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U.S. Securities and Exchange Commission

Speech by SEC Staff:
Remarks Before the NAVA Compliance and Regulatory Affairs Conference


Andrew J. Donohue1

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

Washington, D.C.
June 2, 2008


Thank you very much for that kind introduction. I would like to thank NAVA for inviting me to speak at this conference.

Before I commence my remarks today, I need to remind you that my comments represent my own views and not necessarily the views of the Commission, the individual Commissioners or my colleagues on the Commission staff.

I noticed that this year's conference theme is "Managing Risk in a Changing World." I think that this theme is quite important and I hope to touch on a few items today related to this theme. We are indeed living in a changing world. The last year has seen the market turmoil touched off by the difficulties in the subprime mortgage market, leading to a liquidity crisis in large sectors of the financial community. The Dow Jones Industrial Average has declined by almost 11% since July of last summer and the housing market is struggling. Despite this gloomy news, investors are still entrusting their assets to investment companies. In 2007 annual net sales of all mutual funds topped $1.1 trillion, an increase of 71% over the year before. And combined net assets of variable annuity contracts saw continued growth in 2007, with net assets at year's end of nearly $1.5 trillion, an 8% increase over net assets in 2006.

Our changing world is also witnessing the Baby Boomer generation reach retirement age. It is estimated that there are nearly 77 million baby boomers. In 2007 almost 10,000 people turned 60 every day; or in other words, over 400 every hour. These boomers have spent the last several decades accumulating assets for their retirement with the knowledge that they may not be able to rely on Social Security or defined benefit pensions as their parents did before them. As they approach retirement age, the focus for these folks changes from one of accumulating assets to managing those assets to meet their needs for the remainder of their years. So naturally a major concern for many of these baby boomers is making sure their assets are not exhausted during their lifetime.

I was not surprised that NAVA identified the upcoming challenge for Baby Boomers approaching retirement as early as 2001. Back then NAVA recognized that individuals approaching retirement change from being growth investors focused on increasing assets to income investors focused on asset and income management. As noted then, a 65 year old couple has a 50% probability that at least one of them will live past 94. We are talking about 30-plus years of income that a retiree may need. And think about how much change can take place in 30 years. Thirty years ago the cost of a brand new Ford Mustang Coupe was about $3,800; today, a new Mustang will run you about $19,600. And filling up your tank in 1978 would have only cost you 63 cents per gallon. I don't think anyone in the room needs me to remind you of what gas costs today. My point is simply that increased longevity is only part of a retiree's story; inflation does not stop during those extra years of retirement.

You may hear this scenario and think that these are changes that suit the annuity industry well. I would agree with you, but I also want to point out some of the challenges that this scenario poses. As people continue to invest in the securities markets despite market turmoil, and as a large and important segment of the investing public is comprised of people seeking to live through retirement off their investments, the variable products industry faces the important challenge of bringing to market products that are well designed and priced to meet the investment objectives and needs of this evolving demographic. Part and parcel of this challenge is funding these products with investment management vehicles that are well managed in the interests of investors.

The staff is well aware of the challenges you face. We face corresponding challenges as regulators of these products, and just as the challenges you face may offer great opportunities for expanding your business and providing a critical service to our nation's retirees, the staff is challenged to continue protecting investors in a fluid and changing marketplace. While our respective challenges may be different, they are also fundamentally intertwined. Properly understood, our roles are complimentary; we are not at cross purposes. In order to ensure that investors have access to the best products with the greatest degree of investor protection, it is incumbent upon us to work together. That is why I welcome conferences such as this one where we can share ideas on how best to meet the challenges we face together.

Let me take a few minutes and review with you some of the ways we are approaching these challenges, hopefully as part of a broader dialogue at this conference and beyond.


Let me start with a few words about disclosure. One of the most important challenges in your changing marketplace is providing clear disclosure of complex products to a diverse group of investors. Variable insurance products are increasingly complex, which makes it critically important that your investors understand these products, how they work, and what they cost. The growing complexity of these products is making good and effective disclosure that much more difficult. Ironically, the more difficult it becomes by virtue of this complexity, the more crucial good and effective disclosure becomes for precisely the same reason. It is vital that you clearly convey to your customers the costs, risks and benefits of the products you offer. Failure to do so will only result in confused and disappointed investors and, ultimately, damage to your reputation.

The need to tell the whole story, and to do so with accuracy, tends to result in longer disclosure documents. Unfortunately, the longer the document, the less likely it is that an investor will actually read it or understand it. Hence the shift towards the layered disclosure approaches that has been at the core of our thinking about the future of disclosure regulation.

In November, the Commission proposed a mutual fund disclosure reform initiative, which, if adopted as proposed, would result in far-reaching changes to mutual fund disclosure requirements. The core of the November reform proposal is the summary prospectus — a concise, plain English summary of key information about a mutual fund's investment objectives and strategies, costs, and risks, with more detailed information available both in paper and in a user-friendly online format. The concept behind the proposal is layered disclosure that is designed to allow each mutual fund investor — and each intermediary, analyst, and other user — to quickly find and use the information that he or she needs and wants.

