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Intrinsic Value is all-important and is the only logical way to evaluate the relative attractiveness of investments and businesses.
Welcome to the American Equity Investment Life Holding Company's Fourth Quarter 2017 Conference Call.
At this time, for opening remarks and introductions, I would like to turn the call over to Julie LaFollette, Director of Investor Relations.
Good morning, and welcome to American Equity Investment Life Holding Company's conference call to discuss fourth quarter 2017 earnings. Our earnings release and financial supplement can be found on our website at www.american-equity.com. Non-GAAP financial measures discussed on today's call and reconciliations of non-GAAP financial measures to the most comparable GAAP measures can be found in those documents.
Presenting on today's call are John Matovina, Chief Executive Officer; Ted Johnson, Chief Financial Officer and Ron Grensteiner, our President of American Equity Investment Life Insurance Company.
Some of the comments made during this call may contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act. There are a number of risks and uncertainties that could cause actual results to differ materially from those expressed or implied. Factors that could cause the actual results to differ materially are discussed in detail in our most recent filings with the SEC. An audio replay will be made available on our website shortly after today's call.
It is now my pleasure to introduce John Matovina.
Thank you, Julie. Good morning, everyone. Thank you for joining us this morning.
We ended 2017 with strong fourth quarter results. Our non-GAAP operating income was $74.5 million or $0.82 per share. These amounts were the second best quarter in the company's history, surpassed only by the third quarter of 2017 results, which included a sizeable benefit from unlocking of our actuarial assumptions.
As a reminder, the three key areas that drive our financial performance are growing our invested assets and policyholder funds under management, generating a high level of operating earnings and the growing asset base through investment spread and then minimizing impairment losses in the investment portfolio.
So, for the fourth quarter of 2017, we delivered 1.6% sequential growth in policyholder funds under management. On a full-year basis, we generated a 12.9% non-GAAP operating return on average equity and that excludes the impact of the actuarial assumption reviews and the loss on extinguishment of debt that we had in the third quarter and our investment impairment losses, after the effects of deferred acquisition cost and income taxes were just 0.04% of average equity.
The growth in policyholder funds under management for the quarter was driven by $1 billion of gross sales that represented a 10% sequential increase. As we noted in our third quarter call, we capture higher new money yields since late June, allowing us to enhance our product offerings and competitive positioning. Sales momentum picked up in the quarter and you'll hear more about the sales environment and competition from Ron a bit later.
We had a modest sequential increase in the investment spread in the fourth quarter, reflecting a larger benefit from bond transactions and prepayment income, a slight increase in the over-hedging benefit. And our low level of investment impairment losses once again reflects our continuing commitment to a high-quality investment portfolio.
I'll be back at the end of the call for some closing remarks, but now I'd like to turn the call over to Ted Johnson for additional comments on the fourth quarter financial results.
Thank you, John. As we reported yesterday afternoon, we had non-GAAP operating income of $74.5 million or $0.82 per share for the fourth quarter of 2017 compared to non-GAAP operating income of $56 million or $0.63 per share for the fourth quarter of 2016.
Investment spread for the fourth quarter was 275 basis points, up five basis points from the third quarter of 2017 as a result of a four-basis point increase in the average yield on invested assets and a one basis point decrease in the cost of money.
Average yield on invested assets was 447 in the fourth quarter compared to 443 in the third quarter. The increase in average yield in the quarter reflected a larger benefit from non-trendable investment income items, which added 12 basis points to the fourth quarter average yield on invested assets compared to five basis points from such items in the third quarter of 2017.
Non-trendable investment income in the fourth quarter of 2017 included 11 basis points from fees from bond transactions and prepayment income. The average yield on fixed income securities purchased and commercial mortgage loans funded in the fourth quarter was 427 compared to 439 in the third quarter of 2017 and 403 for the first six months of 2017. In January, we invested new money at 412.
The aggregate cost of money for annuity liabilities was 172 basis point, down one basis point from the third quarter. The benefit from over-hedging the obligations for index-linked indentures was eight basis points in the fourth quarter, compared to six basis points in the third quarter of 2017.
We continue to have flexibility to reduce our crediting rates if necessary and could decrease our cost of money by approximately 49 basis points, if we reduce current rates to guaranteed minimums. This is up from 47 basis points at the end of the third quarter.
Interest expense on notes payable for the quarter was $6.4 million down from $7.6 million in the third quarter. Third quarter interest expense included $1.2 million for our [6.58%] notes due in 2021, which were redeemed on July 17.
Our effective income tax rate in the quarter was 33.1%. Income tax expense in the quarter was reduced by roughly $900,000 from the income tax benefit for share-based compensation. This benefit varies from quarter-to-quarter based on stock option exercise activity and the vesting of restricted stock and restricted stock units. The effective income tax rate excluding this item was 34%.
