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Personal Finance

What Belongs in 401(k) Plans?

Setting reasonable limits on what investments should be offered.

A Guessing Game

No, 401(k) plan sponsors should not offer bitcoin as an investment election, as a company called MicroStrategy MSTR will soon do, courtesy of Fidelity. In “Bitcoin in Your 401(k)? Not so Fast,” published on April 27, 2022, Morningstar’s Madeline Hume explains why “mixing bitcoin and 401(k) plans is a terrible idea.” She writes:

At this point, the asset class lacks academically substantiated valuation models. Stocks have free cash flows and bonds have loan principals that can be modeled and give these securities their value. Bitcoin has neither, and that makes it too volatile for direct investment through 401(k) plans.

Exactly. Not only does bitcoin currently lack an academically substantiated valuation model, but it will always lack such a model. Because bitcoin cannot earn or distribute cash, mathematical approaches for valuing bitcoin cannot exist. In that sense, bitcoin resembles gold, which has been an asset for several thousand years, and still resists analysis. For good reason, no 401(k) plans feature gold.

Fiduciary Hijinks

As a side note, MicroStrategy’s announcement was thoroughly self-promoting. The company’s core business is small. Its stock market value derives almost entirely from—can you guess?—its purchases of bitcoin. To wit, the company has spent $4 billion on bitcoin and has a market cap of $4.4 billion. Says CEO Michael Saylor, “We’re kind of like your nonexistent spot ETF.”

(If you immediately understood Saylor’s comment, you have either my congratulations or pity, depending upon my mood, because that means that you are fluent in investment jargon. To outsiders, that sentence is unintelligible.)

MicroStrategy’s 401(k) addition directly improves its business prospects, by creating the impression that demand is rising among retirement plans for bitcoin—the asset upon which the firm’s future depends. Meanwhile, MicroStrategy’s participants are uniquely unsuited to hold bitcoin, since its fortunes are directly correlated with their employer’s. Thus, the company that should be the very last to insert bitcoin into its 401(k) plan is instead the first. How ironic.

Found Wanting

But fiduciary decisions are a topic for another column. To return to the topic at hand: Assets that can't generate cash should not be in 401(k) plans. (The sole exception being money market funds when interest rates are puny. At such times, money market funds may not pay interest, but they can pay when conditions warrant.) No bitcoin, no gold, and without question, no nonfungible tokens.

Also inappropriate are investments that don’t price daily. Yes, retirement accounts allegedly have long time horizons and therefore should not require much liquidity. In the actual world, however, 401(k) investors frequently close their accounts long before they retire. They change jobs, or conclude they need the money, abruptly redeeming funds that were intended to be held for decades.

Another problem with illiquid investments is comparability. Securities that lack marketplace prices are instead valued irregularly, through pricing services or internal appraisals. Those estimates are sometimes overoptimistic, collapsing when put to the test. In addition, they understate risk. If an investment rises by 25% during the year’s first half, then drops by 20% in the second, it will end up where it started. Publicly traded securities will reveal the interim gyrations. In contrast, an illiquid holding might show no volatility whatsoever.

The Participants’ Perspective

So far, I have addressed only what plan sponsors should do, not how plan participants should invest. There is a difference. Although bitcoin is by nature speculative, and private-equity funds (to cite an example) are too complicated to be evaluated by everyday investors, that doesn’t necessarily mean that 401(k) accounts should not contain either bitcoin or private-equity funds. Perhaps bitcoin will provide extra diversification, and private-equity funds extra returns.

Perhaps. That is for the professionals to decide—the portfolio managers who run the 401(k) industry's target-date funds. They, not employees, should be deciding what role that bitcoin might play in a portfolio, and if they can employ private equity profitably, while understanding the controversial details of how those companies are valued, and appreciating the performance-sapping effect of increased competition. If such assets are indeed helpful, they belong in target-date funds, not as stand-alone 401(k) selections.

For private equity funds, an additional advantage to being part of a larger fund is higher returns. A fund that invests in illiquid securities and stands on its own must either hold a cash buffer or risk selling into market weakness because of untimely redemptions. In contrast, when illiquid investments are held by target-date funds, they face no such danger. To meet redemptions, target-date funds can sell their abundant publicly listed securities.

The Rule Book

As a general principle, I support investor freedom. People may invest as they wish in their taxable accounts, or outright speculate through online gaming—all fine with me. In fact, I would remove a barrier for retail buyers by eliminating the antiquated accredited-investor regulations that restrict access to hedge funds and private-equity funds. If the small fish want to swim with the sharks, let them.

In this specific instance, though, I must demur. First, 401(k) plans are privileged. They enjoy a tax benefit, courtesy of the government. In exchange for its benefit, the government has the right to oversee how those plans are run. Second, 401(k) regulation operates largely through trial and error. Defense lawyers police plan sponsors by filing lawsuits. The process is inefficient. Adding bitcoin and private-equity funds as plan options would spur more suits, thus incurring more waste.

The correct 401(k) structure seems straightforward to me. Keep the plan lineup on a tight leash by banning speculative and illiquid investments. Give target-date managers all the rope they desire. And permit 401(k) participants who disagree with my counsel to buy what they wish—but through a brokerage window, as opposed to the plan’s official lineup. I can’t say fairer than that.

Note: This article was originally published on April 28, 2022.

The author or authors do not own shares in any securities mentioned in this article. Find out about Morningstar’s editorial policies.

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