The Risk Free Investment Options Are Changing: A Guide for Plan Sponsors

The Risk Free Investment Options Are Changing: A Guide for Plan Sponsors Benjamin J. Smith, CFA Principal, Chief Investment Officer

Contents Overview. Money Market Mutual Funds. A New Alternative to Money Market Mutual Funds: Investing in a Bank Money Market Deposit Account.. Other Alternative Cash Options in Retirement Plans... Conclusion.... 1 3 7 10 13 About Guidance Point Retirement Services & Disclosures.... 16

Overview 1

Overview 2 The shift from defined benefit to defined contribution plans over the past 40 years has resulted in employees taking on more responsibility for their own retirement outcomes. It has also meant that professional investment decisions have increasingly been replaced by the non-professional investment decisions of plan participants who are typically inexperienced, prone to counterproductive behaviors, and in need of general assistance. As prescribed by the Employee Retirement Income Security Act of 1974 (ERISA), an applicable defined contribution plan must offer not less than three investment options, other than employer securities, to which an individual who has the right to divest under paragraph (b)(1) or (c)(1) of this section may direct the proceeds from the divestment of employer securities. Each of the three investment options must be diversified and have materially different risk and return characteristics. For this purpose, investment options that constitute a broad range of investment alternatives within the meaning of Department of Labor Regulation section 2550.404c-1(b)(3) are treated as being diversified and having materially different risk and return characteristics. 1 Generally, plan sponsors spend very little time analyzing the money market or cash type of investment option as highlighted by ERISA and the structural benefits and deficiencies of differing types. Money market funds have recently undergone reforms that may impact their investment strategy and use within the defined contribution setting. 2 According to the Investment Company Institute 3, at the end of 2014, there was over $2.73 trillion invested in 528 different money market funds. Money market funds (MMFs) are a popular and widely used capital preservation option within retirement plans with their main investment objective being to maintain a stable value of $1 per share of the fund. To accomplish this stable value mandate, the fund seeks to limit exposure to losses from credit, market and liquidity risks. The Investment Company Act 4 of 1940 Rule 2a-7 restricts the quality, maturity and diversity of investments by money markets. Under the act, the fund is restricted to the highest credit quality debt, and debt issues must mature in less than 13 months. The fund as a whole must maintain a weighted average maturity of 60 days or less and cannot invest more than 5% of holdings in one issuer except for US Government securities or repurchase agreements. The fund is able to pay dividends to investors which comprise the entire investor s return from this type of fund. 1 https://www.law.cornell.edu/cfr/text/26/1.401(a)(35)-1 2 Murphy, Elizabeth, ed. (June 30, 2009), "Money Market Fund Reform" (PDF), Securities and Exchange Commission: Proposed Rules, Securities and Exchange Commission, pp. Release No. IC 28807; File No. S7 11 09, retrieved 2010-12-12 3 http://www.icifactbook.org/fb_data.html#section4 4 https://en.wikipedia.org/wiki/investment_company_act_of_1940

3 Money Market Mutual Funds

Money Market Mutual Funds 4 Money market mutual funds (MMMFs) are the most popular and widely used capital preservation option within retirement plans, and it is important for plan fiduciaries to understand how they are constructed and new legislation impacting these funds. The oversight of these funds is not unlike other mutual fund analysis that an investment fiduciary performs on behalf of their defined contribution clients. Generally, money market mutual funds are measured by their performance relative to a benchmark and peer group, manager tenure, asset level, expenses, quality of holdings, portfolio manager process, and historical ability to maintain a stable net asset value (NAV) of the fund. Since the credit crisis in 2008, regulators have been working hard to update laws to help promote the financial stability of the U.S. economy. In July 2014, the U.S. Securities and Exchange Commission (SEC) adopted amendments to money market fund rules intended to increase transparency and give investors additional protection. The amendments create a distinction between retail and institutional MMMFs and give fund managers new tools to curb heavy redemptions during market stress and tight liquidity, such as the ability to impose liquidity fees and/or suspend redemptions known as redemption gates. Many of the new regulations generally affect only institutional money market mutual funds. As the end client of the defined contribution space is a retail plan participant, 401(k) and 403(b) plans have been classified as retail investors of MMMFs. One of the largest changes under the new regulation includes pricing the institutional prime money market fund s NAV at a floating or variable level. Prime money markets for both retail and institutional investors may now be subject to new liquidity fees and/or redemption gates. The liquidity fee for prime money market mutual funds is classified as an optional fee of up to 2% if the fund s weekly liquid assets fall below 30% (if the fund s board of trustees determines the fee is in best interests of fund) and a required fee of 1% if they fall below 10% (unless the board finds that fee is not in best interests of fund or that imposing a lower or higher fee of up to 2% would be appropriate). 5 Redemption gates may result in additional delays of up to 10 business days in any 90-day period that may be imposed if the fund s weekly liquid assets fall below 30%. 6 5 Charles Schwab Understanding the new money market fund rules June 2015 6 Charles Schwab Understanding the new money market fund rules June 2015

