CITs in 401ks: The Good, the Bad and the Ugly
The New York Times recently ran a story that might interest the typical 401k plan fiduciary (“A Low Fee Option May Be Coming to a 401k Near You,” New York Times, March 16, 2010). Like many similar articles, this piece reads like the author has discovered a new-found panacea to all that ails the 401k fiduciary. The article offers this tantalizing lead: Collective Investment Trusts (CITs) have “been around for decades and they’re cheaper than mutual funds, yet few companies offer collective investment trusts in their 401(k) plans. But that seems to be changing.”
As luck would have it, I was personally involved in creating CITs in the early 1990s specifically to market to 401k plans. As usual, be careful about elixirs marketed as cure-alls. CITs, like any other investment products, have good, bad and ugly characteristics. I’ll share my experiences with you here:
The Good: The primary advantage of CITs to the bank (CITs can only be offered by Trust Companies) offering them is the lack of significant regulatory oversight compared to mutual funds. For example, while mutual funds fall under the jurisdiction of the Securities and Exchange Commission (SEC) and the rigorous rules of the Investment Company Act of 1940 (40 Act), CITs are monitored only by either federal or state banking authorities. In addition, while mutual funds must register with each state they’re offered in, CITs have no such requirement. This translates into a dramatic fee savings which the bank can either pocket or pass on to the 401k plan sponsor.
What’s more, since most banks don’t or can’t charge a trust fee directly to the CIT, all fees must be negotiated with each individual plan sponsor. This gives larger plans a lot of leverage to bargain for significantly lower fees. Indeed, most of the companies cited in the New York Times article happen to be very large. The Times quotes Morningstar data analyst Adam Baranowski, who says, “Mutual funds charge an average of 1.25 percent of assets, twice the average 0.63 fee level of collective trusts.” Of course, many plan sponsors – no matter what their size – currently use institutional fund shares, which can have expense ratios well below 1%, so the Times might not have told the whole truth.
The Bad: Smaller companies have much less leverage when negotiating. As a result, a bank will often charge a typical trust fee, which can range from 1% to 1.5%, much higher than the expense ratio of institutional class mutual fund shares. In addition, CITs don’t have the same public reporting requirements that mutual funds do (in fact, banks are prohibited from marketing CITs). As a result, the use of CITs may increase administrative costs. These cost increases shouldn’t offset cost reductions for larger plans, but they might eat into the perceived savings.
Similarly, the migration away from managed portfolios to mutual funds in the 401k market occurred because of the vast amount of publicly available data for mutual funds. Not only did this make life easier (and less costly) for recordkeepers, but it gave employees readily available data from multiple independent sources. As it stands today, any attempt to collect data on CITs (if it’s even legal) will suffer the same limits as similar attempts to collect data from individual investment advisers. Such universes tend to have a survivor bias, meaning, since disclosure will remain voluntary, only those CITs with better performance numbers will have an incentive to report.
Moreso, individual investors will find CITs won’t offer the flexibility of mutual funds. Not only will they find it hard to obtain good (and audited) independent data, they will also find they can’t rollover their money into the CIT upon leaving the plan.
Finally, in order to qualify as a CIT investor, the 401k plan must have a trust relationship with the bank. This can be a fairly innocuous relationship. However, I’ve seen many plan sponsors reluctant to enter into such a relationship.
The Ugly: Of course, for every Yin there’s a Yang. While avoiding the SEC and the 40 Act might lower costs, it also increases the risk to investors in CITs. Recall the original reason for the creation of the 40 Act: Many investors lost money during the 1929 crash because they had invested in bank CITs during the 1920s and those banks subsequently failed. Although trust companies separate trust assets from the bank’s balance sheet, the lack of regulation can often lead to unpleasant surprises. Just look at the concerns over hedge funds today. As CITs become more popular, there will no doubt be pressure to increase regulation (and increase costs) – but only after a spectacular failure.
In the end, CITs might seem a good solution for reducing fees, especially for very large plans. But, as usual, caveat emptor.