What you do with that information is up to you. Be warned, many of you will probably gag.

Without any thought or planning the 401(k) has become America’s pension plan. The days of guaranteed retirement income for life are long gone, and along with them the financial security that the traditional pension plan provided.

However, to date the 401(k) solution is deeply flawed. The widespread failure of 401(k)s plans to provide adequate retirement income security for American workers has caught the attention of the courts, regulators, the administration, Congress, academics and participants.

These failures include outrageous costs which bear no resemblance to value provided, deeply embedded conflicts of interest, sustained underperformance of underlying investment vehicles, inadequate disclosure, inappropriate investment menus, defective plan design, insufficient participant education, and flawed default provisions. Cumulatively these defects do all but guarantee the failure of the participant’s outcome.

While there are many excellent plans, far too many are so expensive and perform so poorly that participants are often better served to invest their retirement savings elsewhere or at least invest no more than necessary to capture matching contributions.

It isn’t unusual to find 401(k) plans with total costs paid by the participant exceeding 3% of account total annually (a few outliers have plan expenses as high as 7%), with investment choices limited to subpar proprietary funds, and with payments to the various providers not related to services rendered.

Confusion about who provides what service, how much is their direct and indirect compensation, and whether or not the various parties are acting in a fiduciary capacity is the rule. The combined impact on participant accounts and retirement funding is devastating.

Despite a number of significant shortcomings 401(k) plans are the backbone of the American retirement system, and we know that families that have 401(k) plans have a great deal higher net worth than those without access. So, it’s critical to improve this vital retirement funding component.

After years of study, thousands of hours of congressional testimony, hundreds of hearings, uncountable public comments, the DOL issued their final Reg 408(b)2 and 404(a) (who makes up these names, anyway?) designed to force better disclosure. With this better information it is hoped that both plan providers and participants will make better decisions, leading to improved retirement preparation for America’s workers. While the industry has been successful in delaying implementation, it appears that they will finally become effective third quarter 2012.

The Department of Labor (DOL) has recently released new rules regarding the ERISA 408(b)(2), ERISA 404(a), and electronic delivery.  408(b)(2) regulations become effective July 1, 2012, while the new 404(a) participant disclosure rules become effective August 30, 2012 with the first quarterly statements under the rules for calendar-year plans due by November 14, 2012.

The regulations expand the definition of fiduciary investment advice, and cause many consultants that are not currently fiduciaries to be considered fiduciaries. By mandating significantly higher levels of disclosure the regulations will give previously unavailable key information to decision makers.

The flurry of enacted and proposed band aid fixes will go part of the way to improving the retirement landscape. But, regulations, legislation and the threat of court action can only go so far. The various fixes provide information and guidance to plan fiduciaries, but by themselves can’t make them better fiduciaries. The plan sponsor must either develop fiduciary practices and procedures or delegate them to someone that can.

Participants make widgets or deliver services. Acting as a fiduciary and developing appropriate procedures and practices is generally outside their skill set, and a distraction from their primary interest of running a successful business. Frankly, few firms rise and fall based on the quality of their 401(k) plan.

I’m not suggesting for a moment that they don’t care. Nobody wants to have a crummy retirement plan. Most employers would want for their employees to receive maximum benefits for each dollar set aside. But, wishing won’t make it so. And leaving it to a product pusher that “takes care of it all” is unlikely to generate a quality plan.

The Employee Retirement Income Security Act (ERISA) requires that plan sponsors enter into only agreements with “reasonable” fees, and decisions must be made exclusively in the interest of the participant.  However absent disclosure requirements, plan sponsors had no feasible ability to determine the reasonableness of their fees, or the parameters for the decision making process. In particular, the “bundled product” solution was appealing, but lacked any clarity. If the plan provider was not acting as a fiduciary, then the entire responsibility for the plan choices falls to the plan sponsor, the ultimate fiduciary.

As background, when ERISA became effective in 1974, the pension world changed dramatically, and for the better. But, reporting and record keeping became so complex that only giant institutions had or could afford the main frame computer capacity to manage the accounts. Large insurance and mutual fund companies stepped up and provided the technology and systems which enabled them to become the dominant players in the field. Remember in 1974 computer time was more valuable than gold, and the machines filled giant warehouses.