Money Market Mutual Funds 5 Due to recent regulation around money markets, all mutual fund complexes are now required to report defaults and insolvency, shadow price declines, and any financial support, commencing July 14, 2015, through Form N-CR. The new Form N-CR is an important part of the amendments adopted by the SEC on July 23, 2014. This document provides MMF shareholders with additional transparency by disclosing if a MMF experienced any one of the five material events identified below. If a MMF experiences any of the material events listed below, it must file an initial report on Form N-CR with the SEC within one business day after the occurrence followed by a second more detailed filing on Form N-CR within four business days after the occurrence. In the case of three of the events, a MMF must disclose on its website substantially the same information that is required in the initial report Form N-CR. MMFs are required to file Form N-CR with the SEC for any material events occurring on or after July 14, 2015. Because the compliance date for the amendments relating to implementation of liquidity fees and redemption gates is October 14, 2016, a MMF will not be required to report those material events until that date. Key Dates for Money Market Mutual Funds in 2015 and 2016 By July 14, 2015: 1. Defaults and Insolvency: A MMF is required to file a Form N-CR with the SEC if the issuer or guarantor of a security that makes up more than one half of one percent of its total assets either defaults or becomes insolvent. 2. Decline in Shadow Price: A MMF is required to file a Form N-CR with the SEC if its current NAV per share deviates downward by more than one quarter of one percent from its intended stable price of $1.00. 3. Financial Support: A MMF is required to file a Form N-CR with the SEC if it is provided with financial support by a sponsor or affiliate. In addition to filing the Form N-CR with the SEC, a MMF must also disclose this event on its website.

Money Market Mutual Funds 6 Key Dates for Money Market Mutual Funds in 2015 and 2016 (continued) By October 14, 2016: 4. Liquidity Fees: A MMF is required to file a Form N-CR with the SEC if it (i) imposes a liquidity fee; or (ii) has less than 10% of its total assets invested in weekly liquid assets, regardless of whether it imposes a liquidity fee; or (iii) removes a liquidity fee. In addition to filing the Form N-CR with the SEC, a MMF must also disclose this event on its website. 5. Fund Redemption Gates: A MMF is required to file a Form N-CR with the SEC if it either suspends or resumes the use of redemption gates. In addition to filing the Form N-CR with the SEC, a MMF must also disclose this event on its website. If any of the above events occur, the Money Market fund s Form N-CR must maintain this disclosure for one year from the date of the event. Another due diligence checklist item for money market funds is to understand the client base of the fund. Many fund companies sell their money market funds to corporate treasury accounts in order to accumulate larger pools of assets to the strategy. During times of financial stress, corporate treasury sales may impact a retail investor since a corporate investor will be able to liquidate their large positions before individual investors, potentially impairing the returns of the remaining shareholders. Many money market mutual fund sponsors are currently undergoing product changes in response to the recent SEC money market reforms. These include changing the objective of the fund away from a prime classification to a government or US Treasury option in order to avoid the liquidity fees or fund redemption gate features associated with the prime money market fund option. Before investing in a money market mutual fund or selecting it as an option for your retirement plan, the plan fiduciaries should check with the product sponsor for any recent or upcoming changes to the product.

