CITs and 403(b)’s – Good, Bad, or Jury’s Out?

This week we chat with Aron Szapiro, director of policy research for Morningstar. Aron is responsible for developing research reports on policy matters, coordinating official responses to regulatory proposals, and providing investor-focused comments on policy issues to clients and the press. He also chairs Morningstar’s Public Policy Council. His research has been covered in The New York Times, The Wall Street Journal, The Washington Post, The Journal of Retirement, and on National Public Radio.

Recently, Aron has been working on several projects and proposals related to retirement savings innovation. In June, Morningstar published a piece on CITs in 403(b) plans (free download) covering a current congressional proposal, and the concept that these investment vehicles could bring costs down for public sector retirement savers in 403(b) plans -- typically professors, teachers, administrators and others associated with public schools. State programs like 529 College Savings plans and State-facilitated retirement savings programs are interested in CITs too, but generally can’t yet use them. (I know if I’m wrong someone will speak up here). The current proposal has bi-partisan support – we’ll see if it passes – but a fresh look at CITs seems timely.

(Note, no attorneys were consulted during this conversation, so you can consider this to be a layperson’s discussion between ourselves and Aron.)

Aron – it’s great to catch up – tell us a little bit about yourself and your team

Yes! So I have the best job in corporate policy work -- I report up through the global head of research at Morningstar. We did that deliberately when we created this role in 2016, because we wanted to be in a strong position to use available data to come to independent conclusions about what will be best for investors. I lead a small, global team. We’re currently four people in Chicago, New York, Washington DC and London – I feel like they're all rock stars. There’s a lot of interdisciplinary work with others at Morningstar too. The whole setup makes it easy to do research around these types of issues, and easy to advocate for investors.

And, how is the pandemic treating you?

Well we’ve learned that when you are parents looking after a four-year-old and a one-year-old while working at home, it turns out you're bad at both things! At work I think the youngest member of my team really misses going into the office, where from my perspective, I'm traveling less. I think our Zoom meetings have become easier actually now that everyone’s in the same boat.

OK, before we go deeper into this chat – Aron – what the heck is a “CIT”?

Good one – let’s start there. “CIT” stands for Collective Investment Trust. These are pooled investments that are exempt from the Securities Act (aka the Investment Company Act of 1940). They tend to be registered through banks either at the state or federal level. And, from the perspective of the end investor they look an awful lot like any other pooled investment, including registered open-ended mutual funds that investors have become so familiar with.

From the perspective of the CIT sponsor (that is, product offeror), there are some differences. Sponsors are not supposed to market them, and only certain qualified investors are allowed to invest in them. Ordinary individuals couldn't go and buy shares in a CIT unless it is offered through a plan or some other permitted arrangement. And, CITs are explicitly allowed in ERISA-qualified retirement plans, like 401(k)s.

So, the net effect is that they are a simpler way to offer a pooled investment, with fewer regulatory requirements than traditional open-ended mutual funds. Regulatory filings for mutual funds are predicated on their being available to ordinary investors -- with all the disclosures and conditions that come along with that. So those are the basics. In our recent paper, we get into a bit more detail about the different flavors of CITs and how they're registered. Just for the truly curious!

We understand there’s some proposed legislation related to CITs and 403(b)’s – tell us more

Well – there’s a bill that's been introduced in Congress relating to the use of CITs in 403(b) plans.

For somewhat archaic reasons 403(b) plans, except for some kinds of church plans, can't invest in CITs. That's because 403(b)'s are limited to investing through insurance products and mutual funds. So it isn't that they're supposed to be “banned” from CITs exactly so much as it is that insurance products and mutual funds are generally the only two things they are allowed to invest in. When we look at the US Department of Labor Form 5500 data, we see that a few 403(b) sponsors have tried to get CITs into their plans through various arrangements that seem pretty complex. But as a practical matter, very few are attempting to find ways to get around the general prohibition.

So how is this impacting folks who are saving for retirement in their 403(b) plans?

It’s not great for a few reasons. One - CITs are really the “direction of travel”. Many target date funds now are being principally distributed through CITs.  Target date funds are one of the main ways people invest for retirement today.

It’s also true that CITs just tend to be a lot cheaper vehicle for the same investment strategy. We have a good database on this -- we can look at the strategy level and then just say, okay, what's the cost difference between the cheapest mutual fund class and the equivalent CIT. Now, sometimes we don't have the fees for the CIT, and sometimes they are negotiated on a plan by plan basis. But by definition, if you are offering a CIT wrapper for the same strategy that you have as an institutional share class mutual fund and you're negotiating, presumably you're going to end up at a lower price than what could just be bought off the shelf with the institutional share class. So, we think that they're basically always cheaper.

There’s a reason this is true - and it's because there are fewer regulatory filing requirements. CITs have to produce certain information that plan sponsors expect, such as detailed investment information to share with participants, because participants want to see that kind of thing. But it's still less onerous than the filings mutual funds have to do.

And so, about 25% of 401(k) assets are now invested in CITs. That trend to use CITs is now moving from the large plans into the midsize plans. These are the vehicle of choice for a lot of plans right now and I think more going forward.

That's really interesting. We had no idea that CIT adoption in the 401(k) world was so high.

Right? But CITs are where you're going to get the lowest fees for the same strategy. And if you're a large enough employer to manage this, and again, this is moving down to midsize plans, you’re going to look at it. Plan sponsors never want to pay more than they have to, if there’s a less costly option for a strategy they're interested in. You better believe they're going to consider it.

