Active & Passive Inflation Plan Design Target-Date Solutions Blog

CITs

Small Changes May Produce Better DC Participant Outcomes

26 October 2021
5 min read

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.

Projected 10-Year Annualized Returns Have Fallen Sharply Post-Pandemic
Bar chart of projected returns for 60/40 portfolio: 5.4% in 2018, down to 4.5% in 2019, and 3.1% as of 2020.

Data do not represent past performance and are not a promise of actual results or a range of results. 
Hypothetical portfolio consists of 60% stocks and 40% bonds. Stocks are represented by a universe similar to the MSCI World Index; bonds are represented by 60% global investment-grade bonds and 40% global sovereign bonds; both are reported in and hedged into US dollars.
As of December 31, 2020
Source: AllianceBernstein (AB)

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.

CITs Offer Advantageous Pricing and Active Management
Fee levels from $0-250 million. Fund static at 0.57%. CIT from 0.39% to 0.35% at 100 mil. Separate account 0.45% to 0.31%.

For illustrative purposes only. 
There can be no assurance that any of the above-cited advantages will apply to a particular CIT or similar investment product or service. Display shows total expense ratio for a mutual fund and CIT, including operating expenses. Expense ratio for separate account does not include operating expenses.
Source: AllianceBernstein (AB)

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).

The Power of Modest Return Improvements
Improving investment returns by just 1% per year on average over the course of a working career has the potential to make spending last for 10 additional years. That can make the difference between participants sustaining their lifestyles in retirement or not.
Area graph shows fee savings and extra return can add 23% at fund peak, and 10 years of spendable income.

Results are simulated. This is a hypothetical illustration only.
The savings phase simulates a defined contribution participant salary of $40,000 at age 25, linearly increasing to $65,000 by age 65, making yearly contributions of 6% of salary at age 25 increasing by 0.5% per year to a maximum 15% with a 100% company matching contribution up to the first 6% of salary. In the spending phase, assuming an estimated $22,750 (35% of final salary) benefit from Social Security, $35,750 (55% of final salary) is deducted at the beginning of each year. A yearly investment return of 5.6% is assumed until age 40, then linearly decreasing to 2.5% at age 80 and remaining constant thereafter. In the ""1% Greater Return Scenario,"" a yearly investment return of 6.6% is assumed at age 25, linearly decreasing to 3.5% at age 80 and remaining constant thereafter. Inflation is assumed to be a constant 1.9% and dollar values are expressed in real purchasing power terms.
Source: AllianceBernstein (AB)

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.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams. Views are subject to revision over time.

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