Self-Directed IRA Investing

There has been much discussion and media coverage (e.g., Wall Street Journal) following comments from Democratic Congressman George Miller regarding the need to overhaul the American pension and retirement systems, which he deems “inadequate” after the losses of approximately 40 percent of retirement wealth in the last year. One suggestion, is that the Government take over retirement accounts and invest them in indexed mutual funds! Now that makes a lot of sense, except for the fact that such investments experienced the same degree of loss in the past year that he is complaining about! Of course, with the Government’s success with Social Security (excuse me while I regain my composure), it makes perfect sense to turn over what’s left of our retirement accounts to Washington to manage. Wrong!

I’d suggest that Washington focus on fixing the economy and the regulations that permitted the fiascos in the mortgage and securities industries (think layered Collaterialized Debt Obligations (CDOs)) and credit default swaps) and that lead to our 2008 financial meltdown and the demise of many of our iconic financial institutions, before tinkering with our retirement accounts. Maybe turning around the economy so that value can be returned to our portfolios (in the form of stock and mutual price increases) would help too?

In all fairness, Mr. Miller claims that the Wall Street Journal is conducting a misleading campaign about Democratic efforts to improve retirement security, and some of his suggestions make sense. For example, he wants more transaparency on the fees the securities industry charges on assets held in retirement accounts. After all, someone has to be paying for these multi-million dollar bonuses executives in these firms receive. It can’t be those “no fee” IRAs, can it? Actually, yes it can, as the costs and profits mutual funds deduct from their investment earnings using your retirement account can reduce your net reurn by 4 percent! Of course, they don’t call that a fee, but, once again a duck that looks like a duck, probably is. That’s 4 percent you could have made if you made the same investments yourself through a self-directed account!

Mr. Miller, however, isn’t the only prominent individual who wants Government to take over the management of money you set aside from your income through defined benefit plans (e.g., 401(k)s). Ms. Teresa Ghilarducci of New York’s New School for Social Research thinks that Latin American countries have it right with nationalizing pensions. She suggests the Government force us to set aside 5 percent of our income and then give it to Social Security to manage! She might want to rethink that as some Latin and European countries are trying to relinquish control of their increasingly unpopular national plans back to their citizenries due to their generally lower rates of investment performance, growing debt obligations, and the inherent inflexibility of the plans in terms of responding to aging populations. Moreover, there is a great desire on the part of the public to permit more investment diversification for retirement accounts, which will greatly lower risk we all currently face today from having 97 percent of our retirement assets locked into the stock market.

If our leaders in Congress really want to help all of us with our retirement accounts, I suggest they do something that will end the current evaporation of wealth and that loud sucking sound coming from the vortex of the economy we are all living in, before they attempt to take what little we have left in our retirment accounts and put it in their coffers! If you agree, send a little love email to your Congressman and let him or her really know how you feel.

The IRS recently issued guidance to its auditors concerning a business model that is being marketed over the Internet that they consider to be: “a retirement plan design that appears to operate primarily to transact in employer stock, resulting in the avoidance of taxes otherwise applicable to distributions from tax-deferred accumulation accounts.” Not accidentally, I’m sure, they have entitled such a business models as “ROBS” for Rollovers as Business Startups. As you can imagine, the IRS doesn’t want anyone to “rob” the Department of Treasury of its taxes!

While they say that not all such “ROBS” transactions are non-compliant, they have issued a 15 page analysis of potential conflicts between certain ROBS models and the law. Specifically, they are concerned about:

1.) discrimination in that, in most cases, the schemes only benefit the businesses’ principal individual;

2.) that initial valuations of the stock are inadequately supported by appraisals;

3.) that promoters are compensated for developing such plans and that as fiduciaries they could be in violation of the “exclusive benefit rule”;

The IRS defines the ROBS transaction as follows:

1.) “An individual establishes a shell corporation sponsoring an associated qualified retirment plan. At this point, the corporation has no employees, assets or business operations, and may not even have a contribution to capital to create shareholder equity.

2.) The plan document provides that all participants may invest the entirety of their account balances in employer stock.

3.) The individual becomes the only employee of the shell corproation and the only particpant in the plan. Note that at this point, there is still no ownership or shareholder equity interest.

