In October 2008, the Reserve Primary Fund "broke the buck," and its $1 net asset value dropped to 97 cents. That may not seem like much, but it sent shock waves through an industry already shaken by the Lehman Brothers bankruptcy two days prior.
Even though the Reserve Fund held only 1.2% of its assets in Lehman Brothers debt, the bankruptcy was enough to send panicked institutional investors rushing for the exits, resulting in massive outflows of $350 billion from money market funds before the U.S. Treasury Department stepped in with temporary guarantees.
Those guarantees are long gone, replaced by rules governing money market fund providers that are designed to help avoid or mitigate the impact of future runs.
In 2010, the SEC undertook limited reforms to improve fund transparency, strengthen liquidity and credit quality requirements, and restrict riskier types of holdings. In July 2014, the agency went even further by
adopting a beefed-up rule designed to make money funds less susceptible to heavy redemptions and loss of principal during a financial panic.
Oct. 14 is the compliance deadline for the rule adopted in July 2014. The rule provides fund boards with tools allowing them to suspend redemptions amid severe market volatility as well as charge so-called “liquidity” fees of up to 2% on redemptions. If plan fiduciaries haven't done so yet, they should start preparing now to assess how the new regulation will impact the investment options available to participants.
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The new rule essentially divides MMFs into three buckets: institutional, retail and government funds.
Because institutional investors triggered most of the outflows during that hectic week in 2008, the new rule singles out institutional MMFs for special treatment by requiring these funds to maintain a “floating” NAV of $1. Share valuations are priced out four decimal points and may fluctuate based on daily market pricing. As the name implies, institutional fund shares are available only to businesses, defined benefit plans, endowments and other corporate investors, not individuals.
Under the new rule, retail and government MMFs are allowed to maintain a stable $1 NAV. However, like institutional funds, retail MMFs are subject to fee and gate requirements, with fund boards able to impose one or the other when weekly liquidity levels in a fund drop below 30%. In addition, a default 1% fee is charged for redemptions when a fund's weekly liquidity level drops below 10%. With regard to gates, fund boards may suspend redemptions for up to 10 business days in a 90-day period.
Although the boards of government MMFs also have the option to impose fees and gates, they are not required to do so. As a trade-off, government MMFs are required to maintain the most liquid and conservative holdings of the three types of money market funds. A previous SEC requirement allowed government MMFs to hold up to 20% in derivatives or other risky investments, but that has been reduced to a mere one-half of 1%. Thus government MMFs (which are available to both institutional and retail investors) are likely to be the preferred choice for many investment fiduciaries concerned that gates could be imposed at a time when participants (and other clients, for that matter) may urgently need to withdraw cash.
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What does all of this mean for plan fiduciaries, which have an ongoing duty to ensure that all investment options are suitable?
If by chance a current MMF option is converted to an institutional MMF, it will no longer be available to participants or their beneficiaries and must be replaced. While this miscue is unlikely to happen, plan fiduciaries should make sure that the replacement fund is either a retail or government MMF, or a suitable cash equivalent. Given the likelihood that most government MMFs will opt out of using fees and gates, government funds will likely prove to be popular choices for many 401(k)-type plans.
That said, fiduciaries may want to consider other cash options as well. The most recent wave of class-action lawsuits includes fiduciary breach claims challenging the suitability of money market funds given their current low yields. Some plaintiffs have alleged that plan fiduciaries should have offered stable value funds, which typically offer higher yields.
The new SEC rule also mandates the disclosure of additional information about MMFs that will be helpful to fiduciaries in the monitoring process. For example, additional information on specific holdings in a MMF will be stepped up from monthly to a daily basis. Share values will be posted daily on the funds' websites, including the 30% required liquidity holdings.
Finally, funds will be required to disclose in the prospectus or Statement of Information a 10-year look-back period on key events. This information must include the use of gates, fees or sponsorship support to maintain stable share values, as well as occurrences in which daily liquid assets dropped below 10%.
All of this suggests that now is the time for plan fiduciaries to carefully assess the cash option in their 401(k) plan. The once-plain-vanilla money market fund is due for a serious makeover.
Blaine F. Aikin is executive chairman of fi360 Inc.
