Collective Investment Trusts: The New Wave in Retirement Investing. May 2008

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1 Collective Investment Trusts: The New Wave in Retirement Investing May 2008

2 Collective Investment Trusts: The New Wave in Retirement Investing The SEI Knowledge Partnership is an ongoing source of actionable business intelligence and advice for SEI s investment management clients. It engages clients and industry experts in analyzing the trends and issues that will reshape business conditions in the years to come. The Partnership is designed to help SEI clients: Identify issues Keep abreast of changing best practices Develop more competitive business strategies Its agenda currently centers on issues concerning: Business strategy Marketing, sales, and distribution of investment products Investor and client experience Business and investment operations Legal and regulatory change 2

3 Executive Summary What are CITs? Collective investment trusts (CITs) are an institutional-only investment vehicle aimed at the retirement plan market, including the definedcontribution plan market. They are similar to mutual funds in that they are comprised of pooled assets invested with a specific philosophy and strategy. However, there are several factors that differentiate CITs from mutual funds, including a simpler structure, exemption from the 1940 Investment Company Act, and generally lower operating costs. A growing trend. While CITs have long been available to retirement plan sponsors, this structure has recently attracted renewed interest and is rapidly growing in terms of asset flows and penetration of the 401(k) retirement plan market. In 2006, CITs were found in 41% of defined-contribution plans versus 32% of plans in An estimated $500 billion in assets were invested in CITs as of the end of Based on Morningstar data, CIT assets nearly tripled from 2004 to 2007 and grew by more than 150% between 2005 and 2007 alone. Morningstar also reported getting data on at least 63 new CITs launched between January 2008 and April Collective Investment Trusts: The New Wave in Retirement Investing 3

4 Collective Investment Trusts: The New Wave in Retirement Investing Executive Summary (continued) Factors Driving CIT Growth Demand for retirement solutions. Sponsors of defined-contribution plans are gravitating toward investment products that are more institutionallyoriented and allow for solutions that are robust enough to meet the needs of increasingly outcome-oriented investors. CIT advantage: As an institutional-only structure that can invest in alternative asset classes and vehicles as well as listed securities, ETFs and mutual funds, collective investment trusts provide flexibility in tailoring investment solutions to plan sponsor and participant objectives. They also allow managers to cost-effectively start up new funds and customize allocations for specific plans. Technology advances. New technologies have removed some of the previous obstacles to the use of CITs within retirement plans, including pricing, reporting, and transparency issues. CIT advantage: Today CITs trade on the same platform as mutual funds. Internet connectivity allows plan participants to track performance of their CITs on a daily basis. Public policy. The Pension Plan Protection Act (PPA) of 2006 was a major catalyst for CIT growth, in that it affirmed automatic enrollment of plan participants into tax-qualified plans and outlined qualified default investment alternatives for plans that enjoy certain relief from fiduciary liability. Recent litigation has added to the scrutiny of fees paid by plans and participants. CIT advantage: Thanks to their regulatory status and relatively simple structure, CITs have operational cost advantages that can translate into lower fees. This makes it likely that plan sponsors will increasingly select CITs, or assembled products using CITs, such as target-date and target-risk funds, as plan default options. The ability to negotiate and customize fees is another plus for CITs. Fees may vary among and within plans as long as there is a documented rationale for fee levels. 4

5 Challenges / Requirements Asset managers wishing to offer CITs must deal with a variety of needs and issues. Trustee capabilities. By law, CITs must be maintained by a bank or trust company. This means CIT managers must either be housed within a bank or partner with a bank or trust company. Infrastructure and operating systems. Siloed legacy systems are not likely to be flexible or powerful enough to accommodate CITs. To be competitive, CIT managers will require robust, vehicle-agnostic operating systems. Capabilities include handling a broad range of asset classes and packaging types, real-time pricing, efficient management of recordkeeping, accounting, and fee allocations. Transparency / comparability. Not being subject to SEC disclosure requirements, CITs are less transparent than mutual funds. Management fees, for example, are generally combined into a single trustee fee with no breakdown, making point-to-point fee comparisons with mutual funds more difficult. CITs are also less transparent at an industry level, making their performance and characteristics harder to track, though Morningstar is beginning to remedy this transparency issue. Competition. CITs face competition from ETFs, which can offer similar cost advantages; from separate accounts, despite their cost and complexity; and from mutual funds, which continue to attract assets. Legal and regulatory compliance. While CIT compliance requirements are far less cumbersome than those for SEC-regulated funds, managers offering CITs must deal with applicable banking regulators and specific audit and reporting requirements associated with the CIT structure. Collective Investment Trusts: The New Wave in Retirement Investing A Major Business Opportunity Given the strength and momentum of the CIT trend, it is clear that asset managers will need CIT capabilities to compete in the 401(k) market going forward. CITs also represent a major opportunity for asset managers regardless of size, so long as they can meet the associated challenges and requirements, as outlined above. Managers can take advantage of the CIT structure to enter the 401(k) market or become more competitive within that segment. It also allows managers to quickly and cost-effectively bring new products to market, lower overall operating costs, and even reduce the costs of managing separate accounts. 5

