Crypto, Private Equity, Annuity Contracts Are Impossible to Benchmark

By Christopher B. Tobe, CFA, CAIA

Crypto, Private Equity, and Annuity contracts are impossible to Benchmark because of a lack of transparency accountability and liquidity. Valid Benchmarks require investable securities. These issues make it nearly impossible for any of these contracts to be exempted from being a prohibited transaction in an ERISA plan. [i]

According to the CFA Institute, a valid benchmark should meet the following criteria:

Specified in advance: The benchmark is defined before the evaluation period begins.
Measurable: The benchmark’s return can be calculated regularly and in a timely manner.
Unambiguous: The identities and weights of the securities in the benchmark are clearly defined.
Reflective of current investment opinions: The manager is knowledgeable about the securities in the benchmark and their factor exposures.
Accountable: The manager is aware of and accepts responsibility for the benchmark’s performance and constituents.
Investable: The assets of the underlying index are available for purchase by investors.

These attributes are impossible for contract-based investments like Crypto, Private Equity, and Annuities since you do not own any securities. There is no accountability, they are ambiguous and use different forms of accounting than securities.

Benchmarks can work when you compare a security-based active investment fund with a security-based index fund as highlighted in Brotherston vs. Putnam.[ii]

These are one sided contracts, not securities, in favor of the vendor and to the detriment of the investor. Looking at these from an ERISA particularly 401(k) context these contracts have severe fiduciary issues which I feel prevent them from an exemption from prohibited transaction rules. The Burden of Proof is on the Plan Sponsor to document that these contracts are not Prohibited Transactions.[iii]

I think the conflicted contract nature of these investments allows them to manipulate or avoid benchmarks altogether. While plan sponsors should never have entered into these contracts in the first place, how do you hold them accountable for the damages they have caused participants. If you compare them against benchmarks to the lower risk investments they should have invested in, it conceals the damages. You must find comparable contracts with the same types of high risk to find the actual damages.

Annuity Contracts

I wrote last month that Annuities should not be allowed in 401(k)s as Prohibited Transactions. Annuities are a Fiduciary Breach for 4 basic reasons. [iv]

Single Entity Credit Risk [v]
Single Entity Liquidity Risk in illiquid investments [vi]
Hidden fees spread and expenses [vii]
Structure -weak cherry-picked state regulated contracts, not securities and useless reserves [viii]

These breaches make it impossible for most annuity products to qualify for exemptions to Prohibited Transactions which need to fill these 4 major obligations. [ix]

A. Care Obligation

B. Loyalty Obligation

C. Reasonable compensation limitation

D. No materially misleading statements (including by omission

I do not believe few if any annuities meet these 4 obligations, and the

burden of proof is on the plan sponsor that the annuities they use in their ERISA plans have a valid exemption. [x]

I have extensive experience showing damage by annuity contracts in large 401(k) and 403(b) plans. These are primarily fixed annuity IPG contracts within the broad category of stable value with no maturity and discretion by the insurer to pay rates that maximize their profits, at the detriment of participants. Some Fixed Annuity providers will claim money markets as a benchmark, despite having over 20 times the risk. The Federal Thrift Savings Plan has a high-quality stable value product, the G fund which they state is impossible to benchmark. [xi]

Single entity Fixed annuity providers have attempted to compare to the diversified Hueler Stable Alue Index despite having 10 times the risk. The proper comparable has been to other IPG fixed annuities with single entity risk, which has used in over a dozen cases specifically comparables like TIAA and MassMutual cited in detail in 2 ERISA Hospital Cases: Columbus, GA and Norton Hospital.

Private Equity Contracts

Private Equity contracts have mostly been contained in non-ERISA plans but this may be changing. Economic and Policy Research’s Eileen Appelbaum said “Much as private equity firms may wish it were different, they have been mostly unable to worm their way into workers’ 401(k)s and abscond with their retirement savings,”[xii]

Private Equity flunks all the impartial conduct standards in numerous ways.

