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 views of the Commission, any of the Commissioners, or any of my colleagues on the staff of the Commission.
These are uncertain times for our nation's investors and for those who issue and sell investment products, including variable insurance. A positive sign is that assets in variable annuities, at almost $1.6 trillion, remain near their all-time high.1 In addition, the retirement income solutions offered by the industry are designed to address the needs of the many investors moving toward retirement in today's uncertain market environment. However, there are significant challenges facing the business, particularly those presented by the persistent low interest rate environment and by volatile equity markets both here and abroad.
The Division has observed the industry undertaking several initiatives to address these challenges and curtail risk exposure in the contracts being offered. In addition, some insurers have chosen to exit the business. An industry on solid financial footing is important for investors, who rely on insurers' ability to pay promised benefits. At the same time, some contract changes are not good for investors. For example, many recent changes have reduced benefits for new investors. Other changes have limited the ability of existing contract owners to make additional payments into their contracts in order to take advantage of the benefits of those contracts.
I can tell you that these are challenging times for us at the Commission as well, as we go about the mission of protecting our nation's investors. Today, I would like to highlight a few themes that are important to the staff in this uncertain environment — first, communicating effectively with investors; second, adopting a risk-based approach; and, third, acting as a continuous improvement organization. I believe the same considerations are important as you develop and maintain best practices that serve your investors.
The first theme I'd like to touch on is communicating effectively with investors. This may sound simple in concept, but its importance cannot be overemphasized. I would like to share with you a couple of initiatives that highlight our commitment to this goal.
The first is the staff's recently published financial literacy study that was mandated by the Dodd-Frank Act. This study was conducted to identify, among other things, the existing level of financial literacy among retail investors; methods to improve the timing, content, and format of disclosures; and the information most useful to retail investors in making investment decisions.2
The financial literacy study drew upon a number of sources. These included public comments and a Library of Congress staff review of quantitative studies on the financial literacy of retail investors, as well as focus groups and an online survey.
According to the Library of Congress staff review, studies show consistently that American investors lack basic financial literacy. Studies have found that many investors do not understand key financial concepts, such as diversification or the differences between stocks and bonds and that they are not fully aware of investment costs and their impact on investment returns. The Library of Congress staff review concludes that "low levels of investor literacy have serious implications for the ability of broad segments of the population to retire comfortably, particularly in an age dominated by defined-contribution retirement plans."3
The financial literacy study identified methods to improve the timing, content, and format of disclosures, as well as useful and relevant information for investors to consider when either selecting a financial intermediary or purchasing an investment product. The study noted that, generally, retail investors prefer to receive disclosures before making an investment decision. In addition, retail investors find information about fees and expenses, performance, principal risks, and investment objective to be useful and relevant when purchasing an investment product. The study noted that investors prefer clear, concise, understandable language, using bullet points, tables, charts, and graphs. Investor preferences are mixed with respect to paper versus online disclosure. Finally, the study stated that investors favor "layered" disclosure, that is, an approach in which key information is sent or given to the investor and more detailed information is provided online, with a paper copy of the more detailed information sent upon request. A majority of respondents to the online survey agreed that a mutual fund summary prospectus highlighted important information and was well-organized, clear, concise, and user friendly. In my view, the industry and its advisers should consider the findings of the study when preparing disclosure documents.
This study provides grounds for optimism that a variable annuity summary prospectus, if designed and implemented effectively, could provide better disclosure for investors in your products. The framework that was designed for mutual funds — that is, the provision of key information in a summary prospectus, together with online delivery of the statutory prospectus and paper delivery upon request — may provide a useful model for improving the disclosure that variable annuity investors receive.
I know, and appreciate, that the industry has worked hard to try to adapt the mutual fund summary prospectus in a way that is workable for variable annuities. That effort involves difficult decisions about how to adequately convey to investors and financial advisors the terms of complicated products, with a wide variety of benefits, risks, and costs. Like you, we are committed to making improvements in the important area of helping variable annuity investors to make informed investment decisions. Investors in variable annuities deserve our best efforts on this important initiative.
Another development at the Commission is the new Investor Advisory Committee. This committee was established by the Dodd-Frank Act to advise and consult with the Commission on, among other things, regulatory priorities, the effectiveness of disclosure, and initiatives to promote investor confidence and the integrity of the securities marketplace. By statute, the members of the Committee include a representative of state securities commissions, a representative of the interests of senior citizens, and members who represent the interests of both individual and institutional investors.4 I expect that this Committee will be an important line of communication between investor representatives and the Commission.
