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With the Fifth Circuit Court of Appeals’ decision to vacate the Obama fiduciary rule on May 7, the securities, life insurance and retirement industries had effectively thwarted a big threat to their product distribution model. But, based on what I’ve heard at industry conferences, they’re not uniformly satisfied with their victory. That’s no surprise. The Obama Department of Labor was the messenger, not the cause, of industry’s problems.

“It’s as if the rule never existed,” attorney Steve Saxon of the Groom Law Group said last week at the Insured Retirement Industry conference. But, as he and others have conceded in public in recent weeks, the issues that inspired the rule still exist. As the thrill of victory subsides, they’re reacquainting themselves with the headaches of playing a game without clear rules.

The incestuous, over-priced business model they defended is obsolete anyway. Brokers continue to migrate from the commission-based world to the fee-based advisor world. The law still requires intermediaries to be “prudent” and act in clients’ “best interest.” Technology continues to commoditize what they do and squeeze their margins. Index funds still crowd-out active funds. The conflicts of interest inherent in third-party payments for distribution still make investors distrust them.

At retirement conferences, discussions about certain elements of the Obama rule have bordered on the nostalgic. Some IT departments and business units who spent millions of dollars adapting their technology to the rule are said to resist reversing their improvements. The guidelines for marketing IRAs to 401(k) plan participants are said to be muddy again. Brokerages have to go back to using the obsolete “five-part test” to distinguish salespeople from advisors; but the test doesn’t fit today’s fluid, multi-licensed advisory practices.

So far, neither the DOL, the SEC, the federal courts nor the National Association of Insurance Commissioners has replaced the Obama rule with anything more palatable to the financial industry or as appealing to consumer groups. The Fifth Circuit Court of Appeals decision ignored 40 years of change in the way America saves for retirement. The Field Assistance Bulletin that the Department of Labor said it wouldn’t enforce the Obama rule, but that created new confusion. The Securities & Exchange Commission’s “best interest” proposal, now open to public comment, aroused little enthusiasm. New York and other states now threaten to create a patchwork of five or six different state fiduciary standards. In a May 14 podcast, attorney Fred Reish of the firm of Drinker Biddle said, “We’re in the middle of a mess.”

Where the rule came from

The seeds for the 2017 fiduciary rule, or at least some of them, were planted 20 years ago, when several major life insurance companies decided to demutualize, cut costs, demobilize their captive agent forces, and rely on third-party distribution. But third-party marketing and distribution was not cheap; fund companies had to pay for shelf space at brokerages and insurers had to pay competitive commissions to independent insurance agents.

Those payments posed a conflict of interest for the intermediaries. The advisors’ interests naturally aligned with the parties who paid them—the product manufacturers. “A” shares were replaced by manufacturer-financed “B” shares. The manufacturers’ subsequent recovery of those acquisition costs from clients had to be engineered into products. As a result, products became more complex and less transparent.

The Obama DOL didn’t invent this problem, or the blurring of designations in the financial world. Brokers and insurance agents, supposedly limited to making one-off recommendations, taking orders and executing transactions for self-directed investors, have created a raft of titles designed to suggest that they provide trustworthy advice. More confusingly, one person, with the right licenses and designations, can switch hats and adopt the role that works best from a compensation or regulatory standpoint. Studies showed that investors are blind to these distinctions.

The DOL didn’t invent the transition from defined benefit to defined contribution, which turned savers into investors and retirees into their own pension fund managers. It didn’t create equity-linked insurance products, which straddle the insurance and investment worlds. Nor did it attach living benefit riders to annuities and create a new class of personal pensions.

Most importantly, no one foresaw the unintended consequences of rollovers, which allows trillions of dollars of tax-deferred savings to move into a regulatory grey zone between the DOL and the SEC. It didn’t invent the blurring of education and marketing by recordkeepers when participants prepared to change jobs and became candidates for rollovers. It didn’t invent the vast differences between the 401(k) world and the rollover IRA world.

When they execute a rollover, all those newbie investors who grew up in the captivity of the 401(k) plan have to learn how to survive in the (relative) wilderness of the brokerage world. They’ll have more options, but they will be slow to discover that the prices will be higher and standards of conduct lower. Prior to the fiduciary rule, the brokerage world openly celebrated the rollover trend as a “bonanza”: Trainloads of dumb money were coming to town.

For consumerist policymakers in the Obama administration, this was not a bonanza; it was a train wreck. The DOL recognized that the 401(k) had replaced DB and risen in importance for retirement security, that the tax-deferral subsidy has helped fatten 401(k) accounts, and that the 401(k) system was in danger of becoming a mere incubator for rollover IRA brokerage accounts whose higher fees would devour the beneficial effect of tax deferral.

Tax-deferral was in danger of becoming an industry subsidy, not a saver’s subsidy. This is what prompted the creation of the rule. The DOL’s attempt to clarify these problems was flawed. It was also a deep threat to the manufacturer-financed product distribution system. But it was not, as the Fifth Circuit judges labeled it, “arbitrary and capricious.”

