Speech by SEC Staff:
Remarks Before the ALI-ABA Conference on Life Insurance Company Products
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
Good morning. It is a pleasure to be here today. I would like to thank Joan and Steve for their generous invitation to speak at this conference. Before I begin, I need to remind you that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners, or my colleagues on the Commission staff.
November 17, 2006
Today, I would like to discuss with you some of the regulatory challenges that are keeping us busy in the Division of Investment Management. Many of these challenges relate to the investment management industry as a whole and not just to the variable insurance industry. At the same time, many of the regulatory challenges raise special issues for us as we strive to carry out the Commission's investor protection mandate in the area of insurance products and for you as you strive to serve your customers. I appreciate the opportunity to share my thoughts on these issues for a few minutes this morning.
I. Simplified Disclosure and XBRL
I was pleased to see that disclosure issues are front and center on your conference agenda because the Division is actively pursuing investment company disclosure reform. The ultimate goal of the initiative is to facilitate more user-friendly, plain English disclosure for mutual funds, variable products, and other investment companies and to streamline the delivery of information through the use of the Internet, interactive data, and other technological means.
This effort is particularly important in the context of variable insurance products. The complex nature of variable insurance products has resulted in complex disclosure documents. There are, of course, disclosures for both the contract and for the underlying funds. For the many variable products that offer a wealth of investment options, there may be disclosures for 50 or more underlying funds. In addition, innovation in product design has led to a multiplicity of product features, resulting in more choice for consumers, but also resulting in more disclosures.
The unfortunate consequence of product innovation, which can have many benefits for consumers, has been that many potential investors confront an information overload. To state what I believe is obvious to all of you, the average investor with paper-based access to all of the information about a variable product, or even with access to the online equivalent of this paper, will have a difficult time figuring out what the critical information is, much less finding and digesting it in a timely manner, and will have an even harder time comparing it against similar disclosures for other insurance or financial products.
The Division is interested in finding a better way to highlight the key information that is critical to an investment decision, perhaps a short summary of the most essential information. I was pleased to learn this past summer that industry representatives are working on recommendations for an improved disclosure regime for variable annuities, using a streamlined document containing key disclosures, which could potentially be hyperlinked to more detailed information.
As many of you are no doubt aware, earlier this year, the Commission held a Roundtable that considered mutual fund disclosure issues. Participants at the Roundtable were drawn from the ranks of investor advocates, industry, research organizations, academia, and self-regulatory organizations. The consensus of representatives of these many different viewpoints appears to be that a short-form disclosure document could be more efficient than the current prospectus as a tool for getting key information into the hands of investors - and by that I mean the critical information they want and need to make an informed investment decision.
In our disclosure reform initiative, the Division is considering recommending that investment companies be permitted to offer securities pursuant to a streamlined disclosure document that must be delivered to investors in paper or, with consent, electronically. More detailed disclosures would be available on the Internet or delivered directly to investors upon request. The streamlined disclosure document would include key information necessary for an investor to make an investment decision, such as costs, investment objectives and strategies, risks, and, in the case of a variable product, insurance benefits. One model we are looking at closely is the current fund profile.
We are also examining the possibility of updating and streamlining fund shareholder report requirements. Reform in this area could have a large impact on variable products issuers, many of whom choose to forward the shareholder reports for all of the many investment options to each investor without regard to which funds a particular investor has chosen.
One of Chairman Cox's key disclosure initiatives is the use of interactive data to make information that is disclosed easier to access, analyze, and compare. The Commission has an ongoing pilot project to test so-called XBRL. XBRL is, essentially, a set of computer tags that permit the information in financial statements to be accessed and analyzed in an automated fashion. As some of you know, the Investment Company Institute has announced a project to extend XBRL by creating additional tags that will cover all of the information in the risk/return summary of a mutual fund prospectus.
The Division is exploring a recommendation that would expand the Commission's XBRL pilot program to permit mutual funds to submit tagged risk/return summary information. Interactive data has the potential to enable users to sift through the wealth of available information and to analyze and compare that information - all in an automated fashion that would free investors, third party analysts, and others from having to read through extensive documents to find the particular nuggets of information they seek. The benefits of interactive data and other electronic tools could be multiplied many times over for variable insurance products, with their wide array of features and investment options. I am hoping to see robust participation in the interactive data initiative by many in the investment management industry so that, together, we can work towards giving investors access to the particular information they want rather than "one size fits all" disclosure.
