sales; Jim McCaughan, global head of asset management; and Larry Zimpleman, responsible for our asset accumulation businesses. Julia Lawler, Senior Vice President and Chief Investment Officer, will also be available for questions.

Some of the comments made during this conference call may contain forward-looking statements within the meaning of private securities litigation reform act. There are a number of risks and uncertainties that could cause actual results to differ materially from those expressed or implied. Factors that could cause actual results to differ materially are discussed in the company's annual report on Form 10-K for the year ended December 31, 2002, filed by the company with the Securities and Exchange Commission.

Barry?

Thanks, Tom, and welcome to everyone on the call.

This morning I will comment briefly on our results, and then I result discuss our continued progress and execute our growth strategy with emphasis to our efforts to accelerate U.S. retirement services growth, drive growth and profitability in select international markets, create a successful asset management organization, and effectively manage and utilize capital. Michael Gersie will provide a detailed overview of the first quarter financial results.

Operating earnings for the first quarter 2003 were exceptional and we are extremely pleased with our results. Compared to a year ago, operating earnings per diluted share increased 24% to our record 63 cents in the first quarter. Mortgage banking was a key driver. I would also point to very strong performance from our retirement businesses, the life and health segment and Principal international, particularly in the face of a difficult economy and a challenging interest rate and equity market environment. Our results continue to be enhanced by the diverse nature of our businesses, which was a benefit in 2002 and again in 2003. Our ability to drive earnings growth reflects strong execution of our strategy and a sharp focus on fundamentals.

Let's start with the discussion of sales. As you may recall, 2002 was a truly outstanding sales year. Record mutual fund sales, record individual annuity sales, and record pension full service accumulation sales which increased 81% to $6 billion. The first quarter proved to be a continuation of our strong sales success. Compared to the first quarter, 2000, mutual fund sales improved 15% to $423 million. Individual annuity sales improved 3% to $288 million. And full service accumulation sales increased 101% to a record $2.5 billion. Full service accumulation sales for the quarter benefited from both a first quarter seasonality boost and solid Key Corp. win activity. As discussed at year end, we expected Key Corp. sales to continue through the first half of 2003. However, in an effort to maximize close ratios, we put extra sales resources against the remaining cases and were able to wrap them up during the first quarter. While we won't have the benefit of Key Corp. conversions in our sales results going forward, we do expect very strong full service accumulation sales for the remainder of 2003 ranging from $1 billion to 1.5 billion per quarter. Further, given the first quarter strong sales, we are confident we can surpass full year 2002 sales results for each of these three key retirement and investment products.

Reflecting outstanding sales over the last several quarters as well as excellent retention, we were experiencing strong deposits. In the first quarter we delivered $6.2 billion in deposits from our U.S. asset accumulation businesses, including full service accumulation deposits of $3.6 billion, which were up 38% from a year ago. Full service accumulation also achieved record net cash flows or deposits less withdrawals of $1.8 billion. Employer level rates declined to more normal levels in 2003 as we move beyond the demutualization effect prevalent in 2002. The net cash flow number translates into more than 4% of beginning of year account value. This is well above our long term expectations of between .5 and 1% of beginning account value per quarter and more than 60% of net cash flows for all of 2002. I would add that we also seen improvement during the quarter versus first quarter '02 in both employee deferral rates and employee participation rates in our full service defined contribution business.

We announced some high profile bundle retirement services wins during the quarter including the Gallop organization, one of the world's leading management consulting firms; Meredith, one of the nation's leading media and marketing companies; and the National Geographic Society, the world's largest nonprofit scientific and educational organization. Our efforts to induce takeover sales as well as the sales of larger cases within our SNB target market continue to drive results. We are driving growth in the under-100-employee market. The Principal security builder retirement program launched in 2002 specifically for the under-served small business market is also showing strong sales momentum with first quarter sales of 330 plans. Our sales growth also benefited from continued efforts to capitalize on new distribution alliances. In the first quarter our alliance partners sold more than $410 million of retirement and investment products. Principal Advantage, which was launched in 2001 to access financial advisors who prefer registered products, also continued to deliver strong results with sales of $332 million. Our ability to grow also reflects our uncompromising focus on meeting customer's needs and exceeding their expectations. We have a highly competitive product and service platform which we continuously refine and improve.

