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Great-West Lifeco Inc
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Good afternoon, and welcome to Great-West Lifeco's Second Quarter 2018 Results Conference Call. I will now turn the meeting over to Mr. Paul Mahon, President and Chief Executive Officer of Great-West Lifeco. Please go ahead, Mr. Mahon.
Thank you, Oliver. Good afternoon, everyone, and welcome to Great-West Lifeco's Second Quarter 2018 Conference Call. With me on the call today are Garry MacNicholas, Executive Vice President and Chief Financial Officer; Stefan Kristjanson, President and Chief Operating Officer, Canada; Bob Reynolds, President and Chief Executive Officer of Great-West Lifeco U.S.; and Arshil Jamal, President and Chief Operating Officer, Europe. Before we start, I'll draw your attention to our cautionary notes regarding forward-looking information and non-IFRS financial measures on Slide 2. These cautionary notes will apply to today's discussion as well as to the presentation material. I am going to provide an overview of Lifeco's second quarter results, including headlines from our Canadian, U.S. and European businesses. I will also provide an update on our Canadian business transformation and the progress we're making to enhance our digital capabilities. Garry will then take you through a more detailed financial review. After our prepared remarks, we'll open the line for your questions. Turning to Slide 4. The company delivered strong results in the second quarter with earnings up 17% year-over-year on an adjusted basis. As noted on the slide, earnings included a $60 million positive impact from refinancing activity in the U.S. segment. Excluding this impact, Lifeco's adjusted earnings increased 8% year-over-year. The Canadian segment reported earnings growth of 7% year-over-year, excluding the restructuring charge in last year's results. You recall that at the time we announced the restructuring charge, we also announced targeted cost savings of $200 million by Q1 2019. We've been tracking well on this program, having achieved annualized run rate reductions of $170 million thus far. I'll provide more color on Canadian expenses on the next slide. Moving to the U.S., Empower Retirement continued to show strong momentum with higher sales, fee income, assets and participants compared to a year ago. At Putnam, net asset flows of USD 1.6 billion in the second quarter were the highest in 7 years. These flows are reflective of Putnam's strong investment performance with 87% and 79% of fund assets performing above the Lipper median on a 1-year and 5-year basis, respectively. U.S. results also benefited from the lower corporate tax rate this year. In Europe, operating performance was solid across the regions and businesses in the quarter, and we took strategic actions to support growth in our core markets. Our U.K. business, Canada Life Limited announced an agreement to sell a block of legacy policies to Scottish Friendly. This divestiture, together with the acquisition of Retirement Advantage at the beginning of the year, was undertaken to streamline operations and allow for an increased focus on the retirement market in the U.K. The transfer of these policies to Scottish Friendly is expected to occur in late 2019. Also, during the quarter, Irish Life group announced an agreement to acquire a majority [stake] in Invesco Limited, Ireland, the country's largest Irish-owned independent financial consultancy firm. As a manager of corporate pension plans, Invesco is a natural adjunct to Irish Life's group pensions business. Finally, the company maintained its strong [capital] position and financial flexibility with a LICAT ratio of 133% at June 30, 2018. Please turn to Slide 5. Our Canadian business transformation is progressing as planned. Part of our transformation, as you may recall, involved a significant workforce realignment. Through a culmination of voluntary retirement, redundancies and controlled hiring, we trimmed our workforce by 13% over the past year. This workforce realignment, in addition to real estate consolidation and process reengineering, has contributed to the realization of sizable cost savings to date. We've achieved 85% of our targeted reductions and are on track to reach $200 million in pretax annualized savings by Q1 2019. While we've made solid progress on our transformation savings program, there was an elevated level of spend in the second quarter due to the acceleration of digital initiatives, primarily the ramp-up of our agile labs. Our first lab, which is focused on new onboarding processes for individual customers and advisers, is in its final phase and a market pilot is scheduled for the fall. Our second lab, which focuses on enhanced digital enrollment for group customers launched in July. We've also implemented a digital workplace program in Canada and are updating our infrastructure to drive operational effectiveness across the business. These digital investments are expected to improve customer and advisor expenses and drive unit costs lower. Looking ahead, we would expect a moderation in expense growth in Canada as ramp-up costs decline and adoption of new digital technologies increases. Turning to Slide 6. Net earnings this quarter were $831 million, up 42% year-over-year. Earnings were up 17% year-over-year on an adjusted basis, excluding restructuring charges in the second quarter last year and up 16% in constant currency. As noted, earnings included the positive impact of $60 million after tax related to refinancing in our U.S. segment as a result of U.S. tax reform. Excluding this impact, earnings were up 8% year-over-year. Also, as previously noted, Great-West Life's LICAT ratio was 133% at June 30, above the company's internal target range of 110% to 120%. Lifeco cash was at $900 million at the end of the quarter and is not included in this LICAT ratio calculation. Moving to Slide 7. Total sales were strong for Lifeco in the second quarter, increasing 32% year-over-year or 35% in constant currency. Canadian sales were softer, down 6% compared to the prior year quarter with lower group wealth and individual customer sales, partly offset by higher Group Insurance sales. U.S. sales were up 45% or 50% in constant currency. Empower sales increased 46% in U.S. dollar terms, driven by large plan sales. At Putnam, both mutual fund and institutional sales were higher year-over-year leading to positive net flows of $1.6 billion noted earlier. Turning to Europe. Sales increased 14% or 10% in constant currency, with higher sales across most product segments in the U.K. and Germany. Retirement Advantage, which we acquired in January, also contributed to U.K. sales growth. In Ireland, higher fund management sales were partly offset by lower pension sales.And turning to Slide 8. Fee income for Lifeco increased 4% year-over-year. Canada's fee income was up 4%, primarily due to higher average assets and higher other income related to Financial Horizons Group, which we acquired in the third quarter last year. In the U.S., fee income was up 3% in constant currency with higher fees from growth in assets and participants at Empower, partly offset by lower performance and other fees at Putnam. In Europe, fee income increased 14% or 10% in constant currency, driven by higher fee income in Ireland and Germany and higher other income in our Irish Life Health business. Referring to Slide 9. Adjusted expenses increased 7% year-over-year. As a reminder, we define adjusted as excluding restructuring charges. In Canada, expenses were up 10%, reflecting the acceleration of digital initiatives discussed earlier as well as the inclusion of the Financial Horizons Group business and several other onetime items. We've achieved $170 million of pretax annualized expense reductions and are on track to reach the $200 million target by Q1 2019. In the U.S., adjusted expenses were up 6% in constant currency due to business growth, partly offset by cost efficiencies at Empower. The year-over-year increase also reflected in expense accrual release in last year's results that did not repeat this year. In Europe, adjusted expenses increased 9% in constant currency, mainly due to the inclusion of Retirement Advantage this year, along with higher information systems expenses and overall business growth. I will now turn the call over to Garry MacNicholas. Garry?
