Alternative Investments by Retirement Plans

December 2012Newsletters For Your Benefit

In the current investment climate involving historically low interest rates and an uncertain stock market, we have been approached by clients, consultants and third party administrators with the same request: “Can a plan invest in non-traditional investments, such as real estate?” The short answer is yes, as long as one follows the rules. Needless to say, there are numerous rules that must be followed. This article presents an overview of the pertinent considerations.

Prohibited Transactions

Prohibited transactions come in two flavors: (1) outright prohibitions; and (2) more nebulous prohibitions involving self-dealing and conflicts of interest. There are absolute prohibitions against the plan from dealing with a party-in-interest (i.e. any person or entity with a relationship with the plan such as its sponsoring employer and the owner of the employer). Practically, this prohibits the plan from purchasing an investment from its sponsor no matter how attractive the investment. Self-dealing prohibitions are more nebulous. For example, a plan may not participate in an investment with one made by a related party for the primary purpose of achieving a minimum threshold investment. However, if the plan can independently justify the prudency of the investment, it may be permitted.

General Fiduciary Considerations

Under ERISA, plan trustees are required to invest prudently and to diversify investments unless clearly prudent not to do so. Accordingly, it is critical that trustees carefully document their analysis of the investments chosen. Gut feelings and overall business acumen are no substitute for a carefully documented file. In the alternative, the fiduciary rules may be avoided in plans covering only an owner and his or her spouse and via utilization of self-directed accounts.

Potential Discrimination Issues

When seeking to avoid the fiduciary considerations through use of self-directed accounts, certain IRS discrimination rules come into play. In general, tax-qualified plans such as 401(k) plans may not make “benefits, rights and features” available to highly paid employees that are not available to the rank and file employees. Thus, participants should not be denied the opportunity to participate in an attractive investment. On the other hand, more speculative investments favored by owners and the more highly compensated are not necessarily appropriate for rank and file employees and those participants should not be forced or encouraged to invest in any investment that does not pass fiduciary muster.

General Tax issues

Plan sponsors need to be mindful of the interplay between the tax attributes of qualified plans and the lower capital gains rates available on the gain from the sale of real estate. While the income and gains from sale of assets are generally not taxed on assets held by a pension plan, (see discussion of unrelated business taxable income, below) the proceeds are eventually taxed at ordinary income rates when distributed from the plan. While the deferral of tax is a valuable benefit, plan sponsors need to be mindful of the disparity in tax rates. In addition, the depreciation deductions generally available for the owner of real estate are not available to a tax-exempt retirement plan. However, the losses can be used to reduce the amount of any unrelated business taxable income generated.

Unrelated Business Taxable Income

Unrelated Business Taxable Income comes in several varieties. It comes into play when a tax-exempt entity, such as a retirement plan, operates an active business and the income attributable to those business operations becomes taxable. In general, this rule does not apply to passive investments like real estate. However, when the plan takes a loan to purchase the property, the portion of the income attributable to the financing becomes taxable.

Audit, Valuation and Increased Bonding Requirements

Most plans investing more than 5 percent of their assets in anything other than publicly and other widely traded investments (“qualifying” assets), are required to obtain audited financial statements. For plans with less than 100 participants, the auditing requirement can be avoided by raising the amount of the required bond from 10 percent of the value of the plan assets to 100 percent of the “non-qualifying” plan assets. In any event, each year plan trustees are required to make a good faith estimate of the fair market value of each asset held by the plan. When rank and file participants share in the investment, best practices require that an independent third party valuation be obtained.

Practical Considerations

While it may seem obvious, plan sponsors are cautioned that all assets owned by the plan, including real estate, must be held by the plan and not in the name of the sponsoring employer or its owner. Similarly, any insurance maintained on the property/real estate should be in the name of the plan. Any mortgage on the property/real estate should be in the name of the plan. Personal guarantees of the mortgage by a related party could be a prohibited transaction unless properly structured.


Undoubtedly, the amount and complexity of the requirements will discourage some plan sponsors. However, under the right circumstances and with the correct guidance, alternative investments are not only doable but represent highly attractive options for many retirement plans.

For more information regarding this topic, please contact Harvey M. Katz or any member of the Fox Rothschild LLP Employee Benefits and Compensation Planning Practice Group.