401(k) Plans With Non-’40 Act Investments

Mutual funds have served defined contribution (DC) plans very well, providing a convenient means of investing the small, frequent contributions of many participants, all guided into professionally managed individual accounts. As the world of 401(k) plans has evolved, however, mutual funds have turned out to be a fairly expensive way to invest—a particular concern during periods of modest returns, such as the last decade. Powerless to raise the inherent returns on participants’ investments, sponsors are focused on improving outcomes by bringing down costs, the largest of which is typically investment management fees.

Mutual fund families have obliged with lower-fee versions of their mutual funds for 401(k) plans, creating non-revenue-sharing and institutional share classes, but sponsors and their advisers are not stopping there.

“An adviser should say to the fund manager, ‘Thank you very much for your institutional share class,’” says Rob Kieckhefer, managing partner of The Kieckhefer Group, which advises about $1 billion in DC assets, in Brookfield, Wisconsin. But, Kieckhefer says, the next question advisers should ask is: What’s the next step? One solution—collective trust funds (CTFs), also called collective investment trusts (CITs)—is borrowed from the defined benefit (DB) world and becoming increasingly available to smaller plans.

Some plans are turning to separately managed accounts (SMAs). A third alternative—still to be entirely worked out—comes from the retail investing universe, replacing conventional mutual fund investments with lower-cost exchange-traded funds (ETFs).

In a retirement context, CTFs are investment funds that pool the assets of many pension plans, whether DB or DC, into a given portfolio. They are administered by banks or trust companies, and day-to-day management of the portfolio can be carried out by the bank or a subadviser. Accordingly, many CTFs are joint arrangements between banks and investment management firms that wish to deliver their established strategies in a lower-cost format. As recently as five years ago, CTFs were dominated by stable value funds, but today a variety of active and passive strategies in domestic, international and global equity and fixed income are offered. Target-date funds (TDFs) also appear in CTF form.

The structure of CTFs offers significant cost savings over mutual funds in several ways. CTFs receive an exemption from having to register with the Securities and Exchange Commission (SEC) under the Investment Company Act of 1940. Without those filings and mutual fund boards to contend with, the burdens of regulation and compliance are lower.

Because the plans themselves invest in the CTFs on behalf of participants, funds have a small number of institutional investors—rather than the thousands of individuals who buy mutual funds—which reduces operational complexity and cost. For a large-cap indexed equity strategy, observers say, while the median management fees on institutional class mutual funds might run at 20 to 25 basis points annually, a $100 million account in a CTF might incur fees of 5 to 10 basis points.

CTF fee rates also have the potential to be flexible, unlike mutual funds where all investors in a given share class pay the same rate. “In a CTF, there can be different fee rates for different investors, as long as there is a valid reason,” says Joel Lieb, managing director in the Investment Manager Services division of SEI Investments Co., administrator of $33 billion in CTF account assets, in Oaks, Pennsylvania. “Depending on the services being provided to a plan, the size of the investment and the platform a fund is on, a trust company has flexibility in structuring fees.”

Advisers can thus leverage their existing relationships with managers. “We started using CTFs about five years ago,” Kieckhefer says. “We went to one of the large mutual fund managers and said, ‘Across all our clients, we’ve got about $400 million invested with you, and we’d like something cheaper than the institutional share class.’ They set up a collective trust for the strategies we were looking for, and on $10 million of AUM [assets under management], we saved 20 or 25 basis points on the expense ratios of a couple of funds.”

Not being tied to mutual fund regulations provides CTFs with additional investment flexibility, as does their makeup of institutional investors. “While the potential investors in mutual funds are a wide audience, CTFs are a sort of ‘gated community,’” observes Susan Czochara, head of defined contribution products at Northern Trust, Chicago, which administers CTFs with $85 billion of assets as of June 30, 2012.

“Having a small institutional client base worked in their favor about a decade ago, during the mutual fund market-timing scandals,” when mutual funds were plagued by certain hedge funds and other opportunistic traders that exploited their operational gaps, Czochara says.

And during the financial crisis, when securities lending practices added risk to some managed portfolios, “many of our largest sponsors moved to nonlending CTFs,” recalls Sue Walton, senior investment consultant in the Chicago office of Towers Watson.

