Compliance August 18, 2015

Clearing Up Money Market Fund Reform Misunderstanding

Retirement plans will not necessarily have to divest from retail money market funds under SEC’s pending reforms, but plan sponsors and advisers may decide it's best.
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Some qualified retirement plan sponsors and service providers are misinterpreting the likely impact of the Securities and Exchange Commission’s (SEC) money market fund reforms, opining the rulemaking will necessarily drive defined contribution (DC) plans away from retail money market funds.

The SEC is focusing on educating the retirement planning industry about the likely impacts of money market fund reforms adopted in 2014. In short, the rule amendments require providers to establish a floating net asset value (NAV) for institutional prime money market funds, which will allow the daily share prices of these funds to fluctuate along with changes in the market-based value of fund assets. The rule updates also provide non-government retail money market funds with new tools, known as liquidity fees and redemption gates, to address potential runs on fund assets. 

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The retirement space is still in the process of digesting the rule changes. The good news is that sponsors and advisers have until October 2016 to decide how they will address the nearly 900-pages of rulemaking. But the timeline is tighter than some may think, given the complexity of money market funds and the potential for a late-mover premium should too many sponsors wait until the last minute to make changes.

One important section of the rulemaking for plan sponsors and service providers to understand starts at page 225, running through about page 271. The passage contains helpful discussion of what it takes to qualify as a retail money market fund, and how floating NAVs will be calculated and applied, along with guidance about the fees and redemption gates that have caused some Employee Retirement Income Security Act (ERISA) fiduciaries to doubt whether they’ll still be able to offer retail money market funds.

This is a common misconception—that retirement plan fiduciaries will be flat out required to start using government-sponsored money market funds, which will not gain the use of liquidity fees and/or redemption gates. In fact this is not the case, and the rules provide important exceptions for investing in retail money market funds that could ease plan sponsors’ fiduciary concerns.

NEXT: Important NAV exceptions

Critical for plan sponsors to understand is the fact that there is an exception for the floating NAV requirement for any money market fund that is a retail fund—and retail funds are defined under the new rulemaking as funds in which only natural persons can invest.

The money market fund rulemaking generally understands DC retirement plans as collections of natural persons, rather than as a distinct class of institutional investors. This, in turn, means most DC plans will be able to continue to invest in retail money market funds.

A big question for plan sponsors will be whether they feel comfortable, considering their fiduciary duty, with the prospect of plan participants potentially facing liquidity fees and gates within retail money market funds. The impact of these gates could potentially be dramatic, should a situation like the 2008 financial crisis occur again. In certain cases of stressed liquidity for a retail money market fund, a liquidity fee would go into place that could damage plan participant returns. In other cases, a redemption gate could be implemented, lasting up to 10 days, preventing all withdrawals from a money market fund.

Redemption fees and gates are not necessarily at odds with the fiduciary duty, especially if plan sponsors do a good job educating their plan participants up front about the money market fund changes. Indeed, the whole point of implementing liquidity gates and fees is to protect investor assets against sharp drops resulting from runs on money market fund assets. It could be distressing for a plan participant to face a liquidity fee or redemption gate, but plan sponsors can protect themselves from liability by educating participants about this possibility, and coaching them to stick with their long-term investing goals even during short-term periods of market stress.

NEXT: Other money market fund considerations

Plan sponsors and advisers should also be prepared to face changes coming from fund providers and recordkeepers.

Even in cases where a DC plan decides it is comfortable sticking with its current money market fund option, the plan’s recordkeeper or investment provider could decide change is necessary. This situation is likely to be faced by at least some plan sponsors, given that more and more fund providers are adding and changing options to get ready for the rule implementation in fall 2016.

Something else to consider is that it will be harder, if not impossible, for defined benefit (DB) plans to qualify as natural person investors. Therefore DB plans are probably likelier to have to switch to government money market funds, or another similar asset class.

Both DB and DC sponsors will have to be vigilant with regards to their recordkeeper’s shifting capabilities under the rulemaking. There are still a lot of operational systems issues that need to be addressed to ensure that the liquidity fees and redemption gates can smoothly go into effect.

On its website, the SEC urges retirement planning professionals to read a recently issued FAQ publication that addresses a number of retirement plan-related issues under the money market fund reforms. In particular FAQ 16 (which explains issues related to retail funds) and 17 (about forfeiture accounts) as well as FAQs 26-31 about the operation of fees and gates may all be of interest.

