Mitch Atkins, FINRA’s former South Region Director who is now Principal of FirstMark Regulatory Solutions, recently had the opportunity to participate on a panel at FINRA’s South Region Compliance Seminar. The panel, which also included a member-firm representative and two FINRA representatives covered the topic of suitability, and focused in particular on two products, non-traded REITs and L-Share Variable Annuities.
The FINRA panelists expressed concern regarding what they are seeing as improper or unsuitable sales of L-Share classes of variable annuities. Several issues of note mentioned by the FINRA panelists included the time horizon of the customer and the fee structure of the product. Before we get into that here, a primer on L-Shares may be worthwhile.
L-Shares, like any other share class, are designed with a specific purpose in mind. First, an L-Share typically has a surrender period of 3 to 5 years, compared to a typical B-Share variable annuity which has a surrender period of 7 years. Typically, deferred sales charge variable annuities have a declining surrender charge. In the instance of a B-Share, this surrender fee schedule might be: 7%, 7%, 6%, 5%, 4%, 3%, 2%, 0%. Meaning if the product is surrendered in year one, the fee is 7%, year two, the fee is 7%, year three, the fee is 6% and so on. But in an L-Share situation, the surrender fee schedule looks more like this: 8%, 7%, 6%, 5%, 0%. So clearly the L-Share recoups a higher percentage if surrendered earlier. In exchange for this early termination of the surrender period, the products have higher M&E fees (Mortality and Expense). For example, a typical B-Share may have an ongoing M&E expense of 1.25% which is charged to the contract holder each year. However in a typical L-Share product, this ongoing fee is 1.65%. As a result, the higher ongoing fees over time can be substantial.
The FINRA staff’s point in this scenario is that broker-dealers and their associated persons must have a reasonable basis to believe that a recommended transaction in a variable annuity is suitable for a customer based on the information obtained from that customer about their investment profile. If a customer has a long term time horizon, an L-Share may not be the most appropriate share class to recommend.
Here are several key points were made during the presentation about monitoring transactions in L-Share variable annuities. First, broker-dealers must conduct an effective due diligence process such that they understand the products being sold, as well as the features of those products and for which of their clients that product may be appropriate. Second, broker-dealers must have written procedures that are designed to address the specific features of the products they sell, including in this instance, L-Shares. Some broker-dealers do not have specific procedures addressing these products. Third, firm training programs must address the unique features of these products, and that also means training the principals reviewing the transactions, not just the representatives selling them. Fourth, firms are required to monitor the sales of the product and the riders selected. In some instances, long-term riders are inappropriately being recommended with the shorter-term L-Share. Finally, questions regarding the suitability of the product should be confirmed directly with the customer when appropriate.
Broker-dealers should ensure that their supervisory systems are adequate to match customer time horizons with recommendations in L-Shares. These share class issues are not new. However, just like the days of the A vs. B share mutual fund, FINRA is now seeing issues with variable annuity share classes. As with any other recommendation, documenting the rationale for the recommendation is a critical aspect of a good recordkeeping system.
If you have questions regarding this aspect of suitability or any other issue, contact Mitch Atkins, Principal of FirstMark Regulatory Solutions at 561-948-6511.