For a while the giant institutions had the field all to themselves. The pitch was simple: We will do it all, record keeping, tax returns, compliance, participant education, investments and advice. And it’s free! Well, free was a pretty compelling price point, and relieving plan sponsors of all those headaches was invaluable.

Of course, it wasn’t free, and the “bundled product” solution provided cover for obscene charges paid by the participants and the perfect environment for breeding conflicts of interest. Additionally, bundled product providers seldom acknowledged fiduciary responsibility for their recommendations, leaving the entire liability for their decisions on the plan sponsors. Meanwhile the plan sponsors were led to believe that the provider was acting as a fiduciary. Disclosure ranged from opaque to nonexistent. Many plan sponsors and participants are simply stonewalled when requesting relevant information.

Long experience indicates that plan sponsors can’t rely on the payroll service/insurance company/brokerage house/or fund company to overcome their deeply embedded conflicts of interest to fix their plans. Those sales entities have little interest and strong disincentives to fiduciary behavior. Most of them absolutely prohibit their agents from accepting fiduciary responsibility.
A number of unsavory practices quickly emerged:

• Restricting the investment choices to funds that shared management fees with the provider
• Use of proprietary funds where better performing, lower cost alternatives existed
• Mortality and expense charges with no economic benefit to the participants
• Special class funds with additional fees over and above retail costs
• Use of retail funds where lower cost institutional class funds were available
• Per account and per position fees assessed at each participant level
• Termination fees that effectively locked in plan sponsors from changing providers

Individually and cumulatively these fees may easily exceed “reasonable” standards, and the decisions often violate the requirement to be in the participants’ sole best interest.

Today, of course, your Iphone has more computer capacity than NASA had to put a man on the moon. So, most PC’s could easily handle record keeping for hundreds of plans and the Internet provides infrastructure for seamless communications between remote providers. The stranglehold that the giant institutions had on the market is effectively broken and many excellent providers exist that can dramatically lower costs and improve every aspect of plan design.

However, without critical information, comparisons and informed decision making are impossible.  The new regulations fix that.

Even the best intentioned, most diligent retirement plan sponsors and participants may have had difficulty extracting critical information from plan providers.  That’s about to change. The new DOL Disclosure Regulations could greatly benefit both plan sponsors and participants.

Legg Mason Tower

True, over a period of 15 consecutive years  from 1991 to 2006, Miller’s Legg Mason Value Trust (LMVTX) was able to outperform the S&P 500.  But what followed over the past half-decade before Miller’s retirement has left many latecomer investors far worse off than if they had never followed the “hot money” into Miller’s fund in the first place. Chasing performance into this fund eventually became a “value trap” in itself.

Unfortunately, similar to a golfer who gets themselves into trouble, Miller too often tried to go for the amazing shot to make the highlight reel but he was no Bubba Watson out of the pine straw at Augusta.   Bam!… into the water….Crash!…. into the hazard……Kaboom!…straight into the tree.

As prices fell in 2008, Miller doubled down on the likes of AIG, Wachovia, Freddie Mac, and Bear Stearns. Boy that hurts! From January 2008 to December 2011 his fund’s assets fell from $20.1 billion to $2.8 billion while experiencing one of the worst stretches of investment performances in modern times.

Additionally, it is difficult to overemphasize enough how keeping fund expenses low over time is so vital to your future wealth.  To add salt on the wound for recent “hot money investors” Miller’s fund charged a sky high expense ratio of (1.77%) for Legg Mason Value Trust.  If the performance being chased doesn’t actually materialize, then high fees are even more of a significant headwind on your long-term portfolio, especially during inevitable market downturns.

Some investors made out like bandits during Miller’s 15-year run, but, as his legend grew, assets poured in. Because so many investors climbed on at the top, far more was lost on the downside than was made on the upside.

In addition to avoid chasing the “hot money” one of the more confused concepts today is the benefits of rebalancing or dollar-cost averaging of a specific stock vs. a broad index fund.  Rebalancing and dollar cost averaging have proven to be important portfolio tools, but there are some major differences in rebalancing with a specific stock vs. a broad market index .  With a broad market index you are diversifying  company risk, sector risk and sometimes country risk.

