Principal Financial Group, Inc. (PFG) Earnings Call Transcript & Summary

Good morning. I'm Tracy Benguigui, insurance analyst at Barclays and I'm very pleased to host a fireside chat with Deanna Strable, CFO of Principal. How are you?

I'm doing great, Tracy. Thank you for having me today.

I thought maybe we can kick-off with opening marks, might your [indiscernible].

Yes. So those of you that may not know Principal as well, we are a global financial services company, really focused on pretty quick new businesses, asset management globally. So U.S. emerging markets as well as developed countries across the globe. Retirement, primarily in the U.S. and then benefits and protection, I think of the group benefits product insurance solutions here in the U.S. as well. I think coming into the year, obviously, at the end of the year, a lot of macro headwinds. Those are starting to turn into some tailwinds, interest rates are helpful over the long term, but in the short term is likely having some pressure on flows, in our asset management business, consistent with the rest of the industry. But we are starting to see a little bit of kind of green shoots that maybe looks like the second half of the year may show some improvement relative to the first half of the year. But even given some of the slow issues, we really do feel really good about our outlook. And long term, we feel very well positioned to our long-term targets of 9% to 12% EPS growth, 14% to 16% ROE and 75% to 85% free cash flow. We have done -- changed our business mix a little bit in the last couple of years. We exited our retail life business. We exited our retail fixed annuity business. So our general account and balance sheet is smaller, but really are focused on those places where we think we can -- we have differentiation and can win and grow above the market in those lines of business. So I'd say those would be my opening comments, and we can go to Q&A.

Okay. I'm going to build off of that. You did reiterate the 75% to 85% free cash flow expectation. So you did have lower buybacks in the first half of the year and tighter holdco cash, $800 million, which is your minimum threshold. So can you just walk us through how you think you'll achieve that metric by the balance of the year?

Yes. So we do see seasonably lower free cash flow in the first quarter, really driven by dividends up from our non-life subsidiaries as well as bonuses and cash flow relative to that in the first quarter. We also saw really good organic sales opportunities, specifically around pension risk transfer in the first quarter. So that further pressured the free cash flow in the first quarter, but we're not changing our full year expectation on pension risk transfer. So again, it's more of an acceleration rather than an increase in that. We went in the second quarter and actually saw free cash flow above 100%. So year-to-date, I think cash flow has been really around that level. Buybacks were slightly lower, but it was really -- given the bank crisis and the real estate resulting real estate cycle, we wanted to be a little bit cautious and ultimately, really, we'll look to deploy that as we go into the second half of the year.

Great. So your RBC is around 407% and you did experience some positive credit risk. So let's just play out a scenario if credit risk would shape up to be more negative into the outlook, what would RBC look like? Would it still be above 400%?

Yes. So we're going to manage our dividends out of the life company to ensure that our RBC is at or above that 400% level. So you probably wouldn't see impact on RBC, you'd probably see impact on, again, the dividends to the holdco and ultimately, the deployment out of that. Having said that, you did mention we did have slightly positive credit drift in the first half of the year. But when you added in the losses, we were right around a $50 million capital impact from the balance sheet, which is actually pretty in line with what we would expect. And so again, I'd say we're still going to target that 400%. We still feel good about that 75% to 85% and don't really see a significant impact from our credit growth as we go through the rest of the year. I think one of the things I want to focus on there, our balance sheet is smaller. It came down about 25%. So any impact from that will be muted. We also have a very high quality. So we -- extra portfolio and it's very much aligned with our liability structure. So we're not the sellers in those situations and so again, as I did reiterate the 75% to 85% feels good, and we do feel good about that RBC ratio at the life company as well.

Got it. In your opening remarks, you did talk about some of the strategic updates you've done and not only have you completed your SGFA deal, but also closed block. Is there other risks and opportunities that you may be contemplating?

Yes. I'd say -- the first thing I would say is we constantly evaluate our portfolio. If you go back, at one point, we were in the residential mortgage business. We were in the medical business, we were in Australia. And ultimately, we're going to enter and exit markets when we don't see we can bring value to our customers and value to our shareholders. Having said that, the recent transaction really was a combination of a very intensive analysis for our entire portfolio mix. And so sitting here today, we feel really confident, don't see anything on the horizon. Obviously, we'll look for those opportunities. But I'd say any additional one in the short term would be modest and much smaller than what we did contemplate here in the last 12 months.

