Financial advisors almost invariably counsel their clients to invest their retirement savings in growth instruments such as stocks and real estate during their working years. But the time eventually comes when at least a portion of retirement assets must be shifted into more conservative holdings that pose less market risk. The need for growth gives way to the need for capital preservation and liquidity, and there are relatively few investment vehicles that can satisfy both of these objectives at the same time. Money market accounts are one such instrument that typically pay slightly higher rates than traditional savings or checking accounts.
What is the Money Market?
In order to understand how money market accounts work, it is necessary to have a basic knowledge of the debt markets. All debt instruments can be divided into two categories: the capital market and the money market. Any debt instrument with a term to maturity of more than 270 days is considered to be capital market security, while all debt securities with a maturity of 270 days or less are considered to be money market instruments. These instruments include commercial paper, treasury securities with maturities of nine months or less, whiskey warehouse receipts and repurchase agreements. The constant maturation of these short-term debts make the money market the most liquid segment of the fixed income market.
Money Market Accounts
There are two basic types of money market accounts. The ones that are offered by banks and other savings institutions are essentially a type of premium savings account that invests directly in money market securities. The other is offered through a mutual fund that invests in money market instruments. The vast majority of retirement accounts offered by banks, mutual funds, investment advisers and brokerage firms use either a proprietary money market mutual fund account or that of a major mutual fund company. The number of institutions that use another fund company's money market fund, however, seems to be shrinking. More and more institutions now offer their own proprietary money funds that pay interest according to a tiered schedule.
There are several reasons why money market funds are used to hold cash in retirement plans:
- Liquidity – Money market transactions are always completed either the same day as the purchase or sale request is received, or the next business day, if the request is received after the close of business that day. There is no lag between the settlement and transaction dates as there can be for other types of funds, and sales charges are seldom, if ever, assessed when shares are purchased or redeemed. Money market accounts that are used in retirement plans and IRAs are also generally exempt from many of the restrictions that banks and credit unions place on taxable retail money market funds and accounts, such as a monthly limit on the number of withdrawals and minimum required account balances. Virtually all IRA and retirement plan distributions are taken from money market funds or accounts; if securities are sold in order to make the distribution they are always swept into the money market fund before the proceeds can be distributed. IRA owners who need to take distributions should therefore keep an appropriate portion of their assets here, so they can easily make withdrawals.
- Safety and stability – Although many of the securities in money market funds are backed by the U.S. Treasury, they are not guaranteed instruments in and of themselves. The vast majority of these funds, however, maintain a constant price of $1 per share at all times, although on very rare occasions the share price of a handful of money market funds has dipped below this price. Of course, the money market funds offered by any bank or credit union are federally insured by the FDIC. Money market funds are consequently a key alternative for conservative investors who wish to avoid risking losses in the markets.
- Higher interest – Money market funds typically pay higher rates of interest than other types of demand deposit accounts such as checking and savings accounts. The rates of interest that the funds pay will fluctuate with the current interest rate environment, but they will typically float at a slightly higher level than the rates offered in other types of liquid accounts. The interest that they pay accrues on a daily basis, and the share price is not affected by changes in interest rates. Some money market funds are tiered to pay a higher rate of interest on amounts that exceed a certain threshold, such as $10,000. It should be noted, however, that money market funds are not an appropriate vehicle for long-term growth; they are essentially cash accounts and thus will never pay a rate that materially outpaces inflation. All interest that is generated in the money market in an IRA or retirement plan, however, is nontaxable until it is withdrawn (or never taxed for Roth plans and accounts). Of course, there are money market funds that pay state and federal tax-free interest as well, but the tax advantages of these funds are generally negated inside retirement plans.
- Convenience – The safety and liquidity provided by money market accounts and funds allow investors to place their money there without worry. Most retirement accounts will automatically sweep the proceeds from sale transactions as well as all deposits that are not specified for another use into money market funds, where they will begin earning interest on the date of deposit. Money market sweep accounts can guarantee that all of the client's spare cash is at least earning a minimal rate of interest when it is not otherwise being used.
The Bottom Line
Money market accounts and funds hold billions of investor dollars around the world. They are commonly used in retirement accounts because of their safety, liquidity and convenience, and because they pay competitive rates of interest. While the current interest rate environment has made money market funds somewhat less attractive for moderate and aggressive investors, it is still the vehicle of choice for many retirement savers who do not wish to risk their principals. For more information on money market funds and accounts, consult your investment or financial advisor.