______________________________
Stephen E. Roth, Esq.
Partner
Sutherland Asbill & Brennan LLP
1275 Pennsylvania Avenue, N.W.
II. THE 1996AMENDMENTS:INCREASED PRICING FLEXIBILITY . . . 1
A. The 1996 Amendments to the 1940 Act . . . 1
B. The “reasonableness” requirement of Section 26(e) . . . 2
C. Comparison of variable contract charges before and after the 1996 Amendments . . . 2
D. The SEC’s “latent” jurisdiction over insurance charges . . . 4
E. Effects of the 1996 Amendments . . . 5
F. The “reasonableness” representation . . . 5
G. Insurance company directors’ responsibility for “reasonableness” . . . 7
H. Underlying fund fees and expenses and Section 26(e) . . . 7
III. VARIABLE PRODUCT INNOVATION. . . 9
A. Variable annuities: guaranteed “living benefits” . . . 9
B. Variable annuities: enhanced guaranteed minimum death benefit . . . 16
C. Emerging variable product charge structures . . . 17
IV. INSURER-SPONSORED MUTUAL FUND INNOVATIONS . . . 21
A. Background . . . 21
B. Group term insurance linked to mutual fund investment . . . 21
C. Dow 10 funds . . . 22
V. APPLICATION OF THE PLAIN ENGLISH RULES TO VARIABLE PRODUCTS. . . 24
A. Introduction . . . 24
B. Effective dates . . . 24
C. Brief summary of substantive “plain English” requirements . . . 25
D. Special issues for variable products . . . 26
VI. SIMPLIFIED MUTUAL FUND PROSPECTUS. . . 29
A. Introduction . . . 29
B. Impact of 1998 innovations on underlying fund prospectuses . . . 30
C. Special issues for underlying funds . . . 32
VII. FUND PROFILES . . . 33
A. Introduction and overview . . . 33
B. Underlying fund profiles . . . 35
C. Insurance industry concerns with using underlying fund profiles . . . 35
VIII. FORM N-4 AND THE VARIABLE ANNUITY PROFILE. . . 36
A. Introduction . . . 36
B. Current status . . . 36
C. Recent SEC developments . . . 38
D. Insurance industry concerns with recent SEC disclosure innovations . . . 40
IX. ADMINISTRATION AND CONGRESSIONAL TAX PROPOSALS AFFECTING VARIABLE CONTRACTS41 A. Background . . . 41
B. Administration budget proposals . . . 43
C. Current benefits legislation . . . 45
The author expresses his appreciation to his colleague, Mary Jane Wilson-Bilik, Esq., for her assistance in preparing
*
this outline.
Stephen E. Roth, Esq.* Partner
Sutherland Asbill & Brennan LLP Washington, D.C.
I. INTRODUCTION
Recent statutory changes have given new pricing flexibility to insurance companies issuing variable contracts. Pricing flexibility, in turn, is spurring significant product innovation. At the same time, the Securities and Exchange Commission (“SEC”) is requiring insurance companies to “simplify” their variable product prospectuses and put them into “plain English.”
This outline briefly discusses the recently-enacted “reasonableness” standard governing fees and charges under variable contracts, and identifies issues this standard presents for underlying funds and insurance company boards of directors. It then provides an outline of innovative variable product features, and discusses the SEC regulatory issues these features can raise.
The outline also discusses the SEC’s new “plain English,” simplified prospectus, and profile initiatives, focusing on the unique issues these initiatives pose for variable products and underlying funds. The outline closes by discussing certain tax proposals being proposed by the administration and Congress that could have an impact on variable insurance products.
II. THE 1996AMENDMENTS:INCREASED PRICING FLEXIBILITY
A. The 1996 Amendments to the 1940 Act. In 1996, Congress enacted the Investment Company Act Amendments of 1996 (the “1996 Amendments”) as Title II of the National Securities Markets Improvement Act of 1996. Until the 1996 Amendments1/ were passed, the Investment Company Act of 1940 (the “1940 Act”) and regulations thereunder placed strict limits on the charges that could be deducted under variable contracts. These limits were derived from 1940 Act limitations on charges deducted in connection with mutual fund contractual plans, with the nature of the limitation
depending on the types of expenses the charge was designed to cover. Faced with these pricing constraints, issuers of both variable annuity and variable life insurance contracts looked to mortality and expense risk charges and advisory fees as sources of profit on their variable contracts.
The 1996 Amendments amended the 1940 Act by adding new Section 26(e), thus fundamentally changing the SEC’s approach to regulating variable contract charges. By eliminating the regulatory “straight-jacket” that for years constrained the design of variable contracts, the 1996 Amendments have permitted insurers to introduce new product features and designs and to charge consumers prices that are competitive with the fixed market.
Pricing is now subject only to the constraint of new Section 26(e) of the 1940 Act and its requirement that total fees and charges under the variable insurance contract be “reasonable.”
B. The “reasonableness” requirement of Section 26(e). Section 26(e) of the 1940 Act requires variable contract charges to be “reasonable.” More specifically, it2/ requires that aggregate fees and charges under a contract be reasonable in relation to:
C the services rendered by the insurance company,
C the expenses the insurer expects to incurred, and
C the risks the insurance company assumes in sponsoring the contract. The 1996 Amendments make it unlawful for a registered separate account funding variable insurance contracts, or for any sponsoring insurance company of such account, to sell a variable insurance contract unless the fees and charges deducted are
reasonable. The sponsoring insurance company is required to represent in the variable insurance contract registration statement that the charges deducted meet the
reasonableness standard.
The 26(e) standard gives insurers the flexibility to price their variable contracts more rationally. Insurers can design variable contracts with innovative product features and price those contracts competitively.
C. Comparison of variable contract charges before and after the 1996
Amendments. The following table demonstrates the impact the 1996 Amendments have had on the regulation of variable product charges.
Charge Before 1996 Amendments After 1996 Amendments Administrative Charges No numerical limits. But SEC staff No direct limit. But
interpreted Section 26(a) of the 1940 administrative charges are a Act to require administrative charges tocomponent of aggregate be “at cost.” charges that must be
“reasonable.”
Cost of Insurance Any portion of the amount deducted as No restrictions apply. May be “cost of insurance” that exceeded cost an asset-based charge. But of insurance rates based upon the 1980 these charges are a component CSO tables generally was deemed to of aggregate charges that must be “sales load” and was subject to the be “reasonable.”
SEC’s limitations on sales loads, with several exceptions.
Mortality and Expense Subject to a “reasonableness” standard No direct limit . Exemptive Risk and Other and SEC staff limits of 1.25% for relief not required. But Insurance-Related variable annuity and 0.90% for variableinsurance charges are a Charges life contracts. Variable annuity3/ component of aggregate
issuers were required to obtain an SEC charges that must be exemptive order before mortality and “reasonable.” expense risk charges could be
deducted.
