Remarks to the IRI 2012 Government, Legal & Regulatory Conference
Associate Director, Division of Investment Management
U.S. Securities and Exchange Commission
June 26, 2012
Thank you, Dan, for that kind introduction, and good morning. I bring greetings and regrets from Eileen Rominger, who very much wanted to be here. Before I begin, I must note that my remarks 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.
In the last several years, both market participants and regulators have been confronted with challenging and volatile markets. Every swing of the market contributes to the uncertainty of investors, and in particular the baby boomers who are looking for income to sustain them in their retirement. Likewise, economic conditions challenge you in your efforts to address these investors’ retirement needs.
Having watched the market movements of the past decade, investors near or in retirement are naturally wary as they turn their attention from saving to the task of funding a steady income that they will not outlive. That is part and parcel of the variable annuity business and the central appeal of the products you offer, and this should be a great time to be in the business. However, the volatility that has characterized the recent economic environment has strained many firms’ ability to offer the products that investors are seeking for this purpose. Despite sales of variable annuities having increased approximately 12% in 2011 over 2010, some of the large established firms in the variable annuity space have either left the business or curtailed offerings. The dynamic climate of changing economics and changing participants in the business makes this a time that calls for care in the design of variable products and attention to investor protection.
In that regard, I would like to begin with some observations about product developments and then move on to some thoughts about disclosure reform, and wrap up by outlining some of the positive changes underway at the Commission and the Division of Investment Management.
II. Product Development
As you are well aware, living benefits have figured prominently in annuity sales in recent years. While investors remain keenly interested in income protection, a central theme of filings in the Office of Insurance Products at the Commission this past year has been the paring back of living benefits, and repricing of those benefits. In addition, the staff continues to see added restrictions on investment choices available to contract owners choosing these benefits. By limiting investments to more conservative portfolios, insurers limit their exposure to market volatility.
So let’s review the bidding: if all of these changes are brought to bear on a given investor, the investor may be paying more for a less generous living benefit, and in the bargain he or she has agreed to limit the investment options, thereby restricting the potential for participation in equity market gains. Each of these moving parts affects the performance of a variable contract, and together they may significantly reduce the benefit of the contract to the investor. For this reason, it is essential that offering materials clearly highlight the costs and limitations associated with living benefits, so that investors can make an informed decision.
I urge you to review your prospectuses and marketing materials to ensure that investors and their financial advisers have the information necessary for such an assessment, presented in a way that brings these moving parts into focus. I would also note that the insurance features of a variable contract, including living benefit provisions as well as death benefits and long-term care provisions, have value only to the extent of the insurer’s solvency and claims paying ability. An insurer’s “guarantees” are not guaranteed beyond the ability of the insurer to make good on the promises in the contract, and this idea should be conveyed to investors clearly and unambiguously.
Another area to consider is the treatment of investors in contracts that are no longer being sold. Although a variable contract is enforceable in accordance with its terms, most contracts do not ensure any particular number or type of underlying investment options, nor do they promise to make new features available under the contract. When a company discontinues sales of a contract, one possibility is to “orphan” that contract — allowing the number of available investment options to dwindle — while the insurer offers a larger number of funds and innovative features only under the contracts that it currently markets. When you discontinue sales of a contract, I urge you to focus on the long-term interests of your existing contract owners as well as the reputation of your company. If a disparity in the servicing of older and newer contracts were to result in newer contracts being more attractive by comparison, thus encouraging exchange activity, I would ask whether such a scenario is consistent with your obligations to your investors.
On that topic, from time to time companies market new contracts to holders of older contracts of the same company. The current environment — with rapidly changing economic conditions and frequent re-pricing of contracts — could be viewed by some as prime time for this activity. In some cases, incentives may be offered to holders when they relinquish older contracts that may feature living benefits or other provisions that have proved costly for the insurer. Exchanges may raise questions of suitability. For instance, there is often an easily identified class of investors for whom the switch would not be advantageous, such as those whose living benefits rider provides a generous payout percentage and who expect to use those benefits. On the other hand, there may also be a group of investors for whom the new contract, viewed in light of any incentive being offered, may be preferable to the old one. For example, investors who do not expect to take advantage of a living benefit in the old contract may prefer a new contract with an increased account value or lower charges.
