Speech by SEC Staff:
Keynote Address at the Insured Retirement Institute 2011 Government, Legal & Regulatory Conference
Eileen P. Rominger1
Director, Division of Investment Management
U.S. Securities and Exchange Commission
June 28, 2011
Thank you for the kind introduction. I am very pleased to be with you today. Before I begin, please note that my remarks here today represent my own views and do not necessarily reflect the views of the Commission, any of the Commissioners, or any other member of the Commission staff.
This is my first occasion to speak to you as Director of the Division of Investment Management. I have been looking forward to this opportunity because, based on my work with the staff so far, I find the area of variable products to be dynamic and challenging. It seems that I have come on board at a critical time of changing landscapes, product innovations, and rapid developments in your industry. It is already clear to me that the variable insurance products industry is wasting no time in tackling what is perhaps the most pressing economic concern of the aging boomer generation: the management of retirement income.
This means that we are seeing a proliferation of new product designs and innovations. Some of these raise substantive regulatory concerns, often driven by the fact that variable separate accounts must operate within the regulatory framework of the Investment Company Act. But even the simpler, more traditional variable contracts we see that do not present significant regulatory issues still face the challenge of clear and useful disclosure, as even the simplest contract designs can be difficult to explain in straightforward plain English. In short, I am struck by the many challenges raised in the regulation of variable contracts. As your industry rises to meet the changing need for retirement income solutions, I look forward to working with you towards our shared goal of protecting the interests of investors.
I would like to review with you a few of the newer product ideas the Division has seen of late and, where appropriate, relate these to some of the broader themes commanding the staff’s attention currently.
I. Insurance Company Control Over Underlying Investments
As you know, the proliferation of so-called living benefit riders in variable annuity contracts has been one of the dominant forces driving contract sales in recent years. Since the market decline in 2008, variable annuities have attracted many investors by virtue of the newer contract benefits – the so-called “living benefit” options offered to owners of variable annuities. These provide insurance with regard to minimum contract values or minimum periodic withdrawals. Of course, these benefits have both direct and indirect costs. First, the investor pays directly for these benefits by way of a charge against contract value, which significantly affects investment performance and reduces the upside potential of the contract. Since 2008, when so many of these benefit riders were “in the money” as a consequence of the recent global financial crisis, the staff has seen many filings reflecting increased fees charged for these benefits.
In addition, purchasers of these optional benefits are facing increasing limitations on investment choices, reflecting an effort by insurers to limit volatility of the investments that are subject to the benefits. For example, variable annuity contracts often prohibit allocations to the more volatile funds, or require participation in a conservative asset allocation model that is designed and maintained with reference to the insurer’s exposure under its living benefit riders. An important staff concern here has been to ensure that investors are apprised of the trade-off involved in such an arrangement. While living benefit riders do provide a measure of protection from a down market, it should be clear to those purchasing the riders that these investment restrictions minimize the likelihood that the riders will ever be “in the money” and actually provide a benefit to the investor, and that such restrictions also may limit the upside potential of the investment.
Many insurers also control underlying investments by implementing so-called “stop-loss” features of the contract. These features typically operate as asset allocation models that move account value among underlying funds pursuant to a formula. Account allocations are changed to more conservative investments, such as government bond funds or money market funds, during declining markets and, in most cases, moved back to the original allocation during periods of sustained market growth. As a disclosure matter, it is important that any ability of an insurer unilaterally to change account allocations be clearly explained. For adequate disclosure, I believe the contract prospectus should set forth the precise parameters under which account allocations may be changed. It should also explain the effects of such changes, such as the possibility of missing a market uptick during a period of fixed income allocations.