II. Revenue Sharing
Revenue sharing continues to be a troublesome matter. I know that you are all well aware of the recent enforcement actions by the New York Attorney General's office and the New Hampshire Bureau of Securities Regulation resulting in settlements that call for specific disclosure of revenue sharing arrangements between fund advisers and the insurance company offering the funds as investment options.
In the Division, we continue to consider the disclosure and regulatory issues raised by the practice of revenue sharing. Advisers of funds often pay, out of their profits, amounts intended to compensate those who sell fund shares, service shareholder accounts, or provide other services to the fund. When funds themselves make payments for these kinds of services, either pursuant to 12b-1 plans in connection with distribution of fund shares, or pursuant to administration, transfer agency, or other service agreements, the amounts paid out of fund assets must be disclosed in the prospectus. As you are aware, the Commission has proposed a requirement for point of sale disclosure by broker-dealers of revenue sharing and similar arrangements that could create conflicts of interest in connection with sales of funds and variable products. This proposal and the many thoughtful comments on the proposal remain under consideration.
We are also considering the regulatory issues that may be raised by some of these arrangements. Certainly, it is settled that a fund may pay for legitimate distribution services under a bona fide 12b-1 plan, and that an adviser may pay out of its profits for legitimate distribution or other services rendered. However, recently the Division has received inquiries about some arrangements that have caused us to ask questions about the nature of the services being provided in return for revenue sharing payments. One place these questions have arisen is in the context of funds of funds, in which a variable annuity may offer as an investment option a fund of funds managed by an affiliate of the insurer. In these structures, a contract owner would choose to invest in the fund of funds, and the fund of funds would have complete control over its underlying investments - indeed, the fund of funds' investment adviser would have fiduciary duties with respect to the selection of those investments. In such a structure, I am curious about the extent to which revenue sharing payments from an adviser of a bottom-tier fund to the insurance company or other affiliates of the adviser of the fund of funds could represent payments for services rendered rather than kickbacks for purchases of shares of the bottom-tier funds, which could raise issues under Section 17 of the Investment Company Act. We are considering these issues, and we welcome your thoughts as to the appropriate disclosure requirements and regulatory treatment of these arrangements.
III. Market Timing and Rule 22c-2
Market timing has been an area of continued focus for the Commission and the staff. Market timing not only can dilute the value of shares of long-term shareholders, but it also tends to disrupt the management of the fund's portfolio. Variable annuities can be particularly attractive to market timers, both because of tax deferral on the gains realized in timing transactions and also because the timer's transactions in a particular fund's shares are aggregated with those of all contract owners and submitted as an omnibus trade by the insurer's separate account, making it difficult for funds to detect and deter timing activity. This latter problem is addressed by several of the provisions of Rule 22c-2 - those calling for information sharing agreements between intermediaries and funds, as well as agreements requiring intermediaries to honor restrictions imposed by funds on particular shareholders whom the funds have identified as violating their frequent trading policies. We are hopeful that these provisions will go a long way towards stemming the tide of market timing through intermediaries such as insurance company separate accounts.
In September of this year, the Commission adopted amendments to rule 22c-2. The amendments reflect many of the thoughtful comment letters we received, including several from the variable products industry.
Virtually every commenter requested an extension of the compliance date originally established under the rule. In response to comments concerning the difficulties of entering into revised agreements with intermediaries and changing systems to accommodate the transmission and receipt of trading information, the Commission extended the rule's compliance date. The amendments also resolve certain ambiguities regarding the financial intermediaries with whom funds are required to enter into agreements and the consequences of an intermediary's failure to enter into an agreement with a fund.
Of particular interest to this group is the Commission's response to a comment letter that requested guidance in dealing with transfer requests that cannot be honored because the fund to be purchased in the transfer has blocked further purchases by the relevant contract owner under its market timing policies. The letter noted that a transfer comprises both a redemption of one fund and a purchase, with the redemption proceeds, of another fund. If an insurance company were to honor the redemption portion of a transfer request but not the purchase portion, practical questions would arise with respect to the proper disposition of the redemption proceeds. The recent release clarifies that if a fund instructs an intermediary to restrict a purchase, the intermediary may notify the investor that it will not effect the redemption portion of a request to exchange into the fund, as well as the purchase portion of the request.
The release also addressed the concern that some in the variable insurance industry have articulated regarding state insurance and contract law issues that might arise in connection with a redemption fee charged to investors who invest in funds through insurance company separate accounts. The recent release clarifies that nothing in rule 22c-2 would preclude a fund that is concerned about the legality under existing contracts of imposing redemption fees on contract owners from choosing not to impose the fees with regard to contracts that would not permit imposition of such fees.