The Investor Advisory Committee is now up and running. The Committee has established several working subcommittees, including Investor as Purchaser, Investor as Owner, Market Structure, and Investor Education. The Committee and its subcommittees are tackling a variety of issues of interest to retail and institutional investors, and the Committee recently submitted its first recommendation to the Commission in the area of general solicitation in Regulation D offerings. You can find out more about the work of this Committee through the "Spotlight" section of the Commission's website.5 Its meetings and recommendations are public and available on the website.
While we're on the subject of communications, I urge you to think comprehensively about your communications with investors, whether in prospectuses or sales presentations. In my view, the goal should be to make all communications clear and concise — and to convey the information that is important to investors. And, while the Division anticipates that investors would benefit from an improved disclosure framework, we urge you not to wait. Take a fresh look now at your prospectuses, illustrations, and other marketing materials, with a view to assessing whether they are effective communication tools and changing them when they are not.
My last word on communications will be about communications between you and us. We are interested in hearing from all our constituencies, and I've talked a lot about our significant outreach efforts to investors. We also welcome your input on issues of importance to variable annuity investors and participants in the industry. Let me also encourage you to get in touch with the staff as early as possible when thinking through disclosure or regulatory issues in connection with your work on new product design or the administration of existing books of business. To the extent that you have business needs that drive timing, earlier contact with the staff will facilitate resolution of any issues on the desired timeframe.
As you may know, I came to the Division of Investment Management from the Commission's Office of Compliance, Inspections, and Examinations. In OCIE, we worked hard to implement a risk-based approach to examinations. What I'd like to do now is talk briefly about a similar approach the staff of the Division is taking as we consider our regulatory priorities. This is an approach that evaluates the initiatives we are considering in terms of their impact on investors and on capital markets.
In this era of limited budgets, one of my goals since taking the helm of the Division is to ensure that we are allocating our resources wisely. Toward this end, I have asked the staff to take a fresh look at policy initiatives with a view to prioritizing those matters based on the significance of the issues to be addressed and the potential impact of the initiatives. In essence, we're applying a systematic cost-benefit analysis to the prioritization of our work. We're looking at factors that further the SEC's mission, including the risks to investors, capital formation, and efficient markets that would be addressed by various initiatives as well as the impact that various regulatory approaches would have on investors, capital formation, and efficient markets. We're also looking at impacts on the operational efficiency of regulated entities, as well as on our own operational efficiency, and the resources needed to bring various initiatives to fruition.
Our bottom line is that we want to be smart, efficient, and effective when we devote precious staff resources to the problems facing investors and the markets. Our goal is to generate the best return on taxpayers' investment.
We're also extending a risk-based approach to the regulatory issues that we address on a day-to-day basis. Along these lines, I'd like to highlight a letter issued a few months ago by the Office of Insurance Products that provided no-action assurance to an issuer of variable annuities used to fund 403(b) retirement plans that are subject to ERISA.6 In this letter, the staff stated that it would not recommend enforcement action if the sponsor of a 403(b) retirement plan makes a default allocation of investor assets into an annuity that carries the restrictions on withdrawals required by tax law, notwithstanding the requirement in the 1940 Act that variable annuities be fully redeemable.
As you may know, in an existing staff no-action letter issued to the ACLI, the staff stated that it would not recommend enforcement action if insurers sell variable annuities to 403(b) plans that contain the withdrawal restrictions required by tax law. This letter required that plan participants provide an acknowledgement of those restrictions. 7 The recent letter relaxes the acknowledgement requirement in two limited circumstances: first, where investor assets are allocated to a new 403(b) annuity offered in replacement of an existing 403(b) annuity or custodial account and, second, where allocations are made in connection with a participant's automatic enrollment as permitted by the Pension Protection Act. In both of these cases, obtaining acknowledgements can be difficult; indeed, the premise of automatic enrollment is that the employee has not taken any action with respect to plan enrollment.
In determining to issue the letter, we looked at the degree to which the acknowledgement was or was not necessary to address risks to investors. Here, there were a number of factors suggesting that other mechanisms were in place to address those risks, including the following. The recent no-action letter left in place a number of protections from the ACLI letter. In addition, the letter relates only to 403(b) plans where the sponsor — who would determine that an existing annuity should be replaced or an automatic enrollment should be made — is an ERISA fiduciary. And any automatic enrollments would comply with the Pension Protection Act and implementing rules of the Department of Labor.
I view this letter as an example of a risk-based approach to the staff's administration of the Investment Company Act — in this case, the redeemability provisions — that seeks to remove unnecessary burdens where possible without compromising the protection of investors.
I know that the business of the insurance industry is risk and protection against risk, so there are probably few groups that are as focused on risk-based approaches as my current audience. And I know that you take very seriously the investment and longevity risks your customers face and how you can help them address those risks. Separate from offering protections from these risks, however, I believe it is important for you to think through and convey to your contract owners as clearly as possible the contract risks your customers face as well. Imbedded assumptions in new product designs about interest rates, market volatility, or the robustness of hedging operations need to be carefully examined. The failure of these assumptions, in my view, is neither good for the long-term success of your business nor for your customers.
