finra

Rick Ketchum

Chairman and CEO, FINRA

Insured Retirement Institute Government & Regulatory Affairs Conference

 

April 29, 2010
Washington, DC

Listen Now/Download | 36 min. 51 sec.

 

Thanks very much, Lee [Covington], and it's great to be with you today. Your introduction was very kind, but when you really get down to it, you described two things of significance to this audience: one of which is I didn't seem to be very good at holding a job, and the other which is sadly, I'm one of your Baby Boomers that needs to think more about retirement at some point. But it is great to be back with you today. I want to tell you just how impressed I've been with respect to the efforts of both Lee and Cathy [Weatherford] in the last year.

 

It's clear this is an organization with a great deal of focus that both understands the importance of representing you as their members and also understands the incredible importance from the standpoint of educating investors in a time when that couldn't be more significant. As Lee indicated, and I won't repeat too much, a year ago I talked with you after just becoming CEO of FINRA and reflecting on a time that was truly extraordinary both for FINRA and for all of you working with investors and trying to manage firms. When you think back, it is indeed interesting to reflect on the things that have changed, and the things that have not.

 

A year ago, we faced an environment of a truly frozen investor public with deep concerns from the standpoint of investor confidence in an economy where it was absolutely not clear where it was going to go, at risk of double-dip recessions, and facing a reflection of two years where there were fundamental questions as to how the industry at large had served investors and, as well, how our economy was going to be put back together.

 

We sit on the other side in a different place, and of course the other piece of that was how your firms were going to be able to deal with an investing public that was fundamentally frozen and be able to control that impact on your business. I, and I think we, reflect some things that have changed in very, very positive ways. We obviously sit in a point of an improving economy—certainly still vastly uncertain with dramatic questions ranging from issues of European sovereign debt, to the short and medium term viability and strength of our municipalities and state governments, and the impact that can have on investing over that time period. And there are still legitimate concerns with respect to the impact of the Federal Reserve Board basically withdrawing from a level of support from the standpoint of the mortgage market and the impact, whether it be from inflation or the ability of the private sector, to step back in. No one suggests we're not in an uncertain time now, and no one suggests that doesn't if anything increase the importance and responsibility of the role that you play, but yet there are good things, as well.

 

We have had a year of rebound from unrealistic lows from the standpoint of the equity market. And, as I talked to many of you both here and around the country, a willingness of investors to be able to think again of alternatives, and a recognition by investors of the need to be able to respond to all that they've lost and perhaps some of the decisions that weren't terribly wise from their complete withdrawal from marketplace investments in the last year.

 

Some things haven't changed, of course. A year ago, we sat with an uncertain environment as to where financial legislation and financial reform was likely to go, and we talked a great deal about everything from regulating over-the-counter derivatives to whether there would be a fiduciary standard applied on a common basis across investment advisors and broker-dealers, to questions of systemic risk and the like. And now, we sit a year later and the honest answer a year ago continues to be the answer today, which is "Who knows?" The only difference is that the answer may be that somebody will know perhaps in a matter of weeks or at least a couple of months as opposed to the uncertain situation, and also some things we do know better. We do know that, that some of the profound proposals from the standpoint of change and financial reform are not likely to happen. We do know that the basic regulatory approach with respect to securities and the position of the SEC and thank heavens—with that position of FINRA are not really a matter of challenge with respect to where the legislation's going, but we do recognize that there remain, from that standpoint, uncertainties for your business, uncertainties for us, and challenges to make sure that whatever comes out of financial reform, we collectively from a regulatory standpoint and from a business standpoint need to be able to move forward and make it right.

 

We also recognize the obligations we both have to deal with in the new world. From FINRA's standpoint, we've tried to do a number of things in the last year to try to rethink our program. You'll see today an examination and enforcement program that is really in very many ways profoundly changed. We have a substantial focus from the standpoint of fraud detection with a new Fraud Detection Unit to ensure that where serious problems are identified with respect to an industry participant, it gets escalated quickly, it gets focused, and we move to enforcement action as quickly as possible, so that we're in a process of acting with regard to serious fraud before more investors are harmed as opposed to simply swinging in and sweeping up the bodies at the end. No one can assure that there won't be another Madoff or Stanford, and the rest, but we can clearly do everything we can to ensure that we are fundamentally focused on fraud detection.

 

The other piece which will be a matter of time in making, but I think you'll begin to see in the next year or two, is that we're looking to change our exam program in a very profound way to be far more risk-based and to be far more informed with respect to the different types of business models that exist out there. If there's one thing I found going around this country, it is that many things about the way FINRA operates and the way the District Offices operate, people feel pretty good about. But there is a continuing frustration in the fact—particularly for those of you with firms that aren't exactly the same as a large number of other firms—that there's not enough understanding about your business and that there doesn't seem to be enough reflection of where there is real risk from an exam standpoint and where's there's not. I think you'll begin to see changes.