6 Collective Investment Trusts: The New Wave in Retirement Investing Introduction Collective investment trusts (CITs) are an investment structure that has been available to defined-benefit and defined-contribution retirement plans for decades. CITs, sometimes referred to as commingled funds, are similar to the mutual fund structure, in that they pool assets from clients with common investment objectives, but differ from them in a variety of ways. Until recently the popularity of collective investment trusts was limited in part because of their limited transparency and the lack of daily pricing and trading. Through the 1980s and into the 90s, CITs were also overshadowed by the rapid growth of mutual funds as the primary investment vehicle for 401(k) plans. The tide has now reversed. Collective investment trusts are quickly coming to the fore of defined-contribution retirement plan investing for three reasons: Changes in public policy and in the attitudes of plan sponsors are pushing fiduciaries toward more cost-effective investment solutions and more customized pension plan economics. The regulatory status and structure of CITs give them cost advantages that translate into lower, more customizable fees. Sponsors of 401(k) plans are becoming more concerned about the investment outcomes being realized by plan participants. Accordingly, plan sponsors want to be able to offer within definedcontribution plans investment solutions as robust as those that have been available on the definedbenefit side robust meaning solutions capable of delivering the absolute performance and risk/ return characteristics fitting their particular needs. Compared with the mutual fund structure, which has limitations in this regard, CITs are a better fit since they can invest in alternative asset classes and vehicles as well as listed securities, ETFs and mutual funds. Today s advanced technologies, including trading platforms and company intranets, allow plan participants to track their CIT assets and performance on a daily basis, thus removing a major obstacle to the use of CITs in 401(k) plans. Not only have CITs grown rapidly in recent years, this trend is likely to continue based on expected impacts of the Pension Protection Act of First, the PPA s provisions concerning automatic employee enrollment into retirement plans are expected to increase plan participation rates and assets. Second, the PPA s provisions regarding qualified default investment alternatives would support the trend towards low-cost investment alternatives. This suggests asset flows to CITs will continue to rise and may even gain further momentum. While the ultimate extent and full implications of the growth of CITs are not yet known, it is evident that they represent a major and possibly underestimated area of opportunity for asset managers in the years ahead. For those who have yet to enter the 401(k) arena, the CIT structure offers a relatively easier way to gain a foothold; CITs can be established more rapidly and with less expense than mutual funds or separate accounts. From the perspective of those managers who have an established presence and large installed base of mutual funds, CITs represent a potential competitive threat in terms of lowered barriers to market entry. In any case, it is clear that asset managers who want to compete in the 401(k) market will require CIT capabilities going forward and will need to address the number of challenges associated with this investment structure. With this analysis, the SEI Knowledge Partnership hopes to help asset managers understand the dynamics of the unfolding CIT market and better position themselves to capitalize on its growth. 6

