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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Keynote Speech at 2010 Retirement Income Industry Association Awards Dinner


Andrew J. Donohue1

Director, Division of Investment Management
U.S. Securities and Exchange Commission

Boston, Massachusetts
October 4, 2010

I. Introduction

Thank you very much for the kind introduction and for inviting me to join you this evening. I appreciate the opportunity to speak with you. As you may have heard, I will shortly be leaving my position as Director in the Division of Investment Management at the SEC. As a matter of fact, this will be one of my last opportunities to speak with market participants in my current position. And, although I have not had the opportunity to speak with you before, I think it is particularly fitting that I get the chance to do so now, as issues related to retirement and the aging investment population are extremely significant, and are often at the core of many of the policy issues we grapple with in the Division of Investment Management. Tonight I would like to offer you my thoughts on the regulation of the fund industry as it relates to retirement issues and let you know what we are working on in the Division. Before I do, I need to state for one of the last times, the standard SEC disclaimer 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.

In addition to the significance of retirement issues, I also appreciate the chance to speak with you this evening as I feel your group represents a very important idea in the financial world — we are all in this together. The markets are now, and ever-increasingly, interconnected and interdependent on each other. This applies to different types of market participants as well — you each rely on each other in the various market roles you play. The idea of stepping back and sharing information across different industry sectors — as you say, the “view across silos” — is a great approach to developing best practices and understanding what is going on in the retirement area. I truly commend you for making this concept such a successful reality in the RIIA.

One of the things I learned in my position is that this idea of stepping back and viewing the market as a whole is also critical to developing effective and balanced policies and regulations. I think looking at the fund industry in this way has been helpful in developing regulatory initiatives from both the investor’s perspective, as their focus is on the end product, as well as taking into account the individual industry components so regulations do not impose unnecessary costs, burdens and disruption.

Over the course of my tenure, as the Division took this approach with respect to the issues we were addressing, our appreciation of the issues evolved. One thing that happened as market events ensued was that investor views and concerns changed. Interestingly, these changing views seem to have a generational component, implicating the retirement context. We are seeing uncertainty among investors in general as they are overall making fewer equity investments and moving into perceived safer investments, like cash and bonds. The flows in and out of mutual funds also show general uncertainty. Since the beginning of 2008, stock mutual funds have seen cash outflows totaling roughly $245 billion, while bond mutual fund inflows were almost $616 billion.2 For retirement funds, prior to the 2008, 401(k) investors had reportedly seven of every 10 dollars of their retirement funds in stocks, whereas now that number is below 60%.3 However, the most conservative investors: according to one study, are the 18-28 year olds of the so-called Generation Y and the 29 to 45 year old Gen Xers.4

Regarding fund investors, there is also an apparent generational difference in market perceptions. According to the ICI, investors aged 65 and older have a more favorable view of the fund industry than those investors younger than 35.5 They also noted that risk tolerance among investors differs by age — and I think interestingly, that although the willingness to take risk is strongly affected by age, which is not new, this willingness to take risk has varied over time within age groups. Most recently, over the past two years, the willingness of the youngest fund shareholders to take investment risk moved lower, while among the oldest fund shareholders it increased.6

I think these developments are significant as we work to restore confidence in our markets, particularly among younger generations, so they may accumulate sufficient assets to enjoy retirement without unnecessary financial stresses. In this regard, much of our focus in the Division recently has been on disclosure designed to provide investors with access to the information they need to understand market risks and make informed investment decisions, as well as to minimize certain types of risks that we have seen arise in the fund industry.

II. Disclosure and Fees

Streamlined Disclosure Documents

As access to information is so critical to investor confidence, I believe one of the most important initiatives for mutual funds and their investors during my tenure in the Division was the Commission’s adoption of the Summary Prospectus in 2008.7 However, the credit for this initiative does not really go to me, as it was the result of years of development, creative and diligent work by the Division staff and, notably, an admirable collaboration among the Commission, the fund industry and fund investors. With this working environment, the result was a revolutionary change that approaches mutual fund disclosure from the investors’ perspective; providing investors with key information in a form they can truly use, with more detailed information available on the internet. With the success of the Summary Prospectus, the Division staff has been evaluating this idea of streamlined, user-friendly information in other areas, such as shareholder reports, which are long and dense, but yet contain information of vital importance to investors.

