Originally posted in 401(k) Wire (subscription required) Aug. 22, 2022. By Greg Wait, CEBS.

Advisors and consultants are fielding questions from plan sponsors about potential liability for excessive fees. For example, recently a plan sponsor’s CFO told us their fiduciary insurance carrier included a new questionnaire with their renewal application. It was titled “Fiduciary Liability Insurance Excessive Fee Questionnaire.” The document very specifically addressed areas in which plan sponsors might be exposed to an excessive fee lawsuit.

The questionnaire asked if the plan sponsor has explored the availability of less expensive investment vehicles—such as collective investment trusts—as potential replacements for each of the plan’s mutual funds.

Another question asked if the plan sponsor has received any inquiries from specific law firms that have brought these lawsuits against 401(k) plans. Because of litigation over investor fees, the cost of defending and/or settling these cases has skyrocketed, putting pressure on fiduciary insurance companies that have defended plan sponsors. In response, fiduciary insurance carriers are raising premiums, increasing deductibles, reducing liability limits, and/or specifically capping class action exposure.

Advisors and consultants are key allies for plan fiduciaries seeking to limit plan costs—and to maintain fiduciary liability coverage. In some plans, the use of collective investment trusts (CITs) may be helpful for both purposes.

Low-cost mutual fund solutions

While there certainly are 401(k) plans that fail to closely monitor all plan expenses, the focus of this article is low-cost investment management. Some might suggest that the best way to protect a plan against excessive fee lawsuits is to offer only low-cost index funds in the 401(k) menu, although this clearly is not a requirement under either ERISA statutes or DOL regulations.

Almost all investment vehicles available to qualified retirement plans have multiple share classes, with the only difference being the expense ratios of each class. Historically, higher expense shares have provided revenue sharing to compensate plan recordkeepers or advisors. While revenue sharing credits to service providers may have appeared to reduce plan expenses paid directly by the sponsor, this approach tends to generate higher expenses (paid indirectly by plan participants…this is the point of the lawsuits) over time as plan assets grow.

So, a more prudent approach is to create a plan menu that is void of mutual funds that pay revenue sharing and includes only the lowest expense share class of each fund selected through sound investment analysis.

Low-cost CITs vs. mutual funds

A low-cost fund selection process should consider collective investment trusts (CIT) as well as mutual funds. Collective investment trust funds are very similar to mutual funds in that they are pooled investment vehicles managed with a common investment objective.

Mutual funds are typically offered by investment management firms and available to retail and institutional investors, including qualified retirement plans. CITs are commonly maintained by a bank or trust company and are only offered to certain qualified retirement plans, such as 401(k) plans.

Many 401(k) plans already offer at least one CIT in the form of a stable value fund, even if the rest of the investment menu consists of mutual funds. Both mutual funds and CITs can have multiple share classes with different expense structures, and plan sponsors need to check with their recordkeeper to be sure selected mutual funds or CITs are available on its investment platform.

While there are many similarities between mutual funds and collective trust funds, there are some key differences that plan sponsors should consider. Mutual funds are regulated by the Securities and Exchange Commission (SEC), under the Investment Company Act of 1940 and must adhere to strict filing requirements. CITs are regulated by the Office of the Comptroller of Currency (OCC), as well as the IRS and DOL.

Mutual funds are governed by a prospectus, whereas CITs are governed by a trust document and investment/operating guidelines. Because CITs are available only to qualified retirement plans, they are held to ERISA fiduciary standards, which mutual funds are not.

Most importantly, CITs can often be a lower-cost alternative to comparable mutual funds because they avoid SEC filing requirements, have less overhead, and reduced retail marketing expense.

CIT examples

Many mutual fund investment management firms also manage CITs with identical investment objectives and strategies. For example, T. Rowe Price manages one of the oldest and largest series of target date retirement funds in the industry. These funds are offered in both a mutual fund and CIT structure; however, their CITs are only available to qualified plans with a minimum investment of $20 million in the target date funds. Similarly, Parnassus Investments, a leader in sustainable investing, offers the Parnassus Core Equity Fund (PRILX) as the Parnassus Sustainable Core Equity CIT with a lower expense ratio, currently with no minimum investment.

CIT key advantages and challenges for plan sponsors

To summarize the advantages and challenges to a plan sponsor considering CITs:

Advantages

  • May be less expensive than a comparable mutual fund
  • Flexible, and possibly negotiable, pricing for qualified plans
  • Held to an ERISA fiduciary standard
  • Potential to customize a product using multiple investment managers

Disadvantages

  • Often have very high minimum investment criteria
  • No publicly available information
  • No portability outside of a qualified plan
  • Additional paperwork required, including an application, letter of direction, participation agreement

As the 401(k) landscape continues to evolve and more scrutiny is given to plan expenses, and as more collective investment trusts become available at lower minimum investment levels, plan sponsors and their advisors should be sure to assess this investment structure.

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Opinions expressed are those of the author and do not represent individual advice or recommendation.  Readers should consult with accounting and/or legal professionals in preparing and filing taxes.  Jan S Grimm and Riverwater Partners do not receive compensation or referral fees from parties for engaging in tax professional recommendations but we are happy to connect you with a trusted resource if you should have any further questions
Sources:
Fiduciary Liability Insurance Excessive Fee Questionnaire, Chubb (for Aon Panel), December 2020
Exposing Excessive Fee Litigation Against America’s Defined Contribution Plans, Euclid Specialty, December 2020
401(k) Lawsuits Explode in 2020, Investment News, December 8, 2020
Collective Investment Trusts, Lower Costs and Greater Flexibility, Michael Nelligan, CFA, State Street Global Advisors, February 2018
The Advantages of T. Rowe Price Collective Investment Trusts, 2021
Parnassus Sustainable Core Equity CIT Fund Fact Sheet, Third Quarter 2021