Variable Annuity Sales Section 27(a) of the 1940 Act limited No longer subject to the 9.0% Load sales loads to 9.0% of premiums to be limitation of the 1940 Act.
paid in under a variable annuity Variable annuity sales charges
contract. remain subject to NASD Rule
2820, which limits variable annuity sales loads to 8.5% of premiums paid under the contract, although the NASD has proposed a rule
amendment that would eliminate any limits on sales load. Sales loads are a4/ component of aggregate charges that must be “reasonable.”
Charge Before 1996 Amendments After 1996 Amendments Variable Life Rule 6e-3(T) imposed the following No longer subject to the Rule
Sales Load limits: 6e-3(T) limits. Instead, sales
- If the owner surrendered within 24 loads are subject to the
months of purchase, the insurer must reasonableness requirement for refund any amount of sales load that aggregate charges.
exceeded 30% of premiums up to the
first “guideline annual premium,” 10% No need to obtain relief for of premiums up to the second “DAC tax” charges or from the “guideline annual premium,” and 9% of“stairstep” provisions of Rule any additional premiums. 6e-3(T).
- No more than 50% of any premium could be deducted as sales load, in contrast to much higher first year commissions under fixed life insurance products
- No sales loads that averaged more than 9% of premiums equal to the sum of 20 “guideline annual premiums” - A “non-increase” requirement generally prohibited any sales load deduction from being proportionately higher than any prior sales load deduction from that contract.
- Restrictions applicable to sales loads on increases in face amounts were complex and expensive to administer. - An SEC free-look right and
cancellation notice was required if the sales load on any premium exceeded 9%.
D. The SEC’s “latent” jurisdiction over insurance charges. The 1996 Amendments gave the SEC the authority to adopt future rules imposing specific limits on all charges deducted under variable insurance contracts, including insurance charges. The SEC5/ staff has stated that it will adopt pricing rules only if it finds evidence of abusive pricing practices. The new SEC rule-making authority is the quid pro quo the insurance
jurisdiction over “insurance” charges, such as risk charges, that the industry had in the past maintained were beyond the SEC’s purview.
E. Effects of the 1996 Amendments
1. On product design. Both variable annuity and variable life issuers have been taking advantage of the pricing flexibility to introduce new product features. Insurers can now charge customers what these product features are
“reasonably” worth, without being subject to arbitrary price limitations. Sales loads, administrative charges, mortality and expense risk and other insurance-related charges can now reflect the amount and timing of the corresponding expenses and mirror the charge structure found in fixed products.
For example, variable life sales loads can be deducted as a prescribed dollar amount per $1,000 of face amount of insurance, instead of as a percentage of premiums actually paid into the contract, permitting insurers to support distribution systems for their variable life contracts similar to their fixed
contracts. There are also numerous possibilities for combining and simplifying variable life charges.
2. Regulatory effects. The 1996 Amendments have changed the SEC’s
approach to regulating variable insurance products, allowing the staff to focus more on disclosure and to de-emphasize pricing design issues. With the
passage of the 1996 Amendments and the elimination of the need for exemptive relief to charge mortality and expense risk charges, the SEC staff has been able to develop the long-awaited Form N-6 for registering variable life insurance policies and has devoted considerable effort to applying the SEC’s plain English initiative to variable products.
F. The “reasonableness” representation. While insurers may price new product features without being constrained by the pre-1996 limits, they remain constrained by Section 26(e) of the 1940 Act. It is unlawful for a registered separate account or the sponsoring insurance company to sell a variable insurance contract unless the aggregate fees and charges under a particular contract are “reasonable” in relation to the services the insurance company renders, expenses the company expects to incur and the risks the company assumes. And the sponsoring insurance company must be prepared to6/ represent in the product’s registration statement that the charges deducted meet the reasonableness standard.
1. How to make the “reasonableness” representation. Section 26(e) requires the reasonableness representation to be included in the product’s registration statement; the representation is not required to be included in the product’s prospectus. Rather the SEC Staff has indicated that the7/
reasonableness representation should be placed with the undertakings required by the applicable registration statement. Although the sponsoring insurance8/ company avoids prospectus liability per se by this approach, significant liability may result if the requirement for reasonable fees and charges is not met.
2. Renewing the “reasonableness” representation. There is some question as to whether the reasonableness representation must be “renewed” each time a post-effective amendment is filed, effectively imposing an obligation on an insurance company to monitor the profitability of outstanding contracts to ensure that fees and charges continue to be reasonable, or to modify fees and charges, if necessary.
Section 26(e)(2)(A) of the 1940 Act requires only that the insurer represent in the registration statement for the contract that charges are reasonable. On its face, this language would not seem to require the representation to be made in subsequent post-effective amendments. Additional language in Section 26(e)(2)(A) that requires insurers to represent that charges are reasonable in relation to expenses expected to be incurred supports this interpretation. On the other hand, the statute provides that the representation must be made “beginning on the earlier of August 1, 1997, or the earliest effective date of any registration statement or amendment thereto for such contract” following the statute’s effective date; the use of the term “amendment” could, however, be intended only to require the reasonableness representation be made in the first post-effective amendment made with respect to a registration statement that was effective when the statute was passed, not each subsequent post-effective amendment. This issue is important because contracts generally become more profitable later in the product cycle, and some products may become more profitable than expected.
3. Comparison with Section 36(b). Section 26(e), unlike Section 36(b), does not impose a fiduciary duty with respect to the receipt of compensation. However, the “reasonableness” standard may impose a somewhat more rigorous standard than the judicial interpretations of Section 36(b) -- that investment advisory fees not be so disproportionately large that they bear no reasonable relationship to services provided, and could not have been the
product of arms-length bargaining. The SEC staff has suggested that the reasonableness standard is closer to the balancing of interests test by which mutual fund sales charges must be judged under Section 22(b) of the 1940 Act. 9/
G. Insurance company directors’ responsibility for “reasonableness”
1. Director liability. Section 11 of the Securities Act of 1933 (the “1933 Act”) makes the directors of an issuer responsible for the content of a10/ registration statement. Section 11 allows any person buying the security to bring a private right of action against every person signing the registration statement, including any director of the issuer at the time of the filing, if the registration statement contains any material misstatement or omission.
Directors of a company issuing variable contracts may be held personally liable under Section 11 of the 1933 Act for any material misstatements or omissions in a registration statement, including any misstatement with regard to the “reasonableness representation” required by Section 26(e).
2. Director due diligence. Directors can avoid liability under Section 11 only if they can show they conducted appropriate “due diligence” to determine that the registration statement contained no material misstatements or omissions. The level of diligence required to meet the “due diligence” standard depends on a number of factors, such as whether the statement is “expertised.”
Insurance companies sponsoring variable contracts may wish to provide their directors with information that will assist directors in their due diligence
investigation with regard to the reasonableness of a contract’s fees and charges. They might also provide directors with the opportunity to ask questions
regarding registration statements or post-effective amendments that contain the reasonableness representation.
