Reconsideration. Capital Preservation FEATURE

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1 Capital Preservation Reconsideration By WARREN HOWE National Director, Stable Value Markets MetLife and MARK PARACER Assistant Research Director LIMRA Secure Retirement Institute LIMRA Secure Retirement Institute Review / Issue 2,

2 It has been almost a year since the final rules overseeing money market mutual funds (MMFs) went into effect. The new rules, made structural and operational reforms to address risks of investor runs on money market funds, while preserving the benefit of the funds. According to the SEC, the amended rules build on MMF reforms adopted in March 2010, following the 2008 financial crisis, which were intended to reduce the interest rate, credit, and liquidity risks associated with money market fund portfolios. Further analysis since 2010 led the SEC to conclude that additional structural changes were necessary to prepare for potential future situations when the short-term financing markets could come under stress or when credit losses could cause a fund s portfolio to lose value. The two rounds of reform sought to limit the impact future significant events would have on institutional money markets. Specifically, the new rules mandate a floating net asset value (NAV) for institutional prime MMFs (including municipal funds), replacing the traditional $1 stable NAV. This adjustment allows the daily share prices of these funds to fluctuate along with changes in the market-based value of fund assets. The rules also supply non-government money market fund boards [with] new tools liquidity fees and redemption gates/suspensions to address runs, according to the SEC. As we approach the one-year anniversary of the 2016 MMF reforms, now is an opportune time to review the actions plan sponsors have taken or plan to take to comply with the new rules. The decision to retain an existing MMF, change to a different class, or replace the fund with stable value will have a considerable impact on participant outcomes and is subject to Employee Retirement Income Security Act s (ERISA s) demanding fiduciary duty standards. From a fiduciary standpoint, if they have not already done so, defined contribution (DC) plan sponsors should promptly review their plans capital preservation options and consider stable value as a preferred alternative to money market funds. Stable Value Stable value contracts include Guaranteed Interest Contracts (GICs), Separate Account GICs, and Synthetic GIC contracts. Traditional GICs are group annuity contracts that are promises to pay a specified rate of return for a specific period of time. The contract is the plan s or trust s asset and is backed by the contract issuer s general account. The wrap feature of a traditional GIC is non-participating, as the credited rate is guaranteed regardless of either the actual investment experience of the general account or the amount or timing of participant withdrawals. Separate Account GICs are group annuity contracts where the contract liabilities are supported by insurance company separate accounts. Like the assets of its general accounts, the assets of insurer separate accounts are owned and managed by the insurer and may be sub-advised by one or more third-party investment managers selected by the insurer. Unlike the general account GIC, both the insurance contract and the assets of the separate account are ERISA plan assets. With Synthetic GICs, the qualified plan trust owns and holds the underlying invested assets that support the stable value fund. The plan sponsor enters into a separate contract with a wrap provider. Stable value options are generally funded for smaller plans by collective investment trust stable value funds or for larger plans as individual accounts usually managed by a stable value manager. 22 LIMRA Secure Retirement Institute Review / Issue 2, 2017

3 Capital Preservation Options in DC Plans Some plan participants are continually looking for ways to keep their retirement portfolio values as stable as possible. One way for plan sponsors to help their participants achieve stability is to include a capital preservation option in their DC plan investment line-ups. The primary types of capital preservation options offered in DC plans are stable value and money market funds, with stable value the most prevalent. According to the Stable Value Investment Association, there is nearly $821 billion invested in stable value assets in DC plans. However, these two capital preservation options differ vastly. While money market funds are designed to provide daily liquidity outside of DC plans, only stable value was designed specifically and exclusively for DC plans. Compliance With MMF Reform Rules Two rounds of reforms have reduced money markets expected returns, made them less customer friendly, and underlined the fact that they are designed for general retail use. The new MMF rules highlight that money market funds are not able to accommodate the special characteristics of the qualified DC plan participant environment. DC plan participants who select money market funds are sacrificing additional returns in exchange for retail liquidity they do not need. The new rules created three new classes of institutional money market funds prime, municipal, and government. To comply with the new rules, some plan sponsors may have replaced their plans institutional and retail MMFs with government MMFs. While that may have been an easier option for plan sponsors to implement, it may not have been the right choice for their participants. Others have already shifted to, or are planning to offer, stable value. In October 2016, coincident with the latest rule taking effect, LIMRA surveyed 1,095 DC plan sponsors of all sizes. 1 According to LIMRA s research, just 21 percent of plan sponsors had, at that time, already made a change to their capital preservation options in response to MMF reform. Additionally, nearly half (46 percent) said they would be making a change to their DC plan investment lineups. Among the 46 percent of plan sponsors who plan to respond to the reforms in the near future, nearly half (46 percent) will change the type of money market funds they offer, according to the LIMRA study, while 24 percent will offer stable value instead. Others are unsure of the change they will make or are planning to make a less typical adjustment. According to MetLife research conducted in the summer of 2017, 83 percent of plan sponsors consider stable value the more Figure 1 Response to Money Market Fund Reforms 13% Figure 2 Anticipated Changes 6% 20% 46% 24% 46% 21% 24% Will Make Changes Will Not Make Changes Have Made Changes Not Sure Change Type of MMF Not Sure Offers SV Instead of MMF Other Based on 1,019 DC plan sponsors familiar with Money Market Fund Reforms. Based on 465 DC plan sponsors that are familiar with Money Market Fund Reforms and anticipate making changes in response. LIMRA Secure Retirement Institute Review / Issue 2,