However, unregistered does not mean completely unregulated, Lieb says. “For instance, SEI is a state chartered trust company, reports to the Pennsylvania Department of Banking and Securities, and is audited by them every two years,” Lieb explains. “Also, a CTF is not exempt from ERISA [Employee Retirement Income Security Act] as mutual funds are. Regardless of the size of a plan, being a trustee for a CTF has a high level of fiduciary responsibility.”

Because CTFs are essentially private vehicles, regulations do not require the public disclosures of returns as mutual funds do. In fact, trust companies are limited in advertising and marketing. That does not mean CTFs are kept secret, however. Morningstar maintains a CTF database for advisers and sponsors that covers performance, fees and asset flows, and prepares the equivalent of fact sheets for distribution to participants. Still, “some sponsors want their participants to be able to Google the funds they are investing in,” Czochara notes. “That’s not readily available for CTFs, but participants are able to get that information from their recordkeeper’s website.”

A plan’s assets need not be enormous to gain a benefit from the cost savings of CTFs. “Size is not important to us,” notes Charlie Russella, president of Wilmington, Delaware-based Wilmington Trust Retirement and Institutional Services Company. The firm administers 90 funds managed by 62 subadvisers, with total assets of about $10 billion. “We have plans with assets of $200 million or $300 million, as well as startups,” Rusella says. “Our average CTF account size ranges from $3 million to $5 million.”

Separately Managed Accounts

Even lower costs are available through investing in SMAs where a manager or bank establishes a fund exclusively for one plan. “Separate accounts by far beat the commingled options of collective trusts and mutual funds,” says John Hsu, senior analyst at researchers Cerulli Associates in Boston. However, separate accounts have very large minimum investments, requiring a critical mass of plan AUM of $500 million or so, as well as a more complex infrastructure, says Lori Lucas, head of the defined contribution practice at consultants Callan Associates, San Francisco. “It’s a smaller step to move from mutual funds to a CTF than to a separate account,” Lucas says.

Exchange-Traded Funds

The low fees and diverse markets available through exchange-traded funds have long offered promise as the backbone investment vehicles for DC plans—but that promise remains unfulfilled. Few recordkeepers have brought their mutual fund-based systems forward to accommodate ETFs, and advisers have not been sure how to present them to sponsor clients. In the latest comprehensive DC industry survey from PLANADVISER’s sister publication PLANSPONSOR, published in November 2013, just 3.7% of plans had adopted ETFs as an investment option.

“ETFs haven’t set the 401(k) world on fire as they have on the retail side, for a variety of reasons,” says Greg Porteus, head of DC intermediary relationships in the U.S. and Canada at BlackRock of New York, which offers the iShares series of ETFs. He elaborates: “The first is recordkeeping. ETFs trade during the day, rather than after the close as mutual funds do, and they trade in shares, rather than in dollar amounts. And ETFs’ settlement terms are ‘T+3,’ rather than the ‘T+1’ of mutual funds.” Moreover, the conventional purchase and sale of ETFs entails brokerage commissions, which can become very costly very quickly, considering the large number of small transactions in a typical participant account.

The fee simplicity of ETFs—low management fees with no add-ons for distribution—also works against their role in 401(k)s. “We don’t have any plans with ETFs,” Kieckhefer says. “We see reluctance to use them from the recordkeepers. Any recordkeeping fees would have to be wrapped on somehow, and the sponsors and participants will wonder what they’re paying for.”

Nevertheless, about 100 different administrators and recordkeepers, primarily outside the top 25 or so firms in the business, have stepped up to offer ETFs in 401(k) plans. According to Porteus, “systems at the big firms were built in the 1980s, when the only options were mutual funds and collective trusts. The big firms are doing fine with mutual funds and are slow to change, while smaller firms are more nimble and looking for a competitive edge.”

One of the first platforms to assimilate ETFs, dating back to 2009, was developed by Ascensus Inc., a provider of recordkeeping and administrative services based in the Philadelphia suburb of Dresher, Pennsylvania. Neil Smith, executive vice president of strategic business support services, explains that the standard objection over commissions on small, frequent ETF purchases was overcome by aggregating trades. “When you roll it up into large numbers, the systems can keep the commissions to a minimum,” Smith says. “To the participant, it looks just like a mutual fund.” 