Before I leave the area of market timing, I would note that a recent focus of enforcement activity in this area has been on the phenomenon of hedge funds engaging in market timing through variable annuities. For example, last year the Commission brought an action against Millennium Partners, a hedge fund that used multiple accounts and fictitious entities to conceal its identity in order to engage in market timing. In addition, the 2004 cases against Conseco and Inviva involved insurance companies permitting and/or facilitating timing in their annuity contracts by hedge funds. These examples show that the Commission takes this problem seriously.
IV. Fund Governance
I would like to talk briefly about fund governance. Last August, the comment period closed on the Commission's request for additional comment on the 75% independent director and independent chair requirements. We received over 14,000 comment letters. Of those, over 13,700 were form letters sent by individuals through a letter writing campaign. The other approximately 300 letters were submitted by individuals, fund advisers, directors, trade associations, consumer groups, and others.
This was a remarkable response in terms of its sheer scope. Although the open issue identified in the recent D.C. Circuit court's decision focused on costs, few commenters gave specific cost data -- though we are closely reviewing the cost-related information we received. Commenters largely commented on the merits of the independent chair and 75% independent board conditions.
The comment letters on this matter indicate that views on this issue continue to be strongly held. The Division is reviewing the comment letters closely with a view toward making a recommendation to the Commission.
Putting the rulemaking to one side, I would emphasize that, under the Investment Company Act, fund boards are charged with important responsibilities, perhaps most prominently in the area of management contracts and the associated fees. Variable insurance fund boards are no exception. Indeed, some of the structures that have been widely used by insurance funds, such as reliance on manager of managers exemptive orders to change subadvisers without a shareholder vote, arguably put a premium on an active and engaged board. I would encourage the industry to look at insurance fund boards and to put in place structures that will, to the greatest extent possible, encourage robust and independent boards.
V. Rule 12b-1
Rule 12b-1 is an issue that I would like to tackle during my tenure though it will not be in the immediate future. At a minimum, the factors that boards must consider in approving or renewing a 12b-1 plan deserve a fresh look. The current factors bear little relation to the reality of how the marketplace has evolved with respect to the use of rule 12b-1 fees. At the opposite end of the spectrum is full repeal of rule 12b-1. Another possibility is treating 12b-1 fees as account-based fees, assessed directly on individual investors, rather than fund fees. This approach was floated when the Commission proposed the directed brokerage ban under rule 12b-1.
I cannot predict where on this spectrum any recommendation we may make will fall, but it certainly is an issue that the Division is seriously considering. After 25 plus years' experience with rule 12b 1, it is time for a reexamination of the rule. The marketplace has evolved, and it is unclear whether rule 12b 1 continues to serve the purpose for which it was intended. In many cases, rule 12b-1 fees have become a substitute for a sales load on fund shares. Amendments to the rule could make it better conform with reality and eliminate the need for the board to make judgments about factors enumerated in the rule that have limited relevance to current 12b-1 plans. As the Division considers revisions to rule 12b-1, we will be mindful of the two-tier structure of variable insurance products, and we welcome your input on any issues that we should consider.
VI. Sales Practices
I'd like to turn next to a very important topic - sales practices. Sales practices associated with variable products are a recurring area of concern for several reasons, not the least of which is the high level of exchange activity in the industry, which is estimated to represent more than half of gross sales for variable annuities. The high rate of exchanges, in combination with product complexity and sales to seniors, together make variable product sales practices an area of continuing concern. For the Commission, the bottom line is that the investor's interests come first.
A. Product Complexity
I know first hand about the pressures of competition in the financial services industry. The variable insurance industry is, of course, no exception and the intense competition in your industry has often led to complexity of product features and product charges. Innovation in response to competition has led to a virtual alphabet soup of new product features: GMDBs, GMWBs, GMIBs, to name a few. All of this innovation can be a good thing when it results in products that are better tailored to investors' needs. At the same time, all these additional features can have the effect of confusing investors and, quite frankly, can be difficult to understand for the selling brokers as well. Good sales practices are especially important in this environment. It is critical that you know your customer and the customer's needs and clearly explain to the customer the product he or she is buying and its costs. I was heartened to see a story in the press last week suggesting that some insurers are placing a premium on simplification as well as innovation in new product design.
