美國信安金融集團 (PFG) 2009 Q2 法說會逐字稿

Good morning and welcome to the Principal Financial Group second quarter 2009 financial results conference call. There will be a question-and-answer period after the speakers have completed their remarks. (Operator Instructions). I would now like to turn the call over to Tom Graf, Senior Vice President of Investor Relations. Please go ahead.

Thank you. Good morning and welcome to the Principal Financial Group's quarterly conference call. If you don't already have a copy, our earnings release, financial supplement, and additional investment portfolio detail can be found on our website at www.principal.com/investor. Following a reading of the Safe Harbor provision, Chief Executive Officer Larry Zimpleman and Chief Financial Officer Terry Lillis will deliver some prepared remarks. Then we will open up for questions.

Others available for the Q&A, John Aschenbrenner, responsible for Life and Health Insurance; Dan Houston, responsible for US Asset Accumulation; Jim McCaughan, responsible for Global Asset Management; and Norman Sorensen, responsible for International Asset Management and Accumulation. Also available is Julia Lawler, our Chief Investment Officer.

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

Thanks, Tom, and welcome to everyone on the call. For the second quarter, we saw the continuation of a return to more normal capital markets that started late in the first quarter. We view our operating results for the quarter as solid, reflecting our strong operational focus and disciplined expense management. Our general account portfolio also had solid performance, reflecting its diversification and focus on risk controls. Finally, our ability to raise $1.15 billion in equity and $750 in long term debt has significantly strengthened our balance sheet, positioning us to navigate through current challenges and emerge even stronger as the business climate improves. We believe these positives will help investors refocus on the fundamentals that make The Principal a compelling long-term investment. I'll discuss each of these in more detail.

First, operating results. Earnings per share of $0.69 for second quarter 2009 compares to $0.97 in the year ago quarter, and net income per share of $0.52 compares to $0.64. With the Standard & Poor's 500 daily average down 35% compared to the year-ago quarter, as expected, we experienced a decline in assets under management and in turn operating earnings and net income. Terry will discuss second quarter 2009 results compared to a year ago in more detail.

Importantly, market gains in the second quarter helped drive strong sequential improvement in assets under management, operating earnings, and net income. Comparing second quarter 2009 to first quarter 2009, assets under management increased 9% or $21 billion to $258 billion. Operating earnings increased 22% to $201 million, driven by a 50% or $58 million improvement from our three asset management and accumulation segments, and net income improved 33% to $150 million. This reflects higher operating earnings and an investment portfolio that continues to perform well. Second quarter results again confirm the quality and diversification of our investment portfolio and our continuing belief that while capital losses will be higher than normal over the next several quarters, they will remain manageable.

Over the trailing 12 months, a period that covers some of the worst equity and credit conditions in decades, we delivered nearly $800 million in operating earnings and nearly $350 million of net income. This strength and consistency of results differentiates us from peers, reflecting the resilience and diversification of our businesses, the diversification of our investment portfolio, and disciplined risk management.

I'd like to expand on some of the factors that make us different from our peers. Our broad mix of fee, spread, and risk businesses has enabled us to deliver revenue stability during periods of significant market volatility. We benefit from a broad customer base that covers small and medium sized businesses and their employees as well as institutional and retail investors. We also benefit from our leading position in employer sponsored payroll deduct benefit plans, which has created a strong base of recurring deposits.

We have built and maintained a conservative liability profile, backed by a well diversified investment portfolio. For example, we have purposefully made variable annuities with guaranteed living benefits a small part of our business, with a block of just over $1 billion. This results in our life company capital ratio as being significantly less leveraged to equity market changes than peers.

During the quarter we continued to take action with our portfolio in response to changing market conditions. We continued to invest new cash into high quality liquid assets, with the majority going into agency mortgage pass-throughs and NAIC 1 corporate bonds. Compared to a year ago, cash and cash equivalent holdings are up 184% to $4.3 billion and government backed securities are up 18% to $3.2 billion.

We continue to manage our exposure to ratings drift risk, selling or tendering about $525 million of securities. This generated $28 million of the $81 million of after-tax credit losses in the second quarter. Excluding these intentional sales, credit impairments improved slightly on a sequential basis, which is the third consecutive quarter of improvement. In these sales, we emphasized reducing our BBB and below investment grade bond holdings, where we believe the risk of downgrade or potential default had significantly increased. About 45% of these sales related to BBB and 40% to below investment grade. We also continued to scale back the investment only business and in turn are waiting to commercial real estate, which is down from 26.8% of total invested assets and cash as of June 30th, 2008 to 25.0% as of June 30th, 2009. Over the past three quarters, we have reduced the investment only block by $4.6 billion, freeing up about $180 million in capital.

