Washington, D.C.
Nov. 13, 2014
Thank you, Steve, for your kind introduction. Good morning and thank you for inviting me to speak to you today. Before I begin, let me remind you that the views I express are my own and do not necessarily reflect the view of the Commission, any of the Commissioners, or any other colleague on the staff of the Commission.[1] I welcome the opportunity to be here today among professionals who work in the dynamic field of investment products issued by insurance companies.
Today marks the third time I have had the opportunity to share my thoughts at this conference, and as I reflect upon the shifting landscape of variable insurance products over that time period, the words innovation and change come immediately to mind. From product design features to the underlying investment options offered, many changes affect the landscape that investors in insurance products navigate when they make investment decisions. We at the Division of Investment Management have sought to be proactive in identifying and formulating appropriate policies to identify and mitigate risks associated with these changes in order to better fulfill our critical mission to protect investors, promote informed investment decisions, and facilitate appropriate innovation in investment products and services. I work with nearly 200 highly motivated people who are committed to carrying out this mission. This morning I would like to discuss some of the ways in which the Division staff seeks to accomplish our goal of proactive regulation by (i) actively monitoring and analyzing industry trends, (ii) publishing guidance to the industry, and (iii) undertaking various rulemaking initiatives.
Division staff has worked and continues to work diligently to take stock of various emerging trends affecting the asset management industry in real time, rather than reacting to problems raised by industry developments after they occur.
Our Disclosure Review and Accounting Office reviews and comments on the numerous prospectuses, shareholder reports, and other disclosure documents filed by variable products issuers, mutual funds, exchange-traded funds, and other investment companies each year. Division staff works hard to develop ways to analyze this river of information that flows to us through the disclosure review process and systematically identify and analyze investment company industry trends to inform our regulatory responses. This assists the Division´s efforts to monitor and analyze risks affecting the asset management industry.
In our efforts as a Division to be proactive in our mission to protect investors and promote informed investment decisions, the Disclosure Review and Accounting Office is refocusing its efforts to assess the consistency and effectiveness of staff comments on the many disclosure documents reviewed each year. This is intended to result in a number of beneficial outcomes for both the public and the Commission staff, including identifying emerging disclosure issues, promoting quality and consistency in staff comments, improved training for new and existing staff, informing policy decisions, and providing improved guidance to registrants concerning disclosures to investors.
Through the review and comment process, our Disclosure Review and Accounting Office continues to monitor and assess the various changes occurring in the variable products space. By way of example, until recently, the primary focus of variable annuity contract design was the so-called living benefit features, such as guaranteed minimum accumulation and withdrawal benefits. More recently, Division staff has observed several issuers scaling back their offering of these features while others have launched new annuities that offer no living benefits at all. These so-called "investment only" contracts raise distinctly different, but equally important, disclosure issues. For example, in the staff´s view, investors and their financial advisers need disclosure that will enable them to assess whether the tax deferral and annuitization features of such contracts are worth the fees charged under the contract.
In addition, Division staff continues to monitor contract modifications, including the recent flurry of changes designed to limit insurers´ exposure under the guarantees many companies undertook before the actual cost of those guarantees to the insurers came fully to light. One change we have seen is an increase in buyout and exchange offers and incentives for early annuitization. In addition, some have recently taken steps to manage this risk through changes in underlying fund management and, in particular, changes that limit the volatility of underlying funds through the introduction of volatility management overlays to the portfolios of the funds. Such changes may raise important disclosure, suitability, and other concerns.
Specifically, while insurance companies have long been known to rely on the use of derivatives to hedge risks associated with living benefit riders and other general account obligations under variable insurance contracts, the staff has noted a recent increase of underlying funds beginning to utilize such instruments to hedge risk and limit volatility at the fund level. In the staff´s view, this use of managed volatility strategies at the fund level in connection with contracts that provide living benefits may, in some cases, result in limited benefits to contract owners who have already paid for protections against market loss, particularly to the extent that they limit upside earning potential. For example, if an underlying equity fund is changed to add a managed volatility component after a contract owner has allocated contract value to that fund, the staff generally believes that insurers should consider whether adding downside protection is redundant with the living benefits contract owners may have already purchased and/or suppresses the potential for gains that may have motivated the original equity investments.
In short, we are seeking to be proactive in identifying changes in the variable insurance product space, and to ascertain whether such changes raise investor protection concerns, whether they are consistent with existing disclosures and, more fundamentally, whether they constitute a failure on the part of the issuer to honor the letter and the spirit of the bargain struck with investors.