4.) The individual then executes a rollover or trustee-to-trustee transfer of available funds from a prior qualified plan or personal IRA into the newly created qualified plan. These available funds might be any assets previously accumulated under the individual’s prior employer’s qualified plan, or under a conduit IRA which itself was created for these amounts. Note at this point, because assets have been moved from one tax-exempt accumulation vehicle to another, all assessable income or excise tax otherwise applicable to the distribution have been avoided.

5.) The sole particpant in the plan then directs investment of his or her account balance into a purchase of employer stock. The employer stock is valued to reflect the amount of plan assets that the taxpayer wishes to access.

6.) The individual then uses the transferred funds to purchase a franchise or begin some other form of business enterprise. Note that all otherwise assessable taxes on a distribution from the prior tax-deferred accumulation account are avoided.

7.) After the business is established, the plan may be amended to prohibit further investments in employer stock. This amendment may be unnecessary, because all stock is fully allocated. As a result, only the original individual benefits from this investment option. Future employees and plan participants will not be entitled to invest in employer stock.

8.) A portion of the proceeds of the stock transaction may be remitted back to the promoter, in the form of a professional fee. This may be either a direct payment from plan to promoter, or an indirect payment, where gross proceeds are transferred to the individual and some amount of his gross wealth is then returned to the promoter.”

So what is the upshot of this approach. According to the IRS Memorandum, dated October 8, 2008, the IRS is actively evaluating the legitimacy of ROBS-type transactions. As of the date of the memorandum, they had identified nine promoters of this transaction (”scheme”), and an investigator has been assigned. They also indicate that they are coordinating their investigations with the Department of Labor due to potential ERISA Title I prohibited transaction issues. They are also actively reviewing the tax returns of employers who have engaged in ROBS transactions and they are moving on to a “review of promoter activity”.

I would suggest that if you are considering entering into an arrangement that appears to similar to what is outlined above as a ROBS transaction that you first consult with a knowledgeable ERISA or Employee Benefits attorney before execution. The same recommendation would apply if you have already executed a similar transaction. Otherwise, your plan could be subject to invalidation, taxes and penalties.

With all the bad news appearing daily in our morning paper, I hesitate to mention (especially on Halloween eve) that what remains of your retirement account may not be as safe as you might think. Most people have experienced a 40 percent decline in the value of their retirement account(s) since October of 2007. That’s because 97 percent of retirement accounts are invested in the stock market, and we all know what’s going on there. But with the failure of Bear Stearns, Lehman Brothers and the forced transition of Goldman Sachs and Morgan Stanley to a new regulatory structure, and the crash of 2008, you may not be aware of the feeling of some Wall Street insiders about the future of the brokerage business.

Recently, I had a Registered Investment Advisor (RIA) walk into my office in San Francisco looking for a new home for $40 million worth of retirement accounts that he manages for his clients. He is currently associated with a broker/dealer, but he has decided to go independent for several reasons. First, he no longer trusts broker/dealers, having been effected by the Lehman Brothers and Bear Stearns failures, the uncertainty of the strength of money market deposits, recent securities scandals, and the failure (his words) of the SEC to prevent what happened with the securities products associated with packaged sub-prime mortgages.

So he is now in the market for a new custodian for his clients’ accounts and having done some research, is interested in PENSCO Trust. We chatted for a while as I explained our services, and having felt satisfied, he left to return to Boston to begin executing his plan.

After he left it occurred to me that his interest in becoming independent of Wall Street seemed to be a growing sentiment not only from disgruntled investors, but many professionals whose businesses have been associated with Wall Street, including independent RIAs. Both groups want to escape from the market risk they bear when their or their clients’ assets are vulnerable to large volatile swings in the market that are primarily created by when holders of massive amounts of stock market assets (e.g., mutual fund companies, large pension funds, hedge funds, and fund of funds, etc.) buy and sell, as well as more protection for their portfolios through diversification. So it seems that the harsh lesson from the crash of 2008 (not to put all your eggs in one basket), was learned not only by investors and owners of retirement accounts, but by many of their own professional advisors!

As a result of this trend towards more diversification and less risk, PENSCO Trust is seeing more people fleeing from the traditional markets looking for alternative asset investments such as real estate, precious metals and private equity. But there is another reason we are seeing an influx of assets and especially retirement account cash. Savvy investors are concerned about the safety of their cash balances. Many are aware that there cash is only insured up to $100,000 by the SIPC which is the insurer for most brokerage firms. If a broker fails, they may not see more than $100,000 of their cash deposits back!

