Participants are pressing plan sponsors to make cryptocurrency investments available in their 401(k) plans. While Bitcoin may immediately come to mind when cryptocurrency is mentioned, there are at least 100 types of cryptocurrency now available to investors. Participants and fiduciaries have heard about the huge profits some make from cryptocurrency, and some proponents of cryptocurrency investing have been emphasizing the potential tax benefits of sheltering cryptocurrency gains from immediate taxation by investing through IRAs and tax exempt trusts. There could even be a permanent exemption from taxation if ROTH accounts are used. Less or nothing is said about the legal liability and potential risks.
The market remains unregulated, and cryptocurrency is an extremely volatile investment that can lose much of its value in a short period of time. Both President Biden and the Department of Labor have now taken steps that should alert fiduciaries about their legal exposure if they make these investments available through their plans. Their actions come on top of enforcement actions by the SEC and Chairman Gary Gensler’s characterization of the market as like “the Wild West.”
The Biden Executive Order.
President Biden issued an executive order calling for the agencies with jurisdiction over cryptocurrency to develop plans to provide a coordinated approach to regulating the market and creating consumer protections. While not listed in the order, these agencies include the CFTC. We don’t know when or how agencies with jurisdiction will respond to the executive order.
The DOL Statement.
The DOL has been expected to issue guidance on cryptocurrency for some time, and it finally issued informal advice in the form of Compliance Assistance Release No. 2022-01. Coming on the heels of the Supreme Court’s Hughes v. Northwestern decision holding that fiduciaries must make sure that every available investment in a plan’s menu is prudent, which it cites, the Release urges plan fiduciaries to “exercise extreme caution” in deciding whether to make cryptocurrency available. The Release indicates that this caution should be exercised regardless of whether the investment is direct or is valued based on the value of cryptocurrency, and regardless of whether it is available through a self-directed brokerage account.
The DOL cites the following issues raised by current market cryptocurrency investments:
They are risky and volatile
Investments are highly speculative
Custodial and recordkeeping concerns, since assets in a digital wallet must be protected against theft and there may be no recourse and assets may be permanently lost if a password is lost or forgotten
The possibility of entering into illegal transactions and the risk that law enforcement could shut down or restrict platforms as a result of illegal activity.
The difficulty of valuing cryptocurrency investments, and unreliable or inaccurate valuations
The inability of some participants to make informed investment decisions given that cryptocurrency is hard for even experts to evaluate.
DOL Will Initiate Investigations.
The DOL states that it expects to begin investigating plans that make cryptocurrency investments available to participants and to ask the responsible fiduciaries to justify how their actions are consistent with ERISA’s duties of prudence and loyalty. This adds the risk of enforcement action following such an investigation to the factors fiduciaries need to consider when weighing requests for these investments.
What About Self-Directed Brokerage Accounts?
While many fiduciaries have thought that making these investments available through self-directed brokerage accounts would be less risky, the DOL Release indicates that there may be an underlying fiduciary obligation to see that available investments are prudent even under self-directed brokerage options. As a compliance matter, these programs are typically made available on a non-discriminatory basis, so they are likely to include less sophisticated participants who fail to understand the risks.
What are the Options?
Given the agency pronouncements and the executive order, it is very difficult to justify cryptocurrency as a prudent investment at this time. Since 401(k) plans and social security are often a participant’s only source of retirement income, the argument can even be made that speculative and volatile investments such as cryptocurrency are inconsistent with the goals appropriate for retirement plan investing. Indeed, plans that provide only lump sum distribution options at retirement may force participants to lock in large losses at that time.
The SEC has approved a cryptocurrency futures fund, but it has been asked to approve direct ETF cryptocurrency funds, and has not yet done so. If the SEC does approve some ETF cryptocurrency funds, they will have professional management and pooled investments, and there will be a formal trading platform. The DOL could also change its position on self-directed brokerage accounts. If either of these changes happens, or agencies begin to regulate the market, the legal and risk scenarios may change.
In the meantime, a few options for participants and fiduciaries to consider are:
Participants with self-directed IRAs may make cryptocurrency investments through their individual IRAs. Certain IRA providers are already making these investments available and IRA owners may direct their own investments without exposing third party fiduciaries to liability. IRA owners should be careful, however, that any investment arrangements they adopt do not fail to comply with the custody requirements for IRA assets.
Investments can be made in companies that benefit from the cryptocurrency market, such as blockchain companies. There is at least one blockchain fund.
Plan sponsors who want to proceed despite these government cautions would be well-advised to look to professionals to manage the investments.
The vendors currently offering cryptocurrency investments have capped the portion of the account that may be invested in cryptocurrency. While this does not address all of the DOL’s concerns expressed in the Release, investment caps are an important limit on risks and potential participant losses.
However, even if plan fiduciaries provide clear and comprehensive investment disclosures to participants, there is always the risk that participants who have losses may sue on the grounds that they did not fully understand the risks and/or assumed that the plan was endorsing cryptocurrency investments by making them available. The bottom line here is that, given the DOL’s current views, it will be difficult, if not impossible, for fiduciaries to find a way to offer cryptocurrency investment through their plans without substantially increasing their risk exposure and incurring higher fiduciary insurance premiums.