Speech by SEC Staff:
"Variable Products: New Challenges for a Changing Marketplace"
by Paul F. Roye
Director, Division of Investment Management,
U.S. Securities and Exchange Commission
At the ALI-ABA Conference on Life Insurance Products:
Current Securities, Tax, ERISA, and State Regulatory Issues
November 11, 1999
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 in this speech are those of the author, and do not necessarily reflect the views of the Commission or other members of the staff of the Commission.
Thank you and good morning. Itís a pleasure to be here with all of you today.
The last decade has seen phenomenal growth in the variable insurance products industry. Assets have climbed from $31 billion in 1990 to approximately $700 billion today. Since 1994, assets in variable annuity subaccounts have grown an average of 36% per year, compared to about 25% per year for total mutual fund assets. In addition, variable annuity sales have been increasing at an average rate of 8% to 10% a year, to an estimated $100 billion this year. Variable life policies have seen a similar expansion, to over $48 billion in assets as of the end of August.
As the variable insurance products market has grown bigger, it has also evolved. Participants in the industry are competing through an innovative variety of products. This evolving marketplace presents an array of challenges for both the industry and those of us who regulate it. Indeed, as I come up on my one-year anniversary as Director, I am struck by the number of tough issues we are wrestling with as a result of changes in this industry how to ensure that useful, and not merely overwhelming, disclosure reaches investors when products may have 25 or 30 investment options; how to foster vigorous competition that works to the benefit of investors; how to disclose in a straightforward way variable life fees and charges that are by no means straightforward. Over the next few months, a major challenge to the industry is being presented by the coming of the new millennium. And all of us are confronting the new competitive and regulatory landscape created by the breaking down of traditional barriers within the financial services industry.
I will say more about the Commissionís response to these challenges in a moment. But first, let me emphasize one point. The variable products industry will determine its own future a future that depends on the industryís creativity and ability to compete and meet customer needs, and also, in no small measure, on maintaining the confidence of investors.
As the variable products industry builds on its past success, it is imperative that you not become complacent about proper compliance and disclosure practices and the sales practices of those who distribute your products. The interests of investors must be paramount in your plans. Unless the variable products industry builds and maintains investor confidence, the industry itself will be harmed. Let me turn to some of the specific issues weíre addressing at the Commission today.
II. Corporate Governance
One topic that the Commission and staff have been focusing on recently is corporate governance, and the effectiveness of independent directors in protecting the interests of fund investors. This issue has received a great deal of attention and Chairman Levitt has made improving the mutual fund governance structure a top priority of the Division. The media have produced stories criticizing mutual fund directors and the amounts that some independent directors are paid. Shareholders have filed lawsuits challenging the independence of directors, based on the number of boards on which they serve and the compensation they receive.
The Commission hosted a roundtable last February on the role of independent investment company directors, to determine what problems independent directors are encountering and how their effectiveness can be enhanced. As a result of that roundtable, the Commission proposed a series of initiatives last month.
First, the Commission proposed that independent directors constitute either a simple majority or a two-thirds super-majority of the boards of funds that rely on any of ten commonly used exemptive rules (including rule 12b-1 and the rules that permit funds to engage in affiliated transactions). Now, the Investment Company Act of 1940 contains a minimum independence requirement of 40%. We at the Commission believe, however, that a fund board that has at least a majority of independent directors is better equipped to perform its duties and responsibilities. We believe that the dynamics of the decision-making process will be improved with at least a majority independent board and that such a board is better able to exert a strong and independent influence over fund management and oversee areas where the fundís and shareholdersí interests might diverge from the interests of the adviser.
Second, the selection and nomination of new independent directors would be left to a fundís current independent directors. Independent directors who are selected and nominated by other independent directors are unlikely to feel that they owe their positions to fund management, and are more likely to speak their minds, question management aggressively, and make investorsí interests their sole concern. This selection and nomination process should give the board an opportunity to consider candidates that have the right mix of backgrounds, skills, and experience to complement those of existing board members.