On a related topic, underlying funds are frequently managed by advisers that are affiliated with the insurance company. This has been true throughout the history of variable contracts. However, with the proliferation of living benefits under these contracts, the Division has become increasingly concerned about potential conflicts of interest that may result from the fact that the amount of an insurance company’s liability under living benefit riders is directly related to the performance of funds that are managed by its affiliate. Recently, we have begun to see prospectus disclosure acknowledging the conflict, and even indicating that the management of a fund could be influenced by the risk exposure faced by the adviser’s affiliate, the insurance company. Further still, one recent filing disclosed an arrangement under which a fund, which will be a required investment allocation for participants in certain living benefit riders, will be managed through adherence to a formula that uses data provided periodically by the affiliated insurer.
Again, I think it is vitally important in these kinds of arrangements that investors understand the trade-off inherent in an investment of this type. Traditionally, variable annuities offered investors a tax-efficient way to participate in the equity markets, albeit at a cost to cover the insurance company’s mortality and expense risks under the contract’s annuity feature or death benefit. I believe an investor purchasing a living benefit rider should be fully informed of any aspect of the arrangement that could limit the market participation reasonably expected by the investor.
Beyond the disclosure implications here, keep in mind that separate accounts and underlying funds, as investment companies, are subject to the Investment Company Act’s conflict of interest provisions. These were designed by Congress to prevent any overreaching on the part of fund affiliates in their dealings with the fund. From that perspective, I think it is important that the board of directors of any fund that may be subject to conflicting interests on the part of its adviser be vigilant watchdogs for the fund’s investors, ensuring that arrangements entered into are for the benefit of those investors. To accomplish that goal, I believe board deliberations should squarely address any potential conflict on the part of the fund’s adviser and other service providers. Meanwhile, a fund’s adviser and the insurance company that offers a fund on its platform should be careful in formulating arrangements to head off any potential for overreaching in their dealings with the fund.
II. Other Contract Developments
I would like to turn now to some other contract developments. As more and more investors turn their attention from accumulating assets to managing income, we expect to see more new types of annuities, funded by or patterned on instruments that have become popular elsewhere in the marketplace. Two indexed annuities that were recently registered bear similarities to structured notes that lately have garnered a lot of attention both in the media and from the Commission staff. These contracts, if held to term, promise some percentage of the return of a specified equity or commodity index, but provide only very limited downside protection if the contract is surrendered early. In this regard the contracts are similar to certain so-called “structured notes with principal protection.”
On June 2nd of this year the Commission’s Office of Investor Education and Assistance and FINRA jointly issued an investor alert about those instruments, which I commend for your review. It noted that, while these structured products have reassuring names, they are not risk-free, and the terms of such notes related to any protections to or guarantee of principal require a careful review. For example, despite the name “principal protection,” protection levels vary, with some of these products potentially returning as little as 10 percent of principal. The investor alert also pointed out that these products can have complicated pay-out structures that can make it hard to accurately assess their risk and potential for growth. In addition, the products have fees, whether implicit or explicit, even if the sales materials suggest otherwise, which of course will limit returns.
Annuities are a form of insurance, which may suggest safety of an investment simply by virtue of the type of issuer. But annuities patterned on the operation of these structured notes call for caution on the part of investors along the lines set forth in the recent investor alert. The staff’s review of the annuity filings I mentioned earlier focused on effective disclosure of the considerable risk associated with the minimal downside protection. I believe it is important that anyone working towards future filings regarding similar products should do all that you can to prepare disclosure aimed at ensuring that investors are not confused or misled. And I would caution you, as well, that you will be well served by exercising vigilance with respect to the suitability of sales of these products.
III. Disclosure Issues Related to Derivatives
I have already mentioned the need for clear, effective disclosure in variable contract and underlying fund prospectuses. I thought I would take this opportunity to stress one aspect of that theme. As funds are increasingly designed and managed with reference to insurance company obligations under living benefit riders, derivative hedging transactions are likely to play an increasing role in the management of these funds. I would like to speak for a few minutes about the disclosure implications of this trend.
