The U.S. Government Wants to Help Investors. Does It?

Working on policy research at Morningstar, we get a lot of questions asking why the government is (or is not) doing something and why government bureaucrats think an approach will be helpful. We find that many people have an idea of how the government operates that fundamentally misses how it tries to accomplish policy goals. In this column, we will discuss the tools the government uses to help investors. We hope it provides a better understanding of the government’s policy decisions. It is a summary of a longer white paper we plan to release later this spring.

Despite popular perception, governments are not top-down hierarchies that directly carry out social programs through their bureaucracies. Rather, as Lester Salamon argues in The Tools of Government, governments typically try to induce third parties to carry out their policy goals with a variety of tools.[1] For example, to promote homeownership, the U.S. Congress set up loan-guarantee programs with banks and provides generous tax benefits for buying a home. Instead of providing the poor with “government cheese,” food assistance programs provide vouchers for people to buy groceries at stores. To get people to eat better food, the government requires food and beverage makers to disclose nutritional information on packaging, and it imposes excise taxes on some junk food and alcohol.

Similarly, for investors—particularly people saving for retirement—the U.S. government mainly uses three tools to help them invest for their future:

• Tax incentives, which promote investing for retirement.
• Disclosures, which help people understand which investments might best suit them.
• Regulation, which governs the standards of conduct for financial advisors.

We’ll examine how effective these tools have been in achieving their policy goals and which tools hold the most promise for helping investors meet their goals in the future.

Tax Incentives To encourage people to save for retirement, the government provides tax incentives. As all financial planners know, contributions to traditional retirement accounts are tax-free, and the accounts are not taxed until retirement. Even more importantly, these incentives are designed to encourage employers to offer retirement plans to their workers because company contributions are tax-free as well; the principals at a business can personally benefit from setting up a plan that helps both them and their workers.

These tax incentives—while undoubtedly effective at nudging some workers to save for retirement— have had mixed results. According to the Boston College Center for Retirement Research, there’s still a significant shortfall between what workers have saved and what they ought to have saved to maintain a similar standard of living in retirement. Half of all households are projected to be unable to maintain their current lifestyle in retirement. Furthermore, tax incentives have proved to be insufficient to encourage small businesses to provide retirement plans for their workforce. While 91% of workers at large employers (those with more than 500 workers) have access to a defined-contribution plan, only 48% of workers at small employers (those with fewer than 50 workers) do.

In fact, past efforts to increase the tax incentives for retirement have not improved retirement security. The Economic Growth and Tax Relief Reconciliation Act of 2001, and the increased defined-contribution deferral limits that came with it, did not seem to spur more small employers to offer retirement plans for their workers. A 2011 analysis by the U.S. Government Accountability Office found that the number of small plans rose from 697,000 in 2003 to 705,000 in 2007. It seems unlikely that further gains in retirement savings and the number of retirement plans will be achieved solely using tax incentives.

Disclosures To help investors become more informed and bring transparency to capital markets, the U.S. government requires companies to make numerous financial disclosures. Since 1934, the SEC has required public disclosures for publicly offered securities. Other disclosures, such as filing documents for registered advisors (Form ADV) and annual defined-contribution plan filings (Form 5500), are designed to help regulators look for potential problems, but they also can shed light on investments and investment advisors.

Disclosures have undoubtedly helped many investors make more-informed choices about how they invest their money, but disclosures are insufficient to markedly improve investors’ outcomes. This is because many investors lack basic financial literacy, which undermines some of the value that disclosures provide. In a 2012 study mandated by the Dodd-Frank Act, the SEC found that, in general, “investors have a weak grasp of elementary financial concepts and lack critical knowledge of ways to avoid investment fraud.”[2] The SEC further found that women, African-Americans, Hispanics, and elderly investors “have an even greater lack of investment knowledge.”[3] In a forthcoming report, Morningstar’s Ray Sin and Ryan Murphy find that many investors are still unresponsive to fee disclosures in exchange-traded funds, even when these fees are prominently featured as part of the decision-making process.

Unfortunately, some disclosures are sent to individual investors but are not given to third parties, which further hampers the effectiveness of disclosures in helping investors make informed decisions. Investors often rely on the data collected by third parties, who can in turn contextualize the information. (For example, Morningstar helps investors compare similar mutual funds.) In cases where there is limited or no disclosure data for third parties to access, ordinary investors who lack context are hurt.