Private equity offering documents generally prominently state (in capital, bold letters) that an investment in a private equity fund is speculative, involves a high degree of risk, and is suitable only for persons who are willing and able to assume the risk of losing their entire investment. Can engage in borrowing, or leverage, on a moderate or unlimited basis. No assurance of diversification since funds generally reserve the right to invest 100 percent of their assets in one investment. Heightened offshore legal, regulatory, operational and custody risk.[xiii]

Private Equity has a myriad of conflicts of interest, self-dealing practices. The investment manager determines the value of the securities held by the fund. Such a valuation affects both reported fund performance as well as the calculation of the management fee and any performance fee payable to the manager. [xiv]

Private Equity has business practices that may violate ERISA. Private equity fund offering documents often disclose that investors agree to permit managers to withhold complete and timely disclosure of material information regarding assets in their funds. Further, the fund may have agreed to permit the investment manager to retain absolute discretion to provide certain mystery investors with greater information and the managers are not required to disclose such arrangements. As a result, the fund you invest in is at risk that other unknown investors are profiting at its expense—stealing from you. [xv]

Plan sponsors will have a tough time justifying Private Equity as being exempted as a prohibited transaction given these facts. With such a lack of controls on the contracts, benchmarks are mostly useless.

Private Equity Benchmarks have been manipulated in U.S. public pensions to get higher bonuses not only for the Private Equity managers but for public government staff. [xvi] Private Equity benchmarks typically add a premium of 2%-6% to small cap index for leverage and liquidity. I think the high end of this range could be appropriate for damage comparisons given the fiduciary issues of the assets.

Crypto Contracts

Crypto has not been used extensively in ERISA plans as of now, but it is increasing.[xvii]

It was first discovered in Brokerage Windows, in which plans feel they have less fiduciary accountability. Companies running Brokerage Windows have been paid $millions by Crypto companies to put their options on their Brokerage Window Platform. In the article, “401(k)s with Bitcoin Should Expect Lawsuits: Lawyers,” the trade publication “Ignites” quotes Jerry Schlichter as saying that. Any employer who would follow the Fidelity lead by offering cryptocurrency and a 401(k) plan is exposing itself to very serious risk of a fiduciary breach…. As an unproven, highly volatile investment, Bitcoin would test the prudence standard under the Employee Retirement Income Security Act….The account will carry a fee of up to 90 basis points plus undisclosed commission fees, which would be 20 times as much as a simple index fund. Any 401(k) plans with a brokerage window will be subject to severe fiduciary liability unless they can prove they have provided 100% prudent options. This will most likely lead to much more litigation and many more settlements, as the cost of proving 100% prudent options will be extremely expensive. [xviii]

Burden of proof is on plan sponsors that Prohibited Transactions crypto in their plans qualify for a Prohibited Transaction Exemption. I have seen no evidence that any form of Crypto has met the qualifications for an exemption.

The Department of Labor in 2022 severely questions the reliability and accuracy of cryptocurrency valuations. A major concern is that cryptocurrency market intermediaries may not adopt consistent accounting treatment and may not be subject to the same reporting and data integrity requirements with respect to pricing as other intermediaries working with more traditional investment products.[xix] Under that guidance, which the DOL issued last month (April 22), employers could be responsible for risky crypto trades their workers make in workplace 401(k)s. The DOL’s employee benefits enforcement agency will launch what it’s calling “an investigative program” that requires plan officials to “square their actions with their duties of prudence and loyalty” if they allow crypto investments in self-directed accounts, according to the guidance.[xx]

The CFA institute writes. The unfortunate reality is that none of the proposed valuation models are as sound or academically defensible as traditional discounted cash flow analysis is for equities or interest and credit models are for debt. This should not come as a surprise. Crypto assets are more similar to commodities or currencies than to cash-flow producing instruments, such as equities or debt, and valuation frameworks for commodities and currencies are challenging. Custody is challenging and there is significant technological risk. As recently as 2018, researchers uncovered a bug in the bitcoin code that, if left unchecked and exploited, could have led to significant (theoretically infinite) inflation in the issuance of new bitcoin [xxi]

The lack of any valuation parameters makes benchmarks impossible. Comparisons should be flexible. One of the main comparisons should be the most popular Crypto asset Bitcoin.

