Interpretive Letter to Marilyn J. Sponzo, Jorden Burt
February 3, 2003
Marilyn A. Sponzo
406 Farmington Avenue
Farmington, CT 06032-1964
Re: Separate Sales Contests under NASD Rule 2820(g) for Group Variable Annuity Contracts and Employer-Sponsored Retirement Plans
Dear Ms. Sponzo:
I am responding to your letter dated October 28, 2002 to NASD wherein you request interpretive advice on behalf of your client Hartford Equity Sales Company, Inc. (“HESCO”) and Hartford Securities Distribution Company (“HSD”), which are both registered broker-dealers and affiliates of Hartford Life Insurance Company (“Hartford Life”), regarding the application of NASD Rule 2820(g)(4)(D) to sales incentive programs for associated persons of HESCO and HSD. HESCO and HSD serve as underwriters and distributors of variable life insurance products issued by Hartford Life and certain of its affiliates. HESCO engages in retail sales of proprietary mutual funds, variable annuities, and variable insurance products. HSD does not engage in retail sales.
NASD Rules 2820(g)(4)(D) (“Rule”) generally permits a non-cash sales contest sponsored by a member for its associated persons, or by a non-member company for associated persons of an affiliated member, provided that: (1) the contest is based on the total production of all variable contracts distributed by the member; (2) the contest requires that credit received for each variable contract is equally weighted; (3) no unaffiliated company participates in the organization of the contest; and (4) the recordkeeping requirements of Rule 2820(g)(3) are satisfied. In your letter, you ask whether group variable annuity contracts for employer-sponsored retirement plans (“group VAs”) can be characterized as a separate and discrete product for purposes of the total production and equal weighting requirements of the Rule.
You state that the applicability of the Rule to unregistered group VAs, which comprise a larger share of the employer-sponsored retirement plan market than registered group VAs, was codified in October 2001 with the adoption of NASD Rule 0116. You state that broker-dealers that sell unregistered group VAs and individual variable annuities (“individual VAs”) now must determine whether these products must be combined in the same incentive program. You believe, because group VAs and individual VAs differ significantly in their fundamental characteristics, that group VAs should be treated differently from individual VAs for purposes of the total production and equal weighting requirements, and need not be combined in the same incentive program.
In your letter, you offer the following reasons why group VAs should be subject to separate incentive programs from individual VAs:
You state that group VA contracts have a unique design. You state that group VA contracts serve a different purpose in the market place, have a different cost structure, typically have lower “front” commissions and higher “trail” commissions, target different audiences, and have different distribution strategies from individual VA contracts.
Purpose in Marketplace. According to your letter, group VA contracts are designed to be compatible with the basic operation of the types of retirement plans in the market in which they are issued. You describe a group VA contract to be typically structured as a master contract between the insurer and the plan. You state that participating employees are not actual parties to the group VA contract, and usually look to the plan itself as the source of their rights and benefits. You state that if participating employees have rights under the group VA contract, such rights are usually evidenced by the issuance of certificates. You further state that the inception and termination dates of the group VA contract are determined by the insurer and/or the plan, and have no relationship to the dates of an employee’s participation in the plan; rather employee participation in the group VA contract is determined in accordance with the terms of the retirement plan.
In contrast, you state that an individual VA contract is typically structured as a contract between the insurance company and the owner, who in most cases is the annuitant, and whose legal rights and obligations are set forth in the annuity contract. You state that the individual VA contract is effective upon issue.
Cost Structure. You state that because group VAs are used to fund retirement benefits for multi-participant retirement plans, plan sponsors frequently purchase administrative services in connection with the product, such as recordkeeping, valuation of participant accounts, and/or participant account statement preparation. You state that unlike an individual VA, the price of a group VA contract not only reflects the cost of insurance and other expenses, but the level of administrative services selected as well.
Commission Payouts. You state that group VAs typically pay lower “front” commissions and higher “trail” compensation than individual VAs, reflecting a difference in the distribution effort required for each product. You state that in the group VA market, one sale (to the plan sponsor) generates premium from (or for the accounts of) multiple participants and that the "one sale/multiple investor" paradigm arguably justifies a lower commission rate than the “one sale/one investor” paradigm of the individual VA.
