Thanks to a soaring stock market, many individual investors are finding their portfolios are flush—and likely overweighted in stocks.
While those traditional assets have performed remarkably well over the last year, economic uncertainty is growing. Inflation fears and hints that the Federal Reserve is ready to raise interest rates are leaving financial advisors on the hunt for ways to protect and grow their clients’ retirement accounts in case the market turns.
One way to do that is to look beyond the standard stocks, bonds and mutual funds to non-correlated assets that can move independent of the traditional markets.
This is the approach used by some of the world’s largest investors, the people who invest in college and university endowments. The members of the National Association of College and University Business Officers reported that as of June 30, 2020, less than half of their endowment investments are in traditional assets, such as stocks and bonds, with the rest in non-traditional assets such as private equity.
While such alternative investments, like private equity, hedge funds and real estate, once were available only to institutional investors, increased awareness and enhanced technology platforms have helped make it easier for individuals to move retirement funds into tax-advantaged self-directed Individual Retirement Accounts (SDIRAs) and access these asset classes.
What assets can be held in an SDIRA?
IRS rules allow SDIRAs to hold many alternative assets, including:
- Real estate, including commercial and residential rental property;
- REITs;
- Hedge funds;
- Certain gold and silver coins;
- Private equity, including business ventures and private placements;
- Debt/loans/promissory notes;
- Cryptocurrencies; and
- Traditional assets, like stocks, bonds, mutual funds and ETFs.
Because alternative investments are often complex and require specialized processes, most traditional retirement management companies do not offer their clients these potentially lucrative investment options.
That’s where the “self-directed” funds come into play. However, despite the name, many investors choose to retain a relationship with a financial advisor to help manage their SDIRA.
Do Investors Want to Invest in Alternatives in SDIRAs?
In May 2021, Millennium Trust Company surveyed 500 people with an income of $200,000 or more and found that more than four out of five investors expressed interest in adding alternatives like real estate, private equity, hedge funds and precious metals to their portfolio; however, fewer than 10% actually own alternative assets in their IRA. Evidently the interest is there, but the awareness and education on how to accomplish this may not be aligned.
Overall, 80% of the investors surveyed by Millennium Trust said they would be willing to invest up to one-quarter of their portfolio in alternative investments. However, more than one-quarter reported they had not discussed alternatives with their financial advisor during the previous year. “Persistently low interest rates will attract investors of all types drawn to the promise of outperformance, diversification, and lower correlation with public markets,” according to Prequin, which provides data, analytics, and insight to the alternative assets community.
The firm’s November 2020 Future of Alternatives 2025 survey found that 81 percent of investors expect to increase allocations to alternatives. The value of alternative assets under management will grow by nearly 10 percent annually to reach $17 trillion by 2025, Prequin predicts. In particular, the firm says, private equity will more than double from 2020 to 2025 and private debt will grow by 72 percent, with growth in the other asset classes to be more modest at around 5 percent annually.
Why Use a Custodian?
IRS rules require that retirement assets be held by a qualified custodian. Since most third-party retirement account companies do not offer alternative investment options, opening an SDIRA often requires finding a custodian to hold non-traditional assets.
The SDIRA custodian’s job is to facilitate and manage the transactional paperwork involved in adding alternative assets to a retirement portfolio. It is important that alternative assets are properly titled and held in the IRA to maintain their tax-advantaged status. Not doing so potentially results in IRS taxes and/or penalties. A specialized custodian also provides tax reporting, reports valuations of assets on an annual basis, and if requested, assists in the sale or exchange of the asset.
Ultimately, an experienced alternative custodian that understands the space solves for three main advisor concerns. 1.) The custodian should make portfolio aggregation easy, with data feeds to help view the positions of the alternative asset and connect the alternative assets with traditional assets at other custodians. They should, however, also provide the option to hold traditional assets alongside alternatives for the accountholder’s ease and convenience. 2.) The custodian’s understanding and ability to custody many different assets allows advisor clients to gain diversification they may be looking for or that may benefit their long-term strategy. 3.) The custodian should have an advisor service model in place that caters to the needs of the advisor and clients.
Working with an experienced custodian helps make a complex process easier for advisors and allows them to offer more value to their clients.
How Do You Find the Right Custodian?
There are three important things to consider when choosing a custodian for an SDIRA:
- Knowledge and experience
- Service and support
- Fees
Let’s take those one at a time.
Choose a Knowledgeable and Experienced Custodian
These questions will help determine whether a custodian has the expertise your clients need:
How long has the company been offering this service? It’s wise to look for a custodian that has been operating in the alternative space for a long time—ideally 10 years or more. The longer the company has offered custodial services for alternative assets, in addition to traditional, and simultaneously grown assets under custody, the more experience and expertise it has gained.
What is the value of the assets under custody? The larger the portfolio and value of alternative investment assets under custody, generally the broader the custodian’s depth of how to custody various types of alternative investments.
Does the company have experience with all types of alternative investments? It takes a breadth of knowledge and experience to custody investments as varied as real estate, private equity, commodities, precious metals, and cryptocurrency.
Examine the Level of Service and Support
To determine the level of service and support a custodian offers, you’ll want to know:
- Are they familiar with the advisor service custody model?
- Does the alternative asset account use data feeds to integrate seamlessly with assets at my other custodian, so I can easily get a full picture of my client’s holdings?
- Do they allow traditional IRA investments (stocks, bonds, mutual funds), as well as alternative investments in the IRA?
- Are they client-focused with an emphasis on service and response times?
- How easy is it to open an account, and how long does it take to fund the account?
- What is their process for determining if they will custody an asset?
- How often will they report the value of the assets?
- Do they make it easy for my client and me to manage these alternative investments? For example, do they offer a debit card to access funds for repairs to an apartment building held in the IRA?
Ensure a Transparent and Straightforward Fee Structure
Every directed custodian will have its own fee structure and set its own fees. It’s critical to take the time to fully understand how much it will charge overall.
Look for one-time fees, like those paid to open the account, annual fees charged to keep the account, and transaction fees, such as charges levied each time a bill is paid from the account. The company that charges the least to open an SDIRA might make its money by charging for every subsequent transaction, while a custodian that charges higher initial or annual fees may not charge per-transaction fees.
In some cases, it’s easy to find a simple fee structure posted on the company’s website. In other cases, it may take some digging to ferret out all of the details.
Who is the Right Candidate for a Self-Directed IRA?
SDIRAs are a strong option for investors who are knowledgeable about a particular type of investing, such as real estate, that they couldn’t otherwise include in their regular retirement account. They also work well for investors who are willing to take on potentially outsized risk by investing in things such as cryptocurrency, or investors who are simply looking for ways to diversify beyond traditional equities.
Because SDIRA custodians are not allowed to give financial or investment advice, the responsibility of research, due diligence, and investment decisions rests solely with the account holder and his or her financial advisor.
The custodial SDIRA business is growing. Finding the right custodian is key to potentially benefitting individual investors and their retirement futures.
Tom Kurinsky is the Co-Head, Director of the Custody Services division at Millennium Trust Company, LLC.