Speech by SEC Commissioner:
Remarks Before the NASD Spring Securities Conference
Commissioner Annette L. Nazareth
U.S. Securities and Exchange Commission
May 18, 2006
Good morning. I would like to thank Mary for her welcome remarks and kind introduction. I appreciate the opportunity to speak before you at such a well attended and informative event. From a look at your agenda for the next two days, you will have many opportunities to learn about recent industry developments and important compliance issues.
Over the years, I have appreciated NASD's diligence in hosting events such as this and its focus on investor protection generally. I applaud Bob Glauber, Mary, and many others at NASD for their efforts in this regard. I also applaud each of you for, among other things, your attendance here today. Your willingness to invest your time and money to participate in sessions devoted to topics such as just to name a few insurance products, anti money laundering, ethics, and suitability considerations, deserves to be recognized.
If you have occasion to visit the Commission's wonderful new building in Washington hopefully not for an enforcement related reason you will no doubt notice two things. First, of course, you will notice the welcoming pictures of five smiling commissioners, including yours truly. Second, above our pictures you will notice the Commission's mission statement: to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.
I will focus my remarks today on the first part of our mission investor protection and the related issue of suitability of financial products for investors. When complex financial products are sold to investors, both regulators and industry participants have a vested interest in ensuring that the investments are appropriate. To accomplish this, regulators have taken a number of approaches, including requirements regarding suitability, disclosure, and adequate supervision. Today, I will focus on investor protection primarily through the lens of suitability issues presented by four financial products.
I have chosen these four because they are illustrative of products that are more prone to retail investor confusion and where compliance could be generally improved. It is my hope that these illustrations will assist you in meeting your suitability obligations. Before I begin, however, I must remind you that my remarks represent my own views, and not necessarily those of the Commission, my fellow Commissioners, or the staff.1
II. 529 Plans
I would first like to discuss 529 plans, which are tax advantaged savings plans that are designed to encourage savings for education costs. It is notable that all 50 states and the District of Columbia sponsor at least one type of 529 plan. Earnings in 529 plans are not subject to federal tax and, in most cases, state tax, so long as a customer uses the withdrawals for eligible expenses. In addition, some states allow their residents to deduct contributions to 529 plans from the state income tax returns for the state that sponsors that plan. This benefit is generally reserved, however, for the 529 plan of the customer's state of residence.
529 plans come in two varieties: a pre paid tuition plan and a college savings plan, the latter of which permits an account holder saving for college to establish an account for a beneficiary for the purpose of paying the beneficiary's eligible college expenses. The account holder typically may choose among several investment options for his or her contributions, which the plan then invests on their behalf.
Generally speaking, I recognize the benefits of vehicles that permit individuals to invest in education, including 529 plans. One certainly cannot overemphasize the value of education to our society. This does not mean, however, that there are no suitability issues presented by the sales of 529 plans. The fact is, with 50 states and the District of Columbia offering at least one type of 529 plan, there are a dizzying number of choices today. The college savings plans can be maddening to compare: many are given different state tax treatment, have different contribution limits, offer multiple investment options and multiple share classes within each investment option, and have different fee structures. As to fees, broker sold college savings plans typically involve loads and annual distribution fees. Other fees for these plans may include enrollment fees, annual maintenance fees, and asset management fees.
In light of the complexity of the college savings plans, it is especially important that brokers make suitable recommendations to their customers. As the shares of 529 plans are municipal securities, their sales are primarily governed by rules of the Municipal Securities Rulemaking Board. The NASD and the Commission, however, are responsible for inspection of broker dealers and enforcement of MSRB rules for securities firms. MSRB Rule G 19 applies to the recommendations and transactions of 529 plans by broker dealers. It requires that broker dealers have reasonable grounds for believing that the recommendation is suitable, based on information available about the investment and information about the customer's financial status, tax status, investment objectives, and other relevant information.
The MSRB has stated that broker dealers must recognize that this product is designed to pay for higher education expenses, a purpose that should match the investment objectives of purchasing customers. Therefore, it is reasonable to conclude that a 529 plan would not be a good vehicle for investments that are not earmarked for qualified education expenses. Another concern is that a recommendation would be made to an account holder to invest more funds than he or she might reasonably be expected to use for a single beneficiary.
