How to Explain CITs to Sponsors

Collective trust funds (CTFs), or collective investment trusts (CITs), are pooled investments and, in the U.S., predate mutual funds. Created and managed by banks and trust companies, they saw some use in the first 401(k) plans, but “early on, collective trusts involved tons of paperwork, required high minimum investments, and performance was a mystery for participants wanting information,” says Greg Porteous, head of DC [defined contribution] intermediary strategy at State Street Global Advisors in Boston. As the defined contribution industry grew, plan sponsors found mutual funds to be a more convenient, ready-made solution for investing millions of small contributions from employees’ pay.

But much has changed, Porteous says. “The paperwork has been simplified. Performance reporting is reliable, and lower minimums make CTFs available to smaller plans. The real catalyst, about 10 years ago, was the trading of CTFs on NSCC [National Security Clearing Corp.]—the same platform [as] for mutual funds.” Fund researcher Morningstar now maintains a database on 2,500 U.S. CTFs, with assets of $4.8 trillion. Porteous adds, “We see a lot more inquiries [about CTFs] from advisers serving small to midsize DC plans.”

CTFs are structured somewhat differently than mutual funds, and, for plan sponsors and their advisers, they may take some getting used to. Yet, they offer several potential advantages over their mutual fund competitors.

CTFs can provide greater returns on their underlying investments, by making the assets work harder. “[They] are institutional DC accounts, and, because the fund flows are steadier, there is not a lot of ‘hot money,’ as there can be in some mutual funds,” notes David O’Meara, senior investment consultant at Willis Towers Watson in New York City. “A more stable asset base allows portfolio managers to hold less idle cash, so there is less cash drag on portfolio returns.” Slower turnover of assets also reduces trading costs, he says.

CTFs also are able to cross trades within their portfolios, Porteous explains. “Many trades don’t have to go out to the market, avoiding some transaction costs.” He points out that, from 2000 through 2015, State Street was able to handle, internally, 85% of the trades in its Standard & Poor’s (S&P) 500 Index fund and 73% in its MSCI EAFE Index fund.

There is more: “In general, DC plans are tax-deferred, but when a fund buys international stocks, there are taxes to be paid on the dividends,” Porteous says. “Collective trusts pay a lower tax than mutual funds do, and, depending on which index a fund is tracking, the benefit can be from 7 basis points [bps] to 30 basis points in annual returns.”

Significantly, fees can be lowered. Unlike with mutual funds, fees on collective trusts are subject to negotiation. “Mutual fund fees are fixed by share class, while trust fees are determined on a plan’s overall relationship with the fund trustee,” notes Susan Czochara, head of retirement solutions product strategy at Northern Trust Asset Management in Chicago.

Size matters in such negotiations, so that larger plans are likely to realize lower fees. However, smaller plans can leverage their adviser’s relationships with CTF trustees. “Mega-size plans can negotiate fees on their own,” says Todd Stewart, managing director of investment research in the Knoxville, Tennessee, office of SageView Advisory, which oversees $88 billion for 1,250 midsize DC plans across the U.S. “While a $300 million plan is sizeable, we can [additionally] bring our overall asset base to bear, to drive down fees further. You can’t do that on the mutual fund side.”

Lastly, CTFs are subject to a different regulatory structure, which lowers the cost of trustees’ operations. Under Securities and Exchange Commission (SEC) rules, mutual funds have to draft and file voluminous prospectuses, which creates a big additional expense for fund managers, O’ Meara says.

Now, this is not to say that CTFs are not regulated. Simply stated, the primary regulator of U.S. mutual funds is the SEC, while collective trusts are overseen by the Office of the Comptroller of the Currency (OCC), a banking regulator. And, depending on how they are marketed and the asset composition of the trust, collective trusts are also regulated by the IRS, the SEC, the Financial Industry Regulatory Authority (FINRA) and the Commodities Futures Trading Commission. The finer points of CTF regulation are well-explained in a comprehensive white paper, “Collective Investment Trusts,” published on the website of the Coalition of Collective Investment Trusts.

Advisers looking to take advantage of CTFs need to shift their mindset—if only somewhat. “Advisers’ due diligence on a CTF, versus that on a mutual fund, is about 90% the same,” says Bruce Ashton, an Employee Retirement Income Security Act (ERISA) specialist in the Los Angeles office of attorneys Drinker Biddle & Reath. “They would look at the investment performance and cost of the fund, and the history and ability of the trustee and investment manager, as well as any sub-advisers managing the day-to-day investments. Frankly, I don’t see much difference.”

He does note one important difference: ”The trustee is an ERISA fiduciary to the plan, whereas the manager of a mutual fund would not be. That’s a good thing, in that there is another fiduciary minding the store. But the adviser needs to take that into account and perform some extra due diligence on the trustee, looking at its experience managing collective trusts” and what backs up its fiduciary pledge.

According to Ashton, crucial to a collective trust is to include IRS-eligible qualified plans as investors, which exempts it from securities registration. “There is also a requirement that the trustee ‘create and manage’ the fund, meaning it has oversight over everything. At some level, the adviser will need assurance that the bank or trust company is maintaining that degree of control.”

The OCC publishes a helpful Comptroller’s Handbook on retirement plan products and services, intended to guide its examiners’ work on collective trust funds. Plan advisers might want to consult it as well, for due diligence direction. OCC examiners are encouraged to look at banks’ risk compliance, the security of their information systems, and any customer complaints, as well as the strategic plans of banks that offer CTFs. “Because the regulatory environment is complex, and dedicated processing systems are costly, providing retirement plan services requires a substantial and long-term commitment,” the handbook states.

Given that the trustee serves as a regulatory backstop, “it’s important to understand the trustee’s role,” Stewart says. “For a given fund, is the trustee well-established, and are CTFs a core business? Or are the trust services being provided in-house by the asset manager as a sideline?”

Stewart also points out the consideration of critical mass. “A manager may have a huge legacy mutual fund product and create a CTF to follow the same strategy. But if you map $50 million in cash into a new CTF with assets of just $20 million, there might be a cash drag for a day or two as the manager puts it to work, and that can [have a] significant [impact on] performance.”

The extra homework for CTFs is not negligible, and there are additional documents to sign. Stewart acknowledges that, among his midsize plan clients, the majority of assets still reside in mutual funds. “But enough has changed within the industry that, in many cases, there are significant cost savings on the table with CTFs—you can frequently save 10 basis points versus [with] an R6 share class—and on a $100 million account that is real money,” he says. “We feel an obligation to our clients to have the conversation about all the available options.”

Art by Daniel Špaček