So, given that the regulatory requirements are lighter – maybe “much” lighter – would you say CITs as a vehicle are inherently riskier than an equivalent 40 Act mutual fund?

Well, I don't think they are when they show up in the ERISA context. And the reason is that as soon as CITs show up in 401(k) plans, all of the obligations which are really the highest standard under the law come into play here. This is true both for the sponsor selecting them, and for the CIT itself. And those are pretty strong protections. As part of our work we did a lot of research on this -- we're just not seeing any circumstances where people are creating exotic, risky CITs and then using them in retirement plans.

We feel like we should knock on wood when you say that Aron.

Yes - so that's why we have a suggestion in the white paper that we believe would improve this bill. Specifically, we recommend that the CITs made available in 403(b) plans be limited to those already available to investors in 401(k) plans.

Here, what you see is you see a strategy that already exists in an R2, R6 or institutional share class being organized as a CIT for the 401(k) market, because it's a way to shave even a few more basis points off of that institutional share class offering. You are also seeing the compounding effect of other benefits. For example, CITs as far as we can tell don't generally have revenue sharing arrangements or anything like that, that would make them more costly for savers.

One note - I'm certainly not advocating that these go mass market. I think that they are just a unique way to help get a high quality investment into the hands of participants at a lower fee with the help of the administrative streamlining afforded to CITs.

So that's the idea. We think it's pretty clever. I've gotten feedback -- there are some people who don't love it. But most people seem to think what we propose is a pretty reasonable approach. We’d be fine with the bill passing as is, we see good value in 403(b) savers having access to CITs. At the same time, we think our recommendation would strengthen the bill.

Aron, let us ask you a couple of other questions. We know you’ve been really busy. Tell us about some of the other things you're focusing on at Morningstar.

Interestingly, we are in the middle of three regulatory efforts with 30 day comment periods at the moment.

On ESG. As you know, on June 23 the DOL introduced a proposed rule on ESG (investing based on Environmental, Social and Governance criteria) and retirement plans. At first reading this seems to have an archaic view of ESG investing. The DOL’s focus seems more aligned with the old socially responsible screening approaches, and that is not in sync with what I see every day. We see traditional asset managers, advisers and investors thinking through managing various ESG risks, and making that a central part of their investment evaluation process.

We see this not as a hippie dippie, tree hugger kind of thing, but more because those risks really drive the ability an entity to continue to generate profit or cash flows for investors. You see this in real life all the time now where if you have a social practice that might attract the ire of regulators, that's a problem. If you are a company that's relying very heavily on a process that produces negative environmental outcomes, that may catch up to you awfully quickly. So, we’re still framing this one up, but we expect it to be a major feature of our team's work this summer.

On MEPs and PEPs. The US Department of Labor (DOL) also has a request for information on the extent to which pooled employer plans (PEPs), which will go live on January 1, 2021, should be able to skirt current prohibited transaction exemption requirements (PTEs), and whether there's a need for new PTEs. And we're trying to evaluate that as fairly as we can. We've got great data on this and on what sorts of investments are out there and the extent to which those investments might trigger the need for PTEs.

And, related to PEPs, we have a paper coming out shortly that looks at multiple employer plans asking, what do we see in the data here? And what we find is really interesting. I’ll bottom line it. There's a lot of promise for pooled employer plans. As they scale, fees come down. That's what you'd expect to see, that’s what you’d like to see.

Now, there’s also a massive standard deviation in fees for small plans. And that could be a real problem because if the PEPs marketplace fragments and you've got a bunch of small PEPs, small employers could have a pretty good chance of being one of the 30% that are in a plan with an all-in fee of over 150 basis points. That's not much of an improvement from the dynamic today.

Luckily we think the DOL probably has the tools to cope with this.

Tools available to the DOL requiring clear disclosures from pooled plan providers that participating employers can easily use to compare plans. It also includes making sure it's easy for an employer to leave one plan and join another. And probably most critically, the DOL should think long and hard about extending audit and reporting relief to PEPs with fewer than a thousand participants, as they are now invited to do by the law. We think this is risky, because it's entirely possible that the US could have a bunch of small PEPs that wouldn't be reporting any information. And that would be a huge blind spot. By way of comparison, MEPs with less than 1000 participants currently make up 87% of the marketplace. So I really don't want to see a repeat of that in the pooled employer plan marketplace.

If we’re serious about using these as one tool in the toolkit to help small employers offer a higher quality retirement access to more workers, we shouldn’t create a black hole without a lot of information and very little ability to enforce anything.

Right. And as a research guy that doesn’t work for you either.

I admit I have a strong self interest in having Form 5500 get better, not worse! And I didn't think it could get worse, but here's a law that could potentially make it worse. I glossed over this the first few thousand times I read the bill, and then I realized, Oh, most of the, most of the MEPs that are under a thousand participants stay that way over five years. So maybe that would be a good cutoff to say, look, if you're going to be small indefinitely, you’ve got to a file Form 5500 like you would today if you have more than a hundred participants.

We are glad you're working on MEPs and PEPs -- what's your targeted publication date?

July 23rd, which I guess I'm committing to right here and now. July 23rd that white paper will be out and we'll probably do a webinar on it as well.

Awesome. Aron, thank you for this thoughtful conversation about CITs, MEPs, PEPs, and ESG. We think we have the acronyms covered today.

We do! Thank you for your interest in our work.

Interested in more? You can access more of Aron’s research and writing for Morningstar here, and you can connect directly with Aron Szapiro here.

This piece was featured in July 2, 2020 edition of Retirement Security Matters. For more fresh thinking on retirement savings innovation, check out the newsletter here.