 

Through our Coordinator Program, we want to have more continuing, ongoing conversations with what's happening to your firm, how things are changing, where you are throwing your efforts, both from the standpoint of your business model and otherwise. We want examiners who come in to understand what's happening in your firm and focus their exams as much as possible where there are real risks from an investor's standpoint. We also want to spend more time on firms that truly pose risks to investors and less time on firms that from their record pose far less risk. All these are things that require continuing communication with the SEC, too. We see a new group at the SEC that is truly open to rethinking how you develop an effective exam program, and hopefully what you'll see in the coming year or two is a FINRA exam program that continues to be more knowledgeable about really what makes your firm tick and more wise from the standpoint of where we choose to spend most of our time.

 

But it's not just us that have made significant changes. As I recall, it was exactly at this time last year that you announced your new name and a new mission, with a focus on research, education, and advocacy that seeks to advance the interests of consumers and investors. I'm pleased to see how much you've accomplished in a relatively short time. Your website is filled with useful, easy-to-understand information about the ins and outs of retirement planning. Through radio ads and videos on YouTube that tout the need for retirement planning and a "Retirement Financial Fitness Plan," IRI is also promoting public understanding and helping to remove the "fear factor" that can be prevalent when trying to plan for the future. Investor education is, of course, one of our top priorities at FINRA—and a key component of investor protection. In a world where financial products are growing ever more plentiful and complex, it is critical that investors receive unbiased information about their choices. They need to hear about both the disadvantages and the advantages of any particular product, and they should get a clear and complete picture of the costs.

 

At FINRA, we take a multi-faceted approach to investor education. We conduct in-person educational forums and investor workshops across the country. We offer a wide array of online resources and interactive tools—such as FINRA's BrokerCheck system and mutual fund expense analyzer—to help investors better understand our markets and compare investment products and professionals.

 

Through FINRA's Investor Education Foundation – the largest foundation in the United States devoted to financial literacy – we support innovative research and educational projects aimed at segments of the investing public that could benefit from additional resources. Among these is a report by researchers from the College of William & Mary entitled An Experimental Study of Annuity Choice that explores psychological aspects of the decision whether to buy an annuity or to invest retirement savings in the stock market.

 

And while investor education is critical, the ongoing education of financial industry professionals is equally important. We would much rather arm brokers with education about our rules and regulations than impose an enforcement action after investors have been harmed. In that regard, we offer a number of educational programs for compliance folks and frontline staff. We're delighted that IRI is featuring our compliance podcasts on its Web site to help its members stay current on important regulatory information, news and other topics.

 

Today I'd like to touch on a number of topics that affect your industry and the investors in your products. This will include the annuities landscape, regulatory activity related to annuities and the broader financial industry, including the questions of where we're going from the standpoint of regulatory reform.

 

The Annuities Landscape
The United States is on the cusp of an era in which the work of anyone involved with annuities, insured retirement products and retirement planning will play an increasingly important role in the nation's economic security. The Administration on Aging, a federal agency, reports that while people 65 and older represented more than 12.4 percent of the U.S. population in the year 2000, they are expected to account for over 19 percent of the population by 2030. And as you surely recognize, this aging of the population will foster heightened interest in, and demand for, a wide range of retirement-related products.

 

Annuities occupy an important place on the retirement planning landscape. They have a long history that dates back to the Roman Era, at which time individuals could make a one-time payment to a contract known as an annua and in return they would receive income payments once a year for the rest of their lives. Today, annuities come in many different shapes and sizes, and the industry is experiencing strong growth, with sales increasing from $164 billion in 1999 to $264 billion in 2008.

 

Variable annuities in particular may be poised for strong growth in the years ahead, both because of the nation's demographic profile but also because of the guarantees provided by many of these contracts. Those guarantees will look even more appealing in the aftermath of the market volatility of the past few years – a period that has seen a steep plunge in the retirement savings of millions of Americans. Making matters worse is that significant numbers of people who have self-directed retirement accounts have been forced to tap into their retirement savings. A FINRA survey of 1,500 Americans last year found nearly 9 percent of respondents had taken out a loan from their retirement accounts during the previous 12 months, and almost 5 percent have taken a permanent hardship withdrawal. These depletions are most prevalent among those earning between $25,000 and $75,000 a year.