Other suitability issues arise from recommendations on the underlying investments in the college savings plans. A significant issue in this regard is the age of the beneficiary, because it will generally determine the time in which the account holder will need to draw on the investments for eligible expenses. Broker dealers should consider, for example, whether more conservative investments are appropriate to recommend as beneficiaries near college age. The time that will pass before funds are needed is also important in the determination of which share class is suitable. As share classes have different fee structures, a broker dealer should consider the appropriate class for each particular customer based on their investment objectives.
Also, "rollovers" from one 529 plan to another may be done on a tax free basis. Although changing plans is a significant benefit that permits customers to choose the best option for them, it is not intended to be a tool to permit broker dealers to recommend an excessive number of rollovers. Recommending that a customer engage in frequent rollovers may put the federal tax benefit in jeopardy or be viewed as churning. Also, rolling over a 529 plan from a customer's home state to another one may have tax consequences. Switching investments to 529 plans from other investment vehicles also raises suitability concerns. For example, a recommendation that a customer convert investments in a Uniform Gift to Minors account into a 529 plan may result in the customer losing certain benefits.
There are also tax implications in the sales of 529 plans. Each state offers a 529 plan. Although customers are not limited to the plan of the state in which they live, many states offer their residents incentives to invest through their plans. As I have indicated, this incentive generally comes in the form of a tax deduction from state income tax. This doesn't necessarily mean that a person's home state will always present the best choice for them, but a broker dealer should consider any foregone tax deductions when making a recommendation.
There is some evidence, however, that this may not be happening. In 2003 and 2004, for example, NASD reviewed the sales practices of several broker dealers selling 529 plans and found that the vast majority of sales were made to residents outside of the state that sponsored the 529 plan. In fact, many of the firms had more than 90% out of state sales as a percentage of their total 529 sales. Again, this doesn't necessarily mean that each of these firms violated their suitability obligations in making recommendations, but these numbers raise some red flags.
III. Variable Annuities
The next product that I would like to discuss is the variable annuity. Variable annuities have been a source of longstanding concern at the Commission, NASD, and other regulators, and as a growing portion of our population ages, it is a product that is receiving increasing attention from the financial services industry. As you may know, a variable annuity is a contract between an investor and an insurance company under which the insurer agrees to make periodic payments to the investor, beginning immediately or at some future date. The value of a variable annuity may vary depending on the performance of the investment options typically mutual funds selected by the investor.
The good news about variable annuities is, among other things, that they provide investors with a host of underlying investments and optional features. The bad news, however, is that the myriad of features and fee structures inherent in some annuity products has resulted in confusion for both the representatives who sell them and the investors who purchase them.
For example, features such as minimum income and stepped-up death benefits may be useful to some investors. But we are concerned that some of these features are so complex that many investors may not understand what they are buying. Similarly, many variable annuities offer long term care or disability insurance benefit options. These "bells and whistles" aren't free, however, and assessing the additional charges that accompany them may be difficult for investors to fully appreciate.
Moreover, it is not apparent that they are always necessary or useful to the particular investors who purchase them. Even without the additional charges that may accompany these optional features, the annuity fee structure may be difficult to understand. Variable annuities typically assess surrender charges, mortality and expense risk charges, administrative fees, and the expenses associated with the underlying funds.
The commissions earned by broker dealers from sales of variable annuities have often been higher than commissions earned from other securities typically owned by retail investors. These high commissions create an incentive for registered representatives to recommend these products to investors over products with less lucrative payments. If investors have difficulty understanding the features and costs of what they are purchasing, it may be hard for them to assess which optional features would suit their needs, to compare one variable annuity to another, or to compare a variable annuity to other investment products. Therefore, I believe that variable annuity sales raise heightened investor protection concerns and that appropriate suitability determinations would go a long way to allaying these concerns.
As you know, there are suitability requirements in the sales of all products that broker dealers sell to their customers. Suitability gives rise to a "legal obligation" under the federal antifraud provisions as well as an "ethical duty" under SRO rules. Commission actions against broker dealers for making unsuitable recommendations generally are brought under the antifraud provisions of the Securities Exchange Act of 1934.
