The appeal and pitfalls of holding unconventional assets in retirement accounts
While non-traditional asset classes held in individual retirement accounts may have return and portfolio diversification benefits, there are "unique complexities" that limit their value for most investors.
Retirement investors and advisers concerned about generating income later in life amid a gloomy forecast for stocks and bonds may be eying more unconventional asset classes as a way to juice returns and diversify portfolios.
While there may be benefits associated with holding esoteric asset classes, from real estate to precious metals to farming interests, in individual retirement accounts, experts warn of pitfalls extending beyond investment risk, such as costly tax penalties, that should temper such choices for most investors.
“For most people, it’s probably not something that I would say is a great idea,” said Jeffrey Levine, chief retirement strategist at Ed Slott & Co. “I wouldn’t tell people they should never do it, but they should have a good reason for doing it.”
Concerns about an overvalued stock market have grown following eight consecutive years of gains. Further, an environment of rising interest rates doesn’t bode well for bond prices, which tend to move in the opposite direction.
“I think the main reason there’s so much interest in having direct investments in these nontraditional items in retirement accounts now (as opposed to a decade or two ago) is simple: That’s where the money is,” said Tim Steffen, director of financial planning in Robert W. Baird & Co.’s private wealth management group.
And these investments are becoming more broadly accessible. Liquid alternatives funds increasingly bring alternative asset classes, otherwise largely accessible only to the wealthy, to ordinary investors.
Securities and Exchange Commission member Michael Piwowar recently suggested lowering the threshold to be considered an “accredited” investor. Such investors, currently limited to those with a net worth of $1 million or more, excluding the value of their primary residence, have access to private and exotic investment strategies.
There are only three things disallowed as IRA holdings: collectibles, life insurance and S corporation stock.
“Other than that, you can own absolutely anything,” Mr. Levine said. “If you want to own a tree farm, you can.”
Real estate, private equity and hedge funds are the most common “unconventional” assets held in retirement accounts, according to a report released by the Government Accountability Office in January. Others include limited liability companies and limited partnerships, precious metals, promissory notes, church bonds and private placements.
Alternative assets are typically lauded for their return potential and low correlation to traditional asset classes. For example, over the 20-year period through 2016, direct real estate had a 0.23 correlation to U.S. equities, a 0.12 correlation to non-U.S. equities, a 0.13 correlation to real estate investment trusts and a negative 0.03 correlation to U.S bonds.
DIRECT REAL ESTATE
Over the same period, direct real estate produced an annualized return of 9.3%, which compares to 7.9% for U.S. equities, 5.1% for non-U.S. equities, 9.7% for REITs and 5.3% for U.S. bonds.
There are about 500,000 retirement accounts holding $50 billion in unconventional assets, according to the GAO. But this is just a baseline reference — the totals are likely higher since the federal government’s data collection to date has been sparse, the GAO said, though it is ramping up efforts to get more information on unconventional assets from IRA custodians.
IRAs as a whole hold more than $7 trillion in assets.
Mr. Steffen and other experts believe investing via liquid, registered vehicles such as mutual funds and exchange-traded funds is the best way to access nontraditional asset classes, since most people aren’t qualified to evaluate direct investments, which pose greater risks.
There are plenty of reasons to be wary of direct IRA investments.
For one, it’s easy to inadvertently run afoul of the IRS’ prohibited transaction rules, which prevent investors from engaging in both direct and indirect transactions with their own IRAs, said Michael Kitces, partner and director of research at Pinnacle Advisory Group.
Engaging in a prohibited transaction disqualifies an IRA and triggers income taxes on holdings, in addition to a tax penalty if the investor isn’t yet age 59½.
Take the example of an investor using an IRA to purchase a rental home. The investor can unwittingly commit a prohibited transaction by renting to certain relatives, personally repairing the rental home or paying for repairs with personal funds rather than IRA assets.
‘UNIQUE COMPLEXITIES’
“There are very unique complexities with IRAs and nontraditional assets once you get out of mutual fund and ETF form,” Mr. Kitces said.
Further, IRA investments can trigger unrelated business income tax, the tax levied on income from the unrelated business activities of an otherwise tax-exempt entity, for which additional tax forms need to be furnished to the IRS.
Financing a real estate purchase inside an IRA using debt can trigger UBIT, for example, Mr. Kitces said. There also may be some quirky scenarios to sort out — for example, if a property requires repairs but there isn’t enough money in the IRA to pay for them; such repairs can be financed with debt, but that then brings UBIT into the picture, Mr. Kitces said.
Valuation also presents a challenge, depending on the asset. The IRS requires valuation once a year on Form 5498, which provides information on IRA contributions. However, if the asset is hard to value, can an investor rely on the prior year’s valuation when performing a Roth conversion several months later, Mr. Levine asks, or when taking a required minimum distribution?
ILLIQUID ASSETS
RMDs themselves pose a problem. How does one take a distribution from an illiquid asset? Investors need to ensure there is cash or other liquidity in the IRA or a different one to meet those requirements, Mr. Steffen said.
RMD aggregation rules, though, often make it fairly easy to navigate distribution requirements, Mr. Kitces said, because investors can take the RMD from another IRA.
Custodians such as Millennium Trust Co., Equity Trust Co., Pensco Trust Co. and The Entrust Group that handle these types of self-directed IRAs often charge additional annual fees to service these accounts, which can be a drag on investment return.
“The reality is you get what you pay for, and you’re getting professional administration and record keeping,” said Terry Dunne, senior vice president and managing director at Millennium Trust.
David Blanchett, head of retirement research at Morningstar Investment Management, said it’s important to put the benefits of diversification in the context of cost.
“It’s not that these things can’t add value, but will they actually add value for investors after all the fees are incorporated?” he said, explaining that the true cost of alternative assets held in IRAs can exceed 2%, which may overshadow the marginal benefits of the strategy.
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