7 Trends Favoring CITs Several factors are combining to increase investor and intermediary demand for use of CITs within qualified retirement plans. Growth of U.S. Defined- Contribution Plan Assets The primary market for CITs is 401(k) plans, which account for the vast majority of the definedcontribution plan market. Both the overall U.S. retirement market and its defined-contribution segment are growing significantly (see figure 1, page 7). Since 2002, total assets in U.S. definedcontribution plans have grown by 50%, to $5 trillion. This rate of growth, coupled with changing demand for solutions, make the retirement market fertile ground for new solutions. Figure 1 U.S. Retirement Plan Assets AUM ($ Billions) $16,000 $14,000 $12,000 $10,000 $8,000 $6,000 $4,000 $2,000 $ IRA Private DB Private DC Public Retirement Q 2007E Source: SEI, Investment Company Institute Collective Investment Trusts: The New Wave in Retirement Investing Regulatory Changes The Pension Protection Act of 2006 (PPA) may prove to be the catalyst triggering a major leap in the collective investment trust market. Many employers are scrambling to comply with PPA provisions that clearly permit companies to set up automatic enrollment requirements for their qualified plans, which reflect the need to comply with the qualified default investment alternative requirements of the PPA. These QDIAs can be balanced accounts, life-cycle, or managed accounts. One provision of the PPA mandates that plan sponsors seek out low-cost investment options on their 401(k) menus. This provision is driving business specifically to CITs, given their relatively lower fees. Meanwhile, the Department of Labor has confirmed that certain target-date portfolios (including CITs) qualify as QDIAs under the PPA and therefore are eligible for certain fiduciary liability relief. Legislation relating to fee disclosure has also been introduced in Congress, though no bill has yet been passed, and the Department of Labor has issued proposed fee disclosure regulations. All of these developments are generally pushing employers in the direction of lowercost solutions including CITs. 7

8 Collective Investment Trusts: The New Wave in Retirement Investing Litigation A number of lawsuits have been filed against definedcontribution sponsors over excessive fees charged By increasing the focus on plan fees and avoidance has been investigating fees charged in 401(k) plans. to such plans. The U.S. Supreme Court has recently of losses, these developments encourage plan issued an opinion confirming 401(k) participants sponsors to incorporate CITs into their retirement may sue plan sponsors for breaching fiduciary offerings as a defensive measure against regulatory responsibilities for their individual plan accounts. or participant action. Also, the Government Accountability Office (GAO) Shifting Demand for Retirement Solutions CITs dovetail neatly with the broad trends that are transforming the retirement market. Embedded solutions. Investors growing outcome More flexibility in solution design. Plan sponsors orientation is reflected in the growing popularity and intermediaries are also seeking investment of products such as asset allocation, target-date, solutions that are more robust and flexible and life-cycle funds that incorporate multiple in keeping with changing investor demand. investment products along with an advice Investors generally are becoming more outcomeoriented. Rather than deciding they want to buy a component. CITs lower, more customizable fees make them an attractive element of assembled separate account, mutual fund or ETF, investors and embedded-advice products which tend to be now are seeking solutions that will deliver the relatively expensive to offer. desired characteristics in terms of return, risk, and customer experience, regardless of how Fee pressures. As defined-benefit retirement investments are packaged. This trend gives CITs plans have given way to defined-contribution increased appeal. It also forces asset managers plans, plan sponsors have become more competing in the 401(k) market to become more conscious of plan costs and fees; increasingly vehicle-agnostic and more willing to package they also seek the same fee customization they their expertise in a variety of ways, despite the enjoyed under defined-benefit plan structures. operating complexities involved. Technological advances. Today s faster networks and widely available connectivity are enabling the CIT trend in that they eliminate the transparency and reporting advantages mutual funds formerly had. Plan participants can now go to a website and look up the value of their CITs on a daily basis. 8

9 What are Collective Investment Trusts? In several major respects, CITs are similar to mutual funds. They are a vehicle through which qualified retirement clients with common investment objectives can pool assets into a single portfolio that is invested with a specific philosophy and strategy. As with mutual funds, investors benefit from economies of scale. CITs likewise may invest in a wide range of active or passive investment strategies, asset classes, and vehicles, including equities, fixed-income, alternatives, mutual funds, and ETFs. In fact, many mirror popular mutual funds. There are, however, several important points of difference between CITs and mutual funds. Key Characteristics of CITs Collective Investment Trusts: The New Wave in Retirement Investing Availability. CITs are inherently an institutional product. They may be sold only to qualified retirement plans, including defined-contribution, defined-benefit, 401(k), Taft-Hartley and public 457 plans. They are not publicly offered, which is one of the keys to their lower start-up and operating costs. Regulation. CITs are exempt from Securities and Exchange Commission (SEC) registration under both the 1933 Securities Act and the 1940 Investment Company Act. Rather, they come under the jurisdiction of the Trustee s applicable bank regulator. Not being subject to SEC rules means that CITs operate with fewer trading restrictions and lower compliance costs. Management. Only banks or trust companies may maintain CITs, which may be advised by a bank asset manager or subadvisor. Technically, the trustee could replace the asset manager if performance is unsatisfactory. Growing Appeal The regulatory status, simpler structure, and institutional-only availability of CITs generally result in lower start-up and operating costs; these cost savings can be passed on to participants via lower plan fees. Their cost advantage combined with their investment flexibility makes them especially wellsuited to 401(k) plans. In the past, the lack of transparency and daily valuation and reporting capability blocked the use of CITs in the 401(k) market. But all that has changed with advancing technology. Thanks to improved networks and connectivity, collective investment trusts can now be priced on a daily basis. Investors can also track the daily net asset values of CITs online. A pivotal development was the November, 2000 action by the National Securities Clearing Corporation (NSCC) allowing CITs onto its Fund/SERV settlement platform. This allowed CITs to be traded and tracked the same way as mutual funds. (Note that in this context, trades actually reflect participant contributions and withdrawals since CITs themselves are not traded.) 9

