Sponsors of defined contribution (DC) plans have less than a year to prepare for sweeping reforms that will make money market funds (MMFs) a far less attractive option for plan participants. Plan sponsors using these popular options should assess how the SEC reforms, along with evolving technical factors and macroeconomic forces, are likely to affect different types of MMFs. Fortunately, if a change is needed, there are several capital preservation alternatives for sponsors to consider – including stable value, short-duration and white label bond strategies.
The SEC reforms, which go into effect next October, will transform key elements that have made MMFs popular since their introduction in the U.S. in 1971. MMFs now have stable net asset values (NAVs) and daily liquidity. The new rules will impose potential liquidity fees and gates on many MMFs and require institutional prime funds to move from fixed to variable net asset values (NAVs). They are a response to the events of September 2008, when the bankruptcy of Lehman Brothers forced the Reserve Primary Fund, the oldest money market fund, to “break the buck” by pricing its shares at 97 cents.
The reforms mark a sea-change in an asset class that has been a staple of DC plans for decades. In PIMCO’s 9th Annual DC Consulting Support and Trends Survey, which captures opinions from 58 U.S. consulting firms that serve over 8,500 clients with DC assets in excess of $3.2 trillion, almost all consultants (98%) believed it important or very important for plan fiduciaries to review the use of MMFs in a DC plan given the pending reforms. The recommendation to review plan options was further underscored this year by a unanimous Supreme Court decision, which implied that trustees have a “continuing duty to monitor trust investments and remove imprudent ones.”
Should plan sponsors decide to make a change, the implementation of reforms in October 2016 doesn’t leave much time.
PIMCO believes that capital preservation strategies – along with global fixed income, inflation-hedging options and global equities – are one of four key pillars of a DC plan’s core investment lineup. Each contributes to ensuring a balanced selection of diversifying asset classes (see Figure 1).
To help ensure long-term, positive outcomes for participants, we think that sponsors should focus on three key goals when deciding on a capital preservation option: 1) liquidity, 2) limited risk to invested principal and 3) generation of real returns to help participants maintain and potentially grow the purchasing power of their retirement assets.
Historically, MMFs have delivered on these objectives. Market dynamics over the past decade, however, have presented headwinds to MMFs that will likely continue. Compressed short-term bond yields, changing supply and demand dynamics, and now next October’s implementation of the SEC’s money market reforms all have eroded the ability of MMFs to deliver on these critical aims.
What is changing? What do I need to know?
The SEC’s sweeping reforms change structural and operational aspects of MMFs to address risks of investor runs on MMFs, while trying to preserve the benefits of the funds. Some changes, such as enhanced disclosures and strengthened stress testing, may pass unremarked, while others may upend the popularity of MMFs in DC plans.
All institutional prime MMFs, for example, will have floating NAVs in contrast to the current fixed $1 NAV. However, retail MMFs and government MMFs may maintain a $1 NAV, making them more likely to be used in DC plans.
Unfortunately, retail MMFs will be subject to mandatory 1% liquidity fees and possible suspensions of redemptions (i.e., “gates”) for up to 10 days. This has raised concerns over the use of retail MMFs in DC plans, as these limitations are well outside the bounds of traditional participant expectations of MMFs, creating communication and other challenges for sponsors.
The easy choice for a sponsor would seem to be to switch to a government MMF, as these will maintain a $1 NAV, be exempt from mandatory fees, gates and – given ongoing near-zero policy rates – result in an almost imperceptible reduction in current yields.
And many large fund complexes would seem to agree. Over the past 12 months, various MMF managers have worked feverishly to restructure their offerings, with many transitioning much of their institutional and retail MMF offerings to government MMFs, dramatically increasing demand. For instance, the world’s largest MMF recently converted to a government fund. All told, up to $1 trillion in money market fund assets could seek to transition to all- government holdings, according to Crane Data.
However, PIMCO believes this “easy” choice runs no small risk of hitting headwinds, leading to additional difficulties for the industry, sponsors and participants.