The staff is also evaluating streamlined disclosure for variable annuities. I believe that disclosure in this area is particularly important. As the aging baby boom population of investors has shifted its primary focus from the accumulation of wealth to the management of that wealth and the production of income, perhaps the primary investment goal of retirees and of those planning for retirement, is ensuring that they produce an acceptable level of income and do not outlive their savings. Annuities are designed specifically to address this concern, but the loss of liquidity that attends annuitization historically, I believe, resulted in very low annuitization rates.

What may be the most dramatic story in the variable insurance world of late has been the development of so-called guaranteed minimum withdrawal benefits, both as features of variable annuities, as well as stand-alone products, which provide streams of income similar to annuity payments but without some of the loss of liquidity that typically comes with annuitization. Many of these products are very complex in their design and operation, making it very important that issuers provide clear and useful disclosure regarding how the products work and the risks of investing in them.

Clear understanding of these matters is very important to investors in these products, many of whom are seniors, particularly in light of the long-term nature of these investments, and the significant surrender charges and tax penalties that may face an investor getting out of one of these investments. For that reason, the Division carefully reviews these disclosures in registration statements. There should be an effective spotlight on any provisions that may undermine the reasonable expectations of investors in these products, such as the ability of an issuer to narrow the underlying investment options, or provisions that could cause the investor to lose the benefits through failure to adhere to stringent limitations on, for example, permitted withdrawals or asset allocations.

Investors should also understand that the fulfillment of the issuer’s obligations under one of these arrangements is subject to the issuer’s creditworthiness, and typically is not guaranteed by any third party. In general, issuers, as well as those recommending the arrangements, must be diligent to minimize the likelihood that an investor in one of these products could be misled and/or frustrated in his goal of managing income during retirement.

Rule 12b-1 Reform

Another important initiative intended to improve investor information and transparency, as well as provide other investor protections, is the Commission’s recent proposal to reform the regulation of mutual fund distribution fees, or 12b-1 fees.8 The proposal, designed to modernize regulation of the way that mutual funds pay for the costs of promoting and selling — or distributing — fund shares, provides an investor-oriented approach to regulation in this area. There are of course two main ways that mutual fund investors pay for the distribution of fund shares — through a front-end sales load, or investors can buy a fund, or a fund class, that pays for distribution over time. There are also, I should mention, no-load funds and those which do not charge 12b-1 fees. However, for those that do, and use the method of having investors pay for distribution over time, the fund’s returns are reduced over time by these distribution costs — often significantly. For front-end loads, the amount invested is reduced by the amount of the sales load.

In preparing its recommendation for reforming rule 12b-1, the Division staff took into account significant input from fund investors, fund directors, mutual fund managers, and other regulators — the consensus being that the 30-year-old rule needed to be updated to better reflect modern distribution practices. In 1980, when rule 12b 1 was adopted, one of the main purposes for fees was to pay for advertising and promotion. Today they are used mostly to pay for investor services and to compensate sales personnel for selling fund shares — essentially a substitute for a front-end sales load. Rather than paying for new investors to invest in the fund, 12b-1 now involves existing investors paying for themselves.

The reforms proposed by the Commission, if adopted, would regulate the portion of distribution fees that serve as a front-end load substitute. The proposed reforms would limit the cumulative sales charges paid by individual fund investors (whether up-front or over time), improve the disclosure of distribution fees in fund prospectuses, shareholder reports, and transaction confirmation statements, and provide more appropriate roles for fund directors in reviewing and approving these fees. The proposal would also, for the first time, allow funds to choose to offer a class of shares that could be sold with sales charges that are established by broker-dealers, rather than by funds, to promote greater price competition and as a result provide a new alternative means for investors to purchase fund shares at lower costs. The comment period on the proposal ends November 5th.

