With excessive fee lawsuits extending to the 403(b) space, and account assets growing larger with time, 403(b) plan sponsors are inquiring about offering collective investment trusts (CIT)s on their plan menu—which are like mutual funds, but tend to be at a lower cost.
Bruce Ashton, partner in the Employee Benefits and Executive Compensation Practice Group at Drinker, Biddle and Reath in Los Angeles says, “A CIT is a trust maintained by a bank that holds assets of various types of retirement plans. They are tax-exempt so long as they meet a number of requirements. Because they are entities that invest assets for others, they may also be characterized as ‘investment companies’ or mutual funds. Absent an exemption, they would have to register as mutual funds with the Securities and Exchange Commission (SEC). Fortunately, there is an exemption—section 3(c)(11) of the Investment Company Act—which provides one for collective trusts that hold investments for qualified plans, governmental plans and church plans. The ‘maintained by a bank’ requirement is important in this context, because it means that the bank must actually control the decision-making authority over the investments.”
According to the 2017 PLANSPONSOR Defined Contribution Survey, collective trusts overall are used by 16% of plan sponsors who responded to the survey (14.2% in 2016), and 57% of plan sponsors with plans over one billion dollars (56% in 2016). Why are more defined contribution (DC) plan sponsors using CIT’s? According to Ashton, “CITs are very much like mutual funds and can be traded essentially the same as mutual funds, but they tend to be lower-cost.”
403(b)(9) Church Plans
What types of 403(b) plan sponsors can use CITs? Ashton says, “The tax law permits virtually all types of 403(b)’s to participate. The problem lies in the securities laws: 3(c)(11) permits only qualified plans, government plans and church plans. Therefore, tax-exempt 403(b)’s can’t participate unless the CIT can qualify for another securities law exemption or the CIT registers as a mutual fund… which defeats the purpose.”
Consequently, 403(b) plans are restricted to two types of investments—403(b) annuity contracts, and 403(b)(7) custodial accounts, also known as mutual funds.
The only exception is 403(b)(9) retirement income accounts offered by church plans as they are not subject to the investment restrictions of 403(b)s.
More DC plans are using CITs because plans are getting bigger, and with size comes the pricing power needed for access. And fees are a big issue for fiduciaries—finding the best share class—as is litigation.
Michael Sanders, principal, Cammack Retirement Group in New York says, “Defined contribution CIT usage has ticked up over the last few years because if you have a large pool of money in a qualified plan and you want to dial in the fees and not necessarily pay the share class, you might develop, for instance, your own large cap growth CIT that allows a plan sponsor to have a custom or white label fund in which the plan sponsor can name the investment and hire the underlying manager. On a large scale, it is cheaper than its mutual fund equivalent and it can allow for easier fiduciary due diligence.”
Two Ways to Deploy a CIT
Unlike a mutual fund which fiduciaries select according to the best fund for their plan demographics, this type of CIT has to be built. Sanders says “A plan sponsor needs an RFP to hire an investment firm, codify the assets to create the structure and do the communications around it. Even though it’s not a mutual fund you have to communicate to your participants what you’ve done. Unless you have enough funds to build something it could end up costing a plan sponsor more money.”
Ironically, Sanders says, “Most church plans, the only type of 403(b) plan that can use CITs, do not have the scale to take advantage of these custom CITs because a plan sponsor has to have at least a billion dollars to build their own and many church plans are fragmented. Many parish plans are run individually, folding up to one board or the parishes have multiple vendors.”
But as an alternative, and perhaps further frustrating to 403(b) plan sponsors, many investment management firms are creating CIT versions of popular mutual funds to enable them to lower costs. Mutual fund companies have come out with CIT versions of their mutual funds or target-date funds allowing easier access to the advantages of CITs for plan sponsors. All qualified plans other than 403(b) plans, no matter their size, can take advantage of these vehicles, as can 403(b) church plans.
The 403(b) plan law was enacted in 1958 and at that time plans could only offer annuities. In 1974 the Employee Retirement Income Security Act contained a provision that allowed 403(b) plans to offer mutual funds, and a 2015 law allowed church plans to offer CITs.
Higher Education Missing Out
But, Sanders says, “where these CITs could work well is in higher education. These plans tend to be larger and potentially have the scale it would take to drive down fees for the participants. CITs would allow higher education plan sponsors to provide an array of investments and few communication changes. They could also clearly label each investment to allow for easier communications. Participants could have their asset allocations set up and not be deterred by a fund that isn’t doing well. That’s happening underneath the engine so they don’t get caught up in that. But, it’s not available to them.”
Administrators at the University of California (UC) clearly agree that CIT’s have an advantage in higher education retirement funds. The UC began offering collective investment trusts for its 403(b) plan in the fall of 2017, marking a rare instance of a 403(b) plan, other than a church plan, offering such an investment option.
The university benefited from a private-letter ruling from the Internal Revenue Service (IRS). Although the IRS letter provided an exemption for prohibitions on non-church 403(b) plans offering collective investment trusts, the university declined to provide the letter, describe a summary or say when the ruling was issued.
Ashton says that the UC private-letter ruling “appears to have been a one-off and that they were able to ascertain a no action letter from the Securities and Exchange Commission. If a sponsor is not certain if an action violates the securities law it basically goes to the Securities and Exchange Commission and asks something such as in this case: ‘If our 403(b) holds certain types of investments are we going to be required to be registered under the investment company act, and the mutual fund act?’ According to news reports, the SEC issued a no action letter but the letter could not be located.”
The Future of CITs and 403(b)s
When asked if any rule changes in the 403(b) market might allow CIT usage, Sanders said, “ultimately mutual fund fees have been coming down, and the majority of 403(b) plans are smaller—it’s a non-issue. They would not be taking advantage of CITs anyway.
“But in the larger 403(b) market, it would be very good if CITs were available. I don’t know that anything will change. I don’t know that this one piece of the code (the Internal Revenue Code) will garner the amount of attention it will need to make it happen. But if it did happen, it would be a good additional tool that large plan sponsors would have, and the UC is a great example of a large plan sponsor that can take advantage of this.”
Ashton adds, “Theoretically 403(b) plan sponsors would save money by using CITs. The value of the CIT is that since it doesn’t need to register under the federal securities laws, plan sponsors don’t have the cost of registration/prospectus preparation and keeping a prospectus current so there’s a lot of savings on the part of the CIT. It operates and trades almost like a mutual fund but doesn’t have the associated expense of being a mutual fund.”
In addition, Ashton says, employees in industries that use 403(b) plans such as health care industries, schools, and other non-profits are paid lower than many industries that use 401(k) plans and they could gain more from the use of CITs. “Generally speaking 403(b) plan sponsors have been less involved or not involved at all with their plan and, not to disparage the insurance brokerage industry, they have seen this as an opportunity to make a nice piece of change by serving as the adviser to 403(b) participants. Brokers receive a very healthy commission on the annuity products and mutual fund shares.”