Principal Financial Group, Inc. (PFG) Q1 2019 Earnings Report, Transcript and Summary

Good morning, and welcome to the Principal Financial Group 2019 Outlook Conference Call. There will be a question-and-answer period after the speakers’ have concluded their prepared remarks. [Operator Instructions]. I would now like to turn the conference call over to John Egan, Vice President of Investor Relations.

Welcome to Principal Financial Group’s [Technical Difficulty] presentation related to today’s call are available at principal.com/investor. Following a reading of the safe harbor provision, CEO, Dan Houston; and CFO, Deanna Strable, will deliver some prepared remarks. Then, we will open up the call for questions. Others available for the Q&A session include Nora Everett, Retirement and Income Solutions; Tim Dunbar, Principal Global Investors; Joel Pitz, CFO of Principal International; and Amy Friedrich, U.S. Insurance Solutions. 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 filed by the company with the U.S. Securities and Exchange Commission. Additionally, some of the comments made during this conference call may refer to non-GAAP measures. A description of these non-GAAP financial measures may be found in our 2019 outlook call slide presentation on our website. Dan?

Thanks, John. I’d also like to thank everyone joining us on the call and everyone who participated on our recent Investor Day. Before Deanna gets into the details of our outlook for 2019 and an update on business unit long-term guidance, I’ll share certain points that reinforce our ability to deliver sustainable, profitable growth and create long-term value for our shareholders. Principal continues to adapt and evolve. We’ve expanded our solution set and our distribution platforms around the world. We continue to make tremendous strides using technology to take away pain points and remove barriers to customer action. We become more diversified and at the same time more integrated. We’ve turned aspirational businesses into industry leaders by intensifying our focus on the needs of our customers, individuals, small to medium-sized businesses and institutions and through strong execution and effective capital deployment. Over the past five years, we’ve increased reported assets under management, or AUM, by more than $200 billion, an increase of 43%. We’ve also increased our AUM in China, which is not included in the reported AUM by nearly $140 billion, a 13-fold increase over the same period. AUM and premium growth has fueled an increase in pre-tax operating earnings of more than $600 million, or 45% comparing the trailing 12 months ended September 30, 2018, excluding the 2018 assumption review to reported full-year 2013. This represents compounded annual growth of 10% in pre-tax operating earnings. Since the end of 2013, we’ve deployed more than $1 billion to strategic acquisitions, while continuing to invest heavily in organic growth. We’ve also returned more than $3.7 billion to shareholders, approximately one-third through repurchases and two-thirds in the form of common stock dividends. Our current dividend yield exceeds 4%. Today, Principal is a top 40 global asset manager. We’re the second largest pension provider in Latin America in terms of AUM and a partner in the third largest funds company in China. In the U.S., we’ve ranked in the top five in Defined Contribution, Defined Benefit, ESOP and non-qualified deferred compensation. We’re top three in group benefits and pension risk transfer. We’re a top 20 adviser of whole fund family and a top 20 provider of life insurance. Our leadership reflects broad expertise, managing assets appropriate for long-term investment strategies, developing income solutions, creating best-in-class retirement and employee benefit programs and helping business owners and individuals manage risk that can derail financial security. The current operating environment undoubtedly presents challenges. Yet more than any other time in our history we face these challenges from a position of strength, with a track record of strong investment performance, a broader and deeper set of solutions, an expanded distribution network and a continued commitment to exceptional customer service. As discussed at our Investor Day a few weeks ago, in 2019, we’ll continue to invest in digital business strategies and several key areas, including customer and adviser experience, direct-to-consumer sales and advice offerings and our global investment research platform. We expect these investments to improve our ability to help customers, enhance efficiency and scalability and ultimately, deliver compelling revenue and expense improvement over time. I’m highly confident about what we can accomplish over the next three, five, 10 years and beyond to help customers and clients around the world achieve financial security and success. To that end, we’ll continue to play a significant role in influencing the formation of effective pension systems in emerging markets, advocating for plan designs that enable workers to fund retirements that could last 40 years and simplifying insurance and communicating its value within a comprehensive financial plan. While our position is strong, we have no intention of standing still. We’ll continue to adjust as customer needs change, and will continue to evolve our strategy with a goal of achieving above market growth for the company and superior long-term value for our shareholders. Deanna?

