Back to the Future – Collective Trust Make a Come Back to 401k World

Introduction
What is a Collective Trust?
Collective Investment Trusts Compared to Mutual Funds
Which Retirement Plans can use Collective Investment Trust Funds?
The Legal Perspective
Collective Investment Trust Funds—Historic Milestones
In Summation

Introduction

As the retirement plan industry has evolved, so has the structure of investment vehicles used in 401(k) plans. Collective Investment Trust funds (“CITs”) have been available for decades. However, the early versions of CITs provided investors little access to underlying holdings data and fund values were calculated infrequently, typically only once per quarter. As a result, CITs were quickly overshadowed by mutual funds because mutual funds provided daily valuations and higher degrees of transparency. Today, CITs are in much greater demand as the limitations of the past have been eliminated and plan sponsors are seeking cost-efficient investment solutions.

What is a Collective Trust?

Collective Investment Trusts (“CITs”) are the first cousin of the mutual fund and have been around since 1927. CITs are not new to the retirement plan industry. In fact, they have been a preferred option for many defined benefit plans since Congress amended the Internal Revenue Code in 1936 to provide tax-exempt status to certain bank CITs.

In 1999, there was less than $800 billion in CITs, according to government estimates. At the end of the first quarter of 2010, total assets invested in CITs are estimated to be over $1.6 trillion, a 14% increase from a year earlier, according to Morningstar. The TSP or Thrift Savings Plan for Federal employees and members of the military established by Congress in 1986, currently comprises over half of these CIT assets.

Part of this growth can be attributed to recent court settlements requiring companies to find ways to lower their plan expenses. Many have turned to CITs as the cost-saving solution for their retirement plans. Additionally, companies are using CITs to deal with the forthcoming fee disclosure requirements. While plans with assets over $250 million are the fastest adopters of CITs, companies of all sizes are taking note of this trend and following suit by using CITs in their plans as well.

In addition to the U.S. Government Thrift Savings Plan, other large, well-known companies offering CITs in their plans include Caterpillar; Time Warner Cable, Inc.; Dow Chemical; Hewlett-Packard Co.; and Viacom.

Advantages:

Limitations:

As an institutional-only vehicle, CITs benefit from operational cost advantages that can translate into lower plan fees – they enjoy a relatively simple structure and regulatory status (CITs avoid registration as investment companies under the Investment Company Act of 1940).   CITs are valued and priced daily because they are tracked on the same platform as mutual funds through the National Securities Clearing Corporation (NSCC) trading.

CITs are only available to the retirement plan market and not the general public, so participants cannot roll over their CIT-balances when they leave their company plan. They must liquidate the CIT holding and then roll over the cash balance.   Unlike mutual funds, CITs do not have ticker symbols and daily prices are not available in newspapers. Participants can go online to the organization (record-keeper) holding the account to get this information. Additionally, Morningstar tracks over 1,000 U.S.-based CITs.

Collective Investment Trusts Compared to Mutual Funds

CITs and mutual funds share a number of important similarities. Here are five things they have in common:

1. Both are pooled investment vehicles with professional management that are subject to some form of regulation.
2. Both are governed by a controlling document providing the basis for investment objectives and how they will be operated and managed. A Declaration of Trust is used for CITs and a Prospectus for mutual funds.
3. Data is more widely available today for CITs, and fact sheets now tend to be readily available for both vehicles. Both mutual fund and CIT investors receive the performance of the overall fund, net of any related expenses.
4. Trading for both CITs and mutual funds is automated and standardized. In addition, transaction processing is available for both CITs and mutual funds through the NSCC’s Fund/SERV® trading platform.
5. Similar to a mutual fund, a portfolio manager or sub-advisor is hired by the Bank or Trust Company sponsoring the CIT to invest the assets according to the defined investment objectives.

There are two major differences between CITs and mutual funds: (1) how they are regulated and (2) their availability.

Mutual funds are regulated by the SEC under the Securities Act of 1940, whereas CITs are regulated by the OCC. While CITs are subject to oversight by the sponsoring Bank or Trust Company board of directors and have annual financial statement audits and disclosure requirements, they do not incur some of the additional costs associated with other compliance activities required of mutual funds by the SEC. These typically include items such as having a separate fund board of directors, creating and delivering proxies, prospectuses, and Statements of Additional Information.

Mutual funds generally do not have eligibility restrictions and are usually available for purchase by most investors (i.e., after meeting the minimum initial investment and other possible criteria). Alternatively, CITs are available only to certain types of retirement plans.