During the first quarter we launched a number of new products and product enhancements including the Principal separate account, Principal split dollar plus and Principal variable universal life accumulator II. We also began streamlining and enhancing our combined defined benefit/defined contribution product and service. These introductions demonstrate our ongoing commitment to delivering a comprehensive array of employee benefit solutions to help growing businesses attract and on retain employees. We received two important awards during the quarter that recognized our strong customer focus. We tied for first in client satisfaction in Boston Research Groups's 401(k) plan sponsor satisfaction study and The Principal was one of six firms to receive the seal of excellence for defined contribution statements. Our ability to deliver strong financial performance in these difficult times also reflects our focus on managing expenses and managing capital. As we did in 2002, we have once again established a minimum 25 million cost savings target. Through the first quarter we are on track to exceed that goal.

In terms of effective use of capital, we closed and quickly integrated two important acquisitions during the quarter. BCI Group, which enhances our defined benefit and ESOP capabilities, closed in January; and another one in Mexico, which makes us the fourth largest player in that important mandatory pension market, closed in February. Our efforts that began three years ago to grow institutional asset management mandates have built strong momentum over the past four quarters with nonaffiliated assets under management growing 124% to $17.9 billion. Our acquisition of Spectrum Asset Management has been an especially important contributor. With another big win during the first quarter, a new $1.5 billion closed in preferred securities mandate for an investments, Spectrum's assets under management now exceeds $7.5 billion. Since our acquisition in the fourth quarter of 2001, Spectrum's assets under management have increased by $6.5 billion or more than 650%. Another sign of principal global investors progress in building a small asset management organization is continued improvement in our MorningStar investment performance where the domestic and international equity funds and our pension separate accounts, 75% are in the top half for the trailing 12 month period and 92% are in the top half for the 3 month ending March 31, 2003. We certainly encouraged by the improvement of equity markets during the month of April and hopeful they will continue to improve. Because of our continued focus on the fundamentals of sales, investment performance, customer and asset retention and expense management, we are very well positioned to take advantage of stronger equity markets going forward.

In addition to utilizing capital to fund organic growth and for strategic acquisitions, our top two priorities in 2003, we will continue to opportunistically repurchase shares. In the first quarter we bought back 6.5 million shares for $184 million at an average price per share of $28.17 from the program authorized by the board in November 2002. Moving to operating earnings guidance, we expect the second quarter, 2003, to range from 56 cents to 59 cents per diluted share. We are confirming our full year 2003 operating earnings guidance of $2.25 to $2.40 per share. But based on our strong first quarter results, we would now guide toward the upper half of that range. The operating earnings estimates are based on certain assumptions including domestic equity market performance improvement from March 31, 2003, levels of roughly 2% per quarter throughout the remainder of 2003. As previously described, 2003 guidance also reflects an estimated additional 4% per share for stock option expense and employee stock purchase plan expense and an estimated additional 11 cents a share related to our pension benefit expense compared to 2002.

Mike will discuss credit loss in more detail but I will make a couple of brief comments. We have a high quality and very diversified investment portfolio. While credit market conditions remain difficult, we are encouraged by our improvement in credit losses in the first quarter. We are cautiously optimistic that these losses are abating and will return to normalized levels in the intermediate turn. In handing it over to Mike, I would like to comment on our operating return on equity. For the trailing 12 months, our ROE has climbed to 12.3% from 11.1% a year ago. We will continue working hard to deliver growth and build value for our shareholders and we remain confident we will meet our ROE target of 12.5% for 2003.

Mike?

Thanks, Barry.

I'm assuming everyone has had the opportunity to review earnings release and financial supplement. I'll spend a few minutes covering the current results and providing financial detail for each business segment. Then I will close with comments on the quality of our general account portfolio and our expectations for credit losses.

As Barry indicated, we are pleased with our results for the first quarter. We delivered strong operating earnings growth despite very difficult market conditions. Total company and segment results are even more satisfying given we achieved them while carrying additional pension benefit costs and stock option expense during the quarter of $11 million after tax or 3 cents per share. There are several things I would like to highlight at the segment level starting with US asset management and accumulation. Full service accumulation earnings rose 15% driving a 7% improvement for the pension business. Though our earnings for the total segment declined slightly, segment fundamentals continue to be very good. As Barry described, net cash flows were exceptional. And new sales were excellent. As you know, we continue to face a very challenging environment. Growth was again constrained by equity market performance but we continue to aggressively manage expenses to maintain pricing margins. We are also experiencing a lower than average asset yield than a year ago. However, our assets and liabilities are well matched and we have been able to maintain pricing spreads. While equity market declines negatively impacted account values, segment assets under management still increased 6% from year end and 17% from a year ago.

