June 8, 2011

Collective trusts - Investment Pools

Five complexities advisers should weigh about collective trusts

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On average, collective trusts cost about 26 basis points less than retail shares of mutual funds, says Jeremy Stempien, a Senior Consultant at Morningstar, Inc. With fee awareness heightened in light of new regulatory requirements and recent plan sponsor lawsuits, sponsors increasingly find that compelling.

Like mutual funds, collective investment trusts (CITs) pool assets from multiple investors into a single investment portfolio, but only institutional investors can use collective trusts. CITs have been around for decades, but have regained momentum in retirement plans in recent years.

“One of the major things in collective trusts’ favor is that they seem to weather the storm in terms of the level of fees and the litigation plan sponsors have been subject to,” says Clifford Kirsch, a New York-based Partner at law firm Sutherland Asbill & Brennan LLP’s Financial Services Practice Group. They also allow for more customization and the comfort for an employer that the trustee has taken on a fiduciary role. When considering collective trusts versus mutual funds, plan sponsors and their advisers need to weigh those advantages against the complexities of collective trusts, like the five below.

Minimum asset requirements:

“It has evolved on both sides. The minimum requirements for collective trusts have come down significantly, but there are certain collective trusts where the minimum has gone up,” Stempien says, attributing the decreases to efficiencies developed by the trusts as well as intensified competition. “Companies really are trying to maintain products that can allow small investors to take advantage”—but not that small. “I have seen plans as small as $50 million to $100 million using collective trusts,” he says. Average investments are hard to quantify, since “CITs are reported on a voluntary basis,” he adds.

Oversight Differences

“They are not regulated as mutual fund products, and they are not regulated under the Investment Company Act. They are regulated as banking products,” Kirsch says. Collective trusts have less-stringent regs than mutual funds, Stempien says, such as not being required to have prospectuses, but that does not make selection fundamentally harder for sponsors. “With CITs, there is an added layer of due diligence of the trustee or bank,” he says. “With a mutual fund, you may only need to perform due diligence on the subadviser running the fund but, for the CIT, you may need to perform due diligence on both the subadviser and the bank/trustee that creates the CIT.”

For many banks/trustees, creating CITs is a core part of their business and they do it well, so there may be very little need to worry about their motives, Stempien says. “However, what sponsors should be careful of is if an asset manager creates or purchases a bank/trustee simply to have it create CITs for that asset manager’s products,” he says. “In this case, there may be a conflict of interest.” For instance, if the subadviser strongly underperforms, the trustee may not want to replace the subadviser. “They may not want to bite the hand that feeds them,” he adds.

The Impact of The Bank’s Fiduciary Role

Unlike mutual funds, these trusts “live under the Section 3(c)(11) exclusion of the Investment Company Act that basically says that, if you are a collective trust fund ‘maintained by a bank,’ you are subject to an exclusion from the definition of an investment company in the Investment Company Act. That means a bank cannot just operate in a custodial relationship; it has to maintain overall responsibility for investments,” so advisers cannot completely direct the investment without any involvement from the bank, Kirsch says. “An investment adviser teaming with a bank has to enter into it with the view that the bank will oversee and direct advisory services, and the adviser is acting in a subadvisory role. The adviser will work jointly with the bank to establish the investment objectives and to determine if there are drifts from style, for example.”

Transparency Challenges

Collective trusts now can offer daily pricing, which helps a lot, but challenges remain. “Collective trusts are not required to be as transparent” as mutual funds, Stempien says. To a large extent, plan sponsors and advisers have to arrange with trust officials if they want details revealed beyond the information disclosed in standard Declaration of Trust agreements, he says, which might include specifics they want about investment holdings.

Mutual funds have a lot of detailed fee-reporting requirements, Stempien says. “Collective trusts report the fees as one trustee line item,” he says, “so it is difficult to break out the investment-manager fee from the operational fee.” However, 408(b)(2) fee-disclosure requirements may not be an issue, he says, if sponsors or trustees can display fees to participants in any manner they choose.

Tougher Benchmarking

“Benchmarking certainly can be an issue,” Stempien says. “Collective trusts can be customized to a client’s requirements, or a pool of investors’ requirements. If I have a collective trust and I have set it up so the manager cannot invest in my company stock, or in alcohol or tobacco stocks, that can make it a challenge to assess how well the manager did.”

—Judy Ward

Clarifying Collectives

Target Client

Collective Trust (CT): ERISA and certain governmental plans (includes 401(k) or other participant-directed plans)

Mutual Fund (MF): Almost all U.S. institutional and individual investors

Investment Discretion

CT: Sponsored and managed by bank or trust company; Investment manager may be retained as nondiscretionary subadvisor

MF: Investment manager of registered investment company in accordance with guidelines established by fund’s prospectus

Regulatory Considerations

CT: Exempt from SEC registrations; Governed by bank regulations (e.g., Office of Comptroller of Currency); Unlimited number of participants

MF: Subject to SEC regulations under the Investment Company Act of 1940 Subchapter M for tax purposes; Unlimited number of participants

Governing Body

CT: Board of Trustees

MF: Board of Directors

Costs

CT: Lower overall fees because of no SEC regulatory reporting and processing requirements

MF: Higher fees because of SEC reporting and processing requirements; other marketing expenses

Information Access

CT: Daily unit values obtainable from third-party administrator or plan recordkeeper

MF: Daily unit values available in newspapers