Is FINRA Doing Its Job To Protect Investors Like You?

Read Ric’s Take On “Complex Investments”, The State of Financial Literacy, and The Many Questions That FINRA Needs To Answer

Do you own any investments? What makes you think you're qualified to buy them? FINRA, The Financial Industry Regulatory Authority, which oversees stockbrokers and mutual funds and the sale of those products, is concerned that many investors are buying complex investments that they don't understand. FINRA wants to protect and serve these investors and protect them against these complex products. By the way, what exactly is a complex investment product? FINRA defines that as, “a product with features that may make it difficult for a retail investor to understand the essential characteristics of the product and its risks”. Well, I think we would all agree that we want to protect investors from themselves. We want to protect investors from the risk that they may find themselves involved in an investment that is beyond their ability to understand.

FINRA Now Wants You To Pass A Test Before You Can Invest

But what FINRA wants to do about this is unacceptable. FINRA wants to require that investors pass a test before they're allowed to invest in these products. Well, I guess we could maybe argue that that might be okay if these products are truly complex. The question is, what does FINRA define as a product that falls under this complex definition? Some of these investments make perfect sense: Mutual funds that use derivatives for hedging or leverage, structured notes, mutual funds that sell short, non-traded REITs, and reverse convertible funds. I think we can all agree that yeah, those are pretty complex products, but does it really require that you take a test before you're allowed to invest in them?

And how about these investments? All of what I'm about to tell you are listed by FINRA as a complex investment, and they want you to pass an exam before you're allowed to invest in it. We're talking about closed-end mutual funds, multi-strategy funds, asset-backed securities such as Ginnie Mae's issued by the government, absolute return funds, and emerging market funds. All of these are considered by FINRA to be complex products, and the list doesn't even stop there. FINRA’s says high-yield bond funds are complex products. So are global real estate funds, variable annuities, even target date funds. All of these, according to FINRA, are complex products that ordinary consumers don't have the ability to understand. And FINRA wants you to have to pass a test in order to be able to invest in them. Target date funds are the most popular investment vehicle in four one k's in this country, and FINRA wants to require workers around the US to pass a test before they're allowed to buy a target date fund and their 401(k). Really?

My Obligation To Submit A Public Comment Letter To FINRA

I've been in the financial services profession for 37 years. I'm founder of both the Digital Assets Council of Financial Professionals and the Truth About Your Future, LLC. Through these companies, I teach both consumers and financial advisors about personal finance via my national radio show. This is in addition to my podcasts and videocasts, books, monthly newsletter and my events as well. I'm also the founder of Edelman Financial Engines, the largest independent financial planning and investment management firm in the nation, which now serves over 1.3 million households and manages about $300 billion in assets for those families.

I submitted a public comment letter to FINRA expressing my disagreement with this proposal. FINRA is correct that investment products have gotten very complex. Long gone are the days when investor options were solely stocks and bonds. Today, there's a myriad of products that exist, often with confounding structures, investment strategies, fee schedules, liquidity restrictions and tax implications. FINRA well knows that far too many consumers purchase these investment products that they don't understand, often because their decisions are based on hearsay or slick marketing pitches. Indeed, the vast majority of Americans are financially illiterate, including most investors, and that's evidenced by every study done on the subject, including those conducted by FINRA.

Joining The Quest To Advance Financial Literacy in the U.S.

I've been in the fight to improve our nation's financial literacy for nearly 40 years. I've worked for decades alongside the Employee Benefit Research Institute, the Jumpstart Coalition for Personal Finance Literacy, the American Savings Education Council, America Saves, and others. Four years ago, I founded the Funding Our Future Coalition. It now has more than 75 corporate, academic, nonprofit and think tank members. It's now the largest coalition ever formed to help Americans achieve financial security. And thanks to my deep involvement in this movement and my many years as a FINRA-licensed financial advisor, I can say with some authority that FINRA is correct to acknowledge that investment product complexity has exceeded the knowledge base for most investors and that efforts are indeed needed to reduce this gap.

However, the idea of requiring investors to pass a competency exam is fatally flawed. Testing investors before they invest so they can prove they have the knowledge required to make informed investment decisions is completely unworkable. Any attempt to implement would create havoc in the marketplace. It would disrupt the entire asset management industry and materially harm millions of Americans who are striving to save for retirement.

