Alternative Investments in a Qualified Retirement Plan

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1 FIRST ALLIED RETIREMENT SERVICES Alternative Investments in a Qualified Retirement Plan Guy J. Hocker III, Esq. President, The past few years have been difficult for all investors as long-held inverse correlations have eroded and traditional diversification approaches have lost efficacy. One outlet for the sophisticated investor is alternative investments. This asset class has gained traction as traditional securities move together correlated in response to the general market. What is clear is that alternative investments should be considered in portfolio design: qualified retirement plans share the same portfolio goals, seeking to achieve a riskappropriate diversified portfolio. What are the IRS and Employee Retirement Income Security Act of 1974 (ERISA) rules impacting the use of alternative investments and how confidently can the advisor recommend this asset class? Definitions Just to be clear, alternative investments are defined broadly here as all investments that are not traditional stocks, bonds or cash. Qualified retirement plans are those plans established under 401 or 403 of the Internal Revenue Code, including 401(k), 403(b), profit sharing, money purchase, defined benefit and cash balance plans. All these plans are subject to IRS rules, and if there are non-owner participants, then ERISA investment guidelines also apply. IRS rules The IRS rules governing permissible investments in a qualified retirement plan are broad. The main requirement is that the investment be domiciled in the United States that s pretty broad. This would not preclude investing in a global mutual fund, because the mutual fund itself is here in the U.S. Essentially, anything in which a trustee wishes to invest could likely be invested in via a qualified retirement plan. There are some important caveats. First, the IRS has a set of prohibited transactions. Some of these are investment related, and can be summed up as an IRS prohibition against self-dealing with qualified plan assets. Selfdealing in retirement assets isn t limited to alternative investments, but it tends to pop up with alternatives in IRAs and qualified plans.

2 page 2 The rules associated with Unrelated Business Taxable Income do not prohibit an investment by a qualified plan, but certain investments could result in Unrelated Business Income Tax being payable from the qualified plan. The IRS defines certain people as disqualified persons. Disqualified persons are the plan trustee, the owner of the employer/plan sponsor, and certain relatives. Others, such as officers of the employer, could also be disqualified persons. Prohibited transactions generally include the following: a transfer of plan income or assets to, or use of them by or for the benefit of, a disqualified person; any act of a fiduciary by which plan income or assets are used for his or her own interest; the receipt of consideration by a fiduciary for his or her own account from any party dealing with the plan in a transaction that involves plan income or assets; the sale, exchange, or lease of property between a plan and a disqualified person; lending money or extending credit between a plan and a disqualified person; and furnishing goods, services, or facilities between a plan and a disqualified person. OK, that all sounds scary, but what it boils down to is that the trustee can t personally benefit from the plan assets and can t buy from or sell to the plan. Still, after all this, the world of investments according to IRS rules is broad. Unrelated Business Income Tax Unrelated Business Income Tax is based on Unrelated Business Taxable Income. The rules associated with Unrelated Business Taxable Income do not prohibit an investment by a qualified plan, but certain investments could result in Unrelated Business Income Tax being payable from the qualified plan. While not illegal, many trustees consider the challenges of Unrelated Business Income Tax to be a barrier to investing in certain alternative investments. The main source of Unrelated Business Taxable Income from commonly marketed alternative investments is Debt Financed Income. For example, leveraged real estate partnerships could generate Unrelated Business Taxable Income. Since Unrelated Business Taxable Income applies to IRAs and qualified plans alike, promoters of alternative investments are familiar with these rules. It is appropriate to ask the promoter about Unrelated Business Taxable Income, if only to correctly analyze the true after-tax return. Again, all this sounds daunting. But, the good news is that most alternative investments are not subject to UBIT, so the wide world of alternative investments remains available to qualified plans.