Our risk-based capital ratio at December 31 was 3.78 up from 3.75 at the end of this year's third quarter. The increase in the RBC ratio included four points from a decline in required capital for production, which we estimate for interim periods using trailing 12-month sales and five points from the excess of the increase in our adjusted capital and surplus over the increase in required capital from growth in assets and reserves.
RBC was negatively affected by six point due to the reduction in adjusted statutory capital and surplus, resulting from the revaluation of our statutory deferred tax assets due to tax reform. On the subject to tax reform, we expect our non-GAAP operating effective income tax rate to fall from 2017's level to a range of 20% to 22%.
Our current analysis indicates that tax reform will have a relatively small benefit on new business pricing because the acceleration of cash payments resulting from changes in the tax reserve deduction and the capitalization and amortization of deferred policy acquisition costs will on a present value basis substantially offset the benefit of the lower statutory tax rate. We expect any benefit from tax reform our new sales will be competed away.
However, we expect to capture much of the benefit on earnings generated by our in-force business. The economic benefit will not be as large as the drop in the statutory tax rate would suggest as the change in the tax reserve deduction, which accelerates cash payments for income taxes will be implemented for in-force over time.
Our expectations are based on our current understanding of the new law and may be revised based upon regulatory direction and further analysis.
Now I'll turn the call over to Ron to discuss sales, marketing and competition,
Thank you, Ted. Good morning, everyone. As we reported yesterday, gross sales for the fourth quarter of 2017 were $1 billion, that's up 10.3% compared to the third quarter of 2017. This is the second time in the last eight quarters that we reported higher sales sequentially.
Our sales typically follow the larger market directionally and early indication suggest that fixed index annuity sales were higher in the fourth quarter. While positive, we continue to face headwinds from the DOL fiduciary rule, low interest rates and the strong equity market.
However, recent volatility in the equity market may provide a wake-up call regarding the value of safe money products like fixed indexed annuities. There has been a lot of emphasis placed on accumulation in the last couple of years and at times like these where the real benefit of fixed index annuities shine, principal protection, locked-in interest and guaranteed income.
American Equity Life was in a strong competitive position for guaranteed income, caps and participation rates throughout the fourth quarter as a result of product changes we made in September and early October. In September, we increased income on our guaranteed income products and in October we introduced a new lifetime income benefit rider for Foundation Gold fixed index annuity, which offers very attractive guaranteed income. We also reintroduced a popular no-fee version of our rider.
Finally, we increased participation rates and caps on our accumulation offerings. Several of our competitors had rate reductions in September and October, but subsequently reversed course and raised caps and participation rates, even so, we remain in a strong competitive position for guaranteed income caps and participation rates.
Reflecting the independent agent's emphasis on accumulation, we continue to focus more of our marketing efforts on our Choice series at American Equity Life. The Choice series accounted for 33% of American Equity Life sales in the fourth quarter versus 22% in the third quarter and 17% in the second quarter.
Choice 10 was our best-selling product in the fourth quarter, supplanting bonus gold, which have been our best-selling product for several years. When coupled with the optional market value adjustment rider we introduced in early 2017, the Choice 10 offers some of the highest participation rates among annual reset fixed index annuities and compares very well with the hybrid index, multiyear term products, which certain distributors have focused on.
We're not fans of the hybrid index products that often have little or no trading history, add unnecessary complexity to the fixed indexed annuity product and lack the transparency, which we believe is important and safe money insurance products.
The changes we made in the fourth quarter helped us gain momentum. Pending business at American Equity Life averaged 2,249 applications during the fourth quarter and was at 2,353 at the end of December compared to 2,178 applications when we reported third quarter 2017 earnings. As of this morning pending stands at 2,343 applications.
To augment our competitive position at American Equity Life, we plan to introduce a new guaranteed income product in March. We will have a premium bonus and non-bonus version of the product. Each version will have two fee-based options for lifetime income, allowing the policyholder to decide at the time of purchase whether to activate lifetime income after a shorter or longer deferral period and a no-fee option, which will have lower lifetime income than the fee-based options.
This product incorporates significant input from our distribution partners and we expect it to be well received in the market as income levels are anticipated to remain competitive.
Eagle Life sales in the fourth quarter increased by $77 million or 53% on a sequential basis. Increase in our participation rates in October was the primary reason for increased sales. When our rates are competitive, the bank advisors and registered representatives prefer to sell our products due to our excellent service and simple product design.
Pending at Eagle Life stands at 205 applications today compared to 213 when we reported third quarter earnings. Our distribution footprint at Eagle Life continues to grow. In the fourth quarter, we added one new selling agreement and 314 representatives.
In total, at year-end, we have nine wholesaling distribution partners, 58 selling agreements and 5,897 representatives. Our development efforts for Eagle Life have largely focused on third party wholesalers with support from a small home office staff. We plan to increase the engagement and number of Eagle Life's home office personnel dedicated to distribution in 2018 with the expectation of cost effectively increasing Eagle Life sales.