Target Date Funds

As you likely know, another area that the Commission has focused on is target date funds, which are increasingly popular in 401(k) plans. These funds are designed to make it easier for investors to hold a diversified portfolio that is intended to automatically become more conservative over time. Target date funds attempt to address a variety of risks, including investment risk, inflation risk, and longevity risk. However, as you might expect, funds have taken different approaches to balancing these risks and thus funds for the same retirement year may have significantly different asset allocations, especially as the target date approaches and thereafter.

Market losses incurred in 2008 by 2010 target date funds and the increasing significance of target date funds in 401(k) plans have given rise to a number of concerns, including the potential for the fund’s name to contribute to investor misunderstanding and the degree to which the marketing materials may have contributed to a lack of understanding by investors of the funds and their associated investment strategies and risks. In June, the Commission proposed rules to provide enhanced information concerning target date funds intended to reduce the potential for investor confusion.9 The Division staff is currently reviewing the comments submitted by the public regarding the proposal.

III. Risk

Money Market Funds

The Commission has also taken a number of actions to address potential risks that have arisen in different areas.

For example, in February of this year, the Commission adopted rules designed to strengthen money market funds and make them more resilient.10 The rules do this in a number of ways: they limit money market funds’ ability to assume certain risks, lower the maximum weighted average maturity of fund portfolios, further limit a fund’s ability to invest in “second tier securities” and, for the first time, require money market funds to maintain a significant portion of their assets in highly liquid securities. If a money market fund does break the buck, the rules allow for funds to immediately suspend redemptions so that the portfolio can be liquidated in an orderly manner.

While the new rules effectively reduce the risk in money market funds and strengthen them, thus making it less likely that another fund will “break the buck”, and protecting shareholders’ interests in the event that happens, the events of the fall of 2008 showed that money market funds are susceptible to runs, particularly by institutional investors. The regulatory framework under which money market funds operate can be made to more effectively deal with that fundamental risk, and the Commission has noted that it expects to issue a release addressing these issues and proposing further reform to money market fund regulation.11

Systemic risk was also the focus of a number of aspects of the Dodd-Frank legislation. With respect to investment management, the new legislation authorizes the Commission to adopt rules regarding the collection of data from advisers to hedge funds and other private funds for the purpose of assessing systemic risk.12

Derivatives and Sophisticated Products

Finally, when thinking about risk, one area of concern that has arisen in conjunction with our interdependent markets and which I feel exemplifies the need to look across silos at the market as a whole, is in regard to derivatives. I have spoken often of my concerns regarding funds’ use of derivatives and my belief that these instruments, while affording the opportunity for efficient portfolio management and risk mitigation, also can present potentially significant additional risk as well as raise issues of investor protection. Over the last two decades, investment companies have moved from relatively modest participation in derivatives transactions, limited to hedging or other risk management purposes, to a broad range of strategies that rely upon derivatives as a substitute for more conventional securities. Investment companies seeking to mimic hedge fund strategies, typically involving derivative products, have become more commonplace. New categories of investment companies have emerged: absolute return funds, commodity return funds, alternative investment funds, long-short funds and leveraged and inverse index funds, among others.

The regulatory challenge in this area is that the current investment company regulatory scheme didn’t contemplate these types of investments. Rather, its approach is geared to a very different environment. For example, many areas of protection concerned, such as concentration and diversification, are based on the amount of money invested, rather than the degree of economic exposure the fund has undertaken to a particular security, company or sector. However, now, with so many derivative instruments available to enhance an investment strategy, a fund’s manager can design a portfolio in a multitude of ways to create different exposures that are unrelated to the amount of money invested and are not necessarily reflective of the types of instruments the fund holds. Furthermore, utilizing derivative instruments may expose the fund to a host of risks, including market, liquidity, leverage, counterparty, legal and structural risks, not otherwise addressed through regulations that anticipated more traditional investments.