Thanks, Dan, and thank you for joining our call. It was great to see many of you at our Investor Day a few weeks ago. This morning, I’ll focus my comments on three areas: two allocation changes going into effect in first quarter 2019, 2019 and long-term guidance of key drivers for each business and our 2019 capital deployment plans. As shown on Side 6. In first quarter 2019, we will be making changes to how we allocate certain expenses and net investment income among the business units. These changes were evaluated in conjunction with an enterprise-wide global financial process improvement process. Our 2019 and long-term guidance ranges reflect these allocation changes, so I’ll spend sometime this morning explaining what’s changing. It’s important to note that there is no impact to total company financial results from these changes. Starting with the expense allocation changes. On an annual basis, we are estimating that approximately $100 million of compensation and other expenses will move from the business units to corporate. These are expenses that benefit the entire organization and are better managed at the corporate level. By moving these expenses to corporate, we are simplifying the expense allocation process, increasing transparency and allowing for more effective expense management across the enterprise. It was also a good time to review our internal capital allocation methodology, especially given the numerous potential changes over the next few years to the NAIC risk-based capital formula. On an annual basis, approximately $50 million of net investment income earned on this capital is shifting between RIS and U.S. Insurance Solutions segment. We are simplifying our allocation process and better aligning our internal capital allocation with overall enterprise capital targets. The estimated income statement line item impacts of these allocation changes by business unit are available in the appendix on Slide 17. Again, there is no impact to total company results for either change. Slide 7 also illustrates that there is not a material impact to the contribution to pre-tax operating earnings by business from these allocation changes. Both allocation changes go into effect starting in first quarter 2019. Fourth quarter 2018 results will be reported under the current allocation methodology. A recast version of the fourth quarter 2018 financial supplement and other history will be released in February 2019. Turning to Slide 8. At our recent Investor Day, we highlighted some details of our accelerated digital investments. At the event, we said the net pre-tax operating earnings impact would be approximately $50 million to $60 million in 2019. This is similar to the net impact in 2018, with a slightly greater investment, partially offset by the beginning of revenue and expense benefits from the initiatives. Before we move to the 2019 outlook, I’d like to discuss some potential impacts from recent market volatility. Looking at equity markets, the S&P 500 index has declined about 6% from the end of the third quarter 2018 through November 28. This impacts fourth quarter 2018 results and is impacting our guidance for 2019. We estimate a 10% drop in the equity markets, results in lower annual operating earnings of approximately [46%] [ph], with about two-thirds of the impact in RIS-Fee and one-third in PGI. In these businesses, lower fees from lower account values and AUM, driven by the negative market performance are pressuring our revenue and margin expectations for 2019 relative to 2018. Equity markets also have an impact on DAC amortization in RIS-Fee. Based on S&P performance through November 28, we expect RIS-Fee’s fourth quarter 2018 DAC amortization to be above our expected quarterly run rate of $20 million to $25 million and negatively impact fourth quarter pre-tax operating earnings. It is also worth nothing that fourth quarter 2018 will also be negatively impacted by normal seasonality of expenses. Additionally, through November 28, Principal International’s fourth quarter results have been negatively impacted by $18 million of lower than expected encaje performance. With this recent volatility, I want to remind you that, when using one point in time to forecast the next year, small movements can have large impacts. We are providing you our best estimate at this time based on our underlying assumptions, as shown on Slide 9. For equity markets, we are assuming a 2019 S&P 500 daily average between 2,830 and 2,860, based on levels as of the close on November 28. This translates into a less than a 3% increase in the daily average over our assumed 2018 levels. This is lower than our 6% price appreciation assumption and compares to a 16% increase in the daily average as of the end of the third quarter 2018 on a trailing 12-month basis. For foreign exchange, we are assuming approximately a 2% headwind on Principal International’s growth of combined net revenue at PFG share, due to assumed foreign currency exchange rates for 2019 relative to 2018. Note that our future foreign exchange rate assumptions are based on external consensus as of November 2018. Our 2019 effective tax rate guidance range of 16% to 20% is lower than our 2018 guided range of 18% to 21%. Macroeconomic pressures are lowering our 2019 pre-tax operating earnings expectations in PGI and PI, both of which have a higher effective tax rate. Additionally, after excluding some unusual tax items in 2018, our year-to-date effective tax rate is at the low-end of our 18% to 21% guided range. As announced last week, our Board of Directors approved a new $500 million share repurchase program. The weighted average diluted share count guidance of 280 million to 282 million shares reflects a range of anti-dilutive and opportunistic repurchases in 2019. We will continue to take a balanced and disciplined approach to capital deployment and will evaluate share repurchases based on valuation and other deployment opportunities. Corporate pre-tax operating losses are expected to be $300 million to $320 million in 2019. As I previously discussed, this includes approximately an additional $100 million of compensation and other expenses, due to the expense allocation change and a full year of expenses associated with robust wealth. As a reminder in 2018, corporate benefited by more than $15 million, due to a positive outcome from IRS negotiations on taxes from prior years. On Slides 10 through 13, we provided the 2019 and updated long-term guidance ranges by business unit. These ranges reflect the estimated allocation changes I discussed earlier and thus aren’t comparable to prior guidance ranges. The 2019 outlook ranges were built off third quarter 2018 trailing 12 months revenue metrics, recast for the estimated allocation changes and exclude the impacts of the 2018 assumption review, as well as the accelerated performance fee and elevated expenses in PGI. These estimated recast figures can be found in the second column on Slides 10 through 13 for each business. Turning to Slide 10. RIS-Fee’s 2019 net revenue growth guidance range is negative 2% to positive 2% and is lower than our long-term guidance of 1% to 5%. 2019 net revenue growth is being impacted by the unfavorable equity markets I discussed earlier, as well as changing plans sponsor preference for fee arrangements instead of commissions. As a result of this shift, we’ll report both lower fee revenues and lower commission expense with no impact to pre-tax operating earnings. We expect this change will have a negative 2 percentage point impact to our net revenue growth rate over 2018. Margins in our RIS-Spread have increased due to a benefit from the allocation changes. RIS-Spread is benefiting from both the net investment income and the expense allocation change, resulting in margin expansion. As shown on Slide 11, we expect Principal Global Investors operating revenue growth to be slightly lower than our long-term expectations due primarily to current unfavorable market performance and industry headwinds. Moving to Slide 12. Principal International’s 2019 net revenue and margin are expected to be lower than our long-term outlook due to foreign currency exchange headwinds, pressures primarily in Latin America and the higher DAC amortization that we discussed on our third quarter 2018 call. As shown on Slide 13, we are revising specialty benefits 2019 and long-term loss ratio range favorably to 60% to 66% due to a continuation of the positive trends in the small to medium-sized business market and our focus on effective claim management and pricing discipline. Both specialty benefits and individual life are expected to continue to have strong premium in fee growth and margins. Moving to Slide 14. We expect to deploy $1 billion to $1.4 billion of capital in 2019, reflecting our continued very strong financial position. We will continue to take a balanced and disciplined approach to capital deployment and we evaluate deployment opportunities against a minimum return relative to our cost of capital. Over the long-term, we continue to target externally deploying 65% to 70% of net income per year with fluctuations in any given year. Over the long-term, our business mix and strategy will allow us to continue to deliver total company non-GAAP operating earnings growth of 9% to 12% per year. We do, however, expect short-term pressure on this metric, given macroeconomic and industry pressures. Looking at 2019 specifically, the midpoint of our guidance ranges imply an annual growth rate in non-GAAP operating earnings per share in the mid single digits, excluding the impact of the 2018 assumption review and the PGI third quarter 2018 significant variance. We also continue to target ROE expansion of 30 to 60 basis points per year over the long-term, with fluctuations in any one year, with an ultimate target of non-GAAP ROE, excluding AOCI other than foreign currency translation adjustment between 16% to 17%. We remain confident in our diversified business model and our ability to execute on our strategy and consistently deliver above market growth. This concludes our prepared remarks. Operator, please open up the call for questions.

