According to the latest available data from Cerulli, CITs rose to $3.1 trillion in assets by the end of 2018, up from $2.5 trillion at the end of 2015, representing a three-year CAGR of 6.56 percent. While net assets contained in CITs still pale in comparison to the $50 trillion in mutual fund assets, this growth stands out given they are only available to Employee Retirement Income Security Act of 1974 (ERISA) contribution plans.
Unlike mutual funds, which are regulated by the Securities and Exchange Commission (SEC), CITs are sponsored by banks or trust companies, the latter of which is often an affiliate of an asset manager. However, considering them unregulated – as they are often described – is a misnomer. The primary regulator for CITs is the Office of the Comptroller of the Currency (OCC). There are also distinct areas of CITs which are also overseen by ERISA, the Internal Revenue Service (IRS), the Financial Industry Regulatory Authority (FINRA), and the Commodity Futures Trading Commission (CFTC).
Platform Availability: A Game-Changer
Although the growth rates of CITs in recent years have put them more firmly into the industry’s consciousness, CITs have a venerable history dating back to 1927. Their use in defined benefit pension plans and defined contribution (DC) plans such as 401(k)s has only taken off since 2006, when several technical industry innovations helped to make CITs more accessible to plans. These innovations included a landmark decision by the National Securities Clearing Corporation (NSCC) to make CITs available on its Fund/SERV platform, the industry standard for trading mutual funds. This moved trade interactions between CIT sponsors and pension plans away from telephones, faxes, and wire orders to an automated technology platform which allowed the defined contribution market to automate and simplify the processing of 401(k) orders. This quiet technological revolution helped push CITs from relative obscurity into the limelight.
CITs received yet another boost in 2006 with the adoption of the Pensions Protection Act, which helped clear the way for CITs to be used as Qualified Default Investment Alternatives (QDIAs), which are intended to encourage employees to save for retirement. The QDIA designation is important for suitability assessments when plan sponsors consider their own compliance obligations to regulators. The designation may also relieve plan sponsors from certain fiduciary responsibility with respect to selecting default investments for automatic enrollment plans. For plan participants, particularly those who have a limited understanding of financial vehicles, automatic enrollment through a QDIA ensures they are contributing to an investment retirement account.
Unique Sales Proposition: Lower Costs
The single biggest differentiator for CITs is their lower costs compared with most mutual funds. Since they are not regulated by the SEC, there is less of a burden for regulatory reporting, filings, and disclosures, thus reducing overhead expenses. Because CITs are not directly sold to retail investors, but rather to qualifying pension plans, there is also less shareholder trading on an ongoing basis. Less trading means there are fewer portfolio trading expenses than are common with mutual funds, which must rebalance portfolios frequently to deal with fluctuations in capital flows as well as market movements. Less frequent rebalancing often means CITs have lower capital gains taxes, contributing to lower costs. Since CITs are only sold through tax-exempt retirement plans, they are typically held for longer periods (spanning decades, in some cases), so they rarely trade materially on market cycles or news developments. In this way, CIT inflows and outflows are generally more predictable and lack the “churn” that defines many non-retirement investing accounts.
With ERISA’s fiduciary focus on reducing fees, recent data shows the use of CITs is growing in defined contribution plans, while mutual fund use is declining.
According to investment consultant Callan Associates, which publishes an annual survey of defined contribution plan sponsors, from 2011 to 2018, the usage rate of CITs by defined contribution (DC) plans increased from 44 percent to 75 percent. In comparison, mutual fund prevalence has declined by 12 percent in the same period, falling from 95 percent to 83 percent.
Other Growth Drivers
CITs have a degree of commercial autonomy that is not available to mutual funds. For example, CITs are authorized to negotiate their fees with clients, unlike mutual funds, where everyone in a mutual fund share class pays the same price. Providers are able to structure a tailor-made CIT portfolio for just one large retirement plan or a small group of plans and negotiate different level of fees with each plan depending on the nature and scale of their relationship.