To assess and respond to the challenge of regulation in this area, the Division has undertaken to review derivatives activities of investment companies and the implications of those activities for the regulatory framework. In conducting this review, the staff is asking fundamental questions — how should we measure the derivative instrument itself for purposes of say leverage protections? Do existing regulations sufficiently address whether funds’ procedures for pricing and liquidity determinations of their derivatives holdings are appropriate and do the current disclosure requirements adequately address the risks created by derivatives? Has the Commission provided adequate guidance concerning leverage issues? And, generally, how are funds addressing risk in this area? Is board oversight sufficient and do funds have the appropriate expertise and maintain robust risk management systems and procedures in light of their investments?

This is an area I believe is extremely important and one that needs to be addressed in a manner that permits the appropriate use of derivatives consistent with the protection or fund investors and the policies underlying the 1940 Act.

Mandates under Dodd-Frank

Finally, in terms of the Division’s regulatory agenda, and our markets, we are seeing new and potentially revolutionary changes on the horizon. With the enactment of the Dodd-Frank Act, and the changes it may present, how we see our markets may dramatically change. For example, one area I know you are interested in — and which certainly requires us to step back, look at the market and reconsider how we view traditional market participants and their regulation, is consideration of the fiduciary status of retail broker-dealers. As to how the traditional regulatory regimes governing broker-dealers and investment advisers may be harmonized, we will need to wait and see, but you are certainly not the only ones interested in it. The Commission has already received over 3000 comment letters related to its study into this matter mandated by Dodd-Frank.

IV. Conclusion

I would like to conclude my remarks this evening by encouraging your engagement in the regulatory process on matters affecting your industry — from your individual perspectives, from the perspective as to how regulatory initiatives will affect retirement investment as a whole, and most importantly, how they will affect investors. One surprise I had in my experience at the Commission was how effective cooperation among the Commission and industry can be. We saw this with the Summary Prospectus, as I mentioned, and also with money market funds as the industry stepped forward to work with us to address certain necessary reforms following the financial crisis. Also with rule 12b-1 we were able to engage in thoughtful exchanges with many industry participants, as well as other stakeholders, which I believe truly enhanced our ability to make a well-informed recommendation to the Commission. Your input, including your comments on Commission proposals, is a necessary and very important part of the regulatory process. The Commission and staff take them very seriously. Now we are seeing considerable involvement by all parties as the Commission considers the initiatives mandated under the new legislation. The importance of retirement investment to the security of so many in this country, I think makes your involvement in what we do at the Commission that much more critical.

I thank you again for listening this evening.

1 The Securities and Exchange Commission disclaims responsibility for any private publication or statement of any SEC employee or Commissioner. This speech expresses the author's views and does not necessarily reflect those of the Commission, the Commissioners, or other members of the staff.

2 The Investment Company Institute

3 Hewitt Associates

4 See Adam Shell, Could Investors Fleeing Stocks Become a Lost Generation? (citing a 2010 Scottrade American Investor Study), USA Today, Sept. 2, 2010

5 See Ownership of Mutual Funds, Shareholder Sentiment, and Use of the Internet, 2010, Investment Company Institute, September 2010 Research Fundamentals

6 Id.

7 See Enhanced Disclosure and New Prospectus Delivery Option for Registered Open-End Management Investment Companies, Investment Company Act Release 28584 (January 13, 2009).

8 See Mutual Fund Distribution Fees, Investment Company Act Release 29367 (July 21, 2010) (Proposed Rule)

9 See Investment Company Advertising: Target Date Retirement Fund Names and Marketing, Investment Company Act Release No. 29301; June 16, 2010

10 See Money Market Fund Reform, Investment Company Act Release 29132, February 23, 2010

11 See id. at Section I. See also SEC Chairman Mary Chairman: Statement on Money Market Funds Before the Open Commission Meeting, January 27, 2010 at http://www.sec.gov/news/speech/2010/spch012710mls-mmf.htm

12 See Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act.


Modified: 10/13/2010