[Operator Instructions] Your first question comes from Erik Bass with Autonomous Research.

Hi. Thank you. I was hoping you could provide some more detail on the driver and the decline in the assumed margin in RIS-Fee. I guess, it looks like it’s below your long-term target range, but I’d have thought it would also be helped a bit by the revenue adjustments for next year. So just any more kind of details on the moving pieces would be helpful there?

Yes. Thanks, Erik. This is Dan, and look forward to responding to that. Again, I would just make this broader comment. I have a lot of confidence in the RIS-Fee business. It’s obviously going through a lot of change. We’re taking a very deep look at the expense structure that goes into the RIS-Fee business, but small to medium-sized businesses continue to demand high-quality services to help support them in providing these capabilities. Two of the big headwinds obviously is this past year’s equity markets, where we haven’t had the benefit of getting to a new higher starting point, which is obviously very good for revenue growth. And the second is around geography. But I’m going to ask Nora to go ahead and provide some additional thoughts and perspectives on the RIS-Fee business.

Sure. Good morning, Erik. To Dan’s point, the primary driver impacting our assumptions around 2019 margins in the lower equity markets, and again, we struck this on November 28. So if you look at November 28 and you look at kind of average that S&P index as your proxy and average fee revenue coming in relative to 2018 and then we push our assumptions forward off of November 28 for 2019. That’s a significant impact with regard to feel revenue, which translates and impacts our margins. So that, as that few revenue gets impacted just the declines relative to fixed cost, significantly impact that margin, and again, we’ve seen equity markets come up today. So to Deanna’s earlier point, point in time matters. Two, we’re going to continue to invest in this business. You think about that accelerated digital investment and not just for this P&L, but when we make those investments in the business, as Dan described, it also creates revenue growth for other P&Ls around the Principal Financial Group. And finally, with regard to the reallocations actually, RIS-Fee on a net basis, if you look at the reallocations, it’s about $19.4 million negative. So as you look through and I know you just received the information, but as you look through those reallocations, both with regard to net investment income and with regard to comp another, you’ll see a net negative with regard to the RIS-Fee line.

