Unconventional Assets in DC Plans Remain Poorly Understood

Federal data collection efforts to date have captured little information on retirement accounts holding unconventional assets—such as real estate, precious metals, private equity, and virtual currency. 

A new report out from the Government Accountability Office (GAO), titled “Improved Guidance Could Help Account Owners Understand the Risks of Investing in Unconventional Assets,” suggests there is a significant lack of reliable data around the use of “unconventional” assets within defined contribution (DC) plans.

“Federal data collection efforts to date have captured little information on retirement accounts holding unconventional assets—such as real estate, precious metals, private equity, and virtual currency,” the report notes, “making the prevalence of such accounts unknown.”

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According to GAO, in tax year 2015, the Internal Revenue Service (IRS) began requiring that custodians or trustees of individual retirement accounts (IRA)—including banks or other institutions approved to hold account assets—report selected information on unconventional assets in their clients’ accounts to IRS.

“As of November 2016, IRS plans to begin compiling the new IRA asset data in 2017, but has not specified when the new IRA asset data will be available for analysis,” GAO reports. “Seventeen of the 26 custodians, who GAO identified as allowing retirement accounts with unconventional assets and who participated in GAO’s data collection effort, reported having nearly half a million of these accounts in their custody at the end of calendar year 2015. IRAs made up the vast majority of accounts and assets reported.”

GAO’s review of industry documents found that individuals wanting to invest in unconventional assets through their IRA “generally agree to be responsible for overseeing the selection, management, and monitoring of account investments and shoulder the consequences of most decisions affecting their accounts.” For example, owners of such accounts assume a fiduciary role, which makes them assume greater responsibility for overseeing the selection, management, and monitoring of account investments, and shoulder the consequences of most decisions affecting their accounts.

According to GAO, current IRS guidance “provides little information to help IRA owners understand their expanded responsibilities and potential challenges associated with investing in unconventional assets.”

“Targeted IRS guidance for these IRA owners may help them navigate the potential compliance challenges associated with certain types of unconventional assets,” GAO argues.

NEXT: GAO calls for more guidance 

Among the most common challenges for which GAO would like to see guidance include the difficulty of monitoring such investments for federal tax liabilities.

“IRA owners are not always aware of the need to monitor the gross income from certain unconventional assets in their accounts for ongoing federal tax liability,” GAO warns. “For example, IRA owners who invest in active businesses or debt-financed properties need to monitor their accounts for ongoing tax liability that must be paid from the IRA. Failure to do so can result in underpayment penalties.”

Another challenge named by GAO is obtaining annual fair market valuations for non-publicly traded assets.

“IRA owners investing in hard-to-value unconventional assets can face challenges meeting their responsibilities to provide updated fair market value information to their custodian to meet IRS's annual reporting requirement,” GAO suggests. “Failure to provide an updated fair market value in a timely manner can result in a custodian prematurely distributing account assets to the owner at a fair market value that is not current, potentially incorrect, and which could lead to a loss of tax-favored status for their retirement savings.”

GAO adds that, without further guidance from IRS, people who invest their retirement accounts in unconventional assets may be placing their savings at additional risk.

“Retirement accounts allowing such unconventional investments increase owners' responsibilities in ways they may not understand—and mistakes can trigger taxes and penalties,” GAO concludes. “Moreover, account custodians may prematurely close an account or let valueless assets and fraud go undetected because they did not accurately determine the value of unconventional assets. We recommended that IRS improve guidance for account owners with unconventional retirement assets and clarify how to annually value such assets.”

The full analysis is available for download here

Retirement Savings Models Simplify a Complex Picture

Current savings models for defined contribution plan participants should be accompanied by education about the realities of life.

Consider this: A young woman enters the workforce at age 25 and is automatically enrolled in a defined contribution (DC) plan at 3% of pay. The plan automatically escalates her deferral by 1% until the woman is deferring 10% of pay annually. When you add to this a safe harbor match and give the participant 7% per year returns, she theoretically retires by age 60 a wealthy woman.

