Speech by SEC Staff:
Remarks at the 2010 ALI-ABA Conference on Life Insurance Company Products
Andrew J. Donohue1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
October 28, 2010
Thank you very much for the kind introduction. I am very pleased to be here, although I find it somewhat bittersweet. As most of you probably know, I will soon be leaving my position as Director of the Division of Investment Management at the SEC. While I am really looking forward to the next chapter in my career, I have very much enjoyed the challenges I have faced at the Commission, and I take pride in the work of the Division during my time there. Let me one more time — maybe the last time — state the standard 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.
Today, I would like to review with you a few recent developments at the Commission, as well as some of the initiatives that the Division staff is currently considering. With regard to the former, I want to acknowledge the valuable input that you, as industry participants, have contributed to the process in many cases. As to the latter, I want to stress the vital role that you can and should play as these initiatives move forward, keeping investor protection in sharp focus in each case.
II. Disclosure and Summary Prospectus
First, let me start with a few words about the fund summary prospectus initiative. I'm fairly certain that, when I come to review the memory of my tenure as Division Director, the mutual fund summary prospectus project will loom large in my mind. As access to information is so critical to investor confidence, I believe that the Commission's adoption of the Summary Prospectus in 2008 was one of the most important initiatives for mutual funds and their investors during my time in the Division. I must point out, however, that the credit for this initiative does not really go to me. The final product was developed over years of creative and diligent work by the Division staff and, notably, an admirable collaboration among the Commission, the fund industry and fund investors. The result of this remarkable collaboration was a revolutionary change in the approach to mutual fund disclosure; providing investors with key information in a form they can truly use, with more detailed information available on the Internet. I think this approach will prove to be a boon not only to individual investors seeking information in a useful and effective presentation, but also to investor confidence generally, and therefore to the markets overall.
As regards the implementation of the summary prospectus by fund companies, indications I have gotten from the staff generally have been encouraging. It is my sense that those of you who worked on the first submissions should be commended for a strong effort at implementing the form amendments and at preparing prospectus summaries for the funds underlying variable products. You are off to a great start, and I encourage you to continue fine-tuning these documents, listening to your investors, and to the various parties in the chain of distribution, to craft truly effective summary disclosure in this new format.
With the implementation of the Summary Prospectus well underway, the Division staff has been evaluating the idea of streamlined, user-friendly information in other areas, including variable annuities. I believe that disclosure in this area is vitally important, particularly in light of the increasing complexity of the products themselves, and also of the central role these products play in the financial plans of so many investors, especially those who are in — or approaching — their retirement years. The experience of the mutual fund summary prospectus is encouraging to the staff as we consider the possibility of a variable annuity summary prospectus. Representatives of the industry have submitted a rulemaking petition in support of a disclosure regime that would take a similar "layered" approach to disclosure for variable annuities. We have had much additional helpful input from the industry on the topic as well. Paradoxically however, the same thing that makes the need for such reform so important — the inherent complexity of these products — also makes the goal so very challenging. I applaud the industry for its active involvement and willingness to help the staff work through the issues raised by this initiative — it is a good start — but in my view there is a ways to go before we have a workable blueprint for summary disclosure in the variable annuity context. I encourage your continued involvement in this challenging initiative.
Even apart from a variable annuity summary prospectus, I see important and challenging disclosure issues raised by the way annuities are positioned in the markets of today and of the near future. As the aging baby boom population of investors shifts 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 as I understand it, the loss of liquidity that attends annuitization historically has resulted in very low annuitization rates.
As many of you know, 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, which are increasingly being offered as features of variable annuities, as well as stand-alone products. GMWBs provide streams of income similar to annuity payments but without the loss of liquidity that comes with annuitization. Many of these products are very complex in their design and operation, making it very important that insurers provide clear and useful disclosure regarding how the products work and the risks of investing in them. For that reason, the Division carefully reviews these disclosures in its review of registration statements. Clear understanding of these matters is critically important to investors in these products, particularly in light of the long-term nature of these investments, and the significant surrender charges and tax penalties that an investor may face when getting out of one of these investments. 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 selection of 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 must be diligent to minimize the likelihood that an investor in one of these products could be misled and/or frustrated in his or her goal of providing for and managing income during retirement.
III. Target Date Funds
Further on the subject of retirement planning — the use of target date funds has become an increasingly popular tool in the retirement planning strategy toolbox. The date included in the name of such a fund typically corresponds to the year in which the investor intends to retire. Most target date funds are designed so that the fund's mix of investments will automatically change and become more conservative as the target date approaches and often continuing for a significant period after the target date has been reached. This automatic asset allocation has been referred to as a fund's "glide-path."
In theory one could expect a substantially similar glide path — and the asset allocation mix at a given point in time — for all funds of this type with the same target date. Funds of this type seek to address three types of risk: market risk, inflation risk, and longevity risk. As funds differ in how they address these risks, they have taken different approaches to realigning their portfolios over time, so that funds with the same target date in some cases have significantly different asset allocations at the target date and thereafter.
Investors and the Commission staff took note of market losses incurred in 2008 by various 2010 target date funds. It was noted that several of these funds had significantly divergent returns, and that investors in these funds may not have been well informed about the investment policies and volatility of these funds. To address the concern for potential investor misunderstanding stemming from target date fund names, in June of this year, the Commission proposed changes to its advertising rules to help clarify the meaning of a date in a target date fund's name, and to enhance the information provided to investors in these funds. These rule amendments, which the Commission has not yet considered for adoption, were designed to bring about more thorough understanding of funds marketed and sold with reference to an investor's retirement date. The staff is currently considering comments that have been submitted on the proposal.