Thanks, Paul. Starting with Slide 11. Net earnings in the second quarter were $831 million or $0.84 a share, an increase of 17% year-over-year on adjusted basis. Earnings per share were $0.78, up 8% year-over-year, excluding the U.S. refinancing impact mentioned earlier. In Canada, adjusted earnings increased 7% with higher basis changes in individual customer and strong morbidity results in group customer. In the U.S., adjusted earnings were up 4%, 6% in U.S. dollar terms, excluding that U.S. refinancing impact. Empower results were strong with earnings of USD 42 million compared to USD 36 million last year, all in US dollars. At Putnam, earnings declined due to lower fee and net investment income and higher expenses. Europe's adjusted earnings were up 10% compared to last year, 7% in constant currency, reflecting solid operating results across businesses and longevity assumption changes, partly offset by lower investment gains. Turning to Slide 12. This table shows the segment and total Lifeco results from a source of earnings perspective. And as a reminder, the source of earnings categories above the line are shown pretax. Second quarter results reflected healthy expected profit growth, a significant contribution from management actions and changes in assumptions, and the positive impact of refinancing in the U.S., which drove that increase in earnings on surplus. These items were partly offset by lower experience gains compared to very strong gains a year ago. Expected profit increased 6% or $42 million, primarily due to group long-term disability repricing in Canada over the past year and higher fee income in all segments. Higher expected release of margins for annuity of mortality improvement in the U.K., offset by lower expected release of interest risk margins in all the segments. New business strain was broadly in line with last year and lower compared to last quarter, primarily due to a large reinsurance longevity swap with upfront strain that occurred in Q1 2018. Experienced gains of $69 million were lower than the second quarter last year. The decline was partly attributable to lower trading gains, which contributed $45 million this quarter compared to the $120 million this quarter last year. Other experience gains contributed $14 million this quarter with favorable morbidity experience in Canada and Europe, partly offset by unfavorable expense experience in Europe. Management actions and changes in assumptions resulted in the release of $232 million this quarter. Europe contributed a $147 million, mainly due to updated annuitant longevity assumptions in the U.K. The $83 million in Canada reflected updates in after-tax return assumptions on certain assets, partially offset by updated policyholder behavior assumptions. Earnings on surplus of $75 million, primarily reflects the positive impact of refinancing U.S. segment on a pretax basis, which was $81 million. All of this comes together in adjusted net income, net earnings before tax shown on the middle of the page, of $1,032,000,000, which is up 17% year-over-year on adjusted basis. The effective tax rate on shareholder earnings of 16% was at a more normalized level compared to last quarter's lower rate. Turning to Slide 13. Lifeco's uncommitted cash position remained strong at $900 million. This is not included in the Great-West Life LICAT ratio, but would be equivalent to about 4% on the ratio. Our book value per share was $21.22, up 6% year-over-year. Looking at the return on equity, and just a reminder, it is based on a rolling 4 quarters. The adjusted return on equity was 14.2% in the second quarter and we continue to target a long-term ROE of 15%. Reported ROE of 12.5% reflects the restructuring charges last year as well as the charge for U.S. tax reform and the net charge on the disposal of the Nissay Asset Management investment in Q4 last year. Turning to Slide 14. Assets under administration were $1.4 trillion, up a $114 billion or 9% year-over-year, driven by market performance and overall business growth. That concludes my formal remarks. Back to you, Paul.
Thank you very much, Garry. With that, operator, we will now open the line for questions from analysts. And if I can just make a comment for analysts, I'd like you to direct questions through me and then I will direct traffic.
[Operator Instructions] The first question is from Steve Theriault of Eight Capital.
If I can just start with a clarification, Paul. You talked about moderating expense growth in Canada in the second half. Was that relative to the first half of the year, where expense growth was in the range of 6% or relative to Q2 where it was particularly elevated in the range of 10%?
I would say that the moderation should be -- and it's going to moderate down. It's not going to be a jump down, but it would moderate relative to the 10% and we'd see it further moderating from that. So we will get back to a more normalized rate of expense growth. But right now we are investing in this incremental digital capability, all with business cases behind it to drive better overall expense and performance results.
Okay. And then a question on Empower. Appreciating the earnings are up year-on-year, but from what I can see a lot of that is on the tax side, right. So when you look at it -- if I look at it on a pretax basis, the earnings are -- looks to be down a bit year-on-year. So I guess, I'd like to get a better sense of participant growth. And I know this comes up from time-to-time, but there's no question that sales have been better. And in our past conversations, you feel like you're growing a lot faster than the market, but so we still see -- but we still see participant growth around the 3% level. So I guess, the question is, if you're growing sales so fast, why are we not seeing that translate into -- translate that into a pickup in the participant growth? And is there a lag into the earnings that you could flag at all?