Finally, I regularly receive comments, emails and letters confirming American Equity's excellent service culture is alive and well. In a recent email an exasperated agent exclaimed he called a competing company and was on hold for 26 minutes before reaching a live representative.
The next day his client called the company and was on hold for 45 minutes. At American Equity our phones are answered by a live person in 60 seconds. It's the little things that make all the difference.
And with that, I'll turn the call back over to John.
Thank you, Ted and Ron. We're pleased with our fourth quarter results as the spread remain relatively stable and non-GAAP operating earnings increased despite continued headwinds from low interest rates. Although our sales were down on a year-over-year basis, we're pleased with the sequential increase and the renewed momentum we are seeing at both American Equity Life and Eagle Life.
Our current product offerings are competitive and the new product we expect to roll out in March has us excited about the year to come. We believe the value proposition we've always offered our agents, transparent products, attractive renewal crediting history, an unparalleled service remains as attractive as ever.
Although sales were soft, 2017 was a good year for American Equity. Policyholder funds under management increased by 7.1% and we had record non-GAAP operating earnings of $285 million or $3.16 per share and even if you exclude the impact of unlocking of our actuarial assumptions and the loss on extinguishment of debt, our operating earnings were $262 million or $2.89 per share, far surpassing our previous records of $205 million and $2.53 per share set in 2015.
We welcome the Department of Labor's delay of the fiduciary rule to July 01, 2019 and are hopeful that the regulations unduly burdens -- unduly burdening distribution of annuities by independent agents will be substantially revised. While the eventual outcome of the fiduciary rule remains uncertain, we remain prepared to respond and grow our business.
Looking ahead to '18, tax reform should be a positive for our bottom line, while the acceleration of tax payments will likely offset much of the benefit of a lower statutory rate for new sales, we expect to benefit from a lower rate on our enforced business and we will be sharing a portion of that benefit with our employees through higher payouts in our semiannual employee bonus pool.
Our long-term outlook remains favorable due to the growing number of Americans who need attractive, fixed index annuity products that offer principal protection with guaranteed lifetime income. Since our founding in 1995, American Equity has created an unparalleled platform in the fixed index annuity industry and we're fully prepared to participate in the growth we see ahead for our market.
On behalf of the entire American Equity team, thank you for your time and attention this morning. I'll now turn the call back over the operator for questions.
[Operator instructions] Our first question comes from the line of Kenneth Lee with RBC Capital Markets. Your line is now open.
Hi. Thanks for taking my question. Just had one on the competitive environment. You mentioned in the prepared remarks some kind of rate increases from competitors, do you think these rate increases are in reaction to the recent tax reform or do you see the potential for further rate increases coming up ahead, thanks?
Well, I'm not sure Ken that we can say that it was due to the tax increases or their investment portfolio. Most of our primary competitors all made some type of change whether it was increasing rates on accumulation type products or adjusting or guaranteed products, but it's difficult to say what the rationale was.
Got you. And I'll also take one more question, in terms of the competition from the volatility magic indexes, those hybrid products, just wondering about how efforts are going to educate independent agents on the relative benefits to AEL's products, what was mentioned in the past and just seem whether you've been seeing either increased competition from these products versus based on the last few quarters, thanks?
Well, Ken what we have been doing with our distribution is just showing the performance of the S&P 500 over a long period of time. It's got a track record that goes back what 50, 60 years something like that. We've seen some index credits as high as 16% in the fourth quarter and our average index credit in the fourth quarter was I want to say 5% or 6%. So pretty decent.
So, we talk about the performance of the S&P, the fact that it's transparent, the fact that it has a long history and frankly, we think a lot of these hybrid type indexes when they talk about performance compared to the S&P 500. So, the process is just educating on the transparency and the strength of a long-standing index.
Okay. Thanks.
Our next question comes from line of Dan Bergman with Citi. Your line is now open.
Hi. Good morning. It looked like the court spread declined a few basis points in the third quarter level and given this has been holding in pretty steady it's not actually increasing a little bit earlier in 2017. I just wanted to see if you had any thoughts on what you saw in the quarter and how we should expect core spreads to trend ahead given all the moving pieces like the recent product investment changes and rising interest rate, thanks?
First of all, we still are and while we are investing at a higher rate or did in the latter half of last year, that still is a rate that's below our overall portfolio yield. So, there is some pressure on the top line. When we look at cost of money, it gets a little bit harder to distinguish a little bit because we do now have products that have different spread targets for different cost of money that's flowing through there.
All of the renewal rate adjustments primarily we have a small block that we implemented some renewal rate adjustment on in the last -- in the fourth quarter, but predominantly everything is already through and so now there's no more cost savings on the cost of money coming through for renewal rate, but we did see overall when you looked at adjusted spread, it came down when we look at it four basis points from last quarter.