For example, the paucity of public disclosure is a problem when retirement savers try to determine if rolling over an old 401(k) into an IRA or a new 401(k) is a sensible idea. Figuring out the strengths and weaknesses of one’s 401(k) is difficult. Sure, an investor can look at the plan’s fees and investment disclosures, but because that information is not public, she cannot put it in context to reveal whether a new employer’s 401(k) is better than an old employer’s.

Regulating Advice Finally, the government regulates the advice that broker/dealers and Registered Investment Advisors can offer to ordinary investors, to better protect and advance these investors' interests. Regulation is something of an amorphous term, used to describe a variety of government actions. For the purposes of this column, we define it based on political scientist Peter J. May's chapter in The Tools of Government: Regulations are "rules that govern expected behavior and outcomes, standards that serve as benchmarks for compliance, sanctions for noncompliance, and an administrative apparatus that enforces rules and administers sanctions."[4]

The U.S. government regulates advice unevenly, with three regulators—the Department of Labor, the SEC, and the Financial Industry Regulatory Authority—applying different standards. The spectrum runs from a fiduciary standard—wherein an advisor must put the client’s interests first—to the suitability standard aimed at ensuring that clients get products appropriate for their investment situation and are treated fairly by advisors.

The Labor Department regulates investment advice for most employer-sponsored retirement plans (such as 401(k) plans) under the strict fiduciary standards of the Employee Retirement Income Security Act of 1974. In addition, under ERISA, retirement investors can use the court system as remedies for breaches of fiduciary duty. This provides a strong incentive for retirement-plan sponsors to take their fiduciary duty seriously and offer workers retirement plans without excessive fees. In recent years, lawsuits against employers who have breached their ERISA-mandated fiduciary duty have returned millions of dollars to retirement investors.

The SEC directly regulates RIAs and ensures their compliance with the Investment Advisers Act of 1940, largely through mandating disclosures RIAs must make with some attention to the process advisors use to generate recommendations. RIAs are fiduciaries, but the standards that apply to RIAs are not as strong as those that apply to fiduciaries under ERISA. In particular, individual investors cannot sue in court for breaches of the advisers act, unless they can prove an unsuitable recommendation was made intentionally. Further, under ERISA, the default is that fiduciaries must refrain from engaging in conflicted transactions; the Advisers Act instead mandates that “material conflicts of interest shall be disclosed” and prohibits fewer transactions by default.

Finally, the SEC has also delegated authority to Finra, a so-called “self-regulatory organization.” Finra regulates broker/dealers who sell mutual funds and other products to retail investors. It enforces a lower standard for financial advice meant to ensure that recommendations are “suitable for the customer” based on “the customer’s investment profile.” Financial advisors working for broker/dealers can operate more similarly to salespeople rather than impartial advisors, if the recommendations they make are suitable and they follow standards of fair dealing with customers.

Mixed Results The government relies on three primary avenues to help investors, each with mixed results. Tax incentives are helpful to many investors, but more tax incentives are unlikely to increase retirement savings or broaden access to retirement plans. Financial disclosures have effected change, but disclosure regimes could be more robust. Making nonpublic disclosures more readily accessible to the public would hugely benefit investors and those trying to serve them.

Finally, regulating advice has been a controversial topic for years. The Labor Department finalized regulations to expand the number of fiduciary advisors to include most people working with clients’ IRAs, but the enforcement mechanism is on hold. Still, there seems to be growing consensus in the industry that regulators should better align the standards advisors follow in various contexts. The chairman of the SEC sent out a request for information on May 31, asking for input on approaches the SEC might take. We will see what happens next, but there is still room for the government to change the way it uses this tool to help ordinary investors.

[1] Salamon, L.M., editor. 2002. The Tools of Government: A Guide to the New Governance (New York: Oxford University Press).

[2] SEC. 2012. "Study Regarding Financial Literacy Among Investors." August. https://www.sec.gov/news/studies/2012/917-financial-literacy-study-part1.pdf

[3] Ibid.

[4] May, P.J. 2002. “Social Regulation.” In The Tools of Government: A Guide to the New Governance. Edited by Lester M. Salamon (New York: Oxford University Press)

This article originally appeared in the April/May 2018 issue of Morningstar magazine. To learn more about Morningstar magazine, please visit our corporate website.