 

The survey also revealed that large numbers of Americans are not doing any retirement planning. Just 42 percent of respondents said they had attempted to calculate how much they would need to save for retirement. And it was those with the lowest incomes who were the least likely to do any planning. This is a discouraging finding at a time when the shift from defined benefit plans to defined contribution plans has transferred the burden of providing an income stream in retirement from employers to individuals. Not only must individuals take greater charge of their financial wellbeing once they retire, but they must also forecast future financial needs, navigate increasingly complex financial markets and manage risk, both during and after their working years.

 

The erosion of retirement savings will be one of the most painful legacies of the financial crisis – and it underscores the importance of the work being done by IRI, FINRA, and other entities to promote investor education and retirement planning.

 

Annuities can continue to play a valuable role in helping certain people meet their retirement needs. And to that end, I am pleased to see that one of the priorities of the Obama Administration's middle class task force is promoting annuities as one option to help people reach a secure retirement. As part of this effort, the Treasury and the Department of Labor are seeking public comment on what they can do to improve retirement security for workers who participate in employer-sponsored retirement plans through annuities.

 

Regulatory Response
Heightened interest in annuities from consumers and the Administration will be accompanied by continued scrutiny from regulators. It has to be that way if indeed those products continue to earn and gain the confidence that they truly should have. As you know, FINRA has always closely monitored variable annuity sales practices, and a particular concern is the inappropriate sale of these products to seniors. It is extremely disturbing – and unacceptable – that many abusive sales concerning seniors involve variable or indexed annuities.

 

In 1999, having become increasingly concerned about industry practices in selling variable annuities, we published best practice guidelines covering disclosure, suitability, account opening and sales practice issues. But it became clear that while some firms embraced the best practice guidelines, many did not, and our exams have raised more and more red flags.

 

As a result, we turned to rulemaking. Today, a cornerstone of our regulation of variable annuities is FINRA Rule 2330, formerly NASD Rule 2821, which governs variable annuity sales practices. Parts of the rule – those dealing with recommendations and training – took effect in May 2008. The rule's remaining provisions – concerning principal review and supervision – took effect in February of this year.

 

The staggered implementation of the rule reflects our determination to listen to legitimate concerns. We listened closely to industry views about the mechanics of the rule to make sure it did not impose any burdens that are not necessary for investor protection.

 

Our careful analysis led us to modify the rule in various respects. For example, we:

  • Limited the rule's application to recommended transactions;
  • Revised the time period for registered principal approval; and
  • Allowed firms to send customer checks to insurance company suspense accounts before principal's approval of the customer's application.

Although this rule took some time to complete, the final product resulted in a workable approach that strengthens our protection of investors in variable annuities.

 

With the rule having been in effect, at least partially, since mid-2008, we now have some experience with the types of problems we are seeing at firms. For example, we have uncovered inadequate compliance policies and procedures. We also have found that some firms failed to obtain customer information, such as information about customers' liquidity needs and tolerance for risk.

 

Unfortunately, we have also encountered unsuitable recommendations to purchase or exchange variable annuities, although failures to document a suitability analysis were a more frequent finding than actual unsuitable recommendations. Other problems have included inadequate training and supervision, and failures to document transaction approvals. I hope that firms will learn from the experience of others and focus their compliance efforts in these areas.

 

Of course, we continue to expect firms to rigorously supervise the purchase or exchange of any variable annuity.

 

In particular, a skeptical eye should fall on any proposed replacement of a variable annuity with a guarantee that provides a higher payout than the cash value of the subaccount. Investors stand to lose this benefit if they replace the product with another annuity contract. The principal must know the value of the guarantee and whether it is "in the money," and must evaluate the comparative guarantees of each product to ensure the replacement is suitable for the customer.

 

Over the years, variable products obviously have become dramatically more complex, making it more difficult for investors to understand matters such as guarantees, riders and their associated fees. This is a subject that was on my mind when I spoke to you last year, and it continues to deserve your closest attention.

 

Before selling a variable annuity, your account executive should carefully review the product in detail with the customer, and have a reasonable basis to believe the customer understands the product's features—including risks and costs—and suitability. This conversation is part of every rep's responsibility to each customer.

 

Let me give you an example of why this is so important. When the economic downturn caused many to withdraw cash from their variable contracts, many consumers were caught unaware and lost their contract guarantees because of declines in their account balances. Even owners of contracts with a "no-lapse" provision can lose their guaranteed withdrawal benefits if they make excess withdrawals. This is precisely the type of issue that should be the subject of a meaningful conversation between the rep and the customer and precisely the reason from a best practice standpoint to go beyond what the regulatory requirements are to push your salespersons and your account executives to be regularly talking with their customers, regularly reviewing their position to ensure when they make decisions like this that they have the benefit of your advice and a true understanding of the contracts that they own.

