Most investors probably don’t spend too much time thinking about their cash holdings. They most likely view their cash as a necessary evil: It earns next to nothing right now, but the trade-off is principal stability (or, for non-guaranteed investments, something pretty close to it) and liquidity.
But for investors with meaningful cash holdings, as is the case for many retirees, even small variations in cash yields can add up to a nice chunk of change. Due to changes in the interest-rate environment, what was the best-yielding cash vehicle a decade ago may not be today.
Moreover, cash and cashlike instruments are not on an equal footing when it comes to guarantees. While nearly all of the major cash and cashlike instruments have done a good job of protecting investors’ capital over time, investors seeking an ironclad guarantee of principal preservation will want to focus on FDIC-insured investments.
New Rules for Money Funds In addition, new regulations for money market funds are set to go into effect in mid-October; while they mainly affect institutional owners of mutual funds (i.e., not individual investors), they underscore that there are some crucial differences between money market mutual funds relative to other cash and cashlike vehicles.
Building on 2010 rules passed in the wake of a large money market fund breaking the buck–or letting its net asset value drop below $1–during the financial crisis, the money market fund rules going into effect this year specifically aim to address the risk of heavy investor redemptions from a portfolio with constrained liquidity. Specifically, the rules require certain types of money market funds to use a “floating” net asset value, as well as to impose fees or install “gates” to stem outflows in periods of constrained liquidity.
All retail money market funds–those geared toward individual investors–will maintain a stable $1 per share net asset value. But beginning three months from now, both institutional prime money market funds–that is, those that are allowed to invest in short-term corporate debt as well as government-issued debt–and institutional municipal money market funds will be required to let their NAVs “float” based on the value of the securities in their portfolios. Additionally, the new regulations will require prime and municipal money market funds–both retail and institutional–to impose redemption fees and install “gates” when liquidity has dropped below certain levels, in an effort to stem high redemptions in periods of market duress. Government money market funds for both institutional and retail investors will be able to retain a stable $1 per share value; such funds aren’t required to impose fees or install redemption gates, either, but can do so at the discretion of their boards.
How to Choose? From a practical standpoint, the new money market fund rules probably won’t have a big impact on retail fund investors. The money market funds they hold outside of their retirement plans will maintain stable NAVs, though the prime and muni money market funds for retail investors will be required to impose redemption fees and gates if the portfolio is deemed to have insufficient liquidity. Meanwhile, investors’ 401(k) plans may switch to a government money market fund to avoid owning a fund with the floating-rate requirement or liquidity restrictions; indeed, many plans already have.
That said, the fact remains that money market mutual funds don’t offer FDIC guarantees; nor are their yields currently as high as many competing alternatives that are FDIC-insured. So how should yield-hungry, safety-conscious cash investors proceed? In the end, the right answer requires investors to balance the competing virtues of yield, guarantees, liquidity, and convenience. Here’s a closer look at the best products for investors with varying profiles.
If you’re looking for the highest yield right now: Which cash or cashlike vehicle offers the best yield at any given point in time tends to be a moving target. In the past, one of the key benefits of money market mutual funds was that their yields were better than competing alternatives. Today, certificates of deposit, which are insured up to FDIC limits, tend to provide the best yields among true cash vehicles: You can find three-month CD rates as high as 0.50%, and higher yields still if you’re willing to lock your money up for a longer term. For example, five-year CD rates are closing in on 2%, right in line with what high-quality intermediate-term bond funds are yielding.
The big trade-off with CDs, of course, is a lack of liquidity; you’ll face a penalty if you need to get your money out before the CD matures. One workaround is to buy CDs with varying maturities–anywhere from three months to five years. That enables you to calibrate your CD purchases to coincide with anticipated spending needs; such a strategy has the salutary effect of allowing you to reinvest in different interest-rate environments. Moreover, some CDs don’t carry early-withdrawal penalties, and even if they do, those penalties may be low enough that the extra income you’ve earned along the way makes up for the penalty. Financial planner Allan Roth has said he has used this strategy extensively with his clients.
If you’re looking for a higher yield with greater liquidity: If you want daily liquidity, a decent yield, and FDIC protection, your best bet will tend to be an online savings account or a savings account through a credit union. The former offers FDIC protection, up to the limits, whereas credit union accounts are insured by another entity, the National Credit Union Administration. A recent scan of savings accounts on bankrate.com uncovered savings-account yields in excess of 1%, and many of these accounts come with check-writing privileges. (Don’t confuse the term money market account with money market mutual fund; deposits in the former are FDIC-insured, while the latter are not.) Just be sure to read the fine print before signing on to earn a higher yield on your money. It may be that the tantalizing yield applies only to balances under a certain level, often as low as $15,000. A good workaround is to stake money needed for ongoing liquidity in the online or credit union savings account and additional cash funds in CDs.
If you’re looking for a high(er) yield within your retirement account: Consider a stable-value fund. While stable-value funds’ yields are not high in absolute terms, they are higher than the yields on many competing cash instruments; for 401(k) investors, the stable value fund will almost certainly yield more than the money market vehicle, especially if that money market fund is a government fund. That’s because stable-value funds invest in bonds and, thus, can pump out higher yields than true cash instruments, while also employing insurance wrappers to help keep their net asset values stable.
The potential drawbacks of stable-value funds are twofold. First, stable-value funds are only available within the confines of company retirement plans like 401(k)s, so unless your withdrawal from such a plan meets certain criteria, you’ll pay a penalty plus ordinary income tax to take your money out prior to retirement. Thus, stable-value funds fall short on the liquidity front for most investors, though they still may be reasonable choices as part of a strategic asset-allocation plan. Second, even though stable-value funds buy insurance wrappers to help protect investors’ principal the assets aren’t guaranteed or eligible for FDIC protections. This article provides more detail on the pros and cons of stable-value funds.
If you’re seeking convenience to manage your cash alongside your long-term holdings: Money market funds aren’t FDIC-insured. Moreover, yields on money market mutual funds are currently below some competing cash alternatives, though they’ve certainly been higher than competing instruments in the past. At this point, convenience will tend to be the best rationale for holding a money market mutual fund. Specifically, money market funds enable you to hold your cash assets alongside your long-term assets. You can see your investments in totality, and you can also have cash at the ready to facilitate opportunistic purchases, for example.