H. Underlying fund fees and expenses and Section 26(e). Section 26(e)(3) states that the “fees and charges deducted under the contract” include “all fees and charges imposed for any purpose and in any manner.” The determination must be made by the sponsoring insurance company -- not the underlying fund(s). However, the breadth of the reasonableness standard raises the issue whether, in determining reasonableness, the sponsoring insurance company must analyze underlying fund fees and charges together with the other fees and charges deducted under a variable contract.
1. How should an insurer assess the reasonableness of underlying fund fees and charges?
a. Affiliated funds. If the underlying funds are affiliates of the insurance company, the insurer may take investment advisory fees into account when projecting its return on investment for a contract, and therefore it makes some sense to include investment advisory fees in aggregate contract charges. However, under an adviser-subadviser structure, when the subadviser is not affiliated with either the adviser or the insurer, the subadvisory fee does not inure to the benefit of the insurer and should therefore, at least arguably, be excluded from aggregate contract charges. Expense caps and reimbursement arrangements would seem to represent lost revenue for the insurer.
b. Unaffiliated funds. When there are unaffiliated funds, and no fees are paid to the insurer by the fund or its adviser or other fund affiliate, insurers could arguably rely upon the determination of the fund’s board, pursuant to Sections 15 and 36(b) of the 1940 Act, regarding the
appropriateness of fund fees and expenses.
2. When are 12b-1 fees and revenue sharing included in the “reasonable” determination? Special considerations may be called into play when the underlying fund or an affiliate pays fees to the insurer.
a. 12b-1 fees and the reasonableness requirement. If an insurer selects a fund with a 12b-1 fee that the fund pays to the insurer or its affiliated broker-dealer for administrative or distribution services, the insurer would arguably be receiving that fee under the contract and therefore arguably should take that fee into account in making the reasonableness determination with respect to that contract.
b. Revenue sharing arrangements. To the extent an insurer receives payments from the underlying fund’s investment adviser or other fund affiliate for the performance of administrative or other services, the insurer is receiving a revenue stream that it likely took into account in pricing the contract and therefore that revenue arguably should be taken into account in determining the reasonableness of aggregate contract charges.
3. What comfort might insurers seek from underlying funds? If insurers must take underlying fund fees and charges into account, insurers face a dilemma to the extent they are not involved in setting or reviewing those fees and charges. Therefore, some insurers have considered mechanisms for performing “due diligence” in this context. Possible mechanisms include: a. Participation agreements. Participation agreements could be used
to address insurers’ concerns regarding underlying fund fees and expenses in the context of overall reasonableness. The fund board could represent that it has satisfied its obligations under Sections 15(c) and 36(b) in approving the advisory agreements, or insurers could take some comfort from a representation in the participation agreement that the underlying fund issued its shares in compliance with the federal securities laws.
b. Direct due diligence. The insurer could conduct some level of due diligence on underlying fund fees and expenses, including a review of board minutes and supporting materials and obtaining information on comparable funds.
c. Opinion of counsel. Insurers could seek some form of comfort from fund counsel and/or counsel to the fund’s independent directors regarding fund fees and charges. For example, comfort could be sought as to the reasonableness of the fund’s fees and charges in relation to the services rendered and the expenses expected or on
whether the fees and charges are “within the range of industry practice.”
III. VARIABLE PRODUCT INNOVATION
Insurers are using the increased flexibility offered by the 1996 Amendments to introduce new contract features. These new features are designed to compete with financial products offered by other financial institutions, such as mutual funds and other life insurance products.
A. Variable annuities: guaranteed “living benefits”. Guaranteed living benefits (GLBs) are a recent innovation that offer living protection against investment risks under variable annuity contracts. GLBs offer protection against a portion of the investment risk owners assume by guaranteeing a minimum level of benefits, provided specific conditions are met.
1. Types of GLBs: GLBs can be divided into three types:
a. Guaranteed Minimum Accumulation Benefits (GMAB). The insurer provides a guaranteed minimum account value if the contract remains in force for a specified period of time.
For example, one company provides a guarantee, at no cost, that ten years after the issue date, the value in each subaccount will equal the initial premium, adjusted proportionately for any transfers and withdrawals. The benefit is forfeited if the contract is in the annuity phase on the tenth contract anniversary. The benefit is credited on a subaccount-by-subaccount basis.
In another example, an insurer offers a single premium variable annuity contract with a principal protection option (PPO). The PPO is
available only if the entire single premium is allocated to designated underlying funds. The PPO offers a guarantee on either 115%, 100% or 90% of the single premium at the end of the eight year term. The charge for the guarantee varies with the level of the guarantee, up to 2.00% annually. If the owner surrenders or partially withdraws from the contract before the end of the eight contract year, a cancellation fee is assessed at a rate of 4.00% of premium, declining to 0% at the end of 8 contract years. This fee is in addition to a 9-year contingent deferred sales load. If the guarantee is invoked, general account funds will be used to increase contract value held in the subaccounts up to the guaranteed amounts and, unless notified otherwise, the company will transfer the entire contract value to the money market account on the guarantee’s expiration date. After the guarantee expires, the owner can choose to remain in the contract, purchase a new guarantee, surrender, or annuitize.
b. Guaranteed Minimum Income Benefit (GMIB). The insurer provides a guaranteed minimum income payment determined by applying a defined guaranteed account value to certain explicit fixed annuity options after the specified waiting period has elapsed. The guarantee is triggered only if the contract is annuitized and specific annuity options are chosen.
One company provides a GMIB that permits contract owners to
annuitize with fixed payouts based on the greater of: (a) contract value and (b) a guaranteed payout base -- purchase payments accumulated with interest (generally at 6% annually), less withdrawals and
withdrawal charges. To invoke the GMIB feature, a life annuity with a period-certain must be purchased, which uses “conservative” actuarial assumptions. The request for annuitization must be made while the annuitant is between age 60 and 83. The annual charge for contract owners electing the GMIB guarantee is .45% of the guaranteed minimum death benefit in effect.
c. Guaranteed Payout Annuity Floor (GPAF). The insurer provides a guaranteed minimum income payment amount for variable annuity income options.
One insurer offers variable annuity payments that are guaranteed never to be less than the initial variable annuity payment. Variable payments are also “stabilized” -- i.e. held constant -- during each year. The company assesses a charge of between 1.25% - 2.25% of daily net asset value in variable investment options. (This is in addition to mortality and expense charges assessed during the annuity phase.) The fee compensates the insurer for bearing the investment risk that the company may be required to make payments after all annuity units have been used in an attempt to maintain the stabilized payments at the initial payment level.
