FINRA imposes numerous communications rules specifically on investment companies. The key rules for the exam are covered in this chapter. In particular, the focus is on:
If you’ve researched mutual funds, you’ve probably seen ranking systems like Morningstar. Morningstar provides investors with general information, research, and data on various types of securities (primarily funds). For example:
Morningstar is well known for its 5-star system, which ranks mutual funds based on performance. While their methodology is intense (and not necessary to know for the exam), the basic idea is that Morningstar compares similar funds (e.g., growth funds, high yield funds) and ranks them based on risk and return. This chart summarizes its ranking system:
| # of stars | Ranking of fund |
|---|---|
| 5 | Top 10% |
| 4 | Next 22.5% |
| 3 | Next 35% |
| 2 | Next 22.5% |
| 1 | Bottom 10% |
To put that in context:
Most fund companies display their Morningstar ranking in marketing materials and on their websites. You’ll often see it prominently displayed, like in these examples:
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.
This definition matters because investment companies can display rankings only in one of two situations:
In other words, firms like Vanguard, Charles Schwab, and Fidelity can’t create arbitrary rankings (e.g., “our funds are the best available!”). They can display rankings from independent ranking entities like Morningstar, or they can create their own rankings only if those rankings are based strictly on performance measures (e.g., 1-year, 5-year, 10-year returns).
FINRA also requires specific disclosures whenever an investment company ranking is shown:
Just as Morningstar ranks funds on a 5-star scale based on overall risk and return, bond funds can also 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 for these ratings requires the following, whether the rating is displayed by the organization that created it or by the mutual fund company:
Additionally, the following disclosures must be made:
FINRA also regulates member firm communications related to variable insurance products (variable annuities and variable life insurance). The relevant FINRA rules cover the following topics in these communications:
General considerations apply to all variable insurance products. Specific considerations apply to particular products or situations. Both are covered here. The relevant FINRA rule addresses:
Product identification
Communications should clearly identify the security being offered. This is especially important when a “proprietary name” is used (e.g., the ABC Lifetime Income Program). The security type (e.g., variable annuity) should appear somewhere in the communication.
Liquidity
Variable insurance products are long-term investments and may involve substantial fees and/or taxes if cashed out early. Communications should disclose potential fees and tax consequences and should clearly describe 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 guarantees. Variable annuities guarantee payments until death if annuitized (although the amount of the payments varies). Variable life insurance guarantees a minimum death benefit.
FINRA rules prohibit financial professionals from overemphasizing or exaggerating these guarantees because they depend on the insurance company’s solvency. If the insurance company goes out of business, the guarantees may not be fulfilled. Also, guarantees can’t be presented as protection from investment risk, since variable insurance product returns depend on the performance of the separate account.
Fund Performance Predating Inclusion
Variable insurance products give investors access to various funds in the separate account. Depending on the issuer and product, some funds may be available now but were not available in the past.
For example, assume a Vanguard fund just became available in a New York Life Variable Annuity. A representative may want to show how the annuity would’ve performed in the past if that fund had been selected in the separate account (even though it wasn’t previously available). This is permitted as long as there were no significant changes to the fund at the time it was added or afterward (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. Communications may emphasize separate account features (e.g., potential growth over time), as long as they also include a balanced discussion of relevant risks.
Hypothetical illustrations of return
Representatives often provide prospective customers with hypothetical returns on variable insurance products. While projecting performance is prohibited, hypothetical illustrations are allowed if they are balanced and include the maximum fees that may be charged.
For example, a representative could show a hypothetical return of up to 12% on a separate account and its effect on variable life insurance cash value, as long as another hypothetical is also shown using a 0% return and its effect on cash value.
A deferred variable annuity typically involves a lengthy accumulation phase, with the intention of annuitizing the contract years later in retirement. These contracts often involve significant surrender charges and/or taxes if distributions are taken early.
To recommend the purchase of a deferred variable annuity, the representative must believe the following:
A common industry practice is encouraging a customer to transfer assets from another firm. For example, a representative at ABC Insurance Company encourages a potential client to exchange an annuity at XYZ Insurance Company for one at ABC. Exchanges can involve significant surrender charges if done during the surrender period, although taxes are typically avoided.
To recommend an exchange from one product to another, the representative must consider the following:
*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:
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