In recent years, retirement plan sponsors have searched for ways to increase performance, while still maintaining a risk-averse strategy.
Many are looking beyond traditional stocks, bonds and mutual funds, and taking a closer look at so called “alternative investments” including hedge funds, private equity offerings, real estate investment trusts, currency funds, oil and gas and real estate limited partnerships, and limited liability companies (LLCs). These types of investments generally see greater returns than traditional investment vehicles.
While other investment and operational factors may increase the risks to the overall investment portfolio, these types of alternative investments may ultimately be a valuable addition to traditional institutional portfolios.
The Employee Retirement Income Security Act of 1974 (“ERISA”) requires that fiduciaries (i) act for the “exclusive purpose” of the plan, (ii) act with “prudence,” (iii) “diversify” plan investments, and (iv) act in accordance with the “terms of the plan.” ERISA further requires that a fiduciary diversify the investments of the plan so as to minimize the risk of large losses,1 unless under the circumstances it is clearly prudent not to do so.2
While, in general, it is impossible to predict with certainty the performance of an investment, prudence requirements may be met by a process that requires investments to be examined for factors such as the risk of loss, the opportunity for return, diversification, liquidity, current return and projected return.
Issues to Consider
Alternative Investments hold both distinct advantages and disadvantages for pension plans.
Lack of liquidity is generally not an imminent concern for pension plans, as payouts are not required until a future date and liquidity is only needed when the monies eventually come due. As such, pension plans can invest in these for higher returns, without placing as much importance on the liquidity of the investment.
However, lack of liquidity can also lead to a lack of transparency (the underlying investments are not necessarily disclosed on a frequent basis) and difficulties in pricing (since they are not traded frequently on the open market to establish a fair value). Furthermore, some alternative investments, like hedge funds, are subject to less scrutiny from regulators and pose additional risks in terms of governance.
With the recent heightened focus on the reasonableness of the fees paid under a contract or arrangement, fiduciaries should review all existing contracts and arrangements to ensure that they are in compliance with the requirements of ERISA.
If the contract or arrangement does not qualify under an ERISA exemption, the plan fiduciary who participated in the arrangement could be deemed to violate the prohibited transaction rules of ERISA and the service provider could be deemed a disqualified person under the internal revenue code and be subject to excise taxes.
With the increase in risk and, hopefully, return, come additional tax compliance considerations. Alternative investments held in pass-through entities (partnerships, LLCs) can generate unrelated business income and potential foreign informational filing requirements.
Unrelated Business Income Tax
Tax-exempt investors such as pension plans are subject to tax on their share of the unrelated business taxable income (“UBTI”) and Unrelated Debt Financed Income (“UDFI”) that is “passed through” to them. This generally comes from trade or business income earned in the underlying activities of the pass-through, or from investment earnings of the pass-through (interest, dividends, rents, gains/losses) that are debt financed.
This information is reported annually to the investor on Schedule K-1, which is required to contain certain disclosures of UBTI for exempt organizations. The organization files a Form 990-T to report and pay any Unrelated Business Income Tax (“UBIT”) that may be owed at the federal level, and must additionally perform analysis to determine any necessary state-level tax reporting requirements.
Foreign Informational Reporting
As a result of investments held in pass-through entities, as well as direct investment in foreign entities (foreign corporations, hedge funds), transactions may occur which result in Foreign Informational Reporting requirements.
The Internal Revenue Service (“IRS”) has instituted severe penalties for noncompliance with said requirements. The filing requirement determination for these types of investments involves a complex set of rules and regulations, and should be thoroughly examined to ensure full compliance.
It should be noted that the IRS currently has an Offshore Voluntary Disclosure Program (“OVDP”), under which organizations can voluntary file any prior year foreign informational returns that may have been missed, and subsequently be considered fully compliant and avoid the potential assessment of any penalties should the IRS discover this omission on their own.
Fiduciaries of a pension plan should identify the plan investment objectives and find alternative investments that fit their needs. However, they also need to ensure they are familiar with each of their alternative investment funds, including the underlying investment strategies and activities and the related tax consequences.