Be proactive as you consider how best to inform your investors about contract risks. I make this statement in light of initiatives being undertaken by some insurers to address the risk exposure they face under previously offered benefits. For example, the staff has noted that several recent filings announced companies' decisions to stop accepting additional purchase payments on outstanding contracts. In most cases, the affected contracts were those with a living or death benefit that appears to have been too generous for the issuing insurer to maintain in a sustained environment of low interest rates and volatile equity markets.
These actions may have surprised some investors who had hoped to fund their retirement income over time through ongoing purchase payments, including established automatic purchase plans. Regardless of whether any or all of the companies had effectively reserved the right to suspend payments, one has to question the message this course of action sends to investors in these products generally. I fear the message might read something like this: "here is the deal we are offering you, unless we find out later that we miscalculated, in which case you may have to go elsewhere to build annuity value and possibly pay a surrender charge on your investment with us on your way out." This episode strikes me as a prime example, first, of the importance of risk-testing the design of product offerings and, second, of good marketing and sales practices that apprise investors of the risk protection that they are buying and the risk protection that they are not buying.
On a related note, several issuers of variable annuities, again generally those with generous living benefits, have recently made exchange offers for newer contracts that do not feature those benefits. Some insurers have also offered inducements, such as cash bonuses, to contract owners who surrender their contracts or terminate living benefit riders. These actions raise questions about the suitability of both the original transaction and the exchange, where the original transaction was perhaps premised on the value and importance of the living benefits and the exchange removes or reduces those same benefits.
A careful consideration of the risks associated with the design of any product could assist in avoiding the scenarios playing out now. Going forward, the Division urges you to keep in mind steps you may have to take in the future to limit your risk, think through how this affects your customers, and consider how you can make your customers aware of the risks they may face with the product you are selling them.
I would like to touch on one additional theme, and that is the importance of keeping a vigilant focus on your organization, with a view towards continuous improvement. In the Division, and throughout the Commission, we are striving to be a continuous improvement organization, looking for ways we can work smarter and work better. For example, as many of you know, at the Commission, we have undertaken an ambitious initiative to develop more robust cost-benefit analysis in Commission rulemaking. This includes a more integrated analysis of economic issues in Commission rule releases and earlier involvement of economists to analyze alternative policy options.
We are also equipping the Division with new expertise. We have acquired or are actively looking for business expertise in the areas of ETFs, derivatives, and financial analysis. In addition, we have established a new group focusing on risk and examinations. Resources permitting, we would like to add expertise on the business side of the insurance industry.
More broadly, the staff has begun an intensive inquiry into the work of the Division to better understand what our strengths and areas for improvement are and what opportunities are available to exploit those strengths and improve our operations. This inquiry, which we refer to as "Moving Ahead" — comprises five broad categories, namely, people, processes, technology, structure, and strategy. While the staff is currently in the early phase of this initiative, I am excited about its prospects and hope that I will have more to report to you in the future.
Likewise, I encourage your efforts at continuously improving how you do business and serve your customers. Ask yourself how you can move the ball forward in developing best practices in your sales efforts, compliance programs, contract owner servicing, and communications. There is a good deal of innovation in the variable products industry, and compliance practices and disclosures to investors require continuous review to ensure that they keep pace with that innovation. In an increasingly complex marketplace, this is an increasingly complex task. I am confident that you are up to that task.
I appreciate the opportunity to share my thoughts on the work of the Division and some areas for consideration by your organizations. The Division is committed to working smarter and working better in its mission of protecting the nation's investors. I hope that, within each of your organizations, you, too, will undertake efforts to enhance the ways in which you serve your investors. Thank you.
1 Morningstar, Variable Annuity Net Asset Flows (Second Quarter 2012), retrieved October 19, 2012, from MorningstarDirect database.
2 SEC, Office of Investor Education and Advocacy, Study Regarding Financial Literacy Among Investors (Aug. 2012).
3 Federal Research Division, Library of Congress, Financial Literacy Among Retail Investors in the United States (Dec. 30, 2011).
4 Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, Pub. L. No. 111-203, §911, 124 Stat. 1376, 1822-24 (2010).
5 U.S. Securities and Exchange Commission, Spotlight: Investor Advisory Committee, http://www.sec.gov/spotlight/investor-advisory-committee-2012.shtml.
6 ING Life Insurance and Annuity Company (pub. avail. Aug. 30, 2012).
7 American Council of Life Insurance (pub. avail. Nov. 28, 1988).