Advisors Face More Scrutiny in the ‘Alternative’ Zone

March 07, 2012

By Linda Koco
Contributing Editor, AnnuityNews 

Financial advisors who recommend “alternative investment” options inside of variable annuities will be subject to greater scrutiny than if they only recommend an annuity’s traditional subaccounts, according to a securities attorney. 

Examples of alternative investments could include hedge funds, commodities and derivatives. 

That greater scrutiny could happen due to guidance that the Financial Industry Regulatory Authority (FINRA) has laid out for securities firms in Regulatory Notice 12-03.

Issued earlier this year, the 11-page document spells out supervision and compliance requirements for financial firms and their reps regarding sale of “complex” products containing novel, complicated or intricate derivative-like features.

Advisors who work with alternative product options inside of variable annuities would be subject to certain education and supervision requirements, says James J. Eccleston of the Eccleston Law Offices, Chicago.

The development is somewhat akin to what has happened to annuity advisors on the traditional fixed annuity side of the business. If they decide to offer the more complex fixed indexed annuity products, they are subject to greater educational regimens and closer supervision. 

The new FINRA Notice says that financial firms need to heighten their supervision of, and compliance procedures associated with, complex investment products, and that reps will need training and education that prepare them to work with such products.

The document does not say one word about variable annuities. However, if a variable annuity includes complex products like alternative investment subaccounts, then advisors who sell that annuity will be affected, says Eccleston.

This applies to alternative investments

The FINRA document also does not mention the term “alternative investments.” However, because alternative products tend to be more complex than traditional stocks, bonds and mutual funds, Eccleston believes the notice should be taken to apply to all alternative products, whether offered inside a variable annuity or as a standalone investment.

Alternative investments are a catch-all term for a wide range of investments that the financial industry considers to be unique or non-traditional as compared to traditional stocks, bonds and mutual funds.

Examples can range from commodities, private equity, and derivatives to hedge funds, limited partnerships, venture capital investments and more. (Some experts also also include tangibles, such as fine art, coins and antiques.) 

Client demand — and advisor demand — for alternative investments have grown since the 2008 market downturn, when investors started looking for greater diversification and greater non-correlation between asset classes. Variable annuity carriers responded by adding alternative subaccounts to more of their policies.

Today, 25 active individual variable annuity carriers offer a combined total of 39 unique subaccounts in the broad category of alternative investments, according to Frank O’Connor, product manager for the Morningstar variable annuity database. These subaccounts tend to use short, long or bull market investing strategies, he says.

Those carriers offer 63 individual variable annuities combined, he adds. And each offers one or more alternative subaccounts.

A lot of those subaccounts did not show up inside variable annuities until after the market crash of 2008, he adds. In fact, he says, “67 percent of the alternative subaccounts available today were added to the products after year-end 2008.”

The upward trend got another push just this week when Jackson National Life debuted a new variable annuity, Elite Access. That product has 40 subaccounts, and 12 of them are alternative options in areas such as managed futures, commodities, listed private equity, global infrastructure, convertible arbitrage and emerging markets debt.

Be careful

Access to alternative investments can be good for the customer, says Eccleston. But advisors do need to be “very careful” with making a recommendation to use these investments, he says, alluding to the FINRA Notice.

For advisors, the notice means that “you have to be very cautious. Be sure you understand these products and that the client understands them, and be sure that you fully disclose the risks and benefits of these options,” says Eccleston.

For investment firms, FINRA focuses on training and supervision with an eye toward due diligence and suitability. “The firms need to thoroughly vet these products before ever letting a rep offer it to anyone,” he says.

The products that FINRA says could be considered “complex” include: asset-backed securities, unlisted real estate investment trusts, products that include an embedded derivative component, products with contingencies in gains or losses, structured notes, exchange-traded products, and products with principal protection that is conditional or partial, or that can be withdrawn.

How do FINRA’s due diligence, suitability and full disclosure requirements for such products differ from the same requirements for traditional investments? They are the same, Eccleston says, “but the level of analysis, rep training, and disclosure increases when complex products are being sold.”

Do advisors really want to offer alternative investments? The idea may seem daunting to some. But in a poll of more than 500 registered investment advisers and fee-based advisors last summer, Jefferson National found strong interest. The New York carrier reported that that 68 percent of the advisors had already increased their use of alternative investments, and 67 percent were expecting their allocation to alternatives to continue to increase.

Linda Koco, MBA, is a contributing editor to AnnuityNews, specializing in life insurance, annuities and income planning. Linda can be reached at [email protected].

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