FINRA imposes a number of communications rules that apply specifically to investment companies. The key rules you’ll want for the exam are covered here. In particular, this chapter focuses 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 many types of securities (with a primary focus on funds). For example:
Morningstar is well known for its 5-star system, which ranks mutual funds based on performance. You don’t need to know the details of its methodology for the exam, but you should understand the basic idea: Morningstar compares similar funds (for example, growth funds and high yield funds) and ranks them based on risk and returns. This chart summarizes the star rankings:
| # 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:
Many fund companies display Morningstar rankings in marketing materials and on their websites. You’ll often see them 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, FINRA rules prevent firms like Vanguard, Charles Schwab, and Fidelity from creating arbitrary rankings (for example, “our funds are the best available!”). A firm may display:
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). This connects directly to what you already know about bond price volatility:
Standard & Poors Global is one organization that provides bond fund volatility rankings. The applicable FINRA rule 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, including variable annuities and variable life insurance. The relevant FINRA rules address the following topics:
General considerations apply to all variable insurance products. Specific considerations apply only to certain products or situations. The relevant FINRA rule covers:
Product identification
Communications should clearly identify the security being offered. This is especially important when a product is marketed using a proprietary name (for example, “the ABC Lifetime Income Program”). The communication should still identify the security type (for example, “variable annuity”).
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 often marketed with guarantees, but those guarantees have limits.
FINRA rules prohibit representatives from overemphasizing or exaggerating these guarantees because they depend on the insurance company’s solvency. If the insurer fails, the guarantees may not be met. Also, guarantees can’t be presented as protection from investment risk, since returns are tied to the performance of the separate account.
Fund Performance Predating Inclusion
Variable insurance products give investors access to various funds through the separate account. Sometimes a fund becomes available only after the contract has been in existence for a while.
For example, assume a Vanguard fund just became available in a New York Life variable annuity. A representative might want to show how the annuity would have performed in prior years if that fund had been available and selected. This is permitted as long as there were no significant changes to the fund at the time (or after) it was added to the separate account (for example, the expense ratio increasing significantly after it became available).
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 (for example, potential growth over time), but they must also include a balanced discussion of relevant risks.
Hypothetical illustrations of return
Representatives often provide hypothetical returns to prospective customers. While projecting performance is prohibited, hypothetical illustrations are allowed if they’re balanced and assume the maximum fees that could be charged.
For example, a representative may show a hypothetical return of up to 12% on a separate account and explain how it could affect variable life insurance cash value, as long as the representative also provides another hypothetical showing a 0% return and its effect on cash value.
A deferred variable annuity typically has a lengthy accumulation phase, with the intent to annuitize years later (often in retirement). These contracts commonly include 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. If the exchange occurs during the surrender period, it can trigger significant surrender charges, although taxes are typically avoided.
To recommend an exchange from one product to another, the representative must consider the following:
*36 months can feel like an arbitrary time frame, but exchanges within 3 years are more likely to involve 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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