Why is this so critical?  Well, for example, if you bought at low prices during the scandal that took down Enron, you saw prices go even lower.  If you tried to catch the falling knife of the sector specific tech boom, you might still be waiting for a positive return on your money eleven to twelve years later. For country risk, look at Japan’s Nikkei index, which topped out nearly 23 years ago.  Low prices tended to get lower.

The recent missteps over the past five years are no laughing matter for LMVTX’s investors.  As you can see from the red line in the chart below, the Legg Mason Value Trust had a five-year annualized loss of (-6.9%) vs. a positive return for the S&P 500 and SPY ETF (blue line) of 2.01% through the end of March 2012.

Moreover, LMVTX had a cumulative loss during that five-year period of -30.05%!  This compares to a 10.48% cumulative return for the S&P 500 with the index being significantly less volatile as well.  It is true that large cap value happened to be out of favor during that time period, but even the passive indexed DFA US Large Cap Value fund (DFLVX) (yellow line) was able to outperform Miller’s fund by a cumulative 26.76% with almost exactly the same volatility.

I went back and looked through Mr. Miller’s quarterly report from the fourth quarter 2006, which also happened to be the first calendar year during which he underperformed the S&P 500.  While there was some modesty in the report, there was also a slight tone of overconfidence.   In this report, even Bill Miller admits that the streak was somewhat to do with luck, stating, “There was, of course, a lot of luck involved in the streak.  It could hardly be otherwise, as the late Stephen Jay Gould pointed out in his analysis of Joe DiMaggio’s 56-game hitting streak.”
Bill Miller also discussed that “valuation is inherently uncertain, since it involves the future.” Yet Mr. Miller ironically goes on to say that “There are some things you can say about the future with a probability approaching certainty, such that Citi will make its next dividend payment” …while true, who the heck cares about receiving a dividend payment if the stock falls 97% over the next two years!   To make matters worse, instead of cutting losses on bad stock picks, Miller’s strategy always is to keep buying more at a “cheaper” price.  From a Fortune magazine article in late 2006, The Greatest Money Manager of Our Time, it mentions there was a time another fund manager asked Miller how low he would keep buying a certain stock.  He replied, “As long as it still has a quote.”

My point is not to pick on Bill Miller but to call out a fallacy that hurts many investors today.  Following the latest and greatest fund performance is a sure fire way to put your financial future at risk.

Let’s not spend too much time lamenting Mr. Miller’s retirement. He gets to keep Utopia, his 235 foot yacht, at one time the ninth largest in the U.S.

So what’s an investor to do?  Buying into global diversified markets indices, spreading out the rebalancing risk, and reducing taxation of investment accounts has proven to be a safer and more predictable way to gain wealth for the long-run than to pick and choose money managers based on historical performance.

There is no silver bullet for an active money manager to out-perform the markets forever.  Secular changes do occur and the consequences are highly unpredictable.  Chasing past performance invariably turns out to be a losing strategy.

Here’s a modest suggestion: If you hold your employer’s stock in your 401(k) dump it; if you are a plan sponsor you should terminate any option for company stock in your plan. In fact, the SEC and Department of Labor should prohibit it.

While use of employer stock in retirement plans is decreasing, there is no excuse for allowing it all. We certainly don’t have to look far to find hundreds of thousands of employees where all or a good portion of their retirement funds vaporize when their company failed. To name a few of the most notorious including Enron, Global Crossing, United Airlines, US Airways, and now General Motors, where State Street Bank and Trust is being sued in federal court for including an option to buy GM stock in that company’s two 401(k) plans.

From the employee’s point of view there are dumb investments, and then there are really dumb investments. These employees have signed up for a great deal more risk than they need to.

The general rule that diversification is good doesn’t stop at the company fence. A diversified portfolio helps protect investors against all the things that will go wrong that we can’t even imagine today. Any first-year finance student knows that diversification carries no penalty in return reduction. Diversification is as close to a free lunch as investors can hope for. Likewise, concentration of investments is bad, leading to higher risk without any higher expected return.

