PSNC 2020: Moving the Investment Menu Beyond Mutual Funds

At the virtual panel “Moving the Investment Menu Beyond Mutual Funds,” held as part of the 2020 PLANSPONSOR National Conference, Todd Kading, president and co-founder, LeafHouse Financial, said his company works with 1,000 advisers in all 50 states and Puerto Rico as a 3(38) fiduciary to help with investment selection. All told, LeafHouse serves several thousand plans and 1 million participants with $12 billion in assets. From this position of strength, “we can offer scalability to advisers and bring pricing you would ordinarily see only among mega plans to smaller plans and even startups,” Kading said.

This enables LeafHouse to suggest funds other than mutual funds, such as collective investment trusts (CITs), separate accounts and exchange-traded funds (ETFs), he said.

In explaining the differences between the various investment options available to sponsors, Kading said that under the Investment Company Act of 1940, “mutual funds are regulated by the SEC [Securities and Exchange Commission]. Costs are built into share classes, and they are sold via prospectuses. They are expensive to set up and the minimum is high.”

CITs are overseen either by state regulators or the Office of the Comptroller of the Currency (OCC), Kading continued. “A participation agreement has to be signed, the trustee oversees it, and it is limited to corporate retirement plans,” he said.

“Separate accounts can be offered in an ERISA [Employee Retirement Income Security Act] plan, but it is more complicated to do so,” Kading said. “An insurance company creates an investment structure governed by the state, and they are typically put inside CITs.”

As for how ETFs operate, Matthew McLaughlin, senior vice president, institutional consulting director, Graystone Consulting, said, “ETFs have become extremely popular among investors. They tend to be lower cost than mutual funds and can be traded during the day, so people can manage their portfolio more actively.” ETFs really only make sense for small plans that cannot get institutional pricing, McLaughlin said.

The University System of Georgia (USG), which consists of 26 public colleges and universities, had a separate retirement plan for each of these entities, with a total of 600 investment options, said Lisa Joe, director of retirement programs and services at the University System of Georgia. Today, the system has a 403(b), 401(a) and 457 plan that offer only 10 to 12 investments in each, along with a brokerage window for those who want to invest in an ETF or individual stocks or bonds, Joe said.

The lineup also includes CITs because of their lower cost, she said. “Pricing was the most important consideration, along with maintaining the same investment strategy that was in the institutional mutual funds,” Joe said.

Along with that, the system replaced a stable value fund as its default with a Vanguard target-date series, she said. However, it kept the stable value in the lineup, she noted. “It was important for us to keep that in our program because it provides a higher yield than some other short-term investments,” Joe said.

In making the change, the system relied heavily on its recordkeepers, TIAA and Fidelity Investments, to communicate to participants the differences between mutual funds and CITs, she said.

Kading noted that, in recent years, smaller plans have added CITs to their lineups. He stressed that they offer wonderful advantages, most important of which is “dramatically decreasing the price of active management by as much as 40%.”

However, regulations preclude 403(b) funds from using CITs, he noted. For those plans, he said he makes it a point to negotiate better prices from mutual fund providers.

McLaughlin noted that one of the big differences between mutual funds and CITs is that CITs typically have 50 to 60 stocks in their portfolio, whereas mutual funds typically have 200. “It could be argued that perhaps the 60 CIT stocks are the best ideas and all those other stocks in a mutual fund are fillers to add liquidity,” McLaughlin said. “It is the adviser’s job to track performance.”

“The other half of the equation is that the administration and operations of CITs are more complicated and require product research into their assets and the CIT’s relationship with the trust company,” McLaughlin continued. “Is the trust company solid?” For the answers to these questions, sponsors need to rely on advisers, he said.

To this point, Kading said, “We have an investment desk tearing these things apart.” In one case, for instance, LeafHouse discovered that a popular large-cap growth mutual fund that created a CIT clone was delivering returns 2 percentage points lower in the past two years.

He said separate accounts “are insurance wrapped investment vehicles that decide the underlying investments and fees. You often find these in group variable annuity contracts. Those structure could mimic what you are doing in CITs at even lower expenses.”

However, separate accounts are not common in ERISA plans, Kading reiterated.