Diversification issue: How much RE in the plan?

[rodin011]

DB Plan with over 1MM in assets wants to purchase an investment property. The plan will pay the entire cost with no financing.

The 2 owners' PVAB, combined, exceeds 90% of the total PVAB of the plan.

Assuming the purchase is a bona fide investment , that every year an accurate appraisal is provided , etc., and that the plan will always have enough cash to provide termination benefits for the other participants: is there anything that would forbid the plan to invest about 75% of assets in such property? I know that we have to report on the annual 5500 if more than 25% of plan assets is invested in a single asset. However I wonder if there is any "legal" limitation as long as the non owner employee benefits are not in Jeopardy.

Thanks for help.i

[PensionPro]

Is the investment in the best interests of the plan? A fiduciary is required to examine the level of diversification, degree of liquidity, and the potential risk/return in comparison with available alternative investments. Potential investments should be compared to other investments that would fill a similar role in the portfolio with regard to diversification, liquidity, and risk/return. In light of the rigorous requirements established by ERISA, the Department of Labor believes that fiduciaries who rely on factors outside the economic interests of the plan in making investment choices and subsequently find their decision challenged will rarely be able to demonstrate compliance with ERISA absent a written record demonstrating that a contemporaneous economic analysis showed that the investment alternatives were of equal value. ERISA makes no direct distinction between fiduciary standards for DB and DC plans. There is no magic number but the plan should be in a position to withstand the DOL's close scrutinty. Does an analysis of the plan's liquidity needs take into account the possibility of benefit payments to the owners?

[rodin011]

The owners plan to retire in 5 to 7 years. Until then they plan to contribute each year substantial amount of money (in the range of 300k+). Therefore the percentage of plan assets invested in that property will - under normal conditions- substantially decrease. If death or other circumstances would require payment of benefits to owners, and if the sale price of the property is substantially lower than purchase price then, indeed there may not be sufficient assets to pay the owners full benefits. But is this scenario much more different than what happened to the equity markets in 87, 92, 2001 and more recently, during the current recession? Even the most diversified portfolio had moments of 30% to 40% losses when the benefits of the owners could have been be in jeopardy. An index fund portfolio for any plan is probably considered an acceptable investment , while its risk/return ratio is probably no lower than an RE investment that in a few years will become a small % of the portfolio.

And , I quote, " A fiduciary is required to examine the level of diversification, degree of liquidity, and the potential risk/return ", I doubt that- especially in the small business market- any Plan Sponsor, usually the fiduciary has the expertise to evaluate this factors. And even for a professional adviser, are there any "yardsticks" to define them? Any regulations that define them?

We do not give investment advice, but we should be able to answer such question or at least to be able to direct the client to competent adviser. But I have no idea who can

perform , analyse, judge and approve or not the "level of diversification, degree of liquidity, and the potential risk/return " or to have a "written record demonstrating that a contemporaneous economic analysis showed that the investment alternatives were of equal value"

So, I am still in the dark, even though it seems to me that buying a piece a property that is clearly not a prohibited transaction and not financed, is no different and no riskier

than any equity investments for this particular situation.

But I may be wrong and it would not be the first time....

[Bird]

I wouldn't be overly concerned with the diversification and potential risk/return factors. Liquidity, yes; it's easy to think you're going to sell this in 5 to 7 years but selling a property is not always that easy. Also someone also has to put a fair value on this each year. And you can't file a 5500-SF.

I think with real estate, you can go through a checklist and determine "yes, this is a fine investment for a retirement plan" but on a practical level, it's a (royal) pain in the butt at best. And for what...they're going to make above-market returns?...which simply reduce future contributions in a DB environment. I don't see the upside. Maybe I have a bias because on my end (as a TPA) everything just grinds to a halt when you have stuff like this in a plan.

[PensionPro]

From experience liquidity is a critical issue. Death, disability, plan termination, employment termination, depreciation of assets, etc. are all factors to be considered. Volatility of the investment portfolio and how it affects the management of benefit liabilities is worth thinking about. Increase in the plan's liabilities during a period of declining asset values may not be a desirable outcome in a DB plan. As you point out these issues exist when investing in equities, etc., however the issues are magnified when investing a majority of the plan's portfolio in a single illiquid asset with high risk/reward characteristic.

[John Feldt ERPA CPC QPA]

FWIW:

If you really want to invest in this kind of stuff, consider the capital gains taxes (lower?) vs the regular income taxes (higher?). Is it truly best to invest within the plan like this? Perhaps use your pocket change (money outside the plan) to invest in this kind of stuff instead.