Morningstar - Q3 2020 - 14

Dispatches

company. They are managed in accordance with
common investment strategies. Individual
investors cannot buy CITs. However, many kinds
of retirement plans-such as 401(k) plans,
other qualifying defined-contribution or definedbenefit plans, and government 457(b) plans-may
invest in CITs.
CITs can offer a significant benefit to workers
saving for retirement: reduced expenses.
Morningstar's analysis demonstrates that CITs are
often a more affordable investment option
for retirement investors than mutual funds. CITs
are not marketed and regulated in the way that
mutual funds are. This means that CITs'
administrative and regulatory costs generally
are lower than those of mutual funds and that
they have lower expense ratios.

In fact, in many cases, firms offer CITs and
mutual funds for the same investment strategy,
allowing us to compare the net expense
ratio of CIT tiers and mutual fund share classes
of the same strategy. In an estimated 91%
of cases, the CIT version of the strategy is cheaper
than the mutual fund version.2 Even when
we consider only the least expensive CIT tier and
mutual fund share class, CITs are still cheaper
82% of the time.
We found that the asset-weighted average
expense ratios of both active and passive
CITs are roughly half those of their mutual fund
counterparts. The table below demonstrates
that across all investment strategies, as
of year-end 2019, the average active and passive
CIT is cheaper than the average active and
passive mutual fund.3
Average Asset-Weighted Expense Ratio (%)
Active

Passive

Mutual Fund

0.65

0.08

CIT

0.37

0.05

Source: Morningstar.

There are limitations to comparing CIT and
mutual fund costs via net expense ratios alone,
however. This is because of the types of
expenses each investment type does and does
not incorporate into its ratio. The mutual fund
expense ratio often includes subtransfer agency
fees, and the management fee of the mutual
fund may be higher because of revenue-sharing
arrangements that support the distribution
of the fund. These fees generally offset the direct
administrative costs plans pay to recordkeepers;
meanwhile, plans offering CITs would be billed
separately for the services. Because subtransfer
agency and revenue-sharing expenses are
not reported explicitly, they cannot be deducted
from the mutual fund net expense ratio
to allow for an apples-to-apples comparison
with CIT expense ratios. Instead, it can be
more beneficial to consider the total cost of plans
that offer each type of investment, bringing
together the plan administrative fees and
investment expenses.
The overall cost of 401(k) plans that offer CITs
further supports the notion that the presence of
CITs in a retirement plan reduces its average
expenses. Using the Morningstar retirement plan
database, we can calculate an asset-weighted
expense ratio for each plan by matching
the investments reported by defined-contribution
plans with managed investments (mutual
funds, exchange-traded funds, CITs, and so on),
based on the distribution of the plan's assets
across the investment options.
For the purposes of comparing plans, we bucketed
plans into asset ranges (up to $1 million in assets,
between $1 million and $5 million, $5 million
and $10 million, $10 million and $25 million, and so
on). We then could capture a benchmark of
investment expenses, plan expenses, and overall
costs for plans in that size range.
We found that the median asset-weighted
investment expense ratio of plans with at least

one CIT is at least 10 basis points cheaper
than the median cost of plans without CITs for all
ranges over $25 million in assets. CITs often
have higher minimum investment amounts than
mutual funds and, therefore, are less common
in plans with smaller asset bases.
Plans under $25 million in assets with a CIT
are more likely to include a limited number of CITs,
such as a stable-value offering, rather than
using CITs for their full investment lineup.
As expected, the benchmark plan administrative
fee for 401(k)s with CITs is slightly higher
than for those without; however, the overall cost
is consistently lower. The higher administrative
expenses reflect that plan administrative fees are
directly billed to participants rather than
embedded in the expense ratio of a mutual fund.
With the reduced overall cost, this analysis
demonstrates that plans with CITs are, on average,
less expensive than those without, while
potentially offering more transparency into the
types of fees the participant is paying.
How the CIT Legislation Could Be Improved

While we support new legislation that would allow
403(b) plans to offer CITs to their participants
and we believe it would make lower-cost options
available to potentially millions of publicservice workers saving for retirement, we believe
the bill could be improved.
We think the bill needs to include more safeguards
for participants. Specifically, we believe that
the CITs permitted in 403(b) plans should be limited
to those already included in plans covered by
the ERISA, such as 401(k) plans.4
CITs in 401(k) plans already are connected with
ERISA, allowing ERISA plan participants to
bring an action against the trustee if the trustee
has violated its fiduciary duty. While CITs
generally are considered low-cost products and
we are unaware of any actions in recent
history alleging wrongdoing in the CIT marketplace,

2 This estimate incorporates some double-counting because multiple tiers and share classes can be from the same strategy.
3 While the Morningstar CIT database is comprehensive, covering more than 6,700 CIT tiers, the most competitive CIT fees are negotiated on a client-by-client basis and, therefore, not reported
to public databases.
4 About 9,000 403(b) plans are covered by ERISA. These plans also are generally prohibited from offering CITs, although a smattering of plans have used novel mechanisms to offer modified CITs.
Some church plans have a clearer path to offering CITs.

Morningstar Q3 2020

Morningstar - Q3 2020

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