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SEC Financial Literacy Study — a Harbinger of Future Regulatory Initiatives on Disclosure and Customer Communications

September 11, 2012

On August 30, 2012, the SEC issued a Study Regarding Financial Literacy Among Investors (“Study”) prepared by the Staff of the SEC’s Office of Investor Education and Advocacy (“OIEA”).1 The Study was mandated by Section 917 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank Act”). Although the results of the Study are not surprising, the Study is important because its findings — including that “U.S. retail investors lack basic financial literacy”2 — are likely to drive future regulatory initiatives. In short, we should expect to see proposed solutions crafted to address problems identified in the Study, and some of the customer preferences identified in the Study are likely to feature prominently in the regulatory solutions proposed.

BACKGROUND

Section 917 of the Dodd-Frank Act required the SEC to conduct a study to assess financial literacy among U.S. retail investors and methods to increase it. Specifically, the SEC was directed to identify:

(1) The existing level of financial literacy among retail investors, including subgroups of investors identified by the Commission

(2) Methods to improve the timing, content and format of disclosures to investors with respect to financial intermediaries, investment products and investment services

(3) The most useful and understandable relevant information that retail investors need to make informed financial decisions before engaging a financial intermediary or purchasing an investment product or service that is typically sold to retail investors, including shares of open-end mutual fund companies

(4) Methods to increase the transparency of expenses and conflicts of interests in transactions involving investment services and products, including shares of open-end mutual fund companies

(5) The most effective existing private and public efforts to educate investors

(6) In consultation with the Financial Literacy and Education Commission,3 a strategy to increase the financial literacy of investors

The OIEA used a number of different sources to complete the Study, including a Library of Congress review of quantitative studies of financial literacy among U.S. retail investors, public comments, qualitative research (focus groups) and quantitative research,4 and expertise from a task force drawn from various Divisions and Offices within the SEC.

KEY OBSERVATIONS AND FINDINGS

I. The Existing Level of Financial Literacy Among Retail Investors

The Study concludes, based on quantitative studies reviewed by the Library of Congress,5 that U.S. retail investors lack basic financial literacy.6 According to the Study, investors have a poor grasp of basic financial concepts (such as compound interest, inflation, diversification, and the differences between stocks and bonds) and do not have adequate knowledge of ways to avoid investment fraud. In addition, survey results show that certain segments of the population demonstrate a greater lack of investment knowledge, such as “women, African-Americans, Hispanics, the oldest segment of the elderly population, and those who are poorly educated . . . .”7

II. Methods to Improve the Timing, Content and Format of Disclosures to Investors with Respect to Financial Intermediaries, Investment Products and Investment Services

One aspect of the quantitative research focused on examining the survey respondents’ understanding of three basic disclosure documents: trade confirmations, account statements and sweep account disclosures. Of note is that while investors reported having some general level of understanding of these documents, many of them failed to correctly answer relatively basic questions related to the disclosure documents they reviewed.

The Study identifies investors’ preferences as to the timing, content and format of disclosures:

  • Retail investors generally prefer to receive disclosures before they decide whether to engage a financial intermediary or to purchase an investment product or service.8
  • Some public commentators advocate, and some investors prefer, a “layered disclosure” framework in which investors receive an initial summary disclosure document that provides references to other more detailed disclosures.
  • Some investors prefer summary documents containing concise key information, particularly for disclosures about investment products.
  • Investors prefer clear, concise, plain language; the use of common terminology; and charts, table, graphs and bullet points.
  • Investors consider it to be “absolutely essential” that financial intermediaries disclose fees, disciplinary history, investment strategy and conflicts of interest.
  • Although investor preferences are mixed with respect to the method of delivery, public commentators stressed expanding the use of electronic delivery methods for disclosures (i.e., email, hyperlinks and website postings) while still making paper copies available for those investors who prefer hard copy versions.

Aside from identifying these preferences, the Study does not present any specific solutions regarding the timing, content and format of disclosures. However, the preferences may indicate that the SEC could disfavor disclosures provided for the first time along with a trade confirmation upon the completion of a transaction.

III. The Most Useful Information that Retail Investors Need to Make Informed Financial Decisions Before Engaging a Financial Intermediary or Purchasing an Investment Product or Service

The Study identifies information retail investors find most useful in connection with engaging a financial intermediary or purchasing an investment product or service:

Information Useful to Retail Investors Before Engaging a Financial Intermediary:

  • Fees/expenses/compensation (including with regard to investment advisory clients specifically, the amounts of money (a) the client would pay to maintain the advisory relationship with the adviser; and (b) the investment adviser would receive for providing advice to the client)
  • Sources and amount of compensation to the financial intermediary from third parties
  • Investment performance/past performance/track record of financial intermediary
  • Investment strategy of financial intermediary
  • Disciplinary history of financial intermediary
  • Professional background of financial intermediary
  • The identity of the firm and the scope of services offered
  • Severity, number and plain language description of financial intermediary’s conflicts of interest
  • Availability of the financial intermediary to the customer
  • According to some public commentators, the standard of care (e.g., fiduciary duty or suitability) provided by the financial intermediary to investors