Last quarter probably had 1 point to a 1.5 point to 2 points related to some partnership income, nonrecurring income that we didn't call out that's really related to that, but I think that the decrease we saw is more related to continuing investing yields below our overall portfolio yields.
Now we have seen in regards to cost of money. We've gone through a period -- went through in the fourth quarter really low volatility, now we've seen volatility come back, but that low volatility has the option that we purchase to hedge the monthly point-to-point strategy that can cause that option to increase and we certainly have seen in the cost for the monthly point-to-point option increase over time here in this last year because of the real low volatility.
Now we could see some of that reverse as we go through next year or through this year, depending on what volatility happens in the marketplace, but that is another thing that's putting pressure on our cost of money. Now highlight the monthly point-to-point in a very popular strategy that a lot of money is allocated to buy policyholders.
Just to emphasizes, this is John. The target spread is probably directionally should be declining as we move forward given the change in the mix of business, Ron commented that the choice is now our best-selling product and non-bonus products have spread targets and let's just say 2% versus bonus products and at 2.75% to 3%.
So, if that mix of business holds up the target spread overall is going to go down as we move forward, move through 2018.
Got it. Very, very helpful. Thank you. And then maybe one, it looked like the lifetime income benefit rider fees and DAC amortization came in a little favorable we've been expecting. Is there any sense you can provide on how much these items benefited from the assumption change last quarter?
I guess I am just trying to get a sense was there anything unusual going on in the quarter or is this a pretty representation of how those items may look going forward?
In regards to DAC amortization, I think that's representative of what it should look like going forward. It's a fat new trend. It's related to the unlocking that we did last quarter. So, I think that's nothing unusual. It's just the new pattern of amortization as we go forward post unlocking last quarter.
On the Libor fees, I think we ended up there is that the net Libor fees left the reserve increase was little bit higher or more positive to us than the quarter before. That probably mostly is related to that Libor fees for just higher -- related to the higher growth and account value from index credits than what was expected.
As Ron commented, we saw very strong index credit -- we've seen very strong index credits throughout 2017 and that led to a higher account value growth and has led to higher fees.
Our next question comes from the line of Randy Binner with B. Riley. Your line is now open.
Hey. Good morning. I guess my follow-up on the fees there on the riders, is that -- is isolating? Am I hearing you right. isolating the index credits as kind of the key incremental drive there, if the spreads are lower going forward, higher fees can make up for a lot of that, but I am just trying to gauge in what level of sustainability you have at those higher fees?
The fees don't necessarily drive our core spread.
Yeah, I am sorry. They're different. I am sorry. I was just saying there is puts and takes in the model, that was what I meant.
Correct. I think that I guess I don't know directly how to answer your question there and whether or not, that's going to affect core spreads. Those fees, the way that rider is priced is to break neutral on it, not necessarily to add to the overall profitability.
Now at any one quarter, there might be a little bit of a different pattern of what the net expenses to the company when you net out fees versus the increase in the reserve and the pattern, but it's not driving the core spread here.
Yeah. No, I don't think they're related at all. I was just saying that it's an area of the model that would offset lower spreads and so maybe…
Actual fees versus what have been modeled, yes. You can end up having a benefit from that, if it's different than what's been assumed in the model.
But can we assume, can we assume that there's going to be to the extent that your new products you're introducing this year are focused on providing income riders that there's going to be more fees on an absolute basis coming into the model?
If the mix of sales goes toward guaranteed income, than yes, then there's going to be more account values subject to a fee and so fees will go higher because of growth and products that have guaranteed income. On the other side of that, there's more reserves that will be set up because more products have guaranteed lifetime income on them.
Fair enough, but that would the -- if there's a singular thing in the new products that you think is going to differentiate them, wouldn't the first bullet you go with would be the features that are in the guarantees and the riders?
Maybe it's a question for Ron, like what is the…
Well, when we look at the portfolio we have, we got the Choice series, which is really driven for accumulation and what we find is the agents who maybe do more holistic planning and have a securities license are using them for accumulation and then maybe using the income with other tools and then you have your independent agents who really want the FIAs with guaranteed lifetime income benefit feature.
So, when we look at our sales, yes, the Choice series is significant as far as our sales has been, I think our mix it still going to be heavy lifetime income benefit rider type products and accumulation. So, it's kind of difficult to say if this new product we're talking about is actually going to take away from Choice series type products and be more guarantee type products or what? I just think we have both types of products to appeal to registered reps and independent agents.
Yeah, we wouldn't expect it to take away from Choice sales. We would expect it to take away guaranteed income sales from competitors, all objective.
I am just trying to get to a point where I am just trying to understand what the absolute level of those annuity product charge is going to be going forward, because I think it's going to be higher, but it was quite a bit higher in the last half of '17. So, if it sustains at that level on an absolute basis, that's a change. So, it's a lot more, a lot more product charges coming in. So, all that's really helpful, thanks.
