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:
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 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:
| # of stars | Ranking of fund |
|---|---|
| 5 | Top 10% |
| 4 | Next 22.5% |
| 3 | Next 35% |
| 2 | Next 22.5% |
| 1 | Bottom 10% |
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:
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 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:
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:
Additionally, the following disclosures must be made:
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 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
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. A representative could show a hypothetical return of up to 12% maximum on a separate account and its influence on variable life insurance cash value as long as another hypothetical was provided showing a 0% return and its influence on cash value.
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:
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:
*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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