ERISA’s growth mandate
Once focused on plain vanilla investments (primarily US equities), CITs are seeing a shift toward more diverse asset classes and more actively managed funds. One driver of this trend is ERISA’s requirement not just to retain capital, but to grow assets so that employees will have sufficient funds at retirement. As a result, retirement plans and fiduciaries are being forced to ask themselves if they are able to generate risk-based returns at the right price. This obligation helps explain the discernible move towards more diversified asset bases in the CIT space.
In the last five to ten years, technology has also been a driver in pivoting CITs from vanilla assets into more complex active strategies by allowing for more investor transparency. Not only are most CIT prices now reported daily, but Morningstar, eVestment, and Bloomberg compile fact sheets that enable peer group comparisons of CITs — not just to one another, but also to mutual funds. More than 90 percent of CITs are covered by Morningstar.
Establishing a CIT
Since CITs act similarly to mutual funds and other pooled investment funds, the operational structure is relatively straightforward. Here, we outline some key considerations for asset managers looking to launch a CIT.
Regulatory Oversight of CITs
CITs are subject to various levels of oversight as governed by:
- The Department of Labor (DOL)
- The Internal Revenue Service (IRS)
- State and federal bank regulatory agencies such as the Office of the Comptroller of the Currency (OCC)
- The Financial Regulatory Authority (FINRA), if marketed by a broker-dealer
- Commodity Futures Trading Commission (CFTC)
- The Employee Retirement Income Security Act of 1974 (ERISA)
Key Requirements – Service Providers
A key element of a CIT’s performance and overall success, is the efficiency of its operating model. Sophisticated asset servicing providers are required to ensure accuracy of accounting and performance calculation. Additional service offerings, such as securities lending, can help differentiate a CIT and enhance investment returns. A strong custodian can provide seamless operational support and facilitate revenue generation through these additional services.
- The investment manager and plan sponsor are considered the main drivers behind the launch of a CIT.
- The trustee serves as a fiduciary for the trusts. CIT trustees are responsible for selecting (and removing) the investment managers and sub-advisors who execute the investment strategy and manage the portfolio assets for the trust. CIT trustees may delegate the selection and monitoring of sub-advisors to a designated third party. CIT trustees are ultimately responsible for compliance reporting, fee disclosures, investor fact sheets, and communications.
- The custodian is appointed by the trustee to provide services such as asset safekeeping and income collection.
- The administrator is responsible for day-to-day operational support to the trust and provides NAV calculation, distribution calculation, maintenance of books and records, and financial reporting services.
- The transfer agent provides unitholder services to the trust, such as processing the capital activity, unitholder account opening, unitholder correspondence, and queries.
- Declaration of Trust: Often referred to as plan documents, the Declaration of Trust is the framework of operational and legal terms and conditions pertaining to the trust and the funds established and maintained under it. This includes who will serve as trustee and what powers the trustee holds. The declaration also includes the trust’s purpose, objectives, fees, and other information that would be useful to a plan fiduciary.
While CITs have a reduced regulatory burden relative to mutual funds, it’s important to stress once more that CITs are a regulated vehicle. CITs are underpinned by strong, conservative investor protection regulation and asset safekeeping. A custodian carries out the same services for CITs as they do for mutual funds in terms of independent asset safekeeping and valuation.
Although the DOL’s Fiduciary Rule was canceled and then moved to the SEC as a more comprehensive investor advice rule, ERISA section 404(c) contains detailed requirements for plan sponsors that ensure the safety of employees’ retirement assets.
With a cost advantage over mutual funds, it’s not surprising many sponsors are moving their assets to CITs. For plan sponsors, CITs now enjoy many of the same benefits as mutual funds in terms of transparency and ease of trading, but without the more significant mutual fund regulatory burden that translates into a substantial cost of carry. CIT sponsors must remain vigilant not only in the focus on their fiduciary responsibility but also on performance as that will become a more important differentiator given the increasing proliferation of available information. So while CITs have had a specific, loyal, and dedicated following, there are several market dynamics that suggest they may be moving to a more general mainstream audience.
Brown Brothers Harriman has proven expertise in assisting asset managers with developing their CIT business cases and launching and supporting CITs platforms. We’d be pleased to provide insight and help guide your firm through the process. Please contact Rosemary Gooding if you’d like to discuss your options further.
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