Surging demand, shrinking supply
This surging demand for government securities is occurring while the supply of money market securities, including governments, has declined. For instance, the supply of U.S. Treasury bills is 30% below 2009 levels, and represents only 11% of Treasury debt outstanding, a record low, according to Bloomberg.
We expect this trend could impede government MMFs’ ability to deliver on the objectives of capital preservation options in DC, making other options relatively more attractive. For instance, in our view, the supply-demand mismatch will likely work to keep the nominal yields of government MMFs low and real returns negative, even as the Fed normalizes rates. If so, MMFs, which have eroded participant purchasing power over the last five years by an annualized 1.78% (see Figure 3) or close to 10% on a periodic basis, will continue to fail to help plan participants maintain inflation-adjusted purchasing power.
More concerning, the lack of investable supply could force fund complexes that are unable to source eligible government paper to provide a negative yield
(as has occurred in Europe), hold uninvestable deposits in cash – diluting the MMF’s yield – or turn away new deposits from existing clients, including DC
plans. This would create significant communication and operational complications for sponsors.
Being proactive is a best practice
Whether fiduciaries stay the course with MMFs or select an alternative capital preservation option, PIMCO encourages fiduciaries to conduct a thorough review. We also suggest that plan sponsors review their current MMF offering with partners who not only have general DC expertise but also are steeped in the capital preservation markets.
If a sponsor considers a new capital preservation option, we see three likely alternatives. Suitability will depend on the unique needs and characteristics of the plan and the investment requirements and sophistication of its participants:
- First, consider a stable value option. Stable value has been used in DC plans for more than three decades. It is designed to provide participants with money market fund-like volatility, while seeking to deliver returns over time similar to intermediate-maturity bonds.
Having managed stable value since 1992, PIMCO stands ready to share our expertise. However, we also understand that stable value may not be the optimal solution for every plan. Among other issues, there are unique risks, costs and contractual obligations associated with stable value wrap contracts.
Nonetheless, stable value remains exceedingly popular: In 2013, it was offered by over 59% of all DC plans, according to the Plan Sponsor Council of America’s 57th Annual Survey of Profit Sharing and 401(k) Plans.
Moreover, stable value strategies returned 2.12% annualized over the five years ending 30 September 2015 (see Figure 3), and the U.S. Bureau of Labor Statistics’ Consumer Price Index rose 1.79%. So, stable value has protected purchasing power far better than the Lipper Money Market Index, which returned a nominal 0.01% over the same period.
- Second, consider a shorter-duration bond option. Although some sponsors are reluctant to include a variable NAV product as a capital preservation option, ERISA section 404(c) does not expressly require a plan to offer a constant dollar NAV option.
However, there is a caveat: Sponsors should carefully select a fund specifically designed to address the low volatility needs of plan participants. Typical “off-the-shelf” enhanced cash or low duration funds, whether actively or passively managed, often have unattractive NAV volatility.
In recent years, investors have focused on a variety of new approaches, including PIMCO’s Short Asset Investment Strategy, which have capital preservation and low volatility as stated objectives. These new, “ultra-short” strategies generally invest in ways that are similar to MMFs with a minimal step out in risk and slightly more flexible investment guidelines designed to seek returns closer to inflation.
- Finally, consider creating a white label capital preservation option. Particularly for larger plans, a white label capital preservation option can optimize a blend of solutions – including shorter-duration bonds, stable value and perhaps even MMFs – and seek a customized level of expected risk and return. Here as well, PIMCO has long experience helping sponsors create custom options.
Time is almost up
DC plan sponsors are at a crossroads. Plan sponsors who currently use MMFs now have less than a year to complete a comprehensive review and, if needed, implement changes appropriate for their plan prior to the implementation of the SEC reforms.
The attributes that made MMFs popular have been eroded. MMFs are failing to deliver above-inflation returns for participants, returns are likely to remain low and SEC regulation has over-complicated management of these funds. In addition, plan fiduciaries are under a spotlight.
In our view, sponsors should look beyond MMFs and consider alternatives that deliver liquidity, present limited risk to principal and provide a better opportunity to help protect participants’ purchasing power into retirement.