permitted investments

[PensionNewbee]

can somebody please point me in the right direction - I need to find a concise description of what investments are permitted in DB plans.

Thanks!

[Belgarath]

I don't believe there is one. There are some specific limitations on certain types of investments, such as qualifying employer real property or qualifying employer securities, but otherwise, the funds can theoretically be invested in almost anything. However, under ERISA 404(a)(1)(B) a fiduciary is subject to the prudent person standard of care. And this depends upon so many factors peculiar to any individual plan that there's very little that can be said "across the board." So in practice, if a fiduciary, exercising due diligence, care, skill, prudence etc., determined that investing 5% of the plan assets in shares of the Brooklyn Bridge is a prudent investment, the fiduciary could do that. They just better be prepared to justify their actions (which have an unfortunate tendency to be viewed in the 20/20 vision of hindsight.)

[mwyatt]

Might also want to take a look at the trust agreement of the plan, which should outline the statutory requirements of what the plan can invest in. As Belgarath points out, you also need to consider the circumstances of the plan as this can also govern as to what would be considered a "reasonable" investment.

[AndyH]

Paintings, fine antique automobiles, IOU's/accrued interest on loans, undevelopable land, and margin brokerage accounts are some of the fine investments I've seen in DB plans over the years.

[Blinky the 3-eyed Fish]

I had a client with a $10,000 pen in his plan. I hear it wrote by itself and did the homework for the children.

[mwyatt]

Ah, the horror stories... I remember one local investment advisory firm (who shall remain nameless) who were loading up their client's qualified plans back in the early 80s with oil and gas limited partnerships (let's see, an investment that has as its sole purpose the ability to generate huge phantom tax losses sounds like a great fit in a tax-exempt vehicle to me). Another great one is putting municipal bonds in qualified plans (let's see, we'll pay you lower interest since you don't have to pay taxes on the earnings - oh right, again, maybe this doesn't make sense either since you're not paying taxes in the trust). And we won't even go into the hummel collections (honest), land deals previously mentioned, and vacation homes.

All time greatest investment though had to be a scheme during the mid-80s boom where the fine doctor would contribute the downpayment for a rapidly appreciating personal home, and then the plan and the homeowner would split the gains 50/50 upon sale. Sounded great, until I was valuing this takeover plan in 1991 after the bubble burst and the first mortgage was 30% higher than the current appraised value. From a practical standpoint, only conclusion was a big fat $0 valuation for this original $400k scheme...

[Effen]

I recall a discussion a few years ago with an attorney regarding the client’s investment of a fine art painting. The attorney concluded that the investment was acceptable as long as the painting was not hung anywhere a plan participant could see it. Because if they could see it, then they were enjoying it (big assumption) and that could be deemed an "in-service distribution" since they were "benefiting" prior to a distributible event.

[AndyH]

The one I knew about was in an art gallery, which was thought to pass muster (it did pass an IRS audit or two). But in the end of course the story did not end happily because it was the majority of the plan's assets and it did not perform well (putting it mildly)

[David MacLennan]

I have a few thoughts I could add to help pensionnewbee:

DB plans are not any different than other qualified plans with respect to investments. However, it is sometimes advised to put conservative investments into the DB plan to avoid an unexpected underfunded status. Also, keep in mind only cash can (generally) be contributed to DB plans (the 404 - 412 spread can allow for some non-cash contributions).

What kind of investments can qualified plans make? Any kind! Yes, it's true . . . only some investments have penalties attached to them! The only exception I can think of is that an ERISA plan's investments must be within the reach of US courts, so this generally prohibits "foreign" investments.

There are 2 groups of penalties: prohibited transactions excise taxes, and unrelated business excise taxes. PT's can in some cases have the severe penalty of disqualification, but the IRS seems to reserve this for only the most extreme example of violation of the exclusive benefit rule. "unrelated business" refers to the trust engaging in a business - when tax exempt trusts engage in a business they are taxed at corporate rates. A sub-class of unrelated business transactions is debt financed income - tax exempt entities are generally not allowed to make money by borrowing money.

PT's are discussed in many references.

For unrelated business activity, a good primer may be to read the IRS Examination Guidelines on the topic. Here is an excerpt:

(a) Generally, the unrelated business activities in which a qualified trust engages take the form of either

a trade or business or debt-financed income.

Examination Steps

Techniques are provided on unrelated business income of all types and the Form 990-T filing

requirements. Below also, are examples which may aid in detecting the same or similar issues during an

examination.

Analyze financial statements and/or tax returns prepared by the trust for evidence of the existence of a

trade or business. Receipts derived from business operations may be buried in investment income, i.e.,

interest or dividend and may only be revealed by examining the trusts' books and records.

(a) An IRC 401(a) trust may be engaged in the same business activity as the creator corporation. The

management of the trust is, directly or indirectly, the same as that of the employer. Consequently, there

is a tendency to apply the trade or business expertise of corporate management to the trust's business

activities.

(b) The trust may engage in an activity which complements the employer's business. For instance, the

employer may be engaged in the manufacture of a product and permit the trust to perform all or a part of

the marketing functions.

Sales of Lots: Corporations which are in the business of developing and improving real estate for sale to

customers will often contribute land to their employee trusts which is adjacent to their own development

projects. Or, they will contribute cash and require the trust to invest in such subdivisions. In this manner,

the employer's salespeople can promote and sell the trust's subdivided and improved real property along

with their own and escape taxation on the portion of the activity attributable to trust ownership.

(a) If this activity is being carried on in sufficient volume on a regular and continuous basis, the trust is

also engaged in the real estate business and is subject to the unrelated business income tax under IRC

511.

Vending Machines: The operation of a vending machine route (large or small) is a trade or business.

Trusts find this additional activity appealing as a revenue producer because little effort is required on

their part to derive financial benefits. The existence of this type of income is often hidden in the trust's

financial statements as miscellaneous income, income from sources other than investments, or some

similar caption. All income accounts must be analyzed to make a determination.

Commissions and Fees: An employee trust may earn commissions or fees for services rendered. Income

from these sources commonly stems from sales commissions (real estate as well as personal property)

and finder's or agency fees of various sorts. The income from such activities are subject to the unrelated

business income tax under IRC 511.

Factors: Factoring is a trade or business. The profits derived from this operation do not constitute

interest on investments as may be shown on the financial statements.

Fruit Orchards and Citrus Groves: Some trusts own property and may operate the activity rather than

lease the property.

Timber: In a raw material industry, IRC 482 may apply as well as IRC 513(b).

For example, if the creator corporation is a paper company, ascertain that the price the employer pays

the trust for the timber is reasonable.

Rental of Personal Property: The income derived from the lease or rental of personal property (other

than that leased with real property) constitutes income from operation of a trade or business. Some

examples are: tank cars, boats, automobiles, fishing and skiing equipment, signs and vending machines.

Option Income: Revenue received from unexercised stock options (puts and calls) regularly issued on

stocks held in the trust's portfolio constitutes unrelated trade or business income under IRC 513. See

Rev. Rul. 66-47. Since this income is commonly shown on the financial statements as "capital gains,"

carefully review the broker's confirmation documents which will reveal the existence of such stock

option sales.

Partnerships: If a partnership of which the trust is a member is engaged in a trade or business, the trust

has unrelated business income with respect to its portion of distributable income. Verify this by

reviewing the information return for an entry reported as investment income.

Miscellaneous Business Enterprises: Other ventures in the trade or business category which have been

uncovered are retail stores, cafeterias, parking lots, and mineral interests, etc.