U.S. securities regulators focus rulemaking, exams on retirement products

By Guest Contributor
July 5, 2012

By Stuart Gittleman

NEW YORK, July 5 (Thomson Reuters Accelus) – The U.S. Securities and Exchange Commission will return its rulemaking and examination focus to retail sales of retirement products, a Division of Investment Management official told the Insured Retirement Institute, an industry group.

“[T]o better understand the impact of our regulations on market participants, we are working to staff a new examination function within the division, as required by the Dodd-Frank Act,” associate division director Susan Nash said at the IRI government, legal and regulatory conference last week.The division is particularly focused on variable products, which is the IRI’s industry sector, and is considering issues around the increasing use of exchange traded funds and derivatives and “novel and complex” product designs in separate accounts, Nash said.

Novel and complex

The variable product industry is straining at the task of developing retirement income streams in increasingly challenging and volatile markets and assuring investors they will not outlive their income and that the provider will continue making payments, Nash said.

This dynamic “calls for care in the design of variable products and attention to investor protection,” better product development and disclosure, and working more closely with regulators, Nash said, with particular focus on:

  • product changes such as paring back living benefits, charging more for them and limiting potential participation in market gains that may reduce the contracts’ benefit and require that offering materials clearly highlight the costs and limits so investors can make informed decision;
  • ensuring that investors and financial advisers have the information they need for these decisions presented in a way that “clearly and unambiguously” brings the “moving parts into focus” – including the insurer’s solvency and claims paying ability;
  • protecting investors in contracts that are no longer being sold and may be subject to a dwindling number of available investment options, to avoid jeopardizing the owners’ long-term interests or the company’s reputation, or encouraging improper exchanges. Exchanges may raise questions of suitability and should be closely scrutinized from the investor’s viewpoint, and the offer’s pluses and minuses should be clearly identified for investors and compared in a straightforward way to any incentive being offered; and
  • carefully scrutinizing broker incentives to encourage clients to accept an exchange offer, as well as all sales of variable products, to ensure that the transaction serves the investors’ interests.

One innovative product being introduced, particularly in retirement plans, is the contingent deferred annuity that has a minimum withdrawal benefit which is not tied to assets held in the variable annuity contract, Nash said. The SEC is concerned that investors receive clear disclosure on the limits on withdrawals and on the underlying investments, that retirement income comes first out of investors’ assets and there will be no payout unless and until the assets are depleted, and that the products are not guaranteed except to the extent of the insurer’s financial strength.

Target date funds

Target date fund assets have reportedly grown from $71 billion at the end of 2005 to about $378 billion at the end of 2011 and the funds are becoming a key part of many Americans’ retirement portfolios, Nash said. In April the SEC reopened comments on a 2010 proposed rule to address concerns about fund names and the information presented in marketing materials, and the SEC is testing individual investors’ understanding of these factors. And in May the Department of Labor reopened the comment period on its proposal on target date fund disclosure. Both agencies are committed to ensuring that investors understand what they are – and are not – getting when they invest in such funds.

Prospectus complexity

A key casualty in developing new products and enhancing existing offerings is the ability of investors – and even their financial advisors – to understand what is being offered, Nash said. She urged providers to use clear, plain English language in a usable format, and to not obscure information that investors need with irrelevant disclosures aimed at investors in some other version of the contract.

Nash said the division is working on a new disclosure framework for variable annuities to provide the information investors need when they need it in a manner that is usable and understandable so:

  • buyers have information that helps them make an informed purchase decision; and
  • existing owners have information that helps them understand how their investment has performed and how it has changed, and that helps them to make ongoing decisions such as whether to invest additional amounts in a contract.

The information should be understandable, and should be available “24/7″ in a format that is readily accessible and usable, offers a convenient gateway to related, more detailed information, and makes appropriate use of available communication tools and technologies.

Don’t sink under regulatory and compliance inertia, FINRA says

The sinking of the Titanic 100 years ago has lessons for modern firms and their regulators, Thomas M. Selman, executive vice president for regulatory policy at the Financial Industry Regulatory Authority, told the IRI. The rules did not keep up with the industry – for example, lifeboat requirements were designed for ships with fewer passengers – and it’s easy to put rules in place but harder to keep them up to date. The sinking of the largest and supposedly the safest ship at the time provides lessons for regulators and firms:

  1. A regulator must periodically review its rules, its interpretation of its rules and how it examines for compliance, but it should avoid complicating the ability to comply by changing rules too frequently because industry needs predictability and consistency. Selman acknowledged that FINRA’s rulemaking process can be slow and time-consuming, and can delay efforts to modernize the rules.
  2. A regulator must understand how its industry operates, how businesses have changed, and how, as a result of the changes, existing rules may have become outdated. Ideally, the regulator will understand how business is conducted, how a proposed rule might affect that business and how the rule could be adjusted to accommodate legitimate business practices while protecting its “passengers” – in FINRA’s case, investors.

    FINRA’s commitment is enhanced by its Office of Emerging Regulatory Issues, which analyzes new products and services to understand their possible impact on customers and the soundness of firms, as well as its field examiners, its Office of Fraud Detection and Market Intelligence, and its other staff members. Moreover, FINRA is revising its examination process to ensure that exams are tailored to address the risks presented by various business models and practices, Selman said.

  3. A regulator should consider the burdens its rules impose on its industry, but it must anticipate the possibility that the worst event can happen and remain vigilant for the prospect of catastrophe. The probability of a catastrophe may be small “[b]ut when the stakes are so high, even a small probability of disaster becomes relevant,” Selman said.

    “Perhaps the financial crisis was our Titanic hour. … Whether one agrees or disagrees with all of the provisions of the Dodd-Frank Act, almost everybody assumed in 2008 that Congress would enact sweeping legislation that could not have been enacted before the crisis,” Selman said.

    “There are some decisions, whether to put enough lifeboats on the Titanic, whether to protect the financial system, that no cost-benefit analysis can resolve,” Selman added.

The Titanic disaster also provides three lessons for firms, Selman said:

  1. Identify the risks that arise from developments in your business and don’t become too dependent on regulators or let an innovative program of risk management “deteriorate into a rote exercise.” Don’t wait for detailed instructions on how to protect your customers and your firm.
  2. Review your procedures regularly to ensure that they reflect existing business practices. Firms must ensure their compliance and supervisory systems reflect the products they offer, the businesses in which they engage and the types of customers they serve, and that their reps understand the plusses and minuses of the products they sell.
  3. Consider the purpose, not just “the black letter law,” particularly when developing policies and procedures for new rules, and new interpretations and enhancements of existing rules that apply to your business. For example, the amended suitability rule codified longstanding interpretations and FINRA has provided extensive guidance, but it can never cover every possible situation, so just and equitable principles of trade and the industry’s fiduciary standard must be the bedrock of each firm.

These lessons are interrelated and are the basis of the self-regulatory organization model, Selman added.

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. <a href=”http://accelus.thomsonreuters.com/solut ions/regulatory-intelligence/compliance- complete/” target=_new”>Compliance Complete</a> provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)

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