A Look At Prudential’s U.S. Retirement Solutions Business

Prudential Financial (NYSE:PRU) is one of the biggest financial services companies in the world, with over $1.107 trillion of assets under management, ranking 12^th in the Towers Watson’s list of world’s largest money managers. ^[1] The company currently has a market cap of $40 billion, with 2013 revenues of $41 billion. Revenues are earned through premiums and asset management fees from insurance and investment products as well as returns on the company’s investments to support its insurance liabilities. Operating expenses primarily consist of insurance benefits and reserves established for anticipated future insurance benefits. The company also pays out dividends to policyholders and incurs costs of selling and servicing its products. Due to the nature of its operations, the discounted cash flow (DCF) model is not applicable for Prudential, but we can follow our sum-of-the-parts framework and use a dividend discount methodology (DDM) to estimate the value of the company.  In a series of articles, we will breakdown Prudential into its constituent parts and see how each business arm impacts the company as a whole. For more information on the DDM approach, please refer to this link.

To start off, we will look at the U.S. Retirement Solutions and Investment Management division, which accounts for over 30% of the company’s revenues and 18% of our $80 price estimate for Prudential Financial’s stock.

See our full analysis of Prudential here

The U.S. retirement solutions and investment management division can be broken down into three sub-divisions: individual annuities, retirement and asset management. The individual annuities division offers variable and fixed annuity products to individual customers across the U.S., targeting mass affluent customers, with household income over $100,000. The retirement division offers retirement income products and services to employers who set up retirement plans for their employees. The asset management division provides investment management products, including institutional portfolio management and mutual funds.

Demographic Trends

In the U.S., the onus of retirement savings and income management is shifting away from employers to employees. Instead of the traditional pension funds that were managed by employers, most companies in the U.S. are offering 401(k) plans that are sponsored by the employers but allow employees to manage how their savings are invested.

Like 401(k) plans, annuities also offer tax benefits and are popular retirement income management products, especially for those who are not employed by a company that offers a 401(k) plan. Unlike 401(k) plans, which have an investment limit of $17,000 per year, there is no limit on the amount one can invest in annuities. An annuity is a product that provides a customer a periodic payment for a fixed number of years. The customer makes either a single upfront payment or installments over a certain number of years in order to guarantee these future payments. Typically annuities are bought to generate income during one’s retired life. A fixed annuity provides a series of payments of a fixed dollar amount for the specified term. A variable annuity also provides periodic payments, but the dollar value of those payments may vary depending on the performance of the underlying investments. Retirement security is one of the biggest issues for the generation of baby boomers in the U.S. and these citizens form the market for annuity products. According to the 2010 U.S. census, there were about 35 million American citizens in the 55 to 64 years age group in 2010.

According to LIMRA data, total annuity sales in the U.S. climbed from $221 billion in 2004 to $265 billion in 2008, but fell to $222 billion in 2010 following the financial crisis. Retirement income management once again emerged as one of the top concerns for U.S. citizens in 2013, as annuity sales across the country increased 5%.  ((U.S. Individual Annuities Sales Survey, LIMRA)) Variable annuity sales as a percentage of total sales have come down from 41% in 2008 to 37%. However, this could be due to the MetLife’s (NYSE:MET) withdrawal from the market. MetLife was the highest seller of the market linked product in 2011 but decided to cut back on sales to reduce risk in 2012. The company recently reported a 49% decrease in sales of variable annuities for the fourth quarter of 2013. Other insurance companies, including Prudential, are also adjusting their strategy regarding the product.

Prudential’s Market Position

Prudential is the sixth largest seller of annuities in the U.S., with a market share of 7%, and the fourth largest seller of variable annuities with a market share of close to 10%. ^[2] More than 95% of the company’s annuity sales last year were through variable annuity products. Prudential uses a distribution network of independent financial planners, wirehouses, banks, and insurance agents including Allstate’s agency distribution force with over 300 wholesalers across the country. Variable annuities offered by the company allow policyholders to invest in proprietary and non-proprietary mutual funds represented as separate account interests that provide returns based on the underlying investment portfolio.

For variable annuities, investment returns on contractholder funds are generally attributed directly to the contractholder, and Prudential’s revenue comes primarily from fee income from account values.  Account values are driven both by sales and market changes. In response to recent market volatility, Prudential had to adapt its products to the environment to manage its risk profile. As a result, net sales in 2013 fell 71% after a 1% increase in 2012. However, equity market appreciation led to a $20 billion positive change in the market value of contractholder funds during the year allowing a 14% increase in ending total account value. As a result, fee income, which has consistently been around 2.5% of the account value for the last four years, grew 17.5%, despite a decrease in sales.

Prudential has reported strong sales of its Prudential Defined Income Variable Annuity (PDI) product, which accounted for 7% of total sales in 2013. We expect moderate growth in sales, combined with market fluctuations, to lead to moderate growth in account values in the coming years. This will have a concurrent effect on fee income for Prudential.

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1. Top investment managers’ assets close to record levels, Towers Watson [↩]
2. LIMRA SRI U.S. Individual Annuities Sales Survey [↩]