Remarks to the 2014 Insured Retirement Institute Government, Legal & Regulatory Conference
Director, Division of Investment Management
U.S. Securities and Exchange Commission
July 1, 2014
Good morning and thank you for that kind introduction and for inviting me to speak with you today. Before I begin, it is my obligation to remind you that my remarks represent my own views and not necessarily the views of the Commission, the individual Commissioners, or my colleagues on the Commission staff.
I was glad to be asked to speak here today, because this group represents companies that are uniquely positioned to address a key concern facing a large and growing segment of the American investing public. That sector, of course, is the retiring workforce of the baby boomer generation; and the primary concern I refer to is funding their retirement. I routinely see newspaper headlines that could be paraphrased to read: “The good news is that we’re living longer. The bad news is we have to pay for it.” Fortunately, we have here today a gathering of professionals in the dynamic field of investment products issued by insurance companies that are designed to provide long-term income solutions for investors facing this challenge.
When I last spoke to this group, a big focus of insurance product design was in the area of living benefit features, such as guaranteed minimum accumulation benefits. Recent articles in the financial press suggest insurance companies are exploring alternatives to living benefit riders as the main driver of sales of variable annuities and that some firms are cutting back their offering of these riders. Recently, there has been an increase in filings for annuities that offer no living benefit riders. One article that caught my attention reported that instead of living benefits, variable annuities are offering underlying funds designed to provide downside protection and generate predictable income using hedging strategies and other approaches similar to what insurers often use to manage risk on their own balance sheets. Some are saying that these funds provide investment opportunities that can, to some extent, replicate the benefits offered by living benefit riders, but with lower fees and greater flexibility.
I mention these particular developments as examples of the many developments being monitored by the staff that affect the landscape that investors navigate when they make investment decisions. The staff in the Division of Investment Management seeks to be proactive in monitoring developments and trends affecting the variable products industry and investors in variable products. Getting out in front of significant industry developments is, in my view, a key element of our mission to protect investors, promote informed investment decisions, and facilitate appropriate innovation in investment products and services through regulation of the asset management industry. This morning I would like to discuss some of our efforts at proactive monitoring of industry trends. I would also like to discuss some of our efforts to enhance communication between the staff and industry participants.
II. Industry Outreach and Monitoring
The staff relies on a variety of sources for our knowledge regarding developments affecting the asset management industry and the potential risks that those developments may present. We look to disclosure filings for new products as well as requests for no-action and exemptive relief. And, of course, we keep our eye on the financial press and other third party sources. But we also seek to stay abreast of emerging developments through high-level engagements with key executives of asset management firms and mutual fund boards, risk-focused examinations, and enhanced data gathering and analysis.
The Division has been working to improve the staff’s awareness of industry developments through a hands-on outreach initiative. As part of this process, we are meeting with senior management at several large asset management firms and with fund boards. In these discussions, we have learned a great deal about the identification and management of risk — risks specific to particular firms or funds, as well as critical risks facing the industry as a whole. These meetings allow us to obtain a focused and informed view of the systems, controls, and personnel, and also to get a sense of the culture of an individual firm. We believe we will be better regulators to the extent that we better understand the workings of the industry we regulate.
Another important aspect of this effort is our risk monitoring program. Our Risk and Examinations Office, or “REO,” which was formally established in 2012, has begun an industry monitoring program to provide ongoing financial analysis of the investment management industry, with a particular focus on strategically important investment advisers and funds. In addition to financial analysis, REO is conducting examinations that gather information from the investment management industry to inform the Division’s policy making. Although REO may conduct its own exams, where practical, REO will join examiners from the Office of Compliance, Inspections and Examinations (“OCIE”) on their examinations of firms. I am excited at the prospect that REO can help the staff to be proactive and get out in front of new industry trends.
With respect to data gathering, the staff is considering ways to improve the usefulness of information we receive about mutual funds and other investment companies. In this regard, the staff is undertaking an initiative to develop a recommendation for the Commission to consider possible ways to modernize and streamline the information that funds report to the Commission, and to give the Commission and the staff more timely and useful information about fund operations and portfolio holdings. In pursuing this initiative, the staff’s goal is not only to improve the quality of the data filed and to inform our efforts to monitor risk, but also to reduce unnecessary burdens by, for instance, making the reporting regime workable with, or at least minimally disruptive to, a fund’s systems and eliminating duplicative filings.
