Money market reform has arrived. The SEC’s sweeping changes, along with technical and macroeconomic factors, will likely make money market funds
(MMFs) safer – if far less attractive – to defined contribution (DC) plan participants. In our view, if plan sponsors want a capital preservation
option that has the potential to deliver returns above inflation, it’s time to consider a change, perhaps to stable value, short-duration bonds or
even to white label solutions.
The SEC reforms, set to take effect on 14 October 2016, transform key elements that have made MMFs popular since their introduction in the U.S. in 1971.
The new rules impose potential liquidity fees and gates on many MMFs and require institutional prime funds to move from fixed to variable net asset values
(NAVs). These changes 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.
DC consultants have recognized that the reforms mark a sea change in an asset class that has been a staple of DC plans. In PIMCO’s 10th Annual 2016 DC Consulting Support and Trends Survey, which captures opinions from 66 U.S. consulting firms that serve over 11,000 clients with DC assets in
excess of $4.2 trillion, 95% of consultants said they were somewhat likely, likely or very likely to recommend switching from a money market fund to stable
value; 49% had similar views about switching to ultra-short bond funds.
The capital preservation space is not as simple as it once was and optimal solutions change. If a sponsor uses an MMF as a capital preservation option,
PIMCO thinks the reforms are a good reason to consider alternatives. This is especially true given the increase in DC litigation in recent years.
Capital preservation and DC
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). Capital
preservation strategies seek to preserve invested principal, generate income, provide a liquid, low-risk investment during volatile markets or offset
riskier investments in a portfolio.
In our view, a successful capital preservation option should meet these conditions:
Liquidity: A significant portion of invested principal can be easily sold or converted into cash under most market conditions without significantly
changing the value of the investment.
- Low risk: The value of invested principal should be reasonably assured over an appropriate time horizon as determined by the sponsor – daily, monthly or
- Real return: Investments should seek to generate real returns, or returns over inflation, to help participants maintain and potentially grow the
purchasing power of their retirement assets.
However, market dynamics over the past decade – including compressed short-term bond yields, changing supply and demand dynamics and now the implementation
of the SEC’s money market reforms – have eroded the ability of MMFs to deliver on all three of these critical aims.
In anticipation of the new regulations, many MMF fund complexes have transitioned much of their prime MMF offerings to government MMFs in recognition of
the market’s preference for a $1.00 NAV product without fees and gate complications. (This includes PIMCO, which merged its prime MMF offering into the
PIMCO Government Money Market Fund, managed by Jerome Schneider, whom Morningstar named its 2015 Fixed-Income Manager of the Year.)
Moreover, the SEC changes imposed significant changes to structural and operational aspects of MMFs, which created challenges for DC recordkeepers,
custodians and trustees. Government MMFs have become DC trustees’ preferred MMF solution because these funds are managed to a fixed $1.00 NAV while
remaining exempt from mandatory fees and gates, reducing their operational challenges. The result: Over the past 18 months, many plan sponsors that used
prime MMFs received negative consent letters from their service providers; these gave notice that the plan’s capital preservation option had changed from a
prime MMF to a government MMF.
In our view, the material SEC reforms and the dramatic realignment of the MMF industry is a prompt to DC sponsors to scrutinize their use of MMFs. This may
be particularly urgent given the recent rise in DC-related litigation.
Do MMFs deliver for DC?
In recent years, MMFs have failed to deliver real returns, one of three objectives of any capital preservation strategy. While nominal yields have recently
budged from zero, real yields remain negative. And with the SEC reforms further constraining MMFs’ already conservative investment guidelines, future
return opportunities will be reduced.
So, with expected returns low, even recent mild inflation can cause negative real returns that will lead over time to an erosion of a participant’s
purchasing power. Lost purchasing power could possibly be made up through higher returns in riskier investments, or the participant could endure a lower
standard of living in retirement. Neither are particularly attractive options.
While conceivable that MMFs may meet all of the objectives of a DC capital preservation option in the future, we think this is unlikely within the next
three to five years. Ultimately, while some plans may face unique situations where MMFs continue to be the best capital preservation option, it is unlikely
they will deliver on the general objectives required by DC plans – particularly protecting participant purchasing power to and through retirement.
And the alternatives are?
If a sponsor has decided to consider a different capital preservation option, or just wants to review the alternatives, we see three reasonable choices,
with suitability depending on the unique needs and characteristics of the plan and the investment requirements and sophistication of its participants:
First, consider stable value. Stable value has been used in DC plans for more than three decades. These strategies are designed to
provide participants with money market fund-like volatility, while seeking to deliver returns similar to intermediate-maturity bonds over time.
Having managed stable value since 1992, PIMCO stands ready to share its 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 2014, it was offered by over 62% of all DC plans, up three percentage points over the previous
year, according to the Plan Sponsor Council of America’s 58th Annual Survey of Profit Sharing and 401(k) Plans.
Moreover, while stable value strategies returned 1.95% annualized over the five years ending 30 June 2016 (as represented by the Hueler Analytics Stable
Value Index), the U.S. Bureau of Labor Statistics’ Consumer Price Index rose 1.32% during the period. So, stable value has protected purchasing power far
better than the Lipper Money Market Index, which returned a nominal 0.02% over the same period.
Second, consider a short-duration bond option. Although some sponsors are reluctant to include a variable NAV strategy as a capital
preservation option, ERISA section 404(c) does not expressly require a plan to offer a $1.00 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 Fund, which seeks to provide
capital preservation and low volatility. These new, “ultra-short” strategies generally invest in ways that are similar to MMFs with a minimal increase 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 short-duration bonds, stable value and even MMFs – and seek a customized level of expected risk and
return. Here as well, PIMCO has long experience helping sponsors create custom options.
Being proactive is a best practice
DC plan sponsors who have previously made a decision to use MMFs as a capital preservation option should understand that the SEC’s reforms are material. As
the capital preservation needs of every plan are unique, it’s possible that an MMF remains appropriate for a particular DC plan. However, MMFs are likely
to continue to generate negative real returns over the next several years, eroding participant purchasing power.
Optimal solutions in the capital preservation space change. If a sponsor uses an MMF as the plan’s capital preservation option, the SEC’s reforms are a
good catalyst to prudently review the rationale, especially as fiduciary risks have increased in recent years. In our view, sponsors should look beyond
MMFs and consider alternatives that seek to deliver liquidity, limit risk to principal and help protect participants’ purchasing power into retirement.