Within our international asset management accumulation segment, Principal international earnings improved by 230%, up nearly $5 million in the first quarter. The increase primarily reflects improved earnings in our Chilian operation and also in our Mexican pension business including strong results from our second quarter 2002 acquisition of Zurich Aforay. These strong earnings were in spite of the negative impact of foreign currency movements. Principal international continues to deliver steady growth in assets under management, up 11% from year end and 26% from a year ago reflecting growth in net cash flows and strategic acquisitions.

Moving to life and health, earnings were again strong in the first quarter up 9% compared to a year ago. Earnings growth was driven primarily by improved loss ratios for group life, mental, disability, and dental/vision. Segment return on equity reached another all-time high at 13.8% up strongly compared to 12.2% at March 31, 2002. This was another great result, but I point out that some favorable items during the quarter needed after tax earnings by $4 million. On numerous occasions we expressed our unwillingness to sack fight profitability for growth. We are very disciplined in our pricing, exiting unprofitable states and unprofitable lines, particularly in group medical. While premium is still increasing, we have experienced the decline in insured lives for medical and dental. Our challenge going forward in it segment would be to reverse these declines. We are focused on key growth markets and we are reallocating resources appropriately. We will continue working very hard to drive growth in the segment through enhancements through our distribution force and our product offerings. We are seeing a number of promising signs including group life and disability production which are up solidly from a year ago. I also want to briefly mention an amendment to our medical reinsurance agreement. Contract continues to provide catastrophic coverage in event of high loss ratios. However, it will not provide for the use of superior experience in one year to strengthen coverage in future years. Net payments for the reinsurer will now be treated as expense item rather than running through seeded claims and premiums.

Moving to mortgage banking, as Barry mentioned, the segment was a key driver of our operating earnings growth. Mortgage banking earnings doubled from a year ago to $52 million which translates to a 36.3% return on equity for the trailing 12 months. This first quarter is another excellent example of the macro business hedge of work. Heavy refinancing activity resulted in impairment of the servicing portfolio and at $57 million servicing loss and also generated exceptional loan production earnings of $110 million. I would like to take a minute to break the $57 million servicing loss into its components. $56 million after tax loss from refinements to our model, building more conservatism into the mortgage servicing rights valuation. The $9 million after tax loss from other impairments of mortgage servicing rights. Hedge gains offset nearly 80% of the impairments from prepayments associated with interest rate movements. Our financial hedges work well, and as expected. $8 million from servicing operations. This result is depressed from the normal run rate because of expected higher mortgage loan refinancing during the first quarter. I believe this detail helped emphasize a couple of key points: That we continuously update our valuation model to reflect the current environment and place a realistic value on servicing rights and that we continue to effectively hedge against the risk associated with interest rate movements. The final point I want to make is that while earnings from servicing operations are muted during periods of high refinance activity, strong growth of our servicing operation over the past 9 quarters positioned us well for the future. Our portfolio includes more than 950,000 loans and our principal balance is doubled to $113 billion since December 31, 2000. So when interest rates ultimately pick back up, we would expect production earnings to decline our servicing operation is positioned to deliver us very strong earnings. Earnings at a more normal run rate of around 25 to $30 million per quarter based on our current servicing portfolio.

As a follow-up to discussions in our most recent 10-K, I wanted to provide a quick update on our $4 billion loan warehousing facility which we use for asset back nonrecourse financing of residential mortgage loans. New rules under FASB interpretation 46, consolidation of variability interest entities, becomes effective in the third quarter for this type of facility. Under these rules, our warehousing facility would not qualify for off balance sheet treatment. We are currently contemplating changes to the facility but cannot predict at this time whether we will be able to continue receiving nonconsolidation treatment. If we were required to consolidate the facility, the impact would be an increase of approximately $4 billion in assets and liabilities on the balance sheet, but no income statement impact. We discussed this matter with the rating agencies and anticipate no rating issues associated with the change of reporting presentation.

Before moving to questions, I briefly like to discuss credit quality and our fixed maturity securities portfolio. Our realized net capital losses of $54 million for the quarter reflects $53 million of losses from impairments and impaired sales of our fixed maturities. This is a 31% decline from fourth quarter and very much in line with loss guidance we provided at year end. Importantly the decline in losses is accompanied by a strong improvement in a gross and unrealized losses down 27% from year end to $358 million. This unrealized loss equates to approximately 1% of our fixed maturity portfolio and .7 of a percent of our total assets in cash. As you can see, we have been very rigorous and aggressive in recognizing and accounting for problem assets.