Our exposure to CMBS continues to decline. In July we took advantage of continued improvement in AAA CMBS, pricing selling $40 million at par, an improvement of 20% to 25% from pricing as of March 31st. In addition, we expect about $400 million will pay off at maturity over the course of 2009. Of the $314 million of commercial mortgages that matured during the second quarter, 53% financed externally. This demonstrates continued strong market demand for the type of loans in which we have historically invested -- loans with strong borrowers, high occupancy, good loan-to-value, and high debt service coverage, primarily in the $5 million to $20 million range. Of the 47% that we have refinanced during the quarter, just over half met our current more conservative underwriting guidelines. These loans have an average loan-to-value of 53% and an average debt service coverage of 2 times. The remainder of the loans we refinanced have an average loan-to-value of 75% and average debt service coverage ratio of 1.5 times. For loans maturing over the remainder of 2009, we expect around 80% will be financed externally or by us within our current underwriting standards.

As I mentioned in May, we completed two capital raises totaling $1.9 billion. This accomplishment over a two-week period demonstrates continued investor confidence in our ability to deliver sustainable, profitable growth. As of June 30, relative to a risk based capital ratio of 350%, our excess capital position was approximately $2 billion between the holding company and the life company. I would remind investors we have $441 million of long-term debt maturing later this month. After completing our capital raises, we moved $500 million of capital from the holding company to the life company. We estimate our life company risk based capital ratio to be in the range of 375% to 400% at quarter end. Given our successful capital raises, we reduced commercial paper outstanding by $365 million during the second quarter. Excess capital was also reduced by $285 million due to credit ratings drift.

With the narrowing of credit spreads during the quarter, we experienced a $3 billion improvement in net unrealized losses. Along with our equity capital raise, this resulted in book value including AOCI improving 102% from March 31st to $16.19 per share. Using synthetic indexes versus cash bond prices and adjusting for the impact of higher interest rates on net unrealized losses through midyear adds approximately $6 to $7 per share to book value. Terry will discuss this in more detail.

While the return to more normal capital markets has created positive momentum, the operating environment continues to present challenges. Rising unemployment continues to reduce the number of participants covered under our existing employee benefit plan offerings, and investment income is down, reflecting our recent focus on investing in more liquid assets. Another key impact is market volatility. Over a period of five trading days in mid-July, for example, the Dow Jones Industrial average increased 7%. In this environment, institutional investors continue to delay funding of awarded mandates. We are also seeing fewer plan sponsors seeking requests for proposals to change retirement plan providers due to the economy. These factors have contributed to lower flows through midyear for two of our three largest sources of net cash flow -- full service accumulation, where net cash flow is down about $1 billion due to lower sales and thus lower transfer deposits; and Principal Global Investors, where third party flows are down about $5.7 billion.

On the positive side, retention remains strong for both businesses. Through midyear, full service accumulation withdrawals are down about $800 million, albeit on a lower base of account values. Contract level withdrawals are down 20% through midyear based on plans. Based on assets, contract level retention remains near an all time high in 2009, similar to the first half of 2008. Withdrawals for both periods are about 50% lower than historical levels.

While recurring contributions have historically been a source of deposit growth for full service accumulation, through midyear they are down about $300 million or 4%. The largest impact is lower participant deferrals, which reflects a reduction in the number of participants as well as slightly lower rates of deferral. We view $3.6 billion of full service accumulation sales through midyear as a solid result in a difficult environment, a result that puts us among the leaders in the industry. With more than $3 billion of net cash flow through midyear or 3.8% of beginning of year account value, we are on track to achieve our long-term target of 4% to 6% for the full year.

Looking ahead, we remain confident in our ability to compete effectively for new business. Total Retirement Suite continues to provide a significant differentiator in the marketplace, making up 65% of our sales year to date. Alliance sales have held up well, down only 6% through midyear, and as mentioned last quarter, the expansion of our distribution relationship with Bank of America/Merrill Lynch to cover defined contribution plans is another positive development on the Alliance front. That said, we are finding most businesses focused on one thing -- surviving the recession. Changing retirement plan providers is not necessarily on their list of top priorities. On the other hand, we are seeing some early signs activity is increasing, with second quarter quote activity up 16% sequentially. I'd remind you, though, that in this environment the sales cycle now tends to take eight to 12 months.

Moving to Principal Global Investors, excluding a $3.2 billion withdrawal from AIG, withdrawals as a percent of beginning of year assets under management declined from 10.7% for the first half of 2008 to 8.8% for the first half of 2009. Over the last 12 months, AIG and two other financially troubled clients have withdrawn a total of nearly $8 billion. Excluding withdrawals from these distressed investors, third-party net cash flow exceeded $3 billion over the trailing 12 months, nearly 4% of beginning of period assets under management.

Reflecting solid flows of new money in a difficult market, PGI has received $7.6 billion of deposits from nonaffiliated clients through midyear. Our participation and search activity remains strong, but again we continue to experience delays in institutional funding due to market volatility. There has been a decline over the past year in the percent of PGI's retirement plan separate accounts in the top two Morningstar quartiles. 50% were in the top half for five-year performance at June 30th versus 75% in the top half a year ago. These results have been hurt by our fixed income products, given our credit bias, which also impacted performance of our asset allocation products. It is notable that with the recent improvement in credit spreads in the second quarter, our three month performance is showing a strong turnaround. 43% of PGI's retirement plan separate accounts were in the top half for the three month period, with 40% of our fixed income and asset allocation funds in the top quartile and 60% in the top two quartiles. We remain confident that our disciplined process and focus on fundamentals will prove highly competitive over a full market cycle.