Our next question comes line of Erik Bass with Autonomous Research. Your line now open.
Hi. Good morning. Thank you. I guess with your RBC ratio above 375% even after the DTA adjustment, how are you thinking about the potential to return capital to shareholders? And is it too early to consider given the uncertainty around potential NAIC changes in sales levels or is this a possibility that you're considering?
The short answer is it's too early, but then let me give you the details behind that. As I said, we've been very focused on ratings. We're very focused on Fitch and wanting to get investment grade with them. They did in their last report, while they do you focus more and more on their Prism model and I think that'll continue, they did start to talk about an RBC ratio at 3.75% versus 3.50% for us to be investment grade.
So that's part of our focus. Again, our focus also is on what does 2018 sales going to look like? I think we feel optimistic about some of the new product features and new products that we're rolling out and so we're in the middle of still doing our capital planning and looking at that. But at this point in time, it's too early to be discussing return of capital plan for the company to shareholders.
Got it. That's helpful. Thank you. And then from an investment standpoint, Jeff I guess, could you provide an update on where you're seeing the best opportunities and I think Ted mentioned that the new money rate was a bit lower in January than in the fourth quarter, despite higher interest rates and was this is a result of the shift in the type of securities you're buying or just tighter spreads?
I guess little bit of both. We're seeing a little bit softer market starting the year. Some of the sectors that we've been investing in take a couple weeks to kind of get flowing again. There's a number of conferences that are in January for ABS, for CMBS, for mortgage loans.
A lot of those are sectors that we've been allocating to and we'll continue to and those markets just take a few weeks to get going and so the first part in January seems like it's always a more challenging time of the year for us to invest.
As we go forward, we're going to be looking for sectors that we don't have to rely on the seasonality or the technicals in the market to deploy the money and as we continue to do that, we're going to see -- we believe we'll see opportunistic spreads for us as we deploy our strategy.
Okay. Thank you.
Our next question comes from the line of Pablo Singzon with JPMorgan. Your line is now open.
Thank you. So, the first question is I just wanted to get your thoughts on the best interest standards that are emerging from the state. So, I think New York has one, Nevada has one. How does the yield position against the standards as we stand now and where do you think things will play out?
Pablo, this is John Matovina. Obviously monitoring those things, Nevada standard I'm not aware that's of applicable to insurance. It was a security standard. The New York standard is insurance, life insurance and annuities. The short easy answer on New York is we're not active in the state. So, if reaching a final standard on New York comes about, really wouldn't have any effect or have very, very little effect on us.
Of course, the concern there is will the New York standard find its way into a broader group of states, which people in our business we've all talked about the fact that that's already happened fairly recently with the cyber regulation that the NAIC actually finalized I think last year.
There's already been an active group on the NAIC side working on suitability that I don't think they have the same ideas as what New York has. So, I wouldn't want to handicap how it might come down, but I think there will be engagement from a broader people and you may not see the same type of outcome that the New York standard gets adopted throughout the country by the individual states.
We're actively involved in working on the enhanced suitability standard and with the committee that's looking at this various insurance commissioners. So, our hope would be that state would wait and participate in that process and that there is a cohesive enhanced suitability standard that applied by all states.
Right. Okay. So just based on your initial read of the New York standard, is it stricter than what agents have to comply with 8424 or is it more or less the same?
I haven't read it, but we have a person in the room that probably can answer that. Renee Montz, is General Counsel.
The New York standard is just different than 8424 ads just to our requirements and I think one of the biggest concerns is it adds life insurance. So, a lot of companies are concerned about that and how that would be applied. The critical thing is to get consistency across the state and the federal regulators.
So that we're pushing forward, we're working with the NAIC. We're still working DOL trying to push them in that direction as well as they rethink their rule.
And consistency is like consistency of definition of terms. You really need to make sure that the terms are similarly defined across these regulations, otherwise it causes us additional cost in regards to compliance.
Got it. Thank you. So, my second question is for Ron. So, I appreciate the wholesaling portion of Eagle Life, so my question is as you look at your competitors in the bank and broker-dealer channels right. So, companies like Global Atlantic for example or Great American or AIG, they tend to lead in more than one product category.
So usually its activities are minor for example. Do you think you'll have to do more of that to grow share in those channels?
You mean other than fixed annuities. We have the multiyear guaranteed annuity and we have the fixed indexed annuity we have with the different surrender charge terms. So, beyond that, we also have the advisory product too I guess, but I don't know how much that'll show up in the bank channel
Right. My question is more and maybe it's just a difference in terms of what they're offering, but they tend to be leaders in more than one per product category right. So, I'm wondering if that's our fee condition to be significant into those channels, because it benefits them or do you think you can grow just by focusing on index annuities?