Got it. Thank you.

Erik, do you have follow-up?

If I could ask one other one on just your long-term outlook for the margins in Principal International. I think last year you were talking about a 40% to 45% target, and it’s now 38% to 43% with a – I think a small benefit from the allocation changes. So is this all the Brazil changes from the third quarter, or is there something broader we should think about?

Well, that that’s certainly one of them. But we have the benefit today of having Joel Pitz as Chief Financial Officer with us from Principal International. We – Luis is travelling out seeing customers and advisers in Asia. So maybe I’ll have Joel follow-up on your question here.

Hey, good morning, Erik. Thanks for the question. You’re exactly right, part of it does relate to the DAC assumption changes that we announced in third quarter 2018. Importantly though, the DAC amortization is muted when you go up three to five years, which is our long-term guidance is. In the short-term, we are going to have about $5 million per quarter of pre-tax headwind because of the amortization. So that is a relevant point. That’s about 1% of our total reduction in long-term outlook. The other impact also relates to Brazil that tied to its contribution to total because of the relative weakening of the Brazilian reais relative the rest our portfolio. So 1% because of the change in weighting, not because of growth in Brazil, but because of the weighting, because of the more significant impact on FX in Brazil and in the other part because of the amortization emergence of DAC, those are the two major items.

Thanks, Joel. Thank you, Erik for your questions.

Thank you.

Next?

Your next question is from John Nadel with UBS.

Hey, good morning. So I think you covered PI, or Principal International. I’m just wondering, when you make the adjustments for the allocation changes, whether it’s expenses or investment income and you look at the long-term margin outlook for each of the business segments relative to last year’s long-term outlook. Is there anything that changed beyond just the change in allocation?

Deanna, please.

Yes, John, thanks for the question. I think the only other thing that you can – is impacting that would be that equity market performance. And so…

Yes.

..again, long-term that hopefully will all mute out, that probably has more impact on the 19 outlook versus kind of what you’re seeing in 2018. But that would be the only other significant impact to those metrics.

Okay. And then in your outlook, whether it’s for the diluted share count or just maybe even more broadly, did you factor in deployment of the full $1 billion to $1.4 of capital deployment?

Deanna?

Yes. So we are factoring that in. Obviously, [indiscernible] is probably determining where that deployment happens. And so we take our best guess relative to dividends and share buyback and M&A and factor that into our EPS guidance.

Okay. But the entirety of that range is in the implied range of your outlook?

Yes, probably the midpoint is probably a good proxy for that.

Gotcha. Very helpful. Thank you.

Thank you, John.

Your next question comes from Andrew Kligerman with Credit Suisse.

Hey, thank you. So, based on your guidance, it doesn’t sound like the RIS-Fee business is – you’ve got a movement of commissions in fee ranges, but the bottom line is unaffected. Maybe just in general, are you feeling any pressures on fees? And if so, could you provide some color?

Hey, Andrew, I think that your observations are really good. When you sort out the geography and make adjustments for the starting point on the markets, I do think it finds itself in a very healthy position. But in terms of broad macro competitive pressures, I’ll have Nora speak to it here in just a minute, but they’re out there. But they’ve been there for a long time. One of the things I’m probably most excited about is the work that Nora and her team, including Jerry Patterson, are working on relative to aligning our expenses, becoming more efficient, so helping us drive revenue and take out some expenses. So a very big initiative, a lot of effort being devoted towards that, while at the same time improving overall customer experience. And a lot of these digital projects that we’ve mentioned do, in fact, go right at the issue of improving customer service. Nora?

Sure, and we talked about this before, Andrew. Certainly, this space continues to be uber-competitive, so there’s no doubt. And that’s not a new phenomenon, that’s been a multi-year pattern. But what you see in 2019 is definitely relative to the long-term guidance, is definitely impacts like that 2% drag on net revenue growth just because of the geography issue around so many plan sponsors and their advisers shifting off a commission-based model to that fee-based model, which is just geography, because it also lower – it lowers revenue growth, but it also equally lowers commission, so no impact to OE. And that that’s just an important factor, as you look at that 2019 number. No doubt, we are going to continue to face those competitive headwinds, but we also see it as an advantage, which is why you see that long-term guidance where it is. Ultimately, there will be consolidation in the space that we’re going to benefit from. And to Dan’s point, we continue to make the right investments for future growth. So we are not going to – we’re going to balance the need to invest with regard to our margins and expense control. But we’re striking the right balance to ensure that over time, we continue to play in that top three with regard to this particular part of the market Defined Contribution and meanwhile also create additional revenue for other businesses around the Principal Financial Group.

