Retirement savers are about to face a barrage of unfamiliar investment vehicles that the financial industry is seeking to unleash upon them. Public officials, staff and consultants for governmental defined-contribution plans need to make sure that the delivery vehicle vendors are likely to pitch for them, known as a “collective investment trust” (CIT), is built to last.
For decades, most of these public-sector 457, 403(b) and 401(a) plans have stocked their investment menus with Securities and Exchange Commission-registered mutual funds. Typically, those vehicles have focused their investments on diversified portfolios of market-traded stocks, bonds and exchange-traded instruments. Employee-participants have enjoyed daily liquidity — the ability to transfer from one fund to another overnight at market value.
Today, however, the defined-contribution industry is facing a strong push by the managers of alternative assets like hedge funds, private equity and private credit funds, and even crypto, to wiggle their way into the retirement-savings marketplace by using CITs to house them. They seek to sidestep 80 years of established fiduciary law and regulations. In the private-sector 401(k) industry, a relaxation of federal fiduciary obligations has been a key objective that went all the way to a 2025 presidential executive order to relieve employers of litigation risks that they have feared when offering these non-traditional alternatives in their investment menus. It’s now caveat emptor for plan participants and gatekeepers.
For governmental defined-contribution plans that already were exempt from private-employer regulations, these new twists on legal and fiduciary liability have been a secondary consideration: They are the tail of the dog in this industry, which builds its investment products for private-sector 401(k) plans first and then offers them to governments as a product-line expansion.
So these new alternative investments will not be purpose-built for government employees. And as often said in the industry, they will be sold, not bought. Very few 457 plan oversight committees are actively crafting RFPs to demand these vehicles in their menus, although it’s foreseeable that the consultants for large plans will bring them up so that the consultants don’t look oblivious to broader industry trends.
Interestingly, one of the forebears of today’s collective investment trusts in the 457 world was sponsored by the International City/County Management Association back in 1972. A distinctive feature of their investment vehicle was the fiduciary oversight provided by a unique advisory council largely composed of public officials and participant municipal employees.
While that itself does not guarantee performance, vigilance or suitability, it’s an instructive feature for a point of comparison with the governance structures and business purposes of many of the newer CITs that will be formed simply to peddle alternative investments. At a minimum, plan sponsors and their oversight committees will do well to check into the composition, governance and structure of any CITs that they might admit into their investment-plan menus. Are they just paper shells, or do they actually perform a meaningful fiduciary or watchdog function? And who are the watchdogs?
The Challenge for Gatekeepers
This then brings us to what’s inside these CITs. Are they carefully designed to benefit the investor or only their managers? Some will ultimately prove to be suitable for public-sector plans, but others won’t. If investment markets have entered a bubble phase, as many fear, an ensuing blowout is likely to crush the flimsier CITs. Today’s red-hot market for goliath initial public offerings is spawning a new generation of untested investment deals and instruments targeting the little guy. Therein lies the challenge for consultants and oversight committees.
The first question for gatekeepers to ask is whether a proposed CIT is transferrable to a new third-party plan administrator when the plan’s operational business is re-bid. Is it a proprietary product of the recordkeeper or its affiliates? It’s important to avoid locking participants into an investment vehicle that is not portable to a new service provider. Although most plans transition to new investment menus with a “mapping” protocol to find near-substitutes, there is no reason to make that process harder than it already is. Worse yet, some proprietary products will be costly to liquidate, locking the plan into an unwanted vendor’s offspring.
Next, plan officials should ask about liquidity of the CIT itself and its underlying portfolio. Recent news reports of wealthy private investors stuck in “semi-liquid” private credit investments should be enough to forewarn plan overseers. The ability to move in and out of an individual investment can differ widely once the industry starts to move away from the traditional open-end mutual fund model with full daily valuation and exchange features. Remember the Hotel California, where you can never leave.
Needed: Transparent Full Disclosure
Plan officials and participants must then look at what’s inside their target date funds, which blend a portfolio mix of various asset classes to provide diversification and a risk profile that many consider suitable for an investor’s age group and planned retirement date. Some of these are now being reformulated into CITs.
If there were to be a run on one of such an umbrella fund’s underlying investments — for collapsing credit or any other reason — how will the fund provide liquidity to a DC plan participant who then wants out? Will the portfolio managers try to wallpaper over the problem by selling other, liquid securities to enable those rushing to the exits to enjoy full book value at the cost of impairing the investment value of remaining investors’ accounts? Will private assets be priced daily for fair market value, as one of the larger fund managers is laudably now planning?
This then brings us to the various forms of alternative investments that will undoubtedly be packaged into CITs and other emerging investment vehicles. Whether it’s hedge funds, private equity, real estate, private credit, crypto, gold or commodities, it’s likely that these new instruments will carry fee structures that make most mutual funds now used in the DC industry look dirt cheap.
These are questions that require full disclosure, in layman’s terms for relatively unsophisticated investors to understand, because most retirement savers will remain oblivious that this is going on. Remember that these target date funds are commonly sold as “set it and forget it.”
What Retirement Savers Need to Know
For starters, plan participants should receive an annual full-cost table showing the all-inclusive fee structures for every investment vehicle in the menu. Private equity funds touting 15 percent expected rates of return, for example, should show how much their 20 percent carried interest — the fund manager’s share of investment profits — will cut into total returns.
My single most important investment suggestion along these lines is that the defined-contribution industry, and 457-plan gatekeepers in particular, should insist that any alternative investments in their plan menus set a minimum rate of return — known in the industry as a “hurdle rate” — before any carried interest and incentive fees are payable. That way, the investing public would not pay escalating fees unless the portfolio managers actually produce investment results at least equal to or better than the analogous traditional public-markets instruments. Private credit managers should not receive performance fees, for example, unless they outperform prevailing corporate bond yields.
Before investing, and annually thereafter, participants should be given fund-level fee tables showing total costs at various levels of investment outcomes in annualized percentage terms. That requires extra effort, but anything short of this is fleecing the lambs.
When markets and marketeers turn euphoric, history shows that patient, prudent money will win out. To quote Warren Buffet, “Only when the tide goes out do you discover who’s been swimming naked.” Bear in mind that there is no star, planet or moon in this universe wherein the best vehicles for alternative investments will be offered earliest to public-sector retirement investors.
The gatekeepers of public-employee DC plans therefore can serve participants best if they avoid hype, cull out the duds and fee vampires, and put a spotlight on product features that novices are unlikely to notice on their own. In this rush for investment success, all that glitters is not gold.
Governing‘s opinion columns reflect the views of their authors and not necessarily those of Governing‘s editors or management. Nothing herein should be construed as specific investment advice.