Speech by SEC Staff:
Remarks Before the ALI-ABA Conference on Life Insurance Company Products
Director, Division of Investment Management
U.S. Securities and Exchange Commission
November 3, 2011
Good morning, and thank you for the kind introduction. It is a pleasure to be here today to speak with you about some of the many important issues surrounding the regulation of variable insurance products. Before I begin, let me remind you that my remarks here today reflect 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.
As you know, the management of retirement income for older Americans is one of the most pressing concerns currently facing our country. The first wave of baby boomers turns 65 this year—a wave that, in the coming years, will quickly become a flood, as approximately 77 million boomers surge towards retirement. Meanwhile, many seniors find themselves with nest eggs that are smaller than they anticipated as a result of the economic downturn of the past few years.
It is no easy task to address the financial interests of senior investors under these conditions, but in my time at the Commission so far, I have seen the variable products industry squarely facing that challenge. Judging by the rapid clip of product design innovations, it is clear to me that participants in your industry are moving quickly to position themselves in response to the needs of these investors. I appreciate the initiative and creativity driving these changes, but at the same time I am mindful of the difficulty many investors face in making informed investment decisions regarding complex variable products. It is vital that issuers of any security clearly convey to investors, in plain English, the costs, risks, and benefits of the products they offer, and I believe this is particularly challenging in the context of variable products.
II. Variable Annuity Summary Prospectus
As I’m sure you know, the Commission adopted rules in January 2009 providing for an improved mutual fund disclosure framework, including the use of a summary prospectus. The optional summary prospectus provides key information about a mutual fund’s investment objectives and strategies, risks, costs and performance in a user-friendly, plain English format. 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.
Almost three years have passed since the Commission adopted the summary prospectus initiative. In that relatively short time period, we have seen an encouraging response from the fund industry. As of June 30 of this year, approximately 75% of mutual funds had opted to file summary prospectuses with the Commission. As many of you know, the staff is now considering a similar disclosure framework for variable annuities. As with the mutual fund summary prospectus, our goal would be to have a document that is useful, easily read and understood; a document that will provide investors with clear and concise disclosure regarding the key features of a variable annuity.
Given the complex nature of many variable annuities, the challenges we face are many. A variable annuity requires an investor to absorb a significant amount of information in order to make an informed investment decision, and conveying that information in a summary document poses challenges. Variable annuity features and fee structures can be extremely complex, particularly if the contract offers multiple optional benefits. Although our goal is a summary prospectus that is concise, it must still provide investors with the key information they need to make an informed decision. Taking the information available to investors in the current statutory prospectuses, and determining what aspects of that information should be disclosed in the summary, is a difficult task.
Further, insurers may change contract features over time. As a result, variable annuity prospectuses today sometimes include disclosure about features or benefits that are no longer available to current purchasers, although the disclosure remains relevant to contract owners who purchased in the past. This problem of evolving contracts is one of the issues that complicates the summary prospectus initiative for variable annuities. As a general matter, an investor is best served by receiving only that information that is relevant to the investment he or she is considering.
Paradoxically, the inherent complexity of variable annuities that makes the need for a variable annuity summary prospectus so important also makes the goal very challenging. Nevertheless, the staff is working hard on this initiative, mindful of the central role variable annuities play in the financial plans of so many investors, especially those who are in or approaching their retirement years. I appreciate your perspective on the challenging issues raised by the variable annuity summary prospectus, and I encourage your continued efforts to improve variable annuity disclosure.
One important way to discover what kind of disclosure investors want and need is to ask them. In that regard, the Division is proceeding on two different fronts to engage investors about how best to provide them with useful disclosure. First, the Division is currently working with the Commission’s Office of Investor Education and Advocacy to conduct investor testing to examine the effectiveness of mutual fund shareholder reports in communicating useful information to individual investors.
The study is designed to gather feedback from investors in order to help us determine how mutual fund shareholder reports could more effectively communicate information to individual investors. The study also will generate a baseline assessment of mutual fund shareholder reports, providing a way to measure potential improvements over time.
