I recall working with a couple preparing for their impending retirement when the real estate market was still going strong. In reviewing their investment portfolio, I discovered they had been repositioning their IRA accounts out of traditional stock and bond investments into private mortgage notes.

The notes represented loans made to buyers of vacant land, primarily for recreational uses, that carried interest rates of 10 percent to 12 percent. A nice, safe return, they reasoned. With yields like that, their portfolio would generate enough income for them to retire comfortably.

Despite our discussions regarding the riskiness of these notes and the fact they could not easily be sold should they need a lump-sum of cash, much of the couple's IRA assets ended up invested in these mortgages. All appeared well until, just before retirement, they received notice that the borrowers were no longer making payments on their loans. Because these private mortgage notes were non-traditional investments, they had to be purchased through a self-directed IRA.

Self-directed IRAs are accounts held by a custodian who allows investors to hold a broader set of alternatives including real estate, tax liens, private placements, and other unregistered, often illiquid, investments. Most IRA custodians limit permissible investments to traditional securities such as stocks, bonds, mutual funds, exchange-traded funds, and certificates of deposit. In recent weeks, I have heard more advertisements, appealing to public frustrations with Wall Street, touting investments in gold and real estate through self-directed IRAs.

While self-directed IRAs can be a perfectly legitimate way to invest retirement assets, investors should always take the time to fully understand the securities they are purchasing, including all potential risks and any limits on when and how they can get their money out of the investment should the need arise. Furthermore, investors must understand that, just because an IRA custodian will allow you to hold a particular asset in your account, does not mean the investment is legitimate, or right for your particular circumstances. Self-directed IRA custodians have very limited duties to the account owners. These duties generally do not include evaluating the quality or legitimacy of any security or trustworthiness of its salespeople.

My pre-retiree investors had no problem opening self-directed IRA accounts at a reliable, trustworthy custodian and purchasing private mortgage notes. The securities they purchased were legitimate, though unregistered, and backed by very little information regarding the creditworthiness of the borrowers buying the land. However, they did not fully grasp the riskiness of the investment they were making and the custodian was under no obligation to communicate the risks to them. They were receiving statements from the custodian showing the interest payments they had received and the value of the notes they held. But, because these notes did not trade on any organized exchange, their market values were always listed as the amount of the original investment, a very misleading measure given that the purchase price was likely far more than the notes could be sold for to another investor.

The rise in interest in self-directed IRAs among both investors and investment promoters recently prompted the Securities and Exchange Commission to issue an investor alert citing several recent cases where the flexibility of self-directed IRAs was exploited by promoters of Ponzi schemes and other fraudulent investments. When risky assets look too risky and safe investments offer paltry returns, investors often forget that risk and return go hand-in-hand over the long run. Investments that promise high returns with little or no risk usually fail to deliver, either because the risks were not well understood at the outset, or, worse, because of fraud.

Investors must be diligent in protecting themselves from these negative outcomes by putting their guard up when faced with unsolicited investment offers, particularly if they involve use of self-directed IRAs.

Ask plenty of questions including whether the investment salesperson is licensed and the securities being offered are registered. Answers to these questions can be checked out by visiting the SEC or state securities administration Web site. Also, be wary of guaranteed returns or returns out of line with what more traditional investments are generating.

David T. Mayes is a Certified Financial Planner professional and IRS Enrolled Agent at Three Bearings Fiduciary Advisors, a fee-only advisory firm in Hampton. He can be reached at 926-1775, david.mayes@threebearings.com or by visiting www.threebearings.com.