It is clearly still a difficult equity and credit market environment. We do have a very high quality, very diversified investment portfolio. We aggressively monitor each investment, and continually assess our exposure to troubled sectors and credits, and actively manage problem or potential problem loans. Based on our watch list at quarter end, we confirm expectations we established at year end. Realized credit, capital losses of $170 million after tax for the year.

This concludes our prepared remarks. I would now ask the conference operator open the call for questions.

At this time, I would like to remind everyone that in order to ask a question, please press star and then the number one on your telephone key pad. Please limit your questions to one question and one follow-up. We will pause for a moment to compile the Q&A roster. Your first question comes from a line of Jeff Hobson with AG Edwards.

Hi. Good morning. I guess I will focus with my one question on any significance to the increase in GIC and/or funding agreements in the quarter. If that's a seasonal trend. And then I have a follow-up next.

Good morning, Jeff. This is Barry. We will have Larry jump in and answer. The primary issue that you are looking at is we were actually under the cap that we have for that business last year, and the first quarter saw us trying to get back to that cap. And so that's why you saw an increase in the reserves and the GIC, and obviously the earnings on that business will emerge over time, so there is a little bit of a lag when the earnings come in. Larry, want to add anything?

I think Barry covered that well, Jeff. Good morning. Again, we were $700 million under the rating agency cap at the end of the year, so we took advantage of that opportunity in the first quarter to add that amount of sales to that investment-only business. And as Barry said, we do expect that give us some life in operating earnings going forward.

Okay. And then on Principal global advisors, you had terrific growth there but you built up staff. When does that start to balance and more even earnings?

Good question. And Jim is here and about to jump in, so I'll just let Jim answer that one.

Thanks, Barry. The decline of earnings compared with the first quarter of '02 was related as mentioned in the press release partly to incentive compensation accruals and to including the offshore expense which had not been included in the PCM sector in 2002. If addition to that, there is another factor was that we had another one DMV securitization in first quarter '03 compared to two in the first quarter '02. So there are a number of factors going on. To address the incentive issue, it's not buildup of staff, it's actually incentive awards which have been earned by our people for better performance. These are related partly to investment performance, partly to the buildup of business. And partly to growth of revenues. For the first two -- that's investment performance and the buildup of business -- the accrual of incentive come runs ahead of the reward to the company, the receipt of the revenues. And over time we expect that to even out and the earnings to come through. Over the longer term, we expect 30 to 50% most of incremental revenues to through the incentive top line. But that leaves a lot over for the bottom line over time. So this is really an early period timing issue.

And, Jeff, I'd just reiterate what Jim said. It's not a buildup of staff, nor is the inclusion of the offshore a buildup of staff. That was really staff that was there and had been reflected in the BT financials. So none of this is about massive buildup of staff. It's about incentive comp coming in ahead of the revenue and it's about including BT staff that we already had to support our offshore.

Okay, great. Thanks.

You're welcome, Jeff.

Your next question comes from the line of Colin Devine with Smith Barney.

Good morning, gentlemen.

Good morning.

Quick question if we talk a little about the 401(k) business, I think everybody will acknowledge that's your crown jewel. It's still only producing what? 20 to odd percent of operating earnings despite obviously spectacular sales growth. When do we start to see that turn around? I guess the concern for everybody is how fast given the potential for the mortgage business is to drop off pretty quickly if rates start to move up?

Good question, Colin. We have never -- at least I hope we have not, touted the pure 401(k) business as the only growth engine of our company. It's an important growth engine, and there is no doubt when equity markets return to more normalized level it will again be a higher percentage of total earnings. However, I would point out we are more of a total retirement services company and our payout business and GIC business, our investment only business, our termination group annuities are a very important part of retirement services. Our annuity business, our mutual funds. And I would also point out that our complimentary businesses built around our SMB are being grown and represent future earnings. So I think it's a little bit of a misnomer to think that we are only a full service 401(k). We are much more, but there is no doubt that's the crown jewel jewel, and to answer your question more directly, when equity markets return to normalized 8 to 10% increase a year, you will see the earnings in that segment return nicely. You have to remember we had a 26% down market over the last 12 months in the S&P, and during that period we actually significantly held our own and then started to increase our earnings in a down market. I really believe the earning power is there and the proof is in the pudding when the market turns and you will see it emerge.

Quick follow-up. Earlier this year you rolled out a new immediate annuity. As far as I can tell, unlike anything else in the industry that allows the customer to make multiple contributions to it, and that's the way we cracked the distribution market. Can you give us an update on where you are with that?

