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Nazareth Discusses Suitability Obligations in Sales of 529 Plans and Variable Annuities

In a speech at the NASD's spring securities conference in Hollywood, Florida, SEC Commissioner Annette Nazareth discussed the suitability issues presented by 529 plans, variable annuities, tenants in common interests in real estate and real estate investment trusts. These products are more prone to retail investor confusion, she explained, and staff reviews suggest that compliance could be improved, particularly with respect to brokers' suitability obligations.

All 50 states and the District of Columbia offer 529 plans, which are tax advantaged savings plans designed to pay for education costs. Nazareth said the variations among the 529 plans make them very difficult to compare. The plans have differing state tax treatments, contribution limits, investment options, share classes and fee structures. Given the complexity of these college savings plans, Nazareth emphasized the importance of brokers making suitable recommendations to their customers.

The Municipal Securities Rulemaking Board primarily governs the sales of 529 plan shares since they are municipal securities. The MSRB has advised brokers that, since 529 plans are designed to pay for higher education expenses, this purpose must match the investment objectives of the purchasing customers. Broker-dealers should consider, among other things, whether more conservative investments are appropriate as beneficiaries near college age. The time frame is also important in determining which share class is suitable.

Nazareth said that tax implications also must be considered. The NASD found during reviews in 2003-2004 that some broker-dealers were selling as much as 90% of their 529 plans to residents outside of the state that sponsored the plan. This raises some red flags, even if there was no suitability violation, she said.

Variable annuities have been a long-standing concern at the SEC, the NASD and among other regulators, according to Nazareth. As the population ages, variable annuities are gaining attention from the financial services industry. One problem with variable annuities is that the fee structure can be difficult to understand, she explained. Variable annuities also frequently pay higher commissions which may provide an incentive to sell these products over other investments, she said.

The NASD has issued best practice guidelines advising brokers that registered representatives should recommend variable annuities only if the customer has a long-term investment objective. Nazareth said the SEC is also concerned with excessive switching of variable annuity contracts which raises particular suitability issues. The tax implications also must be carefully considered, she said.

Tenants in common interests in real estate, known as TICs, are considered nonconventional investments so broker-dealers must ensure that they are sold in a manner consistent with general sales conduct obligations. TICs present a number of suitability issues, Nazareth said, including the lack of a secondary market. 

REITs that are not traded on a national securities exchange or over-the-counter also pose suitability issues. Unlisted REITs may involve a high degree of risk, but their high costs may motivate representatives to make unsuitable investment recommendations. These products pose particular supervisory challenges, according to Nazareth.

In the coming years, Nazareth said that concerns about the sale of complex financial products to seniors will increase. She urged broker-dealers to exercise particular care in the sales of these products to seniors. Nazareth advised that the SEC's Enforcement Division has been active in bringing cases that involve the protection of senior investors. The emphasis on protecting senior investors will only increase as more of the baby boom generation retires, she said.