Exploring Alternative Investment Vehicles in Employee-Sponsored Retirement Plans

Peter Mustian

Sydney Aeschlimann

Mutual funds have historically been the most popular investment vehicle in employee-sponsored retirement plans. However, due to their competitive pricing, alternative options such as collective investment trusts and institutional separate accounts have gained traction in recent years. While CITs and ISAs operate similarly to mutual funds as daily-valued pooled investment vehicles, they have distinct differences that plan sponsors must understand to make informed decisions.

The Rise of CITs and ISAs

CITs and ISAs are commonly used in 401(k) plans, 457 plans and other defined contribution plans covered by the Employee Retirement Income Security Act, emerging as attractive alternatives to mutual funds primarily due to their lower costs. They typically have lower expense ratios, making them appealing to plan sponsors and participants. Currently, CITs are not permitted in 403(b) plans. However, pending legislation aims to amend federal securities laws to allow their inclusion. Despite repeated efforts, this legislation has not yet passed in recent years. If enacted, this change would provide 403(b) plans access to the cost efficiencies and institutional management benefits of CITs.

Regulatory Landscape

Mutual funds are governed by the Securities and Exchange Commission under the Investment Company Act of 1940, requiring registration and compliance processes and associated costs. These expenses are often passed on to investors. By contrast, CITs and ISAs are not subject to SEC registration, contributing to their cost efficiency. State authorities and the Office of the Comptroller of the Currency regulate CITs, while state insurance departments have jurisdiction over ISAs. Both CITs and ISAs must also comply with the Employee Retirement Income Security Act, ensuring adherence to retirement plan standards.

Cost Efficiency

A key advantage of CITs and ISAs lies in their reduced operational cost. Mutual funds serve retail and institutional investors, resulting in extensive operational requirements. Retail investors, who tend to trade more frequently, can contribute to higher transaction costs, distributed across all mutual fund investors. CITs and ISAs primarily serve institutional investors, benefiting from more stable investment flows and lower trading costs.

Investment Standards and Performance

As plan assets grow, many plan sponsors consider transitioning to CIT or ISA versions of mutual funds, provided they meet investment minimums. While these transitions may seem akin to a share class change, critical differences exist. CITs and ISAs, governed by ERISA, may adhere to stricter investment standards than mutual funds. For example, CIT and ISA bond managers can be restricted from investing in below-investment-grade, non-agency residential mortgage-backed securities, which mutual funds may include. These distinctions can result in differences in holdings and performance.

CITs and ISAs also manage separate cash pools from mutual funds, leading to discrepancies in cash flow and trade timing. Frequent trading in mutual funds can create challenges in aligning liquidity and timing for CITs and ISAs to mirror mutual fund investments accurately. These differences can affect performance, making careful evaluation essential.

Reporting Differences

Unlike mutual funds, CITs and ISAs lack SEC-registered ticker symbols, making them less searchable online. Participants, however, can access detailed information through their plan recordkeeper’s participant website. This distinction underscores the importance of transparency and communication when incorporating these funds into retirement plans.

Other Key Considerations for Plan Sponsors

When evaluating CITs and ISAs, we recommend that plan sponsors also consider the following:

• Assets Under Management: Ensure the vehicle has substantial AUM for stability and liquidity. Preference should be given to established vehicles with a solid asset base and track record;
• Investment Holdings: Assess whether the CIT or ISA mirrors the mutual fund’s holdings. Understand any differences and their potential impact;
• Performance Track Record: Analyze historical performance to ensure alignment with the mutual fund. Some CITs and ISAs have underperformed their mutual fund counterparts, net of fees, during certain periods; and
• Legal Review: Be prepared for additional contracts and paperwork. Engaging legal counsel for document review is advisable.

While mutual funds remain a mainstay in employer-sponsored retirement plans, CITs and ISAs present a compelling alternative with potential cost savings. However, their regulatory, operational and performance differences require careful consideration. By thoroughly evaluating these factors, plan sponsors can make informed decisions that align with participants’ retirement goals.

Peter Mustian is the chief operating officer of and a principal in Innovest, providing institutional consulting services to committees and boards of various types of retirement plans, nonprofit clients and wealthy families. He is a member of the Capital Markets Research Group, responsible for asset allocation studies and portfolio construction. He is also part of Innovest’s Investment Committee, which makes decisions on investment related research and due diligence. He is a member of Innovest’s Retirement Plan Practice Group, which identifies best practices and implements process improvements to maximize efficiencies for our retirement plan clients.

Sydney Aeschlimann is a manager on Innovest’s retirement plan practice group, a specialized team that maximizes efficiencies and implements process improvements for retirement plan clients.

This feature is to provide general information only, does not constitute legal or tax advice, and cannot be used or substituted for legal or tax advice. Any opinions of the author do not necessarily reflect the stance of ISS STOXX or its affiliates.