2. Regulatory issues raised by GLBs. Many GLBs have complicated designs and built-in contingencies. Most GLBs charge an asset-based fee for the benefit. All GLBs are contingent, requiring the owner to meet certain
conditions and remain in the variable contract for a particular period of time in order to realize the full living benefit. Some products impose a fee if the owner terminates the living benefit option prior to its maturity. Other GLBs can only be terminated if the owner surrenders the contract. The contingent nature of GLBs presents disclosure issues, while termination fees may require exemptive relief.
a. Section 26(e). Insurers may now set whatever charges are
appropriate for GLBs as long as the charge for the GLB, together with other fees and charges, are “reasonable” in aggregate fees charged.
b. Need for exemptive “redeemability” relief. Units of a variable annuity contract are required to meet the definition of “redeemable securities” under the 1940 Act. Section 2(a)(32) of the 1940 Act defines “redeemable security” as any security which entitles the owner to receive at redemption a proportionate share of the issuer’s current net assets. Rule 22c-1 under the 1940 Act prohibits registered
separate accounts from selling, redeeming, or repurchasing any security except at a price based on the current net asset value of such security. Section 27(i)(2)(A) of the 1940 Act makes it unlawful for any
registered separate account funding variable insurance contracts, or for the sponsoring insurance company of such account, to sell any variable contract unless the contract is a redeemable security.
Collectively, these provisions prohibit separate accounts issuing variable annuity contracts from imposing any restrictions on
redemptions. On withdrawal, a contract owner must receive the net asset value of his security next computed after the request.
If an issuer of a GLB contemplates imposing any special charge in connection with withdrawals or otherwise restricting withdrawals under the Contract, exemptive relief from the redeemability provisions of the 1940 Act likely would be required.
c. Section 17(d) exemptive relief. In 1987, one life insurance company offered a unique guarantee with its variable annuity. If assets remained in the subaccount investing in a fund managed by an affiliate for five years, the sponsoring insurance company would guarantee that the subaccount’s accumulation unit value on the maturity date would be no less than it was at the end of the three-month offering period.
Withdrawals and transfers during the five year period did not receive the guarantee and were made at market value. The insurer charged 0.25% for the guarantee.
In 1987, the sponsoring insurer and the separate account were required to obtain SEC exemptive relief from Section 17(d) and Rule 17d-1 under the 1940 Act. The insurer and the separate account were11/ deemed to be “jointly endeavoring” with the underlying registered mutual fund (advised by the insurer’s affiliate) to make a profit for the fund, while avoiding a loss to the insurer that would occur if the guarantee were triggered.
The SEC order granting exemption under Section 17(d) required the insurer to, among other things:
C obtain the approval of the underlying fund’s board of directors of the guarantee arrangement;
C provide contractholders with prospectus disclosure of the guarantee; and
C provide financial statements of the insurer, as guarantor, in the Statement of Additional Information for the fund’s Form N-1A. The application was consistent with the Commission's
requirement that any insurance company guarantee that is exempt from registration must provide the insurer’s financial statements in the registration statement of the guaranteed securities, as required by Rule 3-10 of Reg. S-X.
Registrants should be aware the arrangements involving fees and affiliates give rise to complex considerations under the 1940 Act that may require exemptive relief.
3. Disclosure considerations raised by GLBs. GLBs give rise to a number of disclosure considerations under the federal securities laws.
a. Prospectus fee table and cost examples. If the charge for the GLB is taken from separate account assets, the charge will usually be listed on the prospectus fee table and included in the calculation of cost examples required by Item 3 of Form N-4. Registrants must usually provide two sets of examples -- one that includes GLB costs, and one that does not.
b. Prospectus disclosure with numerical examples. Prospectus liability under Section 12(2) of the 1933 Act attaches to the12/
disclosure of features that affect separate account value. If charges are taken from separate account assets, or if withdrawals or transfers from the subaccounts affect the value of the guarantee, complete and accurate disclosure of the contingent nature of the GLB, the charges and the collateral consequences of any subsequent actions must be made in the product prospectus.
Often registrants accompany GLB disclosure with hypothetical
contractowner transactions, such as withdrawals, the payment of additional premiums, and annuitization.
Companies often prominently disclose if a GMIB uses “conservative” actuarial assumptions. Disclosure discusses whether alternative, less “conservative” payout options may be more beneficial to the owner under certain circumstances.
c. Prospectus disclosure: condensed financial information for subaccounts assessed a charge for the guarantee. If the GLB charge is deducted from separate account assets, the company will usually establish new subaccounts to account for the higher deductions. These subaccounts will have lower accumulation unit values and, therefore, different financial histories. Current Form N-4 requires variable annuity prospectuses to include condensed financial histories for subaccounts currently offered through the prospectus. Charging a fee may require companies to add potentially lengthy condensed financial information to prospectuses.
d. Statement of additional information: performance data for new subaccounts. Subaccounts subject to a GLB charge will also have unique performance histories. Disclosure regarding standard and nonstandard performance calculations and performance data will be required to take into account the GLB fee.
The method of presentation of performance data for new subaccounts investing in funds already available through the separate account has been the subject of discussion with SEC staff. The Staff’s position may yet be evolving. One view is that a new subaccount investing in a funding option currently available through the separate account adopts the standard performance of the “old” subaccount currently invested in the underlying funding option at the old asset-based charges from the date the “old” subaccount commenced operations. From the point in time when the new charges are introduced, the new subaccount reflects the higher, new charges in calculating its standard performance and footnotes the performance to indicate that periods prior to the assessment of the new charges reflect the lower fees in effect at that time.
e. Hypothetical illustrations of variable annuity payouts. Products offering guaranteed minimum annuitization values often include in the product prospectus hypothetical illustrations of guaranteed minimum payments. Illustrations must be based on assumptions consistent with the provisions of the guarantee and provide full disclosure of those assumptions.
The SEC’s Division of Investment Management has permitted insurers to include hypothetical variable annuity payout illustrations in variable annuity prospectuses, in certain circumstances. The Division’s position has evolved over time and depended on the circumstances.
(1) Original position. At one time, the SEC permitted payout illustrations provided the illustrations generally complied with the SEC’s Statement of Policy regarding advertising and supplemental sales literature, which was originally issued in 1950. The Statement of Policy was amended in 1975 to13/ provide guidance for variable annuity illustrations.
(2) Fidelity model. During the 1990's, the SEC has referred variable annuity issuers to payout illustrations included in a Form N-4 registration statement filed by Fidelity Investments Life Insurance Company for an example of a variable annuity payout illustrations deemed to comply with the Statement of Policy. That example was based on several assumptions about the annuitant and the annuity option selection, as well as a particular assumed investment rate.
(3) Hartford model. In 1997, the SEC permitted an issuer of an immediate variable annuity to include variable payout illustrations in its prospectus that were based on the historic performance of the underlying funds. The illustrations assumed that the owner bought and immediately annuitized the contract on the same date that both the subaccount and the underlying portfolio began operations. Each graph also assumed that the first variable annuity payment is $1,000 and that a 5% assumed investment rate was selected. Unlike the Fidelity model, the Hartford model obviated the need for demographic
B. Variable annuities: enhanced guaranteed minimum death benefit. Variable annuity contracts have traditionally offered a “guaranteed minimum death benefit” (“GMDB”) equal to the greater of: (a) contract value, and (b) premium payments, less specified amounts. Insurers are increasingly offering enhanced GMDBs under variable annuity contracts.
Under the regulatory framework in effect prior to the 1996 Amendments, insurers were required to obtain exemptive relief to charge for the enhanced death benefit. Actuarial issues involved in obtaining exemptive relief were sometimes difficult. Since the 1996 Amendments, insurers may now set whatever charges are appropriate for these features as long as the charges are “reasonable.”
