Mortgage as an investment

The Plan Sponsor has a DB and a 401k PS plan with individual accounts.  Husband, Wife and 1 employee participate in both plans.  The husband currently has an investment in his 401k account for a mortgage to an unrelated party.  Repayments are made to the husband's account in the plan.  The Plan Sponsor called today and would like to issue another mortgage to another unrelated party for $200,000 from both the Husband and the Wife's accounts.  The Husband has approximately $990,000 in his 401k account and his Wife has approximately $400,000 in her account.  (They originally wanted to invest in a mortgage of $1,000,000 between them but it seemed too over the top.)  They also inquired about investing in a mortgage in the DB plan.

We do not recommend real estate investments within a plan but if they wanted to proceed with this, how should they go about it?  I personally think they should get an opinion from an ERISA Attorney well versed in real estate investments within a retirement plan.  Any advice, opinions would be greatly appreciated.

Who is the plan fiduciary with responsibility for investment of plan assets?  Are the 401(k) accounts participant-directed and are the plan and trust terms appropriate for this type of investment? What are the terms of your engagement? Are you competent to assess the plan and trust terms concerning investment of plan assets?

One issue of substance: Be very careful about joint interests, such as H and W accounts, in an illiquid asset.  People get divorced and may wish to take distributions at different times for any number of reasons.  I would not allow two participants to invest in one mortgage loan under self-directed individual accounts.

And then we have the well-worn question about whether or not the other participant must be given the opportunity the opportunity to invest in THE mortgage if the mortgage is being broken up to parts to fit with individual account interests.

As to the 401k plan, what's done has been done but in terms of a new mortgage I would first ask if the option to make non-traditional investments extends to all participants, including the employee.   If not, you have a qualification issue.

As to the DB plan, they should consult an ERISA attorney, but about ERISA 404 issues first before considering any real estate issues.  

The Husband and Wife are both Fiduciaries of the Plan.  I informed the client that we will not provide advice regarding investments of any kind, especially ones that pertain to real estate.  The 401k plan has participant directed accounts and the Plan Document allows investment that may be selected by the participant and approved by the Plan Sponsor with the exception of collectibles.  We have already informed the client that the other participant in the plan must be offered the ability to invest in the mortgage.  Good point regarding the Husband and Wife accounts.  We stay away from determinations regarding real estate in retirement plans which is why we always recommend they seek the advice of an ERISA Attorney well versed in real estate.

There are practical issues here also.  What happens if the person defaults on the mortgage?  Now the plan has to come up with the cash to foreclose on the loan.  The plan forecloses it now has real estate in the plan.  That is a host of problems.  

If they go all in and put most of their account in these types of assets what happens if they need an RMD.  Will the monthly payments be high enough to supply the cash to pay each year's RMD?  It isn't like the plan can borrow money to fund an RMD to be paid later.  

If I thought about it for a while I might think of other possible problems. 

DDB BN, your plan documents must provide for this and all of the other points above are correct, but sometimes these work out to be great investments for the participant business owners (and sometimes not).