But, the problem of employer stock is particularly acute. Economists make a distinction between investment capital and “human capital.” Human capital is the value that the individual brings to society, and may be (very roughly) measured in lifetime wages. Human capital is a “wasting” asset. It’s also a risky asset. Once it’s gone, it’s gone. The flying fickle finger of fate can intervene at any time. So, at least some of it must be converted to investment capital over time. That’s why we set up retirement plans, buy life and disability insurance, and save.

Another problem with human capital is that it is difficult to diversify. Few of us can manage more than one career at a time. So, it makes sense to diversify away from the employer risk in our investment capital. After all, if your company does poorly, some employees (or all of them) may find themselves out of a job at the same time that their stock is in the tank.

It’s easy for employees to deny the problems of the employer, or think that they have “insider” knowledge of the company’s position. They are too close and emotionally vested to make objective decisions.  I saw this in a past life as an Eastern Pilot where employees were buying company stock right up to the day the doors closed.

As deliberate company policy employees were carefully kept in the dark to keep up morale. To ensure an orderly liquidation, Eastern kept information under wraps right up until the hour they shut down. Employee briefings are not held to the same standards that analyst briefings are.

Of course, we have all heard about all the millionaire and billionaire employees at Microsoft MSFT, Apple AAPL, and Facebook. They won the lottery, but for every one of them, there are hundreds of employees laboring away with company stock going nowhere. Retirement investing is not about winning the lottery; it’s about building security and reducing risk. Employer stock is a huge concentrated stock risk.

The spirit and intent of the Employee Retirement Income Security Act (ERISA) holds that pension plans are for the sole and exclusive benefit of the participants. The act mandates that pension fiduciaries adhere to prudent investment practices including the duty to educate and advise employees, diversify investments, and limit risk. That’s pretty straightforward.

But, in the initial ERISA hearings special interests testified that if they didn’t have the right to donate company stock for all or part of their contributions, they would simply not have a retirement plan at all! So, Congress caved, establishing a loophole large enough to fly a 747 through.

From the employer’s side this is a wonderful opportunity.

• Large employee ownership may foster loyalty and increase productivity.
• The stock is held by “friendly” hands that are unlikely to vote against management.
• The employees “sweat equity” funds the company’s capital requirements.
• The company receives a tax deduction as if they had contributed cash.
• If the plan is buying stock on the open market, it supports and enhances the stock price.

But, its’ also a huge conflict of interest where the interests of the participants and shareholders diverge, putting the fiduciary in a hopeless position. For instance, if the fiduciaries were to sell company stock as a result of deteriorating financial results, it would drive the stock price down for other shareholders. The pressure to hold it from the board and other concerned interests conflicts with their duty to make decisions solely on the basis of the employee participants.

In some cases, employees may be required to purchase company stock in order to obtain the “match,” but, it even gets worse. Employers actively encourage employees to purchase even more company stock inside the plan. As if that weren’t bad enough, restrictions on the sale of company stock are routinely imposed on plan participants. Ask any Enron employee how that turned out for them.

It’s time to clean up the 401(k) loopholes that threaten to destroy so many employees’ retirement plans. Make employee stock purchase options in retirement plans a prohibited transaction under ERISA.

Rep. Paul Ryan’s (R-WI) tax plan to lower marginal tax rates depends on broadening the tax base. Of course, broadening the tax base requires reducing “expenditures” or reining in tax deductions we are all used to.

As soon as you start looking for deductions to cut you run into sacred cows, and one man’s legitimate deduction is another man’s obscene loophole.

However, not all expenditures are created equal. Let’s compare two of the most important. Regardless of the merits, Americans expect to deduct their mortgage interest on two houses, and they are very fond of pretax contributions to their pension plans and 401(k)s.

Both expenditures might be likely targets of the new and improved flatter tax proposal currently being debated.

A mortgage interest deduction encourages consumption. You can treat yourself to a vacation home or even a yacht to qualify as a second home. Or you can just splurge on a McMansion. Depending on your viewpoint, you can consider this deduction a sacred right, part of a dysfunctional housing policy, a distortion of capital markets, or an important national economic objective.

The 401(k) deduction is an entirely different animal which encourages savings rather than consumption. In a society with almost zero net savings, there is a far better argument for an incentive which encourages savings and investment rather than consumption.