1. Types of enhanced GMDBs. Enhanced GMDBs can be divided into three types:
a. Contract anniversary value, or “ratchet”. Some life insurance companies offer an enhanced GMDB equal to the greatest of:
C contract value,
C premium payments (less specified amounts), and
C contract value on a specified prior date.
The specified date could be a prior contract anniversary, such as a prior seven-year contract anniversary date. GMDB ratchets “lock-in” contract value on the specified prior date.
b. Initial purchase payment with interest, or “rising floor”. Other insurers offer an enhanced GMDB equal to the greater of:
C contract value, and
C premium payments (less specified amounts), increased annually at a specified rate of interest.
In some cases, a ratchet and a rising floor may be available within the same contract.
c. Accumulated value plus charges. Some variable annuity contracts offer an enhanced GMDB equal to contract value plus some added amount. For example, one company offers a death benefit equal to the
sum of contract value plus amounts deducted from purchase payments for sales charges, risk charges and state premium taxes if applicable. 2. Regulatory issues raised by enhanced GMDBs. The primary regulatory
issue raised by enhanced GMDBs is whether the charge assessed for the feature, together with other fees and charges assessed under the contracts, can be deemed “reasonable” under Section 26(e) in relation to the risks assumed, expenses incurred and services provided.
If an additional charge related to the feature is assessed upon redemption, individual exemptive relief for that charge will also be necessary.
3. Disclosure considerations raised by enhanced GMDBs. Enhanced GMDBs give rise to a number of disclosure considerations under the federal securities laws.
a. Prospectus fee table and cost examples. As with GLBs, if the charge for the enhanced GMDB is taken from separate account assets, the charge will usually be listed on the prospectus fee table and
included in the calculation of cost examples required by Item 3 of Form N-4.
b. Prospectus disclosure: condensed financial information for subaccounts assessed a charge for the enhancement. If the
enhanced GMDB charge is deducted from separate account assets, the company will usually establish new subaccounts to account for the higher deductions. Current Form N-4 requires variable annuity prospectuses to include condensed financial histories for subaccounts currently offered through the prospectus. Charging a fee may require companies to add potentially lengthy condensed financial information to prospectus.
c. Statement of Additional Information: performance data for new subaccounts. Subaccounts subject to an enhanced GMDB charge will also have unique performance histories. Disclosure regarding standard and nonstandard performance calculations and performance data may be required to take into account the GMDB fee.
C. Emerging variable product charge structures. A number of insurers have modified their variable product charge structures partly in response to the new flexibility offered by the 1996 Amendments.
1. No-load variable annuity contracts. These products combine competitive mortality and expense risk charges with a unique trail commission structure. A twist on the “no-load” variable annuity is the “low fee” variable annuity, and the “no-load,” “low fee” variable annuity. The company sponsoring the contract writes the contracts on a direct-response basis, and pays no commissions, does not charge a front-end sales load, and assesses no surrender charges.
2. Variable annuity contracts with “bonuses”. Recently, several insurers began offering various types of “bonuses” and charge deduction features to purchasers of their variable annuity contracts. One company offers exchange credits up to 5.0% in amounts equal to any surrender charges the contract owner pays in exchanging their current variable annuity contract. Another company offers a “credit” of 1.5% to 5.0%, depending on the amount of purchase payment, on the variable annuity contract issued through its variable account. These bonus features raised certain regulatory issues.
a. Redeemability relief. Several companies have obtained exemptive relief from the redeeemability provisions of the 1940 Act to permit them to recapture the bonus at various times during the accumulation period. (1) Prudential. In 1989, Prudential obtained an exemptive order
under Section 6(c) of the 1940 Act from Sections 2(a)(32), 22(c), 27(c)(1), and 27(d) of the Act to recapture the 1% bonus it added to purchase payments in the event of a withdrawal of purchase payments, as opposed to earnings, during the first six Contract years. Contract owners did not14/ have a vested interest in the principal amount of any bonus until 6 Contract years from the date of payment have elapsed. The investment experience attributable to the bonus would be retained by the owners and the principal amounts of the bonus would be retained by the owner if the purchase payment was not withdrawn for at least six years.
(2) Western National. In 1995, on facts substantially similar to the Prudential application, Western National Life Insurance
Company obtained an exemptive order under Section 6(c) of the 1940 Act from Sections 2(a)(32), 22(c), 27(c)(1), and 27(d) of the Act to recapture the 1% bonus it added to
purchase payments in the event the owner made a withdrawal prior to the seventh Contract anniversary from premium payments that exceeded: (1) the 10% free withdrawal amount permitted each year; or (2) the amount permitted under the systematic withdrawal option each year. The principal15/ amount of the bonus did not vest until seven contract years had elapsed from the date of payment of the bonus. The asset-based charges deducted from the separate account were assessed against the entire value in the contract owner’s account, including the bonus amount, even during the period when the owner’s interest in the bonus had not vested. (3) American Skandia. In 1996, American Skandia Life
Assurance Corporation obtained an exemptive order under Section 6(c) of the 1940 Act from Sections 2(a)(32), 22(c), 27(c)(1), and 27(d) of the Act, and Rule 22c-1 thereunder, to recapture any bonus credit it added to purchase payments in the event the owner canceled the Contract during the free-look period, the owner did not fulfill its letter of intent obligation within a 13 month period, or if a medically related surrender or a death occurred within 12 months of receipt of the bonus credit. The asset-based charges deducted from the separate16/ account were assessed against the entire value in the contract owner’s account, including the bonus amount, even during the period when the owner’s interest in the bonus had not vested. American Skandia asserted that the recapture did not deprive an owner of his or her proportionate share of the issuer’s current net assets since the contract owner’s interest in the bonus had not vested at the time of recapture.
b. Uniform pricing. These bonus programs, like analogous arrangements involving retail mutual funds, must comply with Section 22(d) and Rule 22d-1 or Rule 22d-2 thereunder. Relying on a series of SEC no-action letters involving credits in connection with mutual fund purchases, these variable annuity bonuses probably implicate Section 22(d), but can rely on either Rule 22d-1 or Rule 22d-2. Therefore, no exemptive relief17/ has been obtained to date for these programs under Section 22(d).
c. State insurance regulation. Variable products with bonus features also should be analyzed under any applicable anti-discrimination and anti-rebate provisions of state insurance laws and regulations. 3. Variable life insurance: charges based on face amount. Many fixed life
insurance contracts assess sales charges based on a percentage of face amount. Before the 1996 Amendments, variable life contracts were required to charge sales loads based on a specified percentage of premium payments. Since the passage of the 1996 Amendments, insurers have been permitted to base sales charges under variable life contracts on face amount. A number of insurers are now offering VLI contracts with surrender charges expressed as a dollar amount for each $1,000 of face amount, without regard to the level of premiums actually paid into the contract.
4. Variable life insurance: periodic charges and asset-based COI charges. A number of insurers now offer “modified single premium” variable life contracts.