7 A New Alternative to Money Market Mutual Funds: Investing in a Bank Money Market Deposit Account

A New Alternative to Money Market Mutual Funds: Investing in a Bank Money Market Deposit Account 8 Several items must be considered when evaluating the option to invest in a Bank Money Market Deposit Account. Also note that the primary custodian of the retirement plan will generally not offer non-proprietary Bank Savings products. Custodians such as Charles Schwab, Bank of America / Merrill Lynch, TD Ameritrade, and Bancorp have begun to offer Bank Savings products, and others are preparing products in response to recent money market reforms. The first point to be noted is that funds deposited into the Bank Savings Account (BSA) at the sponsoring bank are insured by the Federal Deposit Insurance Corporation (FDIC) up to $250,000 when aggregated with all deposits held by a participant in the same capacity at the sponsoring bank. In a scenario where the sponsor bank is insolvent and cannot meet the demands of the BSA account, FDIC insurance will make the participant whole up to the $250,000 level. Any additional balances for the participant above the balance would not be subject to the insurance. Since the start of FDIC insurance on January 1, 1934, no depositor has lost any insured funds as a result of a bank failure. 7 The second item to consider is the underlying health of the FDIC Insured member bank. To receive the benefit of FDIC insurance, member banks must follow certain liquidity and reserve requirements. Banks are classified in five groups to their risk-based capital ratio 8 (Tier 1 capital ratio): Well capitalized: 10% or higher Adequately capitalized: 8% or higher Undercapitalized: less than 8% Significantly undercapitalized: less than 6% Critically undercapitalized: less than 2% When a bank becomes undercapitalized, the institution's primary regulator issues a warning to the bank. When the number drops below 6%, the primary regulator can change management and force the bank to take other corrective action. When the bank becomes critically undercapitalized, the chartering authority closes the institution and appoints the FDIC as receiver of the bank. Upon a failure of the bank, Federal law requires the FDIC to make payments of insured deposits "as soon as possible" upon the failure of an insured institution. While every bank failure is unique, there are standard policies and procedures that the FDIC follows in making deposit insurance payments. It is the FDIC's goal to make deposit insurance payments within two business day of the failure of the insured institution. 9 7 FDIC. "FDIC: Who is the FDIC?". 8 "Capital Adequacy Ratio - CAR". Investopedia. 9 https://www.fdic.gov/consumers/banking/facts/payment. html

Lastly one needs to consider the underlying performance of the bank savings product. Expenses are not considered in this product as the interest rate offered is net of all operating and administrative fees applied. The chart below demonstrates a sample bank savings product against money market mutual fund and the US Treasury 3 month T-Bill. Please note that the chart below compares audited total return of mutual funds and the US Treasury 3 month T-Bill, whereas bank products display their return stream as Annual Percentage Yield or APY. While both calculations take into account compounding interest, APY is a forward looking measure of expected return while total return measures historical actual return. Unfortunately, the sample bank savings product has a limited product history from which to judge performance. Optimally, it is important to see how the product behaves during rising and falling interest rate environments compared to money market mutual funds and the US Treasury 3 month T-Bill benchmark. Today, this sample bank savings product does offer a performance advantage relative to other products in the market. Axis Title 0.3 0.25 0.2 0.15 0.1 0.05 0 A New Alternative to Money Market Mutual Funds: Investing in a Bank Money Market Deposit Account 9 Performance Comparison of Sample Bank Savings 2012 2013 2014 Bank Savings Yield Avg Money Market Mutual Fund Return US Treasury T-Bill Avg 3 Month Return Unfortunately, the problem with Bank Savings accounts when offered in a retirement plan setting is the extra steps of due diligence required to ensure the safety of the money market account. Additionally, banks typically retain broad discretion to delay withdrawal requests during market disruptions. Regulation D, which governs reserve requirements for banks, requires banks to reserve the right to require seven days notice to make a withdrawal. This provision could be invoked in the event of a liquidity crisis. To comply with the requirement, many sponsoring banks disclose this in the bank savings account plan sponsor agreements and participant disclosures. However, the intent is to never exercise this right. All bank depository institutions must preserve the right to meet regulatory requirements. With mutual funds, this step is easier since holdings are disclosed on a monthly basis, and regulatory restrictions ensure certain types of credit quality and maturity levels based on the type of money market the fund represents. 11