Pablo, we're going to grow by using fixed indexed annuities. We've talked about being really, really good at one thing and that's what we're good at. I think increasing our footprint and getting more boots on the ground is going to help us again to more financial institutions and try to get a bigger market share in the financial institutions that we're currently in.
That is in my prepared comments, talked about a bigger home office staff or distribution. So, we can get out into those financial institutions and tell our story compared to what we have and the competitors.
Pablo, this is John. we have mega products available and there's been times where our rates have been quite competitive. I would acknowledge it probably a Global Atlantic in particular comparing recently. Perhaps AIG has been, has had higher rates than we have on that product, but we've had success in the past with using the mega product to get our foot in the door at a couple of financial institutions and would anticipate that'll happen again sometime in the future.
Okay. Thanks.
Our next question comes from the line of Alex Scott with Goldman Sachs. Your line is now open.
Good morning. First question just on operating expenses, you mentioned putting more boots on the ground to your life distribution. I think it was also mentioned some of the bonus we're sharing some of tax benefit.
Should we think about operating expenses for 2018 being higher by -- just relative to 2017. Can you give us any kind of guidance around how to think about that?
I don't believe what the cost that we're talking here in regards to adding some additional staffing for Eagle for marketing purposes. It's really going to be that incremental to our bottom line that's really going to show up.
And in regards to the comment about tax reform and part of that being shared with employees, we have -- that's just saying if our profit goes up, we already have a profit-sharing type of bonus program with our employees. It's based upon the amount of sales and also some of the same metrics in regards to operating income, growth, etcetera that we would be sharing with employees purely because our earnings would go up because of a lower tax rate.
So that's not necessarily incremental operating expenses that are going to really show up in any significant way.
And the Eagle side, those direct expenses would be in lieu of what we might have otherwise paid in commissions to third parties representing us. The accounting treatment might turn out to be different because those third-party commissions would be capitalizable because they vary with production versus a fixed cost if you got to go through analysis to figure out what you can't capitalize and not far enough we move from that but I better stop there and not get into the accounting.
But I know enough to know that there might be different treatment for in-house cost versus variable cost outside. But on an economic basis, if marketing efforts, sales efforts are successful, it will be cost-effective relative to what we might have otherwise spent for variable cost.
Okay. And then back on the cash taxes, could you give us a way to feel -- a way to think about how much higher the cash taxes would be relatively to GAAP taxes and how or set taxes for that matter and how does it impact your view of I guess true on capital generation and maybe the mix between how it show up in terms of BTA versus other assets?
Well, with the cash tax piece, which you're going to do for modeling purposes is look at the deductibility of reserves and its two pieces, there is one we kind of already talked about new business, but it's really the question is on in force and how that's going to play out.
So that deductibility, so it's 92.81% or let's say 93%. You look at that in regards to the enforced block is there and there is going to be a transition adjustment that happens over an eight-year period of time that's brought in and so what you'll have to do is taking that calculation and calculate out what you believe that transition adjustment is going to be and filling that in over the eight quarters -- sorry eight years, 34 quarters.
And you have to take into consideration how much less cash flow that's going to can result in us to be able to invest.
Understood. Okay. And then for risk-based capital, just thinking about the way that agencies are viewing it the potential denominator impact etcetera. Is there a level you'd be comfortable at operating -- you would be comfortable operating that or is RBC not the right way to think about it or are there other capital metrics that we should be considering as well?
I think we've been saying this for a while and the rating agencies are saying this too. RBC really isn't the capital thing to focus on. RBC is a calculation purely for the regulators in regards to decide when they need to take some kind of action on a company that's having a capital issue.
What's really -- when you look at the various rating agency models and that's what we really have to model to, those are on a pretax basis majority and so tax reform isn't necessarily going to affect that. And yes, we realize that some of the rating agencies still reference an RBC ratio.
However, I think that's becoming less and less important. So really what we're managing to the capital levels that we need for our ratings at the various rating agencies. So certainly, if the NAIC is looking at the RBC calculation, they haven't come out with how they're going to adjustment.
I think there's some thought that there is going to be some other adjustments within the calculation as they go through implementing tax reform in the calculation and it's not going to be just inputting the 20% tax rate across the Board. But what are yet we don't know.
But even post that and looking at our RBC ratio, we're going to be in excess of 300%, which is way above any kind of regulatory action level with more important to us and others I believe is how the rating agencies A.M. Best, S&P, Fitch, are looking at, how this affects their capital models, which I said before, those capital models are being calculated on a pretax basis.
And is there a accrued related for us to just think about maybe even just like GAAP equity the reserves or something like that, where we can think about where you'd target?
I don't think that would be the right measurement to look at. I think what's going to have to happen is once the NAIC recalculates how they want RBC calculated all companies who recalculate your RBC and you be able to back -- then reverse engineer that into the level of RBC you need for the capital you need for S&P and A.M. Best and Fitch and others for the actual debt ratings or ratings, financial strength ratings that you want at the company.