IV. Indexed Annuities
Let me next say a few words about indexed annuities. We are continuing to see innovation and evolution of product design in this area. Notwithstanding the recent withdrawal of Rule 151A, we do have a small but growing number of indexed annuities registered with the Commission because of the particular features and the level of guarantees under those particular annuity contracts. We have also seen the registration of some indexed investment accounts added as investment options within variable annuities. As to these registered contracts and options, the staff is committed to a robust disclosure review process, with a view towards effective disclosure and the protection of investors in these products.
V. Risk — Derivatives and Sophisticated Products
One area of concern that is particularly prominent in view of the markets' recent history, 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. Over the last two decades, investment companies have moved from relatively modest participation in derivatives transactions, limited to hedging or use in connection with temporary defensive positions, to a broad range of strategies that rely upon derivatives as a proxy for direct investment in more conventional securities. I am seeing more and more mutual funds seeking to adopt hedge fund strategies, including their extensive use of derivative products. 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 current regulatory approach is geared to a very different environment than existed when the Investment Company Act and the Commission's rules were first adopted. For example, certain protections under the Investment Company Act, such as those dealing with concentration and diversification, are based on the amount of money invested, rather than the extent of a fund's economic exposure 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 not directly a function of the dollar amount of the investment, 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.
In response to this challenge, the Division has undertaken a comprehensive review of derivatives activities of funds and the implications of those activities for the regulatory framework. In this regard, the staff is asking fundamental questions — for example how should we measure the derivative instrument itself for purposes of leverage protections? Do existing regulations ensure appropriate procedures for pricing and liquidity determinations with regard to a fund's derivatives holdings? Do the disclosure requirements under our current forms elicit effective disclosure regarding the risks associated with derivatives? And, more generally, how are funds addressing risk in this area?
In an effort to have some of the Division's immediate concerns shared with the industry and the public, the staff sent a letter to the ICI on July 30 of this year, which touched on a number of items that registrants should be mindful of when drafting disclosure regarding derivatives. Let me highlight two points from that letter:
"First, the strategies disclosure related to derivatives should be tailored specifically to how a fund expects to be managed and should address the strategies that the fund expects to be the most important means of achieving its objectives.
"And second, often disclosure states that a fund "may, but is not required to, use derivative[s]," A prospectus should make clear whether the use of derivatives is a principal investment strategy and, if so, reflect such use in presenting the risk profile of the fund's investments taken as a whole.
As variable contract issuers continue to seek to offer attractive fund lineups, these contracts will inevitably mirror the retail fund world with regard to the funds' exposure to derivatives. I believe that disclosure of how derivatives might be used by funds is as important in the variable products context as it is in the investment company industry generally. Regulation and disclosure requirements in this area need to be carefully crafted, consistent with the protection of investors and the policies underlying the 1940 Act, so as not to impede the appropriate use of derivatives. I encourage you to assess the effectiveness of your disclosure in this area, to eliminate boilerplate disclosure that is not indicative of the actual use of derivatives in your fund's portfolio, and where necessary to update and improve your disclosure so that it clearly reflects the role of derivatives in the overall investment program of your funds.
VI. Life Settlements
Another topic of interest to the life insurance industry is life settlements. A life settlement is a transaction in which an insurance policy owner sells a life insurance policy to a third party for an amount that exceeds the policy's cash surrender value, but is less than the expected death benefit of the policy. In August 2009, Chairman Schapiro established a cross-Divisional SEC Staff Life SettlementsTask Force to examine emerging issues in the life settlements market and to advise the Commission whether market practices and regulatory oversight could be improved. The Task Force reviewed articles and other resources related to life settlements and met with a number of industry participants knowledgeable about the life settlements market and fellow regulators.
The Commission released the report of the Task Force in July. The report outlined the Task Force's findings about the life settlements market and recommended that the Commission consider certain actions to improve market practices and regulatory oversight. Among other things, the staff recommended that the Commission consider recommending to Congress that it amend the statutory definition of "security" to expressly include life settlements. The staff noted that the uncertain status of life settlements under the federal securities laws has left participants in the majority of the life settlements market without federal law protections against excessive commissions, unsuitable recommendations, or failures by settlement brokers or providers to obtain the best price for a policyholder selling a contract.
In the report, the Task Force stated its belief that including life settlements within the definition of security would bring clarity to the status of life settlements under the federal securities laws and provide a more consistent treatment for life settlements under both federal and state securities laws. The amendment would bring intermediaries in the life settlement market within the regulatory framework of the SEC and FINRA, subjecting them to regulatory requirements designed to protect investors from abusive practices and to promote business conduct that facilitates fair, orderly and efficient markets. Moreover, it would give the SEC clear authority to police the life settlements market, which could lead to early detection of abuses and help deter fraud. With respect to the Investment Company Act, if the definition of security is amended to include life settlements, a pool of life settlements issuing interests in the pool would be an investment company, unless it falls within an exemption, and investors in the pool would benefit from the comprehensive federal regulatory framework the Act establishes for investment companies.
In conclusion, let me again stress the importance of your active involvement in the regulatory process. During my time at the Commission I have been struck by the value of thoughtful and practical input from industry participants on various matters. One notable example of this was our experience with the summary prospectus, and I am hopeful for an equally fruitful dialogue on the challenge of streamlined disclosure for variable annuities. This is not a new message, but it bears repeating: 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. The importance of retirement investment and income planning 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 for listening this morning and I hope we cross paths again soon.
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.