10 Other Alternative Cash Options in Retirement Plans

Other Alternative Cash Options in Retirement Plans 11 An alternative option that is unique to defined contribution plans is the availability of money market hybrid options. These hybrid options can take the form of Stable Value Funds, Guaranteed Insurance Contracts, General Account Funds or Annuities. These are generally characterized by seeking stable returns comparable to those of short-term fixed income securities and stabilize price volatility by investing in a combination of synthetic contracts (backed primarily by a bond portfolio), traditional insurance, and bank contracts. Because these investment strategies purchase contracts designed to preserve a stable net asset value, the retirement plan participants generate income without the price volatility associated with traditional short-term credit instruments. These instruments generally maintain a strict credit policy of the underlying portfolio and the guarantor of the portfolio price. As these investment options are not available in a retail setting, they re not governed by the same considerations applied to mutual funds. Due to this, many retirement plan auditors have difficulty reviewing the pricing function of the fund since the investment provider is providing the value of the fund without any market forces to dictate true economic value of the fund. Short-term fixed income returns with a stable NAV may seem like a deal too good to be true; sometimes it is. The expense ratio of these types of funds may be comparable to fixed income instruments and limit the plan sponsor and participant in how they may invest in the fund. Additionally, the provider of this money market alterative category generally will restrict the plan sponsor by requiring a noncompeting fund provision where traditional money market funds or short-term bond funds are not allowed as retirement plan investment options. They may also restrict the elimination of the option by enacting a put provision that delays the exit of the fund for some period of time in the future. Many times this put provision is a year or multiple years in the future and may trigger a market value adjustment before the fund is removed from the plan.

Other Alternative Cash Options in Retirement Plans 12 In measuring the health of Stable Value, Guaranteed Insurance Contracts, and separate account funds, a key calculation to review is the Market Value (MV) to Book Value (BV) Ratio. The value at which investors typically buy and sell the fund is the book value which is smoothed by the fund s contracts. The actual market value of the fund s holdings can be volatile and differ substantially from the book value. Any time the fund recedes to a level less than 100% (when the fund s book value exceeds the market value), the recovery to 100% is important. This is due to the increase of potential exposure to the credit worthiness of the fund s wrap providers any time the market value of the investments underlying the stable value contracts is below the contract (or book) value. Additionally, when MV/BV is less than 100%, participant withdrawals will worsen the MV/BV ratio. For example, if MV = $100 and BV = $105 (MV/BV = 95.2%) and there is a participant withdrawal of $10, MV is now equal to $90, and BV is now $95. The MV/BV ratio is now reduced to 94.7%. To measure the health of Guaranteed Accounts and Annuities, the credit analysis is similar to the analysis performed on the Bank Savings Accounts. Many of these providers are insurers so the analysis may be a bit different in the manner of performance, but the overall end conclusions should be similar. One must perform a credit analysis of the sponsoring entity including the risks associated with the underlying investment portfolio or nature of the sponsor s business. Like all investment options in a defined contribution plan, the Plan Sponsor has a fiduciary duty to review the performance of these types of investments. Generally, this can be done by reviewing the performance against the Stable Value Peer Group and the Hueler Stable Value Peer Index. Of worry for today s stable value fund investors is the slower reaction to a rising interest rate environment. While money markets are generally tied to the US Treasury 90 day T- Bill, the duration of stable value funds is generally longer than two years. This means that with any rise in short-term interest rates, other options such as money market funds will quickly become more attractive with possibly less risk. Vanguard, in June 2012, issued a white paper titled Stable Value Pooled Funds: Scenarios for Rising Rates and Cash Outflows that simulated several scenarios of rising rates and how it would affect a fund such as the Vanguard Retirement Savings Trust. The end result was in rising rate environments with cash outflows that result from this environment, the MV/BV ratio would be impacted from the level in 2012 (105%) to approximately 98% within a 5-year period. This action would then increase the investor s exposure to the insurance wrap issuers to make up the 2% MV/BV difference. While the effective yield would stay positive from the interest being paid, the cumulative total return may become negative, especially initially, when rates begin to rise.