III. Guidance Updates
Let me turn now to recent efforts by the staff to enhance our communications with industry participants. One focus of the Division’s efforts in 2014 has been to carry forward and to enhance our recent practice of issuing staff Guidance Updates. Guidance Updates, which are available on the IM Webpage, are a vehicle for enhancing our communications with the public and addressing a range of disclosure, regulatory, and compliance matters, by setting forth and discussing the staff’s views on a particular matter in a timely and transparent way. To date, the public’s response to these Guidance Updates has been overwhelmingly positive. The Division issued 14 Guidance Updates during 2013 and 8 so far in 2014. Let me take a few minutes to discuss some of these that I believe will be of interest to those of you working in the insurance products space.
Clear and Concise Disclosure
Just last week, the Division issued guidance designed to further the goal of clear and concise, user-friendly disclosure. As most of you know, in 2009 the Commission adopted rule and form amendments intended to provide investors with information about mutual fund investments that is easier to use and more readily accessible. The amendments require every mutual fund prospectus to include a summary section at the front of the prospectus, consisting of key information about the fund, including investment objectives and strategies, risks, costs, and performance. This key information is required to be presented in plain English in a standardized order. In adopting this format, the Commission stated that its intent was that this information be presented succinctly, in three or four pages, at the front of the prospectus.
The staff has observed that, for many funds, prospectus disclosure, including the summary section of the prospectus, is still complex, technical, and duplicative. Further, the staff continues to see exceedingly long summary sections. Some parts of these do not appear to be true summaries, in that they do not summarize the fuller disclosure set forth later in the prospectus. We observe this particularly in the discussion of principal investment strategies and risks. The Guidance Update highlights certain rule and form requirements that, while not exhaustive of the disclosure requirements, are intended to focus funds on providing investors this clear, concise disclosure. Some of the takeaways from this Guidance Update are the following:
- Information in the summary section need not be repeated elsewhere. When a fund substantially duplicates its disclosure of principal investment strategies and risks, the staff reminds the fund of the requirement to provide a summary and that information need not be duplicated.
- The summary section should be presented in plain English, including short sentences and no legal jargon or highly technical business terms. The staff continues to observe the use of technical terms that are not explained in plain English. Far too often, we observe long, dense sentences and paragraphs that are difficult to read.
- Funds should include in the summary section only information that is either permitted or required by the form.
- If a fund includes in its prospectus information related to strategies and risks that are not principal, the fund should distinguish which of the strategies and risks are principal and which are not principal.
The staff has made similar observations in the review of variable annuity disclosure documents. The staff recognizes that it is a challenge to accurately describe complex features of these contracts, and, in particular, enhanced death benefits and living benefits, in clear, concise language. However, when such benefits are disclosed, the staff believes that it is important to describe in a balanced way the limitations of the benefits, such as the effects of early or excessive withdrawals and the significant impact of investment allocation restrictions. Also, when disclosing similar benefits, registrants should think how best to distinguish each one from the others to avoid confusion.
Fund and Product Names
Another significant Guidance Update set forth the staff’s views and concerns with respect to fund names that suggest safety or protection from loss. In the Division’s view, when a mutual fund includes a word or phrase that suggests safety or protection from loss, the name may contribute to investor misunderstanding of the risks associated with the investment and, in some circumstances, could be misleading.
As noted in the Guidance Update, the Division believes that terms such as “protected” and “guaranteed,” when used in a fund name without some additional qualification, may contribute to investor misunderstanding about the potential for loss associated with an investment. As a result, in the disclosure review process, the staff has requested that some funds and contracts change their names. The staff took this action in response to an increase in the use of the term “protected” in situations where that term was used without a qualification that would adequately describe the nature and limits of any protection offered.