I’m the first to recognize that the 401(k) is an imperfect pension system, but, it’s one of the few bright spots in our savings ability. Families that have access to a 401(k) have twice as many savings and investments as families that do not. To the extent that a tax advantage encourages savings, it’s a more defensible expenditure.

Here’s another huge difference: If I take a mortgage interest deduction, the value of that deduction is gone forever from the U.S. Treasury. It’s never going to be re-captured, but a regular 401(k) contribution is a tax deferral. The value of the deferral amount and all its future earnings must be recaptured in the future when the funds are ultimately distributed to the taxpayer.

Of course, if the government is determined to get theirs up front, they could change the entire 401(k) system into a Roth like program: Pay the taxes on your contribution now, but get tax free income in retirement. The IRS can book the income earlier, but the total tax receipts over the lifetime of the taxpayer will be little changed.

A variation on the hunt to enhance revenues by targeting retirement plans is to limit total deferrals to a lower amount such as $20,000 rather than the present maximum deferral amount of $50,000, or $55,500 for those over 50 so that ‘rich’ people don’t enjoy too much of a good thing.

Given that business owners and professionals enjoy the tax advantages, it provides them with incentive to offer plans to employees and contribute at least the safe harbor amount for each qualifying employee. Take the incentive away from the boss, and far fewer employees will benefit. In this case, I think trickle-down economics really does work.

Limitations on tax favored treatment for 401(k)s are ongoing now in Congress. Generally, I’m in favor of broadening the tax base. Many current deductions serve no national policy purpose, and promote a general feeling of unfairness.

Hopefully, Congress will give the pension treatment serious consideration: Both the Roth and regular 401(k)s offer compelling tax advantages that encourage savings which I believe must be preserved as national policy. We know taxes influence behavior. If we can through enlightened policy nudge people into saving more, it’s a good thing.

What do you think? Would you be willing to give up your 401(k) deductions in return for a lower federal income tax rate? Do you think that would be good policy? What else could the government do to encourage savings?

Only fourteen percent of Americans surveyed by Employee Benefits Research Institute (EBRI) are very confident that they will have enough money to live comfortably throughout their retirement years, while half are not too confident or not at all confident that they will have enough. Not surprisingly, large debt overhangs concern many of the respondents.

Another survey by Merrill Lynch found a large number of people have shifted their projected retirement date to as late as 85 or “whenever they have enough.” Having failed to plan for retirement at age 65 they will presumably fail to plan for 85 as well, the rest may very well never have enough.

Of course, the overarching problem is that across the entire American public, no one is saving anything. Savings rates are grossly inadequate to provide for retirement, even if that was the single objective a family had. The EBRI study found that over half of workers with any savings at all report that they have less than $25,000 put away. Given that amount, most advisors would be very uncomfortable withdrawing more than $1,250 per year to support your lavish lifestyle.

Plainly put, most Americans have forgotten how to save, or even consider that it might be a good idea. It wasn’t always like that. We used to save. But for more than 30 years we have been on a binge. Beginning about 1982 savings rates fell from about 12% of disposable personal income to close to zero as reported by the U.S. Department of Commerce.

Importantly, note that these figures include both debt reduction and contributions to pension plans and 401(k)s. While savings rates typically spike during recessions, there is every indication that we have reverted to our old wasteful ways after being temporarily scared straight in 2008 and 2009.

Our bad behavior spending spree was gleefully enabled by a wallet full of credit cards and bankers ever so happy to endlessly re-finance your house for amounts exceeding its market value.

As the Baby Boomer demographic hump inexorably inched its way toward retirement their savings rate steadily fell. So, it should come as no surprise that age 65 has become a fantasy retirement date for an entire generation. They have chosen to think about it later until it’s too late to do anything about it.

Strangely, while many Americans report that retirement is an important economic concern, very few have even bothered to compute how much capital they might need to finance their life style at retirement, or how much they would have to save to get there.

Yet, with an Internet hosting uncounted free retirement planning calculators, few avail themselves of the service. Interestingly, of those that have made a calculation the average savings rate and accumulation are more than double those that haven’t.

Retirement planning is not rocket science. There are only three factors that determine if you will ever be able to retire: How much you save, how long you save, and what rate of return you get on your savings. Notice that two of the three elements are directly under your control.

