On November 2, 2022, the Securities and Exchange Commission (SEC) proposed amendments to its current rules for open-end mutual funds regarding liquidity risk management programs and swing pricing. At the end of 2021, open-end mutual fund assets totaled approximately $27 trillion, compared to approximately $309 billion for closed-end funds, $7.2 trillion of exchange-traded fund (ETF) assets, and $95 billion of Unit Investment Trusts (UITs).
Defined contribution retirement plans and individual retirement arrangements (IRAs) hold approximately 61.9 percent of all retirement plan assets in the United States. Open-end mutual funds represent 61.7 percent of all 401(k) plan assets and 81.3 percent of other private sector defined contribution plan assets. Changes to mutual funds by the SEC proposal would have significant negative impacts on retirement plan participants.
The economies of scale that exist with these plans give plan participants access to investment options, such as open-end mutual funds, that would not be available to an individual investor with limited investment assets and allow plan participants to diversify their investments to reduce investment risk.
The SEC acknowledged repeatedly throughout its analysis of the proposal the numerous ways in which the swing pricing with a hard close proposal would adversely impact retirement plan participants, but it failed to analyze or attempt to quantify the negative effects.
Although retirement plan participants are long-term investors, retirement plans have ongoing transactions that occur on a daily basis, including periodic contributions to the plans, exchange of assets, asset rebalancing, and withdrawals (both periodic, upon job change, after retirement, and for special purposes, such as loans and hardships).
Over the last 30 years, the development of sophisticated systems for processing retirement plan transactions has enabled retirement plan transactions to be completed over a single trading day, reducing the time that retirement assets may be at risk of erosion due to being “out of the market.” These systems are price dependent, meaning that the transactions require knowledge of a fund’s daily net asset value (NAV) to be completed. Current systems allow plans and participants to submit orders by market close and have the transactions be completed overnight, rather than waiting multiple days to be completed, leading to “out of the market” risks to the assets.
The SEC hard close proposal will upend these processes and require retirement plans and plan participants to submit transaction orders much earlier in the day (e.g., by 12 noon ET), which puts the plan assets at risk of market fluctuations that occur after the orders are transmitted. The proposal also would turn many every-day transactions that now may be completed overnight, such as asset rebalancing or distributions into multiple day transactions, leaving retirement assets “out of the market” during this period. Further, orders that do not meet the hard close deadline will be “out of the market” for at least 24 hours and will be placed once the following day’s NAV is determined.
The SEC hard close proposal will cause retirement plan participants to become “second-class” investors who are “behind the market,” putting them at a disadvantage relative to higher income retail and institutional investors.
The SEC proposal would require a complete redesign of existing trade processing systems because the hard close requirement would render all existing systems inoperable. Some have suggested that full implementation of the hard close requirement would not be possible with respect to retirement plans. According to industry experts, system redesign alone would require billions of dollars of capital expenditures across the industry. In addition, every step in the retirement plan intermediary system would require amendments and revisions with concomitant cost, including (1) amendments to trading agreements and plan provisions, (2) modifying plan administrative procedures, such as changing the price used to determine rebalancing transactions from the current day to a previous (or next) day price, and (3) updating service agreements. The added complexities of the SEC proposal would also contribute to higher ongoing costs for these plans.
The upfront costs of implementing the SEC proposal and the increased ongoing costs will ultimately be borne by retirement plan participants, resulting in erosion of retirement savings.
Implementation of the SEC proposal could take 3-5 years, may not be administratively feasible, and will impose substantial costs on retirement plans and participants, thereby causing erosion of retirement savings. The negative impact of the proposal on retirement plans far outweighs any potential benefits of the proposal.
Retirement plan intermediaries process millions of routine transactions every year. Employer contributions and employee elective deferrals total over $600 billion per year for the more than 83 million participants in a defined contribution plan. These contributions occur in sync with payroll processing (e.g., weekly, biweekly, monthly). Other routine transactions, such as retirement plan withdrawals on job change, rollovers to IRAs, loans, hardship distributions, and required minimum distributions total hundreds of billions of dollars per year.
The SEC proposal is intended to impose costs on transactions that create a “first-mover” advantage for certain investors. However, these types of transactions are not common with retirement plan participants. Approximately 8 percent of retirement plan participants engage in exchange or rebalancing transactions each year and those transactions only occur about three to four times per year.
Retirement plans and their participants will be adversely affected by the application of swing pricing with respect to millions of routine transactions that occur without regard to market conditions and are not intended to gain a first-mover advantage. These everyday transactions, such as retirement plan contributions, asset allocations, loans and hardship withdrawals, required minimum distributions, lump sum distributions, and rollovers to IRAs will face adverse effects.
The costs of retirement plans have declined over the past twenty years. This downward trend has been fueled by the growth in no-load mutual funds, which has brought down average expense ratios. In addition, advancements in the way that plan transactions are processed have helped to drive down costs.
The SEC proposal will reverse this trend. Implementation of the proposal will increase the costs of maintaining retirement plans. Over the short run, a complete overhaul of retirement plan processing systems will be required, resulting in substantial costs that will be passed through to plan participants. In addition, the SEC proposal will increase long-term costs due to the increased complexity of processing retirement plan transactions. These costs will ultimately be borne by plan participants.
Increased costs on plans will cause some employers (particularly small employers, who are particularly sensitive to plan costs) to reconsider decisions to start or continue a retirement plan for employees. The per participant cost of maintaining a retirement plan is highest for the smallest employers. An increase in costs of maintaining a retirement plan can be expected to depress the number of small employers starting and continuing retirement plans.
Including the costs of implementation would further erode retirement plan assets by an additional $10 billion each year (for an all-in cost of approximately $30-50 billion during the implementation period) and additional ongoing increased costs. These costs would be borne by all participants, not just those with routine retirement plan transactions.
Given the costs of the proposed changes, retirement assets face erosion over the saving horizon. Retirement savings plans are intended to help individuals accumulate savings over their working careers to provide financial security in retirement. The SEC proposal (swing pricing and the hard close) creates the potential for risk and uncertainty throughout the saving horizon and substantial erosion of retirement savings. Further erosion could occur as the liquidity risk management provisions of the proposal will reduce returns on mutual fund assets and potentially drive retirement plans and plan participants out of mutual fund investments.
A “set and forget” retirement plan participant with a small initial account balance could face an erosion of approximately $53,342 of retirement savings over a 26-year period solely due the costs of the SEC proposal to impose swing pricing with a hard close.
As seen in the full report, graph 1 shows the potential erosion of retirement savings over 26 years for a retirement plan with an initial account balance of $25,000 when the SEC proposal goes into effect. The participant contributes $5,000 per year and earns a 6 percent annual return on the investments (in mutual funds). There are no withdrawals during the saving horizon and the participant does not exchange or reallocate the investments. In this case, even those participants that “set and forget” their retirement plan would incur costs to their account, through higher upfront costs of approximately 25 percent of average current costs (.22 percent of assets during the first five years, with assumed ongoing transaction and compliance costs at half of this rate) and the effects of swing pricing with a hard close intermittently impacting their contributions. This example includes these higher upfront implementation costs, the ongoing increased plans costs of processing plan transactions, and the cost of the SEC policy on contributions, all of which would be borne by the participant.