10 Collective Investment Trusts: The New Wave in Retirement Investing CIT Growth Trends Since NSCC trading and other technological and regulatory developments have made CITs suitable for use in 401(k) plans, they have rapidly increased in popularity. At this point, most of the major players in the 401(k) market have CIT offerings. Morningstar now tracks more than 800 CITs representing a total of more than $500 billion in AUM, and the total number of funds that exists may be much greater. Based on anecdotal information, they continue to proliferate in number and variety. CITs have been embraced by all categories of defined-contribution plan sponsors and by large and small asset managers alike. While early growth trends are difficult to pinpoint accurately due to changing methods of tracking asset flows on trading platforms, it is estimated that the assets allocated to CITs within definedcontribution plans nearly tripled from 2004 to 2007 and grew by more than 150% between 2005 and 2007 alone (see Figure 2, page 10). Since many CITs do not trade on the NSCC system and some major players in this market do not release CIT statistics, the total assets currently allocated to CITs and their growth momentum may be significantly greater than indicated by this data. Gaining Presence in DC Plans The growing popularity of CITs can also be traced in While it is clear that CITs will not be eclipsing mutual terms of their utilization within defined-contribution funds in the retirement plan world anytime soon, they plans. In 2006, CITs were found in 41% of plans, are making significant inroads and are replacing retail a sizable jump from 2003, when they were offered mutual funds in some retirement plans. by 32% of plans (see Figure 3, page 11). During The PPA appears to support the inclusion of low-cost the same period, the portion of plans offering retail options in 401(k) plans; it is likely that a growing mutual funds dropped from 65% to 54%. number of plan sponsors will adopt CITs as a default Measured by total assets under management within option or as a vehicle in default target-date or targetrisk these various retirement investing vehicles, mutual options. funds have remained dominant in terms of both dollar amounts and their pace of asset growth Figure 2 Growth of Assets Under Management in CITs (see Figure 4, page 11). Separate accounts also made substantial gains in assets through Meanwhile, CITs grew steadily and, as shown in Figure 2, surged upward dramatically in Collective Trust AUM ($ Billions) E Source: SEI, Morningstar 10

11 CITs represent an important and growing area Among segments of the 401(k) market, the smallplan market has particular growth potential. It is of opportunity for asset managers who can take advantage of the CIT structure to enter the 401(k) estimated that up to 80% of small businesses do not market or become more competitive within that have retirement plans. segment. Managers can bring new products to Not only is the trend toward adoption of CITs still in market with relatively short lead times and low startup costs which lessen their overall operating costs. its early stages, the strength of the trend may be even greater than indicated by the available data. Lacking They can also lower the high costs of managing the information infrastructure necessitated by SEC separate accounts by converting them into collective regulation, the CIT industry has limited transparency. investment trusts. Presently it is difficult to identify who all the Figure 3 Utilization of Investment Vehicles in Defined-Contribution Plans key market players are (by percentage of plans) and the size of their presence. A review of AUM ($ Billions) Source: SEI, AITE Figure 4 Defined-Contribution Plan Assets, by Investment Vehicle AUM ($ Billions) An Unfolding Business Opportunity 100% Managed Accounts Separate Accounts Collective Trusts 80% Retail Mutual Funds Institutional Mutual Funds 60% 40% 20% 0% $1,600 $1,400 Variable Annuity Company Stock Collective Trusts $1,200 Separate Accounts Mutual Funds $1,000 $800 $600 $400 the currently available data does suggest that most of the major competitors in the 401(k) market have initiated CIT solutions. While Morningstar and others have increased their coverage of CITs, data from these sources and the NSCC platform are not allinclusive; also, some major players in this market do not release CIT statistics. Thus, asset managers may well be underestimating the potential of the CIT market. Collective Investment Trusts: The New Wave in Retirement Investing $200 $ Source: SEI, AITE 11