I will turn it over to Larry. It's the principal income IRA and not a immediate annuity as it is a comprehensive set of solutions in a single bundle product that allows customers to move in and out of annuatization and to really plan for their full retirement. Larry, want to give an update with the rollout?

Sure. Good morning, Colin. We are very excited about the potential for the principal income IRA. This is a project we worked on during 2002, and we rolled it out late in 2002. We had about $2.5 million in sales so far. We are just getting started rolling that out to our core agent distribution force. It's a very leading edge product that allows a person who is nearing retirement to continue to maintain exposure to the accumulation side of the business while over a period of time beginning to purchase bits and pieces of if you will security income annuity or the more traditional immediate annuity. But the key is you are doing it over a period of time in a very predetermined, guided way. So you are essentially dollar averaging into the immediate annuity marketplace just as you were dollar averaging during the accumulation period. We are very excited about the potential that this gives us in that baby boomer market.

Good luck. Certainly the version I saw was the most exciting product have I seen come out in the last five years. Good luck with it.

We appreciate that.

Next question comes from the like of Joan Zief from Goldman Sachs.

Thank you. Good morning. Could we talk a little bit about interest rates and if interest rates were to stay at these levels, maybe even go a little bit lower, what would be the impact? Which businesses would be affected the most? Clearly the mortgage banking business with the MSRs. But of your core business as well, where would we start seeing the pressure on earnings if interest rates were low for a sustained period of time?

Maybe I will let the entire team chime in since we have all the segment heads here. I guess in a macro level you would think about the mortgage business would remain strong if interest rates remain where they are. Our pipeline is still very strong at the current interest rates, and so I think that would be a very net positive for the mortgage business if they stayed where they are. If they tick down a little bit, you will see the same pattern that you have seen in the past where originations probably pick up again and servicing asset goes down a little bit. But the net effect would be a very positive one. John, on your side or Larry maybe start with you on annuity and the retirement businesses. I think we are well matched so not a huge change.

Just a couple quick comments, Joan. There is really two elements of it for the retirement businesses. The first one would be our GIC staple value portfolio where, as Barry said, we run a very immunized portfolio, and importantly as well, there are no issues really associated with minimum guarantees in that business. I don't see any significant impact from further decline in interest rates. On the individual annuity portfolio, it's a different story but stale good one for us, in that the rates today in that portfolio are averaging something in the neighborhood of 4%. We are still above that actually. We are still above the 3% minimum that does give us some cause for concern, but we still feel like we can stand some further rate declines without any significant impact on operating earnings. And I will turn it over to John.

A little in life insurance but not much.

Yeah. I mean, basically our life and health products are priced for [INAUDIBLE] environment. We adjust our dividends or interest crediting on the individual products as rate goes up and down. So we are in good shape.

Is there any issue with your reserves? Your health or disability reserves if interest rates were to drop?

Well, actually there are very much consistent with the portfolio, so over time if interest rates remain at this rate we will adjust those reserves to the discount rate. But right now we are very good shape with all of our reserves.

Currently all of our new disability -- new disability claims are being reserved at a 5.5% interest rate. We have a lot of margin in the portfolio. Enough margin in the portfolio that we can continue to see a little bit of down market, down interest rates. Again, it would depend on how low interest rates go and how long they stay low with the -- it would depend on if we need to make a reserve interest rate change or not.

My follow-up question relates to your ratings. How are the rating agency -- what are the rating agencies saying to you? What is your expectations of getting off a negative watch from S&P? What do you have to do to sort of get that off the table?

Well, we are obviously in constant contact with the rating agencies, and let me say we have a commitment to maintaining our current Moody rating which is a double-A and S&P while we are on negative outlook, we can actually drop a notch and still feel pretty comfortable even though we are not predicting that will happen. As you well know, Joan, we are one of the few companies that have adequate capital and in fact our risk base capital ratio is over 400%. I think most of the rating agency concerns as they have been continue to be around some of the non core businesses, the mortgage banking business and the like. So I think we are in good dialogue and there is not a lot of movement. There is a good understanding we are fairly stable, and I guess we have a stable negative outlook. Mike, you want to add?