Yes. There's always going to be -- as you're having strong sales, you're going to always have a bit of a lag of earnings because you have your upfront cost of acquisition as you're setting them up. And then obviously, you're turning your attention to getting all the records setup and also getting at your asset management AUM penetration. So those are the opportunities there. We continue to run at about twice the market rate in terms of organic growth. And Garry, I'm not sure whether you can make a comment on the overall -- the profit signature there?
Yes, if you look in the sorts of earnings you see in the U.S. segment, there'll be a strain there. And that strain is largely the representative of those upfront sales cost. So they go right to the bottom line as opposed to getting amortized in the future. So in this period of good organic growth, we will see some of that new business strain on the Empower business. So I think, that's what you're seeing there.
But, I think, another part of your question was, do we continue to see participant growth. And we absolutely do. We're seeing strong participant growth and we've got a strong pipeline as well.
And then -- so I appreciate there's upfront cost. Is there -- like when we think of the second half of the year, do we -- would you envision that we start to see a tipping point in terms of -- because of the tax, it's hard to look at the bottom line. But should we start to see -- would you expect to see pretax earnings growth in the back half of the year? Or is the very strong -- or is it more likely that we'll see just very strong sales in the back half of the year and elevated costs, and so it takes a little more time?
I think, like part of this is about business trajectory. If we were to see a slowdown in sales then you'd start to see those sales kind of being monetized into earnings growth. As long as we continue to see a higher rate of growth, it will have a bit of a dampening effect. But the reality is, we're trying to build this business. We believe this is fundamental growth opportunity. And ultimately, this is going to drive growth in earnings. So it will be a function of the rate of sales. Garry, anything to add?
Yes, I'd just add that also as we grow the business and this will improve the trajectory, rather than getting to trying to guide on earnings. But just one of the improvements to get is the scale. It's a scale business, so as we add the new participants and the new sales cases, they're at a lower incremental costs in the existing book. So we are taking advantage of that scale and driving our unit costs down.
Okay. And one last thing, if I could, just on the numbers. The -- we talked -- you mentioned last quarter about the U.K. longevity experience review, I guess, if you will, that was going on. It sounded like that could come through over a number of quarters. It looks like a pretty sizable number this quarter, evidenced in the source of earnings. But relative to the discussion we had in previous quarters, is there more of this review to come through the P&L and the source of earnings? Or is -- should we view this as you've now reviewed the U.K. longevity experience and this is the conclusion and we can drive on?
I'm going to direct that one to Garry.
Sure. You're right. We did actually reference -- it was a population mortality research done by the industry in the U.K. that we've referenced earlier this year. And indeed, that's what was the driver behind the basis change in Europe this quarter. I would flag that we do our own internal experience studies in the -- generally, for the U.K. in the third quarter. And so I can't prejudge the outcome of those studies, but we do have our own internal experience studies to come in the third quarter this year, and we'll see what that brings us.
Our next question is from Scott Chan of Canaccord Genuity.
Just on Putnam. The sales were very good in the quarter. You guys had best quarterly net inflows. In terms of the sales aspects up 54% year-over-year, was there any particular areas where that was driven by? Like certain products or...
Yes. Why don't I -- I'll start off at a high-level and then I'm going to turn it over to Bob Reynolds to provide a little bit more color. We've seen, as you know, the industry has been, in generally, in outflows for a long period now. And it's driven by essentially outflows on the active side because of the passive play. What we've seen more recently and the industry has seen has been a lift in fixed -- active fixed income sales. So that would be really the profile of the growth we're seeing. Now I would say where it's not just a product growth, we're also seeing strong growth on that front on both retail and institutional and on our defined contribution investment only. Bob, anything you'd add to that?
No. I think the growth we're seeing is across retail, institutional and investment only. And it has been driven predominantly by fixed income, but also our global asset allocation area and some of our equity funds have also attributed to that growth.
Okay. And with -- and you stated in the past that like an acquisition potentially to add scale to Putnam would be a priority. With the asset management sector revaluating lower, especially, lately, is there more opportunities that you see out there right now than you did a year ago?
Yes. I'll take that one. Scott, it's Paul. We definitely see an increased level of activity in the marketplace. And I would say we've never been more active than we are now in terms of assessing opportunities. So I would say that we're encouraged by that. But at the end of the day, you've got to find the right target and right partner. And so we remain focused on that because we think this really represents a significant opportunity for us to unlock value with Putnam.
The next question is from Gabriel Dechaine of National Bank Financial.
Apologies, I wasn't paying full attention there. But on the SoE discussion, the new business being second quarter of a row -- in a row where they're fairly elevated. What was the primary driver there? I got the U.S. bit, but what's happening in Europe?
Yes. I'll turn that one to Garry.
Okay. Yes, just to flag and you'll see it on Slide 12. The -- and in the SIP. The impact to new business was fairly similar this quarter as it was to the Q2 last year. And actually, the drivers are the same. Where we see new business strain is on the Empower side of the investment. Basically, any of the investment are fee-based contracts, where you're not able to capitalize all the upfront expenses. So they go through the expenses, but the good side of that is they're not a drag on future earnings. So that's the vast majority of the U.S. and it's also a good chunk of the European. In the past, what we have seen in periods where we've had high U.K. paid annuity sales, often those can be a contributor or positive impact on new business or gain on new business. We do not have any bulk annuity sales in the second quarter nor do we have them in this period last year to any extent. So that's -- that is often in the past in an offset to that strain. But this is more of a strain in the Irish investment products. Some strain in the Irish retail, but a lot of this is Irish and U.S. investment products that drive the strain.