4 Changes to a plan s line-up and a fund s investment strategy, price, and potential redemption fees and gates must be communicated to DC plan participants. attractive capital preservation option for today s plan participants, in light of MMF reform. LIMRA conservatively estimates this opportunity may create an additional $20 billion in new stable value assets. There are a number of implications to keeping money market as part of a plan s investment line-up. Changes to a plan s line-up and a fund s investment strategy, price, and potential redemption fees and gates must be communicated to DC plan participants. Fees and gates are likely to add complexity to plan administration, including processing participant-initiated and required distributions. There is also the uncertainty and unpredictability of the timing surrounding fees and gates that could be imposed on participants. Each will need to be communicated, on very short notice (i.e., less than one day), to plan participants. Plan sponsors also face potential participant dissatisfaction when fees and gates are imposed. Stable Value: A Viable Alternative to Money Market Stable value funds are attractive to plan participants because they offer safety and stability by preserving principal and accumulated earnings. Stable value is designed to enable participants to make transactions such as transfers to another plan option at book value regardless of the market value of the assets that underlie the stable value option. Book value (also called contract value) is equal to the contributions made, plus accrued interest, minus previous withdrawals or transfers. Because stable value takes advantage of limitations on withdrawals imposed by plan design and penalties on early withdrawals imposed by tax law, it can safely invest for greater return than an option such as money market funds. Stable value funds have a 40-year track record of performing exceptionally well preserving principal and providing a reasonable return on investment, no matter what the market conditions. Stable value has also delivered historically higher returns than money market funds. Not only are stable value returns higher, but over longer periods the volatility of return is lower. Looking over several time periods, the returns on stable value in one-year, five-year and 10-year periods are significantly above what any other capital preservation option can provide. Using a hypothetical example to compare a money market fund with a stable value fund, $10,000 invested in both over a 10-year period would have seen the stable value fund return grow to $13,700, while the money market fund would return only $11,100. The additional $2,600 returned in the stable value fund would continue to earn compounded interest over the life of the plan participant's investment. On a real return basis, which takes into account inflation over this 10-year period, money market eroded purchasing power at an annualized rate of 75 basis points, while stable value enhanced purchasing power. In this example, stable value delivered significantly higher returns than money market with much less volatility. Stable value is also poised for future growth. For example, as the number of DC plans using target-date funds (TDFs), including custom TDFs, continues to increase, we are starting to see growing interest in incorporating stable value into a TDF. Whether it is in an off-the-shelf or custom TDF (where a plan sponsor uses the existing investment options in the plan and has a custom glide path created to overlay the plan s investment options), plan sponsors should consider stable value as the fixed income component of the investment line-up within the TDF. 24 LIMRA Secure Retirement Institute Review / Issue 2, 2017

5 A Catalyst for Action Against the backdrop of regulatory reform, the time is now for DC plan sponsors to reconsider the capital preservation options available in their plans investment line-ups. Plan fiduciaries, sponsors, and advisors will need to act prudently in making the recommendation/decision, even if the decision is to keep a redesigned money market fund. ERISA requires that plan fiduciaries consider appropriate retirement plan objectives; gather relevant data; assess the data and make an informed, reasoned decision based on that data and assessment; and document the process and decision. Some plan sponsors have already replaced their money market funds with stable value, and others plan to follow suit. For those that have not yet determined how they will respond to MMF reform, there is still time to reconsider their use of money market funds. They would be well-advised to consider stable value as the most prudent capital preservation option for their plan participants. Stable value will allow participants to maintain their principal and earn reasonable returns on their investments no matter what the market conditions. 1 Climate Change: Money Market Reform, LIMRA, Warren Howe is national sales director, Stable Value Markets, for MetLife. The division is part of Retirement & Income Solutions (RIS), the company s institutional retirement business, which historically has been responsible for generating over 20 percent of MetLife s operating earnings. Howe, who joined MetLife in 2005, leads the sales and client service team for MetLife s stable value and funding agreement businesses. During his time leading stable value sales, the business increased total assets by more than $30 billion. His team of client relations executives manage relationships with many of the largest RIS plan sponsor-clients across a number of different business lines, including investment strategies for defined benefit pensions, pension buyout transactions, and institutional income annuities. Prior to joining MetLife, Howe spent 16 years at Traveler s Life & Annuity in a variety of roles within the asset management and pension services business. Mark Paracer is responsible for conducting research on retirement plans. He currently is the project director on the U.S. Retirement Plans study, the 401(k) Scorecard, the Stable Value and Funding Agreement Products study, and the In-Plan Income Guarantees study. Paracer also runs the Stable Value, Strategic Retirement Research Network, and In-Plan Guarantee study groups. Prior to joining LIMRA in 2012, he spent 15 years in a variety of roles, including competitive intelligence, operations, marketing, sales, and product development in the mutual fund, life insurance, and banking industries. Paracer received his B.A. in economics from the University of New Hampshire. He can be reached at or mparacer@limra.com. LIMRA Secure Retirement Institute Review / Issue 2,