Savings doesn’t happen by accident. You can attempt to budget savings, but that rarely works. There is always another iPad to buy, and nothing is likely to be there at the end of the month. The most effective plan is to save first. Put your savings on autopilot by saving in your 401(k), IRA, or brokerage account before it hits your pocket. If you segregate your retirement funds before you are tempted to spend them, there might actually be something there when you need it.

You can actually have a secure retirement, but you are responsible to make it happen. You will sink or swim on your own.

An ETN is not an ETF although they share the first two words and letters in their acronyms.: “Exchange Traded” and “ET.”  Other than that, they are from different universes. Don’t confuse the two.

There is a lot to love about ETFs for investment advisers seeking pure market exposure at the lowest possible cost with the widest diversification in a particular part of the world’s market.  They offer transparency, liquidity, efficiency, economy and they are marked to market whenever trading is open.  You want the S&P 500 and you get the SPY.  How about long Treasuries? The TLT is your fund.

An investor owns his little share of a market basket of stocks in a registered, regulated, segregated, audited, standardized instrument. Just like the open end mutual funds we are all familiar with, should the sponsoring company fail, the assets are protected in the separate account and not subject to claims of the sponsoring company’s creditors. In many of the world’s most liquid markets, they are the best game in town. What’s not to like?

With all the above advantages, ETFs have rightly rapidly gained wide acceptance. Well known issuers include iShares, Vanguard, Schwab, Fidelity, Powershares, Northern Trust, Russell, Wisdom Tree, and First Trust to name a few.

With the evolution and acceptance of ETFs have come evolutions like leveraged, inverse, and managed ETFs.  As purely passive investors, my enthusiasm for these issues is virtually nil. It’s still and always necessary to pick and choose investments that meet your particular needs and criteria.

An exchange traded note (ETN), on the other hand, is simply an IOU from a bank, more correctly a hedge fund formerly known as a bank. The investor doesn’t own anything. There is no segregated account of assets. There is no structure or firewall between the IOU and the issuer’s general assets. The investor is just an unsecured creditor of the bank.

The ETN is not a registered security.  Even if it’s issued by a bank, it’s not insured by the FDIC as a deposit or CD might be.  It’s a derivative whose value is loosely determined by changes in an index less fees.

That was enough for us at Investor Solutions. As a fiduciary, we have a prime obligation to diversify away any risk we can. Being an unsecured creditor of a bank is a giant undiversified credit risk on a single entity. So, we crossed them off our list and pretty much forgot about them. Given our later experience in 2008 and 2009 that policy stood us well.

Today there is not a bank or brokerage in the universe whose credit I would trust. You know that they remain undercapitalized and subject to the same downside financial and moral risks we enjoyed in 2008 and 2009. Remember those fun days when even  small businesses were jumping through hoops to break up their deposits into FDIC insured chunks? Would you like to bet the farm that it couldn’t happen again? Not me!

If you don’t think it can happen, just ask holders of EOH Opta Lehman Agriculture Pure Beta ETN, PPE Opta S&P Private Equity Notes 2038 ETN, and RAW Opte Lehman Commodity Index ETN how they liked the Lehman Brothers Ride. Those three funds were listed by Lehman on February 20, 2008. The rest, as they say, is history. When Barclays acquired some of the trading assets from Lehman, they specifically disavowed responsibility for the ETNs. Trading was suspended and the funds delisted.

I take some comfort in regulated securities that have elementary checks and balances and structures designed to protect investors. ETFs are regulated, have boards of directors, auditors and a fairly straightforward and standardized structure.

ETNs are individually drafted, unregulated IOUs designed by organizations with murky financials and proven track record of unscrupulous behavior. Given their highly complex offerings and non standard structures, a sophisticated issuer has plenty of opportunities to enhance their offering at your expense.  Not surprisingly, some do.

Given that an ETN is actually a badly needed contribution to the bank’s capital it’s particularly annoying to find one of them gouging the investor on fees.

Almost all asset classes that are offered as ETNs can be found as ETFs. A very few ETNs in alternative asset classes may claim better tax treatment than a ETF, but we find that most investors could hide a less tax efficient structure inside their qualified plans or IRS to negate any tax advantage the ETN might claim.