12 Collective Investment Trusts: The New Wave in Retirement Investing Advantages of CITs The CIT structure offers plan sponsors, asset managers and investors a variety of advantages relative to other vehicles. (See figure 7, page 17, for a comparison of CIT vs. mutual fund characteristics.) Ability to Offer Robust Retirement Solutions Because CITs can invest in alternative asset classes and vehicles as well as listed securities, ETFs and mutual funds, they offer more flexibility in tailoring investment solutions to plan sponsor and participant objectives. The CIT structure allows managers to cost-effectively develop custom allocation portfolios for specific clients. This could be a particularly notable opportunity for small managers to compete by establishing CITs catering to smaller pension plans (< $100M), a market segment usually overlooked by large asset managers. Operational Simplicity and Flexibility Because CITs are offered exclusively to institutional investors, they avoid many of the administrative burdens involved in offering vehicles through multiple distribution channels, including recordkeeping, tracking, trading and fee allocation. As an institutional product that is free of SEC regulation and the complexities of marketing directly to retail investors, CITs also entail far less effort and expense in the areas of compliance, administration, advertising and marketing. Managers avoid the costs of printing materials such as proxies or prospectuses; instead, CITs are governed by a trust document and may issue a much shorter and simpler disclosure statement for investors. Nor need CIT managers deal with participant-level recordkeeping, field retail investor inquiries, or set up toll-free call centers. These advantages let asset managers offer new investment products and strategies quickly and with lower start-up costs. CIT operations can be further simplified by taking advantage of turnkey CIT services, including administration, operations, processing and reporting to both asset managers and plan sponsors. More Efficient Trading Mutual funds within 401(k)s can often find their trading hampered by short-term trading rules, redemption fees, Rule 22c-2 and other constraints. This gives plan sponsors one more reason to move toward CITs. is less risk of market timing and trading abuses. This, together with the fact that CITs are not under SEC jurisdiction, enables them to be managed with less restrictive and costly rules for trading of underlying securities. Because CITs are not sold directly to retail investors and cannot be purchased by hedge funds, there 12

13 Lower, More Customizable Fees CITs gain a major cost advantage from their relatively less complex administration and operations. These cost savings can be passed on to clients in the form of lower fees. As an example, a comparison of average fees for a CIT and an institutional large-cap equity mutual fund shows the average CIT fee is 26 bps lower, with the advantage attributable to lower operational expenses (see Figure 5, page 13). CIT fees can range as low as 0.25% and at least one instance has been noted of a CIT with total fees less than 0.10%. Such comparisons should not be taken as hard and fast evidence that mutual funds always have a cost disadvantage, since fees obviously vary widely based on share and asset classes. A comprehensive, applesto-apples comparison would be far more granular and complex. Average fee data does, however, illustrate the point that CITs offer operational savings that typically translate into lower fees. This is confirmed by comparing median expense ratios for institutional mutual funds across a variety of asset classes with those for comparable CITs (see Figure 6, page 13). The compounding of even marginally lower fees can contribute significantly to performance over time. The resulting gains are not insignificant, especially over the long time span leading to retirement age. By way 0.80% 0.60% 0.40% 0.20% of example, $10,000 invested in an S&P index fund 0% Management Operational 12b-1/ Total 30 years ago would have grown to $335,270 today, Fees Expenses Recordkeeping Expenses based on the average fee. The same investment Source: SEI, Strategic Insights, AITE in a CIT that is identical except for having a fee 26 bps lower (the average difference from a Figure 6 Median Expense Ratios: CITs vs. Institutional Mutual Funds large-cap equity mutual fund) would have compounded to 1.40% $361,563 an added gain of 1.20% Collective Investment Trusts Mutual Funds more than $26, % Another major selling point for CITs is that their fees are flexible and somewhat negotiable. While pension plans are locked into the fees set by their mutual funds and can only vary them from share 0.80% 0.60% 0.40% 0.20% 0% Intermediate Term Bond class to share class, collective investment trusts can adjust their fees based on certain plans needs and assets under management. Thus, managers can offer a better pricing structure to plans for which they manage more assets. Within this framework it is also easy for CITs to add new fee classes within each trust, and have expense break points based on different asset levels. It is important to note, however, that the fee flexibility of CITs is not unlimited. To the extent that fees differ within and among plans, it is necessary to have a documented rationale for the fees negotiated. It should also be expected that regulators will inquire about CIT fee structures and challenge variations that appear unsupported. Figure 5 Comparison of Average Fees for CITs vs. Institutional Large-Cap Equity Mutual Funds 1.40% 1.20% 1.00% Collective Investment Trusts Mutual Funds International Large Growth Large Value Small Growth Small Value Source: SEI, AITE Collective Investment Trusts: The New Wave in Retirement Investing 13