Third, any person who acts as counsel to a fundís independent directors would be an "independent legal counsel." I believe that independent directors will feel more secure in their actions if they have their own counsel whose advice is not influenced by a relationship with fund management. Independent counsel is a tool that can benefit directors by assisting them in marshalling arguments to balance those presented by management in matters involving conflicts of interest and assist directors to evaluate issues with an independent and critical eye.
Although we asked for comment on the question, we are not currently proposing to require that independent directors have independent legal counsel. We believe that competent independent directors can determine for themselves whether the assistance of legal counsel would benefit them in performing their duties. Given the breadth of directorsí responsibilities and the complexity of the regulatory structure governing funds, however, independent fund directors in most cases would be well advised to have their own counsel, and counsel who is truly independent.
Finally, our proposals would require funds to provide shareholders with better information about directors. Funds would provide basic information about directors to shareholders in the annual report, so that shareholders will know the identity and experience of their representatives. Funds also would disclose fund shares owned by directors, to help shareholders evaluate whether directorsí interests are aligned with their own, and would disclose information about directors that may raise conflict of interest concerns. Finally, the proposals would require funds to provide additional information to shareholders about the boardís role in governing the fund.
We expect that our initiatives will fortify independent directors and enhance their ability to act as forceful advocates for investors. Perhaps the most important role of the independent director is as a "watchdog" in reviewing and approving fund fees -- a role that may be particularly complicated for directors who serve on boards of funds that are investment options for variable products. In particular, the use of a 12b-1 plan by an underlying fund of a variable insurance product raises important issues. Distribution expenses for these products often are paid for at both the separate account level and the fund level. The fund board should consider this in making a determination whether a 12b-1 plan will benefit the fund and its shareholders, and must make sure that legitimate services will be rendered in return for payments under the plan.
III. Bonus Programs
Increasing variable annuity sales have been accompanied by heightened competition. One way that companies have attempted to distinguish themselves from their competitors is through bonus programs, in which a contract owner receives an immediate credit equal to a percentage of purchase payments.
For some months, we have been hearing complaints of an uneven playing field between companies using bonus credits to entice competitorsí customers and companies desiring to maintain their existing customer base. We have been told that this resulted from the Divisionís 1994 Alexander Hamilton letter, which clarified that the restrictions on exchange offers imposed by Section 11 of the Investment Company Act do not apply to exchanges between products of unaffiliated companies. Alexander Hamilton, we are told, opened the door for insurers to raid each otherís business using bonus programs, while leaving the targeted company unable to respond with its own bonus program Ė even a program that is more favorable to investors than those offered by competitors.
We have approached these complaints with several principles in mind. First, Section 11 is an investor protection provision -- prohibiting an issuer from repeatedly switching an investor into new products to extract multiple sales charges. Be assured that, as we consider bonus programs, we will look first to enhance investor protection. Second, the Commissionís role is to protect investors from fraud and unfair sales practices -- not to stand in the way of products being offered to investors that may be beneficial to them. Third, it is our job to fulfill our investor protection mandate in a way that has minimum impact on the competitive landscape.
Applying these principles, we have reached several conclusions. First, we are very concerned by the level of exchange activity that appears to have been generated by bonus programs. Second, Alexander Hamilton is correct. Suitability requirements, not Section 11, are in place to address abusive switching among the products of unaffiliated insurers. Third, our goal should be to preserve the intent of Section 11 while permitting competition to flourish that will allow investors maximum choice.
As a result, the industry can expect two things from the Division in the coming months. We will heighten our scrutiny of bonus programs. At the same time, we will move forward to level the playing field in this area.
We expect to recommend that the Commission grant exemptions from the CDSL tacking requirements of Rule 11a-2 to permit exchange offers that provide benefits to investors for whom the exchange is suitable. We would support an exemption when the insurer is willing to replace the restrictions of Section 11 with heightened insurer attention to suitability concerns -- for example, clear, "plain English" disclosure of the potential downside of an exchange transaction; insurer involvement in confirming suitability; and recordkeeping to facilitate the Commissionís review of the exchange program.
We are, however, very concerned by the fact that bonus credits are often coupled with higher CDSLs, longer CDSL periods, and higher asset-based charges -- all of which can make a bonus more apparent than real. For that reason, we expect to focus increasingly on the suitability of bonus transactions through the Commissionís own inspections program, and we expect to discuss our concerns with sister regulators. We also expect to pay increased attention to disclosure regarding the benefits of bonus programs, and to undertake investor outreach to heighten awareness of the trade-offs between bonus credits and product fees and charges.
