October 2016 SEC Changes to Money Market Investments

The Securities and Exchange Commission (SEC) protects U.S. investors and markets through rigorous oversight and enforcement. To ensure that all investors are on equal footing and to respond to the latest developments in the financial sector, the SEC needs to propose or adopt new sets of rules on a regular basis. From April 2013 to June 2016, the SEC has introduced more than 40 reforms. All of these reforms enhance transparency across financial markets and provide better protection for individual investors. One of these reforms, which changes the rules of money market funds, is set to affect all types of investors, including individual ones, as early as October 14, 2016. Let’s review what this money market fund reform is about and how you can prepare for it in case you already hold or are planning to hold money market funds in your retirement account.

Money market funds are low-risk and low-return investments

Through holdings in short-term (less than one year) securities, money market funds are able to provide investors a diversified cash-equivalent asset. For example, here is a breakdown of asset allocations of the Vanguard Prime Money Market Fund (NASDAQ:VMMXX) as of 07/31/2016:

*Rounding error due to decimal approximation. Before 2014, money market funds allowed investors to earn very low interest and maintain a net asset value of $1 per share. This guarantee of principal made money market fund an attractive option to investors looking to securely park their money. Additionally, some mutual funds would exempt or absorb front-load or other investment fees and some mutual funds holding municipal securities could provide tax exemptions at the federal or state level. This made money market funds attractive to investors in a higher tax bracket with a short-term savings goal.

The 2008 financial crisis forever altered the landscape of money market mutual funds

Unlike comparable investments, such as certificates of deposits (CDs) and online savings accounts, money market funds aren’t covered by the Federal Deposit Insurance Corporation (FDIC). This detail played a key role during the 2008 financial crisis (this is what the movie The Big Short is about), when a severe run on money market funds took place. Due to its exposure to Lehman Brothers debt securities, on September 16, 2008 The Reserve Fund announced that shares in its primary fund would have to be reduced from one dollar to 97 cents due to losses. On September 9, 2008, the total held in money funds was $3.535 trillion and, just 10 days later, it plummeted to $3.288 trillion, when the government plan in response to the financial crisis was unveiled. By “breaking the buck”, the Reserve Fund demonstrated the strong need to reduce the risk of future runs on market market funds.

The SEC’s money market fund reform addresses liquidity issues during times financial distress

On July 23, 2014, the SEC adopted amendments to make structural and operational reforms to address risks of investor runs in money market funds, while preserving the benefits of the funds. The SEC gave a total of two years for investment firms to enforce changes…and the deadline is right around the corner: October 14, 2016! Here is a summary of the key takeaways of the SEC’s money market fund reform:

• The SEC establishes three categories of money market funds: retail, government, and institutional.

• The SEC restricts who can invest in retail money market funds.

• Retail and government money market funds continue to seek a stable one dollar NAV.

• Institutional money market funds are required to maintain a floating NAV per share, rounded to the fourth decimal place. This means that such investors may lose the previous guarantee on their principal offered by this type of funds prior to 2014.

• Fund administrators are now allowed to impose a liquidity fee or suspend redemptions temporarily when a fund’s weekly liquidity level falls below the required regulatory threshold

• The SEC imposes additional requirements to administrators of money market funds, including increased diversification, enhanced stress testing, and additional reporting to the SEC and fund holders.

How does this affect me?

Here are some key considerations for retirement account holders: Determine whether or not you hold money market funds: They should be clearly labeled (example: Vanguard Prime Money Market Fund (NASDAQ:VMMXX)). In the case that you don’t hold any, then the money market reform won’t affect you at all. In the case that you hold money market funds, you now have the opportunity to take a fresh look at your investments and evaluate whether or not money market funds continue making sense for your retirement strategy. Check for a category for each your money market funds: In compliance to the SEC’s reform, every money market fund must be classified as retail, government, or institutional. For example, Vanguard currently has seven retail money market fund accounts, including the Vanguard Pennsylvania Tax-Exempt Money Market Fund (NASDAQ:VPTXX) and the Vanguard Tax-Exempt Money Market Fund (NASDAQ:VMSXX), and two government money market funds, including the Vanguard Federal Money Market Fund (NASDAQ:VMFXX) and the Vanguard Treasury Money Market Fund (NASDAQ:VUSXX). If you hold eligible retail and government money market funds, then keep in mind that the managers of those funds will continue to seek a stable one dollar NAV per share. Understand that money market funds are no longer a “sure thing”: Look into the fine print of the prospectus of any of your money market fund options and you’ll find a notice warning you that a money market fund seeks to preserve the value of your investment at $1 per share, but that it’s possible to lose money by investing in such a fund. Additionally, remember that money market funds continue to not be covered by the FDIC. Some investment firms have been voluntarily waiving the expenses on money market accounts to help avoid negative yields in the persistent low-interest-rate environment and, by end of this year or sometime in 2017, those companies will end that voluntary expense waiver. This creates the potential for negative yields if interest rates remain too low to cover the account’s expenses. Watch out for potential “recoupment” of expenses: In addition to waiving past expenses, some companies managing money market accounts may opt to recoup the waived expense fees for a determined period of time. A common practice in the insurance industry, recoupment means that a firm has already paid the benefits and then takes back those monies after determining that those benefits should not have been issued. Rules vary per retirement account so consult your plan administrator for more details. Inquire about changes in investment options: Depending on your plan administrator, she may choose to change the available options for money market funds for your 401(k) or IRA. If your plan has a default contribution option, she should provide a notice of the change 30 days before it takes effect. In case of a change, make sure to make a decision of how much you want to keep in your old default money market account or if any at all. Your employer can’t add money to the new default money market fund, so your previous contributions would remain in the old account unless you transfer those monies to a different account. Check the expense ratio of available money market accounts: Last but not least, make sure to check the potential gain that you can make by parking your money on a money market fund with your retirement account. As of June 30, 2016, the average annual return of the Vanguard Prime Money Market Fund was 0.25% and its expense ratio was 0.16%. This means that on the fund’s minimum investment of $3,000, you would make $2.7 in one year. Using the rule of 72, it would take you about 288 years to double your $3,000 with that kind of gross return! Even worse, an annual expense ratio above the annual return would eat away entirely any potential growth. By heavily using money market funds, you’re reducing your chances of meeting your nest egg goal by retirement age or, ideally, earlier than that. More information about why expense ratios are so important here.

The bottom line: Take action now!

If you haven’t already, you should receive a notice from your plan administrator explaining money market changes and their effects on your investments. Check with your plan administrator about specific details for your plan and use the provided guidelines to evaluate your investment in money market funds. Depending on your retirement strategy, consider adjusting your current investment in money market accounts and adjust your future contributions to more suitable funds. Image credit: Wikipedia, Library of Congress