Kelly Rodriques, CEO of PENSCO, and Tom Steinberger, senior vice president and head of business development at the firm, give guidance on transferring alternative assets to an independent custodian.

Individuals and families with substantial holdings of alternative investments at the nation’s largest financial institutions may soon be forced to decide where these assets will be held.

To reduce systemic risk, regulators are guiding banks, wirehouses, trust companies and brokerages who custody alternative assets to transfer them to custodians who specialize in administering these assets.

In the past six months, several of the major wirehouses and banks have started directing advisors to transfer, or “remediate” alternative assets to independent successor custodians. These specialized custodians are designed to hold alternative assets such as real estate (real property), private placements (private equity), hedge funds, foreign currency and secured loans, among other types of assets. 

Some financial institutions have given clients and their advisors the names of independent custodians. Other institutions have not, and offer no guidance to their advisors or clients.  Often, advisors and their clients must find a successor custodian in 30 days. If any of the alternative assets are in retirement accounts, time is of the essence to prevent a taxable event from occurring.

A tricky transition

For family office executives and RIAs, the task of finding a successor custodian can be time-consuming and difficult. Alternative assets are complicated and paperwork-intensive. Given the complexity, it can be easy to mishandle the process.

To help family offices and RIAs, PENSCO Trust Company, an independent custodian specializing in alternative assets, suggests a number of steps to manage this transition and ensure continued client satisfaction.

First, wealth management professionals need to find a successor custodian that has investment and technology capabilities to hold a wide range of assets and to serve sophisticated clients. Second, family offices and advisors need to carefully handle the transfer of alternative assets in retirement accounts to prevent an (avoidable) taxable event.

The complexity of administering alternatives

The major challenge with alternative assets is that they are more problematic to administer and less transparent than exchange-traded assets.

Alternative assets require more manual processing, administrative oversight and regulatory reporting.  For example, a private placement or real estate transaction frequently requires a custodian to review voluminous private placement memoranda and other complex documents to understand the details of the investment. In evaluating a custodian, an advisor must decide whether the firm has the investment and compliance expertise to hold many types of alternative assets.

In addition to offering broad capabilities to hold alternatives, an independent custodian should also be evaluated based on the strength of its technology and its commitment to client service. Both are important and provide transparency as the assets move from one institution to another.

Transparency is especially important during the transfer process. Unlike other in-kind transfers, alternative assets can take six weeks or more to register with a new custodian as the documentation is reviewed.

During that period, clients can become frustrated if they don’t understand the status of the transfer. A custodian that can provide wealth management professionals and clients with status updates will minimize client concerns and repeated inquiries.

Preventing a taxable event

If a client has alternative assets in a retirement account, extra care needs to be taken. The custodian must have the experience and knowledge to administer the assets without running afoul of complex laws and regulations. Alternative assets in retirement accounts are subject to numerous IRS and Department of Labor (DOL) laws and regulations.

In particular, custodians need to be knowledgeable about the ramifications and adverse tax consequences of having “a prohibited transaction” occur in a retirement account. Failure to comply with this sometimes complicated IRS provision, as well as all the applicable rules, can subject clients to penalties and tax consequences. (View IRS guidance).

It is important to note that even if an alternative asset in a retirement account is currently worthless, advisors still need to transfer that asset to a successor custodian, which will attempt to obtain an independent valuation from a qualified source for IRS reporting purposes. If an investor doesn’t have a current price for the asset, the IRS could value the seemingly worthless asset above zero. That could trigger tax consequences for an investor.

Similarly, an updated valuation is important if the asset is worth something, but is incorrectly valued at less than the current market price. That, too, could lead to tax consequences, including a penalty from the IRS. And, if the client is under 59.5, an early withdrawal penalty could be applied.

Handled well, the transfer of alternative assets to a successor custodian specializing in these kinds of investments should be a non-event. The key is making sure that family offices and RIAs have the right partner for the job.