Follow-up, Andrew?

Yes. Follow-up on specialty benefits. So last year, you’ve indicated a 62% loss ratio, you’re targeting 60% to 60% now in the long-term. How are you feeling as you – what part of that range are you feeling more comfortable with just given that you’ve had pretty terrific performance recently?

Yes, I agree with your observation about terrific performance and again, a lot of that’s attributable to just a very solid business in a core part of the market this SMB space. And Deanna and Amy have done a good job getting us to this point. But Amy, do you want to add some additional color?

Sure. I think and I think my color really is implied in the range we’re giving is that, we think the midpoint of that range is a good set of assumptions to have. Keep in mind, when you look at the performance from this year in specialty benefits, we do have individual disability performance that was above our expectations in first quarter of this year. So when you’re looking at just this year’s isolated performance, it’s going to be just a little bit better from a loss ratio standpoint than we would expect to see on a normalized go-forward basis. So I would say, it’s very fair to say both those ranges are very, very competitive and attractive and at the midpoint is a good guide to use.

Thanks for your question, Andrew.

Your next question comes from Humphrey Lee with Dowling & Partners.

Good morning and thank you for taking my questions. Related to RIS-Fees, I think historically, you talked about you kind of assume kind of 1% to 3% of kind of core business deposit growth. Should we think about that as embedded in your guidance for 2019?

Yes, that’s a good assumption. That 1% to 3% still in that core SMB franchise is the right way to look at the cash flows.

Okay, got it. And then I think in Nora’s remarks kind of talk about the pre-tax return on that revenue kind of sensitive to the equity market starting point. How should we think about the margin sensitivity relative to the broad SMB markets if we were to think ahead?

Deanna?

Yes, a couple of comments there. And I think we all know that the current market environment is very volatile and obviously, we had to pick a starting point and go off of that. And we have given you kind of a rule of thumb that shows that for any 10% movement in market, we probably have 4% to 6% impact in OE. Specific to RIS-Fee, when I’m comparing the 2019 outlook to the long-term outlook, you can see about a 2% difference between the two. And I’d say, market is probably about 1% of that, with the remainder being digital having pressuring those margins in 2019. But over time, we’ll have a positive impact on those margins. So again, that 6% drop that was embedded in the Outlook translates to about a 1% impact on RIS-Fee’s 2019 outlook.

Okay, got it. Thank you.

Thanks for the question.

Your next question comes from the line of Ryan Krueger with KBW.

Hi, thanks. Good morning. I had a couple of quick ones. First, on International. In terms of the DAC amortization headwind in Brazil, I believe on the call last quarter, you said that would roll – that would gradually roll off over time. Can you give some additional color on that?

Yes, Joel is in a perfect position to respond to that.

Thanks for the question, Ryan. That is true, it will roll off over time. So 2019, we’ll see about $5 million pre-tax per quarter, with it being lessened over time. But at the end of the day, when we add new business, it’s going to also accelerate the capitalized commissions on that new business as well. So it’s not going to roll off as quickly as you might think. So from a closed block perspective, it does roll up pretty quickly. It’s a zero-sum game. But as you add new business on, the assets that we capitalize are going to amortize at a more accelerated pace on a new assumption than the other assumptions. Another important point with this too is that the U.S. GAAP issue-only. So on a Brazilian GAAP locally, this had no impact on our accounting. And so therefore, it doesn’t impact the capital position locally and therefore, does not impact ability to dividend money out of Brazil as well, so that’s another important takeaway.

Thanks, Joel.

Does that help, Ryan.

Yes, that’s helpful. Thanks. And then on PGI, can you give us a sense of either some – your flow expectations or may be organic revenue growth expectations. I know you have the 1% to 5% overall revenue growth, but I guess I was curious what that may be would be if you stripped out the market?

Yes, good question. I want to have Tim Dunbar respond. But before I do that, I’ll just say this. We’ve really taken a very close look in the last couple of quarters into PGI, I think, Tim and Pat Halter, specifically are really verifying and validating the business model, looking at our relative competitiveness, whether it’s the price, the actual performance our various strategies and feel very good about where we stand today in terms of relaunching, if you will, under Pat at Tim’s leadership. But Tim, you want to go ahead and responds?

