401(K) Plans
Certain Investment Options and Practices That May Restrict Withdrawals Not Widely Understood
Gao ID: GAO-11-291 March 10, 2011
401(k) plan sponsors are responsible for offering an array of appropriate investment options, and participants are responsible for directing their investments among those options. While participants expect to be able to switch investment options or withdraw money from their accounts, during the recent economic downturn, some 401(k) plan sponsors and participants found that they were restricted from doing so. GAO was asked to (1) identify some of the specific investments and practices that prevented plan sponsors and participants from accessing their 401(k) plan assets and (2) determine any changes the Department of Labor (Labor) could make to assist sponsors in understanding the challenges posed by the investments and practices that restricted withdrawals. To do this, GAO reviewed relevant federal laws and regulations and consulted with experts, federal officials, service providers, and plan sponsors.
Between 2007 and 2010, some 401(k) plan sponsors and participants were restricted from withdrawing their plan assets from certain 401(k) investment options, including real estate, money market, and stable value investment options, as well as other investment options that lent securities (the practice of lending plan assets to third parties in exchange for cash as collateral that a fund reinvests). In most cases, the withdrawal restrictions were caused by losses and illiquidity in the investment options' underlying portfolios and sometimes contract constraints placed on plan sponsors by the investment options. For stable value funds, and also for those investment options that lent securities, the withdrawal restrictions and their causes highlight the risks that participants face when allocating their 401(k) plan assets to these investment options--and, that losses are borne by plan participants. In addition, participants often do not understand or may receive insufficient disclosures of the risks posed by these investments. Further, plan sponsors may be unaware or receive insufficient disclosures of the risks and challenges involved with those investment options and practices. Labor can take a variety of steps to help plan sponsors who offer stable value funds and investment options that lend securities. Many of these steps can draw upon the changes that the Securities and Exchange Commission and others have already made, or will make, regarding these investment options and recent suggestions from plan sponsors, industry service providers, and other key stakeholders. Specifically, Labor could identify and take action to address those stable value contract constraints that may hinder plan sponsors from performing their fiduciary responsibilities and provide better disclosures to plan sponsors about certain investment options to help sponsors make decisions on behalf of participants. Similarly, revising Labor's prohibited transaction exemption for securities lending to restrict those securities lending arrangements that may pose unreasonable financial terms upon plans and providing more guidance, in general, about such transactions can also help plan sponsors and participants understand the risks that cash collateral reinvestment can pose to plan assets in investment options that lend securities and how to mitigate them.
Recommendations
Our recommendations from this work are listed below with a Contact for more information. Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.
Director:
Charles A. Jeszeck
Team:
Government Accountability Office: Education, Workforce, and Income Security
Phone:
(202) 512-7036
GAO-11-291, 401(K) Plans: Certain Investment Options and Practices That May Restrict Withdrawals Not Widely Understood
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United States Government Accountability Office:
GAO:
Report to the Chairman, Special Committee on Aging, U.S. Senate:
March 2011:
401(K) Plans:
Certain Investment Options and Practices That May Restrict Withdrawals
Not Widely Understood:
GAO-11-291:
GAO Highlights:
Highlights of GAO-11-291, a report to the Chairman, Special Committee
on Aging, U.S. Senate.
Why GAO Did This Study:
401(k) plan sponsors are responsible for offering an array of
appropriate investment options, and participants are responsible for
directing their investments among those options. While participants
expect to be able to switch investment options or withdraw money from
their accounts, during the recent economic downturn, some 401(k) plan
sponsors and participants found that they were restricted from doing
so.
GAO was asked to (1) identify some of the specific investments and
practices that prevented plan sponsors and participants from accessing
their 401(k) plan assets and (2) determine any changes the Department
of Labor (Labor) could make to assist sponsors in understanding the
challenges posed by the investments and practices that restricted
withdrawals. To do this, GAO reviewed relevant federal laws and
regulations and consulted with experts, federal officials, service
providers, and plan sponsors.
