Will cryptocurrencies make the cut in a retirement plan?

next issue no. 8: On the horizon

As a concept, cryptocurrencies have been around a little over a decade, and in that time many people have made — and lost — fortunes betting on the values of these virtual “tokens.”

Given the stories around the price of bitcoin and headlines about their counter-inflationary characteristics, new entry into retirement plans and continued innovation, it is worth exploring what role, if any, cryptocurrencies can play in an investment portfolio, especially when it comes to retirement. But first, let’s define the terms.

Understanding Bitcoin, blockchain and crypto

•       Blockchain
  A shared database or ledger that facilitates the process of recording transactions and tracking assets in a business network that are immutable once closed. As a database, a blockchain stores information electronically in digital format and is best known for its crucial role in cryptocurrency systems, such as Bitcoin, for maintaining a secure, chronological and decentralized record of transactions.
•       Cryptography
  An advanced encryption, along with permissions, that ensures privacy on the network, preventing unauthorized access to recorded transaction details, and deterring fraudulent activity. It is key to the security of the blockchain ledger. Each transaction is recorded on the blockchain using encrypted data. Each user can access their own information and buy and sell crypto securely, using their public and private key. (Source: Blockgeeks¹)
•       Cryptocurrency
  A digital or virtual currency that is secured by cryptography, which makes it nearly impossible to counterfeit or double-spend. Many cryptocurrencies are decentralized networks based on blockchain technology — a distributed ledger enforced by a disparate network of computers. A defining feature of cryptocurrencies is that they are generally not issued by any central authority, rendering them theoretically immune to government interference or manipulation. (Source: Investopedia²)
•      Bitcoin
  A type of cryptocurrency because it uses cryptography to keep it secure. It was the first and is arguably the most well-known version. There are no physical bitcoins, only balances kept on a public ledger that everyone has transparent access to (although each record is encrypted). All Bitcoin transactions are verified by a massive amount of computing power via a process known as “mining;” however, Bitcoin is not issued or backed by any banks or governments, nor is an individual bitcoin valuable as a commodity. (Source: Investopedia³)

Show me the money

Cryptocurrency is intangible. Its value is built upon there being a record of who owns the currency, as that allows for digital transfers without the involvement of a central backer, such as a government or a bank. So the question becomes, how do cryptocurrencies gain (or lose) value. Like any currency, they gain their value based on the scale of market interest: if the demand for it is higher than the supply. When a cryptocurrency is useful, people want to own more of it, driving up the demand. However, it’s important to note that cryptocurrency has limited utility, meaning its applications are mainly industrial and rarely used in mainstream retail. So the assets speculative nature is built upon the limited overall amount of a specific currency, such as Bitcoin, that can ever be mined, and those who hold their bitcoins on the basis of this disinflationary nature creating a scarcity. Obviously as more types of currencies are created, such as Ethereum or Dogecoin or any of the myriad millions of other “coins,” this scarcity element is arguably diminished, but as each coin is created separately there is a lively debate to be had as to the value of any individual coin.

The actual process of determining cryptocurrencies’ valuations is another industry debate stemming from fundamental disagreement on the accuracy and validity of valuation models. Adding to the complexity is the lack of a consistent modeling approach applied across currencies. Hence why these assets are often called “speculative” in nature.

Cryptocurrency is intangible.

Its value is built upon there being a record of who owns the currency, as that allows for digital transfers without the involvement of a central actor, such as a government or a bank.

The Guardian

Bitcoin might well be the Amazon.com of cryptocurrencies: a huge institution in a relatively mature state. Therefore, it arguably could have a role in a retirement portfolio, which by its nature is supposed to be more conservative and driven by long-term asset class trends that de-risk over time. However, cryptocurrencies have only existed just over a decade and are still not even readily available for the individual investor to easily buy. So what’s a fiduciary to do? The primary responsibility of fiduciaries is to run the plan solely in the financial interests of participants and beneficiaries and for the exclusive purpose of providing benefits and paying plan expenses, according to the Department of Labor. This includes carrying out duties with the care, skill, prudence and diligence of a prudent person familiar with the matters. So when considering how cryptocurrencies, or any new asset in its formative stages, may contribute to retirement savings, it’s critical to do so through this lens even if participants advocate to include it.