Great. Maybe shifting gears to commercial real estate share to disclosure. I'm wondering, just within the office loans that are greater than 90% LTV currently, are those loans were the base of the last appraisal or internal valuation? What is the debt yield on this as well?

I don't have the debt yield, but I think one thing -- we only actually have one loan that has a greater than a 90% LTV and it's fully reserved for. So any loss on that would not have any additional capital impact, that's already come through the balance sheet there. So I come back to a very high-quality residential -- I'm sorry, commercial mortgage book, also high-quality office book. We are reevaluating internally those valuations quarterly and we're committed to continue to relook at that office portfolio every quarter, at least in this year, and then we'll reevaluate where the market is at that point. Having said that, we've actually brought down our values around 25% from the peak. And actually, if you compare our values to kind of third-party indexes, we're more than 20% less. When you see our LTVs, they're based on a very current valuation. I think our office LTV is right around 67% given those revalued levels and as mentioned [indiscernible].

We know there's been a lot of focus on upcoming office maturities, but I'm wondering if I could ask you maybe a question that's less readily available, the tenant lease expiration? Is there anything to come in the next 24 months, otherwise, you could talk about maturity.

Yes. I don't -- there's nothing that I'm concerned about from that perspective. Obviously, we're taking a look at anything that is going to -- could be impactful to us from a capital perspective or risk perspective over the next '23 and '24 and looked very closely at those. And again, even to your question of [indiscernible] relative to that.

Yes. Just looking at your business in a simplified financial reporting in a couple of segments, Principal Global Investors, Principal International into Principal Asset Management, the retirement into one segment, U.S. solutions for Benefits and Protection, does these improve your expense structure? Can you share examples of how that simplification, you have enhanced the leadership or investment or client-facing opportunities with just segment reporting.

Yes, a couple of things there, and I'll go through a few of them pretty quickly and then probably spend a little bit more time on the Principal Asset Management one. So the Benefits and Protection is honestly just a renaming as we got out of the retail life business, Full Service business, more on business owners. We felt that Benefits and Protection that are described, the businesses that were within that. So nothing relative to that other than a rename. On the retirement side, we used to have a retirement fee and a retirement spread. What was happening again, after we acquired Wells Fargo Retirement & Trust business, that was becoming very blurred. And we were actually almost manufacturing a split and so combining that into one segment more reflects how we're managing that business and how Chris Littlefield thinks about how the economics of the business works together. And so again, that much more is reflecting how we are managing that business and going to market. The one that probably has a little bit more explanation needed is we took what has historically been Principal Global Investors and our Principal Global Asset Management business, Principal International which was pension retirement and asset management in [indiscernible] market. And we brought that under [indiscernible] as well. At this point in time in our [indiscernible], you can still see the financials of both separately but over time, I think that will [indiscernible] as well. We do think there could be some expense synergies coming from that, but that was not a significant driver of that change. Really the driver of that was listening to our customers. And we think ultimately, more revenue opportunities as we go to market as a consolidated basis versus separately. What we were seeing over time, really driven by kind of the maturing of those emerging markets, from the specification of our clients is the excellent investors in those emerging markets more interested in global products rather than just very locally based products. On the flip side, as we talk to institutional type of customers around the globe, they actually were interested in actually some of those very significant emerging market capabilities as well. And so we're bringing those together really to drive 2 fronts. One, as we think about best practices in those investment teams, making sure we're leveraging those across both the local and the regional [indiscernible], but then more importantly, as we go to market and listen to the needs of the customers, we want to make sure we're bringing all we can to bear as we meet the teams of both those local and sophisticated customers as well. And I think over time, that's really where we're focused. It's not going to be a big thing. It's going to be as we build, but that really was the driver of those changes.

What is the outlook on fee compression and the offset [indiscernible] growth in your customer base on the retirement side.

