More On Legal & Compliancefrom The Advisor's Professional Library
- Scope of the Fiduciary Duty Owed by Investment Advisors A fiduciary obligation goes beyond the suitability standard typically owed by registered representatives of broker-dealer firms to clients. The relationship is built on the premise that the advisor will always do the right thing for the person or entity receiving advice.
- Agency and Principal Transactions In passing Section 206(3) of the Investment Advisers Act, Congress recognized that principal and agency transactions can be harmful to clients. Such transactions create the opportunity for RIAs to engage in self-dealing.
The defined contribution revolution saw employers shift responsibility for funding retirement to employees who weren’t well equipped to become their own pension manager. One easy solution would seem to be information. Give people the right tools and they’ll be better able to select the right investments, the right advisors, and save the right amount of money. But is more information the key to improving retirement security?
New research provides insight into the promise and perils of disclosure as a policy tool. At its worst, disclosure is a waste of time and resources, draining millions of dollars from the financial services industry and achieving few measurable improvements in investor outcomes. At its best, disclosure can instantly achieve efficiency improvements within markets where it’s difficult for investors to assess price or quality.
First, some basic consumer theory. Investors make the best decisions they can but are limited by their knowledge. Collecting knowledge can be costly. A new employee must select among numerous investment options by reading through fund prospectuses or looking for cues of quality. Most people have made investments in learning a work-related skill in order to earn a living, but they haven’t made an investment in how to be their own pension manager. But creating 300 million pension managers doesn’t sound like a sensible public policy goal.
One way to help workers is to give them the information they need to make better choices. This is the appeal of information policy. If ignorance is the problem, then give them a detailed brochure that contains everything they’d need to know to make a better choice. Unfortunately, consumers may have no idea what to do with this information. And more information makes the problem worse.
There is perhaps no sadder example of failed information policy than the mutual fund prospectus. At an SEC roundtable, Don Phillips, Morningstar’s president of investment research, said that fund prospectuses were “bombarding investors with way more information than they can handle and that they can intelligently assimilate.” To its credit, the SEC tried to streamline the fund prospectus to only the most important information. Unfortunately, research shows that investors given a simplified prospectus still focus the most on fund characteristics that are irrelevant (like past performance) and ignore characteristics that matter (like fees).
Disclosure can even be counterproductive. In a 2011 paper, Sunita Sah, then at Duke University, and George Loewenstein of Carnegie Mellon University found that advisors were more likely to give self-serving advice if they first disclosed a conflict of interest to their client. When an advisor admits to a conflict of interest in a face-to-face transaction, this creates two problems. First, the client now feels that if they don’t accept the recommendation they are admitting they don’t trust the advisor—something that is taboo in human interactions.
The second problem is that the advisor now feels less pressure to make a recommendation that isn’t self-serving. It is as if one can absolve one’s sins by admitting to being a sinner. The authors found that recommendations given by participants in the role of advisor were significantly worse for the consumer if they had to disclose conflicts of interest.
Examples may include the ADV Part 2 among RIAs or any number of client disclosures required by FINRA. Duane Thompson, president of consulting firm Potomac Strategies, notes that different disclosure requirements among regulators of financial advisors add to the confusion. “Disclosure across regulatory authorities in the financial services industry varies considerably, even when financial intermediaries provide the same kind of retail advice, such as retirement planning.” Differences in the latitude given to advisors in making self-serving recommendations don’t help either.
GETTING IT RIGHT
The most effective financial disclosure laws have given consumers a little bit of very important information that is easy to use. A great example is the disclosure of a consistent interest rate in banking products—the APR—mandated by the Truth in Lending Act. Before the act, banks could play games by varying the compounding period or other product characteristics in order to take advantage of less sophisticated consumers. With the APR, comparing terms was a piece of cake and anyone could easily select a competitive CD. University of Chicago professor Eugene Fama found that consumer CD rates were basically identical to the similar duration bond rates obtained by more sophisticated investors.
It is easy for consumers to compare a single number. That’s why gas stations go out of business if they charge $4 for a gallon of gas that costs $3 down the street. Many financial markets such as 30-year fixed rate mortgages, savings accounts, and property insurance are much more competitive because it is easy for consumers to compare one number for products that have similar characteristics. Retirement investments aren’t so easy.
