October 14th, 2016 marks the date when the Securities and Exchange Commission (SEC) money market reform comes into effect. Let's briefly recall what the reform is about, and what the reasoning was behind it before we go over your action plan.
Following the collapse of financial markets in 2008, the Reserve Primary Fund, which had more than $60 billion in assets, shocked the financial world by “breaking the buck.” This means its net asset value (NAV) dropped to 97 cents per share. By design, money market funds aim to preserve a NAV of $1, which indicates to investors that principal is “guaranteed” (even though money markets funds are not FDIC insured). You may wonder; how could this happen? Losses caused by Lehman Brothers debt securities that became worthless after company became bankrupt.
The financial panic and disruption of the whole money market industry caused by this event could not be ignored by the regulator. It laid the groundwork for reform that was finally adopted in 2014 and comes into effect this Friday.
What’s Behind the Reform?
In order to prevent similar situations and avoid any financial instability that may be caused by money market funds in the future, the SEC issued a set of new rules. This aimed at addressing risks caused by investor massive redemptions.
The most important part of the reform is based on amending two key elements: NAV and redemption gates and fees.
The new rules require institutional and municipal money market funds to have floating NAVs that will be based on the current value of the fund’s assets. In other words, institutional money market funds will soon be able to trade below $1, and carry the risk of loss of the principal.
Retail, as well as government money market funds may still maintain a NAV of $1.
Redemption Fees and Gates
To prevent runs on a fund, the rules will allow retail and institutional prime and municipal money market funds to suspend redemptions, and even impose liquidity fees when fund’s weekly liquid assets fall below a certain threshold level. For example, if a fund’s liquid assets fall below 10%, the fund will be permitted to impose a liquidity fee of 1%. If it falls under 30%, then the liquidity fee can be raised up to 2% and/or all redemptions may be temporarily suspended.
Government funds are not required to impose fees and gates. However, no one prevents them from doing so.
What Should You Do?
As you can see, SEC money market reform brings about a few important changes that definitely need attention. With that being said, having institutional money markets in your investment menu can potentially become the source of a headache. Moreover, if you don’t take the necessary steps, it may even be classified as a breach of fiduciary duty.
Below you will find a 3-step plan of action that you need to take right away.
Check your plan’s investment fund lineup for money market funds.
If you have institutional prime money market funds, replace them with government money market funds. It does not make sense to offer institutional prime money market funds anymore. Government funds, which provide higher credit standards, usually don’t impose redemption fees and rarely have redemption gates.
Consider stepping outside the money market funds world. Have you looked at other cash alternatives, like stable value funds? If not, make sure to check them out. They yield more and aim to maintain a NAV of $1. However, make sure you know all of the pros and cons. The picture isn't exactly perfect .
No matter what decision you make, make sure you educate and communicate all the changes and potential consequences of the reform to participants. If you decided to go with government money market funds, let them know that the returns are going to be even lower than prime funds.
If for some reason you decide to keep institutional prime money market funds, make sure your employees are aware of redemption fees, the restrictions on accessing the funds due to potential suspensions, and most importantly that their investment can now lose value!
As a fiduciary you need to undertake a prudent process and assess the benefits of each option. You also need to properly communicate the information to your employees in a timely manner. By doing so, you can significantly reduce potential liability and help participants to make better investment decisions.