Compliance January 7, 2015

FINRA Outlines Priorities for 2015

FINRA’s Annual Regulatory and Examination Priorities Letter highlights issues of importance to FINRA's regulatory programs.
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Firm culture, sound procedures for new product reviews and for recommending rollovers are on FINRA’s to-do list for 2015.

Over the ten years FINRA has been issuing its annual letter, big changes have taken place, according to the regulator. Analytics have allowed FINRA to identify registered representatives with higher-risk profiles, resulting in expedited regulatory responses. The regulator also more frequently shares information with domestic and international securities and banking regulators, in particular with the Securities and Exchange Commission (SEC) and the Municipal Securities Rulemaking Board (MSRB).

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In addition to several positive changes the regulator observed—improvement of new products review; better management of conflicts of interest; greater market transparency to retail investors—firms can find a number of lessons instructive.

Challenges in several areas contribute to occasional comprises in the quality of service that firms deliver to customers, and can contribute to compliance and supervisory breakdowns. First, firms should align their interests with those of its customers. Put customer interests first, the regulator emphasizes. Failing to do so is a central failing FINRA has observed. The harm this can cause can also be compounded when it involves vulnerable investors, such as senior investors, or a major liquidity or wealth event in an investor’s life: in other words, an inheritance or rollover of an individual retirement account (IRA).

Poor advice and investments in these situations can have especially devastating and lasting consequences for the investor. Irrespective of a firm’s need to meet a suitability or fiduciary standard, FINRA believes that firms best serve their customers—and reduce their regulatory risk—by putting customers’ interests first.

Take a close look at the culture of the firm, FINRA advises. The regulator says that many problems in financial services have roots in firm culture. A poor culture may stem from management’s undue emphasis on short-term profits or pursuit of rapid growth without a concurrent concern for controls, for example.

Boards of directors and senior executives must outline and adhere to high standards of ethical behavior that are expected and visible throughout the organization and are embedded in the firm’s incentives. These standards should come from the board and executives and not be viewed as a compliance task. The absence of stated standards can contribute to failures at the individual broker level (for example, disregard for customer needs in recommending securities) and can likewise bring about problems with potentially market-wide implications (e.g., manipulation of indices or the manufacture and marketing of unsuitable securities).

Zero Tolerance

Firms must protect their culture against individual bad actors, as well as firm-wide behaviors that can gradually erode that culture. Firm policies should signify that poor practices, whatever the magnitude of the harm caused or potential implications, will not be tolerated.

FINRA also emphasized the need for a firm’s system of supervision, risk management and controls as essential safeguards to protect and reinforce a firm’s culture, and rigorous new-product reviews for product and service offerings.

Conflicts of interest continue as a contributing factor in many regulatory actions FINRA and other regulators have taken against firms and individuals. The regulator said it is reviewing situations where market access customers self-monitor and self-report suspicious trading despite an inherent conflict of interest. And it continues to focus on fee and compensation structures that lie at the heart of many conflicts and which can at times compromise the objectivity registered representatives provide to customers.

Priorities for 2015 focus on key sales practice, financial and operational and market integrity matters.

FINRA Will Be Watching

FINRA’s 2015 surveillance and examination activities that include product-related risk reviews will routinely focus on due diligence, suitability, disclosure, supervision and training. Product-focused concerns may include features of the product itself as well as sales or distribution practices. Some products are complex and may be subject to substantial market, credit, liquidity or operational risks. As always, firms and registered representatives should be attentive to changing circumstances—such as the precipitous fall in oil prices or the rapid fall in some emerging and frontier market indices—that may affect suitability decisions and risk descriptions. Training registered representatives about product features, pricing and valuation, and providing guidance around suitability are important steps in meeting these challenges.

IRA Rollovers

A major area of focus is firms’ controls around the handling of IRA rollovers and other wealth events in investors’ lives. A broker’s recommendations made in connection with a wealth event can have long-lasting consequences for the customer. In 2015, examiners will focus on the controls firms have in place related to wealth events, with an emphasis on firms’ compliance with their supervisory, suitability and disclosure obligations. Firms’ systems should be reasonably designed to help ensure that financial incentives to the associated person or the firm do not compromise the objectivity of suitability reviews.