I'll close my comments with one last example of the benefits of diversification. At $1.2 billion in the second quarter, Principal International delivered its second best net cash flow quarter on record. This reflects strong deposits in Brazil and Malaysia and solid flows in India as fixed income funds in that market return to profitability. Terry.

Thanks, Larry. This morning I'll cover total company and segment results. I'll also discuss investment losses for the quarter and provide an update on our investment portfolio. I'd like to emphasize three key points up front. First, we view second quarter as solid performance in a difficult environment, with the decline in earnings from a year ago reflecting the impact of market conditions on assets under management. Second, strong expense management has helped offset revenue declines associated with declines in AUM. And third, our investment portfolio continues to perform well, resulting in a manageable level of realized capital losses.

Now to total company results. Operating EPS was $0.69 in second quarter 2009, down 29% compared to $0.97 in the year-ago quarter. The decline primarily reflects macro economic conditions which reduce the earnings per share by $0.28 in total. Market conditions, including a 35% drop in the S&P 500 Index daily average, drove down average assets under management 19% from a year ago. Lower AUM reduced earnings per share by approximately $0.16.

Earnings per share were also dampened by $0.07 from lower investment income due to holding more liquid investments and $0.05 due to unfavorable foreign exchange and lower yields on inflation linked assets in Latin America. In addition, market conditions in 2008 resulted in a significant increase in 2009 costs for employee pension and other post retirement benefits, which we refer to as security benefit costs. This reduced second quarter 2009 EPS by $0.07. Earnings per share also reflects the impact of our equity raise in May, which increased weighted average shares outstanding by 12%, reducing earnings per share by $0.08. Against these headwinds, management reduced the fixed component of compensation and other expenses by $0.16 a share from a year ago, softening the impact of the market conditions.

Moving to the segments. US asset accumulation earnings declined $16 million or 10% from a year-ago quarter, a particularly solid result in light of a 17% drop in average account values and higher security benefit costs of $8 million after tax. We reduced compensation and other costs for the segment by 13% from a year ago, helping offset the impact of market on account value and revenues. Second quarter results also benefited from $25 million of lower DAC amortization expense pretax. This primarily reflects market performance trueups and unlocking of expense assumptions for full service accumulation and individual annuities.

Before moving on, a couple of comments on sales within the segment. Larry already discussed full service accumulation, so I'll cover The Principal funds and individual annuities, both of which are down about $1 billion through six months.

The decline in mutual fund sales is consistent with industry experience. Importantly, sales from our two largest sources of production have actually improved 11% year to date. Our national channel of outside broker-dealers and our investment only channel now make up about 50% of total fund sales. Their continued growth in a difficult sales environment bodes well for future sales as the market improves. Regarding individual annuities, the decline primarily reflects our conscious decision a couple quarters ago to moderate sales as part of our focus on capital management and maintaining pricing discipline. This remains an important market to us. We expect this business to return to growth over time.

Global asset management earnings of $8 million in second quarter 2009 compare to $24 million a year ago. The decline reflects significantly lower investment management fees due to the impact of market conditions on AUM as well as lower transaction fees due to the slowdown in the real estate market. The decline also reflects our sale in first quarter 2009 of certain asset management contracts within Post Advisory Group for $50 million. In the second quarter, we received our initial installment of $2 million and we expect to receive the balance over the next four years. Importantly, we continue to capture new institutional assets and to align expenses with revenues through active expense management. This is reflected in a 13% reduction in operating expenses compared to the year-ago quarter, driven by 25% reduction in compensation costs excluding higher security benefits.

Moving to Principal International, earnings were $29 million in second quarter, down 8% from a year ago on a 4% drop in assets in our management. We view this as very strong result in the face of unfavorable macro economic conditions -- notably, modest deflation in Chile and weaker Latin American currencies compared to the second quarter 2008. Adjusting year-to-date results for inflation and currency rates in Latin America, earnings growth would be slightly above our long-term growth target for the segment of 14% to 17%.

Life and health earnings were $58 million in second quarter compared to $67 million a year ago. Individual life earnings improved $4 million or 18%, reflecting lower DAC amortization resulting from the improved equity market performance. Earnings from the health and specially benefit divisions were down from a year ago. Effective expense management and productivity gains for the divisions were more than offset by higher medical and dental claims, higher security benefit costs, lower investment income, and a reduction in membership in existing plans.

Let me also comment briefly on individual life sales. Compared to a strong 2008, we have written essentially the same number of new policies through midyear, but first year premium and deposits are down 45%. This decline is not out of pattern with industry experience. The difficult economy is driving a significant drop in sales of higher premium policies partially offset by an increase in sales of lower premium policies such as term life. Finally, losses of $32 million for the corporate segment were slightly above the normal run rate reflecting our issuance of long-term debt in May.