Retirement side, yes. So as we look specifically at our retirement, and think of that more probably specifically to our record-keeping businesses. So more primarily defined contribution, but there is some defined benefit we saw that as a guidance there as well. We've seen a modest fee pressure. Think of it as 1 to 3 basis points per year perspective and really driven by a couple of things. One is, as our clients look to their lineup -- their investment lineup in the 401(k), they are more and more looking to add lower cost options and those lower cost options then translate into revenue, many times also offset by the expense side. So from an actual earnings perspective, not as impactful from a revenue rate perspective, you'll see some of that impact. The other impact that you have is, one, just give us competition, you will see that what we bring on new sales is at a lower sale rate or a lower fee rate than our legacy block and over time, we have to reprice some of the legacy as well. And so again, as you think [indiscernible] to our long-term revenue outlook for that business, a continuation of that fee compression. But the other thing I want to keep in mind is for every $1 of revenue that we see in that business, it contributes further pretty much in other parts of the context. Think of it as asset management. Think of it as [indiscernible]. Think of it as our annuity products or nonqualified business and Benefits and Protection. And we see that growing as we continue to focus on those opportunities as well. But it is a competitive market. We are a market leader in that. But we do think there will be continued confidence in some level of compression.

Yes. Also staying with retirement, the cash flows you have by a large space labs. You've already highlighted to us as the course of volatility that will likely not decide in the second half of the year. What gives you confidence that your investment performance relative to indices could [indiscernible] around in the second half of the year? Why wouldn't we see the retail flow go to positive product?

Yes. So really, what you're highlighting there is more our account value net cash flow than our AUM net cash flow. And so if you think of our record-keeping business, there is -- some of that account value that is using third-party investments. Some of that is [indiscernible] global investor asset management and much of that volatility is actually being driven by more of the expected shock lapses that came from our acquisition of the Wells Fargo business. What I would say there is, it's happening probably later than normal, primarily due to COVID, the sponsors were a little preoccupied before COVID, went ahead and transfer that business to us and then also now, they're assessing where we think the right fit for that business is. In [indiscernible], we're still tracking at or better than what we thought we would get relative to that acquisition but it's some of that natural movement is more elongated and it could generate some profit in the next 12 months. What we are seeing positively is the pipeline to new [indiscernible], both on the small- to medium-sized business as well as the medium to large business, all segments. One of the things that we have highlighted is that our SMB net cash flow on small- to medium-sized business, net cash flow continues to be positive. Again, that has to be higher revenue and ultimately driving really good growth. But you will continue to see natural volatility, both positive and negative and that large market on a quarterly basis. Ultimately, we want all of our segments to have positive net cash flow, but the nature of the business in large case this year will be volatility. Our focus is driving revenue growth, driving earnings growth and some of those larger case opportunities were pretty low revenue and so not as an impact to the economics of the business.

Great. Moving on to Specialty Benefit. How are you approaching 1/1 renewal thinking about on the favorable experience you and others have seen within visibility in group life?

Yes. So just a little bit of a background on our group benefits business. So the first thing I would say is very diversified by product. So about half of our premium actually comes from dental as well as then the remainder with group visibility and then a growing supplemental benefit perspective, but probably more different from the [indiscernible] as we are almost entirely focused on the small- to medium-size business. So our average case size would be 30 to 40 lives. And because of that, 1/1 is not as critical as those businesses that focus on the small to large business -- or mid to large business. Our renewal dates are slightly higher for 1/1, but are actually much more spread out throughout the year. The other thing that I think is important is because of the net nature, more of our business, almost all of it is 1 year renewable whereas if you -- as you go upmarket, that can be more 3-year rate guarantees, 5-year rate guarantees. So any impact, positive and negative takes longer to reflect in the rates. And so we have a natural process to ultimately reflect any of that experience in our rates. Our loss ratios in that business, like you mentioned, has been slightly better than what we would expect. We're seeing very good experience in our life business. We're seeing very good experience in our disability business. It's partially offset by some payer utilization in our dental business. And so as we think of pricing strategy, we are thinking of a slight increase on our dental business, offset by some slight decreases on our life and disability business. That's more on the new case perspective. On a renewal perspective, it will be more modest. So you'll start to see that flow through as we go through the end of this year and into next year.

Great. What is your profit growth within your joint ventures in Principal International?