E unum pluribus

A problematic vacuum now exists. The conflicts and ambiguities are still there but there’s still no promising remedy in sight. Neither the Fifth Circuit Court of Appeals, the Securities & Exchange Commission, or the Trump DOL has so far brought the kind of clarity to the situation that businesses and legal departments need.

In the Fifth Circuit Court of Appeals, which vacated the DOL rule on May 7, the two majority judges either didn’t know or didn’t care that the financial world has changed. They asserted that “only in DOL’s “semantically-created world do salespeople and insurance brokers have “authority” or “responsibility” to “render investment advice” and that the Fiduciary Rule “improperly dispenses with [the] distinction… between investments advisors, who were considered fiduciaries, and stockbrokers and insurance agents, who generally assumed no such status in selling products to their clients.”

This statement contradicts my first-hand knowledge of the industry. The two judges did not seem to recognize that the DOL was addressing, not imagining, the disappearance of that distinction. In discussing commissions, the judges seemed to think that they’re used only in one-off transactions of little consequence.

They didn’t appear to recognize that an insurance agent can recommend a $100,000 indexed annuity contract with a long surrender period, a lifetime income benefit and a $7,000 commission that’s hidden in the annuity payout rates and still pretend that he’s not giving long-term advice. Abuses in the commissioned sales of annuities to IRA owners are real, not “semantically created.”

The long-awaited SEC staff’s proposal for a “best interest” standard, released on April 18, doesn’t represent much progress either. It said little if anything about insurance products. I watched the hearing where the commissioners reviewed it. Even the four (out of five) who approved it did so with reservations or without enthusiasm. Commissioner Michael Piwowar criticized its vagueness. “This proposal imposes on broker-dealers a new ‘best interest’ standard. This sounds simple enough.”

But “the devil is truly in the details,” he added. “This ‘best interest’ standard is wholly different from the well-established Investment Adviser’s Act fiduciary standard and FINRA’s suitability standard. Unfortunately, after 45 days of reviewing and commenting on this release, I am not convinced that we have clearly and adequately explained the exact differences. This lack of clarity is worrisome.”

At the IRI conference, attorney James F. Jorden said that as a litigator who defends financial services companies, he saw potential legal vulnerability in the SEC’s suggestion that advisors must use “prudence” in dealing with clients.

In the law, he said, prudence usually implies fiduciary responsibility, and not the weaker definition of best interest that the industry hopes for from the SEC. Meanwhile, the SEC will soon lose two of its five commissioners, which will stall action. The Trump administration is not expected to be quick to replace them.

The Trump DOL’s recent Field Assistance Bulletin created more questions than it answered. In advising brokerages that it would not enforce the fiduciary rule, it implied that the rule still exists. “The FAB is somewhat difficult to understand,” said a Wagner Law Group assessment of the bulletin. At the IRI conference, Drinker Biddle attorney Brad Campbell, a former assistant Secretary of Labor, said, “Labor is not the primary ball carrier. There’s nothing on the DOL agenda about the rule. It’s kind of embarrassing. There’s almost nothing on it that’s new in the retirement space. I would have hoped that we would see a more robust policy agenda in the second year of the Trump administration.”

To the dismay of many in the retirement industry, individual state regulators are jumping into the regulatory vacuum where the DOL fiduciary rule used to be. The potential for the emergence of a patchwork of many fiduciary standards is a source of industry concern. The State of New York “has proposed a standard that is very tough on annuities and life insurance,” said Seth Harris, a former Acting Secretary of Labor, at the IRI conference. “The likeliest outcome is that you will get an SEC rule, and then you will have six or seven different state standards of conduct. That will be a big problem for carriers.”

Nature abhors a vacuum, it is said. And so does the financial services industry. But by defeating the Obama fiduciary rule, it has created a vacuum, and there’s no telling what might happen next.

© 2018 RIJ Publishing LLC. All rights reserved.

Not long after Carlos Armando Garcia graduated from MIT with a bachelor’s degree in electrical engineering, he was hanging out with other quantitative analysts at Merrill Lynch in New York when somebody mentioned the company’s 401(k). Garcia remembers thinking: “What’s a 401(k)?”

That was a wake-up call for Garcia, the son of a chemical engineer, a soccer-player and president of his high school class back in El Paso, Texas. If he was clueless about retirement planning, he figured, the same must be true for millions of other Hispanics in the US.

Turning that realization a business took awhile. But in 2016, after co-founding and selling two B2B fintech startups, Garcia launched Finhabits, a bilingual B2C mobile-friendly savings tool that sits on an Apex Clearing platform. Similar to Stash, but with a Spanish spin, Finhabits helps financial neophytes open a Roth or traditional IRA with as little as $5 a week.

“The difference between us and a Betterment or a Wealthfront is that they’re interested in capturing the upper tier of the workforce,” Garcia told RIJ recently. “A lot of their clients already have investments and know a stock from a bond. Ninety-five percent of our client base has never had an investment account. It’s a different market.”

This spring, Finhabits, along with Principal Financial and Saturna, become available on Washington State’s new online retirement plan marketplace, where workers and employers can find simple, low-cost IRAs or 401(k)s. Still only a seven-person operation located in a WeWork co-working space in Manhattan’s Soho district, Finhabits claims to be on-boarding about 1,000 new clients each week at an average weekly contribution rate of $40 per client. “By the end of 2018, we expect to have close to 55,000 accounts and have about $55 million under management,” Garcia said.

