Corp! Magazine – October 2022
The U.S. Department of Labor (DOL) published guidance earlier this year warning fiduciaries who administer retirement plans to “exercise extreme care” when considering whether to include cryptocurrency as a plan investment option. The guidance states further that fiduciaries should be prepared on audit to “square their actions with their duties of prudence and loyalty in light of the risks described”. Around the same time, Fidelity, one of the largest 401(k) plan asset managers, announced that it would begin offering cryptocurrency investment options for inclusion in a 401(k) plan’s investment menu. A statement on the Fidelity website refers to crypto as the “new frontier” and encourages plan sponsors to invest through Fidelity’s exchange traded products. Plan sponsors are left to reconcile the DOL’s warning with an apparent endorsement from the 401(k) giant.
The Rise of Crypto. “Bitcoin”, considered by most to be the first cryptocurrency, increased in value from $1.00 in 2011 to around $20,000 in 2017 before its first fall in value. Its highest value to date reached more than $68,000 per share. Bitcoin’s rapid appreciation has led to an explosion in competing varieties of digital assets and a marketing frenzy. Celebrities and other “influencers” endorsing particular flavors of crypto have found themselves subject to scrutiny and fines by the Securities and Exchange Commission. The value of bitcoin has again fallen to around $20,000 in the period following Fidelity’s announcement. The recent fall is considered the latest “crypto-winter”.
Not a Great Fit. The obvious volatility is not the only thing that has the DOL worried. Crypto is considered extremely difficult to value, even by experts. Digital assets are marketed as innovative high-growth investments that can prove irresistible to inexpert 401(k) plan investors looking for a fast return. Crypto cannot be held in a custodial account like most retirement plan investments but rather is stored as lines of code in a “digital wallet”. The typical 401(k) investor may be hard pressed to explain “blockchain”, a complex decentralized system used to track crypto transactions. Crypto is currently unregulated but that may soon change. It is unclear what effect any regulation will have on the value of existing investments. While not explicitly stated in the DOL guidance, it is clear that the DOL believes the risks cited likely make cryptocurrency of any kind an inappropriate addition to a 401(k) plan investment menu.
The Highest Duty. The Employee Retirement Income Security Act of 1974 (“ERISA”) imposes a duty of loyalty and a duty of prudence on 401(k) plan sponsors who administer and control plan assets (fiduciaries). The U.S. Supreme Court has ruled that it is a breach of that duty to offer an investment that is less than prudent, even if it is one choice among otherwise appropriate investments. Individuals acting as fiduciaries can be held personally liable for losses suffered by plan participants as a result of imprudent actions, e.g. bad investments. The same is true for fiduciaries that engage in self-dealing. Plan sponsor’s acting in this capacity must put the interests and wellbeing of plan participants above all else and do everything possible to protect participants from their own lack of judgment.
A Potential Conflict. Small 401(k) plans are often managed by individual business owners that are themselves employees of the business and plan participants. Business owners often benefit personally from the establishment of a 401(k) plan (it is common for a 401(k) plan to be “top heavy” because owner employees have large 401(k) accounts relative to the staff). The duty of loyalty may be breached if a fiduciary’s actions are motivated by his own investment goals.
“But its my Money”. A 401(k) plan participant enjoys a benefit rare to the tax code: deferral of income tax and tax free investment growth. The price for that benefit is a loss of control in the period leading to retirement. Participants are penalized for early withdrawals and are prohibited from having too much control of plan assets. An “its my money” attitude exhibited by some participants is misplaced and plan sponsors and participants often suffer the consequences of poorly administered loan programs, rollover business startup transactions and self-directed investments. At the same time, employers are under pressure to offer competitive benefits to attract and retain employees. Most 401(k) plans today are “self-directed” (participants can access their accounts online and execute trades from a menu of investments selected by their employer). Some participants expect access to brokerage windows to invest in a larger selection of investments. Access to cryptocurrency may be the next participant expectation to which employers must respond.
Acceptable Risk. Potential liability for choosing bad investments is not new. Over time, safeguards have developed that shield plan fiduciaries from liability from participant losses so long as the range of investments chosen are of a particular character (deemed prudent by the IRS and DOL). Examples of such investments include diversified investments that take into account a participant’s age and years to retirement such as life-cycle or targeted-retirement-date funds, or a balanced or capital preservation fund. These are in stark contrast to any crypto investment currently available.
Caveat Emptor. It remains to be seen whether products will develop mitigating the risk and allowing safe institutional investment in crypto. Some might argue this is what Fidelity has done through its current crypto funds. The DOL does not appear to be convinced. Ultimately, a fiduciary cannot delegate away the responsibility to act prudently. Reliance on Fidelity’s apparent endorsement or an advisor that recommends crypto is itself a fiduciary act. As it stands, 401(k) fiduciaries who add crypto as an investment option will have a very difficult time arguing that they were not warned.
**This article first appeared in the October 2022 issue of Corp! Magazine.