Prospectuses – The Real Truth

If you have invested money in a mutual fund or variable annuity product, you have surely received a nice fat document of magazine size called the “prospectus.” Have you ever read the whole thing? Come on now…be honest. The fact is, almost no one ever reads the prospectus. It is 50 to 100 pages of legalese and disclaimers and confusion.
The paradox is that the prospectus is supposed to be the one document that makes everything clear to you about your investment. I used to write prospectuses for municipal bond issues early in my career. The senior partners at the firm would throw my first drafts back into my office with the admonishment, “Write in plain English, Ashburn – my grandmother needs to be able to understand this!” This throwing and admonishment would usually happen as I was about to go home for the day, and would be followed by, “And I need the rewrite at 8:00 am!”
I have been drowning in prospectuses lately since clients and friends have been asking my opinion of some new annuity products. Since I don’t sell annuities, I am sometimes willing to offer my point of view of the various products out there.
A typical prospectus is written in such a way as to comply with Federal laws requiring full disclosure, while at the same time leaving the investor thoroughly blinded by the sheer volume of content. The investor is left with the unfortunate choice of either hiring a lawyer or independent advisor to interpret the document, or to simply accept the salesperson’s assurance of what the terms of the investment really are.
Herein lays the message of this week’s column. A seller of investments must assure that the potential investor receives complete and accurate disclosure. It is in the area of “completeness” that most disclosure provided by a salesperson falls down. By completeness, I mean not leaving anything out. Perhaps I can best illustrate the importance of the completeness, or non-omission, standard with a little tale about a boy and a cookie jar.
Little Bill came home from school one day to find that his babysitter, Hillary, wasn’t home. So Bill pulled a stepladder over to the kitchen counter, climbed up and helped himself to some cookies. A little while later, Bill’s humorless Uncle Ken walked in and suspected something. Uncle Ken asked Bill, “Did you use that kitchen chair to climb up there and steal some cookies? Tell the truth!”
Little Bill answered simply, “No.”
So, dear readers, did little Bill tell the truth? Absolutely – he used a stepladder, not a chair, to steal the cookies. Did he leave out an important little detail that would make Uncle Ken’s understanding more complete? He sure did. While Bill’s omission might save him from an impeachment, or grounding, it would land him straight into trouble with the SEC if he were selling variable annuities.
Even an oral sales presentation is a form of disclosure under the law. Not only must the seller of the investment be completely accurate and honest, he or she must also tell you about things that are important even if you didn’t know enough to ask! Federal law requires the agent or broker to know what would be important to you, and to tell it to you, even if you had no idea it might be important.
I have recently read short summary handouts or cover letters describing features and benefits of investments products. Some of these summaries make shocking omissions of important facts that are buried deep in the prospectus. An acquaintance of mine showed me a simple letter claiming that a particular investment “guaranteed” a 6% rate of return, even if the equity market did much worse.
As I pored over the finer details, I began to notice all the fees, deductions, caveats and other wiggle-outs that the investment company had working in its favor. In the event the investor needed the guarantee, they would be lucky to receive 2.5% on their money, and only if they left the money in the investment for at least 15 years! In the event of a roaring equity market, the investment company could deny the investor full exposure to equities. A quite different yet more complete story than the one told in the cover letter.
You must make a choice. Either trust that the salesperson really told you everything you need to know, or sit down and read the prospectus. My advice is to take the time to read the prospectus, and insist that the salesperson put all of their answers to your questions in writing. Finally, never ever sign a statement saying that you have read and understand a prospectus if, in fact, you have not. You don’t want to allow a salesperson or broker to get away with Little Bill’s defense.