In addition, the Division is working with the Office of Investor Education and Advocacy and others on a separate study regarding financial literacy among investors that is mandated by the Dodd-Frank Act. The study is required to address general issues regarding financial literacy of retail investors, as well as to identify “the most effective existing private and public efforts to educate investors.” Last April, the Commission issued a request for public comment on existing efforts to educate investors, and we received input from more than 80 commenters.
The Act calls for the financial literacy study to identify methods to improve the timing, content, and format of disclosures to investors with respect to financial intermediaries, investment products, and investment services. The Act also requires the study to identify methods to increase the transparency of expenses and conflicts of interest in transactions involving investment services and products. The financial literacy study is to focus on issues of disclosure with respect to financial intermediaries, financial products, and financial services and not be limited to any one particular product or service, although mutual funds are expressly mentioned in the Act. In addition, there is a focus not only on disclosure content, but also on timing, in particular on information that is needed before the time of an investment decision. And, finally, there is a specific focus on expenses and conflicts of interest.
One way I believe this second study could be useful relates to our responsibilities under a separate provision of the Dodd-Frank Act, which expressly authorizes the Commission to designate information to be provided by a broker or dealer to a retail investor before the purchase of an investment product or service — that is, at the point of sale. Specifically, I hope that the study will be useful to the Commission in considering any potential rulemaking with respect to point of sale disclosure for investment products and services, including variable insurance products.
IV. Living Benefits
I would like to turn now to a topic more near and dear to the variable products industry, namely, living benefits. The proliferation of these benefits has been one of the dominant forces driving the sales of these contracts in recent years. Since the market decline in 2008, variable annuities have attracted many investors by virtue of these benefits, which typically are offered as “riders” under the contracts. These benefits include promised minimum contract values regardless of investment performance of the underlying funds, as well as withdrawal privileges that provide for a stream of income during retirement years, again regardless of investment performance of the underlying funds.
As you know, the market volatility of the past few years has caused many insurers to revisit the terms and the pricing of their living benefits. The staff has seen a wave of amendments to registration statements, adjusting fees for future sales and adjusting promised minimums under these living benefits.
As I alluded to earlier, we understand living benefit options to be a key driver of the investment decision to purchase a variable contract in many cases. As such, we view these benefits, even when offered as “riders,” to be an integral part of the contract offering. For that reason, you should pay as much attention to disclosure concerning these benefits as you do to other features of a variable contract.
I would also like to say a few words about disclosure issues often raised in connection with these benefits, to which the staff pays particular attention. A number of products limit the investment options offered to purchasers of living benefits. Indeed, 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 benefits. An important staff concern has been to ensure that investors are apprised of the trade-offs involved in such an arrangement. I believe that prospectuses should make clear to investors purchasing the benefits that these investment restrictions may limit the upside potential of their investment, and that such restrictions also reduce the likelihood that the downside protection offered by these benefits will ever actually be “in the money.”
Many insurers also control underlying investments by implementing asset allocation models that move account value among underlying funds pursuant to a formula. Account allocations to equity funds, or to funds that may involve a higher level of volatility, are changed to more conservative investments, such as government bond funds or money market funds, during declining markets and, in some cases, moved back to the original fund allocation during periods of sustained market growth. As a disclosure matter, I believe that it is important that any ability of an insurer unilaterally to change account allocations be clearly explained. Similarly, the contract prospectus should make clear to investors the circumstances under which account allocations may be changed and the effects of such changes, such as the possibility of missing a market uptick during a period of fixed income allocations.
Traditionally, variable annuities have been perceived as a tax-efficient way for investors to participate in the equity markets. In my view, it is important that an investor purchasing a living benefit be fully informed of any aspect of the arrangement that could limit the market participation reasonably expected by the investor.
