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On June 5, 2013 the Securities and Exchange Commission released a proposal (the ‘Proposal’) that, if adopted, would fundamentally change how most money market funds operate. In this article we focus on the impact that the adoption of one (or both) of the alternatives discussed in the Proposal would have on defined contribution plans that provide participants a choice of investments, where one of the choices is a money market mutual fund.
We are going to go into a lot of detail on the Proposal, so we thought it would be useful to begin with a brief summary.
The Proposal aims at reforming current money market fund rules to better deal with the problems they have had in recent years, particularly in dealing with the 2008 financial crisis. The SEC is considering two alternatives, either of which may be adopted by itself or in combination with the other:
Floating NAV. Under this alternative, current amortized cost valuation and penny rounding rules would be eliminated. This would, effectively, require that money market funds ‘mark to market’ their net asset value (NAV) daily. Thus, the price of shares would generally no longer be stable at, e.g., $1. Government funds and ‘retail funds’ would be able to continue to use penny rounding but would not be able to use amortized cost valuation. A ‘retail fund’ is defined as a fund “that does not permit a shareholder to redeem more than $1 million in a single business day.” Generally, DC plans would get ‘look through’ treatment and be allowed to use retail funds if the withdrawal of any individual participant is limited to $1 million per day.
Standby liquidity fee and ‘gates.’ Under this alternative, if a money market fund’s weekly liquid assets falls below 15% of total assets, the fund would be required to impose a liquidity fee of 2% on all redemptions unless the board determines that imposing such a fee would not be in the best interest of the fund. In these circumstances, the board could also (or alternatively) impose a temporary suspension of redemptions (a ‘gate’) for up to 30 days. Government funds would be exempt from this alternative.
The Proposal would also substantially revise required disclosures, including advertising materials, prospectuses, registration statements and information on web sites.
For DC plans that allow participant choice and include a money market fund in their fund menu, the key questions are:
Will a government fund (exempt from both alternatives) or a retail fund (exempt from the floating NAV alternative) be an appropriate ‘solution’ or will the possibility of the (marginally) higher returns available in institutional prime funds compensate for added risk?
What sorts of ERISA disclosures will be necessary with respect to whatever sort of fund is used? (The answer to this question is likely to require guidance from the Department of Labor.)
Will there be significant compliance costs, e.g., with respect to implementing (and communicating) the floating NAV proposal and maintaining ‘retail fund’ status?
Comments are due 90 days from the June 5, 2013, publication date. It looks like, unlike last year, there is the ‘political will’ to adopt at least one of these proposals. If the floating NAV alternative is adopted, there is likely to be a long (at least two year) transition period.
In what follows we discuss the Proposal in detail.
Generally, money market funds provide a stable (typically, $1) share price by limiting investments to short-term, high-quality debt securities and by taking advantage of two exemptions available to them under the Investment Company Act. The first exemption permits them to use an ‘amortized cost’ valuation method, under which securities generally are valued at cost (plus any amortization of premium or accumulation of discount), rather than at fair market value (reflecting, e.g., changes in interest rates). The second exemption allows them to use ‘penny-rounding,’ rather than basis point rounding, so that, in effect, the actual value of the fund can be as much as 50 basis points below the $1 target and still price at $1.
One important distinction between different sorts of money market funds is between prime funds, which invest in “short-term obligations issued by corporations and banks, as well as repurchase agreements and asset-backed commercial paper,” and government funds, which invest in “obligations of the U.S. government, including obligations of the U.S. Treasury and federal agencies and instrumentalities, as well as repurchase agreements collateralized by government securities.” Another key distinction is between institutional funds (or institutional share classes) and retail funds (or share classes).
The 2008 financial crisis involved, among other things, a money market fund crisis. As described in the Proposal:
[O]n September 16, 2008, the day after Lehman Brothers Holdings Inc. announced its bankruptcy, The Reserve Fund announced that as of that afternoon, its Primary Fund — which held a $785 million (or 1.2% of the fund’s assets) position in Lehman Brothers commercial paper — would “break the buck” and price its securities at $0.97 per share.
At the same time, there was turbulence in the market for financial sector securities as a result of the bankruptcy of Lehman Brothers and the near failure of American International Group (“AIG”), whose commercial paper was held by many prime money market funds. …
Redemptions in the Primary Fund were followed by redemptions from other Reserve money market funds. Prime institutional money market funds more generally began experiencing heavy redemptions. During the week of September 15, 2008, investors withdrew approximately $300 billion from prime money market funds or 14% of the assets in those funds. During that time, fearing further redemptions, money market fund managers began to retain cash rather than invest in commercial paper, certificates of deposit, or other short-term instruments. … Short-term financing markets froze, impairing access to credit, and those who were still able to access short-term credit often did so only at overnight maturities. …
On September 19, 2008, the U.S. Department of the Treasury (“Treasury”) announced a temporary guarantee program (“Temporary Guarantee Program”), which would use the $50 billion Exchange Stabilization Fund to support more than $3 trillion in shares of money market funds, and the Board of Governors of the Federal Reserve System authorized the temporary extension of credit to banks to finance their purchase of high-quality asset-backed commercial paper from money market funds.