Yes. So post-COVID, I've had the opportunity to visit with a lot of our premier joint ventures across the globe. And so we're privileged to have strong joint venture partnerships with many -- with a few of the very large banks, China Construction Bank, Bank of Brazil and CNB in Southeast Asia. That gives us -- those are long partnerships. Many of those have been [indiscernible] for 20-plus years. We're bringing kind of asset management and retirement expertise to the table and they're bringing the brand in the local market as well as distribution expertise. China is one where we have recently expanded that relationship. So we entered that relationship nearly 20 years ago, but our sole joint venture in China up until late last year was really in the asset management mutual fund perspective. On that at a pretty good step as we sit here today. But we're excited in the fourth quarter that we were also able to enter a joint partnership with them on the pension which is a fairly new market within China with some good prospects of growth. And then we also actually did a 50-50 joint venture partnership with China Construction Bank on the real estate side, very much focused on logistics and infrastructure, and we see some good prospect there as well. Bank of Brazil is another one I'll just mention. We are a market leader with them in the voluntary retirement perspective. Over a 30% market share and continue to be the market leader in both market -- total market as well as net cash flows. There was some pressure over the last 2 or 3 years that's given COVID but we're starting to see that kind of turn around as the signs for good growth there as well. And so as we focus on those joint venture partners, we continue to see a path to double-digit revenue growth in those markets and ultimately an improving returns as more and more of that business is focused in Brazil and China. Those are higher-margin products, and that will contribute to an increased margin profile as well.

Can you touch on any update on $7 billion of fixed funded real estate mandate you anticipate to be invested in the next 12 to 18 months?

Yes. So I'll just step back a little bit. We are one of the top U.S. asset managers in the real estate space in the U.S. And as I just mentioned, we've now started a joint venture in China and we also have a real estate presence in Europe as well. Those are long-standing relationships, a lot of positive flows, if you look at historically, even in the third-party space has come from real estate, and we have many customers that are -- haven't [indiscernible] their real estate leave to us and continue to look at us to provide that solution. Sitting here today, we want to be good to fiduciaries of that money. And as we work with our clients, they have committed to us a -- that $7 billion across a number of different customer -- institutional customers. So we are sitting on it to find the right time to put that money to work and in the right asset classes. And so again, that $7 billion has been there for the last few quarters because we have not been putting the money to work but we are seeing opportunities in the third quarter, being very selective on which asset classes those are. We saw some opportunities in Europe. We've had some opportunities here in the U.S. with a data fund launched of the fund. And so we'll continue to gradually put that to work. I think Pat Halter, who leads our asset management business and use -- our real estate business, thinks that probably will more ramp up in the fourth quarter and in '24. But I think we're seeing some select opportunities in it today.

Great. On outlook on flows at the end of the year, do you have visibility on the industry sales pipeline?

Yes. So obviously, if you look across the asset management business, our industry flows have been fairly pressured. And we are primarily active. And so I'd say that would be -- you've seen actually even bigger pressure as you look at that. One of the things I would say is there's been a few trends that have caused our net cash flow in our asset management business to be negative in the first half of the year. Many of it similar to the rest of the industry but also the real estate environment has been the other driver of that negative flows. Just to put that in perspective, if you would have looked over the last probably 5 years, we probably averaged $4 billion to $6 billion of positive flows driven by real estate. In the first half of this year, that was probably $500 million. And so again, that -- from a delta perspective, it's having a sizable impact on that. And then I'd say the other driver is both institutional and retail, is similar to what everyone is doing. And it's really people staying on the sidelines, taking opportunities to put money in on money market and other things that are yielding very high returns, is the somewhat waiting for the Fed to signal a stop in increasing rates but I do think we're starting to have some really good discussion with those institutional investors that are waiting for that and then ultimately have some real interest in putting that money for, whether that be in fixed income or other asset classes as well. And so again, we do have some visibility into those institutional discussions and flows. We do think the second half of the year will be improved from the first half of the year. Whether that happens in fourth quarter or third quarter, those discussions are still underway, but to again start to see -- we're starting to see some momentum as we sit today.

Great. Well seeing your macro outlook, could you walk through your second half of the year, key assumptions, you're making for equity market, interest rates, foreign exchange and other variables.