Okay. So you're selling everything as you normally do, but aren't getting the offset from payout annuity sales or bulk annuity sales in Europe. Is that the story?
Yes. And Gabrielle, I would note, it's not in this quarter, we're getting them there. It seems like bulk annuity sales tend to be lumpy. You're either going to win in period or you're chasing after the next one. And we're obviously very focused on writing those on a profitable basis, where you're going to see that signature of profitability upfront. So we're patient, but we continue to be active in that market.
Okay. Quick one on expenses, across the company up 7%, pretty elevated. And then -- and you did talk about the elevated tax spending in Canada. Just wanted to know the acquisitions, the First (sic) Financial Horizons and the Retirement Advantage? How big were they as contributors?
Yes. I will turn to Garry in terms of sizing the impact of those relative to digital and other things. And then, perhaps, I'll turn to Stefan for a little bit more color as well.
Sure. So for both Financial Horizons Group and Retirement Advantage, again, just doing the currency translation there -- Financial Horizons Group is in that $10 million, $11 million a quarter range for expenses, it wasn't in last year Q2 at all, it came in and apart with 2Q, Q3. And then Retirement Advantage, it's contributing spend on 2 fronts. One is just the business as usual spend there and then we also have some of the upfront cost, just some of the initial integration type work. And so that's adding about GBP 8 million. And these are pretax numbers, as these are expenses. [I hate them in pounds] so that would translate into maybe CAD 14 million or so, CAD 13 million, CAD 14 million. That gives you a sizing.
Okay. Perfect. And then this is something I've seen over time, I've never bothered to ask the question and I'm somewhat embarrassed to not know the answer. But if I back out the onetime gain on the financial restructuring, $81 million, your negative territory on earnings on surplus. And that's not terribly unusual. I'm just trying to figure out why Great-West doesn't make money on a surplus account and big profit item for peers?
Yes. I'll definitely refer that one to Garry.
Yes. I think what we're seeing there is we have put all of our financing charges through the earnings on surplus as well. And so what you're seeing is lower yields on actual surplus assets and we do tend to keep that reasonably liquid, not entirely, but reasonably liquid. And then you've got the financing fees that they're riding through there on a pretax basis.
Right. And debt cost -- and those are netted out for your peers as well. Is it simply that you got a very 0 risk portfolio or in your surplus account?
It is quite a low-risk overall surplus account.
So next question is from Sumit Malhotra of Scotia Capital.
First question, just want to make sure I'm thinking about this debt refinancing gain correctly. From what I saw in your MD&A that the bulk of it comes from the removal of the interest rate hedge, but -- the bulk of the gain. But in terms of the debt refinancing, does this have any -- or should this have any impact on your balance sheet leverage because from at least the way I calculate it, it looks like it was up quarter-over-quarter in terms of that ratio?
I don't think it was. But I'm going to turn to Garry on that.
No, that shouldn't have had an impact on the -- on our leverage ratio. The -- these were a refinancing of 300 and 500 -- vacuum of the 300 and 500, so it would have had -- should have had virtually no impact. I'm sure if there is anything else going on the CapEx, we can take that offline if it's -- just double check that.
Well, I'll just ask, I think and you'll correct me if I'm wrong. I think the leverage right now is around 27%. I think over the course of this year, we spent a lot of time thinking about the LICAT and how the sector would look on that basis. Just wanted to get an update from you gentlemen as to how you think about the level of leverage that you're comfortable managing with? As some of your peers have definitely moved closer to 20%, just wanted to hear an update from you on how management thinks about leverage and what levels you're comfortable with?
Yes. I'll start off, I think that we don't have discomfort right now. We've got a very -- we've got a very sound book, both on the assets and on the liabilities side. We're comfortable where we're at. I think it fits well with us, but from the standpoint of -- when you've seen us do acquisitions in the past, we've taken up the leverage ratio higher than that and we've been comfortable and we've been able to work through that. Garry?
Yes. I'll just comment on 2 things. First of all, I'll also go back to your first question. On the leverage ratio overall, first of all, we look for a leverage ratio commensurate with our ratings. We like to maintain our strong ratings for our customers and other stakeholders that depend on that. But also, in terms of -- we have, in the past, we often target somewhere in the 25 to 30 range on a running basis. But for the right acquisition opportunity, we have pushed that into low 30s. And we would -- again would consider doing so again if the right opportunities arose. And just on your very first question on the leverage. I think that one of the instruments we place did have some favorable treatment with the -- that was grandfathered on -- it was a sub-debt instrument replaced with senior. So that would have had a modest impact on the leverage ratio, that's probably what you're seeing.
Yes. I think I got you going from 26 to just under 27?
Yes. That's all that would have been, yes.
Okay. Let's move to the U.S. business. And you mentioned the expected profit on a total company level was up 6% year-over-year. So certainly, looking better there of late. But in the U.S., your expected profit was actually a decent size decline. Now even if we adjust for what the currency did over the last year, it's still down. And when I think about some of the positive trends you've had, whether it's been Empower sales, whether it's been Putnam aided by market trends to the extent some of the movements in rates or tax reform come into play in that line, why do you think your U.S. expected profit is -- has shown these negative trends? It has been every quarter, but certainly in this one, it comes in a decent size decline. What are the drivers that are required to get a more consistent growth performance from this piece of the business?
Yes. Garry, you can provide some color on that?