Sounds great, right? However, as John Lowell, partner and retirement actuary with October Three, who is based in Atlanta, notes, this is rarely reality. What if the woman gets married and has children and stops work to take care of the children? Or, what if the woman has a period of time where paying for child care costs, a mortgage or health care urges her to reduce her deferrals or to take a loan from her DC plan? What if she involuntarily loses her job? In addition, Lowell says DC plan participants should understand that 7% per year returns is not a reality.

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This is the problem with retirement savings models, says Drew Carrington, head of Franklin Templeton Investments’ U.S. large market institutional defined contribution (DC) business, who is based in San Mateo, California. “It is also partly a more generalized problem in the [retirement] industry to oversimplify the retirement challenge,” he tells PLANSPONSOR.

Almost all of these assumptions are wrong, he says. People change jobs every five or so years; many new hires will not be fresh out of college and have probably saved somewhere else. Models simplify decisions about retirement, including when a person will retire and when they will claim Social Security. “These are usually household decisions, but models are for individuals,” he notes.

Lowell adds that every time you throw market volatility in the mix, even if it has a mathematical average equal to the assumption, it will bring the outcome down. As a simple example, Lowell says, if the woman in the example has a zero return in year one, then a 14% return in year two, the cumulative return is not 7% compounded, it’s less.

NEXT: Adjusting for reality

Lowell points out that when actuaries do forecasting for defined benefit (DB) plans, they do not look at one set of assumptions; they model multiple scenarios. If the DB plan sponsor is risk-averse, it would look at the poorer outcomes and hedge against them.

Lowell says the same can be done with DC planning models. “The model I would like to see is one in which people are able to input their own individual best estimate of what they think they will do, and the model will perform various scenarios,” he says.

“I’m suggesting a model that doesn’t just show a scenario based on a participant’s input and say ‘Yeah you’re good,’ or ‘No you’re not,’ but one that starts with reasonable expectations, and shows a participant all realistic outcomes,” Lowell adds. “The model will tell a participant what percentage of time they will be in good shape and how often they won’t, as well as what they can do to minimize the percentage of times they are not in good shape, such as change asset allocations. It is OK for a model to use questions like, ‘Do you anticipate work stoppages or periods of time where you will have to stop or lower deferrals?’”

Lowell concedes this is not an easy model to build, but it is “doable.” He says, “If it can be done for DB plans, it can be done for DC plans.”

Until such a model exists, Carrington says it is a great challenge in the industry to help people piece together the complex retirement puzzle. “We have to start talking to participants about the challenge,” he says. “Rather than simply discussing only their DC assets, or only their resources and not their household’s, we need to discuss the more complex picture. This takes a combination of models, advice and communication to make participants aware of the reality.”

Carrington adds that financial wellness is important as well, because it helps people look at budgeting at the household level and issues such as addressing debt. It helps participants address challenges when their savings behaviors do not fit a model’s assumptions.

NEXT: How can plan sponsors help?

Lowell says if a DC plan sponsor adopts a model for participants to use, it should roll out an educational program to help participants use the model in a way that is prudent and informed. Plan sponsors should explain the parameters of the model and what participants might think about when running those parameters. “Obviously plan sponsors have to limit how much to say to participants, but they can say participants may consider work stoppages they may have for personal reasons or changes in lifestyle that may cause them to change deferrals,” he says.

Carrington suggests other things plan sponsors can do to better position participants for success. They can target new hires—especially mid- and late-career hires—with communication that invites them to save at a rate similar to what they did at their prior job, not just at the new employer’s auto deferral percent. “They know they can save at a higher level because they did at their previous job,” he says.

Plan sponsors can also change their plans to accommodate regular withdrawals, not just lump-sums.

They can also choose models that help with Social Security claiming decisions, Carrington suggests, and provide education or access to advice that will help them fund retirement if they retire at age 65 but claim Social Security later.

Carrington believes the retirement readiness picture is more positive than what the data shows or what gets reported. “We look at general things, like average DC plan balance, and that’s very distorted. We don’t take into consideration things like savings from a participant’s whole job tenure or their household situation. Certainly there are things we can do to improve participants’ retirement readiness, but we don’t have to start from scratch. Incremental improvements will enhance retirement for many participants,” he concludes.

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