On a related note, living benefits typically are described as “guaranteed” benefits. The term “guaranteed” as used in other contexts often connotes some level of support of an issuer’s obligations by a third-party guarantor. As used in the variable products context, the term generally has been used to signify a promise by the insurer, the fulfillment of which is subject to the claims-paying ability of the insurer and is not backed by any third-party guarantor. For this reason, the staff is concerned about potential confusion on the part of investors over the nature of so-called “guaranteed” benefits. I would encourage you to review your disclosure to ensure that it makes clear the credit risk associated with any insurer obligation to pay a living benefit — or any other benefit — offered under a variable contract.
Another area of concern relating to the proliferation of living benefit riders is in regard to derivatives. In connection with insurance company obligations under these riders, the companies have for some time engaged in derivative hedging transactions in their general accounts to mitigate and manage their risk exposure. More recently, hedging transactions have begun to play an increasing role in the management of underlying funds, sometimes on the initiative of insurance companies affiliated with fund management. While derivative instruments afford the opportunity for efficient portfolio management and risk mitigation, they also can present potentially significant additional risk. As the use of these instruments at the fund level continues to increase, the need for clear and concise disclosure of the risks associated with derivatives becomes all the more important.
The staff has on numerous occasions highlighted the need for disclosures that clearly inform investors about the attributes of derivatives. As stated in a Commission press release in March of last year, the Division has been conducting a review to evaluate the use of derivatives by funds, including whether existing prospectus disclosures adequately address the particular risks created by derivatives. In July of last year, the staff sent a letter to the Investment Company Institute noting that funds’ derivatives disclosures were in many cases generic rather than specific. The letter observed that several forms of unhelpful disclosure concerning derivatives were commonplace, including laundry lists of virtually all types of derivatives as potential investments, and generic risk disclosure regarding derivatives that may or may not relate to the actual risks facing the fund. In my view, these types of disclosures do not fully apprise investors of the specific types of investments actually expected to be made, or the risks posed by those investments.
Addressing these concerns, the staff observed that strategies disclosure relating 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. 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. The staff also noted that a prospectus should make clear whether the use of derivatives is a principal investment strategy and, if so, tailor the fund’s risk disclosures accordingly.
I encourage you to assess the effectiveness of your disclosure in this area, to eliminate boilerplate disclosure that does not reflect the actual use of derivatives in your fund’s portfolio, and if necessary, improve your disclosure so that it more clearly reflects the actual role that derivatives play in the overall investment strategy of your funds.
I would also like to say a few words about the Concept Release issued this August by the Commission at the Division’s recommendation. The release seeks broad public comment on a wide range of issues that funds face under the Investment Company Act when investing in derivatives. Among other things, the Concept Release asks for information on how different types of funds use various types of derivatives as well as the benefits, risks, and costs of using derivatives, among other things. Additionally, it asks for comment on several specific issues under the Investment Company Act implicated by funds’ use of derivatives, such as restrictions on leverage, fund portfolio diversification, fund portfolio concentration, and valuation of fund assets. The Commission has requested input from all interested persons in order to help determine whether regulatory initiatives or guidance are needed to improve the current regulatory regime for funds and, if so, the nature of any such initiatives or guidance. The comment period is open until November 7. I urge you to express your views about your funds’ experiences with derivatives in the context of variable products. I believe that discussion of how derivatives might be used by funds in your industry is as important as it is in the investment company industry generally. If you think our rules should be clearer, or should be changed in any particular regard, please tell us so. If you think we need to provide more guidance about any aspects of funds’ derivative transactions, please let us know.
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In conclusion, let me stress the importance of your active involvement in all aspects of the regulatory process. I appreciate the industry’s valuable input in connection with the challenging issues we face, including the ones I have discussed today. As always, the staff welcomes your input, and we take it very seriously. The importance of retirement investment and income planning to the security of so many in this country makes your participation in what we do at the Commission all the more critical.
Thank you for listening to me this morning. I look forward to continuing our work to serve the interests of American investors.
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.