Sure. Coming into the year, we haven't looked at the rate. And I've made reference to it in the speaking. I was just -- we had a look at a couple of things. One is the -- the rate of -- release of expected margins on our annuitant longevity improvement assumptions. And also we looked at our -- some of our interest risk provisions. And overall for -- at the Lifeco level, they were fairly balanced between those 2. But we find more of the annuitant longevity shows up in the U.K., so the U.K. would have seen a larger increase. And the U.S. really just had the interest risk margin decline. So what you've got there is a decline from currency and the decline from those lower interest risk margins and assets. That's sort of a onetime change in view. I mean, it's -- so that when you get year-over-year next year, you won't see that same type of movement from that. And then you got, obviously, the growth in Empower and Putnam are helping the other way. But it is that, that interest margin change in neutral with Lifeco, but the U.K. didn't have any offsetting benefit from the annuitant longevity that's where we invested on.
And this might have been what Steve was getting at is, you look in your -- I'm looking at in your presentation slides now and we see the Empower sales up more than 40%, but the fee income only 6%. And you've talked about this in the past, Paul, sometimes there is a timing issue to these 2 things lining up. But when I look at the fee income and the expenses, basically up the same amount year-over-year. Given the sales you've had, it doesn't seem to be driving the leverage you would've thought, given the amount of sales growth?
Again, I would just reiterate, we would look at the leverage. If you looked at it on a year to sales, we would look at that leverage over a period of 2 or 3 years. During the first year, you're going to have your acquisition cost. You'll start to bring the business on -- business comes online in the second, third. Garry, I'm not sure if there is more to add?
Yes. I just -- and I think I just caution on the -- just looking at one -- sort of one quarter-over-quarter snapshot, if you look back, say, over the last 8 quarters, I think you will see a real acceleration in Empower that has been coming through. So these are fairly modest growth, so you can have a bit of that compression with the -- as you say, with sales coming in.
Well, you're right. I know that business, looking at one quarter probably isn't the right way to do it and we'll -- I'll take a longer look on that. Last one. Just want to make sure, I know what's going on here in the assumption changes on investment returns in Canada. The number for that contribution was bigger than we've seen in some time. Anything, specifically, you can give us some detail on what assets you were looking at return assumptions because, as I mentioned, it did seem like a decent sized contribution to the result this quarter, at least in the assumption line?
Yes. Garry can cover that.
Yes. These -- the underlying assets, these were just a -- it's a block of U.S. corporate assets that we had. And we had perhaps been a little cautious in the returns that we're expecting on those. And we've reviewed that except we've changed our views on the amount of that return that it should flow into our actuarial results going forward. So we've been a little more optimistic than we had been in the past, but it was a block of U.S. corporate assets and just our caution when we first bring them on.
U.S. corporate, but it seemed to benefit the Canadian business, is that...
Yes, [mister], U.S. corporate assets that we've -- again, it's in structures and we do our appropriate matching and our appropriate hedging. And it's the net result of the structure and the hedging on those assets to bring them back into our Canadian books. I just make -- I think we've been a little costly in the past, rightly so as we first set them up and then we've had a good look at the track record of those and decided to increase our expected returns on those.
The next question is from Doug Young of DesJardins Capital.
Just back to the Canadian expenses. I just did the math and it looks like if you exclude Financial Horizons, the expenses were up 10% -- sorry, 7%. But I think there was -- there is a component of the digital. But I think, also you had some technology issues in the quarter that may have elevated expenses. So just trying to get a sense of how much of the expense growth this quarter was related to digital and how much related to the technology outage? And can you just maybe elaborate a little bit of what happened on the technology side?
Yes. Doug, those are good insights, good questions. And I'll turn that to Stefan, who can walk you through that.
Thanks, Doug. On the technology side, what it came down is unexpected technology disruption that occurred and it affected a number of our customer in advisor-facing systems as well as some of internal systems. Then it was -- it occurred as a result of some routine maintenance, but at no time was there any -- at any point in time, any unauthorized access to our data. But it did have a -- it was a disruption for sure within the organization. A question might arise as to the impact on sales and it was just nonmaterial. And -- but, we did provision to the tune of -- slightly over $5 million within the quarter to account for the impact of the disruption. And furthermore, from the Canadian expense perspective, from a technology and the ramp-up of expenses, that would be -- the ramp-up cost would be in the tune of above $12 million of expenses.
I would just add that, beyond that, you're going to have inflation that is ....[indiscernible] so if we actually bring Financial Horizons, our digital spend, the provision we set up for that and just the normal inflation that is sort of the summation of those.
And this disruption had nothing to do with the digital transformation you're doing? It was more routine maintenance, is that...
No. It was absolutely routine maintenance that we had to deal with.
Okay. And then just going -- I know there's going to be the sales of the heritage policies in the U.K. in the second half. Have you outlined what the anticipated gain could be from that?
Yes, Doug, it's Paul. I would characterize this as a fairly modest size block of liabilities, and their legacy liabilities. And the real challenger of that block of liabilities is -- it's a tough book of business for us to be servicing and we can be more easily and better serviced, but the partners that we've -- we're going to work with. And I think, Garry should -- can provide a little bit more color on that.
So just to confirm, the financial impact we expect to be immaterial from a earnings or from a capital perspective. And then from a customer service perspective, we exited our direct sales force in the U.K. in 2002. So most of these policies we see sliding to new business at about that time. So as we look forward, the technology investment that would be required to support administering these policies on a new administrative platform would outweigh the financial benefit that we would be able to achieve, whereas, the partner that's going to administer this business has very significantly invested in legacy systems, updating legacy systems, so they can much more easily administer this business and it's really important for us to have found the right partner here, so that our customers can experience good customer service that they have received from us and we expect will be delivered by Scottish Friendly to them starting the second half of next year.
So the next question is from Paul Holden of CIBC.
