illiquid asset

[Scuba 401]

a plan has an illiquid asset allocated proportionately to all participants. when participants terminate it wants to pay out the liquid portion of their account balance but retain the illiquid real estate until it is sold. in researching this i determined that these distributions wouldn't constitute lump sum distributions. can anyone tell me what that would mean to participants and whether this is a problem?

[QDROphile]

Assuming the plan is not an ESOP, the lump sum status is probably a red herring. You should be more interested if a distribution is an eligible rollver distribution. The law about rollovers has changed from focus on the lump sum concept. The plan should be concerned about refusing to distribute when a participant is entitled. Appropriate plan terms might help, but they would be unusual and they would probably not work for someone who is past retirement age.

[Scuba 401]

less than a lump sum is still eligible for rollover right? i can't find anything wrong with a small percentage of the participants account being held back because it is illiquid. lets say the percentage is 96% liquid and 4% illiquid.

[Bill Presson]

less than a lump sum is still eligible for rollover right? i can't find anything wrong with a small percentage of the participants account being held back because it is illiquid. lets say the percentage is 96% liquid and 4% illiquid.

It might not be an issue if the participant chose to be in an illiquid asset. But it's likely a fiduciary issue if the participant wants the entire distribution.

I think the trustee is on shaky ground.

[Belgarath]

"i can't find anything wrong with a small percentage of the participants account being held back because it is illiquid."

Do you have a citation or basis for this opinion? I'd say this is a huge problem. It is a fairly safe bet that the plan terms require distribution of the entire account balance. Just on a basic level, this is an operational error, and potentially disqualifying.

Possible fiduciary issues spring to mind if the plan is investing in things which inherently do not permit a participant's full benefit to be paid without incurring a substantial loss.

[shERPA]

There are minefields on either side of this issue. The lump sum issue is no longer a problem, the distribution should be an eligible rollover distribution regardless of it being less than the full "balance to the credit" of the participant.

I've seen this come up in professional groups where the doctors or lawyers got into an investment when the plan was pooled, later 401(k) was added and the plan went self-directed but it was not feasible to dispose of the illiquid asset. Sometimes it is a limited partnership interest in commercial property, and there could be litigation or other things going on that can drag on for years.

If the trustee uses other cash in the plan to pay out each departing participant their share of the illiquid investment, this means that the remaining participants will be left with a larger and larger share - which might not be good for them. It also means that the fair market value of the asset needs to be appropriately determined, which may not be possible. So by not cashing out, trustee is protecting the remaining participants. By cashing out the trustee may or may not be harming the remaining participants, depending on the FMV and risk of the illiquid investment.

It is not a good position for the trustee, damned if you do, damned if you don't. But there it is, and the fiduciaries need to deal with it my making a fiduciary decision as to what is best on behalf of all participants, and as noted above, operating the plan according to its terms. Best to seek legal advice. Perhaps this is what they've already done.

[ESOP Guy]

I have seen this before where a 401(k) plan allowed people to choose to be in a fund that was a hedge fund and you could not sell before X number of years after the investment had happened. This was the person's choice to get in, they were made to sign a document that said they were told and understand they could not sell even for a distribution until the X number of years was up. That plan's attorney was fine but as you can see they went to great lenghts to protect themselves.

[Scuba 401]

the asset is real estate. is it a problem to tell participants no matter what the asset is that they can't have access to part of their retirement account when they reach retirement even if it is a small part of their account?

in this case if they keep paying people in cash the remaining participants end up with a bigger share of the real estate. while not a great thing today someday this could be really good for those participants. in my view this could be a rights benefits features issue.

[shERPA]

Is there something going on with the real estate such that they can't sell it, or is it that they just don't want to sell it for what the market will bear?

[Scuba 401]

i believe the value has declined and they are hoping that something happens in the future that will make the property viable. a change in zoning or something like that.

[Scuba 401]

"i can't find anything wrong with a small percentage of the participants account being held back because it is illiquid."

Do you have a citation or basis for this opinion? I'd say this is a huge problem. It is a fairly safe bet that the plan terms require distribution of the entire account balance. Just on a basic level, this is an operational error, and potentially disqualifying.