Nothing about the defined contribution retirement system in America is particularly efficient. U.S. Rep. George Miller (D-Calif.) famously posed with three-quarters of a pie to illustrate the estimated 25% of retirement savings lost to excessive plan administrator fees over a worker’s lifetime. Investments within retirement accounts tend to be expensive, not very well diversified, and not necessarily appropriate for the worker’s life cycle stage.
A well-functioning market for retirement assets would provide healthy competition among plan adminstrators to improve the quality of advising services and lower the cost of investing options. Is disclosure the answer?
University of Michigan business law professor Dana Muir believes that there is room for improved disclosure within the retirement industry if the right information is disclosed to the right people. “There is a significant body of research questioning the effectiveness of mandatory disclosure,” says Muir. “Studies in a variety of disciplines indicate that disclosure often fails to enable the person receiving the disclosure to act more rationally than the person would have acted in the absence of the disclosure.”
For disclosure to work, those who get the information need to know what to do with it. This is the problem with giving more information to workers. They don’t necessarily know how to use investment information to select appropriate retirement funds. Muir thinks that “fee and compensation disclosures to plan sponsors are more likely to have an effect on plan fee levels than disclosures to plan participants. Plan sponsors have an incentive, in meeting fiduciary obligations, to consider fee and compensation information.”
Disclosure seems to work a lot better in markets with informed participants who have an incentive to use new information. New York University professor David Yermack found that the mere mention that a CEO was flying a corporate airplane for personal use within an SEC 10-K form led to a same day drop of 1.1% in the firm’s stock price. There is no doubt that mandating firm disclosure through the SEC to investors has improved the stability and efficiency of the U.S. equity market.
In retirement savings markets where employees must participate but often don’t have the knowledge to make complex choices, the best choice may be no choice at all. This is the logic behind providing safe harbor to plan sponsors who select qualified default investment alternatives (QDIAs) for their employees. If the default investment is generally appropriate for the worker’s life cycle stage, then most investors can avoid making bad choices.
Muir, however, doesn’t think the plan sponsors should be on the hook in a system of investment defaults. The sponsors often don’t know more about selecting the right QDIA than employees—particularly if they are small businesses in non-finance fields. And giving employees more disclosure about the risks of a default investment defeats the purpose of a default system. That’s why Muir believes that the primary job of the plan sponsor as a fiduciary should be to select the right plan administrator. Leave it to the experts to select and defend which QDIAs to include in the plan.
New rulemaking by the U.S. Department of Labor is meant to provide disclosure to plan sponsors to help them select the right plan vendor. Joseph Piacentini, chief economist and director of policy research at the DOL’s Employee Benefits Security Administration, imagines that easier access to pricing will both help employers shop around and enhance competition among providers. Piacentini notes that the rule will “lay the groundwork for a more price competitive market, not just on the demand side, but also on the supply side…. Low-cost vendors will attempt to poach business from their higher-cost competitors. Disclosure/transparency as a regulatory tool works by affecting the behavior of the party receiving the disclosure, but also the behavior of the party who must disclose something.”
This is why some within the industry are seeing disclosure as an opportunity rather than a burden. Lance Hocutt, an advisor for Ameriprise Financial in Tuscaloosa, Ala., is looking forward to the opportunity to compete. To him, “the new disclosure rules really help those advisors and plans who already provide full disclosure, level the playing field.” And price isn’t the only way to compete—many employers look for a mix of cost and services when assessing an advisor’s value. “I have a specific client service model for each plan which includes an annual education plan, quarterly meeting dates, and events.”
Hocutt sees the much-needed personalized service he provides to sponsors and employees as an informed advisor’s greatest asset. Until the low-cost competition “will put a broker in front of plans,” Hocutt sees a place for advisors who can provide the right level of service at the right price.
Disclosure may have a role in improving retirement security for Americans after all. But regulators need to recognize when disclosure works and when it is a smokescreen that gets in the way of more effective policy. The defined contribution retirement system is here to stay. It’s in everyone’s interest to make sure employees get high-quality plans at the right price.
Michael Finke, Ph.D., is a professor and coordinator of the doctoral program in personal financial planning at Texas Tech University.