 

Financial Services Reform
While maintaining our focus on enforcement, the volatility of the last few years has led all of us involved in regulating the financial markets to take a hard look at our programs and approaches, and search for better ways to uncover misconduct and protect investors.

 

One of the lessons we've learned is a simple one – investors are harmed when there are gaps in our regulatory system. All of us, from the Congress and the Administration on down, are grappling with how to eliminate these gaps while at the same time allowing for innovation and growth that meets investor needs, and avoiding inefficient regulatory overlaps. This means that we must address the vulnerabilities in our financial system and restore investor confidence. We must create an architecture in which regulations can adapt to changing circumstances in the financial sector.

 

We must identify a set of common investor-protection principles that will eliminate, or at least substantially reduce, the unequal consumer protections across product lines.

 

I won't spend much time talking about the state of the financial reform legislation at the present time, partially because who knows what it's going to look like in two or three weeks, partially because you all spend even more time on this during the day, but something seems clear. It is clear that whatever comes out of this that there will be a focus on a common standard from the standpoint of broker-dealers of all sorts and investment advisors over the foregoing future. We don't know whether that will involve something that provides the SEC actual rulemaking authority at the beginning as the House Bill does—or whether the Senate Bill as it exists will result in the final legislation to push the SEC to have a study with respect to this area. I think as all of you know, FINRA may be a bit more aggressive on our perception with respect to fiduciary duty than you are, but also I think quite nuanced and careful on how we look at the issue.

 

We do truly believe on the other side of the experience of the last decade that an environment in which there is a clear and simple requirement that conflicts—that may in one way or the other influence the recommendation being provided to the customer—are carefully disclosed up front, in plain English, in a clear way, at the time that the investor is involved in making investment decisions. And, secondly, that anyone operating in the financial industry certainly from the standpoint of selling securities or providing advice, whether they be investment advisors or operating out of their broker-dealer hat, should be able to reach the conclusion with respect to the products that they offer and with respect to the particular customer that they are dealing with; that the recommendation they are providing is in the best interest of that customer and; that she, given all her expectations, financial position and sophistication, both understands and is making a decision that is in her best interest; and the firm carefully documents that.

 

That does not mean, let me hasten to say, that when we look at fiduciary issues, we don't recognize that it is critical that any standard of it is first fashioned by the expert agency that truly understands the range of models that exists in the brokerage industry, and, secondly, that any standards shouldn't reflect and be business model neutral. I believe that the diversity of offerings that exists in the securities markets has been fundamental to both providing investors choice and with that fundamental to creating a wide variety of important investor alternatives out there today. That doesn't mean a fiduciary standard can't work, and everything I see from the standpoint of legal analysis with respect to that suggests it can, all the way down to firms that may offer a very limited number of products. As long as the offerings are carefully disclosed, the alternatives that exist in the marketplace are understood by the investor, and the conclusion is made that the recommendation is in the best interest of customers. None of that is simple, uncomplex, or suggests it should be solved in a single wave of a wand by folks in the Congressional sector. It does suggest, therefore, that either of the bills in their present state, whether it be the House or Senate Bill, have it right, and that the right entity to make those careful analyses should be the SEC. And it should allow them to carefully review the entire issue, not operate from the standpoint of political exigencies or emotion, but a clear design to create a better standard for investors that is also business model neutral. I don't know what will come out of it, but it does appear that the type of environment where the SEC will be able to step back and take a careful look will come out of it, and I think that's a good thing.

 

But what about all of us collectively now that we stand at the cusp of financial reform that is not going to fundamentally follow that issue? How do we look ahead and begin a debate and analysis of what the right protections are for investors and what are the right steps to ensure that investors are properly disclosed? That should not be a process that either is going to be fully addressed by financial reform or can be addressed just by looking at whatever standard the SEC comes out with. First, we ought to begin a debate, particularly those of you that truly have the unique opportunity to be regulated by virtually every entity that regulates in this nation, with respect to the issues beyond securities regulation and where that goes in the coming days. You know, you've heard me say it before, but I'll say it again, I think truly we ought to begin a debate beyond just securities about the disparate regulatory environments that exist with respect to the sale of financial products.

 

I do believe that we ought to have a common set of investor protection principles that will eliminate or at least substantially reduce the unequal consumer protections across product lines. It seems to me that a minimum standard—at least across securities, insurance products, banking products, futures and the like—should ensure that every financial service and product results in every person who provides financial advice and sells financial product should be tested, qualified, and licensed. Every such person should be subject to a balanced, business-model neutral fiduciary duty, and regular and rigorous examinations by a regulatory authority. All advertising for financial products and services should be fair, balanced and not misleading. Every financial product and service should be appropriate for the investor to whom it's recommended and every customer should receive timely disclosure for the product and services being recommended. This disclosure should address in plain English the risk, disadvantages and other features of the product or services.