Bonus programs are an area where I would urge variable annuity issuers not to wait for the Commission to come knocking on your door. Ask yourselves whether your products are truly designed with investorsí interests in mind or whether they will act as a spur to harmful and inappropriate sales practices. The annuity industry has from time to time been the subject of consumer complaints, bad press and litigation regarding questionable sales practices. The industry is working hard, through the Insurance Marketplace Standards Association and other means, to address these concerns. We hope that bonus programs do not undermine these efforts.
IV. Disclosure (N-6 and N-4)
Let me turn to a subject of perpetual interest disclosure. We are continuing to work constructively with the industry on our efforts to improve disclosure for variable products. These efforts are part of the Commissionís broader initiative to bring sweeping revisions to prospectus disclosure for all public companies to make all prospectuses simpler, clearer, and more useful.
Toward that goal, last year the Commission 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 reviewed the comments on the proposal, and we have sought additional input on the thorny issues that remain. For example, we are grappling with the question of how to address individualized cost of insurance charges. And, more broadly, we are considering the arguments made by some in the industry as to whether a tabular presentation of fees and charges for variable life insurance products would be practical or beneficial to investors at all.
Along these lines, the American Council of Life Insurance recently conducted focus groups to study investor reactions to the fee table in proposed Form N-6. We welcome this important contribution to the debate and will carefully consider this research along with the many other thoughtful comments we received as we work toward our goal of providing clear, understandable disclosure to investors about fees and expenses.
We are also beginning to look beyond Form N-6 to improving the disclosure in variable annuity prospectuses. Last month, the National Association for Variable Annuities presented us with comprehensive proposals for revising variable annuity disclosure. NAVA made a number of interesting suggestions to address concerns that the Commission and the industry have been wrestling with for some time. The proposals included ideas for revising the variable annuity prospectus, along the lines of the new Form N-1A for mutual funds and proposed Form N-6.
NAVA also proposed broader disclosure reform. For example, NAVA suggested that variable annuity issuers not be required to deliver a complete updated prospectus to their investors making additional purchase payments. Instead, issuers could provide a short summary of material changes. NAVA also proposed that annuity contracts with "market value adjustment" features be registered on Form N-4, rather than on Forms S-1, S-2, or S-3, as is currently the case. 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. NAVA also recommended that we permit variable annuity profiles, like mutual fund profiles, to be distributed to investors without an accompanying prospectus.
The NAVA proposals contain a wealth of ideas, and we will give them serious consideration. We share NAVAís view that disclosure should encourage investors to focus on the information that is most important to them. We look forward to working with all of you as we craft better, more understandable disclosure for variable annuity investors.
V. Other Disclosure Initiatives
We are also working on a number of other initiatives to improve disclosure for mutual funds and variable insurance products. At the top of our agenda is consideration of whether we can improve disclosure of the effect of taxes on mutual fund returns. At present, we are focusing on after-tax return, a measure of a mutual fundís performance adjusted to illustrate how taxes could affect an investor. Two separate measures of after-tax return are under consideration: "pre-liquidation" after-tax return, which assumes that an investor continues to hold a fund throughout the period for which the return is computed; and "post-liquidation" after-tax return, which assumes that an investor sells the fund at the end of the period and incurs tax upon the sale.
We anticipate that funds sold through tax-deferred vehicles, including variable products, would not be covered by the after-tax return disclosure that we are currently designing. For that reason, the effect of this project on variable products should be indirect.
Another of our priorities is revamping Rule 482, to allow funds to use an "advertising prospectus" that includes information the substance of which is not included in the statutory prospectus. This should give funds and variable product issuers greater flexibility to communicate with investors. At the same time, we do continue to have concerns with the focus on performance in fund advertisements. The Rule 482 revisions will serve as an occasion to remind issuers that technical compliance with the rule may run afoul of antifraud prohibitions if a fundís performance record is somehow distorted.
