Setting the Record Straight on CIT Governance, Regulation

Investors can be forgiven for looking at mutual funds and collective investment trusts through a similar lens. After all, both of these pooled asset vehicles are retirement plan staples, and each has its advantages.

However, mutual funds and CITs differ significantly in terms of cost, flexibility and governance. These differences have helped spur a shift in investor preferences, as highlighted by recent Morningstar data. CITs have now surpassed mutual funds as the leading target-date investment vehicles, continuing a trend that began in 2018, when CIT asset growth started outpacing mutual funds. Last year, 84% of retirement plans included CITs in their fund options, according to the Callan Institute.

So, what’s driving CITs’ popularity?

Regulatory Differences Can Lead to Lower Costs for CITs

Both mutual funds and CITs are usually “open-end” investment funds, meaning that new units of beneficial interest can be created when an investor buys into the fund, and those units are extinguished when they redeem out. But who gets to invest—and how they’re regulated—differs between the two vehicles.

Mutual funds are designed for a broad investor base, including retail and institutional investors. They are governed by Securities and Exchange Commission rules, which require extensive disclosure, including prospectuses and semi-annual reports. They are often distributed through SEC-registered broker/dealers. Because mutual funds are available directly to retail investors, they are subject to stringent SEC registration and marketing rules designed to protect individual retail investors.

By comparison, CIT sales are more restricted. CITs enjoy an SEC exemption because they are subject to a separate regulatory regime, and Congress did not want them to be subject to duplicate regulation. Part of that regulatory regime restricts their availability only to institutional, tax-qualified investors like retirement plans. As a result, they are not required to meet the same disclosure and registration standards that apply to funds available to retail investors.

In particular, CITs are subject to the Employee Retirement Income Security Act, are used as investment options in 401(k) or other participant-directed plans, and are selected by a fiduciary investment committee or another responsible plan fiduciary. Those fiduciaries have the obligation to select investment options that are reasonably determined to maximize risk-adjusted financial returns and to monitor the prudence of the continued use of such investment options on an ongoing basis.

Unlike mutual funds, which are available to the general public, CITs are subject to a disclosure regime tailored to their more restrictive market of institutional, tax-qualified investors. Retirement plan fiduciaries and professional investment advisers must utilize a prudent process to select a CIT as an investment option for a participant-directed retirement plan. Once selected, the retirement plan administrator must provide information to help plan participants make informed decisions in choosing among investment options, including mutual funds and CITs, under an ERISA disclosure regulation that has been in effect for more than a dozen years. Under ERISA, plan participants must be provided with: a table comparing investment performance to a benchmark; the fund’s expense ratio; and periodically updated fund descriptions. Overlaid with these disclosure requirements, CITs, like mutual funds, are subject to anti-fraud principles.

The bottom line is: Because mutual funds are required to be registered with the SEC and are subject to a more complex regulatory framework, including detailed governance, disclosure and tax rules, they generally come with higher fees and costs than CITs. In comparison, CITs are tax-exempt and benefit from lower regulatory expenses, leading to reduced overall costs for retirement plan investors.

CIT Regulation Creates Flexibility That Can Protect Investors

Mutual funds are prohibited, with very limited exceptions, from suspending the right of redemption or postponing payment of proceeds beyond seven days. CITs have greater flexibility in this regard, with the goal of ensuring that all participating accounts are treated fairly.

As fiduciaries, CIT trustees have more tools to mitigate the chances that large or sudden withdrawals would adversely impact non-redeeming investors, such as being able to delay or suspend redemptions if, and for so long (with certain limitations) as, the trustee views such steps as necessary to protect the non-withdrawing investors from adverse impacts of large withdrawals on the CIT. This authority is rarely used, but it does give CITs greater flexibility and a valuable option to protect CIT investors and treat them fairly in times of market stress.

