Investment company communications

FINRA imposes numerous communications rules specifically on investment companies. The important ones to know for the exam are covered in this chapter. In particular, we’ll look at the following:

• Investment company ranking communications
• Bond fund volatility rating communications
• Variable product communications

Investment company ranking communications

If you’ve researched mutual funds, you’ve probably encountered ranking systems like Morningstar. This organization provides investors with general information, research, and data on various types of securities (primarily focusing on funds). For example:

• Morningstar’s best growth funds for 2022
• Morningstar’s guide to target date investing

Morningstar is well known for its 5-star system that ranks mutual funds based on performance. While their methodology is intense (and not necessary to know for the exam), Morningstar ranks similar funds (e.g. growth funds, high yield funds) based on their risk and returns. This chart summarizes its ranking system:

For context, a fund ranking better than 95% of similar funds in terms of risk and return would receive a 5-star ranking. A fund ranking better than only 20% of similar funds would receive a 2-star ranking. Most fund companies display their Morningstar ranking on their marketing materials and websites. Investors can typically find them prominently displayed like they are in these examples:

• Fidelity Contrafund (4 stars as of August 2023)
• T Rowe Price International Bond Fund (4 stars as of August 2023)
• Putnam Small Cap Growth Fund (5 stars as of August 2023)

Morningstar is an independent financial services company that does not issue and rank its own funds. FINRA refers to organizations like Morningstar as ranking entities. In FINRA’s own words:

The term “Ranking Entity” refers to any entity that provides general information about investment companies to the public, that is independent of the investment company and its affiliates, and whose services are not procured by the investment company or any of its affiliates to assign the investment company a ranking.

The reason it’s essential to define ranking entities is investment companies can only display these rankings in one of two circumstances:

• The ranking is provided by a ranking entity
• The ranking is provided by the investment company, but only based on performance measures

The relevant FINRA rule prohibits firms like Vanguard, Charles Schwab, and Fidelity from creating arbitrary rankings (e.g., “our funds are the best available!”). They can only display rankings of independent ranking entities like Morningstar or their own rankings if only based on performance measures (e.g., 1-year, 5-year, 10-year returns).

Additionally, FINRA requires several additional disclosures to be made if displaying investment company rankings:

• Name of the fund category (e.g., growth)
• Number of investment companies in the category
• Name of the organization providing the ranking (ranking entity or investment company)
• The length of period the ranking covers (e.g., 5-year returns)
• Criteria on which the ranking is based (e.g., total return)
  • If the total return is the basis for ranking, it must be based on 1-year, 5-year, and 10-year total returns
• Past performance is no indicator of future results
• If the rankings take sales loads into consideration

Bond fund volatility rating communications

Similar to Morningstar ranking funds on a 5-star scale based on overall risk and return, bond funds can be rated based on the volatility of their net asset value (NAV). As you may recall, bond price volatility is something debt security investors should pay close attention to. The longer the maturity and the lower the coupon, the more volatile the changes in the bond’s market price (and the higher the duration).

Standard & Poors Global is one organization that provides bond fund volatility rankings. The applicable FINRA rule relating to these ratings requires the following requirements, whether displayed by the organization creating the rating or the mutual fund company itself:

• The rating does not identify as a “risk” rating
• The rating is based on recent volatility
• The methodology for the rating
  • Must be objective and fair
  • Must be disclosed on the website or over the phone

Additionally, the following disclosures must be made:

• Name of the entity issuing the rating
• The most current rating and the date of the rating
• Description of the rating
• That there is no “standard” method for assigning ratings
• If the rating was paid for
• A description of risks the rating measures (e.g., short-term volatility)
• There is no guarantee the fund will continue to perform as the rating suggests

Variable product communications

Similar to investment company communications, FINRA regulates member firm communications related to variable insurance products (variable annuities and variable life insurance). The relevant FINRA rules cover the following related to these communications:

• General & specific considerations
• Deferred annuity rules

General & specific considerations

General considerations (rules) apply to all variable insurance products. Specific considerations apply to specific products or scenarios. Both are discussed in this section. The relevant FINRA rule covers the following:

• Product identification
• Liquidity
• Claims about guarantees
• Fund Performance Predating Inclusion
• Insurance and investment features of variable life insurance
• Hypothetical illustrations of return

Product identification
Firms and professionals should clearly identify the securities they’re offering. This is especially important when using “proprietary names” (e.g., the ABC Lifetime Income Program). The security type (e.g., variable annuity) should be listed somewhere in the communication.

