Retirement plan sponsors should hold off from including any cryptocurrency or cryptocurrency-related products in their 401(k) menu of options for the time being, based on recent guidance from the Department of Labor (DOL).
Plan sponsors of defined contribution retirement plans such as 401(k) plans have a new problem – the crypto industry wants in, and plan participants may want to invest in such investments. Plan sponsors’ fiduciary duties of prudence and loyalty under the Employee Retirement Income Security Act of 1974 (ERISA), however, may preclude offering cryptocurrency-related investment options. These fiduciary duties require both (1) an independent evaluation of the prudence of investment options before adding them to the plan’s portfolio; and (2) an ongoing duty to monitor and remove imprudent investment options. For traditional investment options, like mutual funds, plan sponsors have years of experience and well-established processes to meet these duties. But cryptocurrency is new and different, and DOL is skeptical. Can plan sponsors offer crypto as an investment option without violating their fiduciary duties? Based on the conclusions in a recent compliance release from DOL, probably not.
Compliance Assistance Release No. 2022-01, 401(k) Plan Investments in “Cryptocurrencies”
DOL recently issued Compliance Assistance Release No. 2022-01, 401(k) Plan Investments in Cryptocurrencies (the Release). The Release gives plan sponsors three warnings, yet stays silent on a critical element of these warnings. First, it tells plan fiduciaries to use “extreme care” before adding a cryptocurrency option to their retirement plan’s investment menu. Second, it outlines DOL’s “serious concerns” about the prudence of investing in cryptocurrencies. Third, it warns of a future investigative program, which will include “appropriate action” to protect plan participants and beneficiaries from imprudent cryptocurrency investments offerings. Taken together, these statements send a clear message to plan fiduciaries: cryptocurrency is a presumptively imprudent investment option. What we don’t know yet is how broadly DOL will define “cryptocurrency option” as no definition is provided in the Release. Given the context and tone of the Release, plan fiduciaries should expect the broadest understanding to be applied.
DOL begins its Release with a recital of ERISA’s fiduciary duties, referring to the recent Supreme Court decision in Hughes v. Northwestern University. Briefly, ERISA fiduciary duties are “the highest known to law” and require fiduciaries to act solely in the financial interests of plan participants. These standards are familiar to any plan fiduciary, but DOL cites the recent Northwestern decision to reiterate that even when participants guide their own investments, including through a brokerage window, the plan fiduciaries still must “conduct their own independent evaluation” of the investment options before adding them to the menu and further monitor the options to remove any that become imprudent. Essentially, plan fiduciaries must ensure a safe playground for plan participants. Warning a participant not to run with scissors is inadequate; the fiduciary must ensure there are no scissors in the first place.
Next, DOL provides its reasoning for doubting the prudence of offering cryptocurrencies as an investment option in retirement plans. DOL points to the “significant risks of fraud, theft, and loss” inherent to cryptocurrencies resulting from five specific reasons:
1) Speculative and Volatile Investments. The Securities and Exchange Commission has characterized cryptocurrency as “highly speculative,” and DOL cautions that their price volatility, known to be substantially higher than traditional investments, can be “devastating” to participants. DOL in particular highlights the risks to participants nearing retirement age.
2) The Challenge for Plan Participants to Make Informed Investment Decisions. DOL interprets the inclusion of an investment option in a plan’s menu as an implicit endorsement of that option as prudent. Thus, “inexpert plan participants” who undervalue risk and overestimate potential gains may believe themselves to be making safe investment decisions when they are actually engaging in high-risk speculation.
3) Custodial and Recordkeeping Concerns. Most of us have heard of the man who lost a hard drive with millions of dollars’ worth of Bitcoin. He resorted to searching through a dump for his lost fortune to no avail. DOL has heard of him, too. Citing the fact that “simply losing or forgetting a password” can result in the total loss of assets, DOL is highly skeptical of the crypto industry’s current trust and custodial practices.
4) Valuation Concerns. There are industry-accepted approaches to valuing traditional assets using discounted cash flows, net present value, and other financial terms which are at least familiar to those of us who do not work on Wall Street. Financial experts have not, however, reached a consensus on how to value cryptocurrency. DOL also points to differences in accounting and reporting practices within the crypto market. Together, these present serious challenges to accurately valuing investments in cryptocurrency options.
5) Evolving Regulatory Environment. DOL warns that fiduciaries must analyze how regulatory requirements affect investments in cryptocurrencies. Because this regulatory environment is rapidly changing and not all crypto market participants operate in compliance with applicable regulations, there is a risk that plan fiduciaries may accidentally participate in unlawful transactions.
Finally, DOL “expects to conduct an investigative program aimed at plans that offer participant investments in cryptocurrencies and related products.” This program will include “appropriate action” to protect plan participants and beneficiaries. DOL makes clear it will demand answers from plan fiduciaries on each of the five risks enumerated in the Release. The message is clear that DOL will review all such explanations with a doubtful eye.
The Various Forms of Cryptocurrency
There remains a problem of interpretation: what is a “cryptocurrency option”? The Release provides two clues indicating that DOL will define it broadly and view the presence of any cryptocurrency as too much cryptocurrency. First, DOL refers to “cryptocurrencies and related products” when announcing its future investigative program. A second hint lies in Footnote 1, which reads:
Although this release specifically references “cryptocurrencies,” the same reasoning and principles also apply to a wide range of “digital assets” including those marketed as “tokens,” “crypto assets,” and any derivatives thereof.
From this definition, we can build a spectrum. First, there is pure cryptocurrency – buying Bitcoin or Ethereum as an asset for possible capital gains. Second, “stablecoins” are pegged to a currency, and a new industry of bankers pay interest on deposits made in their denomination. BlockFi, for example, is pegged to the U.S. Dollar and offers 9% interest on certain deposits. Finally, fund managers may include some form of crypto-based assets in a blended portfolio, and may do so at varying percentages. For example, a target date fund may blend stocks, bonds, precious metals, cash, and crypto to achieve a balance of risk and return. While the first two investment strategies on the spectrum are clearly within DOL’s understanding of a “cryptocurrency option,” the third is less clear. Would 5% of a fund held in Bitcoin be too much? What about 2% in a stablecoin? Given both the tone of the Release and the expansive language used by DOL, caution suggests plan sponsors should avoid any cryptocurrency making its way into their investment menus – in any form and at any level. Whether a particular asset is “derived from” or “related to” cryptocurrency may be arguable. Under ERISA’s fiduciary standards, however, plan sponsors facing personal liability should avoid being the first to have to make that argument.
Additionally, DOL may have signaled a new regulatory approach to brokerage windows. The final sentence of the Release suggests that “allowing” cryptocurrency investment through brokerage windows is a fiduciary act, subject to the duties of loyalty and prudence. This position marks a significant departure from current understandings since most federal courts have held that self-directed investments through brokerage windows are not subject to fiduciary duties. If DOL intends to enforce this view, plan sponsors will face a substantial new burden.
Cryptocurrencies have proven their value to many, at least in the short term. Many people are invested in crypto; many would like to similarly invest their 401(k) plan assets. Nevertheless, ERISA’s fiduciary standards require caution. This recent guidance from DOL makes clear that the agency tasked with monitoring plan fiduciaries has its doubts. For now and in light of the guidance in the Release, the best and presumably only justifiable course for plan sponsors is not to allow any cryptocurrency or cryptocurrency-related investments in their menu of options.
If you have any questions about this legal update, please reach out to the MMM Employee Benefits & Executive Compensation Team.