Sunday, December 21, 2008

401(K) Plan Cash Equivalent Options

As the credit crisis grinds on, issues in the money markets and Fed policy are forcing 401(k) Plan fiduciaries to consider their responsibilities to participants with regard to providing a safe, cash equivalent type of investment option.

To meet 404(c) requirements (as well as their basic fiduciary responsibility), Plans are required to provide a broad range of investment alternatives. The broad range requirement will be satisfied if “participants are afforded a reasonable opportunity to materially affect the potential risk and return on amounts in their accounts; choose from at least three diversified invest­ment categories; and diversify investments so as to minimize the risk of large losses”.

Further, “the three categories of investments in the aggregate (must) enable the participant, by choosing among them, to achieve a portfolio with aggregate risk and return characteristics at any point within the range normally appropriate for the participant”. Traditionally the three core investment categories have been considered to be stocks, bonds and “cash equivalents” (i.e. money markets or stable value funds).

From a modern portfolio theory perspective, cash equivalents anchor the efficient frontier and are necessary both as a standalone option or to modify the risk profile of a portfolio of either bonds or stocks, in order to meet the normal range requirement. Therefore, it is often interpreted to be a required core asset in a 401(k) plan.

404(c) further defines the required attributes of the core cash equivalent option. If any investment alternative permits changes more frequently than once every three months ( most do), at least one core investment must permit the same frequency of change, and the investment into which participants can transfer must be income producing, low risk, and liquid.

If the statutes require that a low risk, income producing and liquid cash equivalent account be available to participants to qualify for 404(c) protection, which alternatives satisfy these conditions?

Treasury Funds - After the Reserve Money market fund broke the buck on September 19, 2008, the US Treasury agreed to provide limited insurance for money market fund balances for participating money funds. Many money market fund vendors took the maximum time allowable to determine whether paying the trivial fee for the government protection was in their best interests. Meanwhile, a large proportion of their prime money market shareholders sought refuge in Treasuries and Treasury money market fund products, driving Treasury yields down further and likely costing these funds and their shareholders many multiples of the cost of the federal guarantee.

Now, as the FOMC recently set its target range for fed funds to 0% to 0.25%, Treasury fund yields are approaching zero, are closing to new money and are forcing Plan fiduciaries to consider whether negative yields are palatable to their participants or prudent from a fiduciary perspective. Plan fiduciaries should inquire how their Treasury fund managers are handling this issue and whether there are any disclosed yield floors in their funds. While US Treasury obligations are still considered low risk and liquid, their ability to satisfy the income requirement is limited, making then the functional equivalent of a "plush pillowtop".

Prime Funds- Meanwhile, those prime money funds which have the benefit of federal money market insurance, seem prudent and protected, at least for balances held as September 19, 2008. New money in these funds leave participants exposed to falling Treasury yields and the credit and liquidity issues associated with continued turmoil in the structured credit, commercial paper and repo markets. CD’s, another common investment in these funds, generally don’t carry full FDIC protection. Government “insured” prime money market funds seem to meet the 404(c) requirements, though fiduciaries should carefully evaluate a fund’s holdings to determine the potential risk and liquidity issues that face new uninsured allocations.

Stable Value Funds - Stable value funds offer a seemingly ideal combination of guaranteed principal and substantial yield in this environment. However, their risks are not well understood. Their risks are structural rather than statistical. Their book value security relies on low variance book/market value relationships, constrained cash-flows, careful contractual compliance and well capitalized wrap providers. A single headline event such as a stable value fund lockup could conceivably create a run on stable value funds regardless of competing funds provisions and employer put options. To protect existing fund-holders and wrap providers, product sponsors might be forced to suspend redemptions. The recent industry trend to provide additional “safe” alternatives and access to non competing fund alternatives may increase the risk of such a stable value fund event. The structural risks of stable value funds and their potential illiquidity should be of concern to plan sponsors. Additional fiduciary due diligence to monitor these risks is essential.

CD’s- Bank or brokerage certificates of deposit have not been traditional choices in 401(K) Plans. Yet they are often available through a brokerage window option. Current yields are respectable and within appropriate FDIC insurance limits could be considered risk free. Liquidity might be a consideration as most CD’s access a penalty for early withdrawal.

As a technical matter, plan fiduciaries must provide an income producing, low risk, liquid fund as a core fund option in their 401(k) plans in order to meet the requirements of Section 404(c). Current conditions in the money markets have altered the characteristics of many cash equivalent products. This requires that investment fiduciaries go through the exercise of re-evaluating the kind of cash equivalent alternatives they offer and performing additional due diligence on their composition and potential risks. In the context of today’s markets, a prudent investor should consider potential risks and illiquidity in much broader terms than might have been necessary 6 months ago.

Thursday, December 11, 2008

401(k) Trading Restrictions Old Fix..New Fault

Following the mutual fund market timing scandals in 2003/2004, mutual fund companies and plan sponsors took action to prevent short-term in and out trading, other wise known as “market timing”. The goal of a market timer of that era was to capitalize on changing markets and in particular to take advantage of arbitrage opportunities in international markets due to stale pricing. While market timing was not per se illegal, it was argued that market timing disadvantaged fund shareholders and therefore required fiduciaries to employ methods to prevent it. Consequently, many mutual funds established a regimen of redemption fees and trading restrictions designed to reduce trading activities in their funds. Some plan sponsors also amended their plan documents to allow for trading restrictions. By definition, these trading restrictions limit the amount of control a plan participant has on their investments.

Section 404(c) of the Employee Retirement Income Security Act of 1974 (ERISA) provides, among other things, that if a plan permits its participants to exercise control over their assets and that they exercise such control, then Plan fiduciaries would not be liable for any loss, or breach which results from that exercise of control. Section 404(c) further provides statutory criteria for determining whether participants would be deemed to have independent control. According to the statute a Plan would not fail to provide the opportunity for control because, among other things it:

"Imposes reasonable restrictions on frequency of investment instructions. A plan may impose reasonable restrictions on the frequency with which participants and beneficiaries may give investment instructions. In no event, however, is such a restriction reasonable unless, with respect to each investment alternative made available by the plan, it permits participants and beneficiaries to give investment instructions with a frequency which is appropriate in light of the market volatility to which the investment alternative may reasonably be expected to be subject".
Could excessive trading rules, which often limit a participant’s ability to execute roundtrip trades within a 90 day period even in the context of a normal, well disciplined rebalancing protocol, be unreasonable in today’s volatile investment environment? One might certainly argue so! Investment fiduciaries should be careful not to shoot themselves in the foot under 404(c) while fighting yesterday’s battle on market timing.