Part of FINRA’s focus will be IRAs, one of the principal vehicles Americans use to save for retirement. According to the Investment Company Institute, over one-quarter of Americans’ retirement savings are held in IRAs and this percentage is growing. Rollovers from employer plans—such as 401(k) plans—play an important role in funding these IRAs. FINRA has stated that, whether in retail communications or an oral marketing campaign, it would be false and misleading to imply that a retiree’s only choice, or only sound choice, is to roll over plan assets to an IRA sponsored by the broker/dealer.

Any communications that discuss IRA fees must be fair and balanced, and the broker/dealer may not claim that its IRAs are “free” or carry “no fee” when the investor will incur costs related to the account, account investments or both. If a broker/dealer does not intend for its registered representatives to recommend securities transactions as part of the IRA rollovers of their customers, then the broker/dealer should have policies, procedures, controls and training reasonably designed to ensure that no recommendation occurs. Similarly, if registered representatives are authorized to provide educational information only, a firm’s written supervisory procedures should be reasonably designed to ensure that recommendations are not made.

Without strong oversight, investors may not obtain the information necessary to make an informed decision, and firms may fail to detect recommendations otherwise prohibited by firm policy.

Interest Rate-Sensitive Fixed-Income Securities

FINRA’s 2014 Regulatory and Examination Priorities letter detailed concerns about the interest rate environment and the potential harm to customers holding interest rate-sensitive products that could result from shifts in that environment, and those concerns remain unchanged. FINRA also recognizes, however, that fixed-income products play an important role in a well-constructed portfolio.

What is critical is that firms’ communications discuss the impact of interest rate changes on price when marketing products that are interest rate-sensitive. In 2015, FINRA examiners will look for concentrated positions in products that are highly sensitive to interest rates—such as long-duration, fixed-income securities, high-yield bonds, mortgage-backed securities, or bond funds composed of interest rate-sensitive securities—and test for suitability and adequate disclosures. Examiners may also review firms’ efforts to educate registered representatives and customers about such products.

Variable Annuities

Assessments of compensation structures concerning variable annuities that might improperly be incentives to sell the products will be a key area of FINRA’s focus. Also under scrutiny will be the suitability of recommendations, statements made by registered representatives about these products, and the adequacy of disclosures made about features of variable annuities.

FINRA’s Annual Regulatory and Examination Priorities Letter can be downloaded from here.

The Markets January 7, 2015

Considerations for DB Investing in 2015

In 2015, the question for defined benefit plan sponsors and their advisers will not just be, “What will interest rates do?”
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Looking at their defined benefit (DB) plan as part of the overall corporate strategy will help plan sponsors determine how to manage assets, says John McCareins, practice lead for DB pension strategy at Northern Trust in Chicago.

Northern Trust continues to encourage plan sponsors to develop an outcome orientation strategy—to see the DB plan as an asset of the company and manage enterprise risk instead of just relying on interest rates to improve funded status, McCareins says. “Our view is, if they focus on their organizational-specific situation instead of trying to guess on equity or interest rates, they will look at how each of three investment ‘buckets’ will work toward the corporate goals and make the portfolio as all-weather as possible.”

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The three “buckets” to which McCareins refers are:

  • Liability awareness—investing in assets that behave in correlation with the plan’s liability;
  • Growth—global equity exposures engineered to manage risk exposure at different points on a funded-status glide path; and
  • Diversification—investing to achieve higher yield and lower correlation to the equity markets or interest rates, for example by investing in global real estate, infrastructure or hedge funds. 

Plan sponsors should be focused on working assets smarter, not harder, McCareins suggests. The equity markets have continued to show above average results over the past three calendar years, and interest rates are at historical lows: putting the two together begs the question, ‘Do I lean toward fixed income or equity?’ Plan sponsors should view each investment or asset class as contributors to risk and return, and each has a distinct role in the DB plan portfolio, he says.