I encourage you to closely scrutinize exchange transactions from the investor’s viewpoint — what precisely is being given up and are the forgone features of the old contract outweighed by the benefits offered in the new contract? If the newer contract has less generous living benefits, or death benefits, that should be identified for investors as clearly as possible and compared in a straightforward way to any incentive being offered.
Broker incentives to encourage clients to accept an exchange offer should also be scrutinized. Ask yourself whether incentives to the broker selling the new contract encourage transactions that are in the investors’ interests or whether they may encourage switching that does not serve your investors’ needs. The current market environment invites scrutiny of whether investors may sometimes be shifted to less generous contracts due, at least in part, to industry economics and broker incentives. Many products have been marketed based on benefits that have been characterized as “guaranteed.” When an investor is offered a different product instead of the original promised benefit, the terms of the exchange deserve scrutiny — by you, by the investor, and by the Division.
Contingent Deferred Annuities
Among the innovative products in the marketplace is the minimum withdrawal benefit that is not tied to assets held in a variable annuity contract — what is often called a contingent deferred annuity. Although there have only been about a dozen of these products registered with the Commission, they have generated a lot of interest. Contingent deferred annuities are now being considered for use in the defined contribution plan market to provide income protection.
Key concerns regarding disclosure for these products generally parallel those of the minimum withdrawal benefits offered under variable annuities. As with a living benefit under a variable annuity, there should be clear disclosure of the limitations that come with an investment in a contingent deferred annuity. There should be no investors who are surprised to learn that their benefit has terminated by virtue of withdrawals in excess of those permitted under the contract; limits on withdrawals should be set forth in clear and prominent disclosure. There should be no investors who are surprised to learn that the underlying assets must adhere to certain risk-return parameters identified by the issuer of the contingent deferred annuity; limitations on the underlying investments should be made clear in the prospectus. And there should be no investors who are surprised to learn that their retirement income comes first out of their own assets and that they have paid for years for an insurance benefit that provides no payout unless and until those assets are depleted; the contingent nature of the annuity should be explained clearly and effectively. Finally, as I mentioned earlier with regard to living benefits under variable annuities, investors should be able to understand from the prospectus that these products are not guaranteed except to the extent of the insurer’s financial strength.
The retirement income market is evolving rapidly. It was reported last fall that two of the largest target date fund providers had entered into agreements to offer minimum withdrawal benefits in tandem with their funds. Perhaps we will see further developments along these or similar lines as insurance companies and asset managers innovate to meet the income needs of retiring investors.
Target Date Funds
And speaking of target date funds, the past six years have seen tremendous growth in the assets of these funds within defined contribution plans. According to Morningstar, target date fund assets have grown from $71 billion at the end of 2005 to approximately $378 billion at the end of 2011. Target date funds are fast becoming a key component of many Americans’ retirement portfolios.
In 2010, the Commission proposed rule changes to address concerns about target date fund names and the information presented in target date fund marketing materials. This past April, the Commission reopened the comment period on the proposal to allow interested persons to submit comments on the results of investor testing with regard to target date funds. After the rule was proposed, the Commission staff worked with a consultant to conduct empirical research on individual investors’ understanding of target date funds and marketing materials related to those funds. The testing involved 1,000 investors who participated in an online survey and were asked questions before and after reviewing information about a hypothetical target date fund, including information that would be required by the proposed rules, if adopted.
The results of the study were posted on the Commission’s website for interested parties to consider in formulating comments. The Division is evaluating the comments received on the testing along with the other comments on the proposed rule, with a view to making a recommendation to the Commission. This target date fund investor testing is one good example of the Commission’s ongoing commitment both to seek investor input and to improve how it gathers and uses empirical information.
Meanwhile, in May of this year, the Department of Labor reopened the comment period on its rule proposal regarding target date fund disclosure. In the release reopening the rule proposal for comment, the Department of Labor noted the Commission’s investor testing and invited additional comments in light of the new research.
Before I leave the subject of product development, I would like to address the effect of product changes on prospectuses generally. Insurers often characterize product changes as enhanced versions of existing products, seeking to modify existing contracts and prospectuses rather than filing new contracts in new registration statements. Thus, new descriptions of often complex features are added to prospectuses that are already lengthy and often difficult to navigate. The casualty here is the readability of the prospectus. The juxtaposition of new contract features with changed and sometimes discontinued features can make it extremely difficult for an investor — or a financial advisor — to identify the information that is relevant. To address this, I urge you to redouble your efforts to use clear, plain English language in a usable format. The information that investors need should not be obscured with irrelevant disclosure aimed at investors in some other version of a contract.
