Know the Risks Resulting From Swing Pricing, Hard Close Proposals

The Securities and Exchange Commission’s mutual fund swing pricing and hard close rules proposals, and the related systemic risk of large trades, are among the biggest and most misunderstood regulatory risks that retirement plan advisers and sponsors must prepare for heading into 2024. 

Just consider what’s at stake. Suppose the SEC proposals go into effect and sponsors still want to offer traditional mutual fund assets to participants. In that case, they should expect retirement plan costs to increase, partly because the new regulations could disrupt use of simple 20-fund lineups that have long been popular with advisers, sponsors and plan participants. Here is an in-depth analysis of the factors at play.

Swing Pricing and Hard Close

Advisers and sponsors should prepare for the possibility that, sooner or later, the SEC may institute its mutual fund swing pricing and hard close proposals or variations thereof. 

The former is a method for managers to allocate costs from inflows or outflows to investors engaged in transactions (by adjusting the net asset value of shares during net redemptions or net purchases), instead of diluting other shareholders. The latter stops trading at 4 p.m. ET, by which time investor orders would need to be received by the fund, its transfer agent or a registered clearing agency in advance of the fund’s pricing.

According to the SEC, swing pricing is a liquidity management tool and a hard close can improve order processing. Together, they can help protect investors from market runs. Mandatory swing pricing and a hard close would effectively remove a material amount of investment manager discretion, while prompting intermediaries and recordkeepers to impose earlier cut-off times, since it often takes funds several hours to receive investor orders.

The U.S. Chamber of Commerce, a business lobbying organization, anticipates that the proposed changes will be costly and technically challenging for both mutual funds and intermediaries. It also predicts that the rules would result in retirement plan transactions taking longer to complete.

However, the charge that the rules would cost the average retirement investor more than $50,000 across 26 years is causing significant concern. The SEC has since acknowledged that the SEC’s initial economic analysis did not address this issue. Despite bipartisan Congressional opposition to the proposed rule, the SEC still seems determined to force mutual fund product design and processing changes to address their dilution concerns.

If swing pricing and a hard close introduce operational challenges (and errors) that inadvertently hurt participant portfolios, plan advisers and sponsors may one day be on the defensive. Sponsors might also feel pressure from participants and regulators to offset either the added costs to the plan or the anticipated loss of savings. 

Systemic Risk of Large Trades

Part of the SEC’s logic for implementing the swing pricing and hard close rules stems from the severe market volatility of March 2020, when the S&P 500 fell by nearly 30% during the initial weeks of the COVID-19 pandemic. According to the SEC, that unprecedented stress event exacerbated underlying weaknesses in U.S. trading architecture. 

Specifically, the SEC contends that open-end funds allow for a liquidity mismatch between the immediate liquidity they give shareholders and the potential illiquidity of their portfolio investments—along with the ability of large trades to significantly move market prices. To the SEC, funds may fail to meet their obligation to satisfy investor redemptions without triggering significant trading costs, while fund investors face dilution risk, so a first-mover advantage incentivizes investors to redeem shares before others, which, in turn, could cause a series of fire sales.

Since mutual funds are core to retirement plans, advisers and sponsors should brace for further measures to mitigate the risk of large trades, which are the drivers of shareholder dilution.

Large trades could be even more challenging to process when T+1 settlement, or settling the business day after trade date, becomes effective next year. The SEC has stipulated May 28, 2024, as the implementation date for moving to T+1 for transactions in U.S. cash equities, corporate debt and unit investment trusts. On that date, the Depository Trust & Clearing Corp. will update the Fund/SERV platform for domestic securities with a T+2 settlement cycle. The SEC, NSCC and DTCC have issued multiple T+1 updates to avoid negatively impacting mutual fund clients.

Regulatory burdens could prompt more mutual funds to pursue conversions into exchange-traded funds, leading to more exchange traded-funds appearing in retirement plans. Participants would need to be notified about any conversions, and all of the sponsor’s financial intermediaries would need to possess sufficient expertise with ETFs to maintain their respective plan duties. 

Next Steps

Sponsors would do well to access industry-specific third-party expertise on becoming flexible, handling other asset types and preparing to accommodate potential swing pricing and a hard close. Meanwhile, plan advisers and plan sponsors must become forward-thinking to anticipate the full downstream effect and how best to mitigate the hurdles these changes would bring to wealth managers.

Michele Coletti is chief operating officer at American Trust Custody, an AmericanTCS business.