Sure. So for 2019, we do expect cash flows to be positive. We would expect that to be back-end loaded. So we’d see some continued negative pressure over the next two or three quarters in our net cash flows. And then just on revenue growth, the negative impact of the market conditions that Deanna talked about that negative 6% would have about a negative 2% impact on our revenue growth rates.

Okay, great. Thanks a lot.

Thanks, Ryan.

You next question comes from the line of Jimmy Bhullar with JPMorgan.

Hi. I had a couple of questions. First, just on the implied improve – so if you look at PGI’s net revenue guidance, you’re talking about like I think 1% to 5% in 2019 improving to 4% to 7% longer-term. And I think in the comments, it was mentioned that part of the weakness is because of the market, as well as just industry headwinds. What gives you the optimum – and what gives you the optimism, like view that industry headwinds a little bit? Are you seeing any of that in the market, or in your results? And then similarly, in both the International and Fee Retirement business, you’re assuming better revenue growth longer-term than what you’re seeing in 2019. And I’m just wondering is 2019 more of the new normal, or is there – are there some concrete things besides the market that are pressuring you in either those businesses in 2019?

All good questions and right at the heart of the reason for having a call like this for today, which is provide you with an outlook on that – on the business and the underlying fundamentals. So maybe I’ll just ask Tim to respond to PGI and then go right to Nora.

Sure. So for the net cash flows, we do expect that from an industry perspective, cash flows will continue to be a bit anemic over the next few years. So certainly, that’s having an impact on our revenue growth rate for 2019. And as you can see, we brought down the long-term guidance by about a percentage. Some of the other impacts that are happening in the marketplace today, which would be concern over global growth, as we see uneven tapering starts to occur rising interest rates, currency volatility. Those are market conditions that we would see abating over some period of time. As you know, we have a really good multi-boutique model. We have great capabilities within those boutiques and good investment performance. So we are still seeing good demand for a lot of our strategies that we have today. And then I’d say, we have a very strong pipeline of new capabilities that we’ve been seeding and developing, including our European real estate group, emerging market debt and equities and our – and asset allocation solutions. So we think we have a lot of opportunities, as we go forward to expand those products, not only within the U.S., but around the world as we work more closely with PI and RIS. Nora, you want to a shot at RIS-Fee?

Sure. Well, certainly, we don’t believe that 2019 outlook with regard to net revenue growth is a new normal. We’ve got confidence around that long-term 1% to 5%. And there’s a number of things and we talked about it already, but it’s probably worth highlighting again. When you strike on November 28 assumptions around the equity market, you’re looking at year-over-year really muted year-over-year growth again, based on those assumptions less than 3%. That has a significant impact then on the outputs around those assumptions, one. Two is that 2% drag, you really do need to recognize that drag on the top line even though it doesn’t filter through to the bottom line, because it does impact – meaningfully impacts that growth number coming from 2018 into 2019. And three, as I talked about earlier, we are making the right investments around digital, around the customer experience. And those investments give us confidence that long-term, we will continue to be a top player in the – in this full service retirement space and continue to benefit the balance of the Principal family.

I’d say, Jim, as it relates to a Principal International, I’m frankly very enthusiastic Brazil has a new President. I think pension policy and economic growth will continue to get back on track, as it was at one time. Chile is in a very similar manner in terms of pension reform. We have a front row seat to that, those discussions feel good about it. But broadly, I would say, these emerging markets, which we enjoyed all those tailwinds for so long and the headwinds the last few years, but the reality is their currencies will strengthen overtime. We’ve already seen some signs of that. GDP growth looks good. They’re all modernizing their retirement systems. They have the same gaps that we have here in the U.S. They’re going to be looking at voluntary systems in addition to augment the retired – required systems. And then the other two sort of big ones out there that give me confidence around 2019 and beyond is one, China. I think, we all heard that favorable sentiment as it relates to the conversations in Argentina over the weekend between President Trump and President Xi. And hopefully, those get resolved here in the next 90 to 120 days. And the second one is some experimentation in India around digital and digital distribution what that might mean. So I’d tell you that, as I listen to Nora and Tim discussed the growth domestically, I’m just as enthusiastic about international markets coming around. Did you have a follow-up Jimmy?

Yes, just one for Tim since he’s taking over PGI and he’s been looking at the business over the past few months. Any changes that you’re implementing or sort of differences in strategy in that business, whether major or minor that we should expect to see over the next year?

Sure. Sure, I think, we talked quite a bit about some of the realignment we’ve done with our distribution and marketing. And I think that work is well underway and will continue. I’d say, the other thing is, I think about asset management globally across all of our businesses that we’re really thinking it more of a horizontal capability that really allows PFG across the platform to grow. And we’re committed really to provide the types of products that our customers need in both retail and institutional to make that happen.

Okay. Thank you.