A link to the FAQs is here.

Compliance August 18, 2015

Group Estimates Fiduciary Rule Cost at $3.9B

A study commissioned by the Financial Services Institute says the amount is nearly 20 times the DOL’s estimate.
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Implementing the proposed fiduciary rule will cost independent financial services firms $3.9 billion in startup costs, according to a study by the Financial Services Institute (FSI) and Oxford Economics. This is nearly 20 times the estimate that the Department of Labor (DOL) gave and does not take into account the ongoing costs of maintaining compliance with the rule.

Further, according to the report, “Economic Consequences of the U.S. Department of Labor’s Proposed New Fiduciary Standard,” the rule will limit advice to high-net-worth individuals alone, as they will be the only people who will be able to afford it.

“The study shows that the DOL’s proposed fiduciary rule would be costly and burdensome to both the independent financial services industry and the investors that rely on the critical advice they receive,” says FSI President and CEO Dale Brown. “It also illustrates the unintended consequences the rule will have on hard-working Americans trying to save for retirement, particularly low and moderate-income investors who need advice the most.”

Startup costs will range from $930,000 to $28 million per firm, depending on size, according to the study. Broker/dealers (B/Ds) would have to substantially change their business models from commissions to fees to be in compliance with the Best Interest Contract Exemption (BICE). As a result, smaller B/Ds might go out of business. And investors may not see the returns they are now getting as they will be pushed into low-cost assets, FSI says. Furthermore, the BICE would open the door to unforeseeable litigation costs, FSI contends.

Recordkeeping will cost firms an average of $200,000, FSI says. Implementing BICE contracts will cost an average of $4.5 million. Training will cost an average of $800,000. Compliance and legal oversight will cost an average of $210,000. Disclosure will cost an average of $870,000. Setting up new system interfaces will cost an average of $570,000. And litigation costs will be substantial, FSI says.

NEXT: The impact on advice

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And investors will miss out of many services that advisers provide, FSI says, not least of which are: encouraging investors to save at a higher rate, preventing investors from taking withdrawals from their retirement savings, providing objective advice in times of market fluctuations, creating an investment plan, balancing portfolios, helping investors feel more confidence about retirement, and helping them with their overall financial plan.

“The reduction in advising that will almost certainly follow adoption of this rule will result in significant qualitative and quantitative losses to all retirement investors, including and especially small investors,” the report says. “The added structures of the new rule will likely lead B/Ds to curtail their offerings, leading to less overall choice for most investors. A good example is the case of variable annuities, which are an important product to many investors concerned about retirement planning.”

PwC’s Financial Services Regulatory Practice also circulated new fiduciary rule research this week—reaching similar conclusions about the likely impacts of the proposed DOL rulemaking.

Based on its staffers’ interactions with the DOL, PwC says it anticipates the new rule “is set to transform the competitive landscape” for retirement plan service providers and “disrupt current business models, particularly for financial institutions that are reliant on traditional broker/dealer activities which are currently not covered by the existing ERISA fiduciary standard.”

Further, PwC says it believes that the rule “will be finalized early next year with the proposals’ core framework intact.”

PwC suggests this puts a huge amount of pressure on DOL to get the carve-outs provided for in the rulemaking language into proper working order. “The first exemption, and in our view the most critical, is the Best Interest Contract Exemption, which would allow financial institutions to continue to receive commissions,” PwC explains. “The second, the Principal Transaction Exemption, would permit a financial institution to engage in the purchase and sale of certain debt securities on behalf of a retirement account.”

NEXT: “Requirements are … ambiguous.”

The report concludes that, whether or not to utilize the Best Interest Contract Exemption and the Principal Transaction Exemption, represents an important choice for financial institutions: “The requirements are strict, complex, and in many cases ambiguous. Businesses relying on the exemptions can expect to incur significant costs to maintain their existing commission-based compensation arrangements.”

PwC believes many companies will not choose to regularly rely on these contracted exceptions, and will instead move to adopt a fee-based compensation model or a more self-directed model for clients.

“In addition to these new regulatory requirements, competitive market shifts are underway, as a number of new low-cost competitors are emerging to challenge the traditional adviser business model,” PwC concludes.

FSI’s study is based on interviews with nearly three dozen executives at 12 companies that employ B/Ds or registered investment advisers (RIAs) that would be impacted by the rule. The full report can be downloaded here.

 

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