Turning to net realized capital losses, we recognized $50 million in second quarter 2009, which compared to $51 million of losses in first quarter 2009 and $85 million of losses in the prior year quarter. Our internal credit exposure guidelines and resulting diversification have continued to help limit losses during this recession. Based on new FASB requirements related to other than temporary impairments, which we early adopted last quarter, net impairment losses on available for sale securities were $134 million pretax. Total other than temporary impairment losses on available for sale securities were $201 million with the noncredit portion, $67 million, recognized in other comprehensive income.

As Larry indicated, book value more than doubled from March 31 to over $16 per share as of June 30th. Our quarter end net unrealized losses were $4.8 billion, down $3 billion from March 31st. This reflects $4.4 billion of improvement from narrowing credit spreads, partially offset by a $1.4 billion increase from higher interest rates. Using the more actively traded credit default swap market as observable data, net unrealized losses for our corporate bonds would have been about $2.6 billion lower for the second quarter, and using the CMBS index, net unrealized losses on our CMBS portfolio would have been about $400 million lower.

So in total, using synthetic markets instead of cash prices, net unrealized losses would have been another $3 billion lower than reported as of June 30, 2009, which would add approximately $5 per share to book value. I'd also point out that since year-end 2008, interest rates have increased net unrealized losses by $1.8 billion. Given our generally well matched portfolio, this significantly overstates the change in book value caused by interest rate movements because it doesn't reflect the corresponding drop in the value of our liabilities. We would estimate this as reduced book value by approximately $1 to $2 per share. Based on this analysis, we view $22 to $23 as a better estimate of book value including AOCI. Given our asset liability discipline and strong liquidity, which speak to both our intent and our ability to hold assets to maturity, let me again emphasize a key point. We will not be forced to sell assets at a loss.

We continue to provide quarterly updates to investment detail on our website. Given investor interest, I'll discuss the updates related to our commercial mortgages and CMBS holdings as of June 30th. Starting with commercial mortgages, our portfolio characteristics remain strong with 1.9 times debt to service coverage, 88% occupancy, and average 67% loan to current value.

I'd also like to make a couple important distinctions between life, company, and bank commercial mortgage portfolios. Life company portfolios tend to be fixed rate, permanent loans on properties that are substantially leased. Bank portfolios generally have a larger exposure to speculative construction loans, which is why bank portfolios tend to generate significantly higher losses, particularly during recessions. The commercial mortgage loans in our portfolio that we believe present the greatest risk of loss are those exceeding 80% loan-to-value with debt service coverage less than 1 times. Our 41 such loans totaling $520 million represent an improvement from March 31 of $35 million, with nine loans exiting and 10 smaller loans entering this category. The primary reason loans exited was improvement in occupancy. Even if all of these loans were to default over the next couple of years with an average loss of 30%, this would generate total losses of only $101 million after tax, over a multi-year period -- again, very manageable.

Regarding CMBS, 100% of the bonds were paying interest as scheduled. Delinquencies within the underlying mortgage pools have risen, but remain within expectations at 4.2%. Less than 10% of our $5.4 billion portfolio was in vintages after 2005 that were rated below A. Our latest internal severe stress scenario resulted in $355 million of cumulative after-tax losses with the vast majority occurring more than three years out. Running our portfolio through two different third-party models validated results from our internal models, further demonstrating that even under severe stress, losses would be manageable, occurring later in the cycle, and over a multi-year period.

In closing, we continue to see signs that some of the environmental headwinds may be easing. Credit spreads narrowed dramatically in the second quarter and have continued to do so into the third quarter. While equity markets remain volatile, we were pleased with second quarter's rebound and continued improvement in the month of July. We also believe that much of the impact of the Fed's stimulus is still to come. The recession may be nearing an end. That said, we believe that signs of a true recovery such as job growth and strong consumer spending won't occur overnight. In the meantime, we continue to control the things that we can and to position The Principal to deliver sustainable, profitable growth over time.

This concludes our prepared remarks. Operator, please open the call to questions.

(Operator Instructions). Your first question comes from the line of Jimmy Bhullar with JPMorgan.

Hi. Thank you. I had a couple of questions. The first one is just on your organic sales and 401(k) business, and what the pipeline looks like -- obviously difficult environment, but I think sales have been down I think four quarters in a row now. But when do you expect the improvement, and if the pipeline is picking up, what do you think -- or how long do you think it will take for some of those cases to close? Is it later this year or early next year? And the second one is just on your health business. The claims have been pretty -- or fluctuated a decent amount the last several quarters. What are your expectations for this -- are for the second half of the year and what do you think drove the variance versus the relatively stronger quarter before?

Good morning, Jimmy. This is Larry. You trailed off a little bit on the last part of the health claims but on the -- ?

Just the variance, what caused the variance versus the quarter before in your margin?

