The implication is that investors are largely at fault for not understanding how brokers and advisers differ. Recent research from RAND and AARP suggests something else
Authors: Knut A. Rostad and Darren M. Fogarty*
The SEC’s Reg BI is meant, in part, to remedy “investor confusion” according to SEC Chairman Jay Clayton.1 This premise fits conventional wisdom that the problem is investors are “confused.” Stop.
What does this mean? How is confusion typically understood? We might say driving in heavy traffic in a new city is confusing. An elderly person may become confused about what precise time dinner occurs. Indeed, the Oxford Dictionary defines confused as “unable to think clearly; bewildered” or “not in possession of all one’s mental faculties, especially because of old age.” We use the word confused to describe someone who has information but is momentarily unable to think through the issue clearly.
“Investor confusion” has become the catchall phrase used to either explain, defend or criticize most any policy or recommendation dealing with retail investors. The term has luminary status, especially for regulators discussing the enormity of the difficulty dealing with retail investors. At the unveiling of Reg BI in April of last year, Commissioner Piwowar spoke of addressing, “confusion among retail investors” as to the “regulatory regimes” and that “resolving this confusion is no easy task. (This) has vexed the Commission and other regulators for years.”
Is this vaunted status warranted? Does this fairly describe the circumstances regarding investors and their perceptions of brokers and advisers? Recent research on investor perceptions generally and the SEC’s Form CRS suggests maybe not. It suggests that merely saying that investors are confused misses the mark and misstates the issue. It does not capture the whole picture.
This recent research offers a more complete picture that strongly suggests the problem is not, per se, that investors do not grasp the differences between brokers and advisers. It suggests the problem lies with misleading industry communications and explanations of what
*Knut A Rostad is president and founder of the Institute for the Fiduciary Standard. Darren M Fogarty is Research Analyst at the Institute. The Institute is a non-profit that exists to advance the fiduciary standard through research, education and advocacy. For more information see www.thefiduciaryinstitute.org.
Conventional Wisdom: “Investors are Confused; They do not Understand.”
Studies on investor financial literacy often suggest investors are confused and do not comprehend how brokers and advisers differ. Consider the following notable examples in the SEC’s 2008 RAND Study:2
“Most…participants do not have a clear understanding of the boundaries between investment advisers and broker-dealers. Even those [investors] who have employed financial professionals for years are often confused” (p. 87, emphasis added).
“…Many respondents are confused about the methods of payment or the type of firm with which their individual professional is associated” (p. 95, emphasis added).
“Even after being presented with fact sheets, participants were confused by the different titles. They noted that the common job titles for investment advisers and broker-dealers are so similar that people can easily get confused over the type of professional with which they are working” (p. 111, emphasis added).
“Investor confusion” has become the catchphrase in the media.3 AARP, in its critique of Form CRS, refers to investor confusion throughout its press release:4 The phrase has effectively become undisputed conventional wisdom.
“Despite efforts to simplify the form, researchers found more confusion among investors on important issues.”
“Consumers had low comprehension… Consumers misunderstood legal obligations… Consumers did not understand what it meant to have a conflict of interest… Consumers remain confused over fees and costs.”
There is no doubt that investors fail to understand. The question is: “Why?” The research report by Kleimann Communications Group5 that AARP discusses offers a salient answer: “Few participants knew what the word ‘mitigate’ meant and thus were confused about how exactly Broker-Dealer accounts would handle a conflict of interest…Because the obligation to ‘mitigate’ conflicts is not clearly defined in the proposed standard, subject matter experts were unable to come up with the language to clarify this requirement” (emphasis added). 6
Communications from the BD Industry are Misleading; Regulators’ Approval and Legalese Further Muddy the Waters
Broker-dealers have been working day and night to shift the public’s perception about how they conduct business for decades, and the SEC has permitted such behavior – even tacitly encouraged it with its decisions and language over the past decade.7 The resulting Tower of Bable should surprise no one.
Consumer Federation’s Roper and Hauptman document just how confusing the brokerage industry has made it for an investor in their paper, Financial Advisor or Investment Salesperson? They provide 10 pages of examples of broker-dealers “us[ing] a variety of tactics to portray themselves as trusted advisors,” including misleading titles, language that conveys the “impression they offer investment advice and retirement planning,” and “messages that encourage relationships of trust and reliance” rather than arms-length transactions.8 This messaging obscures basic facts and circumstances that make it easy to distinguish between a salesperson and an advisor.
Misleading or Confusing Communications is in Plain Sight in the OIAD Study
The Office of the Investor Advocate / Rand 2018 study (OIAD) seeks to test how well investors “understand the retail market for investor advice.” The Focus Group Handout 1 (attached to this document) seeks to explain the role of BDs and IAs to participants (investors). Unfortunately, it does not succeed. It says of brokers: “A broker is an individual or firm that charges a fee or commission for buying or selling securities for investors.” Of advisers, “An investment adviser is an individual or firm that is in the business of giving advice about securities to clients.” About both, “A financial professional can be both a broker and an investment adviser.” The handout says the greatest difference is that “The broker does not typically monitor … your account:” … “The adviser typically monitors your account.”
To its credit, OIAD acknowledges the handout failed and stated, “more effective ways of communicating to investors the differences” are needed. But this example should raise the question: How many investment professionals could distinguish brokers from advisors based on this description?
New Conventional Wisdom: “Industry confusion”; not investor confusion. Industry and regulatory communications and are confusing to the public and investment professionals.
This research suggests a new conventional wisdom to replace the current conventional wisdom is needed. Current conventional wisdom says the problem is “investor confusion” and implies investors are at fault. To overcome these shortcomings better investor education and disclosure is needed.