B. Sales to Seniors
Many of the new variable insurance product features have been designed to meet the needs of America's graying population. As the number of Americans approaching retirement increases, there is a greater need for financial products and advice that meet their particular needs. With the decline in defined benefit pension plans, and the rise of 401(k) plans, Americans have increasingly become responsible for providing for their own financial needs in retirement. With improved health care and increased longevity, retirees are faced with planning for a longer retirement. Our aging population needs financial products and financial advice that will help to secure their futures for many years to come. Variable annuities, and particularly some of the recently-introduced minimum income guarantees, are aimed at meeting these needs and helping the elderly to ensure that they do not outlive their assets. In this regard, variable annuities are designed to fill an identified need.
But there is a flip side to this story. The accumulated assets of seniors can make them a target for the unscrupulous, and some in the financial services industry have targeted seniors for inappropriate investments. As I know you are aware, the variable annuity industry has been the subject of concerns regarding this type of conduct. Chairman Cox has been focused on working to ensure that America's seniors are protected against those who would cheat them out of their life savings, and you can expect to see a continued focus on senior issues at the Commission.
The Commission is taking a three-pronged approach to fight investment fraud on seniors, which includes education, examinations, and enforcement. If you visit the Commission's website, you can see first-hand the educational materials specifically directed at older Americans. The website provides links to information about investments that are commonly marketed to seniors, including variable annuities, promissory notes, and certificates of deposit. To detect abusive sales tactics that target seniors, Commission examiners will share regulatory intelligence with their counterparts at the state level. Once the staff identifies firms that may be preying upon seniors, they will examine the sales practices of those firms. Finally, we will deal with fraud aggressively. In recent years, the Enforcement Division has brought a significant number of enforcement actions aimed directly at protecting elderly investors, and I expect that the Commission will maintain these efforts.
State regulators and the NASD are also involved in efforts to protect seniors. The work that the Commission does has greater impact because of these cooperative efforts. The cooperative efforts were highlighted during the "Seniors Summit" convened by Chairman Cox this summer, which brought together regulators and organizations that are vitally concerned with seniors to discuss publicly what steps can be taken to better protect our nation's seniors. Chairman Cox recently announced that, given the importance of this mission, the Commission will be making the Senior Summit an annual event.
VII. Equity Index Annuities
My final topic is equity index annuities or, as they have been called more recently, fixed indexed annuities. Some have articulated concerns about high commissions and poor sales practices associated with these products and about whether the products have fallen through a regulatory crack. Equity index annuities guarantee a minimum return, with additional interest credited by reference to changes in a securities index such as the S&P 500. They were introduced in the mid-1990s, and sales have grown dramatically since then, totaling over $27 billion in 2005. Most equity index annuities have not been registered as securities.
The Securities Act provides on its face that insurance and annuities are excluded from the reach of the Act. As this audience well knows, that is not the end of the story because not all products that are called insurance or annuities qualify for the exclusion. There are products such as variable annuities and variable life insurance that, despite their names, cross the line into the realm of securities. In determining whether insurance products are securities, the Commission and the courts have looked to two primary factors: first, the extent to which the investment risk is assumed by the insurance company or the contract owner, and, second, whether the product is marketed on the basis of stability and security or as an investment that is intended to appeal to the purchaser based on the prospect of growth through sound investment management.
The Division is currently taking a close look at equity index annuities and their status under the federal securities laws. Our review is the result of a variety of factors, including concerns that have been raised about the marketing of equity index annuities, changes to the products and applicable state laws in the years since their introduction, and concerns articulated by some in the insurance industry regarding the regulatory uncertainty surrounding equity index annuities.
The participants in the equity index annuity market have a legitimate desire for more certainty regarding the regulatory environment as they design and market new indexed products. Some in the industry have expressed concern about the potential regulatory uncertainties created by the NASD's 2005 Notice to Members, which addressed supervision by NASD member firms of sales of unregistered equity index annuities. As many of you know, the Notice to Members cited the NASD's concern about the manner in which associated persons of member firms are marketing and selling unregistered equity index annuities. Whatever views any of you may have about the regulatory status of equity index annuities and the propriety of the NASD's action, I know that we can all agree about the importance of good sales practices. As you and we wrestle with the issues surrounding this product, I invite each of you to join with me in realizing our common goal of protecting consumers.
Today, I have outlined some of our priorities and some of the initiatives that the Division will be working on in the coming months. In our efforts, we will keep our focus on what best serves the needs of America's investors. I trust that your focus will be the same as you develop and market your products. As long we both keep our obligations to America's investors paramount, I believe that, together, we can create an environment that will permit the variable products industry to thrive. Thank you.