This issue has arisen with regard to funds that seek to manage volatility, for example, by investing a portion of the fund’s assets in cash, short-term fixed income instruments, or other investments. The issue also can arise where a fund has entered into a contract with a third party to make up a shortfall in the value of the fund’s assets below some stated floor value. In those cases, the third party protection may be limited in various ways, for example, by contractual limits on the amount of protection. In addition, protection of this kind is only as solid as the third party provider is financially sound. Obviously, a third party facing insolvency could become unable to fulfill its obligations under the terms of an asset protection agreement.
I would strongly encourage any sponsor of a fund or contract that exposes investors to market, credit, or other risks, and whose name suggests safety or protection from loss, to reevaluate the name and, if necessary, to consider changing the name to eliminate the potential for investor misunderstanding.
Although the focus of the Guidance Update is on fund names, the Division has similar concerns with respect to names of variable insurance products that suggest safety or protection from loss. For example, variable contract names that suggest safety or protection from loss can raise issues that are similar to those raised by funds with third party guarantees. In the case of a variable contract, the insurance company is in some ways similar to a third party guarantor in the mutual fund context. In both cases, the purported “protection” typically is limited in significant ways. I urge you to seriously consider the appropriateness of names of contracts being developed and ensure that the name is balanced and representative of the contract’s actual provisions.
We understand that insurance contracts often provide some protection against risk of loss. However, when an insurance contract is also an investment product, it is important that the product name not overstate the safety and security provided by insurance aspects of the contract in a way that could be confusing or misleading to investors.
Disclosure and Compliance Matters for Funds that Invest in Derivatives
The staff is also monitoring developments with regard to the use of derivatives in funds underlying variable annuity contracts. While insurance companies are known to rely on the use of derivatives to hedge the risks associated with living benefit riders and other general account obligations under variable annuity contracts, the staff has also noted a recent increase in the use by underlying funds of derivatives to hedge risk and to limit volatility, such as so-called “managed volatility” funds, which I generally mentioned earlier. Many variable annuity providers are offering as investment options alternative funds that invest in non-traditional assets including derivatives. In light of this increased focus on derivatives in the variable annuity space, I wanted to draw your attention to the staff’s Guidance Update summarizing the views of the Division staff regarding certain disclosure and compliance matters relevant to funds that invest in derivatives.
The Guidance Update indicates that the staff believes that all funds that use or intend to use derivative instruments should assess the accuracy and completeness of their disclosure, including whether the disclosure is presented in an understandable manner using plain English. Further, any principal investment strategies disclosure related to derivatives should be tailored specifically to how a fund expects to be managed and should address those strategies that the fund expects to be the most important means of achieving its objectives and that it anticipates will have a significant effect on its performance. In determining the appropriate disclosure, a fund should consider the degree of economic exposure the derivatives create, in addition to the amount invested in the derivatives strategy. This disclosure also should describe the purpose that the derivatives are intended to serve in the portfolio — be it for hedging, speculation, or as a substitute for investing in conventional securities - and the extent to which derivatives are expected to be used.
Additionally, the Guidance Update indicates that disclosure concerning the principal risks of the fund should similarly be tailored to the types of derivatives used by the fund, the extent of their use, and the purpose for using derivatives transactions. The risk disclosure in the prospectus should reflect anticipated derivatives usage. The disclosure should not be a laundry list of every risk associated with derivatives. It should instead provide a complete risk profile of the fund’s investments taken as a whole and reflect the fund’s anticipated derivatives usage.
The Guidance Update also notes that investment strategies that employ derivatives may introduce risks in addition to those associated with investments in the cash markets, and that the staff expects funds that use derivatives strategies to address those risks in their disclosures where the information is material to investors. Such a fund should, for example, disclose material risks relating to volatility, leverage, liquidity, and counterparty creditworthiness that are associated with trading and investments in derivatives that are engaged in, or expected to be engaged in, by the fund.
The Guidance Update has a lot of useful information regarding the staff’s views in this area, including disclosure for new funds or funds with limited operating histories. I highly recommend a careful review of this piece.