From El Paso to Wall Street

Garcia’s parents emigrated from Juarez, Mexico to El Paso, Texas, where he was born and grew up. The region is dense with maquiladoras, the assembly plants that sprouted on the border with the passage of NAFTA in 1995. The prospect of a factory job draws people toward the border, creating a market for all kinds of small ventures. El Paso, where 73% of the businesses are Hispanic-owned, is known for entrepreneurship.

“A border town breeds entrepreneurship,” he said. “There’s a constant influx of people from the south, which creates a transient society. They come for a few months and then continue. It creates an opportunity society for the people who cannot cross.”

After graduation from MIT in 2002, Garcia worked as a quantitative analyst for Merrill Lynch Investment Services. He left in 2009 to co-found Fundspire, a hedge fund analytics and reporting service. In 2012, he sold Fundspire to eVestment and started Madison Quant Labs, a hedge fund.

Proceeds from the sale of those firms helped kickstart Finhabits. Outside money followed. “We have funding from New York financial industry executives that support us on their own tab. We have external investors, so we need to produce results. But we’re looking at it long-term,” Garcia told RIJ.

From the Finhabits website

Finhabits’ homepage, like many B2C fintech sites, feels as safe and colorful as the playground in a McDonald’s franchise. “We believed that we could make the savings process simpler and easier. We started by simplifying the message. We shortened the enrollment process to less than 10 minutes,” Garcia said.

The website text emphasizes saving more than investing. A visitor has to plumb the FAQs to learn that portfolios are composed of up to 11 Vanguard or BlackRock exchange traded funds (ETFs), covering stocks (U.S. and international) and bonds (corporate, government, tax-exempt and inflation-protected).

“You just connect your bank account and decide how much you want to contribute each month,” Garcia said. “You can pause it if you have three months with no income. There’s an app for mobile phones.” When clients change jobs, nothing changes, because the contributions don’t go through an employer’s payroll plan.

For Finhabits clients outside the [Washington State] marketplace, Finhabits charges $1 a month for balances under $2,500, and 50 basis points a year for investments. The investment cost is capped at 50 basis points. The average ETF expense ratio is 12 basis points a year.

Sending money home

As for marketing, “We’re on all the important digital platforms such as Facebook, Google, YouTube. We also have TV ads on select networks,” Garcia said. “We have a direct to consumer effort and we have partnerships. We work with credit unions. We’re not talking just about the ‘gig’ workforce.

“There’s only a 10% chance that any worker in a small business has access to a retirement benefit. We have a lot of clients from states with heavy non-white workforce, including California, Texas, Georgia, New York, Illinois, and now in Washington State,” he said.

For the Washington State marketplace, Finhabits clients with balances under $1,500 pay only the fees on the available Vanguard target date fund or balanced fund. The annual wrap fee on balances higher than $1,500 is 50 basis points a year but never more than one percent.

In his search for Latino clients, he has crossed paths with Cindy Hounsell, the director of WISER, the Women’s Institute for a Secure Retirement. Hounsell recently received a $150,000 grant through AARP’s Latina Savings Project to work with MANA, a national Latina organization, to develop and implement a Latina Retirement Savings Project in Topeka, Albuquerque, and Baytown, Texas.

Because the Trump administration killed the federal MyRA program, an Obama-era effort to auto-enroll people into Roth IRAs at work, she found a replacement for it in Finhabits, which has participated in a series of Retirement Savings Workshops with WISER. “What Carlos is doing is great. People in Texas, even if they weren’t Hispanic, thought that what he was doing was wonderful,” Hounsell said.

It’s not that Latinos in the U.S. don’t save. Collectively, they send an estimated $69 billion in savings back to their home countries in Mexico, the Caribbean and the rest of Latin America, according to a 2017 report from Inter-American Dialogue.

A 2007 study, “Causes of Latinos Low Pension Coverage,” suggested that by “the high priority placed by many Latinos, especially Mexicans, on sending money back to their countries of origin tends to crowd out other kinds of spending, like saving for retirement.”

Latinos are also less likely to have a pension plan where they work. “In manufacturing, 39.3% of Latinos participate in a pension plan at work compared to 58.6% of blacks and 67.8% of whites,” said the paper. “In 2001, 44% of Latinos worked for employers who offered pension plans, compared to 64% of blacks and 63% of whites.”

Finhabits’ own research shows an inverse relationship between the Hispanics presence in a city and the share of small business workers with retirement plans. Minneapolis’ population, for instance, is 6% Latino and 39% of small business employees are covered. In Laredo, Texas, the population is 96% Hispanic and only 8% of small business employees have a plan.

But the demographic future could look very different. The trend is Finhabits’ friend. According to the Census Bureau, the Latino population of the U.S. will double by 2060, to 119 million. That’s almost 30%. “The Hispanic population is growing,” Garcia told RIJ. “If current population trends continue, Latinos will eventually become a majority.”

© 2018 RIJ Publishing LLC. All rights reserved.