I’d like to acknowledge the leadership of Bill Kotapish, Zandra Bailes, Michael Kosoff, Joyce Pickholz, and the work of the entire staff of the Office of Insurance Products. Day in and day out, they keep up with your innovations, always focused on investor protection and on resolving the issues that come their way as efficiently as possible.
III. Variable Annuity Disclosure Reform
The Division is proceeding in earnest with our consideration of a new disclosure framework for variable annuities to address the disclosure challenges I’ve described. Today, I’d like to outline some of the overall goals that animate the Division’s consideration. The bottom line is that variable annuity disclosure should provide the information that investors need at the time when they need it and in a manner that is usable and understandable. In particular, I believe that disclosure should do all of the following:
- Effective disclosure should provide information to contract purchasers that helps them make an informed purchase decision;
- Effective disclosure should provide information to existing contract owners that helps them understand how their investment has performed and how it has changed, and that helps them to make ongoing investment decisions such as whether to invest additional amounts in a contract;
- Effective disclosure should provide information that is understandable;
- Effective disclosure should provide information that is available 24/7;
- Effective disclosure should provide investors with access to the types and amount of information that is useful to them;
- Effective disclosure should provide information that is readily accessible and usable, and that offers a convenient gateway to related, more detailed information; and
- Effective disclosure should make appropriate use of available communication tools and technologies. Few could have predicted just a few years ago today’s wide use of tablet computers and e-readers. In this rapidly changing high-tech world, effective disclosure will make use of the communications methods that investors prefer in ways that enhance — and do not obscure — information delivery.
I would like to acknowledge the helpful input of the IRI and other industry representatives, including suggestions regarding ways to adapt the mutual fund summary prospectus regime to address needed disclosure improvements for variable annuities. I want to commend you on the hard and thoughtful work you have put into this. The Division is seriously considering your suggestions, and we appreciate the significant time and resources you have committed to this initiative.
IV. Improving Cost-Benefit Analysis; Staff Expertise
Before I close, I would like to mention an ambitious initiative to develop a more robust cost-benefit analysis in Commission rulemaking. As Chairman Schapiro noted in her testimony before Congress this April, the Commission’s Chief Economist and General Counsel have jointly developed new guidance for conducting economic analysis. Some of the highlights of that guidance include:
- Earlier and more comprehensive involvement of the Division of Risk, Strategy, and Financial Innovation economists in the rulemaking process, so that they can provide economic analysis of alternative policy options before a proposed course is chosen and throughout the course of a rule’s development;
- Assuring that rule releases clearly identify the justification for the proposed rule, such as a market failure or a statutory mandate;
- Where feasible, quantifying the costs and benefits and, where not reasonable to do so, transparently explaining why not, and then qualitatively explaining the remaining costs and benefits;
- More integrated analysis of economic issues in the Commission’s rule releases;
- More explicit encouragement to commenters to provide quantitative, verifiable estimates of costs and benefits, and fuller analysis in rule releases of the information received from commenters about costs and benefits; and
- Greater discussion of reasonable alternatives not chosen.
In general, the cost-benefit analysis of a rule, under these guidelines, should be more comprehensive and also more integral to the rulemaking process from the beginning and throughout, and therefore improve the process overall.
I am also excited about increasing use of experts within the Division of Investment Management to better meet the challenges of regulating investment companies and investment advisers in today’s complex global financial markets. The Division has recently hired an ETF expert to work on regulatory issues specific to this investment vehicle — a vehicle increasingly found in variable product separate accounts. In addition, the Division has launched searches for other experts, including a derivatives expert and a financial analyst to provide advice on novel and complex investment products, including novel variable product designs.
Also, to better understand the impact of our regulations on market participants, we are working to staff a new examination function within the Division, as required by the Dodd-Frank Act.
Thank you for the opportunity to convey my views on important regulatory issues confronting the variable products industry and the Division. Your industry has an important role to play in the future of America’s seniors; this vests each of you with a special responsibility to look out for investors. They are counting on you.
Please enjoy the rest of the conference. Thank you.