We also expect to revisit Rule 482(a)(5)(i), which allows an issuer of a variable contract to deliver an application for the contract along with a contract prospectus containing information about the underlying funds. There has been some confusion in the industry regarding what, if any, other information about the underlying funds may accompany the contract prospectus and application. This is an area we hope to clarify, and your input will be welcome.
We are also considering how to improve disclosure in annual reports to shareholders. Annual reports are a powerful, but too often underutilized, tool for funds to communicate with their shareholders. One area that deserves reevaluation is the schedule of portfolio investments. We are considering how to improve the quality of portfolio information, perhaps by adding summary information about the portfolio. We also expect to consider the possibility of reducing the quantity of unnecessary detail in the schedule. Our approach will be to make sure that the information available to shareholders is not reduced. In this information age, it should be possible to make more detailed information available to interested shareholders through web sites, EDGAR, or upon request, and provide other shareholders with more streamlined, user-friendly information.
This is an area that could have a considerable impact on variable products. Commission rules require only that a variable contract owner receive annual reports for the investment options to which her account is allocated. Nonetheless, in practice, many issuers provide annual reports for all underlying funds to every contract owner. For these issuers and their investors, the benefits of streamlining the portfolio schedule would be multiplied many times over.
VI. H.R. 10
As you all know, Congress has approved, and the President is likely to sign, sweeping reforms to the financial services laws. These reforms have the potential of resulting in major consolidation of industries (the insurance, securities and banking industries) that have been separate in various degrees for well over 60 years. The consequences of these consolidations will be significant both from the insurance industryís perspective and from that of regulators. How will these consolidating 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 increasing complex affiliations? These newly consolidated firms will bear a great deal of responsibility in developing and implementing compliance programs that blend different cultures. The compliance structure of a bank traditionally has varied from that of an insurance company or a 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 interests 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 are a central component of these consolidations.
It is now November, and some of you may be growing weary of hearing about Y2K, and eager to put January 1 behind you. With the changeover now only fifty days away, let me emphasize several points.
First, you should have completed your remediation efforts. You should be confident that come January 1 you can process new orders, allocate incoming funds to the proper subaccounts, and process redemptions in a timely fashion.
In addition, you should be winding up your contingency planning efforts. You should know what to do if you cannot allocate incoming funds or process redemptions. You should know what to do if you can't communicate with underlying funds or service providers.
I have had many discussions with industry representatives about Y2K contingency planning. Well prepared organizations have considered, among other things, the adequacy of services to be provided by third parties, procedures for handling increased redemptions and exchanges, fair value pricing policies and procedures, procedures for contacting key personnel, and lines of credit and borrowing arrangements. All of these items should be reviewed from time to time as a good business practice anyway, and Y2K should provide just another opportunity for review.
For our part, we scrutinized Y2K disclosures with care. When appropriate, we requested that issuers improve their prospectus disclosure. Many issuers are making disclosures in special brochures or on the Internet, which often go into greater detail about Y2K than do their corresponding prospectuses, and we encourage these less formal types of communication.
At the heart of our contingency planning efforts is our focus on possible scenarios and responses in the unlikely event that disruptions occur. Working closely with the industry, we have analyzed a variety of Y2K scenarios -- contingencies for which we need to be prepared, though we expect that they likely will not come to pass. I have told my staff, in thinking about possible disruptions, to favor responses which have the effect of keeping the industry up and running. In other words, we will expect funds and variable product issuers -- except in extraordinary circumstances -- to remain open to price and process transactions. A large volume of redemptions likely will not, in the absence of other problems, form a basis for regulatory relief. But we will consider granting relief to affected funds and issuers in appropriate situations.
Finally, SEC staff will operate a command and control center to gather critical status information from fund groups and others during the last week of December and first week of January. Moreover, there will be Division staff available throughout the New Year's weekend should you need to contact us.
Variable insurance products play an important role in the investment plans of many Americans, an accomplishment in which you can take great pride. That role should continue to grow, but only so long as the industry can enhance its reputation for business integrity. In addition, as the industry adapts its products to meet the challenges of a changing marketplace, the importance of better, clearer communications with investors will increase. I look forward to working with you to meet these challenges. Thank you.