Through our review of disclosure filings and ongoing analysis of industry data, Division staff has also identified the rapid and significant growth in alternative mutual funds.[2] As of the end of September 2014, alternative mutual funds had over $282 billion in assets. Although alternative mutual funds only accounted for 2.3% of the mutual fund market as of December 2013, the inflows into these funds in 2013 represented 32.4% of the inflows for the entire mutual fund industry, with almost $95 billion of inflows into alternative mutual funds in 2013. That is over five times more than the amount of inflows into alternative mutual funds in 2012.[3]
Alternative mutual funds are growing not only in the retail fund space, but also among funds offered as investment options under variable contracts. This is not surprising, as insurance product sponsors have long worked to develop products that have attributes similar to other popular investments, such as so-called structured annuities, or that offer underlying investment options that are popular elsewhere in the investment management space, such as exchange-traded funds, and now, alternative mutual funds.
As is the case with retail alternative mutual funds, promoting informed investment decisions with respect to the sometimes complex investment strategies employed by alternative mutual funds offered as underlying investment options under variable contracts requires a focus on clear and effective disclosure. This is all the more true in light of the heightened risk raised by valuation, liquidity, and leverage issues associated with alternative investment strategies. These heightened risks and the complex nature of the investment strategies employed by alternative mutual funds can make the goal of clear, concise disclosure more difficult to attain.
Division staff is focusing closely on alternative investment disclosure generally and derivatives disclosure in particular. The staff has observed that some funds provide generic disclosures about derivatives that may be of limited usefulness for investors in evaluating the anticipated investment operations of the fund, including how the fund´s investment adviser actually intends to manage the fund´s portfolio and the consequent risks associated with such management. On a related note, when reviewing fund annual reports, in some instances the staff sees a significant impact from derivatives in the Statement of Operations, but little if any discussion of this impact in the Management Discussion of Fund Performance. In addition to the letter from the Division in July 2010 regarding the then-current derivatives-related disclosures by investment companies,[4] our August 2013 Guidance Update discussing "Disclosure and Compliance Matters for Investment Company Registrants That Invest in Commodity Interests"[5] serves as a good measuring stick on how the Division views disclosure and compliance matters relevant to funds that engage in alternative investment strategies and invest in alternative assets.
To further our efforts at proactive monitoring in this area, Division staff is also analyzing data about the actual use of alternative investment strategies (including the use of derivatives) in light of what has been stated in fund disclosure documents and working to ascertain what funds are really doing to achieve their stated investment objectives. The staff generally believes that any disclosure regarding the use of alternative instruments and investment strategies should be tailored specifically to how a fund expects to be managed and operated. Such disclosure should also 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 focus in this regard, those responsible for disclosure generally should consider the degree of economic exposure the alternative investment strategy creates, in addition to the amount invested in that strategy. A similar issue arises with regard to shareholder reports, including the notes to the financial statements, which in some cases do not reflect how a fund actually used derivatives to meet its investment objective. In the staff´s view, a fund should also consider the accuracy and completeness of marketing materials related to its investment objectives and performance. In addition, as funds frequently evolve in this respect, a fund should review its use of alternative investment strategies, including derivatives, when it updates its registration statement annually and assess whether it needs to update the disclosures in its registration statement that describe its principal alternative investment strategies and risks.
No discussion of the Division´s efforts to proactively monitor and analyze industry developments and risks would be complete without highlighting our Risk and Examinations Office, or "REO," which was formed in 2012. REO is a multi-disciplinary office staffed with analysts with strong quantitative backgrounds, along with lawyers, examiners, and accountants. REO maintains an industry monitoring program that provides ongoing quantitative and qualitative financial analysis of the investment management industry. The REO monitoring program´s work includes analysis of the information the industry provides through various regulatory reports, as well as industry information from third party providers.
In addition to financial analysis, REO conducts an examination program that gathers 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.
As part of its risk monitoring efforts, one of REO´s goals is to help the Division identify emerging industry trends and potential risks and to better understand the characteristics, risks, and benefits of new and complex investment products. REO also assists the Division´s efforts as part of a larger Commission initiative to obtain and analyze data to keep up to date with market trends and operational integrity and compliance issues, inform policy and rulemaking, and assist the staff in its examination, enforcement, and risk monitoring activities. I am excited at the prospect that REO can help the staff to get out in front of industry developments and related risks, rather than reacting to unanticipated issues.
