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U.S. Securities and Exchange Commission

Speech by SEC Commissioner:
Remarks before the National Association for Variable Annuities


Cynthia A. Glassman

U.S. Securities and Exchange Commission

Washington, D.C.
June 14, 2004

Good morning, and thank you, Mike, for your kind introduction. I appreciate the opportunity to be here this morning to discuss some of the important issues facing the variable annuity industry. With all of the corporate frauds and significant market structure issues we have been addressing, you may feel like the Commission has been neglecting you. Well, I'm here to assure you that we have not. Many of the recent issues concerning mutual funds directly affect your world, and there are other issues specific to variable products that the Commission has been - and will continue to be - addressing.

Today, I would like to use this time to talk about two separate, but related topics. The first deals with some of the significant compliance challenges facing the variable annuity industry as it continues its development and innovation. Second, because many of the regulatory initiatives that the Commission has undertaken to address recent mutual fund abuses also affect variable products, I would like to discuss some of the more significant and controversial proposals. First, I must make the standard disclaimer that the views I express today are my own and not necessarily the views of the Commission or the staff.

The variable annuity industry is characterized by significant competition, which undoubtedly is a good thing. Competition has had a positive impact on the annuity industry in terms of fostering innovation in product development. Variable annuity products have changed rapidly over recent years in response to competitive pressures and client demands. As a result, the products can now include a wide array of features that were not available only a few years ago. These innovations are driven by the market, and if sold appropriately, can help meet investors' financial planning needs.

However, competitive pressures can also have at least two potentially unfavorable effects for investors. First, the wide array of products and features may make an already complex product even more difficult for the average investor to understand. Most people can appreciate that when they invest in a mutual fund, their money is pooled and invested according to the objectives set out in the fund prospectus. When you layer on concepts like tax deferral, ordinary versus capital gains treatment, mortality expense, death benefits, guaranteed and non-guaranteed values, surrender periods, early withdrawal penalties and various payout options, the product is (to say the least) not as easily grasped by the average investor. There is, therefore, a greater burden on variable product sponsors to provide investors with clear and understandable information in the prospectus, as well as on broker-dealers and their registered representatives who recommend variable annuities to make sure that they ask for and receive the information necessary in order to make sure their recommendations are suitable to particular individual investors.

The second potential problem is that competitive forces may pressure broker-dealers and their representatives to use inappropriate sales tactics or make unsuitable sales or exchanges from one product to another in order to maintain growth rates. Variable products are typically long-term investment vehicles and are generally inappropriate for investors who may need their money in the short term. With respect to product exchanges, it is not clear that investors can adequately evaluate the trade-offs which may be associated with exchanging old variable products for new ones.

As we have seen in several recent contexts, the pressure to meet ever-increasing goals regardless of market conditions can be a recipe for disaster. If left unchecked, isolated issues can become systemic, harm investors and further erode their confidence in the fairness of our markets. Consistent with our new risk-management approach of "looking around corners" to find problems before they evolve into full-blown scandals, the Commission and the NASD have been focused on sales practices in the annuity market for some time. That is a trend that is likely to continue in the near future.

Our examiners in the Commission's Office of Compliance Inspections and Examinations, together with the examination staff of the NASD, last week issued a joint report on "Examination Findings Regarding Broker-Dealer Sales of Variable Insurance Products" ("Joint Report"). The Joint Report was conducted in response to a large number of investor complaints and the desire to better understand compliance and supervision practices of firms that sell variable products. In addition, the NASD has indicated it will be soliciting comment from its members on a rule imposing new sales practice requirements tailored specifically to transactions in deferred variable annuities.

Whether you are involved in management, sales, compliance, disclosure or any other part of the variable products business, you should read the Joint Report carefully-it is available on the Commission's web site. While it is not a comprehensive roadmap for supervising variable product sales, but it certainly draws attention to some issues we must all frankly admit exist in the industry. As Theodore Roosevelt once said, "Nine-tenths of wisdom consists in being wise in time." The Joint Report provides an opportunity for companies to engage in a thorough self-examination of how they are conducting their business, and to be "wise in time" - that is, to determine now whether they have adequately addressed the issues raised in the Joint Report, and, if not, to take action before it is too late. Our intent in issuing the Joint Report was to help firms improve their controls involving the sales of variable products.

Some of the findings in the Report unfortunately will not surprise you, and are quite troubling and worth mentioning to you here in this forum. Among other things, the examinations revealed:

  • lack of adequate suitability determinations;
  • lack of adequate written policies and procedures;
  • inadequate supervision and training;
  • lack of adequate disclosure; and
  • deficient books and records.

Lack of suitability determinations is particularly troublesome. In customer complaints received by the Commission and NASD, investors have indicated that they did not understand the variable product when it was sold to them, and have expressed concerns that the product was not appropriate, or suitable, for them, given their investment objectives. A clear example of the failure to determine suitability can be seen in a recent complaint received by our Office of Investor Education. A 77-year old woman, recently diagnosed with a brain tumor, entrusted $175,000 (the proceeds from a home sale) to a salesperson with the instructions that she needed money for a nursing home for her husband, who was ill and disabled, and also to purchase a car. The money was invested in a long-term annuity which, after payment of withdrawal penalties and market value decline, was worth $70,000.

Similar stories abound in the area of variable product exchanges, where old variable products are exchanged for new products with updated features. By many estimations, product exchanges currently represent approximately half of the sales of variable annuity products. While exchanges generate commissions for firms, they often may not be in the best interests of customers.

A recent complaint received by the Commission alleges that an 82-year old woman was persuaded to exchange a $20,000 variable annuity which, due to market volatility and deferred sales charges, had a value of $14,136 upon surrender. This decrease in death benefits was not disclosed to the customer at the time of exchange, an omission the representative later admitted was "a huge mistake." In addition, the old variable product had only two years left under its surrender period, while the new product imposes a new eight-year surrender period. For an 82-year old, two years can be a long time, let alone an additional six years.

In addition to suitability determinations, broker-dealers need to focus particular attention on whether their representatives are adequately disclosing conflicts of interest in compensation and payments in connection with the sale of variable products. As the Joint Report notes, "High commissions, typically above 5% for variable annuities, help drive sales of these products." Sales charges of that magnitude provide a powerful incentive to salespeople to recommend variable products to investors. In evaluating the product, investors have a right to a complete and balanced presentation - in addition to hearing about the benefits of the products, they have a right to know that their representatives may stand to make more money through the sale of a variable product than they do by selling mutual funds.

As we have seen recently in the mutual fund context, moral lapses and shady practices at a few firms can rock investor confidence in an entire industry, and can put pressure on regulators to respond with additional regulatory requirements. The long-term aggregate cost of complying with such new regulations - not to mention the monetary and reputation costs of an enforcement action - can far outweigh the "quick buck" made through questionable or illegal practices. The Commission is determined to prevent violations of the securities laws, and our approach to civil penalties demonstrates that we are equally committed to making sure that violations that do occur are not profitable for the firms involved. But what, you may ask, are some concrete things firms can do to prevent these issues from arising?

For starters, in a recent speech, Steve Cutler, the Commission's Director of Enforcement, called upon financial services companies to conduct a "top to bottom" review of their business for potential conflicts of interest, and to make sure there are appropriate policies in place to address those conflicts.1 With firms offering more products and services under one roof, there is no way to eliminate all potential conflicts. However, a top-down review of the various business lines, and a risk-management assessment of whether the firm is dedicating appropriate resources to prevent harm to customers, are essential to manage issues that can result from overzealous cross-selling or inappropriate sales tactics. So - please ask yourself: is your firm engaged in a review of conflicts of interest? Is your firm taking steps to mitigate or eliminate conflicts of interest?

In this light, it cannot be stressed enough that tone at the top matters. A CEO and other firm leaders who focus only on numbers create a culture in which questionable practices are tolerated - or, worse, encouraged - to make sure that sales goals are met, regardless of the means necessary to achieve them. One of the frequent deficiencies noted in inspections and enforcement actions has been inadequate written supervisory procedures, which was also a finding in the Joint Report. It is not acceptable for a senior executive to say, "I didn't know that was going on." It is their job to know what is going on, and to make sure the internal rules are clear, understood and followed.

To improve compliance and to ensure a robust compliance infrastructure, late last year the Commission adopted the "Compliance Rule." It will require, as of October 5th of this year, that investment companies, including unit investment trusts, have written compliance policies and procedures designed to prevent violations of the securities laws, and also have a Chief Compliance Officer.

As important as having adequate written procedures is dedicating adequate resources to making sure they are implemented. One of the best vehicles for instilling ethical procedures and preventing fraud is a strong compliance function. That requires more than lip service. It requires money, staff, training programs and - most important -the backing of senior management to instill the right culture. Our "up-the-ladder" reporting rules for attorneys practicing before the Commission, and the requirement that mutual funds have a compliance officer reporting directly to the board, are designed to get important compliance information to officials who can do something about it. In the absence of meaningful action, especially when top executives permit systemic practices that allow them to unfairly profit at the expense of customers, I, personally, would not hesitate to hold senior officials responsible for the actions of subordinates. Indeed, in many of the recent mutual fund cases we have done exactly that.

As the markets have turned up recently, variable annuity sales have also increased. I would like to believe that in each and every one of these sales, the customer understood exactly what was being purchased, that the product was suitable and conflicts were fairly disclosed. Unfortunately, the cynic in me - and my experience in the investor education arena - tells me that is very unlikely. Firms that sell variable products need to ask themselves some tough questions, such as:

  • Are your salespeople engaged in excessive or unsuitable exchanges?
  • Are they inappropriately selling to elderly clients?
  • Have any and all material conflicts of interest been disclosed?

I think I can say with some confidence that these are going to be areas of increased attention by regulators.

