Securities Regulator Makes Protection of Senior/Retiree Investors A High Priority

By James Eccleston

enior investors, as well as Baby Boomers who are retired or who are approaching retirement, should take some comfort from a recent notice to financial services firms, Regulatory Notice 07-43. The Financial Industry Regulatory Authority (FINRA) states that the purpose of the notice is "to urge firms to review and, when appropriate, enhance their policies and procedures for complying with FINRA sales practice rules, as well as other applicable laws, regulations and ethical principles, in light of the special issues that are common to many senior investors."

Why is FINRA concerned? The concern stems from demographics - by 2030, almost 1 out of every 5 Americans will be 65 years old or older. Additionally, the concern is that retirees will live longer yet fewer and fewer of them will be able to rely on traditional corporate pension plans to fund their retirement. Therefore, FINRA states that "the financial decisions made by those who are at or nearing retirement are more important than ever before."

Moreover, FINRA emphasizes that although it does not have "special rules" in place for seniors/retirees, financial services firms especially must be careful when dealing with seniors/retirees. In executing their duties, the notice provides that "age and life stage (whether pre-retired, semi-retired or retired) can be important factors, and firms should make sure that the procedures they have in place take these considerations into account where appropriate." Suitability of recommendations and communications aimed at older investors are "of particular concern." Let's examine FINRA's guidance regarding suitability of investment recommendations.

The notice reminds financial services firms that all recommendations to purchase, sell or exchange a security must be suitable for the investor. For recommendations to seniors/retirees, age and life stage are important factors:

As investors age, their investment time horizons, goals, risk tolerance and tax status may change. Liquidity often takes on added importance. And, depending on their particular circumstances, seniors and retirees may have less tolerance for certain types of risk than other investors. For example, retirees living solely on fixed incomes may be more vulnerable to inflation risk than those who are still in the workforce, depending on the number of years those retirees are likely to rely on fixed incomes. Likewise, investors whose investment time horizons afford less time to or opportunity to recover investment losses may be disproportionately affected by market fluctuations.

As a result, FINRA cautions firms that they must consider a customer's "age, life stage and liquidity needs." FINRA also advises firms that they should consider a customer's primary expenses (for example, a mortgage), sources of income (and whether it is fixed), amount of retirement savings (and how they are invested), extent of health insurance coverage, and whether the customer will be relying on investment assets to pay for anticipated and unanticipated health costs.

In its notice FINRA also discusses risk -- market risk, inflation risk and issuer credit risk -- and why firms "should carefully consider the risk of a product with the age and retirement status of the customer in mind." For example, FINRA cautions firms that older investors may be tempted to "reach for yield to maximize retirement income without the appreciation of the concomitant risk." FINRA states that firms must fully understand the investments that they recommend, must present a "fair and balanced picture of the risks, costs and benefits" associated with their recommendations, and must recommend only those investments that are suitable. The notice also reminds firms that they and their advisers must refrain from making an unsuitable recommendation even if the customer has expressed an interest in that recommendation.

The notice also discusses particular investment products or strategies and why they may be unsuitable for seniors/retirees. FINRA is concerned that time horizon considerations, liquidity needs, volatility and inflation risk may render several products and strategies to be unsuitable for seniors/retirees. These include deferred variable annuities, equity indexed annuities and some real estate investments and limited partnerships, because these products "have withdrawal penalties or otherwise lack liquidity." Additionally, FINRA finds problematic the strategy of using home equity to make investments, as well as the strategy of using retirement savings (including IRA withdrawals) to invest in high risk investments.

Importantly, the notice contains a warning to financial services firms that "a customer's net worth alone is not determinative of whether a particular product is suitable for that investor, even when the investor qualifies as an accredited investor." FINRA states that over-reliance on net worth is "particularly problematic" where the investor has met the accredited investor standard based largely on the value of his or her home, "which may represent the largest asset of many senior investors."

Finally, FINRA extends the analysis from individual seniors/retirees to pension plans. Financial services firms owe a suitability duty even to those so-called "institutional customers." The scope of that obligation, according to FINRA, "varies depending on whether the institution is able to independently assess the risk associated with a particular recommendation and is in fact exercising independent judgment." In that regard, FINRA is "concerned" that pension plans may not be able to assess the risk of new products or products that have significantly different risk and volatility characteristics than previous investments made by the pension plans. As examples, FINRA cites leveraged exchange traded funds (ETFs) or the equity tranches of some collateralized mortgage obligations (CMOs).

As one can see, there appears to be a new era of regulatory concern for seniors/retirees. Investors, and their advisers, should take note.