The Division has also been working to enhance our risk monitoring efforts through our senior level engagement program. Through this outreach initiative, senior leadership within the Division has met and continues to meet with senior management and fund boards at several of the country´s large asset managers. To ensure that we meet with a representative sample of different firms, we consult with OCIE and use a quantitative and qualitative approach to select a diverse cross section of firms based on their size, activity mix, product mix, and geography. I believe these meetings are extremely useful in promoting two-way communication between the industry and the Commission staff. We believe that we will be better regulators to the extent that we better understand the workings of the industry we regulate, and we hope that by meeting with fund boards and senior leadership in a non-examination setting, we can talk openly about potential issues before they arise.
Through our industry monitoring program, the staff has continued its focus to stay on top of market events and to spot trends. For example, our staff has been proactive in monitoring events – such as geo-political, natural disaster, and market events – that may impact funds and advisers. When such events occur, we have focused on maintaining communication with affected asset managers and funds, reviewing disclosures to investors, and assessing the impact on investors´ ability to access funds or trade securities. This is just another example of the staff´s efforts to improve our awareness of industry developments by reaching out to the asset management industry.
Our efforts to monitor and analyze trends in the asset management industry allow Division staff to identify areas where fund managers and investment product sponsors may need additional guidance. Guidance Updates are a meaningful way for the staff to communicate and address a range of disclosure, regulatory, and compliance matters by setting out the staff´s views on a particular matter in an efficient and transparent way. During the year 2014, the Division staff has issued eleven such Guidance Updates.
In this regard, I would like to mention a very recent Guidance Update that the Division issued in October regarding so-called mixed and shared funding,[6] which I believe will be of interest to both product issuers and underlying funds in the variable insurance product space. The Guidance Update provides useful information concerning the staff´s views regarding mixed and shared funding orders in light of the infrequent reliance on such orders.
As most of you know, in the context of variable insurance contracts, "mixed funding" refers to the sale of the shares of a mutual fund to various types of offerees, such as when a fund is used as an investment option in both variable annuity contracts and variable life insurance contracts, or when a fund is used as an investment option in both variable life insurance contracts and retirement plans. "Shared funding" refers to the sale of the shares of a mutual fund as an investment option in variable insurance contracts issued by multiple unaffiliated insurance companies. Mutual funds offered to variable life separate accounts typically find it advantageous to engage in both mixed and shared funding.
For over thirty years, the Division, pursuant to delegated authority, has issued exemptive orders that permit an underlying fund to engage in both mixed and shared funding without participating insurers losing certain exemptions otherwise provided by SEC rules. These orders have imposed a set of conditions that include monitoring by the fund and the participating insurers for the existence of any conflicts of interests among the various types of investors in the fund. Based on our experience with applications for mixed and shared funding orders, as well as discussions with industry representatives, we understand that the exemptions granted in mixed and shared funding orders are relied upon very infrequently.
In the staff´s view, where a participating insurer does not require such exemptions, a mutual fund is permitted to engage in both mixed and shared funding without obtaining such an order from the Division. While an insurer who issues the contracts that offer that fund as an investment option will not have the benefit of the exemptions typically granted by a mixed and shared funding order, the absence of these exemptions may be of limited or no practical significance given the infrequency of reliance on the exemptions. The Guidance Update explains the views of the staff, and I encourage you to take a look.
The Division also released a Guidance Update in June of this past year regarding Mutual Fund Enhanced Disclosure to further our mission to promote informed investment decisions through clear and concise, user-friendly disclosure.[7] The staff has observed that, for many funds, prospectus disclosure, including the summary section of the prospectus, is still complex, technical, and duplicative. In addition, the staff continues to see exceedingly long summary sections or summary sections that do not summarize 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.
The staff has made similar observations in the review of variable product 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 describing similar benefits, which may or may not be mutually exclusive, registrants should pay close attention to how best to distinguish each one from the others in order to avoid confusion.
Overall, with regard to disclosure, the staff views Guidance Updates as another avenue to remove uncertainty and enhance the public´s understanding of the staff´s views on critical issues.
Over the past year, the Division has continued the important work of protecting investors, promoting informed investment decisions, and facilitating appropriate innovation in investment products and services through rulemaking and other policy initiatives.
