Money Market Funds: Change is Coming

    Erik Daley, CFA
    Managing Principal

     

    Introduction

    The money market fund industry is entering the final stages of a multi-year shift in regulatory requirements which will directly impact money market investors for years to come, including qualified plan fiduciaries. The purpose of this white paper is to provide a background of how we got to this point, a summary of the new regulations, an overview of the types of money market funds in the new regulatory environment, and a discussion of the key issues qualified plan fiduciaries should be evaluating with respect to the use of stable principal investment options within their plan’s investment menu.

    Background

    As of this writing, we are seven years from the date in 2008 when the US Treasury Department took unprecedented steps by establishing the Temporary Guarantee Program for Money Market Funds (TGPMM). This was a critical step in helping to stabilize US banking and credit markets, which could have been further tested had money market shareholders begun demanding cash on their current banking deposits.

    Most money market funds (although funds experiencing material distress at the time of the program's establishment were prohibited) signed-up for the program; those that did would have their proceeds guaranteed by temporary insurance.  In exchange for the guarantee, participating funds paid 0.01% annually into the program.  In practice, almost all eligible funds participated for fear of losing deposits to funds that opted into the guarantee program.

    The program was initially scheduled to last for a period of 3 months, however it persisted for nearly a year.  While many broad actions were taken in 2008 to maintain liquidity and security in open markets, the TGPMM was a particularly successful program.  Over the 12 months of existence, the program had no claims and earned over $1 B in participation fees. 

    In the seven years since the 2008 financial crisis, numerous changes in laws and industry regulations have been passed with the goal of preventing future crises; new money market regulations among them. While the TGPMM was successful, the goal of new regulations was to avoid future emergencies from arising.

    In an effort to reduce systemic risk in money market investments, and the externalities of those risks to the system as a whole, the Securities and Exchange Commission (SEC) proposed Rule 2a-7 in 2013.  Rule 2a-7 is designed to limit money market investments in concentrated securities of single issuers.  In 2014 the SEC adopted the final amended rule 2a-7 which created a gradual implementation of significant changes to money market mutual funds and how they are invested.  The last of the phased implementation steps (to take place in the later half of 2016) will create new categories of money market mutual funds.

    The stresses of 2008 do not seem to have materially impacted the size of the money market industry.  While during the 2008 crisis money market issuers took huge deposits into Government Money Market Funds because they were perceived to have a lower rate of default risk, post-2008 asset levels across tax-exempt, prime, and Government Money Market Funds have remained steady1. 

      

    Money Market Fund Types

    The new regulations create basically two types of money market funds: Government Money Market Funds and Prime Money Market Funds. [Please note for the purpose of this paper I will omit a discussion of tax-exempt money market funds, which typically are not used in qualified retirement plans.]

    Government Money Market Funds typically invest in U.S. Treasury securities and securities issued by U.S. government agencies or “Government Sponsored Enterprises” such as Fannie Mae, Freddie Mac and the Federal Home Loan Banks.  Government agency securities are not backed by the full faith and credit of the U.S. government, but are perceived by most to be more secure than non-government issuers.  Government Money Market Funds may also invest in repurchase agreements collateralized by U.S. Treasury or other U.S. government securities.

    Prime Money Market Funds on the other hand, may invest in any eligible money market instruments as defined by the Securities and Exchange Commission under Rule 2a-7, including commercial paper, certificates of deposit, corporate notes, and other private investments.

       

    Rule 2a-7 

    The intent of the SEC in creating rule 2a-7 was to eliminate the threat that would be caused to the financial system if we experienced a systemic collapse of money market products.  The initial phases of Rule 2a-7 focused on quality and diversification requirements that would reduce the risk in underlying holdings.  The last phase of Rule 2a-7 is designed to ensure that money market investments that continue to take risks within the bounds of 2a-7 have features that would prevent a rush of distributions in times of stress.

    To support this protection, Rule 2a-7 creates three potential asset preservation features that money market funds may choose to enlist.

     

    The history of money market funds, since their inception in the 1970’s, was one of safety and liquidity.  While Rule 2a-7 enhances the proposition for safety, the new liquidity restrictions will change how money market funds can and will be used by retirement plans. The table below shows at a more granular level the types of money market funds and the applicability of each of the new regulatory features. Generally, the new liquidity constraints will only apply to Prime Money Market Funds.



    Money market funds in defined contribution retirement plans are deemed as “retail” under the new rule.  As a result, a Prime Money Market Fund would maintain the critical $1 share price, but potentially be subject to liquidity fees and redemption gates at the participant level. This may prove unreasonable to some plan sponsors in exchange for the very low rates of return. 


    Potential Impact of Rule 2a-7 on Defined Contribution Plans

    The only money market investments not affected by the changes brought about by Rule 2a-7 are government money funds.  We have already begun to see significant movement among mutual fund providers and plan sponsors away from Prime Money Market Instruments to avoid any potential redemption gates or liquidity fees.  If this trend holds industry wide, the use of Government Money Market Funds will result in higher quality money market portfolios.  However, in a world where risk and return are correlated, the use of higher quality government securities of ultra-short duration to comply with 2a-7 should reduce expected returns in an asset class where returns are already at or near zero.


