Generating adequate income for clients during their retirement is increasingly a challenge for financial advisors.
Longer life spans, rising health costs and ineffective safety nets continue to exacerbate this challenge. Increasing allocations to alternative assets is one approach used in today’s low-yield environment to provide much-needed diversification as part of a proactive risk-management strategy.
By also considering tax efficiency, advisors can potentially increase returns, while avoiding additional risk. Alternative assets such as real estate investment trusts (REITs), mortgage notes, limited partnerships, limited liability corporations (LLCs), precious metals, joint ventures, actively managed funds and private equity are typically tax-inefficient and are taxed at short-term capital gains or ordinary income tax rates.
Moving these assets into tax-exempt vehicles, such as IRAs and other qualified retirement plans, can increase net income, without adding risk to the portfolio.
Over the past decade, investment professionals’ realization that alternative assets may provide a viable path to higher overall returns for investors has led to explosive growth in this asset class. According to Preqin Investor Outlook: Alternative Assets, $7.4 trillion was invested globally in alternative assets under management at the beginning of 2016.
“Over the next five years,” according to, The $64 Trillion Question: Convergence in Asset Management, a 2014 report by McKinsey and Company, “net flows in the global alternatives market are expected to grow at an average annual pace of 5 percent, dwarfing the 1 to 2 percent expected annual pace for the industry as a whole. By 2020, alternative assets could comprise about 15 percent of global industry assets and produce up to 40 percent of industry revenues.”
McKinsey adds that “investors are now turning to alternatives for consistent, risk-adjusted returns that are uncorrelated to the market. They are also increasingly looking to alternatives to deliver on other crucial outcomes like inflation protection and income generation.”
Indeed, many financial advisors now start off the asset allocation discussion by presenting the four broad asset classes essential for a diversified portfolio: equities, fixed income, alternatives and cash.
The Impact Of UBIT
Certain alternative assets and leveraged investments (e.g., private equity, hedge funds, master limited partnerships [MLPs]) may produce unrelated business taxable income (UBTI), or, if debt financing is used, unrelated debt-financed income (UDFI) when included in IRAs or other tax-exempt vehicles. These assets are popular as income-generators, but are likely subject to unrelated business income tax (UBIT). Generally, the two primary investment categories that generate UBTI in retirement accounts are: