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Speech by SEC Staff:
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| The Securities and Exchange Commission, as a matter of policy, disclaims responsibility for any private publication or statement by any of its employees. The views expressed herein are those of Mr. Roye and do not necessarily reflect the views of the Commission, the Commissioners, or other members of the Commission's staff. |
Thank you and good afternoon. It is a pleasure to be here with you today.
In preparing for this talk, I was struck by how rapidly the variable annuity landscape changes. Bonuses, unbundling, enhanced guaranteed minimum death benefits, guaranteed minimum income or accumulation benefits, long-term care riders, flexible withdrawal provisions, and electronic offerings – these concepts that define your products today were unheard of a few years ago.
When you think about it, that’s not so surprising. Your industry has seen explosive growth in recent years. Since 1994, assets in variable annuity sub accounts have grown an average of 36% per year, compared to about 25% per year for total mutual fund assets. At the end of 1990, the variable product industry had assets of $34.7 billion. This past March, the industry's assets totaled $847.9 billion. That is an increase of well over 2,000%. Variable annuity sales are projected to reach the $150 billion mark this year.
In an increasingly competitive market for financial services, product innovation has been necessary to attract new investors and retain assets already under management. From my perspective, this flood of creativity is impressive, but challenging as well. Just as the dust begins to settle on the latest regulatory issue, something mutates, a new product evolves, and we’re presented with a host of new regulatory issues.
As we confront each new issue, though, we at the Commission -- and you -- have a bedrock of unchanging principles to rely on. Our watchword first, foremost, and always is investor protection. We are guided by the precepts that investors should receive full and fair disclosure about the securities they buy and that those who sell securities should make suitable recommendations. We are committed to educating investors so that they can make informed decisions.
Today I will be talking to you about how we are applying these bedrock principles as we confront the changing world of variable annuities. And I will be highlighting, as well, the ways in which we are asking you to apply those same principles.
In the area of new products, no development has been more visible or more controversial than the proliferation of bonus programs, which offer the investor an immediate credit equal to a percentage of purchase payments. From a marketing perspective, these products have substantial appeal. They offer an investor the opportunity to put his or her entire investment – and then some – to work immediately. Indeed much of the strength in recent variable annuity sales has been attributed to the growth of bonus products.
We are, however, very concerned by the fact that bonus credits are often coupled with higher surrender charges, longer surrender charge periods, and higher asset-based charges -- all of which can make a bonus more apparent than real. Quite simply, we are concerned with the potential for sales practice abuses because the cost of the bonus may be less visible than the bonus itself. And our concerns are heightened in cases when a bonus is paid to an investor transferring funds from one variable annuity to another in a "1035 exchange," where an investor at or near the end of a surrender charge period takes on a new surrender charge period as a result of the exchange.
Quite frankly, we are concerned about where the competition among companies offering bonus products will lead us. What are the implications of bonuses increasing from one percent to five percent to six, seven and eight percent or higher? Higher surrender and asset based charges and longer surrender periods will be necessary to ensure that the companies recover the costs of bonuses at these levels. Lets not forget that interests in variable annuities are "redeemable securities". Do these products effectively become "non-redeemable" if upon withdrawal an investor must have his proceeds reduced by a 8.5% sales load, along with the recapture of the bonus? At some point, we may to draw a line in this area to preserve the redeemability feature of these products.
To address our concerns regarding bonus products, we have been focusing on the suitability of bonus transactions through the Commission’s inspections program. We are working with NASD Regulation to scrutinize sales practices used in marketing variable annuity bonus products.
We also have been paying close attention to disclosure regarding bonus programs. You can expect us to comment on any presentation of a bonus product that does not fully and fairly disclose the downside, as well as the upside, of the product. What we have found in our scrutiny of bonus products is that "there’s no such thing as a free bonus." We are asking companies to disclose the cost to investors of any bonus – clearly and upfront. As you craft disclosure in this area, bear in mind that our goal is to make the costs of bonus programs as transparent as the bonuses themselves so that investors can weigh costs and benefits to make an informed investment decision.
Perhaps more important than what we are doing is what you should be doing. We expect that any firm engaged in the distribution of bonus products will pay particularly close attention to sales of these products, ensuring that adequate safeguards exist to prevent unsuitable sales, and flagging for compliance review any individual sales that appear to be unsuitable.
I would urge you not to wait for our inspections staff or NASDR to come knocking on your door with questions about bonus products. If you are an insurance company producer of bonus products, ask yourselves whether your products are designed with investors’ interests in mind or whether they will act as a spur to inappropriate sales practices. If you are on the sales side, ask yourself whether you have safeguards in place to prevent unsuitable sales and whether you are taking a second look at transactions that appear to be unsuitable. This is an issue that involves nothing less than the integrity and credibility of the industry.
We understand that you operate in a competitive environment; however, increasing sales at the expense of those for whom these products are not suited will not be tolerated. Variable bonus products are an area that demands that sellers of these products have comprehensive procedures to guard against sales practice abuses. The NASD has issued Notice to Members 99-35 that provides a set of guidelines intended to assist broker-dealers in developing appropriate procedures relating to sales of variable annuity contracts. The NASD encourages the use of an exchange or replacement analysis document exploring the basis for replacing one contract with another. The NASD also suggests that members develop "red flag" procedures that can monitor and identify those registered representatives with a higher rate of variable contract replacements and to investigate whether these replacements are unsuitable. If you look at trends in recent SEC enforcement actions, you will see that we are not sympathetic in problematic situations when firms either have no compliance procedures or have compliance procedures, but do not implement them.
We have been criticized by some in the industry for suggesting that insurers and their principal underwriters have some responsibility to monitor the suitability practices of selling dealers with regard to variable products sales. I would just note that the Insurance Marketplace Standards Association, which was formed for the purpose of establishing and promoting ethical standards in the life insurance industry provides in its Code that an insurer must implement policies and procedures designed to provide reasonable assurance that:
Its distributors make reasonable efforts to determine the insurable needs or financial objectives of its customer based upon relevant information obtained from the customer and enter into transactions, which assist the customer in meeting his or her insurable needs or financial objectives.
Accordingly, IMSA standards recognize that some level of suitability monitoring is desirable at the insurance company level, consistent with the goal of promoting ethical standards in the industry.
Last fall, I announced that we would take a three-pronged approach to bonus products – coupling our scrutiny in the inspections and disclosure review processes with investor education to heighten awareness of the trade-offs between bonus credits and product fees and charges. When we began to take a serious look at what we might do in the investor education area, we determined that the Commission needed to fill a broader gap in its investor education arsenal. At that point, the Commission had not developed any investor education materials devoted specifically to variable annuities, and we concluded that we should develop a brochure that would address variable annuities generally, including bonus programs.
To that end, we recently designed an investor brochure that describes variable annuities and how they work, and identify various annuity features, as well as their fees and charges. The brochure also cautions investors in areas where we believe caution is necessary -- bonus programs, purchases of variable annuities through tax-deferred accounts, fees and charges. The brochure is entitled "Variable Annuities: What You Should Know," and it can be found on our web site at www.sec.gov. We expect to have a hard copy of the brochure available soon as well.
I also want to acknowledge the industry’s recent investor education initiatives. I was very pleased to see the introduction of "All About Annuities" on NAVA’s web site. The ACLI, too, recently added an investor brochure to its web site, and individual companies also are starting to undertake valuable investor education efforts. We encourage NAVA, as well as its members, to continue pursuing these kinds of investor education efforts. Having a well-educated investing public will serve the industry well in the long run. Variable annuities are complicated products; we should do all we can to make them understandable to the average investor.
I would now like to turn to the subject of technology and the Internet. Companies providing variable products are embracing the Internet to educate the public about annuities, sell annuities directly, provide an array of customer services and support their distribution channels.
At the end of April, the Commission issued an interpretive release to provide guidance on issues related to the use of electronic media. The release addressed two areas where we’ve received a number of inquiries from variable annuity issuers -- electronic delivery of disclosure documents and all electronic offers. The comment period closes soon -- June 19th. If you have not already done so, I would encourage you to submit any comments you may have on these issues.
The release provides important guidance in the area of electronic delivery. The release clarifies that investors may consent to electronic delivery over the telephone and that a broker-dealer or other market intermediary may obtain an investor’s global consent to electronic delivery of all documents of any issuer. I know that some variable annuity issuers have viewed the need to obtain investor consent as a significant barrier to the use of electronic delivery, and I trust that this guidance will be helpful in easing the consent process.
At this time, the Commission was not prepared to endorse the use of implied consent to electronic delivery, because of our concern that investors could be significantly and adversely affected through their inadvertent failure to object to electronic delivery. I hope those of you who are interested in the implied consent issue will respond to the Commission’s request for comment on whether there are particular circumstances under which implied consent would be appropriate.
The release also makes clear that disclosure may be provided in portable document format (PDF) if it is not so burdensome that it effectively prevents access to the disclosure. Issuers could, for example, use PDF if they inform investors of the requirements necessary to download PDF when obtaining consent to electronic delivery and provide investors with necessary software and technical assistance at no cost.
In recent years, electronic offers have been of interest to the variable annuity industry, with some products having been launched for sale principally through electronic means. To date, the Commission has insisted that issuers provide paper back up for investors who revoke their consent to electronic delivery, as well as investors who want a paper copy of a document, even if they have not revoked consent. I think that, at some point, the Commission will permit variable annuity issuers to offer "e-contracts" for investors who agree to electronic-only delivery. Perhaps such a class of contracts could have lower expenses because of the cost savings attendant to electronic communication. This is an area where the Commission asked for comment, and we look forward to receiving input from any of you who are interested in moving to an all-electronic format.
Both the Commission and the industry have identified a number of areas where disclosure improvements could help investors in variable contracts. We look forward to continued cooperation with you as we all strive to provide investors with the information they need, when they need it, and in a form they can understand.
As you know, the Commission has proposed Form N-6 to improve disclosure to variable life insurance investors by developing, for the first time, a disclosure form specifically tailored for variable life insurance. We have received many thoughtful comments from NAVA and others in the industry, and we are working to finalize the form for adoption so that investors may see its benefits in the near future. Some of the issues involved in Form N-6 have been thorny – for example, how to address individualized cost of insurance charges. We are confident, though, that at the end of the day, we will have a form that results in better, clearer disclosure to investors.
On the variable annuity side, we are in the process of reviewing innovative and broad-ranging proposals submitted to the staff by NAVA last fall. NAVA’s proposals included streamlining the variable annuity prospectus to better focus disclosure on essential information investors need to decide whether to purchase a variable annuity contract. NAVA also suggested that annuity contracts with "market value adjustment" features be registered on Form N-4. This approach could address the long-standing need to design disclosure for "MVA" contracts that is more tailored to the product and to eliminate unnecessary and duplicative disclosure.
The NAVA proposals contain a wealth of ideas, and we are giving them serious consideration. We look forward to working with NAVA and others in the industry as we craft better, more understandable disclosure for variable annuity investors.
NAVA also suggested that variable annuity issuers not be required to deliver a complete updated contract prospectus to their investors making additional purchase payments. Instead, issuers could provide a short summary of material changes. Variable annuity issuers have argued for some time that full annual updates of contract prospectuses are unnecessary and unhelpful because the terms of variable annuity contracts are largely fixed once the contract is issued. NAVA’s suggestion is an interesting means for addressing this issue, and we will give it serious consideration as we move forward to provide better disclosure to variable annuity investors and eliminate unnecessary and duplicative disclosure.
We are also exploring ways to eliminate the need for funds to deliver updated prospectuses to existing shareholders annually. Because a current prospectus must be delivered before or simultaneously with a confirmation of sale, most funds deliver updated prospectuses to all of their existing shareholders annually to avoid having to keep track of who has and who has not been sent an updated prospectus.
Some in the variable annuity industry had suggested to us that we consider allowing underlying funds to provide a short summary of material changes, along the lines suggested by NAVA for the contract itself. We explored this idea with the broader fund industry and, frankly, they indicated that they would be unlikely to use such an updating document. We are, however, continuing to explore whether the profile could serve as an annual updating document for funds, which is another idea that some in the variable annuity industry have suggested. This could be a more effective way of communicating information to shareholders than delivering an entire new statutory prospectus and could result in significant savings to funds and their shareholders.
A number of variable annuity issuers have expressed concerns to us about the information overload they believe contract owners are faced with when they receive annual reports for all the investment options available under their contract. You have asked us to address this by paring down shareholder report requirements. In looking at this issue, we start from the bedrock principle that fund shareholders are entitled to receive a shareholder report that tells them what fund management has done for shareholders. At the same time, a variable annuity issuer is not required to send any contract owner a report for an underlying fund in which the owner is not invested. So, it is in your power to drastically reduce the paper you send to contract owners simply by sending them reports for only the funds in which they are invested. In this respect, a variable contract is not unlike a fund supermarket, which offers a wide range of funds to investors, but only needs to deliver reports for the funds in which they actually invest.
We are, nonetheless, working on revisions to our shareholder report requirements. We will be taking a hard look at the portfolio schedule, with the goal of improving the quality of portfolio schedule information. We will look at the possibility of adding summary information about the portfolio to help investors understand the wealth of data in the schedule. We also will consider whether the quantity of detail in the schedule that is currently delivered to every shareholder can be reduced without reducing the valuable information that is readily available to each and every shareholder.
I would like to turn now to the issue of advertising. We are very concerned with funds and variable contracts engaging in overly aggressive advertising. Many funds achieved extraordinary returns in 1999 -- some in the triple digits. I think everyone recognizes that these kinds of returns cannot be sustained over time.
As you may be aware, Chairman Levitt is sufficiently concerned about this issue that he asked the Division of Investment Management and the Office of Compliance Inspections and Examinations to conduct a special review of fund marketing – including web sites, sales literature, and advertisements. The purpose of the review is to determine whether actual portfolio performance and investment strategies are consistent with what funds are saying to the public -- on their web sites, in their advertisements, and in their prospectuses.
As you know, raw performance numbers do not necessarily tell the whole story. This was illustrated in a recent administrative proceeding against The Dreyfus Corporation and a portfolio manager for one of its funds. That fund had exceptional returns during its first year, in large part because of its investments in IPOs. The Commission found that the fund’s failure to disclose in its advertisements the large impact of the IPOs on its performance, when it was questionable whether the fund could replicate that performance, made the advertisements materially false and misleading. This latest action reflects the Commission’s continuing concerns regarding fund advertising in the wake of the Van Kampen case this past year, in which the Commission instituted similar charges against Van Kampen for failure to disclose that a fund’s high performance was generated largely by investing in hot IPOs.
The concern for potential distortion through advertising is perhaps even greater in the context of variable products. The complexity of variable products creates unique challenges for fair advertising. You have all the same concerns that funds do about presenting past performance in a way that tells the whole story and is not misleading. And you have additional issues that arise because of the two-tier structure of the product. For example, given the recent trend towards the unbundling of contract features, it is important that the costs of the features that are understood to be part of an advertised contract are reflected in the separate account performance presented in the advertisement.
We are currently working on amendments to Rule 482 in which we will seek to promote balance and responsibility in fund advertising. We also expect to implement the change to Rule 482 authorized by Congress in 1996, namely, eliminating the requirement that the substance of the information contained in an advertisement be contained in the statutory prospectus. Eliminating this requirement should result in funds and variable contracts being able to provide investors with better and timelier information. We also expect to reexamine the breadth of the provision in rule 482 that permits a variable contract prospectus to be accompanied by a contract application. Specifically, we will take up an issue that has been the subject of inquiries by variable contract issuers, namely, what advertising and other sales materials for underlying funds may accompany a variable contract prospectus and contract application.
I’d like to talk briefly about an issue raised in a series of recent exemptive applications. The Commission staff has seen an increase in the number of applications requesting Section 26(b) approval for the substitution of underlying funds. Many of these applications have a common theme. A fund unaffiliated with the insurance company is being replaced with an affiliated fund -- one managed by an affiliate of the insurance company. Often the substituted fund is a newly created series of the insurance company’s proprietary fund group, with investment objectives and policies similar or identical to those of the replaced fund. In some cases, the investment adviser of the replaced fund acts as sub-adviser of the substituted fund, so that the substitution does not result in any change in day-to-day portfolio management. The real change is the addition of the insurance company affiliate as investment adviser, or manager of managers, sometimes for an additional fee to be borne by shareholders.
In reviewing these applications, the staff is concerned when it finds that the expense ratio of the proposed substituted funds is higher than that of the replaced fund, particularly where the difference is attributable to advisory fees or 12b-1 fees which, absent a substitution, would be subject to shareholder approval. Under Section 26(b), we can only grant a substitution order if we find it to be consistent with the protection of contract owners. It is difficult, at best, for us to make this finding in the kinds of circumstances I’ve just outlined.
Before coming to us in these cases, you should consider whether a proposed substitution is designed to benefit contract owners in some tangible way. When a proposed substitution could be accomplished by a fund reorganization with shareholder approval of any fee increases, that alternative should be explored. If you decide to seek a substitution order, you should expect the staff to request, as a condition to granting the order that you obtain shareholder approval of increases in fees that would normally be subject to a shareholder vote.
In the coming months, you will see a continued focus on fees at the Commission and on Capitol Hill. At the request of Congress, the General Accounting Office is in the process of completing a study of mutual fund fees and expenses, and we are also completing a study of mutual fund fees. The GAO has indicated that its study will be released soon, and our study should be released this summer. The Division’s report is intended to provide objective data that may be useful to Congress and the Commission in overseeing the mutual fund industry, and to others who are focusing on the effect of mutual fund fees and expenses on investor returns. A representative of the GAO has said that its report will examine issues surrounding the fee-setting process for funds, including the Commission’s oversight role, the role that funds’ boards of directors play in setting fees, whether there are economies of scale in the fund industry, and whether the industry is sufficiently competitive. These reports will contribute to the ongoing dialogue regarding the appropriate level of fund fees and expenses, in light of the growth of the industry.
There is also likely to be increased focus on variable annuity fees and expenses. The investor education brochure that I mentioned earlier urges investors to focus carefully on fees and charges and emphasizes their impact in reducing returns. In some circles variable annuities have a credibility problem. Variable annuity detractors argue that the insurance protection that qualifies a variable annuity for tax-deferred status costs more than it is worth, contending that the products are expensive and oversold. There are some who are seeking to compete on the basis of lower costs, as there is increasing competition from low-cost annuity providers, including products offered exclusively on-line, that impose no surrender charges and have relatively low separate account charges. There are an increasing number of online tools and services that allow investors to comparison shop annuities. Moreover, plaintiff’s lawyers have discovered Section 26(e) of the Investment Company Act, which requires that aggregate charges under variable insurance contracts be reasonable in relation to the services rendered, the expenses expected to be incurred and the risks assumed by the insurance company. Whether a contract owner has a right of action under Section 26 is likely to be addressed soon. Of course, when our staff reviews variable insurance products on inspections you can expect a request for the insurance company’s analysis of the reasonableness of the fees in accordance with Section 26(e). Finally, last year’s market performance has deflected focus on fees and expenses by many annuity investors, but this is likely to change, as last year’s performance numbers are not likely to be sustainable.
I noted that you have several sessions devoted to discussions regarding financial services modernization. Its remains to be seen how the financial services modernization legislation will impact the insurance industry, securities industry and banking industry. Will Citigroup, through the merger of banking giant Citicorp and the insurance behemoth, Travelers Group, be the model for future consolidation?
How will these consolidated industries meet the needs and expectations of investors? What about compliance strategies in a mega-firm, that suddenly finds itself more diverse, with divergent practices, conflicting cultures and increasingly complex affiliations? Newly consolidated firms will bear a great deal of responsibility in developing and implementing compliance programs that blend different cultures. The compliance structure of an insurance company, traditionally has differed from that of a bank or securities firm. An entity that combines two or more of these industries will have to find a way to craft a compliance program that addresses the unique conflicts of interest that can arise in each industry. Inconsistent personal trading policies, conflicting policies governing transactions between affiliates or how these policies are enforced, are examples of the problems that may be created by these consolidations. One of our focuses will be to ensure that responsible oversight of compliance systems is a central component of these consolidations.
I should note that the Commission is likely to adopt soon the regulations required by Gramm-Leach-Bliley to protect the privacy interests of consumers and customers of broker-dealers, investment companies and investment advisers. The legislation provides that financial institutions must provide their customers with a notice of their privacy policies and practices, and must not disclose nonpublic personal information about a consumer to nonaffiliated third parties, unless the institution provides certain information to the consumer and the consumer has not elected to opt out of the disclosure. The regulations will be substantially similar to the privacy rules that have been adopted by the banking regulators. The Commission is considering a compliance date of July 1, 2001, in order to provide firms with enough time to develop the compliance systems that will be necessary to meet the requirements of the regulations. We believe these rules balance the concerns raised in the comments we received on the rule proposal, with the important privacy protections for consumers provided by Congress in the legislation.
I started off this discussion by talking about the remarkable growth of this industry and some of the change that has resulted. Many of the regulatory issues I have discussed today are largely a function of that growth and change. While we may not always see eye to eye on how the regulatory issues should be addressed, I believe that this environment of growth and change presents us with a shared challenge. We, as regulators, and you, as industry participants, share a common interest in the integrity of this dynamic industry. The future of your business lies in the trust of your customers. We urge you to join with us, so together we may address the many challenges that face us in this changing financial marketplace.
Thank you.
http://www.sec.gov/news/speech/spch379.htm
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