The cryptocurrency market is known for its extreme market conditions with wild valuation swings. Bitcoin, the world’s most valuable cryptocurrency, fell below $20,000 in June 2022, tumbling nearly 70% from its high of $68,000 in November 2021. This dramatic volatility is a big reason why investors should be extremely cautious when allocating part of their portfolio to cryptocurrency.
In early 2022, Fidelity Investments became the first firm in the US to announce that employees could add crypto—in the form of Bitcoin—to their 401(k) retirement plans. While this major announcement caught the attention of employers, employees, and retirees countrywide, it did not trigger a mass copycat reaction from other plan fiduciaries.
The legal landscape surrounding the Employee Retirement Income Security Act of 1974 (ERISA) is somewhat prickly at present. Employers are facing an uptick in litigation alleging ERISA fiduciary breach claims based on the investment options and administrative fees in 401(k) plans.
“In this day and age, employers are being sued for offering the alleged wrong target-date funds, when perhaps a different fund with a lower expense ratio could be offered. That’s one of the most vanilla investment offerings out there,” said Wendy Von Wald (pictured), fiduciary liability product manager at Travelers. “Crypto is an investment that’s incredibly volatile and there are huge concerns around how it’s valued and regulated, so you can see why plan sponsors might be hesitant to add it to their 401(k) investment line-up.”
Under ERISA, fiduciaries are required to make “prudent” investment decisions that minimize the risk of large losses and act in the best interests of the plan participants. Courts have commonly referred to the ERISA prudence and loyalty obligations as the “highest known to the law”. The volatility of cryptocurrencies and the potential for negative valuation swings could be deemed too risky to be prudent investment choices.
“The fiduciaries have to be prudent in monitoring not only the investment, but also the provider of that investment, and because crypto can be offered in regulated and non-regulated forms, fiduciaries would have to be careful about making sure they know what entity is actually offering the crypto, which can be difficult these days,” said Von Wald.
“It’s not just a volatility issue; it’s also an evaluation issue as there are many different ways to value crypto. Fiduciaries need to consider what valuation they’re applying, and whether that could be challenged down the road. One of the duties of a fiduciary is to make sure that they’re acting in the participants’ best interests, and that includes deferring costs as well as removing volatility. Crypto does not seem to lend itself well to fiduciaries fulfilling their obligations under ERISA.”
In March 2022, the US Department of Labor (DoL) released ‘Compliance Assistance’ for firms marketing investments in cryptocurrencies to 401(k) plans as potential investment options for plan participants. The DoL cautioned plan fiduciaries to “exercise extreme care” before adding crypto to a 401(k) plan’s investment menu.
“At this early stage in the history of cryptocurrencies, the department has serious concerns about the prudence of a fiduciary’s decision to expose a 401(k) plan’s participants to direct investments in cryptocurrencies, or other products whose value is tied to cryptocurrencies,” the DoL warned. “These investments present significant risks and challenges to participants’ retirement accounts, including significant risks of fraud, theft, and loss.”
ERISA does not dictate which specific types of investment options must be included in a 401(k). Employers are allowed to offer crypto investments if they’ve done their due diligence and are in compliance with ERISA. They may be subject to audit if they actively support and encourage plan participants to invest in crypto.
Many employers use an investment policy statement (IPS) to help govern 401(k) management by the plan fiduciaries. If they’re considering offering crypto as an investment option, Von Wald said it would be wise to have the IPS reviewed by outside counsel to ensure that it caters for crypto. This is an important risk management practice.
“Putting parameters on the amount of investment in a particular in crypto could be a way that plan sponsors could guard against risk. Only allowing crypto to be offered as a part of a brokerage window could be another way to safeguard some of their actions and decisions,” Von Wald added.
“It’s also important for plan fiduciaries to make clear disclosures and to educate plan participants about the risks of crypto, and on an even more basic level, about the purpose of a 401(k). The 401(k) is not meant to be a day trading account; it’s meant to be something that people fund so that they have an income to live off during retirement. I think that basic education about the purpose of a 401(k) is important right now.”
At present, fiduciary liability insurance policies do not typically exclude specific investment options. However, if there’s a rise in litigation around 401(k) plan investments in cryptocurrencies, underwriters may address that exposure in a variety of ways, according to Von Wald, including crypto exclusions, higher retentions, lower coverage limits, and increased premiums.
“It’s still relatively new, so I haven’t seen a lot of enforcement activity in the marketplace,” she said, “but these are all things that could happen … if there’s any frequency of litigation alleging breaches of ERISA due to the offering of crypto as part of a 401(k) plan.”