Information Useful to Retail Investors Before Purchasing an Investment Product or Service:

  • Fees/expenses (such as sales charges, management fees and operating expenses)
  • Past investment performance
  • Principal risks or risk factors (such as credit risk, liquidity and inflation)
  • Investment objectives and strategy (such as growth, income or capital preservation)

IV. Methods to Increase the Transparency of Expenses and Conflicts of Interests in Transactions Involving Investment Services and Products

The Study comments that even though many survey respondents indicated that they understood existing fee and compensation information, the quantitative research data suggests otherwise. However, the Study finds that there appeared to be no consensus among retail investors regarding the best method to increase the transparency of expenses in transactions involving investment services or products. The Study identifies, from the quantitative research, several possible methods to increase such transparency:

  • Presenting information about fees and compensation in narrative format as well as in a fee table
  • Providing fee and compensation information in table or bulleted format, both with or without examples
  • Using simplified wording and making expense disclosures briefer and less detailed
  • For trade confirmations, including disclosures regarding the composition and types of a financial intermediary’s total compensation
  • For potential point-of-sale disclosures, disclosing how a financial intermediary will be paid in connection with the client’s account

The Study notes that public commentators provided other suggestions to increase transparency of expenses for investment services or products:

  • Displaying fees and expenses prominently in disclosures and advertising materials
  • Consolidating all fee and expense information in a central, easily accessible location
  • Expressing fees and expenses in dollar amounts and as a percentage of investment return rather than asset value
  • Providing case studies and illustrations demonstrating the impact of fees and expenses on investment returns

The Study comments that investors had a range of reactions to conflict-of-interest issues. Some investors lacked familiarity with the types of conflicts that may exist; some did not believe their investment advisers had conflicts; and others reported that the current disclosures provided were appropriate. Based on the quantitative research, the Study identifies possible methods to increase the transparency of conflicts of interest involving investment services or products:

  • Presenting specific examples of how, in connection with specific advice given to a client, a potential conflict of interest would operate
  • Providing bulleted or summary table format disclosures
  • Providing more specific disclosures
  • Presenting brief and general disclosures, with more specific information to be provided upon request
  • Disclosing whether an individual financial intermediary will profit from a client’s investment choices, whether the intermediary will earn more from selling certain products rather than other similar products, whether the intermediary will benefit from selling products issued by an affiliated company, and whether the intermediary will receive a portion of the annual asset fees paid by the client
  • For trade confirmations, disclosing whether the financial intermediary is registered as a broker-dealer and/or investment adviser and whether the financial intermediary suggested or recommended the particular investment
  • For account statements, disclosing the financial intermediary’s sources and amounts of compensation

The Study notes that public commentators provided other suggestions to increase transparency of conflicts of interest in transactions involving investment services or products:

  • Providing investors with lists of frequently asked questions and corresponding answers, to highlight types of conflicts of interest
  • Furnishing investors with narrative examples of types of conflicts of interest
  • Requiring that conflicts of interest policies be drafted in plain language and made easily accessible to investors

Finally, the Study identifies further suggestions made by public commentators to increase transparency of both expenses and conflicts of interest in transactions involving investment services or products:

  • Providing clear descriptions of all the sources and amounts of compensation (such as commissions, fees and third-party compensation arrangements)
  • Employing standardized disclosure forms or common terminology to permit investors to more easily compare fees and conflicts of interest between investment products, services and financial intermediaries

V. Identifying Effective Existing Private and Public Efforts to Educate Investors and Developing a Strategy to Increase the Financial Literacy of Investors to Bring About a Positive Change in Investor Behavior

The Study obtained feedback from 80 public commentators (including from investors, financial professionals, industry groups, academics, nonprofit groups and regulators), which it summarized to identify the most effective existing private and public efforts to educate investors. Based on that feedback, the Study identified as the most effective such efforts those that are: based on research and evaluation; focused on clear goals; timely and relevant; centered on important investor education concepts; easily accessible; promoted with strategic partnerships; delivered efficiently; relevant to their target audience; and scalable.