Okay. Thanks, Jimmy.

Thanks.

Your next question comes from Alex Scott with Goldman Sachs.

Hey, my first question is just on the 2 percentage points related to commissions to fees in RIS-Fee. Could you talk about how that may change your sensitivity to equity markets for net revenue going forward? And then also, any kind of color you can provide on, whether that will be like a step function in the first quarter of 2019, or if this is something we’ll see throughout 2019?

Yes, it’s a bit of a math and accounting function. But Nora, you want to respond?

Sure. It will evolve. It will not happen all at once, as you can imagine. And it’s not just the DOL, right, but just the shift in the industry, whether it’s plan sponsor-driven or sometimes adviser-driven, sometimes broker dealer-driven with regard to their expectations on how their advisers in this space will be compensated. We expect to see some significant movement throughout 2019, but there certainly would be a tail on it it’s not going to happen all at once. With that said, we have some significant pieces of our business that can be influenced by a single decision at a broker dealer. So certainly, you could see some lumpiness in this. With regard to the impacts, it’s really – it’s less about the equity markets and more about how that collection takes place. And for us, that impacts the – you have a contra revenue item now on the top line versus revenue. And then you’ve got obviously the – it’s a zero-sum game with regard to that commission expense line than being equally reduced. So it’s really more about geography from our perspective.

Does that help, Alex?

Yes, that’s helpful. I guess, the second question I had on RIS-Spread. It looked like that, I guess, the most capital went into that segment in the new allocation. So I’m just wondering about how should I think about that? This is, I think, one of your longest duration businesses. Does that mean a change in sort of IRRs related to versus how you price the business? And does it change anything about where you’ve got to do on pricing going forward?

Yes, Deanna, you want to take that one?

No, there’s really no impact on pricing. We had already been pricing based on kind of an extra allocation of capital and the associated net investment income and we will continue on that basis. So there was just a little bit of a disconnect between our internal allocation of capital and that external. So this better lines up the financial statements to how we’re pricing. I think, you’re correct. RIS-Spread was the one that benefited the most from the reallocation, both expenses and net investment income and probably saw greater than a 5% positive impact on that margin, but again, no impact on how we’re thinking about the pricing of that. But obviously, those resulting margins are very strong relative to the business that we’re putting on.

Thanks, Deanna.

Alex, maybe to your point with regards to the commissions for whatever it’s worth, whether it’s the NAIC, the DOL, or the SEC. One of the key words has always been around transparency. To the degree, it can be a fee that the – someone is paying for the services rendered. I view that frankly is quite positive that then allows us to reflect and assess what someone is paying for asset management. And then the third bucket, of course, is something that we’ve done around here for a very long time, record-keeping, administrative services, testing, compliance, the manufacturing of the materials necessary and the websites to support the participant. So that level of transparency moving from commission to fee, I view is for the industry very favorable long-term. Thanks for the questions.

Sure.

Your next question comes from Suneet Kamath with Citi.

Thanks. Good morning. I guess, a question for Dan or Deanna on expenses. In the past, when markets have been challenging, you guys have done a good job of really tightening up on the expense side and given the ongoing digitalization expenses that you have. Do you still have capacity to do that in 2019, if the markets aren’t so favorable?

Yes. We absolutely do, Suneet. And as you might expect, that’s something that we look at constantly. It’s been a while think about the 10-year anniversary and a lot of the belt tightening that had taken place. I think, there has been some great investments in IT, an improvement in process and, of course, upgrading talent for the organization. But we do have a, what I consider the formal effort underway to evaluate the expense structures, which clearly went into the creating of the 2019 outlook. And my confidence in our ability to execute on that, that plan is very high. I appreciate the question.

Maybe a follow-up then for Tim on PGI. I mean, I know we talked about this on the last earnings call about positioning for higher rate environment if you have the right solutions in place and strategies in place, et cetera Do you need to do anything on the M&A front to better position PGI for stronger flows ahead?

Yes, I think we have a lot of really good capabilities. And we don’t see the capabilities that we have really waning in terms of investor interest in it like real asset strategies, yield-oriented products. And we do have strong equity offerings in mid-cap, small-cap, international, diversified. We have a deep suite of fixed income capabilities. So while there are some things that we would like to continue to look at in the marketplace, again, those focused on higher value-add capabilities. I don’t think we need anything today in order to realize the growth potential that we think we have going forward.

Okay, thanks.

Thanks, Suneet.

Yes.

And this question comes from the line of Tom Gallagher with Evercore.

Good morning. Just a question on the RIS-Fee segment and some of the puts and takes there. So if the 2 point depressing impact on revenues…

Tom?

Do you hear me?