As a stand-alone investment (via brokerage window or core menu)

• The lack of legal structures and regulatory regimes around these assets make it very challenging to ascribe a long-term value to any given cryptocurrency with any sort of certainty. Further, the asset class has been subject to high volatility during its limited lifespan and limited liquidity. This makes it more difficult to evaluate and measure from a risk/return standpoint and therefore it complicates a fiduciary’s investment selection due diligence process and participant communications strategy, opening participants up to a hirer risk of making uninformed decisions and experiencing losses.

As part of an asset allocation strategy (via multi-asset class portfolios)

• The underlying blockchain technology is a fascinating area for development. A well-diversified portfolio will likely have some exposure to the underlying blockchain infrastructure through its financial sector holdings, and may even have exposure to cryptocurrencies through venture capital holdings. Therefore it is probable that many participants already have some form of exposure to crypto indirectly, which is likely the more prudent approach at this stage of development. Participants who access these holdings through professional money managers benefits from their research and expertise to conduct proper and thorough due diligence, including assessing the acceptable levels of risk and volatility.

In March 2022, the Department of Labor released Compliance Assistance Release (CAR) 2022 01, which relates to 401(k) plan investments in cryptocurrencies. The message to 401(k) plan fiduciaries is to exercise “extreme care” in considering cryptocurrencies as part of a 401(k) investment menu for plan participants. They cite speculative nature, valuation accuracy and custodian risks as just some of their primary concerns. Please visit the DOL website for additional information.⁴ This came one day after the White House releases an executive order on digital assets, and we expect regulatory guidance to continue to evolve.

But I want a bitcoin now!

A difficulty facing advisors and plan sponsors is engaging a younger generation of investors who have experienced a long period of market growth and see value in YOLO’ing Gamestop short-dated options and buy-and-HODL (hold on for dear life) crypto forums that decry the traditional financial institutional structures. General mistrust and a lack of understanding around market makers and regulators are of deep concern.

It is our job as educators to encourage the younger generations to take retirement planning seriously. The old adage, “the best time to plant a tree is yesterday, the second best is today,” has not fundamentally changed and remains fundamentally true for retirement savings. Stories of crypto gains and the latest meme-stocks have greatly accelerated young people’s dismissal of the value that long-term, diversified investment strategies provide. Therefore the conversation has to begin with education. Is bitcoin attractive because it has gone up a lot in value? In that case we can talk to long-term asset growth and the benefits of compound interest. Or are there more fundamental questions about the growth of digital assets, decentralization and a lack of trust in the traditional structures of finance? In that case we have to educate and contribute to a participant’s knowledge, rather than dismiss their concerns. Engagement with participants and identifying where they are on their retirement journey is a significant part of the conversation around cryptocurrency allocations.

Answering the questions that a younger generation has about retirement planning and constructing long-term portfolio allocations to grow assets with relatively low volatility are of equally critical importance.

There is a reason why a diversified portfolio of stocks and bonds that gently gravitates towards a more conservative portfolio allocation over time is the bread and butter of retirement planning. There are innovations being made and asset allocation models are taking into account more sophisticated assets all the time, but that is best left for the professional money managers, rather than for individuals to attempt alone.

Owning cryptocurrency may, in fact, produce some intangible benefit to the owner, which can be enjoyed for more than just their hard-to-determine monetary values. However, as fiduciaries, we need to heed the Department of Labor’s warnings while understanding and addressing participants’ concerns. Diversified portfolios, increasingly with income-producing asset classes, may effectively help participants’ address their retirement needs.