The one point that I would make and maybe I will cover a couple of things. We have a billion dollars of capital at the holding company and so that gives us a little bit of flexibility. One of our issues that we are watching very carefully is in terms of dividend and capacity from the life company to the holding company and given just the generating rating agency concerns about capital and life companies. We will take a pretty good concern of capital extraction from the life company. At least in the near term. But we still have adequate assets sitting at the holding company to support growth. To support potential share repurchases. To support some acquisitions. We think are well positioned and having that billion dollars at the holding company gives us flexibility.

Great. Thank you.

Your next question comes from the line of Julie Oe with UBS Warburg. Your line is open. Your next question comes from the line of Michelle Giordano with JP Morgan.

Good morning. I have a couple of questions. I was wondering if you could elaborate on the competitive environment in the full service accumulation business in terms of pricing, how much competition are you seeing for new business and takeover business? Secondly, what has customer sentiment done over this past year? Are you seeing any changes now in terms of customer -- you know, the individual participants in the plans in terms of their asset allocations or desire to put more assets into the plan?

I'll ask Mike Daley to answer the first one on competitive environment, and then Larry will jump in at the participant level.

Hi, Michelle. In terms of competitive environment, we are seeing two things actually happening out there. There is a weakening in the competitive environment because in these tough times a number of competitors are kind of pulling in their efforts here or retreating from the business. So that's actually making things quite attractive and favorable for us and helping us on the sales front. The other thing we are seeing is the upper echelon certainly as this business matures is getting closer and closer to each other in terms of providing a similar type of service. We continues a the leader, I think, to put pressure on that front path by continuing to upgrade our product and roll out new services and we working on some other elements right now in '03 to take our level of service to an even a higher platform. That summarizes what's going on. Again, I think to Barry's point about the proof is in the pudding. If you look at what's happening out there on the street we are receiving some tremendous receptively from prospects on the sales front.

Is it a similar trend where the banks are the ones retreating from the business, or are there some other players also?

No, it's not just the banks. It's really third tier players are in serious retreat. Second tier players are the ones that are pulling in the reins a bit in these soft equity markets. It goes beyond those local banks, absolutely.

Larry, you want it talk about the participant level?

Sure. Good morning, Michelle. In terms of asset allocation in full service accumulation business, as I have commented in earnings calls previously, there has been just a very slight shift from equities into fixed. Again it's just very slight. For example, the percentage of contributions going into the equity-type accounts has moved from 52% last year to about 50% this year. So again, a very, very modest shift. We think that actually is a positive sign in that a lot of the education we are doing in how to build a portfolio seems to be taking hold. In terms of the other elements that do drive both our deposits our net cash flow and our earnings, I think there has been some unfortunate trade press out there, particularly from the Wall Street Journal articles around participation and deferals and 401(k) plans, and no doubt there has pressure at some of the real larger employers and headline companies that you read about. If you look at our statistics, actually our deferral rates for employee salary referrals are up from 6.2% early in '02 to 6.5% and moved up to 6.7% of salary in the first quarter. Our matches, the employer match remains stable at 2%. And our participation is actually stable to slightly up as I think Barry commented in his remarks. It's a very good story for us.

Thank you.

Your next question comes from a line of Jason Zucker with Banc of America Securities.

Good morning. I wanted to talk about the mortgage banking sector a little bit and in particular just the model refinements. I will ask the question this way: I am curious how discretionary are the model refinements? How often does the model typically change? And then just to help me with the timing and the mechanics, when you made the model refinements in the first quarter, does it come at the beginning of the quarter? Middle of the quarter? At the end of the quarter?

Good morning. Good to hear from you. Let me ask John Aschenbrenner who is involved in that business to answer your questions.

As far as how discretionary, there is certainly judgment calls, but I would say they are not -- there is not a lot of freedom or discretion to arbitrarily make those judgment calls. In the first quarter, we actually made one change in February and then the rest of the changes at the end of the quarter, the end of March. As an example of what types of changes we were making, the biggest change came from the spread in the discount rate we used in our OAS calculation, our option adjustment calculation. That resulted primarily because we've had some increased costs in financing the business. So we are really constantly looking at all of the pieces that go into that calculation and when they need to be adjusted, we are making the adjustment. As I said, there is judgment, but it's pretty narrow range of judgment, I would say.

And how often do you typically make changes to the model?

Whenever they are needed I guess would be the way I would say. We will -- we are constantly looking at it. So any time a change is needed, we will make it. We made two different timing changes in the first quarter of this year.

I believe as -- this is Michael Gersie. We made a couple of model changes last year over a number of quarters. So we do go in and update the model reasonably frequently.