The theme of working assets smarter not harder is leading to demand in alternative and engineered equity investment strategies, McCareins contends. For example, DB plan sponsors are looking into custom hedge fund programs or engineered equity strategies—what some call smart beta. Northern Trust’s engineered equity strategies are somewhere in between passive strategies, that just seek to replicate an index, and active strategies, that focus on one goal, such as achieving returns. Engineered equity strategies can amplify certain factors and minimize others.

DB plan sponsors should be discussing whether their investment strategies continue to reflect corporate goals for the plan, adds Michael Fischer, managing director and institutional investment executive at U.S. Trust in Charlotte, North Carolina. Is the ultimate goal for the plan termination or keeping it going as a strong benefit? The answer will drive investment strategy.

If plan sponsors want to keep their DB plans going, they must assess what risk they want to take with their plans, Fischer says. For example, they may want to control the risk of a negative surprise; if interest rates go down when they expect them to go up, and they haven’t hedged interest rate risk, they may end up with a greater funding requirement than what fits their budgets.

Consulting firm Mercer says the plan’s funded status may determine the best way for sponsors to deal with low interest rates. For a relatively well-funded plan, the sponsor may want to remove interest rate risk regardless of the rate level, either through increasing the hedge ratio or outright transfer of the risk through a cashout or buyout. For sponsors in a deficit position, moving to a high level of fixed income or extending duration may not be ideal. For some sponsors with good credit ratings, borrowing to fund may be a good strategy to access capital at low rates, and it could contribute to the growth side of the plan assets where higher returns can be earned.

An ability to quickly change the plan’s interest rate exposure or hedge ratio is essential for capturing funded status gains in the event that rates rise, Mercer says. This may require investing beyond cash bonds and considering investment instruments such as interest rate swaps and futures.

DB plan sponsors have to manage their fiduciary risk, regulatory risk and market risk, McCareins adds. “If plan sponsors are keeping their plans going, they have to address investment issues differently than if they are planning to terminate the plan or transfer the assets,” he says.

McCareins says he is seeing a trend toward investment outsourcing among DB plans. Plan sponsors are asking why they are allocating resources to managing the three risks when they can share the fiduciary liability with an outsourced chief investment officer (OCIO) firm. In addition, many are losing their retirement plan expertise—pension managers that have been with companies for years are retiring—and resource constraints lead them to elect to outsource investment management rather than retool staff.

Over the past several years, many DB plan sponsors have moved to liability driven investing (LDI) strategies, including a de-risking glide path in which investments change as plans achieve certain funded status triggers. Fischer believes in 2015 plan sponsors will ask whether they should abandon their LDI strategy if they believe interest rates will go up, or, for those that have not adopted an LDI strategy, whether they should adopt one now.

With numerous changes in the pension and economic environment, Mercer says now is a good time for plan sponsors to take a fresh look at their glide paths and ensure that they continue to be effective. The recent publication of new mortality tables by the Society of Actuaries (SOA) will increase reported liabilities for most plan sponsors by anywhere from 5% to 10%, with a corresponding reduction in reported funded status, Mercer says. Sponsors should verify that the allocation and funded status points along the glide path are still consistent with the new liability and end-state targets of the plan.

Given that market volatility is likely to continue in 2015, sponsors on a de-risking glide path may need liquid assets available to effect asset-allocation changes promptly. Some plans may also be able to capitalize on volatility by using a more dynamic or market-aware de-risking program. A dynamic approach might have a de-risking plan that specifies risk or return targets as opposed to specific static asset allocations, which would allow the plan sponsor to identify the optimal portfolio as market conditions change. Using such a dynamic risk management process requires enhanced portfolio monitoring, coupled with a nimble execution and governance process.

Many sponsors looking to terminate their plans or complete a pension risk transfer move to an LDI strategy because, to purchase an annuity to cover DB liabilities, the plan must be more than 100% funded because of premium costs. McCareins believes there will be increasing adoption of LDI strategies despite what interest rates do.

Mercer says plan sponsors that intend to transfer risk to an insurer at a future date may want to invest assets to hedge against annuity price movements.

The bottom line, according to McCareins, is DB plan governance will be an increasing focus in 2015—to manage DB plan risks and improve outcomes. Plan sponsors should have an investment policy statement (IPS), and more importantly, adhere to it, he says.

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