SRO rules regarding suitability are grounded in concepts of professionalism, fair dealing, and just and equitable principles of trade. NASD Rule 2310 squarely addresses suitability determinations and requires broker dealers to make these determinations for each individual customer. According to the rule, the recommendations a broker dealer makes to a customer must have a basis in the customer's particular financial situation and investment objectives. Broker dealers must obtain information about the customer such as their financial and tax status and investment objectives. An even broader requirement, NASD Rule 2110, requires broker dealers to "observe high standards of commercial honor and just and equitable principles of trade." Inherent in the standards and principles mentioned by this rule are appropriate suitability considerations.
As to variable annuities in particular, several years ago NASD provided a notice to members with best practices guidelines for variable annuity sales. The notice states that members and their registered representatives should make reasonable efforts to obtain comprehensive customer information and to discuss relevant facts with each customer. It also explains that a registered representative should only recommend a variable annuity if the customer has long term investment objectives. More recently, NASD proposed Rule 2821, which would establish specific requirements for deferred variable annuities, including a suitability obligation, principal review and approval requirements, and supervisory and training requirements. The Commission is considering this rule proposal.
There are certain suitability issues and sales practices relating to variable annuities that we find to be particularly troubling. First, we are concerned about excessive "switching" of variable annuity contracts. The tax code permits annuitants to exchange their variable contracts tax free for other annuity contracts through so called "1035" exchanges. The opportunity to exchange a variable annuity contract for another with better features, without having to pay taxes on accumulated earnings under the initial contract, may be a favorable one. Query, however, whether investors and the selling representatives have fully considered the costs and benefits of the switch from the investor's standpoint.
Indeed, switching raises particular suitability issues. For example, investors may have to pay surrender charges on the old contract, and the new annuity typically will impose a new surrender charge period. Also, the new annuity may have higher fees and charges or have features that the investor does not need.
The tax implications of variable annuity sales must also be carefully considered. One benefit of variable annuities is that taxes are deferred on gains and income until money is withdrawn. Upon withdrawal, however, earnings are taxed as ordinary income. The ordinary income tax rate may be significantly higher than the capital gain tax rate, which applies to other investments that are held for more than one year. The favorable tax rates currently accorded capital gains suggest that tax deferability for variable annuities is not as valuable to investors as it once was.
We have seen variable annuities used to fund retirement accounts that are already tax deferred. Indeed, the tax benefits of variable annuities are largely negated when an annuity is held in a qualified plan because all of the growth within those plans is already tax deferred. In addition, traditional IRAs require withdrawals by a certain age, regardless of whether mandating withdrawal would cause the contract owner to incur a surrender charge. I would encourage you to pay particular attention when a representative is recommending that a customer hold a variable annuity in an IRA.
In addition, we have broader suitability concerns relating to the sales of variable annuities to seniors. Annuities often have limited liquidity and high surrender charges, and thus may be unsuitable investments for customers who have short term investment objectives or need access to the funds they are seeking to invest.
Regulators have taken action to combat misconduct relating to variable annuities. For example, the Commission and NASD have brought enforcement actions relating to excessive switching and unsuitable sales. In a recent case brought by the NASD for suitability problems, it suspended and fined a broker for selling a variable annuity to an elderly couple, both of whom were 76 years old at the time of the purchase. The broker knew that the customers were about to enter an assisted living facility and had a need for liquidity. He also knew that the customers indicated income as their primary investment objective and wished to preserve the principal of their investment. These factors should have made it clear to the registered representative and the broker-dealer that a variable annuity was an unsuitable investment in this case.
IV. TICs and REITs
The last two products that I would like to discuss this morning relate to real estate, which has been a very hot topic for some time now. Even as I speak, I can already see the question cards being passed down from panicked audience members that read "Do you believe that there has been a housing bubble?" and "Will you please ask your friends at the Fed to lay off the pedal on interest rates?" Well, before you begin writing on those note cards, I should tell you that I must disappoint by instead focusing on the no less interesting topics of "TICs" and "REITs."
