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On July 23, 2014 the Securities and Exchange Commission adopted amendments (the ‘Amendments’) to the rules that govern money market mutual funds. These changes, intended to address issues growing out of the 2008 financial crisis, have been under consideration for some time and have been the subject of a lot of controversy. They generally require the use of (1) liquidity fees and redemption gates for all funds other than government funds and (2) a floating net asset value (NAV) for institutional prime money market funds.
In this article we briefly discuss the Amendments and some issues they raise for plan sponsors. We generally focus on the effect of the Amendments on defined contribution plans that provide participants a choice of investments, where one of the choices is a money market mutual fund.
Under the Amendments, all money market funds, other than government funds and feeder funds in a master/feeder fund structure, would be subject to a new liquidity fee (that is, a fee imposed on a person withdrawing cash from (i.e., selling shares to) the money market fund) and redemption gate (that is, a temporary suspension of redemptions) requirement.
There are two triggers, based on fund liquidity:
If a fund’s weekly liquid assets fall below 30% of total assets, the fund’s board may impose liquidity fees (up to 2%) and/or redemption gates for up to 10 business days in a 90-day period, if the board of directors (including a majority of independent directors) determines that doing so is in the best interests of the fund.
Weekly liquid assets generally means cash, direct obligations of the U.S. Government, certain short-term U.S. Government securities, certain securities that will mature within five business days, and amounts receivable and due unconditionally within five business days.
If a fund’s weekly liquid assets fall below 10% of total assets, it must impose a 1% liquidity fee, unless the fund’s board of directors (including a majority of its independent directors) determines that doing so would not be in the best interests of the fund, or that a lower or higher fee (not to exceed 2%) would be in the best interests of the fund.
The liquidity fees/redemption gates rules do not apply to government funds. Government funds are defined as funds that invest at least 99.5% of total assets in cash, government securities, and/or repurchase agreements that are collateralized fully. We note that a government fund may, on a discretionary basis, impose liquidity fees or redemption gates “consistent with the requirements” applicable to non-government funds, provided the ability to do so is disclosed in the prospectus.
Prior to the Amendments, money market funds were able to provide a stable (typically, $1) share price under exemptions permitting them to use (1) an ‘amortized cost’ valuation method, under which securities generally are valued at cost, rather than at fair market value (reflecting, e.g., changes in interest rates) and (2) ‘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.
The Amendments generally eliminate these exemptions for prime institutional funds (those funds may, however, “continue to use amortized cost to value debt securities with remaining maturities of 60 days or less if fund directors, in good faith, determine that the fair value of the debt securities is their amortized cost value, unless the particular circumstances warrant otherwise”). As a result, those funds will have to calculate a ‘floating NAV,’ marking share value to market daily.
Government funds and ‘retail funds’ will be able to continue to use the amortized cost valuation and penny rounding exemptions.
A retail fund is defined as a fund that “has policies and procedures reasonably designed to limit all beneficial owners of the fund to natural persons.” According to the SEC, participant-directed defined contribution plans would generally be considered owned by natural persons. (Defined benefit plans would not.) It is SEC’s intention to give funds latitude in the policies and procedures they adopt to limit beneficial owners to natural persons. How difficult (and costly) this will be to do remains to be seen.
The SEC is giving institutional prime money market funds two years to transition to a floating NAV.
In the (very long) preamble to the Amendments, the SEC addressed several issues that relate directly to retirement plans.
Some commenters on the SEC’s proposal raised concerns that the imposition of a liquidity fee or a gate might raise problems with respect to: (1) Tax Code section 401(a)(9) minimum distribution rules; (2) plan conversions and rollovers; and (3) qualified default investment (QDIA) rules (the requirement that a participant defaulted into a fund be given a 90 day grace period during which he could ‘undo’ the default).
With regard to these concerns the SEC stated:
[W]e have consulted the DOL’s Employee Benefits Security Administration (“EBSA”) regarding potential issues under ERISA. With respect to general fiduciary requirements on plan fiduciaries obligating them to prudently manage the anticipated liquidity needs of their plan, EBSA staff advised our staff that a money market fund’s liquidity and its potential for redemption restrictions is just one of many factors a plan fiduciary would consider in evaluating the role that a money market fund would play in assuring adequate liquidity in a plan’s investment portfolio.
Additionally, we believe that certain other potential concerns presented by commenters, such as concerns regarding QDIAs and the imposition of a fee or gate within 90 days of a participant’s first investment, are unlikely to materialize. We understand that the imposition of a liquidity fee or gate would have to relate to a liquidation or transfer request within this 90-day period in order to create an issue with QDIA fiduciary relief. Even if this occurred with respect to a specific participant, steps may be taken to avoid concerns with the QDIA. We understand, for instance, that a liquidity fee otherwise assessed to the account of a plan participant or beneficiary could be paid by the plan sponsor or a service provider, and not by the participant, beneficiary or plan. In addition, a plan sponsor or other party in interest could loan funds to the plan for the payment of ordinary operating expenses of the plan or for a purpose incidental to the ordinary operation of the plan to avoid the effects of a gate. We understand that if necessary, other steps may also exist. …
[T]o the extent a gate does prevent a timely minimum distribution or refund, we understand that there are potential steps an individual or plan/IRA can take to avoid the negative consequences that may result from failure to meet the minimum distribution or refund requirements. For example, with respect to the minimum distribution requirement, an individual who fails to meet this requirement as a result of a gate is entitled to request a waiver with respect to potential excise taxes by filing a form with the IRS that explains the rationale for the waiver. In addition, with respect to plan qualification issues that may arise in the event a plan does not make timely minimum required distributions or refunds as a result of a gate, we understand that a plan sponsor may obtain relief pursuant to the Employee Plans Compliance Resolution System (“EPCRS”).
Obviously these issues will only arise in a crisis, but in a crisis they may be problematic, and the SEC/DOL answer is, basically, a work-around with some problems left unresolved.
Money market funds may be used for all sorts of purposes in DB and DC plans. As we said at the beginning, the focus of this article is limited to the effect of the Amendments 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, were a common default investment. After the adoption of that regulation, however, 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 interest 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 Amendments (exemption from liquidity fee and gates and continued amortized cost valuation and penny rounding) makes that sort of fund look like an attractive money market DC plan solution. Moreover, as we understand it, the spread between the performance of government vs. prime money market 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 significant, 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 are exempt from the floating NAV alternative, and it looks like participant-directed DC plans could generally use a retail fund. The administrative issues may, however, be problematic.
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Sponsors of plans that use a money market fund will want to discuss with their record-keeper and fund provider what the appropriate solution for their plan is and what changes to administrative procedures and operations may be required by the Amendments.