Smith is careful to point out that ETFs’ low fees were not Ascensus’ primary motivation for formulating the system. “Back in 2009, we saw that some sophisticated advisers, for their high-net-worth clients, were adding some ETFs to diversify portfolios and, with other ETFs, were introducing new asset categories to boost returns. Advisers are now creating asset allocations for their DC plan clients in the same way. And of course, ETFs can reduce investment expenses, so they have that benefit, too.” As of June, about 2% of the 43,000 defined contribution plans administered by Ascensus made use of the firm’s ability to deliver ETFs.

While one of the big selling points of ETFs to retail investors has been their ease of intraday trading, many observers view those capabilities as antithetical to the slow and steady, long-term objectives of retirement investing. But Charles Schwab & Co. is viewing ETFs from another angle, and sees their real-time character as a major benefit to consultants, sponsors and participants. As a result, the firm likely will be the first major 401(k) player with a full-featured ETF product that accommodates intraday trading, which is expected to be rolled out by the end of the year. “We’ve seen the growth in interest in ETFs from individual investors and their advisers, and in developing this capability, Schwab is challenging the 401(k) side of the industry,” says David Gray, Schwab vice president of client experience in San Francisco.

The innovation is less about real-time trading than about giving participants timely access to their accounts. “A generation ago, people had to wait until the end of the day to get the news,” Gray says. “Today, of course, we have instant news. People don’t necessarily act on everything they hear, but they want the same sort of access with his investments.” In a mutual fund world, a participant has to wait several hours after the close of trading to see his account’s current value; with an ETF structure, a fresh mark-to-market is available at any time. “We think timeliness and transparency is where 401(k)s are headed,” Gray says.

“In the mid- to large-plan market using mutual funds, the weighted average operating expense ratio ranges from 55 to 95 basis points, assuming a mix of active and passive strategies,” Gray says. “With an ETF structure, we think the all-in expenses will be something like 10 to 14 basis points—a significant savings. And given the price wars that have been going on in ETF management fees, we believe that cost could go below 10 basis points.”

Kieckhefer says that while his firm is not currently using ETF-based 401(k) plans, their time is not far off. “Plans built from ETFs are coming,” Kieckhefer believes. “It’s just a question of when. One day the recordkeepers will start to embrace them, and you will see a deluge.” —John Keefe

Alternatives in Plans Raise Red Flags

Regulators want stricter oversight

A report from the Office of Inspector General for the Department of Labor (DOL), released in October, shows concern about the use of alternative investments in retirement plans.

The office conducted an audit due to concerns from the Internal Revenue Service (IRS), Government Accountability Office (GAO) and American Institute of Certified Public Accountants (CPAs) that retirement plan assets invested in alternative and hard-to-value investments may have a direct and harmful effect on the retirement security of plan participants. The audit found that, while the DOL’s Employee Benefit Security Administration (EBSA) has made efforts to improve the oversight of plans that hold hard-to-value alternative investments, it has not taken steps to formalize regulatory guidance such as that recommended by past Employee Retirement Income Security Act (ERISA) councils.

The report noted that EBSA needs to better protect plan participants from potential plan losses that stem from alternative investments and recommended that the agency:

• Propose and formalize guidance, and evaluate recommendations from the ERISA Council;
• Improve procedures in enforcement reviews; and
• Improve Form 5500 data collection, analysis and targeting.

As of 2010, defined contribution (DC) plans had almost $3 trillion in alternative investments, with EBSA estimating that between $800 billion and $1.1 trillion were in hard-to-value investments.

In a response to the audit, EBSA said it did not believe the trillions of dollars invested in alternative investments and hard-to-value assets pose significant valuation concerns. The agency contended that ERISA has already provided sufficient guidance, that its investigative procedures are sufficient and that Form 5500 already focuses on asset valuation.

The agency agreed to consider the recommendations from the audit report but cited no explicit corrective actions it would take.

However, many advisers have yet to recommend alternatives to their plan sponsor clients, according to a survey by Natixis Global Asset Management’s Durable Portfolio Construction Research Center. The 2013 Natixis Survey of U.S. Financial Advisors sought to gather adviser insights on retirement savings, asset-allocation strategies and the challenges posed by a rapidly aging client base.

According to the survey, only one in four (25%) advisers reported using alternatives—such as collective trust funds (CTFs), separately managed accounts (SMAs), exchange-traded funds (ETFs), hedge funds, private equity and commodities—in client accounts on a regular basis. Among those that did not utilize alternatives, 44% reported feeling alternative products are too difficult to explain to clients to warrant regular use. —Kevin McGuinness