The Questions FINRA Needs To Answer

I've got some basic questions about FINRA’s idea. Who will create the training materials to help investors prepare for the exam? Who will write the exams questions? How many questions will the exam contain? Will those questions be, yes? No? True false? Multiple choice? Fill in the blank or open comment? Who will craft the answers to the questions? Will the answers be truly focused on ascertaining knowledge?

Or will the test instead be designed to trap you and trick test takers like using double negatives or multiple choice answers that allow for multiple positives? You know, is the answer A or B or C or A and B? How much time will an investor be provided to complete the exam? What will be the test taking mechanism? Will the investor have to go to a specific location, or will they be able to take the exam in their home or office? Will the exam be on paper like the SAT or online using a computer or smartphone? Will the exam be proctored? How will you prevent fraud? How often will prevent the exam questions and answers from being distributed over the Internet through illicit means? What score is going to be required for you to be deemed to have passed the exam?

How Much Know-how Can FINRA Expect The Average Investor to Attain?

In other words, how much knowledge is FINRA allowing an investor to not have and still be permitted to invest? Will the questions be focused on a specific investment or a broader class of investments? Or will the entire investment management realm be tested? If the exams are narrowly focused? Will the questions allow test takers to demonstrate their knowledge of modern portfolio theory and other strategies that encourage diversified portfolios? Will there be different exams for each investment or class of investment? How many exams must an investor pass? Will questions deal with concepts not directly related to any specific investment, such as portfolio rebalancing and dollar cost averaging? Will questions be adjusted for those who are investing in tax sheltered accounts like IRAs and 401(k)s? Who's going to determine that the questions are relevant, correctly phrased, and that they're comprehensively comprising all the issues that investors face?

In most households, one partner manages the finances, but if a married couple opens a joint account, will both spouses be required to pass the exam? What happens if one of them fails? How will the exam be administered to those who have disabilities or other issues affecting their ability to complete examinations? Proficiency erodes over time, partly as knowledge is lost, partly because of an ever changing economic and product environment. How often must an investor take an exam? All of these questions must be answered, and not merely for what FINRA calls complex investments, but they'd have to do this for every investment.

But Aren’t All Investments Somewhat Complex?

That's because there's really no such thing as an investment that is not complex. Every investment requires extensive knowledge. For example, every investment product deals with account registration, taxation, liquidity and issuer solvency. Just look at account registration. Does the investor understand the legal implications of opening an account in their name only versus an account with a spouse as joint tenants with rights of survivorship, or an account held with others as tenants in common? Or a trust account or a section 529 College Savings Account or an account under the Uniform Transfers to Minors Act or an IRA deductible nondeductible in Roth or an LLC, C-Corp, S-Corp or other registration?

How about taxation? The account registration impacts annual and eventual federal and state liabilities and potential IRS penalties. You've got income taxes, capital gains taxes, estate taxes at both the federal and state levels. And then there's liquidity. Many financial products, even bank certificates of deposit, often have withdrawal restrictions for as much as ten years or more. Investors who don't know this could lose access to their money, incur unexpected fees or lose earned interest. And then there's finally issuer insolvency. The return of capital for many financial products, such as bonds and fixed annuities, are subject to the ability of the issuer to pay upon maturity or the demand of the account holder.

Fairness and Equity in Financial Literacy: That’s Also Missing

Further, there's extensive literature that shows that standardized tests are biased against women, minorities and immigrants. Requiring millions of people to take exams could prevent them from participating in the financial markets and thus interfere with their ability to achieve financial security. Finally, if testing were implemented, what would happen to an investor who fails the exam? Would they be required to liquidate their current investments, forcing you to pay whatever taxes and penalties and surrender charges are charged? 

We've got a financial literacy problem in our nation for sure but forcing investors to pass an exam in order to be permitted to invest, this is not the way to resolve it. Asking consumers to pass a test, proving they're knowledgeable about investments before they can invest. That's like asking patients to pass a test about health care before they're permitted to swallow a pill.

We’ve Already Solved This:  Work With A Financial Professional

There's a better, easier way to solve FINRA’s concern. A solution that's already in place. FINRA should encourage investors to rely on the services of a professional financial advisor. Advisors are already required to pass an extensive battery of exams at both the federal and state levels and are obligated to complete ongoing continuing education requirements to maintain their proficiency. Instead of asking patients to study pharmacology, we merely ask patients to consult their physician, and we should do the same in the financial services industry. Investors should be encouraged to talk to an advisor so they can rely on that professional's demonstrated knowledge, skills and experience to guide them. FINRA’s Proposal 2208 must be killed. It's bad for investors.