The proposal stems from a recognition that fund investors often find current fund prospectuses to be lengthy and legalistic — in some cases even confusing and overwhelming. Fund disclosure documents, however, do contain a wealth of valuable information. The proposal, therefore, would rely on a summary prospectus to communicate key information to fund investors in a streamlined format, with the full prospectus and statement of additional information available on line or in paper upon request. Investors could access these disclosure documents, and the more detailed information they provide, by using on-line, interactive hyperlinks to navigate easily through the layered information.

In essence, the proposed mutual fund disclosure framework would provide information that is easier to use and more readily accessible, while retaining the comprehensive quality of the mutual fund information available today. Those investors who want to continue to obtain their fund information in a paper format would continue to have that ability.

While these proposals do not cover variable product prospectuses, they could have a significant impact on variable product issuers in their role as distributor of underlying fund shares. This new disclosure regime, if approved, would require coordination and cooperation between insurers and underlying funds in the spirit of good and effective disclosure. Providing investors with effective disclosure so that they might make informed investment decisions is the most important objective.

Industry participants are understandably interested in employing this or a similar approach for variable product prospectuses. At this point I would like to recognize the hard work of NAVA, in conjunction with the ACLI, in their efforts to develop a short form disclosure document for variable annuity contracts. I believe that this is a good first step that should help facilitate a productive dialogue between the staff and the industry regarding the requirements of any variable annuity short form disclosure document. At a minimum, I believe any such document must be able to stand alone so that its effectiveness does not rely on information incorporated from other documents; it must disclose all the fees and charges; and it must describe the basic features of the product in clear, concise English. Given the complexity of these products, this is not an easy task. I look forward to hearing about these efforts.

As important as the summary prospectus initiative is, it is but the first prong in the Commission's efforts to make the mutual fund disclosure regime more user-friendly. The second prong is the Commission's mutual fund interactive data project. Interactive data has the potential to enable investors to analyze and compare information with an economy of effort which has never been possible before. Last year, the Commission launched a voluntary filing program to enable funds to file the risk/return summaries from their prospectuses using an interactive data taxonomy developed by the Investment Company Institute. Approximately 20 funds have made filings using the new capability. On May 21st the Commission voted to issue a rule proposal that would require mutual funds to file their risk/return summary disclosure in interactive data format. In addition, on May 14th, the Commission voted to propose a rule amendment that would, if adopted, require operating companies to file corporate financial statement information with the Commission in interactive data format.

In April, the Commission launched a new interactive webpage called the Mutual Fund Reader. The Reader enables investors to read, analyze, and compare the information provided by mutual funds related to fund cost, risk, investment objective, strategy and past performance using the interactive data submissions from the voluntary program. By accessing the new web page, you can "test drive" the capabilities that interactive data offers and get a glimpse of the interactive nature of the future of mutual fund disclosure.


I would like to turn now to the topic of sales practices, and in particular, suitability of sales to senior citizens. Selling suitable products to seniors is a challenge that has grown in importance with the aging of the baby boomer generation. In particular, sales practices associated with variable annuities are a persistent area of concern, especially in light of the high level of exchange activity in the industry, which has been estimated by some to represent more than half of gross sales. Chairman Cox has made clear that the protection of seniors is a high priority at the Commission. The Commission's ongoing initiative to protect senior citizens includes the use of our examination and enforcement resources to identify inappropriate sales practices and prosecute fraudulent conduct that may harm older investors. It also involves the education of senior investors about prudent investing and avoiding scams that may be targeting them.

This focus on suitability has led to a number of developments. The Commission has established an annual senior summit at which regulators, law enforcement officials, and community groups gather together to discuss how to best protect older Americans from abusive sales practices and investment fraud. In addition, NASAA adopted a model rule in April of this year on the use of Senior Certifications and Professional Designations. And FINRA's conduct rule 2821 regarding the sale of deferred variable annuities became effective as to most of its provisions on May 5th.

The new FINRA rule has several specific requirements intended to make sure that variable annuities are sold in an appropriate manner. The rule includes measures to help ensure that the characteristics of the variable annuity are suited to the needs of the individual investor. The rule also includes specific training requirements for brokers and their supervisors. And it includes standards and procedures for supervisory review of product sales. By way of this rule, FINRA has taken an important step forward in ensuring that both seniors, in particular, and investors generally, are not targets of abusive sales practices for variable annuities. I am pleased to see that this morning's panel took up some of the nuts and bolts of complying with Rule 2821 and I am encouraged generally by the importance this conference has placed on the protection of seniors.

Suitability is primarily a job for the industry. In that regard I've taken note of NAVA's efforts on its straight-through processing standards initiative which is intended to automate the annuity sales process. It would be a welcome development if the industry could use this tool to help both selling firms and issuers identify and address potentially unsuitable sales.

Yet despite the progress that has been made, suitability is an issue that requires persistent oversight, as there continue to be abuses. By way of example, let me briefly highlight the findings from the examination sweep that was conducted last year as part of the Chairman's focus on protecting senior investors, which I think illustrates why this remains such an important concern for the Commission. The sweep was focused on "free lunch" seminars, which are largely targeted to seniors as potential investors.

