Money Market Fund Reform Likely Warrants Changes

Some believe more 401(k) plans will switch to government money market funds to respond to SEC rule changes.

The recent money market fund reforms adopted by the Securities and Exchange Commission (SEC), which take effect in October 2016, will require retirement plan advisers to review the money market funds in their plan sponsor clients’ lineups and possibly recommend changes, experts say.

The reforms will affect nearly two-thirds of all defined contribution (DC) plans, as 63.5% have money market funds in their lineup, according to the 2014 PLANSPONSOR Defined Contribution Survey.

The rule amendments require investment managers to establish a floating net asset value (NAV) for institutional prime money market funds, among other changes. The amendments also allow non-government money market funds to use liquidity fees and redemption gates to better control outflows in times of stress.

“Institutional clients in endowments and pension plans aregoing to be greatly affected because of the floating NAV,” says Jay Sommariva, vice president and senior fixed-income portfolio manager at Fort Pitt Capital Group in Pittsburgh. “While on paper, retail clients in 401(k) plans will not be affected because the retail funds will maintain a constant $1 NAV—just like in 2008, when the largest money market fund in the nation ‘broke the buck’ due to its holding of Lehman Brothers and some structured investment vehicles (SIVs) associated with distressed mortgages—there is a chance assets in the retail funds can depreciate. They might also impose a redemption gate or a 2% penalty to take your money out.”

These changes underscore the fact that money market funds, as Sommariva puts it, “were never risk-free and should not be viewed as such” moving forward.

Fund providers seem to be taking note of the changes as well—with large volume providers such as Charles Schwab recently announcing to clients that in times of major market stress, its retail prime and municipal money market funds will have the ability to implement liquidity feeds or redemption gates. This is why Sommariva believes that advisers to 401(k) plans will recommend that the plans replace their retail money market funds with government money market funds, “which provide higher credit and liquidity standards”—and will not have liquidity fees or redemption gates.

The typical money market fund in 401(k) plans today is a prime fund that invests in both corporate and government bonds, says Kendrick Wakeman, founder and CEO of FinMason, a provider of an online financial research tools, based in Boston. As a result of the money market reform, Wakeman expects prime funds will be replaced by a “bifurcated” approach where some funds invest solely in government bonds and others solely in corporate bonds.

“The net effect is that sponsors whose participants want a pure cash alternative will invest in the government money market funds, while sponsors whose participants want to get more yield to at least keep up with inflation will invest in the corporate money market funds, which will have redemption gates and liquidity fees,” Wakeman says. Advisers should begin the conversation with their plan sponsor clients now as to which approach they want to take, he says. If the adviser believes a corporate money market fund is the right choice for the sponsor, they “should be prepared to explain why the extra return is worth the extra risk,” he says.

The redemption gates and liquidity fees should “only be a rare occurrence,” says Joan Ohlbaum Swirsky, counsel with Stradley Ronon Stevens & Young LLP of Philadelphia. “If weekly liquid assets fall below 30%, the fund can impose a liquidity fee up to 2% as well as a redemption gate. If weekly liquid assets fall below 10%, a 1% liquidity fee will be imposed, unless the board decides otherwise,” Ohlbaum Swirsky says. “Under normal circumstances, the fee and gate requirements aren’t expected to be imposed.”

Advisers to pension plans are also likely to move to government money market funds, Sommariva says. “When their money market funds move to a floating NAV, they cannot be considered to be cash, and the best alternative is the government money market funds. I have never thought of stable value or guaranteed fixed-income funds as suitable replacements for money market funds or cash,” because they have inherent risks and are not as liquid as government money market funds, he says. Wakeman, however, doesn’t expect the floating NAV will be of any great concern to pension plans, as “they are sophisticated investors who have a great deal of exposure to equities and are therefore used to seeing the value of their holdings fluctuate.”

Because the new rules include enhanced diversification disclosure and stress testing requirements, along with updated reporting, advisers will need to review the money market funds in a plan’s lineup “more stringently and every quarter,” Sommariva says. “The review should be part of the overall investment policy decision, just like any other investment.”

Advisers should look at the credit ratings of the holdings in money market funds, Wakeman adds. “The reporting will make for more transparency for money market funds,” Ohlbaum Swirsky says. “There will be more information on their daily and weekly liquid assets, along with daily weekly inflows or outflows, and the Securities and Exchange Commission will require them to report their NAV to the fourth decimal place.” In addition, she notes, instead of the money market funds publicly reporting their holdings every month with a 60-day delay, the SEC will require them to publicly report their holdings every month within five business days.

At the end of the day, all money market funds will be invested very differently by October 2016 than they are today, Sommariva believes. Because of the higher credit standards the rule imposes on the funds, “the rules will mandate money market funds to look different—with shorter duration, higher quality and more liquid investments.” That means even non-government money market funds will hold more government securities, he says. And the institutional money market funds with a floating NAV “will dramatically decline in number or disappear entirely. Since the funds can no longer qualify as cash, investors will move into another vehicle,” he says.