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NON-TRADITIONAL PLAN INVESTMENTS. Sean M. Waters, CFA, AIF® CariAnn J. Todd, CPA. NON-TRADITIONAL PLAN INVESTMENTS. CariAnn J. Todd, CPA Manager BeachFleischman, PC Tucson, AZ 682.203.6556 ctodd@bfcocpas.com. Sean M. Waters, CFA, AIF® Investment Consultant

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NON-TRADITIONAL PLAN INVESTMENTS


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    1. NON-TRADITIONAL PLAN INVESTMENTS Sean M. Waters, CFA, AIF® CariAnn J. Todd, CPA

    2. NON-TRADITIONAL PLAN INVESTMENTS • CariAnn J. Todd, CPAManagerBeachFleischman, PCTucson, AZ 682.203.6556ctodd@bfcocpas.com • Sean M. Waters, CFA, AIF®Investment Consultant Cook Street ConsultingDenver, CO800.318.7770swaters@cookstreetconsulting.com

    3. What are Traditional Investments? • Need to understand the typical “Traditional” landscape to adequately evaluate Non-Traditional Investments (NTI’s) • ERISA Duty to Diversify: Imposes upon a fiduciary a duty to diversify plan investments "so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so.“

    4. What are Traditional Investments? • Typical Traditional Investments: • Stocks • Bonds • Cash • Traditional Investment Structures • Mutual Funds • Commingled Investment Trusts • Exchange Traded Stocks and Bonds • Valuation: Generally very easy to value

    5. What are Non-Traditional Investments (NTI’s)? • Definition: • Adj. 1. nontraditional – “not conforming to or in accord with tradition;“ • Alternative Assets: “A term referring to any non-traditional asset with potential economic value that would not be found in a standard investment portfolio. Due to the unconventional nature of some of these investment assets, valuation may be a problem.” Source: www.answers.com, www.thefreedictionary.com

    6. NTI Structures: • Non-Traditional Investment Structures • Limited Partnerships • Hard Assets • Private Equity (stock) • Direct Real Estate • Others? • Often it is the structure that causes the issues… • Issues: Valuation, Liquidity, Administration, Fees, Transparency

    7. Why Consider NTI’s? • Reason 1: Meet ERISA requirement to diversify plan investments "so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so." • Reason 2: Improve efficiency of portfolio • DB: Increase returns and decreased risk of a DB portfolio can have a beneficial impact to beneficiaries and possibly to the corporation (i.e. amount of funding needed) • DC: If implemented properly, a DC participant can achieve the same benefits as a DB plan (e.g. higher ending balance, lower risk along the way, less deferrals needed, etc.) • Fiduciaries have a duty to diversify, but must balance vs. the risks associated with NTI’s • Seems simple but…

    8. Risks of NTI’s? • Valuation • Liquidity • If client needs to raise money • Capital call by the limited partner or investment manager • Transparency • Fraud: e.g. Madoff, et all • Headline • Portability • ERISA Prohibited Transactions • Example: Real estate owned by fiduciary, then put into Plan trust… who does that benefit? DQ the plan?

    9. Types of NTI’s • Liquid/Easily Valued Structures: • Treasury Inflation Protected Bond (TIPS) Funds • High Yield Bond Funds • Real Estate Funds • US • Global • “Absolute Return” (Mutual) Funds – be careful • Commodity Funds • Exchange Traded Funds

    10. Types of NTI’s (continued) • Illiquid/Difficult to Value Structures: • Limited Partnerships • Hedge Funds • Direct Real Estate (usually in a LP but could possibly be in other structures) • Oil & Energy • Hard Assets (e.g. Gold, precious metals, etc.) • Private Equity (stock) • Annuities • Life Insurance • Others?

    11. Advising Clients on NTI’s • “Only invest in what you understand…” • If you don’t posses the requisite knowledge, per ERISA, you must hire someone who does • Fees • Investment s: Tend to be much higher and less transparent • Due Diligence: Fees tend to be higher given the additional work involved in analyzing and monitoring on a regular basis as required by ERISA • Know the structural and valuation issues before you invest • Demonstrate procedural prudence at all times

    12. Valuing NTI’s • On the 5500 • In Audited Plans

    13. NTI’s on the 5500 • 5500 Instructions (Schedules H and I): “Current value means fair market value where available. Otherwise, it means the fair value as determined in good faith under the terms of the plan by a trustee or a named fiduciary, assuming an orderly liquidation at the time of the determination. See ERISA section 3(26).”

    14. NTI’s on the 5500 • Note Schedule H, line 4g: “Did the plan hold any assets whose current value was neither readily determinable on an established market nor set by an independent third party appraiser?” • Truthful answers help you avoid preparer penalties… which are not so nice anymore.

    15. NTI’s on the 5500 • Fair market value is harder to obtain for NTI’s • Data may not be readily available • It could be costly • Who has the expertise to do the work? Probably not the TPA or Actuary.

    16. NTI’s on the 5500 • Start with the Investment Advisor as your primary source of information • Get plan management involved early on • Don’t be fooled, don’t be a doormat • Did I mention preparer penalties??

    17. NTI’s on the 5500 • Gold and other Precious Metals • Make plan management do the work • Estimated bid values may only be an indicator of value not the true value • Once they give you a number: • Ask for the valuation method and source • Document procedures and sources • Make sure plan records are complete as to type of metal, where held, etc.