As many of you know, Money Market Fund Reform is now a reality thanks to the countless hours spent by our staff and to the invaluable comments from various individuals and groups, including representatives of the variable product industry. Money Market Fund Reform seeks to reduce the risk of runs in money market funds and provide important new tools that will help further protect investors and the financial system in a crisis. The adopted money market reforms are intended to make our financial system more resilient and enhance the transparency and fairness of these products for America´s investors.
Moving beyond Money Market Reforms, in our efforts to be an effective 21st century regulator, the Division is using its enhanced efforts to monitor and analyze industry trends and risk to make better and more informed policy recommendations. Among the initiatives under consideration are substantial improvements to data reporting, potential policies regarding the use of derivatives by mutual funds, and expanded stress testing of the largest asset management firms.
For example, in an effort to have more useful and effective data reporting, the staff is considering ways to improve the information we receive in Commission filings about mutual funds, closed-end funds and ETFs. As a result, Division staff is undertaking an initiative to develop a recommendation that would modernize and streamline the information that funds are reporting to the Commission to give us more timely and useful information about fund operations and portfolio holdings. In pursuing this initiative, the staff´s goal is to not only improve the quality of the data we receive and to inform our efforts to monitor risk, but also to reduce unnecessary burdens by making the reporting regime workable with, or at least minimally disruptive to, a fund´s systems, eliminating duplicative filings, and addressing concerns about front-running.
In this regard, we are considering recommending that the Commission propose substantial improvements to Form N-SAR, the semi-annual report to the Commission filed by investment companies, including variable insurance separate accounts. As part of this overhaul, we are aiming to preserve the most useful items in Form N-SAR, adding some others that we think would be particularly valuable, and eliminating those in the form that we´ve found to be less useful. Among issues under consideration is how frequently reports should be filed, for example, annually rather than semi-annually as is currently required. In addition, reports could be filed in a structured format, replacing the very outdated DOS filing that is currently required.
I appreciate the opportunity to share my thoughts on these issues and the work of the Division of Investment Management. I hope I have been able to convey the renewed focus we have placed on a proactive approach to our work monitoring industry developments, synthesizing and analyzing the information collected through such monitoring, and formulating both rulemaking and other regulatory responses, as well as more consistent and incisive comments on filings. We are eager for this approach to enable us to be more focused and therefore more effective in our mission to protect investors, promote informed investment decisions, and facilitate appropriate innovation.
Thank you for your attention and enjoy the rest of the conference.
[1] I would like to thank my colleagues Susan Nash, William Kotapish and Naseem Nixon for their invaluable expertise in the preparation of these remarks. 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 the author and do not necessarily reflect the views of the Commission or of the author´s colleagues on the staff of the Commission.
[2] "Alternative mutual funds" refers to certain open-end mutual funds registered under the Investment Company Act of 1940. 15 U.S.C. 80a. While there is no clear definition of "alternative" in the mutual fund space, an alternative mutual fund is generally understood to be a fund whose primary investment strategy falls into one or more of the following three buckets: (1) non-traditional asset classes (for example, currencies), (2) non-traditional strategies (such as long/short equity positions), and/or (3) illiquid assets (such as private debt). These investments generally seek to produce positive risk-adjusted returns that are not closely correlated to traditional investments or benchmarks. Alternative strategies differ from those of traditional mutual funds that historically have pursued long-only strategies in traditional asset classes.
[3] Based on staff analysis of Morningstar DirectSM open-end mutual fund data.
[4] See Derivatives-Related Disclosures by Investment Companies, Letter from Barry D. Miller, Associate Director, Division of Investment Management, U.S. Securities and Exchange Commission, to Karrie McMillan, General Counsel, ICI (July 30, 2010), available at http://www.sec.gov/divisions/investment/guidance/ici073010.pdf.
[5] IM Guidance Update 2013-05, Disclosure and Compliance Matters for Investment Company Registrants That Invest in Commodity Interests (August 2013), available at http://www.sec.gov/divisions/investment/guidance/im-guidance-2013-05.pdf.
[6] IM Guidance Update 2014-10, Mixed and Shared Funding Orders (October 2014), available at http://www.sec.gov/investment/im-guidance-2014-10.pdf.
[7] IM Guidance Update 2014-08, Guidance Regarding Mutual Fund Enhanced Disclosure (June 2014), available at http://www.sec.gov/investment/im-guidance-2014-08.pdf.