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.