3 page 3 Since Senator Keogh championed the issue in 1962, it has been common for owner-only business entities to establish qualified plans for the owners themselves. Non-ERISA plans Since Senator Keogh championed the issue in 1962, it has been common for owner-only business entities to establish qualified plans for the owners themselves. Since these plans don t have non-owner employees, streamlined annual reporting is available to the IRS via Form 5500EZ. And ERISA investment guidelines do not apply to these owner-only plans. As such, Solo 401(k) plans or Solo Defined Benefit plans can invest in alternative investments freely, subject only to the self-dealing prohibitions discussed above. This is the easiest entry point for assisting qualified plan investors with alternative investments: focus on Solo 401(k) and Solo Defined Benefit plans ERISA and Alternative Investments ERISA has a set of investment rules aimed at qualified plan fiduciaries. Governed by the Department of Labor (DOL), ERISA starts from an other people s money mindset with respect to investing. Simply, a trustee must be more careful when investing participants retirement money. This care is summarized by the term procedural prudence and should factor in the following: Diversification: ERISA 404(a)(1)(C) requires that investments must be diversified so as to minimize the risk of large losses unless, under the circumstances, it is clearly prudent not to do so. This is a facts and circumstances test based on plan and trustee characteristics. The Form 5500 filed with the DOL does inquire if any single investment is greater than 20 percent of plan assets (not applicable if the plan is participant directed), so highly concentrated investments may result in a higher rate of DOL examination. Participant directed plans must provide a diversified set of options, but the result of the participant s decisions does not itself need to be diversified. Liquidity: Part of prudence requires that expected investment liquidity matches expected payouts. In a key fiduciary case, where a trustee invested 63 percent of plan assets in a single parcel of real estate, the court gave great weight to the trustee s analysis of his young workforce not needing liquidity for many years. This helped the trustee to win in court (by the way, he was sued by the DOL, not the plan participants). Unregistered Investments: The DOL issued rules that require plans with unregistered investments to increase the plan s fidelity bond amount. Normally only 10 percent of plan assets need to be covered by a bond, but the rules require 100 percent bonding of all unregistered investments. The good news is that these fidelity bonds are quite inexpensive. Additionally, since these investments do not have a reported value, an annual appraisal of the value of the asset is needed. Many of the promoters of alternative investments are aware of this rule and already provide some annual value determination.

4 page 4 ERISA plans have Summary Plan Descriptions that need to highlight any differences in administrative policy with respect to the alternative investment, such as payout timing based on illiquidity. Participant Directed Accounts In general, trustees use participant directed accounts to transfer the fiduciary risk of investment prudence from the trustee to the participant. This works for alternative investments as well. The trustee must use prudence in making the alternative investment as an option for participants to choose. The alternative investment option can t be discriminatory in favor of highly compensated employees (i.e., owners). This typically happens when only the owner can effectively choose to invest in the alternative investment due to account minimums or accredited investor requirements. Plan Documents and Disclosures The plan document should be reviewed, as not all plan documents allow for alternative investments 1. This is often true with prototype documents or documents supplied by an investment provider, which makes sense because the investment provider wishes for the plan to invest strictly in the provider s product. ERISA plans have Summary Plan Descriptions that need to highlight any differences in administrative policy with respect to the alternative investment, such as payout timing based on illiquidity. ERISA plans will also have to list the alternative investment on the Summary Annual Report, which is part of the Form 5500 cycle. In addition, if the plan is participant directed, new fee-disclosure regulations require that detailed information be provided about each investment available to be chosen by the participants. So, if a plan has a retirement plan investment platform that will be handling the bulk of the disclosure (e.g., John Hancock or American Funds), there needs to be some supplemental disclosures regarding the alternative as an investment option. And, the participant investment election form needs to be completed by all eligible participants. Use of a Third Party Administrator If all the above sounds like some compliance maze that you ve wandered into, then you need the services of a third party administrator (TPA). Not all TPAs are created equal. The trustee and employer should focus on ensuring the appropriate consultative approach and depth of experience in choosing the TPA. It s appropriate to ask how many plans the TPA has with alternative investments now, and how the various compliance points are proactively addressed. Wrapping Up Alternative investments provide diversification for a portfolio. Qualified plans need diversification benefits. Non-ERISA plans can very simply choose to purchase alternative investments. ERISA plans have compliance hurdles in designing and maintaining an alternative investment regime, but

5 page 5 those hurdles are surmountable, especially through the partnership with an appropriate TPA. Please remember that diversification and asset allocation do not guarantee a profit nor protect against loss in a declining market. They are methods used to help manage risk. 1 Alternative investments are subject to significant risks and therefore, are not suitable for all investors. When considering alternative investments, you should consider various risks, including the fact that some products use leverage and other speculative investment practices that may increase the risk of investment loss, can be illiquid, are not required to provide periodic pricing or valuation information to investors, may involve complex tax structures and delays in distributing important tax information, are not subject to the same regulatory requirements as mutual funds, often charge high fees and in many cases, the underlying investments are not transparent and are known only to the investment manager. With respect to alternative investments in general, you should be aware that returns from some alternative investments can be volatile and you may lose all or a portion of your investment. This is not to be considered legal or tax advice. It is provided for informational purposes only. Please consult an attorney or CPA for advice regarding your specific situation.