Wanted to ask a couple questions on Canada Insurance sales. I mean, you guys really concentrated on the individual market. There's been a lot of noise over the last couple of years because of tax reform. So wondering if Q2 sales were may be impacted by the hangover from that? And when we can expect the sales trajectory to sort of normalize?
Yes, thanks, Paul. I'm going to turn that one to Stefan.
Paul, the tax-exempt changes that really sort of surged through the systems through the fourth quarter of 2016 continued along through the first quarter of 2017 and into the first month of the second quarter. So once we got into the third quarter, we would have seen a normalized run rate. That was completely beyond sort of the impact of the tax-exempt changes. So what you're now seeing is our normal run rate within the sales of the Individual Insurance. And we'll be looking to initiatives -- normal business as usual initiatives, which very much on the backs of our digital investments to help increase those sales results.
And so that's actually good lead for my second question, which is, with the restructuring in Canada, I believe, second phase will be increased market share in individual and probably in group as well, and part of that's tied to digital. So when should we start thinking about seeing the impact or benefit from those strategies? I assume it's not going to be one quarter story. It's going to be multi-quarter story. So can you give us some color on how we should think about the progress of improving market share in Canada sales?
Paul, I'll start out, and then I'll turn it to Stefan. So as we're thinking about these transformation initiatives in any other regions, generally, they're going to have multiple benefits. One of the benefits, ultimately, is serving customers and advisors in the way they want to do business. So that whether that's digital or omnichannel or they want to have access to multiple different access points. So that's going to be a customer advisor service benefit. The other benefit we look to, obviously, is a revenue uptick. If we have a better solution for advisors and customers, they'll use us. The other one that was cost efficient is any time you're driving through digital processes, it turn to more of self-service. By definition, you're going to be driving down your costs, and there'll be greater efficiencies. And you'll be able to get greater scale benefits as you grow the business. So we're looking -- as we look ahead, we think of others as both a efficiency play and a service play that will drive revenues. Stefan, maybe, you can speak to sort of the various initiatives we've got one on one.
Yes. To be specific on Canada. I think it's appropriate that you do take a longer view than a one quarter at our first digital lab, which will go into the market. For example, in the fall, starting September within Individual Insurance, that's really focused on fundamentally improving the on-boarding experience for insurance on the term business. And we'll roll it out in a phase basis with groups of advisors and then build from there. And so it will take time to get the full run rate. But we will be running concurrently, and Paul mentioned that we've also started our second lab, which is in the group customer area that began in July of this year. It will come onboard at the end of the year with benefits start to accrue, particularly, on the expense side into the -- into 2019. And then as you ramp them up, the benefits will grow.
Okay. So should we expect this to be then a 2019 type story? Or maybe it even gets pushed out to more a 2020 story when we start to really see the benefits?
I think -- it's Stefan still. This will be an ongoing continuous improvement and sort of set of benefits that come online. And this is how we work now. And in terms of building and bringing new assets to our customers and advisors that can both grow revenue as well as reduce our expense base by automating certain assumptions.
Yes, Paul, to add to what Stefan's saying. He's just referencing to the first 2 digital labs we have. We have another -- a number of them that are kind of under construction that will be launching. And the whole idea is to automate and digitize the business to try and create better customer outcomes and experiences, get more efficient and then win revenue. And a lot of these things will be a function of the adoption rate. And so out of the gate, not every advisor or customer is going to adopt a new way. So we will be trying to drive adoption. So you have to think about this as ramping up over a period of ongoing time, but over a period of quarters and years.
Okay. Fair enough, fair enough. Last question's related to the LICAT ratio. So nice little tick up from 130 to 133 Q-over-Q, but that came more from the base solvency buffer decreasing quarter-over-quarter versus available capital increase. And so just wondering what drove that?
I'm going to let Garry provide a little background on that. Garry?
Sure. There were actually 2 things that were going on. First off, from the quarter over quarter, you see there was a fairly noticeable drop in the pound sterling exchange rate. And we do have through our payout books and other business, we do have a fair bit of capital in sterling. So you see -- and that would affect both the available and the solvency bucket will both come down because that sorts -- in that it sounds it as a modest impact to the ratio probably less than a point. But that will drive both of those. And then the thing which, obviously, we had strong earnings this quarter, that will certainly boost the ratio by close to a couple of points. And then, we also, this is our second quarter doing LICAT. And worse of areas -- again, it's been a major overhaul to the regulatory capital system and there are couple of areas where we had to have -- had to use approximations, and probably on -- little on the conservative side. So as -- just as we find those calculations, we probably picked up a small amount from that as well. So you had a number of factors going on there. But really it's -- the strong earnings is what is -- certainly what helps that. And then it would take some requirements.
Okay. So if I take what you say and kind of try to extrapolate it to the future, then maybe I can expect the LICAT ratio to increase roughly 2 points per quarter, assuming similar level of earnings?
Yes, I think, I would have said that the LICAT ratio would grow maybe 4 to 5 points a year or it could be up to 1 or 2 points. It depends on the earnings level. And also, the unworth -- its underlying business growth is whether if we write large bulk annuities, they tend to have more capital. And if we have tremendous inflow, say an inflows in -- on assets, we still come with much capital. So it's little bit of a mix, but you have that 1 to 2 range. Not bad.
The next question is from Tom MacKinnon of BMO Capital Markets.
I got 2 questions. One with respect to tax and other one with respect to expected profit. So my question with respect to tax is the MD&A says the effective tax rate in the quarter is 15%. And I can duplicate that if I back out the impact of the U.S. refinance gain. The MD&A does mention some other tax noise things in Canada, favorable in both Canadian individual customer and in Canada group, and unfavorable in Canada corporate. So 2 things here. What were those noise items that I mentioned in Canada? Were they material with the dollar amount? And then, more importantly, what should we be thinking about in terms of a tax rate going forward? Is 15%, is that a good number to assume?