Possible fiduciary issues spring to mind if the plan is investing in things which inherently do not permit a participant's full benefit to be paid without incurring a substantial loss.

belgrath, seems maybe you raised a good point. the plan allows for lump sum distributions. would they be able to remove that even if they wanted to? i think they would have to distribute a certificate or something as ive read in some PLR's. this would make sure they were making a lump sum distribution.

[401king]

the plan allows for lump sum distributions. would they be able to remove that?

Can't remove that option - protected benefit. (Saves people from signing up for a 401k where they can receive a lump-sum payment, only to find when they want to withdraw the money that the plan was amended, preventing them from receiving their full benefits).

[Scuba 401]

the plan allows for lump sum distributions. would they be able to remove that?

Can't remove that option - protected benefit. (Saves people from signing up for a 401k where they can receive a lump-sum payment, only to find when they want to withdraw the money that the plan was amended, preventing them from receiving their full benefits).

well...lets say a participant want to receive a lump sum distribution and this plan has this illiquid asset. it would seem to be they would have to distribute something like a certificate to this real estate and i guess it has to be held in a non qualified trust.

[shERPA]

Who knows, the document may have some language dealing with the situation where an asset is not liquid. A lot can be read into the phrase "administratively feasible" for example. As to it being "illiquid", most real estate can always be sold, it's just a matter of price. However a fractional limited partnership interest in a depreciated property is often truly impossible to sell. So it may not truly be illiquid, it is just that the fiduciaries believe it would be imprudent to sell at the current price and believe it to be a good investment for the plan and its participants. This might be a reasonable choice, but then it leads to the distribution issue. if this cannot be resolved in a manner that complies with ERISA, the code and the plan document, or the cost of doing so is excessive, then it may be more prudent to sell the property at its current low value.

A certificate is a less than great option, good luck getting most IRA custodians to hold it, so then the rollover is lost, taxes due, premature distribution penalty, etc. etc.

Again they need to seek legal advice. They need to make appropriate and prudent fiduciary decisions and operate the plan in accordance with its terms.

[MoJo]

While I agree wholeheartedly with shERPAs discussion above, I think most plan trust agreements provide some flexibility in the distribution of illiquid assets, and don't think the withholding of that portion of a distribution is as much of a problem as the decision to invest in the asset in the first place.

That said, since it is real estate, simply distribute "in-kind" (provided the plan allows, or can be amended to allow) an undivided fractional interest in the real estate via a quit claim deed. Easy to do with real estate (complicates the future sale, though, if not all can agree), and some IRA custodians will hold such an asset. Alternatively, the asset can be transferred into an LLC vehicle (held still in the plan), and then units in the LLC can be distributed to the participant in-kind (which eliminates some of the problems with a later sale).

[Scuba 401]

some alternatives were suggested and i would like you all to comment. an additional fact is that this real estate has been declining in value for the a long time and it is unlikely it will ever increase.

option 1 has the plan paying out terminees in cash and reallocating their interest in the real estate to the remaining participants.

option 2 has the real estate being allocated only to highly compensated participants.

i have a problem with both options as they seem to violate the rights benefits and features test because of the potential for the asset to increase in value. any thoughts?

[masteff]

it is unlikely it will ever increase.

I wonder if they're drifting into a breach of fiduciary prudence. I guess the real question is just how illiquid is the investment? Is it truly unsellable or just devalued? Two entirely different things. I know of no land, short of a SuperFund site, that won't sell at some price.

My one or two ideas are likely to cost more to setup and administer than the real estate is worth... such as putting it in an LP and distributing the LP shares in-kind. Or if the executive suite is so in love with the real estate, go in for a PLR to let the company buy it from the plan on the grounds of providing liquity to participants. They need to weigh the costs of 1) risk of being sued for fiduciary breach by maintaining an investment they know to be bad, 2) filing for a PLR and 3) cutting their losses and selling at the current market rate.

And this thread needs to be tagged so when other people come asking about putting real estate in plans, we can point them to this as a case study in why it's a bad idea. I do believe that illiquidity is one of the potential problems about which people are commonly warned.

[shERPA]

Masteff makes a good suggestion. Might be able to get an expro PTE on buying the property out of the plan. Or just sell it. If it is unlikely to go up in value then what's the point of keeping it? Costs and risk outweigh the benefit.

[Bird]

And this thread needs to be tagged so when other people come asking about putting real estate in plans, we can point them to this as a case study in why it's a bad idea.