Since mutual funds are marketed to all types of investors they generally have broad distribution channels (e.g., retail investors, financial advisors, institutional investors). The broad audience often leads to higher marketing and distribution costs and less predictable cash flows. In contrast, CITs have a limited marketing and distribution focus – helping to keep fund expenses lower. Additionally, since they are only available through qualified plans, they tend to have steady, predictable cash flows providing portfolio managers greater control over investment allocations and potentially fewer redemptions during down markets.

Finally, from a fiduciary perspective, trustees of a CIT are considered fiduciaries under the Employee Retirement Income Security Act (“ERISA”) and are held to ERISA fiduciary standards, while mutual funds are generally not held to ERISA fiduciary standards. In this capacity, the Bank, as trustee, must act solely in the best interest of the plan participants and beneficiaries and is generally prohibited from making decisions that are in the Bank’s best interest, but not in the best interest of the plan invested in the CIT. For additional information on fiduciary standards and ERISA please consult an ERISA Attorney.

Which Retirement Plans can use Collective Investment Trust Funds?

Types of Plans that Are Eligible	Types of Plans That Are Not Eligible
Qualified 401(k) plans 403(b) plans (may change given recent regulation) Qualified profit sharing plans 457(f) government plans Qualified stock bonus plans IRAs and Keoghs Qualified pension plans Endowment Plans 401(a) government plans Foundation Plans 457(b) government plans Certain separate accounts and contracts of insurance companies	403(b) plans (may change given recent regulation) 457(f) government plans IRAs and Keoghs Endowment Plans Foundation Plans SEPs, Simple Plans, Owner-only 401(k)s

The Legal Perspective

CITs are administered by a Bank or Trust Company which combines assets for multiple investors meeting specific requirements as established in the CITs regulating document, the Declaration of Trust. Despite being offered by Banks and Trust Companies, CITs assume the same investment risk as other investments and are not guaranteed by the Bank or by the Federal Deposit Insurance Corporation (“FDIC”), the independent agency of the federal government that insures deposits in Banks and thrift institutions.

CITs are regulated by the Office of the Comptroller of the Currency (“OCC”) and subject to oversight by both the Internal Revenue Service (“IRS”) and the Department of Labor (“DOL”).

The Code of Federal Regulations (CFR) Title 12: Banks and Banking (i.e. 12 CFR 9.18) defines two types of CITs.

The first is commonly referred to as an “A1 Fund” because it is authorized under section 9.18 (a)(1). These types of funds are maintained “exclusively for the collective investment and reinvestment of money contributed to the fund by the Bank, or by one or more affiliated Banks, in its capacity as trustee, executor, administrator, guardian or custodian under a Uniform Gifts to Minors Act.”

The second, more commonly known as a CIT, is authorized under section 9.18 (a)(2) and is a “fund consisting solely of retirement, pension, profit sharing, stock bonus or other trusts that are exempt from federal income tax.” The Banking industry typically refers to this type of fund as an “A2 Fund”.

Note: The Trademark Capital Target Retirement Series are A2 Funds. Most of the information about CITs that you’ll find on these pages refers to A2 Funds or CITs associated with qualified retirement plans.

Collective Investment Trust Funds—Historic Milestones

1927 – Collective Investment Trust Funds first launched.

1936 – Congress amended the Internal Revenue Code to provide tax-exempt status to certain Bank Collective Investment Trusts.

1955 – Federal Reserve allowed Bank for combine funds from pensions, profit-sharing plans, etc.

1980s – 401k plans came onto the scene and CITs were used in many early plans. However, mutual funds offered many features that CITs lacked back then.

2000 – The National Securities Clearing Corporation (“NSCC”) added CITs to their mutual fund trading platform, Fund/SERV®.

Collective Investment Trust Funds – Then and Now

Back Then	Today
Lack of pricing flexibility at the plan level Limited product offerings (stable value and passively managed options were most common) Valued quarterly Not traded daily and manually traded Limited performance calculations based on quarterly valuations Limited information available to employees Used almost exclusively in defined benefit plans	Pricing flexibility through NAV and multiple share classes Greater variety of both passive and active investment objectives Daily valuation and liquidity Standardized daily trading Performance continuously available due to daily valuations Fund fact sheets and enhanced communications Used in both defined benefit and defined contributions plans

In Summation

CITs

• are pooled investment vehicles,
• can only be used in certain qualified retirement plans,
• have Banks or Trust Companies as fiduciaries,
• are regulated by the Office of Comptroller of the Currency (OCC), and
• are overseen by the IRS and DOL.

CITs may be appropriate for inclusion in a retirement plan investment menu as they provide all of the benefits of mutual funds and are generally priced more competitively. A careful evaluation of a plan investment menu is an important aspect of proper fiduciary conduct and Collective Investment Trusts deserve serious consideration as a part a comprehensive due diligence process.