I think it's a little hard at this point in time to say okay, RBC ratio should be 325 going forward. Until the NAIC comes out with a new calculation and how they're adjusting it. There's just -- there is not a way to reference what that number will be going forward.
Thanks very much.
Our next question comes from the line of John Barnidge with Sandler O'Neill. Your line is now open.
Thank you. With your stated interest in the ratings upgrade, do you have any interest in participating in pension risk transfer transaction, institutional annuities, flow reinsurance or even block transaction should they come available?
Very, very, very unlikely. I don't think we have the rating to participate some of that stuff or the -- it's not in our DNA. You talked about flow reinsurance and those types of things and so are you talking as an assuming company or as a seeding company in regards to the reinsurance.
As an assuming company.
Yeah, I am with John on that. That's not necessarily in our playbook.
No, that's fair. Now that you're one year up on the election, many organizations going 117 DOL Compliant, along with tax reform. Is there seem to be a general cyber relief and optimism in the IMOs that you've already started to really see come through year-to-date?
Well there is certainly a relief that they don't have to be financial institutions and signed on behalf of their independent agents. There hasn't been a lot of talk about it recently. I think there is a sigh of relief though. There is some work that needs to be still be done because, the full implementation is in 2019.
So, we can't let our guard down completely, but as you put it -- you used a good term, a sigh of relief for now.
And then my last question, there seems to be some conflicting views in the market on impact from tax reform, some think savings are going to be competed away into the product like you, while others think it will be retained to build of RBC.
To the extent you can talk about yourselves, why do you believe it will be competed away and have you already seen signs in January to suggest as much?
We have not seen signs on so far that people have raised rates because of tax reform. When we look at new business and look at our pricing and taken to consideration tax reform, the benefit of the rate dropping to 21%, a majority of that is wiped away when you take into consideration that tax increase and the reserve deductibility. There's a little bit of benefit that you have, but it's not a great deal.
Now in regard to building up RBC, I would look at that as part of the enforced in the earnings that we would expect to capture and others expect to capture over time because of the lower tax rate on that.
Great. Thank you.
Some of those other comments about the new business are they coming off from annuity carriers or they coming from life carriers, which we would know, we know what it looks like on a fixed index annuity. We don't know necessarily know what it looks like on a life insurance product.
That's fair. Thank you very much.
Our next question comes from the line of Ryan Krueger with KBW. Your line is now open.
Hi. Thanks. Good morning. Can you help us think a little bit about the potential impacts of the increased volatility? I think you actually mentioned that that would actually be a positive for some of your products, but presumably that would increase the cost of money on others.
So, I am just trying to think through that and if you feel like you can and if there is an increase that you can offset it through renewal pricing?
So, the reference to volatility and option cost, so on our monthly point-to-point, the options that we buy to hedge the monthly point-to-point with higher volatility those become a little bit cheaper or become cheaper over time versus right now or prior to this activity that we saw in the last week, low volatility has caused those option costs to go higher.
We have a substantial amount of money or policyholder funds that are sitting in the monthly point-to-point because that strategy gives them the highest opportunity in regards to return, but also if there is a higher risk that they could get zero to. But it is a very, very popular option. So, a lot of our option costs in overall option costs can be driven by the cost of that option.
But yes, higher volatility would cause other options to potentially go up, but maybe not as high -- not as proportionally higher compared to the decrease that you might see in the cost for the monthly point-to-point options.
It's not driven around what strategy, not necessarily product or product design.
Okay. So, net, net higher volatility is not a bad thing even potentially could be somewhat…
I caution that, depending on the level of volatility, we certainly have gone through periods of time where volatility has spiked and stayed up for a longer period of time, that can put pressure on our cost of money, because the other options start to increase in cost.
So, it's just really -- it has a lot to do with the mix of business and the mix of what strategies people are in and where they move their money and what that level of volatility is.
Yeah, this goes back quite a few years now but we had an experience as everybody did where volatility escalated for an extended period of time and of course our natural function is we kind of trail that. And so, as cost escalated, we start adjusting some participation rates to get cost back in line, but that's a trailing result but then you always have -- it's only one year to the next.
You get to recent cap some participation rates every year. So, it's not like it's going be a permanent impact and a little bit increase in volatility is not going to have that big of an impact to cause overall cost to go up.
But again, we do have the room to adjust renewal rates, caps participation rates and we talked about that capacity is about 49 basis points and that calculation includes what our ability is to adjust fixed rates and also our ability to adjust Cap some part rates.
Thanks. That's helpful. And then do you have an updated view of the amount of sales in the year that would be roughly breakeven to your RBC ratio?
We're working on capital models right now. I think it's still probably around that $6 billion is what we could produce and capital ratio should stay fairly level for where they are at.