No. We can now. You’ve cut out there. Can you just start your question over again, please?

Sure. Sorry about that. Just a question on the RIS-Fee segment, the change from commissions to fees. The 2 point depressing impact on revenues, which you said won’t have an impact on earnings. Does that mean if I normalized the revenue impact, the reduction in margins would have been more than the 2 points that you’re highlighting. Is that the right way to think about it, or any – anyway of clarifying that?

I don’t think so. We – let’s take that offline with you with John to follow-up, if you don’t mind.

That that’s fine, yes…

Okay.

…happy to follow-up on that. And I guess, just a related question. Just want to understand better the underlying trend that’s occurring there. Can you comment on, is that broadly you’re seeing that moving from commissions to fees? Is it mainly large case, small case? And can you give a little more of an example of what it – what exactly is happening? Is it like really just break-even from a long-term economic standpoint, or do you feel like you’re giving something up, or how do you – can you help sort that out a little bit?

Yes. Let me take a quick shot and then throw it over to Nora. But I view it this way. If nothing else, the DOL fiduciary reg has caused every single plan sponsor out there to be more keenly understanding of the components of the underlining expense structures. And so to the extent that there’s more discussion about how people get paid. It certainly has involved on how Principal gets paid for its services, which I cited just earlier the asset managers we’ve seen pressure there. Advisers fall into that same camp in terms of disclosure. And the fee structure oftentimes could be a fixed amount each year as opposed to commission, which as you know, generally increases with the assets under management. All of that has become, I think, more of a topic of discussion between plan sponsors and their advisers. But with that, I’ll ask Nora to go ahead and provide some additional color.

Sure, Tom. So there’s a couple of different buckets here. One is, there certainly is going to remain a place for a commission-based chassis. There’s no doubt about that. That’s been recognized, as in some cases, the right model and certainly, especially with smaller shops with general advisers. So we would expect the commission-based model to continue. However, what we would also expect is with the larger firms well named broker dealers that you would recognize very large wirehouse distributors, there have been decisions made within those firms in their broker dealer that has said to their advisers, you will move your business to a fee chassis from a commission chassis. So we certainly expect to see some significant pieces of business convert from that commission-based to the fee-based chassis. And so that that’s what we’re looking forward to 2019 and doing our best to estimate based on what we know about our block and what we know about those distributors as to the timing of that of that change that transformation.

That – that’s helpful. And as just one follow-up, sorry on that. And is the – so is the broad trend here, because if I look at it and try and sort of sift through this, it does look like there’s a near-term negative impact to current margins, I might not be fully grasping that. But if there is, would you expect to get some of that back based on the way the accounting is going to flow through here?

Tom, I wouldn’t make the assumption that that’s going to – that that’s a direct correlation. We would expect – there are other things impacting that margin. This is – sitting here today, this is more of a geography issue with regard to where that comes in, whether it comes in above the line as a revenue piece or whether because of this transformation that becomes a contra revenue above the line but we reduce the commission expense below the line.

And we’ll get back to you on how that impacts return on net revenue, because you’re right, if your OE impact is neutral, there will be impact not just on the revenue growth, but on your margin as well. So we’ll follow-up on that.

Thanks for the question. I appreciate it.

Thanks, Deanna.

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

So first, thank you for joining us today for the outlook call. Deanna is going to be in Europe here in the next couple of days meeting with investors. I’ll be in New York tomorrow meeting with investors. We still believe strongly we’ve got a very strong business model and franchise here at Principal that we can build on. And certainly, in 2019, it is diversified. We’ve all seen firsthand the benefit of having diversified business model that’s worked for us well. We’ve also seen and witnessed firsthand the benefit of deploying the capital in the manner in which we have. We didn’t talk about the share buyback. Obviously that was an announcement that was made last week, as we think that is the highest and best use of the capital at this point in time. And then the last item I would – I’d be remiss if I didn’t mention is and we’ll have a chance to do this formally on the next call. But Nora Everett has just done an exceptional job in retirement versus services and leading that organization and we’ll wish her well when she retires at the end of March next year. But at the same time, we’re enthusiastic about bringing someone back to Retirement and Investor Services, who previously had been there. And Renee Schaaf is a longstanding, very capable executive, who has spent the last six years in Principal International seeing firsthand what emerging markets look like, working very much in the retirement space and long-term savings. So, again, thank you for your confidence in the Principal, and look forward to seeing on the road very soon. Thank you.

Thank you for participating in today’s conference call. This call will be available for replay beginning at approximately 12:30 PM Eastern time today until the end of day, December 10, 2018. 2198493 is the access code for the replay. The number to dial for the replay is 855-859-2056 U.S. and Canadian callers or 404-536-3406 international callers.