Yes. If I could make those accurately, I probably wouldn't be sitting in this chair, but I think what we would say is we continue to think there's going to be volatility, right? And so we want to make sure we're positioned for that volatility. I do think we think that the Fed is close to pretty much towards the end of the tightening, but we actually don't see reductions in rates probably until it's the earliest mid next year. From an equity market perspective, we forecast based on 2% a quarter, 1.5% of that would be market appreciation and the other half would be dividends. We've obviously experienced much greater than that increase in the first half of the year. Some give back as we sit here today in the third quarter. And we think there will be continued volatility as we go throughout the year. So again, we forecast on that 2% range, but we then actually do a lot of scenarios around that to ensure that our expenses are aligned to those revenue forecast. And we are being very disciplined, especially in those equity market-driven businesses on the expense side to make sure that we're prepared for what whatever environment plays out [indiscernible].

Likewise, how do you envision alternative investment return, real estate sales and prepayment fees for the balance of the year?

Yes. So again, I think what Tracy is referring to is the drivers of our variable investment income that back our spread and insurance businesses. And we had a time in '21 and early '22 where those -- that was causing enhanced earnings, where those were all running more positive than what we anticipated. And late in '22 and then into '23, we've actually been seeing some pressure on that. Sitting here today, really what we've seen is we actually have more of our variable investment income that's driven by real estate sales. And then we do have impact and [indiscernible] and prepays as well. Prepays have been not surprising, most of our prepays would be on our bond portfolio. And that has been basically 0 for the first half of the year, and we don't really see much of that changing as we go through the rest of the year, maybe towards the end, maybe we'll start to see a little bit of that. Real estate sales has also been pressured, again, back to some of the comments I made earlier, but also has actually been actually right on track with what our longer-term expectations are and actually, that's more improved than what we thought coming into the year. And so again, I think that would be the bright spot relative to variable investment income, but we're still seeing some pressure on real estate sales and prepays. We do see potentially some real estate sales in the second half of the year. That will have some impact again on variable investment income, but probably still be at a level lower than run rate expectations.

In your opening remarks, you talked about already seeing some green shoots continue to emerge, if you could elaborate.

Yes. I think I touched on some of those already. Ultimately, equity markets turning around, SMB continues to be strong. And then ultimately, we're seeing investors have infixed interest that staring to think about putting money back to work in risk-bearing asset classes. And so I'd say those are all positive as well. One of the things that I haven't mentioned is we have committed ourselves to a 40% dividend payout ratio. That would be higher than most of our insurance peers, slightly lower but much more consistent than our asset management peers. We had kept that flat since our strategic review and our transaction is really for 2 reasons. One is we did lose some earnings power from those transacted businesses, so we needed to kind of grow back into those. And then I'd also say macro being negative has some impact on that. Just this last quarter, we announced the increase in that for the first time since then, which obviously, I think, hopefully, is a sign that we're seeing confidence in a return to growth and ultimately, our ability to maintain and continue to have an increase in dividend [indiscernible] overall. And so I'd say those green shoots are across the businesses. But again, feeling good about our prospects for growth and are ultimately meaningful customers and ultimately not meaningful shareholder value.

Great. Do you want to take a pause here and see if there's any questions from the audience. If you have some mic runners. If anyone has questions, please raise your hand. I see the first question.

You mentioned early on the pension risk transfer areas, a new focus. And one, could you comment a bit on how much appetite do you see in the potential seller of this to transact at around or prospectively higher rates and what the competition you see, where it is looking at? And then from your perspective, a part of that, of course, comes with a longevity risk. How much appetite do you have for it? And how much market is there to lay it off to either investors or insurance operators?