Okay. Thanks. In terms of the organic sales pipeline, I'll have Dan handle that and John can talk about health, but as you heard in the earlier comments, we are seeing a sequential building of the pipeline. It's up 16% in second quarter from what it was in first quarter. And, obviously, anything related to size of the pipeline, you'd have to recognize that the 35% decline in the S&P 500 from a year ago obviously makes that pipeline look smaller. But we are -- we are seeing it build and I'll let maybe Dan add a few comments to that before we have John handle the health question.

Thanks, Larry. Just a couple of quick comments. The outlook still looks a little bit tough and then we are seeing pressure on 2009 sales. Most of this is just because of reluctance on the part of plan sponsors to make a change. I think their primary interest is focusing on their core businesses. If we look at the created pipeline relative to a year ago, which is down about 38% from a year ago, and as Larry pointed out, you've got to figure about half of that is related to the market. The other half is related to employers delaying those decisions. And in terms of volume, if we looked at the $100 million plus, it's down about 13% from a year ago. But those that are -- the areas that we are enjoying some success today is in the not for profit area. And secondly, going head to head in the TPA market, which is up 8% relative to a year ago. I'd also point out that Alliance sales are still very strong, representing about 70% of our sales, and we have just opened up a couple of new relationships, including Merrill Lynch. So with that, maybe I'll turn it back to John.

You want to comment?

Sure, thanks, Jimmy. Most of what you're seeing is just the seasonality. When you have a high proportion of high deductible health plans, you're going to see much lower claims in the first quarter as people are using their deductible. The other thing that's going on is there's a little bit of claims development from the first quarter, higher claims from the first quarter that carried over into the second quarter. Okay?

Do you still expect a loss in the fourth quarter based on seasonality or should that change? Because I think in the fourth quarter of -- at least last year, there was a loss in that business.

Yes, we would -- with the seasonality of high deductible health claims, we would expect a small loss in the fourth quarter.

Okay. Thanks.

Thanks, Jimmy.

Your next question comes from the line of Nigel Dally with Morgan Stanley.

First is with your expense management, clearly made a lot of progress in taking out expenses. Are the expense management programs now done or should we expect further reductions in the run rate of expenses beyond what we saw in this quarter as we look forward? Second, you mentioned that you saw quite a number of triple rate securities that you felt were at risk of adverse ratings migration. Can you provide details on what types of securities they were, hybrids, [stress] securities, corporate bonds? any additional color there would be helpful. Thanks.

Okay. Nigel, thanks. This is Larry. Maybe just to take care of the first one on expense management, I mean, I think that what you've seen here is essentially what we feel like we need to do at this point relative to aligning expenses with revenue. The only thing I would maybe point out a little bit there is that there are still some severance costs that are baked into 2Q that obviously won't be sustainable going forward. Our commitment is to take around $400 million out of the run rate expenses during 2009 and we think we are well on our way toward doing that. And I'll have Julia comment on your triple B securities question.

Good morning, Nigel. I just want to remind you that in the sale about 45% were BBB and about 40% of them were below investment grade. And of those that were sold, I would say the bulk were public corporate bond securities across several sectors -- it was across most of the sectors. Consumer cyclical was probably the strongest and financial was probably the second. And we did have a few hybrid securities, but it wouldn't have been the highest percentage. But we certainly [didn't] participate with hybrid securities in either sales or tenders.

Thank you. That's very helpful. Thank you.

Thanks, Nigel.

Your next question comes from the line of John Nadel with Sterne Agee.

Good morning, everybody. Was hoping we could get a little bit more granular on the impact of the S&P. Strong performance, obviously, point to point during the 2Q I think up around 15%, well in excess of a typical 2% assumption I think baked into DAC amortization expectations and things like that. So notice that DAC amortization was lower. I think Terry, you mentioned $25 million pretax. I suspect that that was across the businesses, not just in the annuity line. But if you could -- if you could give us a better sense on how much of that was driven by the 15% S&P versus a normal assumption and how we should think about that. Obviously, the S&P has already had a very strong third quarter to date and who knows if it will hold. But if it were to hold at these levels, should we expect lower DAC amortization yet again and how should we think about that relative to the 2Q levels?

Okay. John, this is Larry. I'll have Terry go ahead and handle those questions for you.

Hi, John, this is Terry. As I mentioned in our comments, $25 million reduction, it's about 60% of that, about $15 million is due to the market conditions, the improvement of the equity market. And another $10 million is due to the impact of the expense initiatives that we have put in place and we see on a go forward basis. You're absolutely right, it's across both the full service accumulation and as well as individual annuities.

Okay. And so just to follow up on that Terry, so 60%, or roughly $15 million of the lower -- I guess is the way to think about that lower than normal DAC amortization, or is that 60% or $15 million relative to 2Q 2008?

That's relative to 2Q 2008, but what you're seeing also is that the improvement in the equity market was very positive in this quarter compared to relatively flat in the 2Q 2008.

Okay. Okay. And then my second question if you could, maybe give us a quick estimate on -- the month of July was obviously very good for the S&P, also good for credit. And just wondering if you could give us a sense for more on almost a realtime basis I guess what your estimate would be for mark-to-market on the investment portfolio through July?