    Cash Equivalents Post 2a-7

    Nearly all defined contribution plans offer one or more “cash equivalents” generally with the purpose of preserving value.  While having a cash equivalent investment is not required in defined contribution plans, the language of ERISA section 404(c) (referring to different assets and participant choice) has cemented the use of cash equivalents in nearly every defined contribution plan.  When selecting a cash equivalent for a defined contribution plan, there are three specific features (in addition to a number of qualitative factors) that plan sponsors ultimately need to prioritize in the evaluation: stability of value, liquidity, and yield.

    Post 2a-7 and the new quality requirements for money market investments, plan sponsors can prioritize any two of these features albeit at the potential expense of the third.

    Stability of Value
    One of the primary attributes of cash equivalent investment options within the investment menu is to provide an option that has a stable principal value. For money market funds, this is the $1/share NAV that has always been a key feature of these types of products. In practice, most plan fiduciaries automatically assume stability of value is a requirement for cash equivalent investment options within the investment menu, as participants have a desire to have at least one choice where they "won't lose money" from day to day.
     

    Liquidity
    Within defined contributions plans liquidity is generally assumed to be ever-present. The new money market rules create constraints on the liquidity of some money market investments for the first time. For defined contribution plans, liquidity has two potential ramifications. At the participant level, consider whether restrictions in liquidity might inhibit participants from exercising the level of control necessary (under ERISA section 404(c)) to limit ability for fiduciaries. At the plan sponsor level, the potential of a money market fund to impose a redemption gate creates a challenge for plan operations that recordkeeping bendors may not be willing to support. Given the new regulations, liquidity is not a guarantee and plan sponsors need to determine how important daily liquidity is for both participants and at the plan level. 


    Yield

    Cash equivalent investment options are not designed to provide capital appreciation, so their expected return is best approximated by their current yield. Within this space the two primary risk factors that affect yield are interest rate risk and credit risk. Rule 2a-7 shortened the permissible duration of money market securities and increased the requirements for investment in government debt which generally has a higher credit profile. As a result, money market funds will be constrained in generating yield relative to their historical performance even when interest rates rise.


    Sophie's Choice for Plan Sponsors


    Before enactment of these final changes in 2016, plan fiduciaries should discuss the role of cash equivalents in their participant-directed defined contribution programs.  Which of the three attributes you prioritize should drive you toward a preferred solution.

     

    While there is no perfect answer to the question of how to use cash equivalents in your plan, committees and fiduciaries should acknowledge the tradeoffs and the intended use.  Doing so will make the evaluation of products and returns more relevant.  For the purpose of this paper we will touch only briefly on the alternative product constructs sponsors might consider as alternatives to a money market fund in their plan.

    Stable Value Options
    Stable value funds can include both wrapped bond portfolios as well as fixed annuity products from insurers.  The objective of these products is to provide capital preservation coupled with steady, positive returns.  For the wrapped bond portfolios, insurance contracts are wrapped around a short/intermediate duration bond portfolio to enable participants to transact in the fund at book value.  Investment returns are smoothed using a formula to ensure that the book value of the portfolio generally tracks the market value of the bonds that make up the return stream.  These products can either be purchased individually (for larger plans) or as part of a collective (shared by many smaller plans).  While the longer duration and lower credit quality of most stable value bond structures provide higher returns, and the insurance provides stability of value to participants, material liquidity constraints exist at the sponsor level that limit the flexibility of plan sponsors.

    Ultra Short Term Bond
    Ultrashort-bond portfolios invest primarily in investment-grade U.S. fixed-income issues and typically have an average duration of less than one year. This category can include corporate or government ultrashort bond portfolios, but excludes international, convertible, multisector, and high-yield bond portfolios. Because of the focus on bonds with very short durations, these portfolios offer minimum interest-rate sensitivity and therefore low volatility and total return potential.  The benefit for plans is full liquidity and an expectation of higher returns attributable to the additional duration risk portfolio managers may take.  The key drawback is that the daily value of the portfolio will fluctuate with changes in interest rate and as a result, the value of the portfolio may experience periods of declining principal value.


    Returns Still Matter

    The US has been in a low interest rate environment since the 2008 recession, and the prospect of a continued period of low rates seems plausible given the state of the economy.  In this rate environment, accumulating fixed income returns is challenging and the three solutions for cash equivalents have very different histories of delivering returns.


    Over the seventeen-year period we reviewed, money market returns trailed inflation while ultrashort bond returns generally were able to replicate inflation.  Stable value type investments have generally been able to prosper, even when materially stressed such as in 2008 when defaults were higher.  But like with all returns, these investments are accompanied by risk.  Whether it is risk associated with the bonds in the stable value pool, or the health of the insurers guaranteeing stability in book value, the risks need to be understood.

     

    Conclusion

    When there is no clear answer, sponsors generally benefit from understanding the range of options.

    1. Review your current portfolio and cash equivalent funding strategy
    2. Adjust your investment policy statement to reflect the goals of the plan
    3. Select the product(s) that meet your organizational objectives
    4. Communicate the product benefits and limits to participants
    5. Reassess
    As with all issues of fiduciary prudence, continual evaluation is necessary as product options and enhancements may become available down the road.  

     

     

    1Data from Investment Company Institute
    2Data from Investment Company Institute
    3Data from Investment Company Institute
    4Returns as of June 30, 2015
    5Returns as of June 30, 2015

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