And our philosophy would be to update it as frequently as we need to make sure nothing gets out of kilter and builds up on us. So I think more frequent adjustments is a good thing. That shows we were trying to keep it very accurate and timely.

Great. Thank you.

Your next question comes from the line of Tom Gallagher with Legg Mason.

Good morning.

Hi, Tom.

One question I really had was on your full service pension business. You gave guidance of sales of a billion to a 1.5 billion, can you translate to what you would expect for net flows knowing there is a lag factor there off the $1.8 billion that you reported this quarter?

We will take shot. Larry, you want to -- it is a little bit difficult to exactly predict the timing on this. Maybe we can give you a general idea.

I would be happy to give you some help on that, Tom. In terms -- as we said previously, in terms of when a sales tern into deposits, there is a couple of -- it does take a couple of quarters for that process to play itself out. The transition of a 401(k), a plan from one provider to another does not happen instantly. When we are reporting sales, it is a lead indicator of what deposits will ultimately be. So I would think what you want to do would be model in a couple a quarter transition of sales numbers into deposit numbers. I hope that gives you some help in modeling.

And just to follow-up on that. Sounds like it's safe to assume you will probably not see a big fall off from the $1.8 billion? Is that fair to assume?

That would be a fair assumption, Tom. Yes, indeed. Because again, we will receive the benefit of large sales in a couple of the previous quarters that are not yet reflected in our deposits or our net cash flow. We were optimistic of maintaining that net cash flow going forward.

Okay. And just one other follow-up. In the GIC market, we've been hearing that it is being described very competitive from a price standpoint. A number of companies seem to be scaling back in the first quarter. Yet you guys seem to push ahead a bit. Can you comment on how you are seeing that market fare and what types of spreads you are getting in the first quarter?

This is Larry again, Tom. I will try to take that. Again, I think we are in a position as we said previously where our sales there are really tied directly to keeping our total volume of business at the caps that the rating agencies have asked us to keep them to. Frankly our position relative to competitors may be a little different. As a result of that, the positive for us is that we can be very, very selective as to which GIC stable values opportunities we pursue, and we are very, very disciplined as to how we run that portfolio. So the end result of all of that is that we are able -- under the current environments we are able to maintain our spreads and maintain our ROEs and pricing margins, and we think we will have the ability to continue to do that barring something we can't see today.

But during the first quarter we brought on the additioned GIC business. It is basically the same kinds of spreads that we had prior, so we were not compromising spreads to get business unequivocally we were not.

Okay. Thanks.

Your next question comes from the line of Mario Mendonco with CIBC World Markets.

Good morning. Few quick questions. On the commercial mortgage side, any update there on delinquency or performance from the commercial mortgages? Also, I would be interested in your total airline exposure is. And then finally, in terms of the guidance you provided, the midpoint to the high end of your guidance range, what sort of mortgage banking earnings do you contemplate in providing that range?

Good question. I was going to answer the first one and then give Julia time to answer the second one but now I have to think about the second one. I think -- and I will answer the guidance. We are now guiding to the upper end of the 225 to 240, and it does have to do with having a good first quarter with mortgage banking. We would I would say continue to expect that there will be an abatement of the refinance move at some point as interest rates stabilize or kickback up. The pipeline is strong right now so we would anticipate a fairly strong second quarter from the mortgage business and then maybe slowing down for the last half of the year. I can't quantify the exact number of -- the exact number for earnings for the year, but it would be close to if not slightly above last year would be a good indication. We do feel very good about where our mortgage business is. And I will ask Julia, you had airlines and mortgage delinquencies.

This is Julia Lawler. Our commercial mortgage portfolio remains strong. I would say that like the real estate markets, our portfolio has seen an increase in vacancies and we are watching it. What we have not seen and don't expect to see is an increase, a significant increase in delinquencies and not losses. Mainly because our portfolio remains very low loan to values as well as interest rates. No real update on our portfolio is the way you put it. Our airline exposure, the total airline exposure in a book value basis is $460 million. Of that, about $115 million is exposure to a much higher quality airlines like Fed Ex and Southwest. So the remaining is the other airline. And about 50% of that exposure to the other airlines is in the higher quality more liquid portion.

And just a quick follow-up to understand. Of the $460 million, was that split equally?

The $350 million equally.

That was 50%.

I understand. Thank you very much.

Next question comes from the line of Eric Berg of Lehman brothers.