14 Collective Investment Trusts: The New Wave in Retirement Investing Challenges Ahead For asset managers, collective investment trusts currently represent another opportunity to compete in the 401(k) market and a chance to take advantage of a potentially major trend that is still in its early stages. CITs are expected to continue gaining market share in terms of the number of defined-contribution plans utilizing them and some analysts predict that CITs will completely replace mutual funds in some company pension plans. But this scenario holds some uncertainties. CITs do face competition as plan sponsors low-cost solution of choice. Additionally, the CIT structure itself presents issues and requirements that must be addressed if this evolving market is to continue on its current growth trajectory. Operations and Infrastructure While their relative operating simplicity is a major selling point for collective investment trusts, CITs pose certain specific requirements that add other dimensions to asset manager operations. Establishing the necessary infrastructure for CITs may also require upfront investment and lead time that managers should factor into their market strategy. Better, faster connectivity has been a key factor enabling the CIT phenomenon. But more technology advances are needed to continue evolving processing and accounting systems that can deliver the capabilities CITs demand. Specifically, they require operating systems and technologies that can: Efficiently handle the full range of investments available to CITs. Provide real-time pricing of all assets, including alternative and unlisted securities or products. Manage recordkeeping issues raised by bundling of trades, which can be key to controlling transaction costs that are incurred through active trading and can undercut the cost advantages of CITs. Accurately allocate fees, which can vary among plans and participant categories, through distribution channels. Adjust for daily, weekly or monthly net asset value. Many asset managers still operate with siloed legacy systems that would hamper their ability to manage CITs. Those who are serious about competing in the 401(k) market will need vehicle-agnostic operating systems. Outsourcing these operations is an obvious solution, but providers of outsourced CIT operating capabilities are still relatively few in number and some of those in this market are still coming up to speed in terms of their capacity and flexibility. 14

15 Collective Investment nt Trusts: The New Wave in Retirement Investing Competition from Other Vehicles Several competing investment vehicles could attract a greater share of retirement assets in the future, undercutting CITs growth momentum. These include: Self-directed brokerage accounts. Some 401(k) plans now allow participants to set up their own accounts within a plan. On the plus side, this can give participants access to a large menu of investment options, potentially including hundreds or even thousands of mutual funds along with ETFs and CITs. This approach does cost participants more, however, as it entails an additional account fee. This retirement scheme could become more popular in the future, since it gives participants more choice while also shifting some responsibility for selecting investment options away from the plan sponsors. ETFs. Exchange-traded funds are growing in variety and offer a cost advantage similar to that of CITs. The average expense ratio for ETFs is 0.59%, the same as the expense ratio for the average indexed domestic equity mutual fund and substantially less than the 1.54% average expense ratio for actively managed equity mutual funds. From that standpoint ETFs are competitive with or have some advantage over CITs, which have an average expense ratio ranging from.55% to.96% for equity strategies. In recent years ETFs have gained assets dramatically and could continue to do so, undercutting the momentum in growth of CITs. At the same time, CITs can themselves invest in ETFs; moreover, they can add value by helping investors select and diversify among the ETFs available. Some CITs have already been designed to hold ETFs exclusively, combining them to build an investment strategy just as stocks or bonds would be in a traditional mutual fund. This provides a cost savings of approximately 60 to 80 bps per CIT, compared with expenses of a mutual fund holding the same ETFs. Separate accounts. This is yet another competing investment option that is gaining assets, despite the cost and operational challenges they entail. Mutual funds. Still the most popular retirement plan vehicle by a wide margin, mutual funds continue to gain assets, thanks to their advantages of incumbency, variety, and familiarity. In the future, asset managers conceivably could also find ways to evolve the mutual fund structure. 15