Good idea.

While the plan is ongoing, I would "simply" pay those entitled to distributions in cash. If the asset is fairly valued, it doesn't really matter if it is liquid or not. Of course the big issue is fair value; you didn't say it directly but it's sounding to me like it is being carried at an inflated value, which is definitely problematic. This is where it gets touchy - as a TPA, I'm comfortable saying "look, you bought this for $100K and we all know it's not worth that right now. You (the trustee) need to tell me what is fair value." If you don't have that conversation, and keep using $100K because that was the original purchase price, I can see some liability (at least perceived) because it's like you are valuing the asset. (Trustee: "Hey, we bought it for $100K and the TPA just kept using that number; nobody told me we had a problem other than it was illiquid.")

Ultimately it's probably best to sell it and be done with it. Unfortunately investors often cling to the idea that something is worth more than the market says it is. If you can get a PTE and get a (the) trustee to buy it, fine. Or if you can ultimately distribute it in-kind to a (the) trustee, then that is fine too...as long as it is fairly valued.

[Bill Presson]

Additional issues include getting an actual appraisal and getting a full bond on the amount or needing an audit.

[Scuba 401]

And this thread needs to be tagged so when other people come asking about putting real estate in plans, we can point them to this as a case study in why it's a bad idea.

Good idea.

While the plan is ongoing, I would "simply" pay those entitled to distributions in cash. If the asset is fairly valued, it doesn't really matter if it is liquid or not. Of course the big issue is fair value; you didn't say it directly but it's sounding to me like it is being carried at an inflated value, which is definitely problematic. This is where it gets touchy - as a TPA, I'm comfortable saying "look, you bought this for $100K and we all know it's not worth that right now. You (the trustee) need to tell me what is fair value." If you don't have that conversation, and keep using $100K because that was the original purchase price, I can see some liability (at least perceived) because it's like you are valuing the asset. (Trustee: "Hey, we bought it for $100K and the TPA just kept using that number; nobody told me we had a problem other than it was illiquid.")

Ultimately it's probably best to sell it and be done with it. Unfortunately investors often cling to the idea that something is worth more than the market says it is. If you can get a PTE and get a (the) trustee to buy it, fine. Or if you can ultimately distribute it in-kind to a (the) trustee, then that is fine too...as long as it is fairly valued.

do you think that paying distributions in cash causes a problem for those left with an ever increasing share of the property? conversely is it a problem if someday the asset is worth more money and they basically didnt give people their share of the property.

[masteff]

do you think that paying distributions in cash causes a problem for those left with an ever increasing share of the property? conversely is it a problem if someday the asset is worth more money and they basically didnt give people their share of the property.

1) Yes, because you still have an illiquid asset in the plan. 2) Do you think it's a problem if Joe sells out of ABC mutual fund today and next year it doubles in price? It was Joe's choice to sell the investment; just be sure Joe isn't strong armed into selling. You would need to have a proper method for valuing the asset for the date of any given transaction so that you have consistent results (aside from the price flucation of the real estate itself).

Have you talked to the client about applying for a PTE to get the real estate out of the plan to either the company or interested individual(s). The DOL has approved such sales before; not sure what the key is in defining how fair market value should be determined. DOL Real Estate related PTE Listing (go down 3/4 to sales by plans of real property) http://www.dol.gov/ebsa/publications/exemption_procedures.html

[John Feldt ERPA CPC QPA]

Conversely, suppose Joe is NOT paid now and the value of the asset drops another 99% over the next 18 months. If Joe was presssured to wait for the value to increase, but it never did, maybe the problem just got worse?

[BG5150]

Where does it say all the participants own each investment pro-rata?

If the trust is all in mutual funds, and my account by coincidence is 1/20th of the total, you wouldn't liquidate 5% of every asset when I cashed out, would you? Why is it any different if a building is part of the mix?

[Bird]

do you think that paying distributions in cash causes a problem for those left with an ever increasing share of the property?

No, as long as it is fairly valued.

conversely is it a problem if someday the asset is worth more money and they basically didnt give people their share of the property.

No, as long as it is fairly valued.

I'm not trying to be cute but that's how it is. The problem, of course, is determining the fair value.

[John Feldt ERPA CPC QPA]

"No, as long as it is fairly valued. " "The problem, of course, is determining the fair value."

very true