Many business owner seek to invest in real estate and private loans (among other assets) inside their defined benefit plans. But is this even legal?
While these assets may be allowable in such plans, in most situations we recommend against it!
In this post, we will discuss some of the downsides of self-directed assets in defined benefit plans. That way, you can decide for yourself if this would be appropriate for you. Let’s jump in!
Background
Self-directed defined benefit plans allow investments beyond traditional stocks and mutual funds. These investments often include real estate, private equity, loans, and other alternative assets.
These assets are commonly classified as non-qualified assets under retirement plan rules. They require strict compliance with IRS and Department of Labor regulations.
Business owners often pursue these strategies seeking higher returns or diversification. However, these benefits come with significant administrative and regulatory burdens.
The main pitfalls of self-directed defined benefit plans include:
- There is a greater need to monitor investments due to increased volatility.
- Requirement to determine fair market value of assets each year.
- Higher third-party administration fees.
- Filing Form 5500 rather than simpler Form 5500-EZ or 5500-SF.
- Requirement to maintain bonding.
Non-Qualified Assets and Compliance Challenges
While a defined benefit plan can hold almost any asset class. There are different compliance requirements for different asset classes. Investments inside a self-directed defined benefit plan fall into two categories:
- Qualified; and
- Non-Qualified.
The most critical distinction between these two comes down to one fundamental question: can the asset’s value be readily and objectively determined at any point in time?
Qualified Assets
Qualified assets are investments with readily determinable fair market values. Here are some examples:
- Publicly traded stocks
- Mutual funds
- Exchange-traded funds (ETFs)
- Treasury securities
- Certificates of deposit
Their prices are published daily on exchanges and financial markets, meaning the plan’s asset value can be calculated accurately and instantaneously.
Non-Qualified Assets
Non-qualified assets, by contrast, are investments that do not have a readily determinable market value. These assets include:
- Real estate
- Private loans
- Promissory notes
- Interests in closely held businesses
There is no exchange or public market that publishes a daily price for a piece of commercial real estate or an outstanding promissory note made to a private borrower.
This absence of a readily determinable value creates an immediate and recurring problem for the plan. Defined benefit plans are legally required to report accurate asset values every single year for funding and filing purposes.
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Asset valuation is just one issue. Let’s go through each pitfall to make sure you understand all the compliance issues.
Downside #1: The Fair Market Valuation Requirement
As noted, one of the most challenging requirements of a self-directed cash balance plan is determining the fair market value of plan assets each year. Without a published market price to reference, the business owner must obtain an independent third-party valuation of each non-qualified asset annually. This can be costly, time-consuming, and an imprecise exercise.
Real estate holdings must be appraised annually by a qualified independent appraiser. Private equity interests require formal valuations that can be time-consuming and costly. Promissory notes and other debt instruments must be evaluated for collectability and current market value.
These valuations are mandatory. The IRS requires accurate annual asset valuations to ensure there are adequate funds to support future retirement payouts. Inaccurate or unsupported valuations can trigger IRS scrutiny and expose the company to significant legal liability. Take a look at what the IRS has to say here: IRS Discussion on Asset FMV
Downside #2: Bonding Requirement
Bonding is not required for solo cash balance plans as long as the plan invests in qualified assets. Once the plan assets included self-directed (non-qualified) assets, bonding becomes a requirement.
Bonding is a form of insurance that protects the retirement plan and its participants against losses caused by fraud or dishonesty by individuals who handle plan funds or property. The IRS deems a high risk of fraud when it comes to self-directions, which triggers bonding.
The amount of bonding required is determined by a specific formula under ERISA. Each person who handles plan funds must be bonded for at least 10% of the amount of plan funds they handled in the prior year, with a minimum bond amount of $1,000 and a maximum of $500,000 per plan. For plans that hold employer securities, the maximum bond amount increases to $1,000,000.
Is a Cash Balance or Defined Benefit Plan Right For You?
The bonding requirement results from annual audit requirements. Specifically, with plans that have fewer than 100 participants, the DOL waives the audit requirement if the plan maintains:
- Less than 5% of its net asset value from “non-qualifying assets.”
- A fidelity bond that covers 100% of the value of the non-qualified plan assets.
As a result of the non-qualified assets, you can have an annual audit or get a bond. Because audits are expensive and time consuming, the only real option is to obtain the bond.
The bond must be obtained from a surety company that is approved by the U.S. Department of the Treasury, and it must be in place before any covered individual begins handling plan funds.
The bond must be renewed annually and the amount must be recalculated each year based on updated plan asset figures. Failing to maintain the required bonding is an ERISA violation that can expose the plan sponsor to penalties and potential personal liability.
Downside #3: Form 5500 Requirement
Form 5500-EZ and 5500-SF are simplified filings for plans meeting strict IRS and DOL criteria. They’re available to one-participant or small plans with standard, easily valued assets.
One of the key eligibility conditions for both simplified forms is that plan assets must be held in qualifying institutions and invested in standard, readily valued financial instruments. Holding alternative assets, like real estate or private equity, disqualifies a plan from using these forms.
Self-directed defined benefit plans must use the full Form 5500 due to their complex assets. The IRS and DOL require detailed schedules, like Schedule H, to verify funding and compliance. Preparing these reports takes more work from accountants and administrators, increasing costs.
These extra filing requirements mean much higher annual compliance costs—often overlooked by plan sponsors. Full Form 5500s, actuarial fees, and possible audits can make self-directed plans far more expensive than expected, outweighing their investment flexibility.