A new conventional wisdom says the problem is “industry confusion” and intentionally unclear or misleading industry messages is the main culprit. These messages are supported by opaque fees and conflicts. They pass regulatory muster and find their way into regulatory disclosures, as noted above.
Investors Know What They Want
Despite this overwhelming industry confusion and communications effort, it’s noteworthy that many investors do understand that the industry messaging is confusing. Investors have plainly stated their expectations of advice. The SEC OIAD’s 2018 RAND Study9 shows that investors expect an advisor to:
- Receive compensation from clients directly;
- Represent their interests, not the interests of others;
- Avoid higher compensation costs and recommend “lowest cost” products, other things equal;
- Explain any payments that may impair their objectivity.
The report shows this quantitatively, not just qualitatively. Investors overwhelming believe that an advisor who is required by law to meet a ‘best interest’ standard will help them choose the lowest cost products, other things equal (73% agree vs. 11% disagree), will disclose payments they receive that may influence them (59% agree vs. 15% disagree), and will avoid high comp when a similar, less costly product is available (61% agree vs. 19% disagree)10. Furthermore, by a margin of 51% to 22%, investors thought it was important or extremely important for a financial professional to receive all of his/her compensation from them directly.11
The study conducted on behalf of AARP by Kleimann (mentioned earlier) also shows that investors do understand conflicts of interest.12
“Consumers did not understand what it meant to have a conflict of interest. They had a vague sense that it would not be good for them, but they do know they want their own interests to come first” (emphasis added).
Investors are unambiguous: they expect their interests to come first. What they find difficult to comprehend is what it means for them when their broker or advisor has a conflict. That is how is the conflict reconciled with the essential nature of the relationship they want and expect from a financial professional. This reconciliation is made more complicated than need be by obfuscating messaging from the broker-dealer industry and the top-down tone from the SEC that ‘conflicts are okay.’
Investors are not confused. They do not lack capacity to think through the information they are given. They are not “forgetful.” However, they do misunderstand how brokers and advisers differ because the information they get from the industry is unclear or misleading. Industry information is confusing. This is the problem both RAND 2018 studies and the Kleimann study suggest is at play. Information confusion. Information or industry confusion suggests a different way to think about conduct standards regulation. This is a framework that investor and fiduciary advocates should articulate and advocate as the new conventional wisdom.
1 In, for example, the November 7, 2018 Remarks to the SEC Investor Advisory Committee, at https://www.sec.gov/news/public-statement/statement-clayton-110718 (“I am very pleased with the progress we have made in achieving the goals of our proposals to address investor confusion…”).
2 Investor and Industry Perspectives on Investment Advisers and Broker-Dealers, https://www.sec.gov/news/press/2008/2008-1_randiabdreport.pdf.
3 See, for example, Elizabeth Warren’s comments in https://www.thinkadvisor.com/2018/09/27/sizing-up-the-secs-form-crs/; ‘Several industry trade groups and firms’ and LPL Financial’s comments on Reg BI in https://www.financial-planning.com/list/rubbish-advisors-firms-trade-barbs-over-secs-best-interest-rule; and, to some extent, ‘Consumer groups’ in https://www.thinkadvisor.com/2018/09/13/secs-new-customer-relationship-form-confuses-consu/.
4 AARP Urges SEC to Revise and Retest the Best Interest Advice Guidance, at https://press.aarp.org/2018-12-7-AARP-Urges-SEC-To-Revise-And-Retest.
5 Report on Development and Testing of Model Client Relationship Summary, https://www.aarp.org/content/dam/aarp/politics/advocacy/2018/12/crs-report.pdf
6 Ibid, at 11.
7 See Conflicts of Interest and the Duty of Loyalty at the Securities & Exchange Commission, https://thefiduciaryinstitute.org/wp-content/uploads/2015/08/SECandConflictsApriil62015.pdf
9 TheRetail Market for Investment Advice, https://www.sec.gov/comments/s7-07-18/s70718-4513005-176009.pdf
10 Ibid, at 72.
11 Ibid, at 65.
12 AARP Urges SEC to Revise and Retest the Best Interest Advice Guidance, at https://press.aarp.org/2018-12-7-AARP-Urges-SEC-To-Revise-And-Retest.
Appendix 7. Focus Group Handout 1
A broker is an individual or firm that charges a fee or commission for buying or selling securities (like stocks, bonds, or mutual funds) for investors.
There are different kinds of brokerage accounts you can choose. You can choose an account where you research an investment yourself and just place orders with the broker, or you can choose an account where the broker makes recommendations to you. With both types of brokerage accounts, you approve each order to buy and sell investments in your account, and you are charged a fee each time you buy or sell an investment. This fee is not based on the value of assets in your account.
A broker may give you some advice to help you decide what to buy or sell, but the broker does not typically monitor the performance of your account or offer investment advice on a regular basis.
An investment adviser is an individual or firm that is in the business of giving advice about securities to clients. The adviser typically monitors your account and offers advice on a regular basis. The advice may include recommendations about specific investments to buy or sell, or it may be more general advice such as how to properly balance your portfolio between stocks and bonds.
There are two different kinds of advisory accounts you can choose: an account where the adviser gives you recommendations and you make the final decision before securities are bought or sold, or an account where you give the adviser the discretion to buy or sell investments on your behalf without seeking prior approval. In either type of account, an adviser will charge you an on-going fee that is usually based on a percentage of the value of assets in your account.
Sometimes, an investor may want a one-time service from an adviser, such as a written financial plan, and an adviser may charge a one-time fee for that type of service.
A financial professional can be both a broker and an investment adviser, and a firm can be both a brokerage firm and an investment advisory firm.