American Council of Life Insurers
February 6, 2004
Jonathan G. Katz, Secretary
RE: Disclosure Regarding Market Timing and Selective Disclosure of Portfolio Holdings; Release No. 33-8343; File No. S7-26-03.
Dear Mr. Katz:
The American Council of Life Insurers is a national trade association with 368 members representing 71 percent of all United States life insurance company assets. Many of our members manufacture variable contracts that are distributed directly or through broker-dealers and other intermediaries. Life insurers also manage one-fifth of America's privately administered pension and retirement plan assets, many of which are funded by variable annuity contracts totaling $918 billion.
As significant participants in the securities marketplace, life insurers have a direct interest in effective solutions to market timing abuses in the mutual fund industry. Our members have carefully evaluated the SEC's proposed disclosure amendments, and have developed suggestions to make the proposal more fully and equitably useful. We greatly appreciate the opportunity to add our views to the important dialog on these matters before the SEC.
Summary of the Proposal
In the release, the SEC proposed enhanced disclosure requirements to combat market timing abuses and selective disclosure of portfolio holdings. These enhancements are intended to deter abusive practices and to enable investors to better understand market timing policies.
These market timing proposals include revisions to the registration forms for insurance company separate accounts funding variable annuities and variable life insurance, on Forms N-3, N-4, and N-6, regarding policies for frequent transfers among underlying sub-accounts, or in managed separate accounts. Among other changes, the proposal would require registered separate accounts to disclose:
The proposal would also require the separate account to disclose with specificity any policies and procedures for deterring frequent purchases and redemptions, and any arrangements that exist to permit frequent purchases and redemptions.
Summary of Position
Evaluation of the Proposed Amendments
We support the general thrust of the proposed amendments. Disclosure enhancements will strengthen protections against illegal excessive trading. The proposed added disclosure will allow consumers to make fully informed decisions.
We do not support, however, the concept in the proposal that registrants must disclose with detailed specificity the nature and operation of tools used to manage excessive market timing. The proposed amendments appear to call for very specific disclosure about a registrant's precise procedures for both detecting market timing activity and for deterring market timing.
Market timing is a continually evolving problem, and exact disclosure of specific techniques and tools will be a static snapshot of practices. Limitation of timing solutions to those detailed in the registration statement is inadvisable for several reasons. Explicit disclosure of the registrant's game plan gives an unwitting roadmap to market timers planning manipulation.
The proposal would require frequent prospectus updates to fully disclose tools developed to address evolving market timing techniques. This will retard quick action to new situations. Detailed prospectus disclosure about the mechanics and operation of market timing tools may handcuff registrants' ability to develop creative solutions to rapidly evolving market timing techniques.
As an alternative to detailed disclosure about the nature, mechanics and operation of tools to control market timing, we recommend general disclosure that registrants will use a variety of tools to thwart abusive market timing activity, at their discretion, and will uniformly apply the standards to all contract owners. This approach encourages development of new solutions, and retards market timers' ability to neutralize or anticipate implementation of market timing controls.
The proposal's required disclosure explaining the absence of selected market timing tools exposes the separate account to unnecessary exposure to litigation. This type of disclosure unnecessarily invites opportunistic litigation that second-guesses business judgment and management decisions.
In essence, the proposal is more than simply disclosure enhancements, and may constitute regulation by disclosure, by requiring explicit details of procedures to prevent and detect market timing. We believe that these deficiencies in the disclosure proposals can be cured by removing the requirement to provide specific, detailed disclosure about registrants' procedures for both detecting and deterring market timing activity.
Fair value pricing methodology provides the most effective means to thwart unfair dilution of net asset values caused by excessive market timing activity. Fair value pricing successfully eliminates arbitrage attractive to market timers, and achieves the most accurate valuation of securities in mutual fund portfolios. The SEC should clearly encourage mutual funds to consistently use fair value pricing.
This methodology efficiently protects all direct mutual investors and indirect investors through two-tier vehicles such as variable annuities and pension plans. Market timing abuses can be successfully cured through clear disclosure and consistent enforcement of market timing practices. We encourage the SEC to develop more specific interpretive guidance about the situations in which fair value pricing is warranted.
Specially focused redemption fees can also retard excessive market timing activity. This mechanism, however, does not work neutrally across all product platforms. For example, the tracking mechanics to correctly assign redemption fees in pension plans or employer groups may be formidable. While redemption fees in direct mutual fund investments operate easily, the same is not true in most two-tier structures such as pension plans.
Unlike mutual funds, variable annuities are strictly enforceable contracts between insurers and contract owners that are subject to state insurance regulation. Some tentative solutions to excessive market timing, such as specially tailored redemption fees, may be contractually infeasible under existing variable annuity contracts. Moreover, any amendments to variable contracts for added redemption fees would need approval of state insurance departments in which the contract was approved for distribution.