Deregistration of Investment Companies
In April, the Division issued guidance on the deregistration of investment companies, specifically applications on Form N-8F. The Guidance Update will be particularly helpful to insurance company separate accounts whose unique organizational structure often results in staff comments related to a handful of line items on the Form. Taking a quick look at this guidance may well save you a round of comments with the staff and speed up the deregistration process. Unlike a managed company, such as mutual funds or closed-end funds, an insurance company separate account typically is organized as a unit investment trust, which does not have an adviser or a board of directors. The Guidance Update provides helpful information about how to respond to questions in the form about advisers and boards. In addition, the Guidance Update provides assistance for answering questions related to deregistration on the basis of “Abandonment of Registration” either in the case of a fund that has never publicly offered securities and plans to wind up or in the case of a fund that will continue to operate as a private fund. The Guidance Update specifically addresses information that should be included for an insurance company separate account that will continue to operate as a private fund. As always, the staff is available to answer any additional questions that you may have when preparing an application for deregistration.
Finally, the staff has issued an update relevant to the many funds that use a so-called “multi-manager structure,” a structure that is very common in the underlying mutual funds offered in variable insurance products. As many of you know, a mutual fund that uses a multi-manager structure may operate pursuant to a Commission exemptive order under the Investment Company Act that allows a subadviser to serve under a contract that has not been approved by the fund’s shareholders, subject to certain conditions. These conditions specify that any new subadvisory contract or any amendment to any existing primary advisory contract or subadvisory contract that directly or indirectly results in an increase in the aggregate advisory fee rate charged to the fund must be submitted to fund shareholders for their approval. The staff periodically receives interpretive questions about circumstances that may or may not trigger an increase in the aggregate advisory fee rate and necessitate shareholder approval under the conditions of the multi-manager orders. Because of the prevalence of these interpretive questions regarding the terms of the exemptive orders, the staff issued guidance to assist funds in complying with this aspect of their multi-manager orders. This update should be of interest to anyone serving as a compliance officer for a fund operating under a multi-manager order.
Also, while on the topic of fee arrangements under a multi-manager structure, I wanted to take a moment to remind you of the importance of fund fees to contract owners. Fees can have a dramatic impact on contract value. As you know, there have been several private actions alleging that a fund’s subadviser does most of the work but the primary adviser retains a large portion of the fee. When you consider fee arrangements for your products, I urge you to remember that fund advisers have a fiduciary duty with regard to the receipt of compensation for services to the funds they manage. And, of course, the approval of advisory arrangements for funds is among the most critical functions of a mutual fund board.
I want to thank you for listening today. I hope you have found my remarks helpful. I started out today by talking about the staff’s efforts to be proactive in monitoring industry developments and trends. What we do with the information we obtain in this way obviously varies depending on the type of information as well as many other variables. In some cases, the information has led to better and more transparent communication with our stakeholders, as I discussed today with regard to our Guidance Update initiative. In other cases, regulatory action is called for. As always, we welcome your feedback and suggestions.
In the coming panel, you’ll hear more from my expert colleagues, Susan Nash and Bill Kotapish, who were invaluable in the preparation of these remarks and on whose counsel I frequently rely.
 I would like to thank my colleagues Susan Nash, Bill Kotapish and Mark Cowan for their invaluable expertise in the preparation of these remarks. 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.
 David Lau, The evolving variable annuity landscape, Mar. 25, 2014, http://www.lifehealthpro.com/2014/03/25/the-evolving-variable-annuity-landscape.
 Guidance Regarding Mutual Fund Enhanced Disclosure, IM Guidance Update No. 2014-08 (June 2014), available at http://www.sec.gov/investment/im-guidance-2014-08.pdf.
 Fund Names Suggesting Protection from Loss, IM Guidance Update No. 2013-12 (Nov. 2013), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-12.pdf.
 Disclosure and Compliance Matters for Investment Company Registrants That Invest in Commodity Interests, IM Guidance Update No. 2013-05 (Aug. 2013), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-05.pdf. On a related note, yesterday, I spoke at a different event specifically about the growing use of alternative investment strategies by open-end funds.
 Deregistration of Investment Companies: Applications on Form N-8F, Guidance Update No. 2014-05 (Apr. 2014), available at http://www.sec.gov/investment/im-guidance-2014-05.pdf.
 Multi-Manager Funds — Aggregate Advisory Fee Rate, Guidance Update No. 2014-03 (Feb. 2014), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2014-03.pdf.