The OIEA Staff and Financial Literacy and Education Commission (“FLEC”) representatives worked together to identify a strategy to increase the financial literacy of U.S. retail investors. They identified four content areas to promote: (1) awareness of different types of risk; (2) fees and costs of investing; (3) proactive steps to avoid fraud; and (4) general knowledge of investment concepts. The Study presents a strategy in which OIEA and other FLEC participants will jointly collaborate to develop programs to develop financial literacy programs that:

  • Focus on specific groups, including young investors, recipients of lump sum payments, investment trustees, military service members, members of underserved populations and elderly investors
  • Promote the importance of researching investment professionals’ backgrounds (an “ask and check” campaign)
  • Improve and promote investor.gov as the primary federal government resource for information about investing
  • Promote awareness of the costs and fees of investing

CONCLUSION

The 182-page Study (211 pages including the Executive Summary) gathers important information regarding what investors know, do not know and want to know about financial professionals and investments products and services. It also identifies when, how and in what format investors prefer to receive the information. In the SEC’s press release, Chairman Schapiro states: “Understanding the needs of investors is critical to carrying out the Commission’s investor protection mission. The study provides important data and insights that will assist the Commission in its ongoing efforts to help retail investors make informed investing decisions.”9 The Study’s identification of financial literacy shortcomings among U.S. retail investors, and its identification of customer preferences, are worth careful review as they will likely shape future regulatory initiatives.

The SEC and FINRA have previously made a number of disclosure proposals that have not yet been adopted, in part because of concerns about whether they really provided information that was useful and important to investors. The SEC twice has proposed, but has not adopted, point-of-sale disclosure requirements for mutual funds.10 And FINRA has proposed, but not adopted, a disclosure document analogous to a Form ADV for broker-dealers.11 The results of the Study may help inform renewed initiatives in both areas. Similarly, the Study may help inform how the SEC harmonizes broker-dealer and investment adviser regulation as it proceeds with its concept of a unified standard of care for both types of firms.

*This alert was co-authored by David Boch, W. Hardy Callcott and T. Peter R. Pound.

Contacts

If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following Morgan Lewis lawyers:

Burke-Timothy
Boch-David
Kroll-Amy
Joseph-Roger
Smith-Edwin

1 The Study is found at http://www.sec.gov/news/studies/2012/917-financial-literacy-study-part1.pdf (last accessed: Sept. 10, 2012).

2 Study, at iii; see also id. at 15 (“American investors lack basic financial literacy.”).

3 The Financial Literacy and Education Commission, established under Title V of the Fair and Accurate Credit Transactions Act of 2003 to improve financial literacy in the United States and chaired by the U.S. Department of the Treasury, consists of numerous federal entities.  In 2011, it released Promoting Financial Success in the United States: National Strategy for Financial Literacy 2011, “a strategic framework focused on increasing awareness of and access to effective financial education, determining and integrating core financial competencies, improving financial education infrastructure, and identifying, enhancing, and sharing effective practices.”  Study, at n. 13.

4 The quantitative research, conducted by a consultant engaged by the SEC, was based on online surveys that examined the usefulness and effectiveness of specific disclosure documents, which included: the Form ADV Part 2A brochure required to be delivered by registered investment advisers; account statements and confirmations; the mutual fund summary prospectus; and hypothetical point-of-sale disclosure documents. The online survey testing included four research panels, each comprised of approximately 1,200 respondents specifically screened and selected for the four types of disclosure documents.

5 The report from the Library of Congress, Financial Literacy Among Retail Investors in the United States (Dec. 30, 2011) is attached as Appendix 1 to the Report and is found here:  http://www.sec.gov/news/studies/2012/917-financial-literacy-study-part2.pdf (last accessed:  Sept. 10, 2012).

6 Included among the studies reviewed by the Library of Congress was the 2009 National Financial Capability Study performed by the Financial Industry Regulatory Authority Investor Education Foundation, which found, based on a national sample of nearly 1500 respondents, “relatively low levels of financial literacy among Americans.” FINRA Investor Education Foundation, “Financial Capability in the United States: National Survey—Executive Summary” (Washington, DC, December 2009), 18, http://www.finrafoundation.org/web/groups/foundation/
@foundation/documents/foundation/p120535.pdf
(last accessed Sept. 10, 2012).

7 Study, at iii, viii, 15.

8 The Study notes that, in some contexts, the timing of the delivery of this information is pre-determined, such as trade confirmations, which must be provided to customers by their broker-dealer at or before the completion of a securities transaction.

9 See Press Release, found at http://www.sec.gov/news/press/2012/2012-172.htm (last accessed:  Sept. 10, 2012).

10 See Exchange Act Release No. 49148 (Jan. 29, 2004); Exchange Act Release No. 51274 (Feb. 28, 2005).

11 See FINRA Regulatory Notice 10-54 (Oct. 27, 2010), found at http://www.finra.org/web/groups/industry/
@ip/@reg/@notice/documents/notices/p122361.pdf
(last accessed:  Sept. 10, 2012); see also “FINRA Proposes Account-Opening Disclosure Statement for Retail Customers,” Bingham.com (Nov. 1, 2010).

This article was originally published by Bingham McCutchen LLP.