Target Audience. You state that the target audience for a group VA includes employers that are corporations, governmental units, tax-exempt organizations and other entities that sponsor stock bonus, pension, profit-sharing, annuity or other deferred compensation plans. You state that this target audience has specific needs related to funding, benefit payment obligations and the general administration of the retirement plans that they sponsor. You further state that, in contrast, the target audience for an individual VA comprises individuals whose investment objectives include retirement income, and whose financial situation and needs are compatible with the purchase of an insurance securities product.
Distribution Strategies. You state that as a result of different target audiences, different distribution strategies are often used for group VAs and individual VAs. You further state that because funding options for retirement plans are subject to complex, highly technical requirements under the Internal Revenue Code of 1986, as amended (the "Code"), and the Employee Retirement Income Security Act of 1974, as amended ("ERISA"), registered representatives involved in the distribution of group VAs often develop specialized knowledge in these areas or rely on advanced sales support from an insurance company business unit that specializes in these areas. Conversely, registered representatives involved in the distribution of individual VAs may need background in the individual income and estate tax provisions of the Code, as well as the compatibility of VAs with, or preference for VAs over, other types of individual financial products.
In addition, in your letter you state that there is no reason to differentiate between registered and non-registered group VAs. You state that group VAs may either be registered or exempt from registration under the Securities Act of 1933. According to your letter, if the sponsoring plan is qualified under Code Sections 401(a), 401(k), 403(a), 404(a)(2), 414(d), or 457(b) and the contract otherwise meets the definition of an exempted security under the Securities Act of 1933, the contract is exempt from registration under the federal securities laws. You note, however, that the contract is still a security subject to the anti-fraud provisions of the federal securities laws and is also subject to the full panoply of investor protections contained in ERISA.
You state that the primary distinction between registered and unregistered group VAs lies in their tax treatment under the Code. You state that both types of group VA contracts, however, share the purpose, design, cost structure, commission structure, target audience and distribution strategy described above. You further state that because registered and unregistered group VAs are so similar, and because both differ substantially from individual VAs, you believe that group VAs, whether registered or unregistered, should be treated as a discrete product for purposes of the total production and equal weighting requirement of the Rule.
Based on the facts and representations set forth in your letter, the NASD staff believes that it is consistent with the purpose of Rule 2820(g)(4)(D) to permit separate non-cash compensation arrangements for group VA contracts and individual VA contracts.
In reaching its position, the staff notes that the primary purpose of Rule 2820(g)(4)(D) is to prevent firms from adopting policies that have inappropriate “point of sale” influences on registered representatives. It is for this reason that the Rule requires that non-cash compensation arrangements be based on concepts of total production and equal weighting by treating proprietary and non-proprietary products similarly for purposes of sales contest. There are instances, however, where the total production and equal weighting requirements of the Rule may apply separately to certain variable products depending on, among other things, the nature of the products and the target audience. For example, in Notice to Members 98-75, NASD determined that the total production and equal weighting requirements may apply separately to variable annuity and variable life products, and they do not need to be combined in the same incentive arrangement because of the substantial differences in design, purpose, cost structure, commission payouts, and target audience for variable annuity and variable life products.
It is the staff’s position, based on the facts and representations contained in your letter, that the group VA contracts differ significantly from individual VA contracts in their fundamental characteristics for purposes of application of Rule 2820(g)(4)(D). Therefore, the total production and equal weighting requirements of Rule 2820(g)(4)(D) may be determined separately for group VA contracts and individual VA contracts and the products need not be combined in the same sales contest.1 Members are still required to meet the recordkeeping requirements of Rule 2820(g)(3) with respect to any sales contest. In this regard, the member must maintain records of all compensation received by its associated persons from offerors, including the names of the offerors, the names of the associated persons, the amount of cash, the nature and, if known, the value of the non-cash compensation received.
I hope this letter responds to your inquiry. Please note that the opinions expressed herein are staff opinions only and have not been reviewed or endorsed by the Board of Governors of NASD. This letter responds only to the issues that you have raised based on the facts as you have described them, and does not address any other rule or interpretation of NASD, or all the possible regulatory and legal issues involved.
Kosha K. Dalal
Assistant General Counsel
Fred McDonald, Director - District 11
1 Note that group VA contracts for registered and unregistered products must be combined for purposes of Rule 2820(g)(4)(D).