Sure. This is Larry, John. Again, take the $4.8 billion that would be the reported number as of the end of June. As we commented earlier, you would add -- or take off about $3 billion if you were to put that on a synthetic basis as of the end of June. So you would be down in that $1.8 billion range. And then if you fast forward it from July 30th to July, you would take off about another $1 billion or so for improvement in July, a little bit of improvement in the CMBS portfolio, pretty meaningful improvement in the corporate credit portfolio. So that would actually get you down if you use both the synthetic, which we believe is a better indicator, as well as updated that to July, you would be down around $1 billion or so of net unrealized losses as of a current date.

Thank you very much.

You bet.

Your next question comes from the line of Randy Binner with FBR Capital Markets.

Thanks. I just want to go back to the expense item. Just want to understand how the accrual of certain compensation expenses might be coming through the first half of the year versus the second half? In a way, Larry, I think you answered the question by saying you'll have $400 million all in. But if the S&P stays up, I just want to understand how you are accruing for compensation expenses, and if we might see an uptick in that with better market conditions as we get into the back half of the year.

Okay, Randy, this -- again, it's -- that's not to say that there won't be in fourth quarter that you might not see some increase in compensation, other expense, whether it's due to -- whether it's due to variable compensation or whatever. But you still ended up because of headcount reduction -- I mean, for example, PGI -- I think Jim has taken out 19% of the employee count in PGI. So because of actual headcount reduction and reduction in base compensation, we are very confident that we will capture that entire $400 million during the course of 2009. But you could see variable comp being somewhat higher in fourth quarter, because that's the normal cycle over which variable comp is paid. But I'll maybe ask Terry if he has any further comment.

You're absolutely right, Larry. In fact, we think we will get the full $400 million reduction out of fixed components, the salaries from our staff, et cetera. We have already accrued for bonuses and incentive compensations as part of the numbers through the first half of the year, and we will continue to accrue as we see the improvement in the market and the additional revenue that may be generated to offset some of that additional expense.

Great. So I mean, bottom line, Terry, it sounds like you feel like the accrual is caught up to where it needs to be if the markets stay at these levels?

Absolutely.

Okay. Great. Thanks.

Thanks, Randy.

Your next question comes from the line of Suneet Kamath with Sanford Bernstein.

Great. Thanks. Two questions. First, on the 401(k) business and the flows, Larry, in your prepared remarks you were talking a little bit about plan participant behavior as opposed to the corporate plan sponsor behavior. And I think you kind of went through the numbers a little bit fast for me anyway, so I was hoping that maybe you could provide a little bit more color in terms of what you're seeing there, because I think in the past you've said that participant behavior has been relatively stable. But it sounds like your comments earlier in the call suggest that maybe we are seeing a change there. And then I'll have a follow-up for Julia.

Okay. Well, Suneet, in terms of -- again, there's a number of elements that go into that recurring deposit figure, as you know. One of those, of course, is the level of employer match. And, again, we would argue that's not the -- that is a contributing item but not the major contributing item in the 4% reduction in recurring deposits. We -- our best estimate is somewhere around 10% of our employers have either reduced their match or eliminated their match. The bigger element really is just the rising unemployment and then slightly lower deferrals from the standpoint of 401(k) participants. So we are seeing deferrals are off slightly. They are off about 0.75% on average from something like 7.25% to about 6.5% and participation is down slightly.

So, again, you put all that together, again, it's not a major item. I don't want to overstate this. I think the recurring deposits are down something like 4% or $300 million. So this is not a major item, but we are seeing a little bit more pressure on the participant side than on the employer side, although there's pressure in both of those areas.

And just a quick follow-up, is there anything that you can really do about that or are we just waiting for the economy to improve and employment to increase?

There are things we do about that. We are out there working hard each and every day. You're familiar with I think with our initiatives called Retire Secure where we actually have salaried employees who are out in the work site meeting with employees one on one and in small groups, and those things really do make a difference. For example, during second quarter we had actually 4% of our employee base actually increased their contribution. And again this is typically as a result of either talking with our Principal connection counselors or meeting face to face with our work site counselors. So, no, we are not -- I don't want to give any impression that we are sitting here and allowing the economy to have its impact. We are absolutely -- and we are moving the needle both in terms of participation and deferrals, but certainly the economy net is a headwind.

Got it. And then just second question for Julia or Terry. Just in terms of your commercial real estate exposure, in your investor supplement you provide some good scenarios for the CMBS portfolio and what losses could look like over multiple years. Just wondering if you applied that same framework to your commercial real estate portfolio, what would the results there show?

I'll have Julia do that.

Good morning, Suneet. What we have tried to do to make the commercial [home loan] portfolio scenarios look similar is create the at risk bucket and try to show you what the at risk bucket might look like over time. Currently it's in that $520 million range as we mentioned. That can move up and down. Loans are going to come in and loans are going to go out. But over time, what we have said -- if we stress that, similar to CMBS, we think that could get up in that $600 million range or $650 million. And if you take that same 30% loss scenario, we figure that you could stress that you're about in that $200 million pre tax over the next to to three years. Is that helpful, Suneet?

