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Aon Retirement and Investment Blog

Capital Preservation in DC Plans Deserves a Second Look

While the burden of generating retirement income continues to shift from employers to employees, increased volatility in global markets and a lasting low interest rate environment create a difficult path forward for defined contribution plan participants. Capital preservation investments like money market and stable value funds, which have historically been the recipient of amplified cash flows during challenging periods, have also been the focus of regulatory reform, increased scrutiny, and ongoing litigation. Though it may be easy to overlook an asset class generally characterized by safety and stability, it is imperative for plan sponsors to take a fresh look at the capital preservation options in their programs and evaluate the fiduciary implications associated with the offerings.
Money Market Funds
Money market funds are open-ended funds that invest in high quality short-term debt such as U.S. Treasury Bills and commercial paper. They are typically associated with safety of capital and have historically offered higher yields than those of bank deposits. Money market funds have garnered significant attention in recent years relating to fees and also some upcoming regulatory changes.
First, with respect to fee levels, money market funds have been in a unique position for some time now. Given the unprecedented low interest rate environment that the U.S. has been experiencing, the yield on a money market strategy is generally not sufficient enough to allow managers to charge the full expense outlined in the fund prospectus without resulting in a negative return to investors. This has led to broad adoption of fee waivers so that performance on the strategies remains at least flat or marginally positive. To further complicate circumstances, some money market funds have what are known as “claw-back” provisions on their fee waivers, essentially giving these asset managers the ability to recoup fees that were previously forfeited due to waivers once yield levels increase. The terms and limitations of these provisions can vary from fund to fund, and additional investigation is recommended, as one would logically expect the performance on money market strategies with claw-back provisions to face headwinds in comparison to competing strategies without such features if and when rates increase.
The U.S. Securities and Exchange Commission issued new money market regulations in October 2014 to take effect two years later, in October 2016. The regulations aim to protect investors by limiting liquidity during times of extreme market stress and increasing transparency and reporting requirements. The rules also remove the ability of some money market strategies to transact at a stable $1 Net Asset Value (“NAV”) by introducing a floating NAV. The new regulations are most easily explained by segregating money market funds into three distinct strategy-types:

Stable Value
Stable value funds are similar to their money market counterparts in that plan sponsors typically offer them in a defined contribution program as a low-risk, capital preservation option. However, portfolio composition, fee structures, and governing rules highlight key differences between the investments.
Stable value funds utilize high quality, short duration fixed income strategies, which are wrapped by institutions that allow the funds to provide:

  1. Stable returns through a mechanism that amortizes market gains and losses over the portfolio duration, applying a “smoothed” crediting rate to the portfolio.
  2. Liquidity provisions to fund participant-initiated withdrawals at a stable $1.00 NAV regardless of the underlying value of portfolio assets.
Because of this unique product structure, stable value fees are a bit more complicated than money market fees. There are three main functions in a stable value portfolio, each of which represents a segment of the fund’s total expense ratio.  
  1. The stable value qualified professional asset manager (“QPAM”) is the first function, and as a registered investment manager, the QPAM is responsible for the fund structure’s creation and ongoing maintenance, liquidity management, and wrap contract negotiation/implementation. This QPAM function represents the broadest range of responsibilities in overseeing the fund and the first cost associated with the strategy.  
  2. The fixed income asset management may or may not be executed by the same organization as the QPAM; in fact, sub-advisory relationships are relatively common within stable value mandates. The management of stable value fixed income is highly customized as a result of the investment guidelines imposed by the wrap contract issuers. Whether the QPAM is managing the fixed income portfolio itself or is outsourcing that function to a third party, this role represents a second cost.
  3. The last cost is the “wrap fee” paid to a counterparty who is underwriting the wrap contract that allows the stable value portfolio to operate with a stable NAV and a smoothed return.  
Adding these three pieces together equates to the investment management expense for a stable value fund. Stable value fees often are not presented consistently, so making sure that all of the underlying parts are accounted for is crucial to understanding the true cost of these funds.
Stable value crediting rates have remained high enough to support investment management fees, therefore avoiding the fee waiver and claw-back issues currently being faced by many money market fund investors. Net-of-fee performance for stable value funds has offered substantial premiums over that of money market products, both in the current environment and over full market cycles. Of course, offering a stable value fund does come with some added administrative complexity. 

Thoughtful consideration on the part of plan sponsors with respect to capital preservation options is critical. As we approach the October 2016 implementation of the new regulations for money market funds, Aon Hewitt recommends that plan sponsors analyze and understand their existing program offerings and potential alternatives (both stable value and money market funds). As we have discussed, factors such as investment approach, NAV treatment, expense structure, and return profile should be taken into account with the understanding that each plan sponsor’s situation is unique and should be approached as such. In many instances, changes to the investment menu may be prudent and action may be required.  
Gregory Fox is a Senior Consultant at Aon Hewitt Investment Consulting, Inc. and works out of Norwalk, CT.

Content prepared for U.S. subscribers, but available to interested subscribers of other regions.

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