    18. NTI’s on the 5500 • Limited Partnership Interests: • Make plan management do the work • Value depends on underlying assets • Once they give you a number: • Ask for a copy of the valuation • Ask about recent sales/trades • Get the K-1 • Ask yourself if the valuation makes sense. • Is it discounted for lack of marketability and lack of control, if applicable?

    19. NTI’s on the 5500 • Real Estate • Make management do the work • Recent professional appraisal is best • Once they give you a number: • Ask for a copy of the appraisal • Compare value to tax assessor • Compare to insurance policies • Ask yourself if the value makes sense

    20. NTI’s on the 5500 • Private Equity (stock) • Make management do the work • Business valuation is best • Once they give you a number: • Ask for a copy of the valuation • If no BV, ask for a documented calculation • Cost is only a starting point • Very, very hard to get a good fair value

    21. NTI’s on the 5500 • Why does it matter? • In a DB plan, valuation of trust assets can determine funding status (affects sponsor). • In a DC non-participant directed asset plan, valuation of trust assets affects participant valuation and distributions. • In an ESOP, valuation of trust assets affects the deduction and distributions.

    22. NTI’s on the 5500 • Why does it matter? (con’t) • Improper valuation could impact proper reporting of a prohibited transaction. • An asset with the same value every year on the 5500 is a red flag to examiners. • An extreme change in value with a jump in distributions is a red flag to examiners.

    23. NTI’s on the 5500 • ERISA Advisory Council – 2008 – Issued their “Report on Hard to Value Assets and Target Date Funds” http://www.dol.gov/ebsa/publications/2008ACreport1.html • Acknowledged the challenges • Emphasized the plan fiduciary’s responsibility for asset valuation

    24. NTI’s on the 5500 • ERISA Advisory Council (con’t) • Hinted at the fact that the issue of valuation should be considered by fiduciaries PRIOR to purchasing NTI’s or Hard to Value assets • Encouraged the DOL to issue guidance to aid fiduciaries in recognizing, understanding and evaluating alternative investment vehicles

    25. NTI’s in Audited Plans • This section refers to plans that are required to file Schedule H (large plans) OR • Small plans that have less than 95% of their assets as “qualifying plan assets” AND don’t have an ERISA Sec 412 fidelity bond covering 100% of the value of the nonqualifying portion • EITHER must engage an IQPA (CPA firm) to perform an audit

    26. NTI’s in Audited Plans • What are qualifying plan assets? • Assets held by certain regulated financial institutions • Shares issued by a registered investment company (mutual funds) • Investment and annuity contracts issued by an insurance company • Qualifying employer securities • Participant loans • http://www.dol.gov/ebsa/faqs/faq_auditwaiver.html

    27. NTI’s in Audited Plans • The audit environment adds a new layer of scrutiny to fair values • Likely a higher documentation standard • FAS 157 reporting is required • Plan management must sign a letter that includes an assertion that all assets are properly valued

    28. NTI’s in Audited Plans • Documentation for Auditors: • “the client said so” is not sufficient • “same as last year” is not sufficient – this is not a realistic answer in today’s market • Auditor will need documentation substantiating the value of NTI’s

    29. NTI’s in Audited Plans • Documentation for Auditors (con’t): • Value will be subjected to scrutiny of source, expertise of preparer, validity, dating, reasonableness, etc. Procedures will depend on auditor’s approach and significance of asset to the plan. • Auditor is not allowed to come up with the value for the plan (impairs independence)

    30. NTI’s in Audited Plans • FAS 157 “Fair Value Measurements”, effective 1/1/08 for most plans. • Under FAS 157, fair value is defined as the price to sell an asset or transfer a liability between market participants as of the measurement date.

    31. NTI’s in Audited Plans • FAS 157 (con’t) • FV measurements assume the asset or liability is exchanged in an orderly manner, the exchange is in the principal market for that asset or liability and that market participants are independent, knowledgeable, able and willing to transact an exchange.

    32. NTI’s in Audited Plans • FAS 157 (con’t) • The plan’s financial statements must disclose the appropriate level of each investment under the hierarchy established by FAS157. • Level 1 – Unadjusted quoted prices in active markets for identical assets • Level 2 – Quoted prices for similar assets in active or inactive markets (observable inputs) • Level 3 – Inputs are unobservable and significant

    33. NTI’s in Audited Plans • FAS 157 (con’t) • Most NTI’s will fall in the Level 3 category • Level 3’s require disclosure of a rollforward of asset activity from BOY to EOY • Auditors will be asking for this. Refer them to plan management or the investment advisor (unless you are a TPA/Custodian).

    34. NTI’s in Audited Plans • The Management Representation Letter • Required at the end of every audit • Must be signed by relevant parties (trustees, sponsor’s owner, CEO/CFO, human resources, etc.) • Asserts that all assets are valued at fair value in accordance with FAS 157

    35. QUESTIONS???

    36. Sean M. Waters, CFA, AIF®Investment Consultant Cook Street ConsultingDenver, CO800.318.7770Swaters@CookStreetConsulting.com www.cookstreetconsulting.com

    37. CariAnn J. Todd, CPAManagerBeachFleischman, PCTucson, AZ 682.203.6556ctodd@bfcocpas.com www.beachfleischman.com