16 Collective Investment Trusts: The New Wave in Retirement Investing Marketability Issues Asset managers need to be aware of some aspects of CITs that could be of concern to plan sponsors or participants. Transparency. As CITs are not subject to the same disclosure requirements as SEC-registered funds, they are relatively less transparent than mutual funds. Fee transparency is a particularly sensitive issue. Because all CIT fees are combined into a single trustee fee with no breakdown, plan sponsors have no basis for point-to-point fee comparisons with mutual funds. This characteristic of CITs, together with the lack of SEC oversight, may raise some concern for some plans sponsors and investors. This may be addressed at some future point by pending legislation and/or pending regulatory action. Asset Rollover. Participants who are moving to a new employer cannot simply roll over the CITs in their plan, for a few reasons: CITs are customized to specific objectives and preferences, they do not trade on the open market and they are offered by a bank or trust company specifically for its own clients. Employee options are to: however, leaves the door open to the possibility that a plan participant could liquidate their mutual fund holdings and reinvest in it (or a similar fund) within the framework of an IRA. With CITs, plan participants generally could not find an identical investment solution outside the 401(k) plan. This could become an asset retention issue for managers, depending on redemption rates. Comparability. CITs do not trade on the market and are generally less transparent than mutual funds since SEC disclosure mandates do not apply. At this point, the information infrastructure for the CIT market is also quite limited. For all these reasons, CIT performance and characteristics cannot be tracked as readily as those of mutual funds. This makes it difficult to penetrate beyond apples-and-oranges comparisons between CITs and mutual funds. Firms such as Morningstar are beginning to fill this gap, however. Morningstar now tracks more than 800 CITs based on over 700 data points, including underlying holdings, gross returns and net monthly returns. Liquidate the CIT and roll over the cash proceeds into an IRA. Neither the CIT nor its underlying securities may be transferred to the IRA. Simply maintain the CIT investment within the plan, if the plan permits this, subject to any dollar thresholds stipulated. There is little apparent difference between mutual funds and CITs when it comes to portability. The sheer number of mutual fund choices available, Retirement plan constraints. CITs may not be used by 403(b) plans, a category which includes many teacher and nonprofit organization pension plans. Investor education. To support growth of this market, asset managers need to do a better job of educating investors about CIT options and helping them understand the differences between CITs and mutual funds with similar strategies and holdings. 16

17 Legal and Regulatory Compliance CITs are generally exempt from SEC regulation by section 3(c)(11) of the Investment Company Act of 1940 (although certain CITs may seek to comply with other exemptions of the Investment Company Act, including 3(c)(1) and 3(c)(7)). Instead, CITs are subject to the oversight of applicable banking regulators and the U.S. Department of Labor and must comply with applicable laws and regulations. While compliance requirements for CITs are less restrictive than those for SEC-registered vehicles, dealing with a second distinct regulatory framework could complicate managers overall compliance efforts. Managers offering CITs will also need to track and address the evolution of their regulatory framework. CITs could be affected by two currently pending bills addressing pension and 401(k) plan fee disclosure, as well as by any future legislation concerning these issues. As of this writing, the 401(k) Fair Disclosure for Retirement Security Act introduced by Rep. George Miller has passed in the House of Representatives. It should be noted that to date, there is no specific industry association with CITs as its sole concern; nor is there one key regulatory body overseeing them. This means that efforts to track CITs or address public policy issues affecting them have been scattershot and may remain so for the foreseeable future. Collective Investment Trusts: The New Wave in Retirement Investing Product Evolution To maintain a competitive advantage within the complex and fast-changing pension investment arena, managers offering CITs must make sure they stay abreast of evolving investor demand, changing market conditions and innovations in other investment vehicles. For example, they will need to consider: How to respond to the market demand for embedded investment advice. How to balance the needs of the plan sponsor with investor-specific outcomes. How to address competition from managers using other vehicles. How the cost advantages of CITs will be affected as baby boomers reach retirement age and a growing number of retirees begin withdrawing plan assets. Figure 7 Overview of CIT vs. Mutual Fund Characteristics Item Collective Funds Mutual Funds Costs Lower; somewhat negotiable Higher Share Classes Multiple Fee Classes Multiple Share Classes New Share Classes Easy to open quick turnaround Expensive and time consuming Private Label Easy Difficult Tracking Morningstar, evestment Alliance, etc. Morningstar, Newspapers, etc. Flexibility Higher Lower Redemption Fees No Yes Trading Restrictions No Yes NSCC Trading Yes Yes Open to Non-Qualified Investors No Yes Portability Limited cash out only Limited cash out only 17