In contrast, fair value pricing presents an effective bar to excessive market timing without the impediments of state regulatory approval or contractual constraints. Incorporation of redemption fees in existing pension plan arrangements may be contractually infeasible. Again, fair value pricing can successfully prevent market timing abuses. We also respectfully encourage the SEC to consult with the Department of Labor and the Department of Treasury to develop alternative arrangements that may be adopted by plan sponsors to curb market timing abuses within pension plans.
Accordingly, we strongly oppose authority for mandatory redemption fees as the exclusive solution to market timing activity. Registrants should be able to implement a variety of tools to effectively thwart abusive market timing. Authorizing across-the-board redemption fees may impair competition by erecting solutions favoring mutual funds that do not translate equitably to variable contracts funding two-tier structures such as pension arrangements.2
Many retirement programs utilize an "open architecture" framework making options available to plan participants from multiple mutual funds. Increasingly, mutual funds have established redemption restrictions that are different from one mutual fund family to another, and from mutual fund to mutual fund within the same family. It would be much less confusing to allow the retirement plan to establish one redemption restriction applicable to all available investment options. Collaboration between the SEC, the Department of Labor, and the Treasury Department to develop "safe harbor" redemption restrictions for retirement programs may be constructive and cost effective.
Balanced Marketplace Competition is Critical
In 1974, Congress amended the Securities Exchange Act by adding Section 23(a), which requires the SEC to consider the anti-competitive effects of rule changes, and to balance any impact against the regulatory benefit to be obtained.3
In a different context, former SEC Chairman Levitt emphasized the importance of reviewing the impact of rulemaking on competition when he stated:
In response to the National Securities Markets Improvement Act of 1996 (NSMIA), the Commission has rededicated itself to considering how rules affect competition, efficiency, and capital formation as part of its public interest determination. Accordingly, the Commission intends to focus increased attention on these issues when it considers rulemaking initiatives. In addition, the Commission measures the benefits of proposed rules against possible anti-competitive effects, as required by the Exchange Act.4
Solutions to market timing abuses should fulfill these important SEC and statutory goals to protect both competition and investors. The SEC should develop corrective rule modifications carefully to prevent any anticompetitive impact. This can be readily accomplished with constructive market timing solutions that operate fairly across all product platforms.
The Operation of Two-tier Financial Products
Life insurers manufacture variable annuities and variable life insurance for distribution to individuals, and groups such as pension plans. These variable contracts are hybrid products with important insurance and securities characteristics. The SEC regulates the issuance and sale of individual variable contracts under the federal securities laws. The Department of Labor and the Department of the Treasury, through the Internal Revenue Service, promulgate rule and regulations governing retirement programs and the products used to fund them. State insurance departments also regulate the insurance features of variable contracts.
Like mutual funds, life insurers' separate accounts funding variable contracts are registered under the Securities Act of 1933 and the Investment Company Act of 1940 because the account values fluctuate according to the investment experience of an underlying securities portfolio. The structure, operation, and distribution of variable life insurance and variable annuities are, however, different from publicly available mutual funds.
For example, variable contracts funded by life insurers generally operate under a two-tier structure. At the top tier, the separate account funds the variable contract based on an underlying menu of mutual funds at the bottom tier. Purchases, sales, and exchanges are transmitted from customers to the life insurance company, which in turn communicates the appropriate instructions to the underlying mutual funds.
The life company processes customer orders directly and through intermediaries. Variable contract customers, therefore, do not have direct contact with the underlying mutual funds. In pension plans, participants transmit allocation instructions through a plan administrator to the life insurer, which conveys the information to the mutual funds underlying the plan's variable annuity contract.
It is important that solutions to market timing abuses work fairly with both pension plan participants and mutual fund investors, in spite of structural differences between the two financial products. Authorizing inflexible solutions to market timing abuses that favor mutual funds would be an unfair response to systemic abuses that originated in the mutual fund industry.
Likewise, inflexible market timing solutions would give mutual funds an unequal marketplace advantage over competing financial products. The mutual fund industry should not be able to obtain leverage over competitors through market timing remedies.
Variable annuities, therefore, have similarities with, and differences from, publicly available mutual funds. Actions addressing mutual fund abuses should be carefully designed with those differences in mind.
As a significant participant in the securities marketplace, the life insurance industry supports responsible remedies to market timing abuses. Disclosure about the risks of market timing, and the application of tools to thwart abusive practices are constructive approaches to this important regulatory issue.
Other revisions are necessary and appropriate, however, to provide a balanced solution across all product platforms. The proposal will prevent abuse, protect investors, and preserve fair competition if it is further modified as recommended above.
The final amendments should provide sufficient time for registrants to incorporate any new requirements, such as negotiation of new participation agreements, or coordination with underlying funds on effective market timing procedures. The SEC should also allow adequate lead-time following final adoption of the amendments to implement and file new disclosure related to the amendments.
We also request that the SEC confirm that incorporation of revised disclosure to fulfill the proposed amendments can be properly filed as a post-effective amendment pursuant to Rule 485(b) under the Securities Act of 1933. This will advance a smooth transition to the new requirements.
Thank you for your courteous attention to our views. Please contact us if you have any questions or need additional information.