The need for disclosures that clearly inform investors about the specific attributes of derivatives has been highlighted by the staff on multiple occasions, virtually from the beginning of the use of derivatives by funds. Just recently, the Division wrote to registrants regarding observations by the staff that funds’ derivatives disclosures were in many cases generic rather than specific, and did not fully apprise investors of the specific types of investments actually expected to be made. The staff noted that several forms of unhelpful disclosure concerning derivatives are commonplace, including laundry list enumeration of virtually all types of derivatives as potential investments; generic language about potential purposes for using derivatives; open-ended, non-specific disclosures concerning the extent of anticipated derivatives transactions; and, generic risk disclosure regarding derivatives that may or may not relate to the actual risks faced by the fund. The staff also observed that some funds provided extensive and hyper-technical discussions of derivatives which, in practice, bore little relation to the actual operation of the fund. These sorts of disclosure relating to the use of derivatives do not provide investors with useful information regarding the operation and management of the fund.
Addressing these shortcomings, the staff noted that disclosure relating to the use of derivatives should be tailored specifically to the intended management of the fund. The level of detail in the disclosure should correspond to the degree of economic exposure the derivatives create, in addition to the amount invested in a derivative strategy. The staff further noted that disclosure should describe the purpose the derivatives are intended to serve and the extent to which derivatives are expected to be used. For example, if the instruments are to be used for hedging, what are the risks being hedged? If for investment purposes, what are the opportunities contemplated?
Finally, the staff also noted that risk disclosures should be tailored to the types of derivatives used, the extent of their use, and their purpose, as a means of providing investors with a complete risk profile of the fund’s investments, taken as a whole.
IV. Summary Prospectus
I’d like now to turn to a topic that I believe has great potential for the variable insurance industry. In January 2009, the Commission adopted rules providing for an improved mutual fund disclosure framework through the use of a summary prospectus. Briefly, the summary prospectus option provides for a concise and user-friendly, plain English document for fund investors containing key information about the fund’s investment objectives and strategies, risks, costs, and performance. More detailed information is available both in paper form and also online in a format that facilitates direct movement between concise information in the summary prospectus and more detailed information in the statutory prospectus.
It has now been over two years since the Commission adopted the summary prospectus option. In that time, the staff has seen an encouraging number of summary prospectus filings. As of March 31, almost 70% of mutual funds had opted to file summary prospectuses with the Commission. Those who worked on the initial submissions should be commended for a strong implementation effort. I encourage you to listen to your investors and to the various parties in the chain of distribution so that you can fine-tune these documents and craft truly effective summary disclosure in this streamlined format.
As the staff gains experience with the mutual fund summary prospectus, we are continuing to consider a similar disclosure framework for variable annuities. In particular, we are studying the feasibility of a summary prospectus for variable annuities that would provide investors with key information in a clear and concise format.
The challenges, of course, are many. Variable annuities can be difficult to understand. They often have complicated features, not the least of which are the living benefit riders I discussed earlier, and they often have complex fee structures.
Disclosure about these products is further complicated because insurers may modify features of existing contracts as time goes on. As a result, any given variable annuity prospectus may include disclosure about features that are no longer available to current purchasers but may remain available to contract owners who purchased their contracts in the past.
While these factors make our task of developing more user-friendly disclosure for variable annuity investors very challenging, they also make the task all the more important. I believe it is essential that investors be provided with clear disclosure and have ready access to the information they need to make well-informed investment decisions because of the central role that variable products play in the financial plans of so many investors, especially those who are in or approaching their retirement years.
We have received valuable input from the IRI and other industry representatives on the topic. I appreciate the industry’s active involvement and willingness to help the staff work through the challenging issues raised by this initiative and encourage your continued involvement as we continue to study improved disclosure in the variable annuity context.
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Thank you for your time and attention today. I hope I have been able to convey a sense of the importance the Division places on the developments we are seeing in the area of retirement income solutions, and on the challenge of investor protection in these dynamic times. As always, the staff welcomes your input and your cooperation, and I look forward to getting to know many of you as we work together to serve the interests of American investors. Thank you.
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.