As a general matter, these contracts typically have modest death benefits in relation to contract value, which permits simplified underwriting procedures such as “tele-underwriting” and periodic cost of insurance charges based on a percentage of contract value rather than “net amount at risk.” In response to the increased flexibility afforded by the 1996 Amendments, companies are simplifying the charge structure and are assessing fees as a percentage of average daily separate account assets, rather than as a function of premium payments.
This is in dramatic contrast to product designs that were required before the 1996 Amendments. Prior to 1996, companies had to monitor the aggregate amount of sales charges deducted and had to stop the deduction when amounts exceeded 9% of premiums, the old limit under the 1940 Act. Now, there is no requirement under the 1940 Act to monitor sales charges on variable life policies, although the insurer may contractually or otherwise limit aggregate sales charges. Additional problems were posed by the practice of recovering premium or other tax expenses through periodic charges, since contract value due to positive investment experience, in addition to premium payments, would have been charged and for these reasons could have resulted in more than the targeted tax expense being recovered. Now, any such issue, at least as it relates to charge regulation, is moot.
IV. INSURER-SPONSORED MUTUAL FUND INNOVATIONS
A. Background. Life insurance companies have become increasingly active in the retail mutual fund marketplace through either build strategies, buy strategies, or a combination thereof.
Several insurers, through acquisition programs, now have one or more retail mutual fund complexes managed by affiliated money managers (e.g., Lincoln National, Prudential, Transamerica, John Hancock, Met Life). Other life insurers have
effectively built retail fund complexes managed by affiliated investment advisers to be offered through the same or closely related distribution networks that distribute their insurance products (e.g., Hartford Life, SunAmerica, American Skandia, Aegon). B. Group term insurance linked to mutual fund investment
1. Description of the product. Several life insurance company-sponsored retail funds are now selling a group term life insurance product that is offered to persons who hold shares of the insurer-sponsored retail funds (Prudential, American Skandia and SunAmerica). The term life product is issued by the affiliated insurer, and the amount of the term death benefit is related to the amount invested in the designated mutual funds.
Eligible investors have the option of purchasing coverage payable at death that is related to amounts paid to purchase retail fund shares and the value of the fund shares held for insured persons at the time of death. Specifically, the death benefit provided by the coverage equals the difference between (i) the value of the fund shares at death and (ii) the amount invested plus either a guaranteed annual growth rate of a specified percentage or the highest anniversary value of the fund shares, subject to a cap as a percentage of the amount invested. There is no cash value associated with this coverage. The premium is equal to a percentage of assets invested and does not vary by risk class.
This coverage is available to natural persons under a specified age, can be terminated at any time, and may be paid for by periodic redemption of fund shares or withdrawals from bank or brokerage accounts. Any contingent deferred sales charges may be waived on these redemptions.
2. Observations. These insurance programs offer a death benefit very similar to a death benefit under a variable annuity contract, but on a stand- alone basis. The mutual fund share investment is taxed in the same manner as other fund
investments, while the additional amount paid at death is presumably designed so as to be treated as life insurance for tax purposes. The coverage provided by the insurer is not registered with the SEC, apparently in reliance on the exclusion for insurance products contained in Section 3(a)(8) of the 1933 Act. The availability of the term insurance may be disclosed in the fund prospectus. These term life programs differ in form and substance from guarantees offered in connection with certain retail mutual funds. For example, a few funds offer a guarantee of the principal amount invested at the end of a prescribed period, with the guarantee being provided by the adviser, an affiliate of the advisor, or a third party bank through a letter of credit. These guarantees are not issued by life insurance companies, are not tied to the death of the investor, appear to be treated as guarantees of a security under the 1933 Act, and are described in detail in the fund’s registration statement.
C. Dow 10 funds
1. Introduction. Because of the unique nature of life insurance company separate accounts, including their treatment under the Internal Revenue Code, from time to time variable product issuers have created innovative investment options that could not easily be offered in a retail mutual fund context. For example,
because separate accounts registered with the SEC need not comply with Subchapter M of the Code, some insurers have in the past offered investment options that were managed in a manner that would not comply with the “short-short” rule that for many years was a condition to achieving pass-through tax treatment under Subchapter M.
The most recent example of an innovative investment option underlying variable insurance products is an option with a strategy of investing in the ten highest dividend yielding stocks of the Dow Jones Industrial Average (the “Dow 10”). While NYSE firms have sponsored UITs investing in these stocks, these UITs have not been particularly tax efficient for taxable investors because, in order to adjust the portfolio periodically (annually) so that it generally remains invested in what are the current 10 highest yielding DJIA stocks, the UIT must liquidate and a rollover to a new UIT portfolio must be effected. The rollover in turn triggers an income tax for the investor. The Dow 10 strategy does not work well in a mutual fund because the concentration in 10 stocks makes it essentially impossible to meet the diversification requirements of Subchapter M of the Code.
2. Structure of Dow 10 investment options. Variable product issuers have been able to overcome these impediments by structuring the Dow 10 option in one of two ways:
a. Management separate account. At least one insurer has structured the option as a management investment company at the separate account level. Under this structure, the separate account directly holds the 10 Dow stocks and the portfolio is repositioned periodically (typically once a year). A modest investment management fee is charged at the separate account level to compensate for the management and administration of the separate account. b. Unit investment trust separate account. Another insurer has
structured the option as a unit investment trust at the separate account level. Under this structure, the separate account (or a sub-account or division thereof) invests in a series of underlying unit investment trusts holding the Dow 10 stocks. To adjust the portfolio to reflect a more current Dow 10 configuration, the separate account periodically
(annually) substitutes the units of another underlying unit investment trust for those of the current unit trust.
3. Regulatory issues. There have been several regulatory issues raised by these Dow 10 options:
a. Exemptive relief from Section 12(d)(3). In order to permit the Dow 10 option to include securities of securities-related issuers (broker-dealers or investment advisers) within the meaning of Section 12(d)(3) of the 1940 Act, exemptive relief must be obtained from the
proscription in that section, as modified by Rule 12d3-1 thereunder, from investing more than 5% of the portfolio in such securities. The SEC has been willing to grant such relief in the context of a portfolio that is not actively managed.
b. Exemptive relief from Sections 11 and 26(b). Where the structure utilized was a UIT separate account investing in an underlying UIT, relief must be obtained from both Sections 11 and 26(b) of the 1940 Act.
(1) In order to effect a series of substitutions of units of one underlying UIT for another, approval must be obtained under
Section 26(b), which prohibits a substitution without prior SEC approval. Unlike the Section 26(b) approval usually obtained by insurance company separate accounts for a one-time
substitution of shares of one underlying mutual fund for another, this relief would provide blanket approval to substitute a new UIT series each year into the indefinite future.
(2) The rollover of one series of the underlying UIT into another series has been deemed to involve an exchange offer that must be approved by the SEC pursuant to Section 11(c) of the 1940 Act.
