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:

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

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:

• A fund that ranks better than 95% of similar funds (based on risk and return) would receive a 5-star ranking.
• A fund that ranks better than only 20% of similar funds would receive a 2-star ranking.

Many fund companies display Morningstar rankings in marketing materials and on their websites. You’ll often see them prominently displayed, like 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.

This definition matters because investment companies can display rankings only in one of two situations:

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

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:

• Rankings from independent ranking entities like Morningstar, or
• Its own rankings, as long as they’re based only on performance measures (for example, 1-year, 5-year, and 10-year returns)

FINRA also requires specific disclosures whenever an investment company ranking is shown:

• 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

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:

• Longer maturities tend to mean greater price volatility.
• Lower coupons tend to mean greater price volatility.
• Greater volatility generally corresponds to higher duration.

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:

• 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 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

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 & specific considerations
• Deferred annuity rules

General & specific considerations

General considerations apply to all variable insurance products. Specific considerations apply only to certain products or situations. The relevant FINRA rule covers:

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

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.

• Variable annuities guarantee payments until death if annuitized (although the payment amount can vary).
• Variable life insurance guarantees a minimum death benefit.

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.

Deferred annuity rules

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.

Definitions

Surrender period

The amount of time that must elapse to take distributions from an annuity without a surrender charge

For example: An investor places $40,000 into a deferred variable annuity with a 6-year surrender period. Surrender charges start at 6%, then decline by 1% every year the contract is held (similar to contingent deferred sales charges (CDSCs). The surrender period is over after 6 years, and the investor can take distributions without surrender charges (although taxes will still apply).

To recommend the purchase of 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 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.

Sidenote

1035 exchanges

Section 1035 of the IRS tax code allows the exchange from one insurance product to another without taxes being assessed. Similar to a rollover from one retirement plan to another, transfers between insurance products are generally non-taxable. In particular, these types of transfers are tax-free:

• Annuity to annuity
• Life insurance to life insurance
• Life insurance to annuity

The only transfer that is not eligible involves moving funds from an annuity to a life insurance contract. The reason is that annuity payments are taxable (growth above the basis is taxable as ordinary income), while death benefits of life insurance policies are tax-free to the beneficiary. If the IRS allowed this, investors could use this loophole and move taxable annuity money into a life insurance product with a tax-free death benefit payment. Bottom line - exchanges from annuities to life insurance are taxable events.

To recommend an exchange from one product to another, 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 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:

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

Definitions

Annuity bonus

Additional money an insurance company matches when premium payments are contributed to an annuity

For example: An insurance company offers an 8% annuity bonus on the initial premium payment. A customer makes a premium payment of $10,000, resulting in the insurance company crediting their account an additional $800 ($10,000 x 8%). With this annuity bonus, the investor’s starting annuity value is $10,800.