Corrupt Structures

Crypto, Private Equity and Annuities in ERISA plan are mostly hidden in corrupt structures. Besides brokerage windows poorly state regulated separate account annuity products and Collective investment Trusts are places to hide these prohibited assets.

Over 50% of 401(k) assets are in Target Date Funds which are made up of underlying funds. This allows for less transparency of the underlying funds.

However, historically the largest structure for Target Date Funds has been SEC registered Mutual Funds. Mutual Funds have transparency and fiduciary standards that do not allow Crypto, Private Equity and Annuities. [xxii] Federal OCC regulated Collective Investment Trusts (CITs) have transparency and fiduciary standards that do not allow Crypto, Private Equity and Annuities.[xxiii] However, many state regulated CIT’s have weak or no transparency or fiduciary standards, so you can allow Crypto, Private Equity and Annuities.

Currently I believe the biggest threat of prohibited investments like Crypto, Private Equity and Annuities will be hidden in target date funds structured as state regulated CIT’s that I outlined in my DOL Advisory testimony in July 2024.[xxiv]

Conclusions

Since Crypto, Private Equity, Annuity contracts are impossible to Benchmark you need to use Comparables. To make valid comparisons you have to compare them to other prohibited transactions that are materially similar, and looking at those similar funds with the best performance is valid for damages.

[i] https://commonsense401kproject.com/2024/10/10/annuities-exposed-as-prohibited-transaction-in-401k-plans/

[ii] 117https://www.plansponsor.com/supreme-court-will-not-weigh-burden-proof-index-fund-comparison/ https://401kspecialistmag.com/brotherston-v-putnamsfar-reaching-401k-fallout/

[iii] https://commonsense401kproject.com/2024/11/19/burden-of-proof-is-on-plan-sponsors-hoping-to-qualifyfor-annuity-prohibited-transactions-exemption/

[iv] https://commonsense401kproject.com/2022/05/11/annuities-are-a-fiduciary-breach/

[v] https://commonsense401kproject.com/2024/03/26/just-how-safe-are-safe-annuity-retirement-products-new-paper-shows-annuity-risks-are-too-high-for-any-fiduciary/ https://www.thinkadvisor.com/2024/11/20/yes-life-and-annuity-issuers-can-suddenly-collapse-treasury-risk-tracker-warns/

[vi] https://www.chicagofed.org/publications/economic-perspectives/2024/5 https://www.chicagofed.org/publications/chicago-fed-letter/2024/494

[vii] https://www.bloomberg.com/news/articles/2013-03-06/prudential-says-annuity-fees-would-make-bankers-dance?embedded-checkout=true TIAA https://www.nbcnews.com/investigations/tiaa-pushes-costly-retirement-products-cover-losses-whistleblower-rcna161198

[viii] Federal Reserve Bank of Minneapolis Summer 1992 Todd, Wallace SPDA’s and GIC’s http://www.minneapolisfed.org/research/QR/QR1631.pdf https://www.chicagofed.org/publications/economic-perspectives/1993/13sepoct1993-part2-brewer

[ix] https://commonsense401kproject.com/2024/10/10/annuities-exposed-as-prohibited-transaction-in-401k-plans/

[x] https://commonsense401kproject.com/2024/11/19/burden-of-proof-is-on-plan-sponsors-hoping-to-qualifyfor-annuity-prohibited-transactions-exemption/ https://fiduciaryinvestsense.com/2024/09/25/chief-judge-of-the-5th-circuit-calls-out-his-brethren-on-decision-to-stay-the-dols-retirement-security-rule/#:~:text=As%20to%20coverage%20under%20the,of%20whether%20advice%20is%20given.

[xi] https://www.tsp.gov/funds-individual/g-fund/ https://www.frtib.gov/pdf/reading-room/InvBMarks/2017Oct_Benchmark-Evaluation-Report.pdf

[xii] https://commonsense401kproject.com/2022/02/15/private-equity-in-401k-plans-a-ticking-time-bomb/