“It takes money to make money,” as the saying goes. Long ago, regulators concluded that high-net worth individuals and institutions with millions of dollars in assets are financially sophisticated enough to understand the complexity of unregistered securities, such as private equity, venture capital and hedge funds. Therefore, they limited these securities to we call an “accredited investor.” The philosophy is based on a desire to protect smaller investors who would be badly hurt if they took a big hit from an investment gone wrong.
According to the SEC, an accredited investor must:
But only 13% of American households fall under the accredited investor definition, and even fewer households actually invest in exempt offerings. This excludes many individuals from valuable investment opportunities and limits new ventures to smaller investor pools. It’s a narrow market, and one that assumes that winning the lottery or inheriting a family fortune is enough to be a “sophisticated” investor.
Because defined benefit plans (i.e., retirement plans) have benefitted from private equity investments, the U.S. Securities and Exchange Commission (SEC) has released a concept called the Harmonization of Securities Offering Exemptions. The release considers many ideas, but most importantly, the SEC reveals that it is willing to consider:
Are you smarter than an accredited investor? Here’s what the proponents and naysayers of accredited investor definition reform have to say.
A 2011 study from The American College of Financial Services and the University of Missouri revealed that financial literacy scores decline by 2% each year after age 60, regardless of gender or educational attainment. Older respondents were more likely to make poor credit and investment decisions. This is an important find due to the fact that half of the country’s discretionary investment assets are held by households over the age of 60, many of which likely fall under the accredited investor definition.
The cognitive decline associated with their age apparently wiped out any advantage these high net-worth individuals may have once had when assessing potential investments. They fared badly when their financial smarts were compared with counterparts in all age groups.
A 2019 report titled, “The Unsophisticated Sophisticated: Old Age and the Accredited Investors Definition,” which was co-authored by a researcher from the aforementioned 2011 study, set out to measure financial “sophistication” across ages. The researchers used financial literacy assessments from two surveys to reach their conclusions. The Consumer Finance Monthly (CFM) and the Health and Retirement Study (HRS). They wanted to know whether older accredited households that have accumulated significant savings are smarter when it comes to assessing potential investments than younger, non accredited respondents.
In both data sets, they found that accredited households age 80 and older are more than 80% less likely than non accredited investors age 60-64 to have high financial literacy scores. In fact, respondents with less than a high school degree were more likely to have a high financial literacy score than older, accredited respondents, according to this analysis.
While accredited investors are more financially literate than unaccredited investors within each age group, older accredited investors had significantly lower financial literacy scores than younger, unaccredited investors—and the difference increased consistently with age.
The researchers asked questions such as:
The disappointing data (for older investors, that is) puts into question the meaning of financial sophistication. Perhaps one’s bank account is not enough to ensure good investment decisions, but a financial litmus test for accredited investors would be equally hard to create and implement. Plus, opponents think there are other factors in the equation that justify the current restrictions. .
Data may show that high school dropouts can outperform some accredited investors when it comes to financial literacy scores, but does that mean private offerings are for everyone? Those who oppose changes to the accredited investor definition have a few important points to make.
Because private offerings are not registered or regulated by the SEC, funds get away with more risky investing methods. Some funds invest in derivatives and distressed debt offerings, which are exceptionally risky. Venture capital funds invest in startups, which statistics show are more likely to fail than not. An accredited investor with more money in the bank is better equipped to take on this level of risk and withstand a loss.
With unregistered securities, there is also less public information available to potential investors. Private equity and other unregistered securities require substantially more research to find a skilled fund sponsor or to gauge fund performance. How these funds report their returns is unregulated, and some fund managers have been known to overstate fund performance in the past. Unsophisticated investors can easily be duped into a poor investment, or even a scam.
Because unregistered securities have the potential for higher returns, skilled fund managers are paid very well. This means higher management fees and, many times, a distribution waterfall that favors the fund over the investor.
In addition, unregistered securities tend to have higher contribution minimums than registered securities. Hedge funds, for example, may require more than $5 million upfront from each pooled investor. This creates a barrier for the average investor—and the average American—who must look elsewhere (e.g., crowdfunding investments, mutual funds, etc.).
Private equity investments are not liquid investments, which can make them disadvantageous for the average retirement plan. While stocks, bonds and mutual funds can be bought and sold relatively easy, a private equity investment requires several years of fundraising and management to successfully sell the operating company. In the meantime, that investment is on hold.
In Morningstar’s letter to the SEC, Jasmin Sethi, associate director of policy research, and Aaron Szapiro, director of policy research, addressed concerns with widening the use of private equity for 401(k) plans:
“Although retirement investors are theoretically long-term savers, almost all investments inside employer-sponsored plans feature daily liquidity for good reason. The labor force in the U.S. is very dynamic; people leave their jobs and find new ones all the time. Further, participants may need their money for hardship withdrawals or loans. Simply because a worker has a long-term investment time horizon vis-a?-vis their retirement does not mean they can give up liquidity.”
It’s uncertain whether the SEC will make substantial changes to the accredited investor definition, but the debate is heating up nonetheless. Whether you believe reform is overdue or not, it’s clear that measuring the sophistication of an investor is much more complex than a dollar amount or a multiple-choice test.
[Editor’s Note: To learn more about this and related topics, you may want to attend the following webinars: Goal Based Investing – Planning for Key Life Events and Advanced Investing Topics: Unicorns and Pre-Unicorn Scalable Private Company Propositions. This is an updated version of an article originally published on August 6, 2015.]
Michele has been a director with Financial Poise since 2012.
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