Good morning. I have two questions. One broad and one very narrow. In your asset accumulation and management area, one of the things I noticed I was talking to Tom last night that year over year because of the decline in the stock market there was very little asset growth as you would expect in the 401(k) business yet earnings were up sharply. On the other hand elsewhere in the pension business in for example, 401(k) and GICs, there seem to be very strong asset growth and yet low earnings growth. The opposite picture. I'm hoping you can help me understand why in one business you would have no earnings -- no asset growth or very modest asset growth, very strong earnings growth and then two other businesses you would have sort of the exact opposite situation and then I will have a follow-up?

We will be glad to address that. And I can see why it would be a bit confusing. Larry, want to explain?

Good morning. I think really the key for understanding the relationship there between account values and earnings is to look at that if you will an average basis over that year over year period. So the thing you want to look at in the full service accumulation business is to look at the change in account value on a weighted average basis over 12 months and it looks like that is going to supplement. It looks like that change is approximately 5% or so for the full service accumulation business. The weighted average account values of the full service business are up about 5%. Now the good news is the operating earnings out of that portion of the business are up about 15%. What that reflects in large measure is our intense focus around operational excellence. I will give you one key stat around that. As you know, we added a lot of volume in that area due to strong sales and yet despite that we are down about 250 full-time equity licenses. Our head count is down 7%. We are driving some significant operational excellence gains. In terms of the full service payout, again, the account values are relatively flat and the operating earnings are flat and that just reflects low interest rates and poor equity markets which dampens the ability to sell a single annuities and the same thing in the investment only business. As has been pointed out, we have strong first quarter sales but looking at a 12 month basis, that hasn't yet turns into operating business on a goo forward basis that will generate higher earnings in future quarters.

My specific or narrow question relates to the mortgage business and it's a follow-up to Jason's question. What is the real distinction? Why do you make this distinction between the model assumption changes and the -- and other adjustments to the value of the MSR? Is that distinction a genuine one? You think it is. You made it such and what is the nature of that distinction?

John, want to jump in?

The prior quarters we have always ended up talking about why we had the valuation change and we broken into the two pieces. One is primarily just interest rate changes and that drives refinancing and it flows through directly. The other is model changes. We feel it helps us and it helps you to understand what's going on in the business. Basically we can and we do hedge against interest rate changes that will flow through the model. We can't and we don't hedge against model changes.

So would it be correct to say that model changes relate to most of the time it things other than changes and assumptions about prepayments?

Not directly. I guess the model has assumptions built in that if interest rates move in a certain direction, prepayments will change because of that movement.

Right.

Those things happen automatically. If we do find out that prepayments are changing more or less dramatically as interest rates change, now we have to go back and change the model.

Got it. Thank you.

Your next question comes from Suneet Kamath of Sanford Bernstein.

I had two questions. First a follow-up to the airline exposure. If you could provide the numbers as of the fourth quarter so we can get a sense of what the change in that position was and second, in the last quarter you put out a press release that regulatory inquire and related to mutual fund sales. I was wondering if you had an update on that?

Maybe Mike you want to take the last update in the New Zealand situation?

You may have seen or perhaps not, a recent news release and I believe it came out in the wire last night. And New Zealand court and the hearing on this matter. Remember, the real issue is that the New Zealand securities commission found that we had a technical noncompliance with filing regulations in New Zealand. Which afforded the investors the right, the return of investments made during the period of noncompliance plus a 10% interest penalty or accumulating interest at 10%. The recent news release would say this is the first step toward trying to get this resolved. It's the first step in getting a judgment that are really over turning the ruling of the New Zealand securities commission. It doesn't change the status of our first announcement. That we are unable to quantify any penalty if any that earning negative impairment if any in our operation. And Julia has the year end numbers in it would be materially unchanged from year end.

Thanks.

We have reached the end of our Q&A. Your closing comments, please.

Again, thank you all very much for joining us on the call. As said, we are pleased with the results from the quarter. I would also like to comment on our commitment to transparency and if we did not answer something or more details that you would like to have, not a lot of time to get into and restricting the questions to one. We didn't answer all your questions but Tom Graf is around today and will give you more detail. There are a number of things that we put together that might be helpful. So we are just very open to providing you with the transparency you need to better understand our story. Again, thank you all for joining us. We look forward to seeing you in various cities in the coming weeks and months as we visit you and investors. Thank you all very much.

Thank you for participating in today's conference call. This call will be available for replay beginning at approximately 1:00 P.M. eastern time until the end of day may 13th, 2003. The number to dial for receipt plate is 1-800-642-1687. And 706-645-9291 for international participants. The access code for the replay is 9489438. Again, 9489438. Thank you for participating.