Yes, Tom, on the starting point. It's Paul. I would say that the 15% number modest plus or minus would be a good normalized view going forward. Garry can provide some context though in terms of the in-quarter issues in Canada.
Yes, and we had -- we did have a number of provision updates. We do most quarters have provision updates up and down. This quarter, in Canada, they were -- we had a true-up this annual calculation [year]tax filings at the end of the second quarter. So a true-up just on the way we calculate our international tax, the investment funding in Canada. So there is a -- this is called a CIF tax calculation, so that actually would generate the gain. And then we have a provision set up against the legacy item that dates right back to the Canada Life acquisition and that went the other direction. They were fairly similar sizes. So neither of them were that large and the net of the 2 was, I think, in the sort of $8 million, $10 million range. So it wasn't a large item in Canada net. So those were the 2 items there.
Okay. All right. And so you think 15%-plus or minus, 1 % or 2% is reasonable to assume?
Yes, in any -- it's a reasonable rate. In any given quarter, the other thing that really impacted is where our earnings happen to arise. Because the jurisdictions we do business in range fairly dramatically, not as much as they used to because the U.S. is obviously coming back towards the rest of our jurisdictions. But there is -- it does matter in any one quarter, so where the expenses arise or any special versions, but something in that 14%, 15% range is good, yes.
Okay. And then a follow-up is with respect to expected profit. And given that you've done some heavy lifting with respect to U.K. annuity -- mortality in the first half of this year. It looks like you've done some significant releasing. How does that impact the sort of the unwind of PfADs on this business going forward? Presumably, wouldn't the level of the PfADs on this business come down as you release some reserves here? And how does -- does that have any kind of modest impact as to how we should -- the expected profit rolls out for the U.K. -- or for Europe, in particular, going forward?
Yes. Garry, over to you.
Are you sure, Paul. Yes, so Tom -- we don't -- we always take it offline on the actuals side. We just -- to the extent that it's your best assets that's changing, that's not going to affect your expected profit. The expected profit is those provisions for adverse deviation. So we've sent our basis changes where some of our best estimates getting updated and that wouldn't have that impact on the ongoing margins coming out. It really is the -- those margins, those PfADs as they are called that drive that. So you won't necessarily -- basis change doesn't necessarily have that direct impact on expected profit, depends on the nature of it.
All right. As long as the constant amount of the PfADs stays the same, it's not a function of the best estimate, right. It's just a constant dollar amount and as you're...
PfADs that drive it.
The next question is from Darko Mihelic of RBC Capital Markets.
Just a couple of questions. First on just getting back to Canada on the expenses. One thing that's sort of tickling my mind here is that you have significant cost saves that you have realized. So if I look at the $170 million that you speak about, I think $131 million of those are to the common on an annualized basis. So if I quarterize that, that's $33 million per quarter. So if I think about the $414 million of expenses in Canada, that's after you've already realized savings of $33 million in the quarter. So I still can't reconcile why you have such a big jump. I mean, if I do that kind of math, I get 20% growth in expenses year-over-year. Can you tell me why my math is wrong? Or what else is there? When you've detailed $12 million of digital ramp-up and maybe $5 million of cost, maybe there is a little bit of Financial Horizons in there. But I just can't fathom, why the costs are up so much?
Yes. Starting point, the $33 million would be an overstatement of what the -- in-quarter impact would be because that would be $33 million run rate at the end of the quarter, but there's -- sort of rising. We had actually significant staff departures in the particular quarter. So it's really closer to $25 million, $27 million, rather than the $33 million. But that's clearly relative to what you're talking about. It doesn't account for the math that you're doing there. I'm going to let between Garry and Stefan kind of walk you through the way we look at the expenses.
Sure. Maybe what I'll start with is just some of the onetime as to levels at -- It's Garry. So say that -- I would have ballpark the more of a $27 million that would -- you'd see in the expenses through as Paul said, because of the way they fell in the quarter for the annualized. The Financial Horizons Group and the -- or call it the change in onetime expenses year-over-year, we often have some onetime expenses like that technology provision that was this quarter. But, whereas, we had some onetime benefits in Q2 last year and expenses this quarter, it's about $15 million delta between those 2. And you add in the $10 million or $11 million for Financial Horizons Group, there's another $25 million for those 2 items. And then you would have to, I think, allow for a reasonable probably in that $12 million to $15 million range just for your business growth year-over-year. It's not just a one quarter sales trying to just -- an overall business growth year-over-year. And then, Stefan, I think, you've detailed some of the digital acceleration...
No. As I mentioned from an acceleration of digital side, that is in the $12 million to $15 million range, and we would expect that ramp up to moderate in the future periods. As we got this mechanism set up and operating, but I do think it's important to factor in business growth and inflation associated with the Canadian business as well, that comes into the calculation.
Okay. That's helpful. And then, just another question. I mean, it's sometimes when you step back and you look at the results, there's a lot of moving parts it seems in this quarter. One thing that I'd like to do is that I'd like the appendix you guys have, where I believe it's page -- let me just get to it here. It's Page 22, when you take your experience gains and your management actions, changes in assumptions and you take it as a percentage of net income before tax, your long-term average is around 21%. If I make the adjustment for the $60 million restructuring refinancing, and I do the calculation for this quarter, you're somewhere around 31%, so a very big difference. Would you -- so when you step back and look at the quarter, do you think that this is an extraordinarily high quarter for these items or is it that we should think about this run rate is being much higher than 21% on a go-forward basis?