The staff had concerns about the suitability of products recommended in 25 of the 110 exams conducted, or in 23% of the examinations conducted. More pointedly, some firms appeared not to consider the individual needs and circumstances of each customer when recommending a product as suitable for that customer. For example, at one broker-dealer, examiners noted that the same investment objective was identified on almost every new account form in one branch. Despite differences in the customers' ages, net worth, income levels and investment experience, almost every new account form indicated that the customers had "growth" and "growth with income" as their investment objectives. Almost every customer was invested in the same annuity product, and in the same three sub-accounts. These facts suggest that all customers were treated the same way when the firm was recommending investments, and not in accordance with their individual needs in light of their various differences.

So while positive steps have been taken, I believe that suitability is an issue that requires constant vigilance and we on the Commission staff will continue to be focused on it. I encourage you to continue your efforts as well.

Rule 12b-1

I'd like to talk to you about an issue that primarily concerns underlying funds, but which also affect the insurers whose products offer the funds as investment options.

Rule 12b-1 fees affect investors where it counts — in their pocket books. This is no less true for variable product funds than it is for retail funds. Unfortunately, however, many investors do not understand rule 12b-1, the services that 12b-1 fees pay for, or even the fact that 12b-1 fees are being deducted from underlying fund assets.

Some of this lack of understanding can be traced back to a regulatory approach that does not match the economic realities of today's mutual fund marketplace. This sentiment was expressed at a 12b-1 Roundtable the Commission held in June 2007. Following the Roundtable, the Commission had a public comment period inviting public input on the issues discussed at the Roundtable.

Both the Roundtable and the more than 1400 comment letters received during the comment period were extremely valuable in helping the staff focus on the issues surrounding rule 12b-1 fees and how they impact investors.

In approaching 12b-1 repeal and reform, the staff is committed to doing so principally from the investor's perspective. We are hopeful that, among other things, a staff recommendation regarding 12b-1 repeal and reform would streamline the regulatory approach, create disclosure that communicates more effectively, and develop a regulatory system that properly protects investors' interests while continuing to ensure that they receive the benefits and services that 12b-1 fees currently pay for.

When viewing rule 12b-1 from the investor's perspective, the staff recognizes that 12b-1 fees are, in many cases a substitute for a sales charge on the fund shares. Unfortunately, however, investors may not fully appreciate that this fee is being automatically deducted from fund assets. Part of the problem is that SEC rules have not treated 12b-1 fees as sales charges, which I believe in many instances is what they have become.

If 12b-1 fees are functioning similar to a sales charge an investor pays over time or an "asset based sales charge" to borrow from NASD/FINRA rules, then I believe the staff should recommend that the Commission treat them as a sales charge — and require that they be disclosed as a sales charge that is paid by investors in the fund.

Viewing 12b-1 fees as a sales charge could further enable a revision to the approach taken to the role of fund directors with respect to 12b-1 fees. Currently, directors of funds that use fund assets for distribution are required to adopt a 12b-1 plan and annually consider its renewal. As part of this process, directors analyze factors contained in the Commission release adopting rule 12b-1 in 1980. These factors presuppose that there is a distribution problem with a fund and that the fund has implemented a 12b-1 plan to address that problem. As a result, a fund board's analysis based on the factors can be difficult and even strained in light of the current uses and economic realities surrounding 12b-1 fees, perhaps even more so for funds sold through variable separate accounts, where there are no sales of fund shares directly to the public. Put differently, when Rule 12b-1 was adopted, the concept was for existing shareholders to pay for securing new investors. In today's environment existing shareholders are paying for themselves.

If the staff recommends that the Commission treat 12b-1 distribution fees as the functional equivalent of a sales charge, we could further recommend that the role of fund directors be significantly revised and made more appropriate to today's marketplace. Fund directors could have the same role with respect to 12b-1 fees that substitute for a charge as they currently have with sales charges themselves. If 12b-1 distribution fees are not treated as the functional equivalent of a sales charge, however, I believe it may be significantly more difficult to recommend that the Commission substantially revise directors' role with respect to rule 12b-1.

In developing a recommendation for reform the staff is seeking to develop a regulatory system that recognizes differences between distribution and shareholder services. To the extent an underlying fund's 12b-1 payments substitute for a sales charge I believe we should seek to regulate them as a sales charge, and more appropriately regulate payments for shareholder servicing. The staff's goal is not to favor a particular distribution channel or business model over another, and certainly not to favor certain types of funds over others. However, since 12b-1 fees that function as asset based sales charges are just that -- sales charges, the staff wants to make sure that they are recognized as such and that the appropriate regulatory treatment is brought to bear.


In conclusion, the challenges raised by the evolving needs of the investing public may be difficult, but I believe those very challenges present great opportunities. We on the staff embrace the opportunity these challenges offer to enhance investor protection in this dynamic changing market for variable products.

Thank you very much for your attention and enjoy the rest of the conference.



Modified: 06/02/2008