Okay. Great. Thank you.
Our next question comes from the line of Mark Hughes with SunTrust. Your line is now open.
Thank you. Good morning. Ted, you've given some of the puts and takes on cash impact of the tax saving. Any way to rough that out? Are you generating half of that gain in terms of additional cash flow, is that the right way to think about it?
No. I don't think. I'm trying to think of a way to as I said before, you're going to have to calculate out, we don't publish tax reserves. So that is part, but you could look and say okay, staff reserves are how many billion, a worst-case scenario is deductibility of 93%. You need to then calculate out that transition adjustment and factor that and being brought in over that eight-year period of time.
And you need to think about how much less cash flow that really means that you're going to have left to invest at your current assumed new money yield.
Right. And if went through that exercise do you have a general sense of where we might end up?
We don't have something that we're publicly saying at that point in time.
Okay. Fair enough. On the spread with the new products, your spread requirements targets are lower. If the old spread target was roughly 300 basis points can you say you again roughly where are we now in terms of what spread would be needed to get a similar return and if you do have the evolving product suite that may lead to even more compression on that again getting you the same ROE?
Mark, we're working through the calculation on a weighted average basis, but we don't have a spread target number, on a weighted average basis to put out there right now. Let me just say 300 basis points and obviously now it's not 300 basis points because the mix of the business is changing as more and more non-bonus product is put out there. We'll have something more on.
Okay. Fair enough. And then Ron, it seems like the pending count is down just a few points year-over-year if I look at last year's similar number at this time, you said you're going to be influenced you think by the industry outlook, do you think sales are up in 2018? Are we turning the corner here in Q1?
Well we typically don't give too much guidance Mark on our upcoming year but there are some positive indicators. One that we use is the number of incoming phone calls to our marketing department. Those numbers are up. The last few weeks we had calls that would match what we had last June and July. So that's certainly a positive.
Optimistic with the new product that we're going to be introducing in March to our field I had in my prepared comments, that we got a lot of input from our distributors. So, if this is what they want then we're going to be able to deliver a good chunk of it, we're optimistic that those sell. But I think we'll have a little bounce in our step this year.
Thank you very much.
We have a follow-up question from line of Pablo Singzon with JPMorgan. Your line is now open.
Thank you. My question is for Jeff. So just going through yields, there seems to have been an uptick in investment and see those are floating rate securities. I was wondering if that's a yield or maybe one of your reinsurers and just given that that's the strategy that some of your peers have engaged in. Just wanted your thoughts on investing in those types of assets.
Yeah, I think we had mentioned in the past that asset-backed securities were an area that we wanted to bring more light in our portfolio. We've traditionally been underweight only relative to the industry, but relative to our peers. CLOs was an area that created some opportunistic yield for us as well as positioning us for a rising short-term rate environment.
It allows some resets in our rates as the fed becomes more engaged in raising short-term rates. So, we see it as an opportunity. It will continue to be an allocation as we go forward. I think what you'll see is a similar allocation to what we did in the third quarter, in the fourth quarter, in terms of purchases.
We will tamper based on valuations if spreads come in on that asset class, it's going to be an area that will reallocate to other areas that seem to be more opportunistic in terms of relative value versus risk. We do have some additional asset classes that we'll be engaged in as we get into 2018 here that we've engaged with some third parties on that we think will offer additional value to the portfolio on a risk-adjusted basis.
So, we did see a little bit of a lower take book yields in terms of purchases for the fourth quarter, but that's just come down to an asset mix and availability of securities at the time we're deploying cash. We'll see that through time, but overall, we remained focused on trying to continue to bring new purchases in line with current yield of the portfolio.
So, we can help offset any depletion in potential spread that would be the result of new asset purchases.
Great. Is there time for one last question or…?
Yeah, we can take one more Pablo.
Okay. Thanks. So, I just wanted to get your thoughts on buffer annuity. So, as you might be aware this is an emerging product or piece into the broker dealer and bank channel. So, I was wondering where do you see this threat in terms of getting share for a person who might be willing to put derivative with a broker or someone in the bank?
That's a good question Pablo. We look at the buffer annuity in our view as actually a security. So, you got to have a securities license to see it. I imagine that it will have an impact, but with fixed indexed annuities and the aged demographics that we're selling to which is the low 60ish as far as age, we think that there is plenty of retirement money out there that is going to be interested in fixed indexed annuities and don't want to take anything less than zero. Well, there may be a distraction. We don't see it as a threat.
Okay. Thank you.
I am not showing any further questions in queue at this time. I'd like to turn the call back to Julie LaFollette for any closing remarks.
Thank you for your interest in American Equity and for participating in today's call. Should you have any follow-up questions, please feel free to contact us.
Ladies and gentlemen, thank you for your participating in today's conference. This concludes the program, and you may now disconnect. Everyone, have a great day.