Conclusion 13

Conclusion 14 After several conversations with product specialists of bank savings programs, money market mutual funds and cash alternatives, several key distinguishing facts did appear. For example, there are approximately $62.78 billion in FDIC Deposit Insurance Fund Assets versus $6.204 trillion in FDIC Insurance liabilities backing up the bank savings programs. 10 There have been thousands of bank failures over the years, including 481, 479 and 463 failed bank institutions in 2014, 2013 and 2012 respectively. A retirement plan fiduciary has less available information about bank savings accounts and cash alternatives as an investment option in their plan and must take extra due diligence steps to ensure the capital adequacy of the sponsoring entity. Selection of a healthy investment provider is a vital and important step to analyze on a regular basis. Bank savings programs are a fairly new product to the retirement plan space, and questions exist about whether they will be treated similarly to money market mutual funds in the future. The lack of history does not allow the investor to analyze performance trends, and meaningful comparisons to the universe of options in the stable value categories are not available. Money market mutual funds have had very few issues in breaking the buck or maintaining their $1 stable NAV. Regulation on money market mutual funds with Rule 2(a)7 is very harsh and specific and has helped to reduce the risk of these funds. While additional regulation has increased protection for investors, it also has created additional oversight expense on behalf of the sponsoring company, and this additional expense is passed along to the end investor through lower yields and performance. 10 https://fdic.gov/about/strategic/report/2014annualr eport/index.html

Conclusion 15 The benefit of stable value funds can be seen in the resiliency of the crediting rate over the past six years. During this time, short-term interest rates have fallen from over 5% to 0%. This decrease in short-term rates has negated much of the attractiveness of money market funds since the majority of funds are paying close to 0% in interest while stable value alternatives have been able to rely on the extended maturities of the underlying portfolio to provide more attractive payment rates. Resiliency in this manner may be a double edged sword in a rising rate environment as money market funds and bank savings products will react more positively to rising rates due to their shorter underlying maturities. Plan sponsors may be locked into stable value contracts for some period time due to weakened MV/BV rates, put provisions and competing fund provisions. With over $2.73 trillion invested in money market funds across the industry, it is clear that retirement plan participants want and need a good cash option in their retirement plan. It is also true that most plan sponsors and retirement plan committees spend very little time considering and analyzing the most appropriate available money market/bank savings/stable value fund option. Guidance Point urges plan fiduciaries to consider the points raised in this paper when selecting and monitoring the cash option offered through their defined contribution plan.

About Guidance Point Retirement Services 16 Guidance Point Retirement Services, LLC. is a provider of independent fee-only retirement plan and investment consulting services to corporate and tax-exempt organizations. The firm was founded to provide fiduciary consulting services to plan sponsors as they face increased regulatory scrutiny and vendor complexity. When providing ongoing investment consulting services, Guidance Point serves as a co-fiduciary or named fiduciary. Guidance Point is designed to address all aspects of fiduciary duty, plan selection, implementation and operation. Please visit guidancepointrs.com for more information. Disclosures This Ebook is not intended to be completely comprehensive or provide complete information on each subject included. You should contact your legal and/or financial advisor for further and additional information if necessary. Investment performance and returns are based on historical information and should not be construed as a guarantee of future performance. Investing contains risk. Some of the asset classes involve significantly higher risk because of the nature of the investments and the low liquidity/high volatility of the securities. Guidance Point Retirement Services, LLC. does not warrant that the information contained in this presentation is completely accurate. Guidance Point Retirement Services, LLC. has made every reasonable effort to ensure that the data utilized and the information reported is factual. If you have any questions about the calculations or numbers provided please contact Guidance Point Retirement Services, LLC. for verification. Investment advisory services provided by Guidance Point Retirement Services, LLC.