18 Collective Investment Trusts: The New Wave in Retirement Investing Conclusion With investors of all types becoming increasingly outcome-oriented and pension plan sponsors seeking more robust and economical investment solutions, asset managers offering retirement solutions will need to be able to package their expertise in a variety of ways. This trend toward vehicle-agnostic solutions has major implications for asset managers business strategy and competitive positioning, as well as their operations. It is also leading plan sponsors to gravitate toward investment solutions that are institutional in nature. As an institutional-only product with the advantages of flexibility, cost and customization, CITs are benefiting from broad retirement market trends, as shown by the dramatic pace of their recent growth. Public policy is also driving assets toward CITs. Given all these factors, it is clear that asset managers will need CIT capabilities to compete in the 401(k) market going forward. In order to offer CITs, however, managers must be able to meet a number of requirements, including: Trustee capabilities. By law, CITs must be maintained by a bank or trust company. This means CIT managers must either be housed within a bank, or partner with a bank or trustee company. Robust infrastructure and operating systems. CIT managers require systems that are flexible and powerful enough to handle a broad range of asset classes and packaging types, real-time pricing and efficient management of recordkeeping, accounting and fee allocations. Outsourced and turnkey operating solutions are available, though the number of providers is still relatively few and their capabilities vary widely. Distinct compliance requirements. While the legal and regulatory requirements applicable to CITs are far less complex and cumbersome than those for SEC-regulated funds, managers offering CITs must deal with the applicable federal and state regulators and with the specific audit and reporting requirements associated. At the same time, the relative simplicity, costeffectiveness and flexibility of the CIT structure allow managers of all sizes to compete for this business. CIT economics also make it possible to develop custom investment solutions for even the smallest retirement plans, thus opening up market niches that large players typically overlook. To be competitive in the fast-evolving 401(k) market, asset managers will need to gear up to fulfill the distinct organizational, operating, and compliance requirements of CITs. Those who can meet these requirements and offer robust, customizable investment solutions packaged as CITs will have a major opportunity to capitalize on an emerging and accelerating trend. 18

19 About SEI SEI (NASDAQ:SEIC) is a leading global provider of outsourced asset management, investment processing and investment operations solutions. The company s innovative solutions help corporations, financial institutions, financial advisors and affluent families create and manage wealth. As of December 31, 2007, through its subsidiaries and partnerships in which the company has a significant interest, SEI administers $426 billion in mutual fund and pooled assets and manages $197 billion in assets. SEI serves clients, conducts or is registered to conduct business and/or operations, from more than 20 offices in over a dozen countries. SEI s Investment Manager Services division provides total operations outsourcing solutions to global investment managers focused on mutual funds, hedge and private equity funds, exchange traded funds, collective trusts, separately managed accounts and institutional and private client services. The unit applies operating services, technologies and business and regulatory knowledge to each client s business objectives. Its resources enable clients to meet the demands of the marketplace and sharpen business strategies by focusing on their core competencies. Collective Investment Trusts: The New Wave in Retirement Investing SEI s Comprehensive Services for Collective Investment Trusts SEI offers a comprehensive, fully integrated operating environment to support the specific needs of collective investment funds. We have nearly twenty years of CIT experience and currently service nearly 100 collective funds representing more than $25 billion in assets. As one of the leading providers of collective funds and pooled investment products, SEI provides all the required trustee, investment management, accounting, administration, transfer agent and plan level servicing, allowing investment managers to: Bring products to market quickly, taking advantage of the growing interest in CITs. Focus on product management and growing and retaining assets. Leverage SEI s fully-scalable, flexible infrastructure to match your evolving CIT needs. Establish multiple fee structures and provide fund level transparency and performance reporting. Offer a simpler, more attractive product structure to access growing retirement plan markets, especially smaller pension plans and plans looking for a customized solution. To learn about SEI s Collective Investment Trust services, please contact us: / ManagerServices@seic.com / 19

20 1 Freedom Valley Drive Oaks, PA This information is provided for education purposes only and is not intended to provide legal advice. SEI does not claim responsibility for the accuracy or reliability of the data provided. Information provided by SEI Global Services, Inc. Additional research and sources compiled from AITE, Morningstar, Lipper, Strategic Insights and the Investment Company Institute (ICI) SEI Investments Developments, Inc /08