In view of this crisis, the SEC has for some time been working on a set of changes to money market fund rules to prevent (or to reduce the effect of) another money market fund crisis. In 2010, it adopted changes to those rules “designed to make money market funds more resilient by reducing the interest rate, credit, and liquidity risks of fund asset portfolios.” An attempt at further reform was made in 2012 that was rejected by the Commission. The current Proposal, however, was approved unanimously by the Commission.
The Proposal released June 5 describes two ‘alternative’ changes to current money market fund rules: (1) a floating NAV; and (2) a standby liquidity fee and ‘gates.’ These are not strictly alternatives, as the SEC is considering adopting both a floating NAV and some variation of the standby liquidity fee and gates rules.
Under current rules, the price of money market fund shares is (except in extreme cases) stable (e.g., at $1 per share). Under the floating NAV alternative, both the amortized cost valuation and penny rounding rules would be eliminated for institutional prime funds. The effect of this change would be to require that money market funds ‘mark to market’ the value of fund shares daily. Thus, for instance, if short-term rates went up, share value would go down (conceivably below $1).
Government funds and ‘retail funds’ would be able to continue to use penny rounding but would not be able to use amortized cost valuation. According to the SEC, penny rounding will result in a stable price; that is, amortized cost valuation is unnecessary to maintaining a stable price.
A ‘retail fund’ is defined as a fund “that does not permit a shareholder to redeem more than $1 million in a single business day.” This $1 million rule would be imposed on the underlying shareholders in omnibus accounts.
Generally, a DC plan’s interest in a money market fund would be treated as an omnibus account, and individual participants would generally be treated as the underlying shareholders. So, in English, the $1 million limit would be applied at the participant level. Thus, generally, a retail fund could allow investment by a DC plan, and the DC plan participants would have a stable (e.g., $1) share price. Obviously, participants with accounts worth more than $1 million would have some issues, but the SEC is considering allowing withdrawals in excess of $1 million in certain circumstances (e.g., where advance notice is given).
With respect to omnibus accounts, intermediaries (e.g., the plan sponsor or, more likely, recordkeeper) would have to satisfy the fund manager that the $1 million withdrawal limitation was being applied at the participant level:
[I]ntermediaries with omnibus accounts would need to provide some form of transparency regarding underlying shareholders, such as account sizes of underlying shareholders (showing that each was below the $1 million redemption limit). Alternatively, the fund could arrange with the intermediary to carry out the fund’s policies and impose the redemption limitation, or else impose redemption limits on the omnibus account as a whole.
The SEC has asked for comment on whether a formal agreement between the fund manager and any intermediary should be required.
For sponsors, implementation of this rule is likely to require some additional administrative work at the plan level. And, generally, the additional complexity of omnibus arrangement is likely to entail higher costs:
[A] retail exemption to the floating NAV requirement could involve operational costs, with the extent of those costs likely being higher for funds sold primarily through intermediaries than for funds sold directly to investors. These operational costs, depending on their magnitude, might affect capital formation and also competition (depending on the different ability of funds to absorb these costs).
The exception for omnibus accounts is in some respects very broad. For example:
[A]n intermediary with investment discretion, such as a defined-contribution pension plan that allows the plan sponsor to remove a money market fund from its offerings, could unilaterally liquidate in one day a quantity of fund shares that greatly exceeds the fund’s redemption limit, even if no one beneficial owner had an account balance that exceeds the limit.
Finally, the SEC is at least open to considering a ‘special deal’ for retirement plans in applying the ‘retail fund’ rule. In the Proposal it asks:
Should we treat certain intermediaries differently than others, perhaps allowing higher or unlimited redemptions for investors who invest through certain types of intermediaries such as retirement plans?
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The floating NAV proposal addresses one issue of particular concern to the SEC: that in a crisis sophisticated investors may be able to act fast enough to get out of a troubled fund at the stable $1 price and ‘stick’ less sophisticated, less nimble shareholders with a ‘broken buck’ (e.g., redemptions below $1). But the SEC acknowledges that there are other reasons why a run on a fund might start: “Adverse economic events or financial market conditions can cause shareholders to engage in flights to quality, liquidity, or transparency (or combinations thereof).” The liquidity fee and gates alternative addresses (to some extent) these issues.
Under the liquidity fee and gates alternative:
Liquidity fee. If a money market fund’s weekly liquid assets falls below 15% of total assets, the fund must impose a liquidity fee of 2% on all redemptions unless the board of directors of the fund (including a majority of its independent directors) determines that imposing such a fee would not be in the best interest of the fund. The board may also determine that a lower fee would be in the best interest of the fund.
Gates. When a money market fund’s weekly liquid assets fall below 15% of total assets, the fund board could also impose a temporary suspension of redemptions (a ‘gate’) for up to 30 days if the board determines that doing so is in the fund’s best interest.