On the other hand, as you may be aware, self-directed retirement accounts’ cash held in banks is insured up top $250,000 per person per bank. In PENSCO’s case, since we are a non-depository bank and trust company, we only place our clients cash into “well capitalized ” (the highest rating by the FDIC) banks that we monitor constantly for their performance. None of the banks we use are involved either in the derivatives or sub-prime businesses and all have a consistent track record for safe and sound operations. Because we use multiple banks, our clients receive up to $250,000 in each bank as some of their money is deposited in each bank. So if one of our depository banks would fail (although highly unlikely, but possible), our clients would receive their $250,000 coverage for that bank and none of their deposits in our other depositories would be effected.

So if you are fortunate to have more than $100,000 in cash deposits in a retirement account at a broker/dealer during these stormy days, you may want to consider moving the excess to a safe harbor with your bank.

I have to say that I am amazed that while America is on the brink of a financial disaster (that none other than Warren Buffet calls America’s financial Pearl Harbor), that our exalted elected officials can’t come to some agreement about a “rescue” plan. Not being informed enough to decide, I can’t say that Bush’s $700 billion plan is the best solution, but certainly something needs to be done quickly to restore confidence in the U.S. economy before our crisis becomes world-wide. If the U.S. dollar starts looking the Mexican peso to the rest of the world, they’ll be a run on the country and not just the Indymac bank!

What are our esteemed Congress men and women thinking? I would assume that after Indymac (a $32 billion bank), AIG ($85 billion bailout), and the demise of such venerable financial institutions as Merrill Lynch, Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac, and the potential for more, including Morgan Stanley, Goldman Sacks, Washinton Mutual, Wachovia, etc., that they can sense the urgency too. Someone should lock the door on Congress and bring in Army cots and rations until they take action.

America, capitalism, democracy are on the World’s and the average American’s microscope as I write. It is like an episode of “House”, with America on life-support, but with no one in the room stepping up to prescribe. To add to the chaos, one Presidential candidate would rather go to the campaign “dance” than visit his father (America) in the hospital! If he is not careful he might miss the funeral. If he doesn’t understand that fixing the economy is the most important foreign policy issue right know, he may not be the right man for the top job. Hello!!! Houston, we have a problem!

Yesterday, Iran’s President Ahmadinejad, a raving lunatic, actually gained credibility for the first time when he said the “American empire is on the brink of collapse”. The sad truth is that he may be right if something isn’t done quickly. It is not inconceivable that the U.S. dollar could be replaced by the yen or euro, if a tourniquet isn’t applied soon.

President Bush said last night that without immediate action by Congress “America could slip into a financial panic.” I would suggest that most of us already have. He even went so far to say that American’s could lose their retirement accounts if we allow Wall Street to crash. Well, he’s right there. Ninety-seven percent of America’s retirement accounts are invested in the stock market. Something I have been railing against for years. At least the fact that most American’s have their retirement accounts trapped in traditional assets and the stock market is being noticed. I have received calls from writers with the Wall Street Journal, New York Times, and Marketwatch.com in the last few days, interested in knowing if we are getting an influx of new clients moving out of the market. The answer, you might guess under the circumstances, is a resounding YES. They are not only moving their assets out, they are moving their entire retirement accounts more than we have seen before. This might bode well for the future relaxation of regulations that permit and support the current shameful stranglehold traditional providers have on their customer’s life savings exposing them to the possibility of near total loss, if you believe the President.

I should point out that while I rant, I believe this time will pass just as the crash of ‘29 and September 11th, but like the others it will not be forgotten. My advice (not legal, tax or investment, of course) is to pay close attention, examine your portfolio allocation, adjust as possible to increase diversification, if you can do so without selling out low. Ultimately, I believe we will see an ebb to the flow, and a long slow recovery. But who am I to prognosticate. I am just another spectator, witnessing a historic set of financial vignettes, hoping the play will end soon.

Last night, James Herold and I attended the Stars of San Francisco Greater Bay Area Muscular Dystrophy Fundraising Event to represent PENSCO Trust Company in an effort of raising (and exceeding our goal) $4,275.

Tom and James on YouTube