Yes, so Darko, I would actually say that this quarter was extraordinarily high. And if you actually were to unpack each of those years displayed from 2005 to 2017 on that page, you would find that there was a lot of volatility from quarter-to-quarter. As you know, we do our actuarial reviews and studies. They tend to be backloaded in the year typically, but sometimes they'll be front-loaded. The tax impacts would be at different times of the year. So we're going to tend to see quite a bit of volatility from quarter-to-quarter. So yes, there is no doubt that, I think, my calculation on that would have been somewhere just below 30%, might have been 29%. But it's roughly in that area depending on how you look at the refinancing. And the reality is it was a high quarter, but we still expect this to be averaging out in that. If you look at it, it's 20.8%, so whether it's 20%, 21%, 22% over time, that's the range we've typically seen. And that's what our expectation would be.
The next question is from Mario Mendonca of TD Securities.
I just want to revisit Tom's and somewhat Darko's question as well. When Garry was answering the question about whether the longevity reserve release would have impact expected profit or something else, I couldn't tell whether you're just giving us an education or whether you're answering the question. Did the longevity release -- was it a release of best estimate or release of provision for adverse deviation?
Garry?
The longevity change in the quarter was a best estimate change. But it doesn't have to knock on impact into the expected profit.
That make sense. Let me just follow up on that a little bit. So if it doesn't affect expected profit, then it does effect experience then going forward. Because you get it one way or another, would it be fair to say that all else equal, the level of experience gains related to longevity then would be lower?
Yes, they would be over time I prefer [indiscernible] for something such a longevity improving assumption, they tend to be quite a ways off into the future. But, at low-interest rates, even when you discount things at a long way into the future, you still get a fairly large number. But it [indiscernible] see this over a long period of time. But yes, that's where we show up. You're, right.
Yes, I guess, the broader point is it's one or the other. But the other thing I wanted to go through then is assumption changes in management action. This is sort of similar to where Darko was getting at. And if I just look at that over the last 4 quarters, the numbers have been -- they've been large. You added the last 4 quarters. Some change in management actions are approaching $650 million, so the number is large. What I'm getting at here is, would those all be best estimate type releases? Or is it a mixture of best estimate and PfADs that are released?
Garry?
Yes, I was just going to say that -- our expected would be a mix-up. I haven't gone through all of them. I would say the majority of them were best estimate. We don't -- we do review our PfADs. We don't change them quite as frequently instructing as[indiscernible] the best estimates. But -- so I'd say that there would be a mix, but the majority would be best estimate.
Okay. And is there anything big on the horizon that we should prepare for in terms of big assumption changes, big experience studies that you're working on that could have an effect here in the next few quarters?
We do our -- we've got our annual review of experience studies in most of our segments to -- still to come later this year. I can't expect right now as to whether they'll be big or not.
Okay. Then just one final question and this relates to the Putnam and the fund industry generally. I trust you saw the press release from Fidelity earlier today, where they're taking their index funds. They're taking their fees down to 0. And where I'm going with this is, did the industry see this coming? And does this matter? Or is this just a market share play for new entrants into investing? Or does this have a more meaningful impact? Or does Putnam have to respond to something like this is where I'm going?
Yes, I have a perspective that I believe it's more of a market share play. But I'm going to turn that one over to Bob Reynolds to provide perspective because he's really close to this in the U.S. Bob?
Yes, I think what you see happening is a race to 0 on the index fund side. Index funds are commodities. So what determines value is pricing. That does not affect Putnam at all. We're an active manager, continue to be in that space. So to me, it is a attempt to gain market share. The index fund business has been driven by 3 main players and people that haven't gotten that type here are trying to gain it through pricing and this is one of them.
But hasn't the move to that type of investing had an effect on the industry as a whole, including the active managers? So does it sort of, in a tangential way, affect the active managers as well?
It had an effect because of the popularity of index funds coming out of 2008. But since June of 2016, you see active managers starting to add significant value to index funds. And it will be a value-added proposition. In fact, it adds value to index funds. I don't see that large of effect if index funds maintain or form in at level that's satisfactory, I think, it's going to be part of the industry. There is no question, it is secular that index funds are now a big part of the business, but a majority of the assets are still inactive.
Okay. Then just one final thing. The flows were huge this quarter, way better than I think anyone was expecting. It seem to imply, Paul, you did -- or that this was performance-based, that performance is really good and so the flows improved, but performance has been good now for, I would say, a year. Why this quarter? What caused it to jump this quarter?
Well, as a starting point, I think I also mentioned that it was bit of an industry phenomenon. We do see -- where Bob was just referencing the passive play having taken a lot of flows since 2008, what we're seeing is, on the active fixed income side, you're seeing the industry go into positive flows and you're seeing the passives starting to go into outflows. You're seeing that phenomenon going on. But as Bob said, our flow characteristics were just not in fixed income. We're also starting to see, whether it's on the asset allocation -- global asset allocation side or on some of the unique equity products that we would have. So it's a combination of 2 things. One would be continuing strong performance. So if you don't have that, you're not in the game. And then the second one would be an industry shift. Because at the end of the day, the industry can't go fully passive. It will -- capital markets will come to an end if it goes there. People will be seeking returns greater than what's happening in the index.
This is the end of the question-and-answer session. I would like to turn the meeting over to Mr. Paul Mahon.
Thank you very much, Oliver. Well, I'd like to thank all of the individuals who dialed into the call. And I'd like to thank the analysts for your questions. And we -- I would encourage you, if you have any other questions, you contact our Investor Relations area for any follow-ups. And we look forward to connecting with you next quarter. And have a great summer break.
Thank you. The conference has now ended. Please disconnect your lines at this time. And thank you for your participation.