I suppose if you were the one person on the planet that understood big bank balance sheets, and if you cared to track their financial condition on a second by second basis, you might want to consider an ETN. No matter how attractive the marketing literature, we are not buying into any unregulated security or undiversified credit risk.

Money market funds are one of the most important innovations in finance of the last 40 years. Once Merrill Lynch introduced their Cash Management Accounts (CMAs) in 1977 there was no going back.

Over time, banks responded with NOW accounts and finally money market funds emerged. Today they hold approximately $2.6 trillion, accounting for about 9% of all mutual fund assets, clearly demonstrating both market need and acceptance.

Because instruments with a duration of less than 180 days can be held at face value, money market funds can maintain a constant net asset value (NAV), even though the underlying assets vary slightly as they march toward maturity and endure interest rate fluctuations.

As long as funds maintain their shadow (the actual) NAV in a range of $0.9950 to 1.0050, money market funds are allowed by SEC regulation to round the effective NAV to $1.00, allowing for transactions at $1.00. This allows money market funds to report a stable NAV, despite the small variations in the shadow NAV (which reflects market values).

If a money market fund’s shadow NAV moves outside the allowable range of $0.9950 to $1.0050, the fund must take immediate corrective actions to bring the shadow NAV back inside the range, or discontinue using amortized cost accounting.

Investors have come to rely on a constant dollar value with almost instant liquidity as a “safe” place to keep their cash. They are such a key part of our financial system that it’s hard to remember a time without money market funds or a world without them.

Since inception the funds have been a giant cash cow for their distributors. Especially during times of higher interest rates investors happily traded off fat fund fees for the perceived safety and convenience of the funds. Fees for “sweep” accounts at brokerage firms like Charles Schwab, Fidelity, Merrill Lynch and Citibank were especially rapacious and contributed mightily to the brokerage houses’ bottom lines.

Most customers never noticed, but the savviest of them quickly learned to keep anything above their trivial cash needs in institutional money market funds which offered lower operating expenses and higher yields. However, in today’s near zero rate environment fees are being squeezed.

If investors respond to anything, it’s yield. So, even tiny differentials will result in a torrent of new assets for the funds. Enter moral hazard. Investors clearly don’t want to do their homework on the risk of the underlying assets. The fund with the highest yield wins regardless of the quality of the underlying investments. So the incentives to stretch for yield are enormous.

While there are quality constraints on the funds, money market fund managers began to juice their yields by including higher risk assets such as commercial paper, repurchase agreements and short term bonds.  So, while money market funds may look the same to the great unwashed investor, under the hood they are not.

All this worked quite nicely until September 2008 when the Reserve Primary Fund in New York said it cut its share price to 97 cents after marking down the value of $785 million in Lehman Bros. debt securities, following the brokerage’s filing for bankruptcy court protection on Monday, September 15, 2008. The resulting run on the bank caused the U.S. government to institute a temporary insurance program on September 16, 2008. That program ended a year later, and the government is understandably in no hurry to reenter the business.

Investors of all sizes need an absolutely safe, fully guaranteed place to keep their liquid assets. I don’t care if you are saving up $300,000 for a new sailboat, or just sold your company for $300 million, you want to be able to draw on it on an instant’s notice without worrying about market fluctuations, potential loss, or liquidity constraints. Unless I’m ready to establish my own account with the U.S. Treasury to buy T-Bills, my options for this important need are fairly limited.

At best, current alternatives are inconvenient. For instance, I’m on the board of a local yacht club that must maintain cash reserves against potential hurricane damage. The manager of the club wastes valuable time and energy maintaining a portfolio of CD’s fully covered by FDIC.

The SEC proposal converts money market funds into short term bond funds. They are far from a perfect substitute. If that’s what I wanted, I could find plenty of them.

In lieu of the SEC proposal I believe that if necessary until interest rates return to a “normal range,” a large number of investors would accept a zero yield and even pay reasonable account fees if necessary in order to maintain the safety, convenience, and liquidity of the traditional money market fund. Such funds could be restricted to invest in only U.S. government guaranteed issues and may even have to post reserves, eliminating the need for government insurance and preserving a necessary fixture of the financial system.