Turning to the arena of mutual funds, the Commission (as I am sure you know) has proposed or adopted several significant rules to deal with the recent abuses. I would like to discuss some of our initiatives with respect to late trading, market timing and fund governance.

To address the issue of late trading, the Commission put out its "Hard 4:00" proposal. The proposal would require that, for an order to be filled at that day's price, the fund company or a registered clearing company would have to receive the order prior to the time the fund prices its shares (usually 4:00 p.m. eastern time). Along with some of the other Commissioners, I noted when we voted on this proposal that it was very prescriptive, and that I was open to alternatives if they accomplished the objective. Not surprisingly, many commenters - including NAVA - have raised important issues concerning the cost of the rule and how it would operate in practice.

With respect to the "Hard 4:00" proposal, my current inclination is to consider setting out the general requirements we are looking for, and let the markets sort out the best way to accomplish them. This view is based not only the representations that significant costs would be associated with the proposal, but also its potentially negative effect on investors. While I have not reached a final decision on the issue, some general characteristics that have been suggested are worth consideration. These include: (1) development of an electronic audit trail; (2) tamper-proof time stamping; (3) enhanced compliance surveillance and timely exception reports - i.e., "warning bells" that go off in real time; (4) executive certification; (5) enhanced independent audits; and (6) enhanced transparency and SEC oversight.

The key is to assure that there is integrity in the system. As long as it is effective, this more flexible approach could have the benefit of protecting investors without imposing undue burdens on intermediaries and funds. As always, the devil is in the details, so we will continue to consider the comments and work on a viable rule.

The Commission has also taken a number of steps to address improper market timing. Although market timing is not illegal per se, it can be harmful to long-term shareholders, and may be inconsistent with the fund's stated policies. Fund boards must, therefore, play a central role in protecting fund shareholders from the potential adverse impact of market timing.

One proposal the Commission has put out to deal with market timing is the mandatory redemption fee proposal. The general gist of this proposal is that round-trip trades that occur within five-days would be charged a 2% redemption fee. My basic concern, which I noted at the meeting where the rule was proposed, is that this is a stop-gap measure and one that can be easily gamed. The real problem is stale pricing, which can only be solved by fair value pricing.

Further, it is not clear that this rule is necessary at this time. The Commission recently adopted rules requiring better disclosure of the risks to a fund from market timing, and the fund's policies relating thereto. Fund boards also already have the power to impose up to a 2% redemption fee if they deem it to be in the shareholders' best interests. Funds can also impose limits on the number of trades an investor can make within a specified period of time, and they have other tools at their disposal to significantly reduce opportunities to profit from market timing.

In addition, if adopted, the Commission's proposal to give mutual funds more investor information from Omnibus accounts should improve funds' ability to police timers. We have been clear that we expect fund boards to be diligent in exercising their fiduciary duties for the benefit of shareholders. A significant issue with the mandatory fee proposal is that it removes from fund boards the responsibility, inherent in carrying out those fiduciary duties, of determining whether a redemption fee is truly in the fund shareholders' best interests.

As I said when we proposed the 2% redemption fee, I supported putting the proposal out for comment only because the Commission committed to a further examination of ways to improve fair value pricing. If timers can exploit stale prices by assigning a more accurate value to the fund, then portfolio managers should be able to undertake a similar exercise to value their own fund. The Commission needs to examine whether there are ways to provide more guidance regarding the requirement that funds fair value price in certain circumstances, and to better enforce our requirement if funds fail to do so. Disclosure, coupled with better guidance and oversight of fair value pricing, may provide a better course to address market-timing issues. Insofar as stale pricing is a major part of the problem, in my view fair value pricing could be a major part of the solution.

Finally, I should mention what has become one of our more controversial initiatives - the proposal to require that fund boards have an independent chairman and be comprised of at least 75% disinterested directors.

From my perspective, it would be helpful to see some solid, compelling evidence that the purported benefits of this proposal outweigh its costs before adopting such a rule. I would note that fund boards already have a supermajority of disinterested directors, and those directors already have the ability to elect an independent chair if they deem it in the best interest of shareholders. It was in the context of these already stringent independence requirements that I asked for evidence that further increasing the level of independence, as we currently define it, or requiring an independent chairman, would improve the metrics fund shareholders care about - high performance and low cost. I will have more to say on this issue when we are asked to vote on the proposal soon.

In conclusion, as an industry, you would do well to implement not just the letter, but also the spirit of the new rules we have proposed and adopted. You would also do well to review the Joint Report, your own business models and compliance controls and, where necessary, "heal thyself." The title of this conference alludes to a new day dawning for the industry. What the future looks like is up to you. You can treat your customers right, be faithful to their interests and your fiduciary responsibilities, and make them happy. Or you can treat your customers badly, line your pockets unfairly at their expense - and make them and us unhappy. It seems to me like that's a no-brainer. Thank you.



Modified: 06/14/2004