V. APPLICATION OF THE PLAIN ENGLISH RULES TO VARIABLE PRODUCTS
A. Introduction. On January 28, 1998, the SEC adopted sweeping new regulations to require all issuers of securities to explain the risks of investing in a way that the average investor can easily understand. Issuers must use plain English writing principles when18/ drafting the front and back cover pages, the summary and risk factors sections of a prospectus, and throughout the entire Rule 498 profile. In addition, the entire prospectus must be clear, concise and understandable and must be prepared using certain writing standards.
B. Effective dates 1. Mutual funds
C All new registration statements filed on Form N-1A on or after December 1, 1998 must comply with the plain English rules.
C All post-effective amendments to Form N-1A filed on or after December 1, 1998, but no later than December 1, 1999, must also comply.
2. Variable insurance products
C New registration statements first filed on Forms S-1, S-2, S-3, N-3, N-4 or S-6 on or after October 1, 1998 must comply with the new requirements. Initial registration statements filed before October 1, 1998, but not yet effective on that date, need not comply with plain English rules before effectiveness.
C Any post-effective amendment filed on Forms S-1, S-2, S-3, 3, N-4 or S-6 on or after October 1, 1998, either to include the company’s latest audited financial statements or to update the prospectus under Section 10(a)(3) of the 1933 Act, must comply with the new plain English requirements.
C Comment: The net result of these “ambitious” effective dates has meant that all variable insurance products and most
underlying funds must revise their prospectuses for May 1, 1999 to reflect plain English principles.
C. Brief summary of substantive “plain English” requirements. In brief, the principles of plain English writing and design are:
1. New Rule 421(d). specifies the 6 plain English “principles” of organization, language, and design that must be applied to the front and back cover pages, the summary and the risk factors section of every prospectus.
2. Amended Rule 421(b). continues to require that the entire prospectus be clear, concise and understandable. (This requirement has been contained in the general instructions to Forms N-3 and N-4 since 1985 and had been contained in the instructions to old Form N-1A since 1983.)
C Restricted use of glossaries and defined terms. Of particular concern to variable product issuers is the requirement of Rule
421(b)(3) to avoid frequent reliance on glossaries or defined terms as the primary means of explaining information in the prospectus. The Rule states that the issuer should define terms in a glossary or other section of the document only if the meaning is unclear from the context, and should use a glossary only if it facilitates understanding of the disclosure.
3. Amended Rule 461(b)(1)-- SEC power to delay acceleration requests. When considering a request to accelerate effectiveness, the staff must consider whether the issuer has made a “bona fide effort to make the prospectus
reasonably concise, readable and in compliance with the plain English requirements” of Rule 421(d).
D. Special issues for variable products
1. “Template/Replicate” review process
a. The request letter. In order to facilitate SEC staff review of the hundreds of variable annuity and variable life prospectuses that had to be brought into compliance with the plain English rules by May 1, 1999, the staff developed a process whereby an insurer and its affiliated insurance companies would file one model plain English prospectus as a “template” filing under Rule 485(a). The insurers requested that all other prospectuses, that were sufficiently similar to the “template” so that the template was a fair representation of the plain English disclosure changes to be reflected in those prospectuses, be filed with the SEC under Rule 485(b)(1)(vii) as “replicate” filings. This process was only available to variable products registered on Form N-4 and S-6 and was not available to any underlying fund or management separate account registered on Form N-3. A plain English variable life product could not be used as a template for a variable annuity and vice-versa.
The staff extensively reviewed the template filing for compliance with the plain English rules. The insurer and its affiliated insurance
companies were required to request “template/ replicate” relief by sending a letter to the Assistant Director, Office of Insurance Products, in which the companies identified by filing number those product filings for which relief would be granted. The companies must represent that:
C The plain English disclosure changes in the template filing are a fair representation of the plain English disclosure changes that would be reflected in the replicate filing.
C Registrants will be able to effectively revise the template and replicate filings to reflect the comments of the SEC staff on the template filing and will so revise them.
C With the exception of plain English disclosure changes made to comply with Rule 421 under the 1933 Act, the replicate filing will not include changes that would
otherwise render it ineligible for filing under Rule 485(b).
In early January 1999, the SEC stated that it wanted to receive the template/ replicate request letters no later than the end of January, accompanied or preceded by the template 485(a) filing. Registrants would receive oral confirmation of their 485(b)(1)(vii) requests. The letter was not required to be filed on EDGAR.
b. Observations about the process
(1) Timing and publicity. The staff announced the availability of Section 485(b)(1)(vii) relief at industry conferences as early as June 1998. The staff finalized the specifics of the process for requesting relief in early January 1999, setting an end-of-January deadline. Those requirements were conveyed to registrants orally.
(2) Scope of template review. Indications are that the scope of the staff’s template review has not been limited to plain English editing. Rather, in at least some instances, the staff appears to be questioning the substance of certain product features and other disclosure matters, where prospectuses have been filed for no other reason than to comply with the plain English rules. While the staff is not commenting on typographical errors, in some instances it has applied an almost word-by-word standard of review to the entire prospectus. Frequent plain English comments include the requirement to delete any right justified margins, add topic headings, and define terms simply. The staff appears to have no preference between the one- or two- column format. The staff is requiring registrants to strictly comply with the requirements of Forms N-4 and
S-6.
C Comment: Until Form N-4 is revised and Form N-6 adopted, issuers of variable
products must apply the plain English rules to their prospectuses within the context of
outdated, but mandated, SEC registration forms and instructions.
2. Cover page. The new plain English rules require the prospectus cover page to be designed and written in plain English. Yet the requirements for the cover page of Form N-4 and Form S-6 have not been simplified (although proposed Form N-6 does contain a simplified cover page). Form N-4, for instance, still requires the front cover page to contain the statements required by Item 1(a)(v)-(viii). 19/
C Query: Will the staff in OIP issue a comment, and possibly deny acceleration, if the front cover page of a Form N-4 prospectus exceeds one page?
CC Query: Would the SEC staff be willing to entertain a formal or informal no-action request that permits variable product
registrants to place some of the items currently required by Form N-4 as front cover disclosure under Item 1(a)(v)-(viii) on the back cover of the prospectus, or to omit such disclosure altogether?
3. Risk section. The plain English rules must be applied to the front and back covers, the summary, and the risk section of every prospectus. But most variable product prospectuses currently do not contain a separate “risk” section. Neither Form N-4 nor Form S-6 expressly require such a section. Must issuers develop a risk section and/or put a risk section in the summary, even if such disclosure is not required by the current form? Or will the staff apply plain English principles to disclosures about risk wherever they appear in the prospectus?
CC Comment: One member of the OIP staff has indicated in a recent article that the plain English requirements apply to disclosures about risk “wherever they appear in the prospectus.” It appears that the staff is20/ reviewing the entire prospectus for compliance with the plain English rules, and not limiting their review to the front cover, summary and risk section.
4. Variable annuity profiles. A variable annuity profile is not a Rule 498 profile. Must it comply with plain English principles, even though it is not a Rule 498 profile?
5. Variable annuity glossaries. Item 2 of Form N-4 requires variable annuity prospectuses to contain either a glossary that defines special contract terms or to use an index of special terms that refers to the page in the prospectus on which each special term is defined. The glossary must appear immediately after the cover page and index. Confusion has arisen because the plain English Rule 421(b)(3) requires issuers to avoid frequent reliance on glossaries and defined terms, and to “ruthlessly” eliminate jargon and legalese. However, the SEC21/ staff, through comments being provided on plain English templates, has reiterated the requirements of Form N-4, despite Rule 421(b)(3), that variable annuity issuers must place either a glossary or index of special terms
immediately after the table of contents. VI. SIMPLIFIED MUTUAL FUND PROSPECTUS
A. Introduction
1. Amended Form N-1A -- Release 23064. On March 23, 1998, the SEC
adopted amended Form N-1A as part of its continuing effort to improve mutual fund prospectus disclosure. The amended Form N-1A retains the structure22/ and disclosure philosophy of the prior Form N-1A -- investors receive a short, condensed prospectus; detailed, more technical disclosure is placed in a separate document, the SAI, that can be incorporated by reference into the prospectus and must be made available on request. Amended Form N-1A streamlines and adds new focus to the prospectus. Technical disclosure about legal and operational matters generally common to all funds has been moved to the SAI.
2. New focus on risk disclosure. The SEC wants the fund prospectus to focus on the risks of the fund’s portfolio taken as a whole and to “minimize detailed and technical descriptions of the risks associated with specific portfolio securities potentially held by the fund.” 23/
The Commission left no doubt that past risk disclosure practices were
inadequate. “[D]isclosure about the risks associated with each type of security in which the fund may invest does not effectively communicate to [investors] the overall risks of investing in the fund. . . .Mere inventories of potential portfolio securities do not assist typical investors in selecting among funds . . . .”24/
3. Call for industry and SEC staff to simplify. The Commission has called on all persons involved in preparing and reviewing fund disclosure documents (including the SEC staff) to exercise discipline, follow the plain English rules and simplify prospectus disclosure. 25/
B. Impact of 1998 innovations on underlying fund prospectuses. In revising Form N-1A, the SEC permitted funds intended for use in connection with variable contracts to modify their prospectuses in specific ways.
1. Standardized risk/return summary (Items 2-3). The risk/return summary26/ provided by funds that are used in connection with variable contracts must include:
a. The fund’s investment objective and principal investment
strategies. The fund should summarize how it intends to achieve its investment objective by describing its principal investment strategies, including the types of securities in which the fund
principally invests or will invest, and any industry concentration policy. b. The fund’s “principal” risks. The fund should provide a succinct
summary of the principal risks of investing in the fund’s anticipated portfolio holdings as a whole, and the circumstances reasonably likely to affect adversely the fund’s net asset value, total return and yield.27/ c. A bar chart. The fund should provide a bar chart of its annual returns
for each of the last ten calendar years (or each year of existence, if less), without deducting sales or account charges. The fund should indicate that sales and account fees are not reflected, and that, if reflected, returns would be lower.
d. The best and worst quarters. Following the bar chart, the fund must disclose its best and worst returns for a quarter during the 10 calendar years or other period of the bar chart.
e. The performance table. The fund must include a table showing average annual calendar year returns for the last 1, 5 and 10 calendar years (or years since inception, if less) for all classes of the fund that are offered through the prospectus. Sales loads and account fees must be reflected.
f. But omit the fee table and example. Any fund that offers its shares exclusively to one or more separate accounts may omit the fee table and example from its prospectus. 28/
However, if the fund is used in connection with a defined contribution plan, then the underlying fund must include the fee table and example. Instructions 3(d)(i) and (4) to Item 3 require that the fee table reflect the full gross operating expenses and not net fee after waivers or expense caps. Net fees may be disclosed in a footnote to the table. However, in a letter to the Investment Company Institute dated October 2, 1998, the SEC stated that it will permit a fund to add the amount of a fee waiver (or expense reimbursement) and net fees to the fee table, provided the fund’s fees are subject to a contractual limitation that requires reimbursement or waiver of expenses. The fund must29/ disclose in a footnote to the fee table the period for which the expense reimbursement or fee waiver arrangement is expected to continue and whether it can be terminated at any time at the option of the fund. The fund may use net fees in computing the examples, but only for the period that the contractual expense reimbursement or fee waiver arrangement lasts.
2. Modify the back cover. Variable product funds may modify the statement required on the back cover by Item 1(b)(1) to state that the prospectus is intended for use in connection with a variable contract.
3. Omit purchase and redemption information (Item 7). While Item 7 required that each prospectus provide certain minimum information about the sale and redemption of fund shares, instruction C(3)(d)(i) to amended Form N-1A permits funds that are used as investment options for plans under Sections 401(k), 403(b) or 457 of the Internal Revenue Code (“Code”) and for variable contracts as defined in Section 817(d) of the Code to omit information on underlying fund share purchases and redemptions.
4. Modify the tax disclosure (Item 7(e)). The prospectus must describe the tax consequences of buying, holding, exchanging and selling fund shares. Disclosure regarding the fund’s Subchapter M status has been moved to the SAI.30/
Funds that are used in connection with variable products are permitted by Instruction C(3)(d)(ii)(B) to amended Form N-1A to modify the tax disclosure
so that it is consistent with offering the fund as a specific investment option under a defined contribution plan, tax-deferred arrangement, or variable
contract. This would allow a variable product fund, for instance, to provide tax disclosure regarding compliance with Section 817(d) of the Code.
C. Special issues for underlying funds
1. Stand-alone fund performance. Funds underlying variable products are required to include in their prospectuses a bar chart and performance table that discloses fund performance without deducting separate account and contract fees and charges. In many cases, the fund performance data will include periods that precede the inception date of the separate account. However, the Commission has stated that underlying fund performance may not be advertised unless standard performance at the separate account level is also disclosed.31/
C Query: Are the bar chart and performance table presentations of underlying fund performance in the fund prospectus
consistent with the language in the Rule 482 adopting release that stand-alone fund performance in a variable product advertisement may be inherently misleading? Do different standards apply because one document is an advertisement while the other is a prospectus? Or has the Commission in effect signaled a change in its position on Rule 482 ads?
C Query: Can any risk of disclosing stand-alone variable fund performance in the fund prospectus be minimized by (i) adding a disclaimer that fund performance is unattainable and will be lower once separate account charges are deducted, and/or (ii) cross-referencing to the product prospectus?
2. Status of generic comment letters from the Office of Insurance
Products. The Adopting Release to amended Form N-1A notes that the 35 Guides to old Form N-1A, as well as the 7 annual generic comment letters, do not apply to registration statements prepared on the amended Form N-1A, although some of the positions are incorporated into the amended form. A new or amended registration statement can be prepared using the form alone. 32/ The Adopting Release can be read narrowly to supersede only those industry comment letters issued by the Office of Disclosure and Review. Are the 14 annual generic comments letters issued by the Office of Insurance Products also