 

I think those are the principles where we ought to get, but it doesn't change the fact that with respect to the securities markets, that we have a special responsibility to ensure their integrity. The question is what do we do as this debate continues on, and so let's talk about how those principles affect your industry. I spoke earlier about the importance of having a meaningful conversation with customers. This conversation is essential for reps to fulfill their responsibility to the customer. Equally important is the responsibility to provide disclosure that is clear and in plain English. I understand that crafting clear disclosure about complicated products can be a challenge. But a failure to do so puts your customers at risk, and puts your reputations at risk.

 

FINRA continues to support simplified, plain English disclosure that would inform customers about the features of the products and services they are being offered. Recent speeches by Chairman Schapiro make clear that the SEC is committed to moving the ball forward. She announced that her staff is developing simplified disclosure for variable products, similar to the Summary Prospectus for mutual funds. This will be a great boon for variable annuity owners. IRI is really to be commended for their efforts to assist the SEC as this project moves forward.

 

Chairman Schapiro has also affirmed that point of sale disclosure remains high on the SEC's agenda. It is on FINRA's as well. To me the issue is crystal clear: retail investors should have simple, meaningful disclosure at the time they are making an investment decision not buried in an account executive doc, not buried alone in an account executive document that is turgid, difficult to understand, and, frankly, is not referred back to at the time investors really need the information. Disclosure that includes easy- to-understand information that allows simple comparison among products. Equally important is information about the compensation and conflicts of the person making a recommendation.

 

In 2005, we developed a model document, called the "Profile Plus," which could serve as the prototype for point of sale disclosure. While the Profile Plus concerned mutual fund disclosure, we believe it also could serve as the model for simplified, point of sale disclosure about variable annuities. The Profile Plus would require disclosure of the costs of investing and the conflicts presented by the way that the dealer is paid, as well as the product being offered – including its investment strategies, risks and performance history. We also offer Internet delivery of the Profile Plus, which has the advantage that the Profile may be hyperlinked to other fund documents, such as the prospectus and the statement of additional information. This enables customers to determine the amount of information they want to review.

 

We've tested the Profile Plus with consumers, and found that they would strongly prefer receiving this type of plain English disclosure online. All of us now sort of live this. We recognize you give us a large account executive document or a brochure from an investment advisor side, we'll stare at it, we'll flip through it, we won't absorb anything. Yet, we and certainly our kids are fundamentally built to respond to simple and short disclosure that calls to attention the risks involved in products and the choices available. And at the same time allows the reader to be able to drill down to get information where she wants it as opposed to where your lawyers think it's important.

 

That's how people work and think today, and that is something whoever is involved in it really has to look at to try to move our disclosure way ahead into a new world and a new era.

 

Harmonization of standards is of course an issue for the annuity industry. The level of protection that a customer receives will vary greatly depending on whether the product purchased is a variable, fixed, or indexed annuity. FINRA is committed to working with other regulators, particularly at the state level, to ensure consistent investor protection.

 

FINRA has worked with the National Association of Insurance Commissioners to achieve more consistent regulation among annuity products. Of particular significance has been our work on the NAIC's model regulation on annuity suitability. We will continue to coordinate with other regulators to ensure that we achieve consistent and vigorous investor protection.

 

For our part, FINRA will continue to take a close look at how we can best protect customers of broker-dealers with multiple lines of business. These customers deserve a consistent level of protection regardless of the type of service they receive from the broker-dealer. For example, we have issued a proposal to ensure that broker-dealers meet their supervisory responsibilities with respect to all their lines of business. We know that many of you have strong views with respect to it, and we are carefully taking those views into context as we take a look at what the proposal should look like on the other side.

 

However, our recent experience with the financial crisis has confirmed that FINRA and other regulators must do everything we can – within our jurisdictional limits – to ensure that customers are protected no matter what financial product or service they receive. We're not going to be in the business of enforcing insurance laws, but we have to be careful to ensure that where there are red flags, we don't stop until we're sure that some regulator is focused and addressing it. We intend to explore various ways in which FINRA, alone and in cooperation with other regulators, can achieve this level of consistent investor protection.

 

In closing, I am confident that IRI will continue to serve as a positive force in the markets. You are a good partner, we look forward to working with you closely to achieve consistent investor protection and to promote the vitality and integrity of America's financial system. Thank you very much.