That's helpful. I guess what I liked about the CMBS scenarios that you went to third parties and validated your results. I'm wondering if maybe you used the Treasury Department's stress test and applied that to your portfolio, what we would see in terms of loss content?

You would see something very similar to that $200 million pretax, because we did attempt to use the Treasury's stress scenario and you would get at about that same 2% or $200 million.

And, again, Suneet, this is Larry. That's very consistent with what you heard, for example, I think when Met had their call last week and as Terry commented earlier in this call. I mean, there are differences between bank mortgage portfolios and life mortgage portfolios. So you wouldn't necessarily have the same cumulative loss percentages for our portfolio that would have been part of the 19 bank stress test. But we think from an economic perspective we absolutely have modeled a very similar result as to what you see for the bank stress test.

Great. Thank you.

Thanks, Suneet.

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

Good morning. I've got a couple of questions. First, I just wanted to confirm that the expense reduction, the $156 million, is -- that's how much fixed costs are down and we are not going to see some of that come back if sales pick up, is question number 1. Question number 2, on the commercial mortgage portfolio, I was curious why you didn't add to the loan loss provision this quarter. Met did. I think you acknowledged about a quarter of your renewals are at terms that you wouldn't do new lending at, loan-to-value is over 80%.

And then the area I really want to spend some time on, Larry, which has not been touched on, is the full service accumulation business and what is really going on there with policy holder behavior when we look at withdrawals. Now, in the past you've made very clear when the market is down, okay, net asset flow should improve. We are looking at on a dollar amount withdrawals are up slightly year over year. But with the drop in the S&P, that would suggest to me that the actual number of people taking their money out here may be up as much as 50%, and that's what I want to get at. I get why sales are flat, I get why recurring deposits are only up 4%, but what's going on with withdrawals?

Okay. Good morning, Colin. First of all, let's go -- I'll deal with the first one is probably the quickest one to get out of the way. The $156 million is truly a reduction in the fixed component of compensation. So it's not something that comes back at some later point. So that one I think we can easily deal with. And I'll have Julia talk about the commercial mortgage, your second question.

Good morning, Colin. As we have said before, our reserve strategy that we've have had in place for many, many, many years, the pooled reserve or what's on the [hold] portfolio is based on historical performance. You will not see, particularly since we have had historical performance being outstanding for the last 20 years, you won't see the reserve on that large portfolio change significantly. What you're going to see is loan specific reserve. So it's going to be specific to each and every loan, which is why we give the stats that we give, and that's based on loan-to-value. And so as soon as a loan reaches something greater than 100% loan-to-value, you are reserving on that loan regardless of how it's performing. So basically all of the reserves we took for the second quarter, those loans are still performing. So that's how you're going to see the loan specific reserve perform.

Okay. What is the reserve today? And why when we are in one of the biggest real estate declines in certainly recent history aren't you reexamining this policy?

Well, the policy has been set over long periods of time for the whole portfolio and it would be done in conjunction with our auditors, so that doesn't change easily. And we review it all the time, but it certainly doesn't change and they have continued to sign off on that policy.

The reserve --

Colin, our auditors are understandably a little bit concerned about setting up or having the ability to set up just general loss reserves that don't tie to specific loans. I think we can all understand why they would have some concern about your ability to do that, and that would be true not only for us, that would be true of all of our peers as well.

That didn't seem to be a problem for Met, Larry, but again you're not giving up the number of the reserve you're holding. Is there a reason for that?

Say that last part again, Colin.

You have not provided the number, although I've asked twice now, for the loan loss reserve that you've got. I appreciate it's on a specific basis. How much are you holding? How much have you written down your book by?

Well, year to date, we -- on our like company portfolio, we have written it down only by the $3 million in first quarter and the $15 million in the second quarter.

Okay.

Those are the loan specific reserves and that's in the Q. We would provide that in the Q and the K.

Okay. Thank you.

Okay. Let's move on to your third question relative to withdrawals, and, again, Colin, I mean, I put a couple of things in context before I have Dan comment on this. First of all, again, as you saw in -- with the at risk or retention in 54% in second quarter, I think we continue to do an outstanding job of retaining those at risk assets. And the second thing I would note is even in an era that's been as difficult as it is, I think our net cash flow through the first two quarters of the year is at 3.8%, beginning of period account value. So we are well on our way towards the typical 4% to 6% that we target in this area. But I'll ask Dan to comment further on your number of withdrawals, which in and of itself is not up near the 50% that you're, I think --

And Larry, just know that I'm not going to let that one go. The net asset flows as far as I can tell, the worst in the company's history, okay, and it's coming in a down market where you've made the point net asset flows go up in the past.

