Alternative investments in retirement plans

Are they a good idea?  Generally, no, let’s dive in…

A simple yet usable definition of “alternative investments” is:  anything that doesn’t show up on a statement from a bank, brokerage firm or similar financial institution.  Some example are:  real estate, privately held mortgages, collectibles, and precious metals.

Most plans will permit these assets, but that doesn’t mean a particular investment isn’t part of a prohibited transaction.  A very simplified definition of a prohibited transaction is a transaction between a plan and a “disqualified person” – generally an owner, or family member of an owner.  Stealing money from a plan is an obvious no-no, but so is borrowing money from a plan, even at fair market rates, and even lending money to a plan is a prohibited transaction, no matter how fair it might appear.

So, potential problem #1 is directly lending or borrowing money to or from a plan, to or from an owner or family member, or otherwise using plan assets for the benefit of the same people.  Note – this includes mortgages, no matter how fairly established.  Other, perhaps more subtle issues would be buying real estate and “using” it – e.g. as a second home, or renting it to a family member, or buying artwork and putting it on your own wall for your own enjoyment.

Potential problem #2 is valuation – what is the investment worth?  Obvious examples are real estate and collectibles; no one knows their true value except at the point of sale.  Such assets should be valued by a qualified and independent appraiser.  Not-so-obvious examples would be a privately held mortgage – it might seem simple enough to read a number off of an amortization schedule, but changes in interest rates will change the value of any debt instrument – a mortgage that is set up at a given interest rate will decrease in value when interest rates rise, and vice versa.  (Does it matter in a one-person plan?  Yes – minimum distributions are based on asset values, and if asset values aren’t right, then minimum distributions aren’t right.)  By the way, we are sometimes given K-1s by clients or accountants for partnership investments – they are utterly and completely useless for our (plan) purposes – they are simply tax documents and have nothing at all on them regarding valuation.

Potential problem #3 is liquidity – having enough cash to perform necessary transactions.  I’ve heard of, but not seen in my own practice thanks to our oversight, cases where the only asset owned by a plan was real estate, and required minimum distributions were due but not able to be paid due to lack of liquidity.

Potential problem #4 is using leverage (borrowing) to buy an asset.  Since plans are already tax-favored vehicles, the government does not want you furthering those advantages through leveraging.  A special Unrelated Business Taxable Income (UBTI) tax applies on excess gains earned through borrowing…up to 40%, and don’t forget the fees to calculate that!

Potential problem #5 is risk.  These investments are almost universally perceived as “better” than publicly traded investments, but the reality is that they are almost always much, much riskier.  Now, there’s nothing wrong with taking on some risk to get higher rewards, but it should be done with eyes wide open, and carefully.  This is especially important for plans with other participants – the trustee must act as a “prudent man” would act, and putting all of your eggs in one risky basket is asking for trouble.  It’s less of an issue for one-man plans, but I’ve seen instances where “sure things” tanked and retirement savings were severely depleted.

To be clear, many assets I’ve just discussed are held by pension plans – buildings, land, partnerships, etc.  But they’re typically help by large plans – those that can afford to have a portion of their assets in illiquid and hard-to-value assets, by virtue of the fact that they have plenty of other, traditional assets.  The problems I just noted are glaring for small plans.

Our recommendation is generally to keep investments in assets where values are set on a market, or in bank accounts or CDs – basically, an account where you get some kind of statement that could be shown to the IRS upon audit.  We run our plans as if the IRS is looking over our shoulder at all times.  It’s boring but safe.

Special note for one-man plans – fortunately, or perhaps unfortunately, questions about these kinds of assets and transactions are not answered on the 5500-EZ or alternate 5500-SF/one man plan, so the issue doesn’t arise in government reporting.  We can comfortably prepare the form with the answers our clients provide, but be aware that if the IRS audits a plan that has a prohibited transaction, they will definitely insist on corrective actions.