Enforcement Differences: Added Layer of Protection for CIT Investors

Regulations for mutual funds are generally enforced by the SEC, with limited private rights of action against the mutual fund itself. Investors can bring claims under certain sections of the Investment Company Act of 1940, but these are mostly limited to issues like adviser compensation, rather than broader fiduciary duties.

By contrast, ERISA provides a strong enforcement mechanism for CITs.  The U.S. Department of Labor is charged with enforcing ERISA’s fiduciary standards and prohibited transaction rules.  Second, plan fiduciaries, as CIT investors, can enforce the fiduciary standards and prohibited transaction rules –an avenue of recourse not available against a mutual fund manager. 

Governance Differences: Additional Economic Flexibility for CITs

Governance is another important point of differentiation. Mutual funds must follow a detailed regulatory structure, typically overseen by a board of directors or trustees. These boards are required to include independent directors, approve the investment advisory agreement and engage various service providers, such as fund administrators, auditors and transfer agents. Mutual funds are also subject to very detailed and proscriptive investment restrictions under the Investment Company Act and must comply with tax diversification rules that limit the percentage of assets that can be invested in any one issuer.

On top of that, mutual funds must distribute nearly all taxable income and gains annually to maintain favorable tax status, which can force an adviser to make or avoid portfolio trades to comply with these tax requirements or face the death-knell consequences of losing their pass-through tax status (which means they would face double taxation: the mutual fund level and the investor level).

CITs, however, operate under more general governance principles based on fiduciary duties under ERISA and banking laws. The CIT trustee can manage the fund directly or hire third-party advisers, provided that the management aligns with fiduciary obligations. This framework gives CITs more flexibility in how they are managed and how they make investment decisions.

CITs do not have the same rigid tax diversification, distribution and governance requirements as mutual funds, which gives them more discretion in managing the portfolio to maximize risk-adjusted financial returns without concern about tax implications. However, CIT trustees must still follow prudent investment practices and exercise investment oversight, as outlined by their respective federal or state bank or trust company regulators.

In addition, the trustees and third-party advisers of CITs used by private sector retirement plans must adhere to ERISA’s fiduciary obligations, which require CITs to be managed with undivided loyalty for the exclusive benefit of the plan’s participants and beneficiaries. These fiduciary obligations were described as “the highest known to the law,” by courts, including the U.S. 2nd Circuit Court of Appeals in Donovan v. Bierwirth, U.S. 6th Circuit Court of Appeals in Chao v. Hall Holding Co. Inc., and the U.S. 9th Circuit Court of Appeals in Tibble v. Edelson Int’l. CIT trustees and advisers must also follow the stringent prohibited transaction rules under ERISA and the U.S. tax code that provide important protections to plan investors.

Managing Conflicts of Interest: Tailored Protections for CITs

 Both mutual funds and CITs are also subject to strict rules regarding conflicts of interest. For mutual funds, these rules come from the Investment Company Act. CIT rules are based primarily on ERISA. Each has exemptions that allow fund managers to engage in certain beneficial transactions under strict conditions. While ERISA’s prohibited transaction rules strictly prohibit conflicts of interest, available exemptions approved by Congress and the Department of Labor help ease the management of CITs.

Overall, CITs and mutual funds face similar challenges in managing conflicts of interest, but CITs benefit from tailored ERISA provisions that specifically address retirement plan investments.

Summary: Why CITs Continue to Gain Market Share

While both mutual funds and CITs are extensively regulated to protect investors, CITs offer unique advantages for retirement plans. Their exemption from SEC regulations and their tax-exempt status result in a more cost-effective and flexible investment option for retirement plan participant. Coupled with ERISA’s fiduciary protections, CITs must follow a longstanding and comprehensive legal structure designed to protect plan participants and maximize their risk-adjusted financial returns. All of which make CITs increasingly attractive when selecting retirement plan investment options.

Jeb Bowlus is deputy general counsel at Great Gray Trust Company, LLC.