TICs, of course, are tenants in common interests in real estate. The sale of real estate may result in the seller being responsible for capital gains taxes on any appreciation. Section 1031 of the tax code, however, permits investors in income producing or rental real estate to exchange the investment for an interest in real estate of equal or greater value in order to defer the payment of taxes on capital gains. TICs permit the investors to pool their assets with other investors in order to invest in larger real estate offerings. Thus, an investor could exchange his or her rights in a rental property for the interests in a pool of assets of a larger property offering owned by several other investors.
A 2003 NASD notice to members reminds broker dealers of their suitability obligations in selling "non conventional investments," which includes TICs. The notice explained that broker dealers engaged in the sale of non conventional investments must ensure that the products are offered and sold in a manner consistent with the member's general sales conduct obligations. Thus, broker dealers would be required to perform both reasonable basis and customer-specific suitability analyses.
Transactions in TICs present a number of suitability issues. For example, a customer may wish to exchange the total proceeds from a sale of real estate for a TIC interest. Although perhaps not a problem inherently, this exchange may result in a significant concentration of the investor's overall portfolio in real estate. Further, there isn't a secondary market for these interests, so TICs are illiquid. Also, there are fees associated with TIC exchanges that reduce or may outweigh the value of the tax benefits provided by the exchange. Last year, NASD issued a notice to members specifically highlighting these and related concerns. Broker-dealers should consider each of these issues before recommending a TIC exchange.
Also, the sponsors of TIC exchanges routinely obtain legal opinions regarding whether a particular exchange structure would qualify as a like kind exchange of real property under Section 1031. As tax considerations drive these exchanges, broker dealers should obtain a "clean" legal opinion or perform sufficient due diligence into the tax risks of the exchanges and ensure that they are disclosed to the investor.
REITs, or real estate investment trusts, are an investment that has increased in popularity among retail investors during the past few years. REITs are entities that invest in different kinds of real estate or real estate related assets, including shopping centers, office buildings, hotels, and mortgages secured by real estate. Interest in these investments has been positively correlated with the strong returns on real estate investments in recent years.
REITs that are not traded on a national securities exchange or the over the counter market present particular suitability issues. For example, because they are not traded on an exchange an investor may not be able to redeem them for years. As a result, these types of securities present liquidity issues. Investors should be informed of the difficulty that they may have in selling their investments and broker dealers should ensure that the customer will not need the money within a short time period. Also, on occasion, REITs have been marketed to customers as a conservative investment. The reality is that unlisted REITs may involve a high degree of risk. Also, they may have high costs that motivate a representative to make an unsuitable recommendation so they present particular supervisory challenges.
V. Special Note on Sales to Seniors
In addition to the suitability concerns relating to particular products that I have discussed today, I would like to take a minute to make special mention of a concern that I believe will grow in the coming years. This relates to the sale of complex financial products to seniors. A significant portion of the population in the United States is preparing to enter into retirement, with some of its members taking substantial retirement assets with them. This week, the Wall Street Journal reported that by 2010, almost half a trillion additional dollars will be rolled into IRAs each year by aging investors looking for more options to fund their retirements.2 In anticipation, the financial services industry has gone to great lengths to anticipate the demands and opportunities created as a result of this retiring generation.
I would urge you to treat sales of complex financial products to seniors with particular care. The Commission has recently announced initiatives that go straight to the heart of investor protection for seniors. Earlier this month, the Commission announced an initiative with NASAA that would seek to protect seniors from investment fraud and sales of unsuitable products. With NASD and state securities regulators, the Commission has already engaged in "free lunch" examinations here in Florida designed to examine high pressure sales practices used to sell unsuitable financial products to seniors. These exams will be expanded to include other states with a concentration of seniors.
Also, our Enforcement Division has been active in bringing cases aimed specifically at protecting senior investors, and our Office of Investor Education and Assistance has been active in ensuring that seniors are armed with the information they need to assess the various financial products available to them. As more of the baby boomer generation retires, I believe that the Commission's emphasis on protecting senior investors will only increase.
I appreciate the opportunity to be with you today and to share my thoughts. Regulators and industry participants alike should be focused on investor protection. As the complexity of products increases, the importance of understanding the products offered to investors becomes more essential for their brokers. I would now be glad to answer any questions.