Sure. And this again, Colin, is simply due to the seasonality of a sales cycle where in second quarter you will typically see fewer transfer deposits coming off of new sales. So that's the primary and almost total explanation for the lower net cash flow in second quarter. So it really has to do with new clients and transfer money on new clients as compared to any increase in withdrawal of existing clients. Retention, again, it remains at an all time high out of the 401(k) block. And if you were to be concerned, it would be if you saw the lapse rates increasing, which are not happening. Retention remains near an all time high.

Let's explore how you're measuring tha,t because I don't know how the market can be down 35% and the actual withdrawals is rising right now, and you're telling me lapses haven't changed. So maybe Dan can help me.

Measuring that through asset level retention. That's how we measure it.

Sure. Just a couple of comments, Colin. Maybe just to speak to just for a moment on the employer match piece, we looked at the customers that had employer matches less this quarter in 2009 versus a year ago 2008, to give you some idea of where some of this loss of recurring deposits are coming from. Part of it is coming from reduced matching dollars from plan sponsors. We looked at roughly 9,000 plans, and there's been roughly a 10% reduction in the sheer number of employees covered underneath these plans. And yet if you look in total, we have actually been able to grow the number of plan participants across the block by roughly 2.2% during that same period of time.

Two other very quick comments and that is the loss of the small plans -- about half of those plans lost were plan terms, not just contract terms. They are no longer in existence. If we looked at the actual number of individuals covered underneath the new plans that have replaced those, those plan counts have come up. If we look at that large 1,000 plus group, we didn't lose a single plan sponsor that was over 1,000 lives. The 10 that you're seeing reductions in were either plants or locations that were terminated, again, going towards reducing overall recurring deposits.

Okay. Thanks, Colin. We need to move along.

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

Hey, good morning, everybody.

Hi, Steven.

A couple of things, if I may. First and foremost, I'm interested -- well, to beat on the dead horse that Colin just beat on, the lapse rate, the withdrawals as a percentage of beginning assets was, I believe, 4.4%. And that's 100 basis point increase from the 3.4% -- even though the numbers, the absolute numbers are the same, that's 100 basis point increase from a year ago. So maybe we can tie into the discussion we just had with those numbers and I would think that would be the most appropriate way to look at it. The second thing is kind of a technical thing. I'm wondering how are loans accounted for? Are they included in withdrawals and if not, maybe how that would have affected that number? And third, any general thoughts on the health insurance business and Obama care?

Steven, I'm not sure on the last one, you said on health insurance business and -- ?

Obama care.

Oh, Obama care.

Yes.

I'm sorry. Just quickly on the withdrawals, I mean, again, if you look at withdrawals for full service accum, if you look at withdrawals as a percent of the beginning value -- if you look at percent of the withdrawals as the percent of account values at the beginning of the quarter, what you find for 2009 would be very consistent with what you find for 2008. So I'm not sure what the math is around the 100 basis point difference, I think again --

I disagree with that, Larry, because you're looking at withdrawals of $3.5 billion on a beginning base of $77.9 billion and that's versus $3.4 billion on a beginning base of $99.4 billion.

Right. I'm -- what I tend to do, Steven, is I tend to look at the withdrawals on the average account value for that particular period. Okay? And so, for example, in 2009 you've got about $3.4 billion in withdrawals, $82 billion of account value, and in 2008 you've got about $3.4 billion of withdrawals on about $99 billion. So again, I haven't done the math on that and I don't know if Dan has any particular comments on that. I mean, again, it does reflect to some extent the impact of the economy. Loans are in there but again, loans are not up in any substantial degree either. So I don't know. Dan, is there more you want to say on that?

Nothing really to add.

Larry, you think we are better off looking at the average as opposed to the beginning?

Yes.

Okay.

And in terms of just the healthcare, health insurance and Obama care, I mean -- obviously I'm not in any position to predict, Steven, what may or may not happen relative to healthcare reform. Again, I think we have been very focused and have our management team here focused on getting the business running successfully financially and then overtime growing the membership, and even though second quarter wasn't necessarily from a financial perspective, if you look at it over a trailing 12 months, the ROE in that business is I think is 15.6%. So again we are happy with the returns over time, recognizing that there's some cyclicality in that business. Obviously if healthcare reform were to happen, we would have to sort of think about that, but that wouldn't be any different than the decision we would make on any other business.

All right. Thanks, guys.

You bet.

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

Well, thank you. I just wanted to thank everyone for joining us this morning and for your continuing interest. There will be challenges ahead. We know that. But we believe we face them as an organization with a track record of effectively navigating these difficult environments. For Principal, we think with the improved equity markets and our successful capital raises, we do believe we are building positive momentum in our businesses. So we look forward to speaking with many of you over the coming months and continue to look for the opportunity to communicate our continuing strengths. So thanks and everybody have a great day.

Thank you for participating in today's conference call. This call will be available for replay beginning approximately 1:00 PM Eastern time until end of day August 11, 2009. 17748880 is the access code for the replay. Again, that's 17748880. The number to dial for the replay is 1-800-642-1687 for US and Canadian callers or 706-645-9291 for international callers. Thank you. You may now disconnect.