Downside #4: Asset Titling
When a self-directed defined benefit plan holds non-qualified assets like real estate or promissory notes, those assets must be titled directly in the name of the plan trust. ERISA requires that all plan assets be held in trust as the legal owner of record.
While this makes sense from a legal protection standpoint, it creates a significant practical problem when the time comes to terminate the plan and distribute its assets. Plan termination triggers a requirement that all assets be distributed or rolled over to participants in a way that satisfies ERISA and IRS rules.
For qualified assets like stocks and mutual funds, this process is straightforward. The custodian liquidates the securities or transfers them in-kind to the participant’s IRA or 401(k). The transaction is completed within days.
Non-qualified assets present an entirely different challenge because they cannot simply be transferred with a few keystrokes. Real estate titled in the name of the defined benefit plan trust must be formally retitled into the name of the receiving IRA or 401(k) trust. This requires a new deed to be prepared and recorded with the appropriate county or municipal authority.
The retitling process becomes even more complicated when the receiving account is an IRA rather than a qualified plan. Self-directed IRAs can hold real estate and notes, but the custodian of the receiving IRA must approve the asset before transfer. Not all self-directed IRA custodians accept every asset type, and some have specific requirements around property type, documentation, and valuation that must be satisfied before they will accept the transfer.
Downside #5: Complexity and Costs
Self-directed defined benefit plans create a compliance burden that is qualitatively different from anything a standard cash balance plan requires. Every alternative asset introduced into the plan trust generates its own set of documentation requirements, valuation obligations, and prohibited transaction risks.
The business owner must monitor each asset continuously to ensure it remains permissible under ERISA and the Internal Revenue Code. A single compliance misstep involving even one asset can jeopardize the qualified status of the entire plan, not just the investment that caused the problem.
The prohibited transaction rules under ERISA Section 406 are particularly treacherous for self-directed plan sponsors who also have business interests outside the plan. Transactions between the plan and a disqualified person, which includes the plan sponsor, family members, and related business entities, are strictly forbidden regardless of how favorable the terms might appear.
Most administrators assess a surcharge for non-qualified assets. At Emparion, that fee is typically $500.
Below is a comparison of filing requirements and administrative burden:
| Plan Type | Filing Requirement | Bonding Required | Complexity Level |
|---|---|---|---|
| Traditional Defined Benefit Plan | Full Form 5500 | Yes | Moderate |
| Self-Directed Defined Benefit Plan | Full Form 5500 with additional schedules | Yes | High |
| Solo Defined Benefit Plan (Standard Assets) | Form 5500-EZ | No (in most cases) | Low |
Why a Self-Directed IRA Is Often Better
Business owners seeking alternative assets in a tax-advantaged account should consider a self-directed IRA over a defined benefit plan. Self-directed IRAs are designed for investments like real estate, private lending, precious metals, and private equity.
Specialized custodians make self-directed IRAs streamlined and accessible, without the complexity of defined benefit plans. Self-directed IRAs offer major cost savings: no actuarial fees, funding certifications, testing, or bonding. Annual maintenance costs are much lower than for defined benefit plans.
Self-directed IRAs have simpler regulations: no actuary, Form 5500, or ERISA funding requirements. The main compliance requirements for self-directed IRAs are avoiding prohibited transactions and keeping accurate asset records—much simpler than those for defined benefit plans.
Self-directed IRAs avoid funding risk: if investments decline, there’s no obligation to cover losses with extra contributions—unlike defined benefit plans. With a self-directed IRA, account balances simply reflect asset values with no required contributions if values fall.
Key Risks and Considerations
Before choosing a self-directed defined benefit plan, consider the following risks:
- Complex compliance rules for non-qualified assets
- Increased administrative and professional service costs
- Full Form 5500 filing requirements every year
- Mandatory bonding requirements for plan assets
- Difficulty obtaining reliable year-end valuations
- Higher likelihood of IRS or Department of Labor scrutiny
These factors can significantly impact the long-term success of the plan. Many sponsors underestimate these challenges at the outset.
Careful planning and professional guidance are essential. Even then, the risks may outweigh the benefits.
Still Want to Proceed?
If you still want to move forward with a self-directed cash balance plan, here is a summary of your steps:
- Open investment account. We recommend using Solera or Titan Bank as they are more familiar with these types of investments
- Ensure the investment is not prohibited transaction: https://www.irs.gov/retirement-plans/plan-participant-employee/retirement-topics-prohibited-transactions
- Pay for bonding: https://www.colonialsurety.com/
- Determine proper valuation of the investment as of 12/31: https://www.irs.gov/retirement-plans/valuation-of-plan-assets-at-fair-market-value
- Complete the plan year funding request form
Bottom Line
Self-directed defined benefit plans offer flexibility but introduce substantial challenges. The combination of compliance, valuation, and administrative burdens is significant. These plans require careful oversight and ongoing professional support. Costs can escalate quickly as complexity increases.
The most critical issue remains asset valuation at year-end. Without reliable valuations, actuarial calculations become less accurate. This can create funding problems and regulatory concerns. Few plan sponsors are prepared to manage this risk effectively.
In most cases, a self-directed IRA is a better solution. It offers similar investment flexibility with fewer compliance requirements. It is generally more cost-effective and easier to manage. For most individuals, simplicity and reduced risk make it the preferred choice.