Yes. Some great questions there. So just talk a little bit. We've actually been in the pension risk transfer business for over 50 years. So it is a core competence of ours. And I think one of the things that interesting about our pension risk transfer business, not unlike when I talked about much more small- to medium-sized business and so if you look at our sales activity in a given year, we tend to be top 5, both in the number of plans we do and the premium levels we do whereas a lot of times what you'll see by our peers is either skewed to very high-end premium, so they're jumbled or they're skewed much more on the plan side. And so we do -- on a given year, we made to 90 to 100 plans but we are targeting around $2.5 billion of sales in a given year. And so -- and about -- I think it's really interesting about 25% of the sales we do in the given year, actually our conversions from our defined benefit record-keeping business. And so I think we play a little bit different than our peers. We aren't going after those some locations that you read about in the Wall Street Journal. One, because competition is way too high. And because of that, the returns that we feel we can get on that are not as attractive as what we can do lower in the market there. We are seeing really good opportunities, obviously, with the interest rate environment, the way it is, funding ratios are at or slightly above 100%. So very conducive for people to rethink their liabilities relative to that. I think the market is going to be very strong for the year, but we are very diligent on how much capital we want to put as at. And so as I work with the leader of that business, we give them a budget and it's up to him to optimize returns relative to that budget. And ultimately, that kind of $2.5 million range will slightly grow every year, but that's a good range to think about for our business and we're able to get returns, 12% to 13%, 14% when as we look across those lack of sales. Relative to longevity risk, we actually are not scared away from that. Given our actuarial background, given our pension consulting that we do for a defined benefit customers and given that in some situations, we can offset that with mortality risk on the life side and diversify away that risk, we feel that we're appropriately managing that risk and the size of that, we feel, is at the right level and it's not outsized relative to that business. So not looking to offload that risk. It's more how we can manage it and price it appropriately, and we feel good about our expertise there.

I know you've done a number of transactions and derisking, but could maybe you just describe the current state of the business in terms of the size of meaning legacy businesses in terms of reserves or what have you? And then if so, can you just kind of characterize what those lines are composed of?

Yes. So are our current general accounts, and I'll look to -- is right around that $75 billion level, that's down from around $100 billion. So that would be ultimately kind of the reduction that we made. Think of that as pension risk transfer, group benefits, variable -- a small amount of variable annuity, life, we do have some legacy retail life much more. We got rid of the ULSG, but we still have some term in UL on a legacy basis, whereas our go-forward strategy is to grow that much more focused on the business owner. And then the other part of the balance sheet would be more MPNs and GIC, both third-party as well as part of our record-keeping retirement platform. So those would be the types of liabilities that are on the book and ultimately, one, I'd say the assets are very aligned to those liabilities, very ALM focus. We do expect to continue to grow those businesses, but we'll be smart at the returns that we're pricing those 4 and ultimately, demand even in the business. So those would be the general account kind of liabilities. I'll pivot a little bit. You were talking about kind of transactions and acquisitions. I'd say the first thing I want to reiterate is we don't feel we need to do an acquisition to deliver on the promises that we make. We feel we have the capabilities and the scale to be competitive and ultimately to deliver on that. When we talked about our capital management strategy, we have fair worked about 0% to 10% to go toward M&A but we also have a very low leverage ratio, so that gives us opportunities if those opportunities arise. We're going to be very selective, primarily focused in the asset management space. We will look every time for benefit but it needs to be very aligned strategically and I'd say a pretty high bar from a financial perspective.

I was going to take you back in an earlier question on PRT and around longevity risk. Do you feel comfortable with taking on deferred lives, which is a little bit different if you walk through comfort and being able to price for that risk?

Yes. So again, I come back to -- 25% of our business is coming from customers that we've recorded to their [indiscernible] and for a number of years. So that gives us really, really good insight into how those differed lives are going to perform, what the turnover is, how their plan design kind of work. And so we leverage those hundreds of actuaries that we leverage on the consulting side will obviously help us pick through the PRT business as well and bringing that on. And so we see one, competition is less. It allows us to get return. But I'd say we've seen that business through. We've been in the business for 50 years and seen the cycle in the different components and the return on that business and the volatility around that has not been anything that I'm uncomfortable taking. So we do feel, again, like I said, very good about that. It's not every case that we're bringing on has differed lives, but we are comfortable with it and we think the mix of business that we have and the spread of that across the number of small- to medium-sized customers [indiscernible] as well.

And you've also said that your outlook for PRT pipeline is $2.3 billion this year. But then I think in one of the questions, you said your typical run rate is $2.5 billion. Is there an update you want to make?

No. $2.3 million is really what we're targeting this year. That can grow a little bit every year from that. So that's a modest amount of difference. That $2.3 million is what we're targeted on this year. [indiscernible], so let's say, we don't see good opportunities for MTN or IO business and we see a great opportunity on PRT. We may pivot and shift some of the capital allocation there, so might flex up a little bit. But in total, it will be very in line with our total capital allocation.

Wonderful. We are just about out of time. So let's give a round of applause to Deanna. Thank you so much.

Thank you, Tracy. Thank you.