Very roughly (the SEC is also proposing changes to this definition) “weekly liquid assets” are: cash; direct obligations of the U.S. government; securities that will mature or are subject to a demand feature that is exercisable and payable within five business days; and certain other “short term” assets.
There is, obviously, flexibility in both the liquidity fee and gates rules. That is, if weekly liquid assets fall below 15%, the fund does not have to impose a redemption fee but (more or less) will need a good reason not to. In the same circumstances, the fund may impose a gate (in addition to or in lieu of the liquidity fee).
The Proposal would, under either alternative, impose several disclosure requirements on funds with respect to the new rule (whichever configuration is finalized — floating NAV, liquidity fee and gates, or both). New or enhanced disclosures would be required in fund marketing materials, prospectuses and registration statements as well as on a fund website. The disclosures are intended to inform shareholders of fund risks, provide greater transparency about the fund’s liquidity and holdings and to change how shareholders perceive money market funds (that is, to in effect move shareholders away from the current ‘no risk’ view of money market funds).
These requirements are relevant to plan sponsors because there are ERISA rules that require that participants (in plans that allow participant choice of investment) be provided with, e.g., fund prospectuses and other materials typically provided to shareholders. Perhaps more importantly, in the context of a DC plan, where there is at least one intermediary (the plan/recordkeeper) and an omnibus account, providing an SEC-approved description of the risks to participants may be considered an ERISA fiduciary ‘minimum.’
We’re not going to go into detail on what disclosures the SEC is considering. Much will depend on what alternative the SEC finally adopts and what sort of fund – prime vs. government, retail vs. institutional – a plan is using. Moreover, we would expect further guidance, perhaps from DOL, on this issue.
To repeat, the focus of this article is on the impact of the adoption of one (or both) of the alternatives in the Proposal on DC plans that provide participants a choice of investments, where one of the choices is a money market mutual fund. Before the adoption of the Qualified Default Investment Alternatives (QDIA) regulation, money market funds, along with stable value funds (SVFs), were a common default investment. After the adoption of the QDIA regulation, they no longer serve that function.
The regulation under ERISA section 404(c) (which generally (and oversimplifying) relieves plan fiduciaries of responsibility for the investment consequences of participant choices where certain requirements are met) requires that a plan provide at least three investment alternatives that offer “a broad range of investment alternatives.” Conceivably, a money market fund may serve as one of the three choices.
The QDIA regulation (especially the preamble to the proposed regulation) included a general critique of the suitability of money market funds as an exclusive, long-term investment vehicle. (E.g., “As a short-term investment, money market … funds may not significantly affect retirement savings. Such investments can play a useful role as a component of a diversified portfolio. However, when such funds become the exclusive investment of participants …, it is unlikely that the rate of return generated by those funds over time will be sufficient to generate adequate retirement savings for most participants or beneficiaries.”) With that in view, and given current rates (money market fund yields are well below 1%), it would seem that the primary function of a money market fund in a DC plan is as a cash management tool.
Given that assumption (that the function of a money market fund in a DC plan is to give the participant a cash management tool), the treatment given government funds under the Proposal (continued use of penny rounding and exemption from liquidity fee and gates) makes that sort of fund look like an attractive money market DC plan solution. Moreover, the spread between the performance of government vs. prime funds is generally relatively small — perhaps less than 10 basis points — although there will be times when this spread will widen. While for institutional investors with billions of dollars at stake even a couple of basis points in additional return will be valuable, for participants with (generally) thousands or hundreds of thousands of dollars at stake, the ability to simply ‘get my money back when I want it’ may be a higher priority.
Retail funds would be exempt from the floating NAV alternative, and it looks like DC plans could generally use a retail fund. But the administrative issues may be problematic – sponsors will want to discuss with their recordkeeper and fund provider just how difficult compliance with the $1 million limit will be. Using a retail fund has a certain intuitive appeal – it is the sort of fund the participant would use for his or her own money. If, however, something like the liquidity fee and gates rule is adopted, with no exemption for retail funds, sponsors will want to consider whether the inability, under that rule, to ‘get my money back when I want it’ is problematic. That rule would only apply in times of crisis, but those are likely to be the times when the participant wants his or her money back the most.
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Comments are due on the Proposal within 90 days of June 5, 2013. Many stakeholders – especially in the fund provider community – have already taken a position on the Proposal. Unlike last year’s failed attempt at reform, it looks like this one – in some form – will succeed.
Implementation, particularly of the floating NAV alternative (either by itself or combined with the liquidity fee and gates alternative), presents a number of problems, and the SEC contemplates (at least) a two-year transition period. The tax issues (e.g., treatment of gains and losses) presented by the floating NAV alternative are particularly difficult. Qualified plans will not have to deal with those tax problems, but they will take time to sort out. So, we would expect that there will be time for sponsors to digest whatever final form money market fund reform takes and consider what will be the best approach for their participants.
We will continue to follow this issue as it develops.