CITs

Defined contribution (DC) plan participants face challenges as they work to grow their retirement nest eggs. By historical standards, projected investment returns in the post-pandemic era are anemic, and a recent surge has brought inflation back into the conversation for the first time in many years.

The good news is that even modest return improvements today could translate into many years more spending power in retirement. Collective investment trusts (CITs) can boost performance in two important ways: through lower fees, which make investing more cost efficient, and as way to access active management strategies, which may also enhance returns.

The Investment Landscape: Lower Returns for Longer

To put some numbers to current investing prospects, 10-year expected returns for a traditional 60/40 stock/bond strategy, already declining before COVID-19, have fallen even further since. Lower return potential has shaved more than 2% from expected annualized returns over just two years (Display). Such a low-return environment makes every bit of added return even more precious.

Some might suggest that the answer is reducing costs through low-expense passive investments. But while passive offers cheap market beta, it may also carry hidden risks. For one thing, different approaches to designing passive strategies can create a surprising amount of dispersion in the resulting returns. The performance of a passive strategy that rebalances its exposures to an equally weighted underlying index annually, for example, can differ substantially from a strategy that rebalances monthly. The difference depends on the volatility of the underlying investments—large price movements, up or down, will be amplified in the fund that rebalances less often.

Passive investments also face potential overconcentration in specific sectors or investments that have fared well recently. The technology sector of the S&P 500, for instance, is twice the size of any other sector today, and the top five stocks in the index make up over 22% of the total—up from 11% in 2010. So, simply going passive alone to save on expenses may create unintended risks.

Active management, on the other hand, provides the flexibility to manage risks dynamically and tap into evolving opportunities. That’s critical in a market where generating extra return and avoiding ill-timed drawdowns is crucial to building long-term savings and better retirement lifestyles. For many investors, adaptability in managing risk and the potential to add value is worth the higher expenses of actively managed strategies.

Quantifying the Cost Advantages of CITs

CITs can combine lower expenses and access to active management. As tax-exempt, pooled investment vehicles, they have the cost savings of a separately managed institutional account and the convenience of a mutual fund. Because CITs are available only to qualified retirement plans and certain types of government retirement plans, their marketing, overhead and compliance-related costs are lower than similar mutual funds. At higher levels of invested assets, the savings can be greater.

What might that pricing advantage look like? In the example below, with $50 million in assets, the CIT has a total expense ratio of 0.37%, which includes management fees and operating expenses (Display). That’s much lower than the 0.57% for a mutual fund with no 12b-1 fees or revenue sharing. Even for accounts as large as $100 million, a CIT might be less expensive than a separate account, as the separate account expense ratio is 0.37% plus operating expenses.

Lower Fees Can Have a Big Impact over the Long Run

Just how much can lower fees mean for a plan participant investing for retirement? Over a long period of time, the cumulative impact may be surprising. Even if a combination of lower fees and better returns boosts returns just 1% per year over the participant’s working years and retirement, that improvement could translate into many additional years of retirement spending.

Let’s assume a 25-year old retirement plan participant begins saving 6% of their $40,000 annual salary and bumps up that percentage each year by 0.5% until reaching the maximum 15% contribution. Over that same period, the participant’s salary increases gradually to $65,000 by age 65, with the company matching contributions at 6% of that salary until age 65. Those account contributions are invested in an aggressive strategy until age 40, then follow a glide path as they begin to decrease risk gradually. By age 80, the investments are 100% fixed income.

The bottom line? Over the participant’s 40-year career, the seemingly modest 1% return boost from lower fees and active potential available through a CIT could add up to a nest egg that’s 23% bigger at its peak. And once the participant turned retiree starts spending at age 65, that additional capital translates into 10 more years of retirement spending (Display).

That’s great news for plan participants—and for plan fiduciaries under growing pressure to minimize costs and increase transparency. According to Morningstar, CITs now make up 43% of target-date solutions, up from 29% just five years ago. We believe this trend will continue, as more plan sponsors recognize the benefits of CITs, including lower costs and more transparency, and the impact those lower costs can have over time.