Investing for Income: MLPs (WSJ)

JULY 18, 2009
Master Limited Partnerships Have Benefits, Risks
By KELLY GREENE

I am semiretired and have started to invest using a self-directed IRA. I also have started to invest in Master Limited Partnerships, mostly pipeline companies, within my IRA. The yields are very nice, and the share values appear to be increasing. It seems that MLPs are too good to be true. There must be a downside. Do you have any suggestions on the downside risks?

—Rick Herbold, Hingham, Mass.

Some financial planners are using, as the reader above is, master limited partnerships, or MLPs, to diversify retirees' portfolios, provide dividend income and try to hedge against inflation. And, yes, there are risks involved.

MLPs are typically limited partnerships that are publicly traded on a U.S. securities exchange. (You can invest in limited partnerships that aren't publicly traded, but the four experts we interviewed didn't recommend doing so.) As of last November, the U.S. MLP market was valued at more than $100 billion, according to a report by Standard & Poor's. You can read it online at www2.standardandpoors.com/spf/pdf/index/MLP_Primer_Nov2008.pdf.

Many MLPs are in the pipeline business, which may protect them somewhat from the energy industry's volatility. "You get paid for the volume going through the pipe, so the cost of the gas doesn't affect you," says Steven Stahler, a certified financial planner in Baton Rouge, La.

James Shelton, chief investment officer of Kanaly Trust Co. in Houston, started buying MLPs last fall. "The yields are still very attractive, and a lot of these MLPs are below highs they reached a year ago," he says.

Mr. Shelton favors three MLPs: Kinder Morgan Energy Partners LP, Enterprise Products Partners LP, and Plains All American Pipeline LP. "We're looking for these 9% stable yields where the dividend is going to grow over time."

Mr. Shelton says he avoids MLPs with "significant commodity-price risk in their business models."

As for the downsides, in throes of the credit crunch late last year, many MLPs fell in value amid fears that they could lose access to capital needed for expansion. So, if lending tightens further, MLPs could take a hit. What's more, if the economy worsens, "that theoretically could reduce the demand for the energy products [the projects] are transporting," Mr. Shelton says.

Also, some smaller MLPs are traded thinly. "When you need to move it, you're going to suffer a pretty significant decline," Mr. Shelton says.

When held in taxable accounts, MLPs provide some attractive tax advantages. Because of its structure, an MLP gets to pass its depreciation of assets and expenses through to investors, who may be able to use the pass-through expenses to reduce or eliminate the tax on the income received from that particular investment, Mr. Stahler says.
But you would lose that tax advantage by holding MLPs in a tax-deferred individual retirement account, and you have to pay ordinary income tax on any distributions you eventually take, says Ed Slott, an IRA consultant in Rockville Centre, N.Y.

And if an MLP investment generates what is known as "unrelated business taxable income," which is likely, the IRA has to file a separate tax return and pay any tax involved from assets in the account, Mr. Slott says.

There are two possible fixes.

First, you may want to consider converting your traditional IRA to a Roth so that you don't have to pay income tax on future earnings (subject to Roth holding rules). However, your account could still be subject to unrelated-business income tax, Mr. Slott says.

Another solution would be to make future investments in "closed-end" funds that invest in a number of publicly traded MLPs, says Mr. Stahler, who has used such funds for retired clients with large IRAs. Such funds aren't subject to the unrelated-business income tax, but still could benefit from potential returns. One example is Fiduciary/Claymore MLP Opportunity Fund, which was yielding more than 8% earlier this week.

Write to Kelly Greene at kelly.greene@wsj.com

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