Liquidity
Variable insurance products are long-term investments subject to substantial fees and/or taxes if cashed out early. Therefore, it’s important to disclose potential fees and tax consequences in communications and to be clear about the level of liquidity risk* involved.

*Liquidity risk occurs when an investor cannot sell a security, or the security can only be sold at a deep discount or with significant fees.

Claims about guarantees
Variable insurance products are known for their guarantees. Variable annuities guarantee payments until death if annuitized (although the amount of the payments vary). Variable life insurance guarantees a minimum death benefit. FINRA rules prohibit financial professionals from overemphasizing or exaggerating the benefits of these guarantees, as they are based on the insurance company’s solvency. The guarantees may go unfulfilled if the insurance company goes out of business. Additionally, the guarantees cannot be related to the investment risks, as variable insurance product returns are based on the performance of the separate account.

Fund Performance Predating Inclusion
Investors with variable insurance products gain access to various funds in their separate accounts. Depending on the issuer and product, certain funds may not have been available in the past but are currently available. For example, assume a Vanguard fund just became available in a New York Life Variable Annuity. A representative may want to show how an annuity would’ve performed in the past if the fund had been chosen in the separate account (even though it wasn’t previously available). This can be shown as long as there were no significant changes to the fund at the time or after it was made available (e.g. the expense ratio rising significantly after it became available to the separate account).

Insurance and investment features of variable life insurance
Variable life insurance policies allow investors to choose specific securities in the separate account. Financial professionals can emphasize the features of the separate account (e.g., potential growth over time) as long as a balanced discussion of relevant risks occurs.

Hypothetical illustrations of return
Representatives frequently provide prospective (potential) customers with hypothetical returns on variable insurance products. While this may feel like projecting performance (which is prohibited), illustrating hypotheticals is allowed as long as they are balanced and factor in the maximum fees to be charged. For example, a representative could show a hypothetical 12% return on a separate account and its influence on variable life insurance cash value as long as another hypothetical was provided showing a 0% or negative return and its influence on cash value.

Deferred annuity rules

A deferred variable annuity typically involves a lengthy accumulation phase with the intention of annuitizing the contract several years later in retirement. These types of contracts often involve hefty surrender charges and/or taxes if distributions are taken early.

To make a recommendation to purchase a deferred variable annuity, the representative must believe the following:

• The customer has been informed of various features, including:
  • Potential surrender period and charges
  • Potential taxes and/or penalties
  • Other fees associated with the product
• The customer would benefit from features of the annuity, including:
  • Tax-deferred growth
  • Annuitization (payments until death)
  • Death benefit
• The variable annuity is generally suitable for the customer

A common practice in the industry is the attempt to encourage a customer to transfer assets from other firms. For example, a representative at ABC Insurance Company encourages a potential client to exchange their annuity at XYZ Insurance Company for one at ABC. Exchanges can involve hefty surrender charges if performed during the surrender period, although taxes are typically avoided.

To make a recommendation to exchange from one product to the other, the representative must consider the following:

• The amount of surrender charges and/or fees assessed
• If the customer would genuinely benefit from the exchange
• If the customer performed another exchange within the previous 36 months*

*36 months seems like an arbitrary time frame, but exchanges within 3 years will most likely be subject to significant surrender charges and/or fees. Bottom line - don’t recommend a client exchange into a new variable annuity if they performed a similar exchange within the past 36 months (3 years).

Some legitimate reasons for an exchange may include the following:

• Better death benefits
• Potential for higher annuity payments
• Annuity bonuses
• More investment options
• Lower expenses and/or fees