What GAO Found:
Between 2007 and 2010, some 401(k) plan sponsors and participants were
restricted from withdrawing their plan assets from certain 401(k)
investment options, see figure, including real estate, money market,
and stable value investment options, as well as other investment
options that lent securities (the practice of lending plan assets to
third parties in exchange for cash as collateral that a fund
reinvests). In most cases, the withdrawal restrictions were caused by
losses and illiquidity in the investment options‘ underlying
portfolios and sometimes contract constraints placed on plan sponsors
by the investment options. For stable value funds, and also for those
investment options that lent securities, the withdrawal restrictions
and their causes highlight the risks that participants face when
allocating their 401(k) plan assets to these investment options”and,
that losses are borne by plan participants. In addition, participants
often do not understand or may receive insufficient disclosures of the
risks posed by these investments. Further, plan sponsors may be
unaware or receive insufficient disclosures of the risks and
challenges involved with those investment options and practices.
Figure: Investments and Practices that Restricted Plan Sponsor and
Participant Access to 401(k) Plan Assets:
[Refer to PDF for image: illustration]
Assets:
Real estate accounts;
Money market funds;
Stable value funds;
Securities lending;
Release of assets.
Source: GAO.
[End of figure]
Labor can take a variety of steps to help plan sponsors who offer
stable value funds and investment options that lend securities. Many
of these steps can draw upon the changes that the Securities and
Exchange Commission and others have already made, or will make,
regarding these investment options and recent suggestions from plan
sponsors, industry service providers, and other key stakeholders.
Specifically, Labor could identify and take action to address those
stable value contract constraints that may hinder plan sponsors from
performing their fiduciary responsibilities and provide better
disclosures to plan sponsors about certain investment options to help
sponsors make decisions on behalf of participants. Similarly, revising
Labor‘s prohibited transaction exemption for securities lending to
restrict those securities lending arrangements that may pose
unreasonable financial terms upon plans and providing more guidance,
in general, about such transactions can also help plan sponsors and
participants understand the risks that cash collateral reinvestment
can pose to plan assets in investment options that lend securities and
how to mitigate them.
What GAO Recommends:
GAO recommends Labor study stable value funds and the practice of
securities lending with cash collateral reinvestment by 401(k) plans
to identify situations or conditions where plan sponsors could be
prevented from meeting their fiduciary obligations, revise one of its
prohibited transaction exemptions, and provide better disclosures and
guidance to plan sponsors and participants. Labor disagreed with three
of GAO‘s recommendations and stated that it will consider the
remaining four. GAO continues to believe in its recommendations.
View [hyperlink, http://www.gao.gov/products/GAO-11-291] or key
components. For more information, contact Charles Jeszeck at (202) 512-
7215 or jeszeckc@gao.gov.
[End of section]
Contents:
Letter:
Background:
Certain Investment Options Placed Withdrawal Restrictions on 401(k)
Plan Sponsors and Participants:
Labor Can Take Steps to Help Plan Sponsors Understand the Risks and
Challenges Posed By Certain Investments and Practices:
Conclusions:
Recommendations For Executive Action:
Agency Comments and Our Evaluation:
Appendix I: Comments from the Department of Labor:
Appendix II: GAO Contact and Staff Acknowledgments:
Glossary:
Tables:
Table 1: Investment Options Typically Offered through a 401(k) Plan:
Table 2: Descriptions of the Three Types of Stable Value Fund
Contracts:
Table 3: Various Parties Involved in a Typical Securities Lending
Transaction with Cash Collateral Reinvestment:
Table 4: Potential Effects on Participants if Market Value Is Below
Book Value:
Figures:
Figure 1: Estimated Aggregate Asset Allocation of 401(k) Plan Assets,
2009:
Figure 2: Stable Value Fund Wrap Contract:
Figure 3: Example of a Simple Securities Lending with Cash Collateral
Reinvestment Transaction:
Figure 4: Reasons Withdrawal Restrictions May Have Occurred Regarding
401(k) Plan Assets:
Figure 5: Potential Risks Associated with Stable Value Fund Wrap
Contracts:
Figure 6: Gain or Loss earned from Cash Collateral from Securities
Lending in Differing Market Scenarios:
Figure 7: Example of a Stable Value Fund Disclosure Provided to 401(k)
Participants:
Figure 8: Example of a Securities Lending Disclosure in Registered
Investment Option's Required Disclosures:
Figure 9: Underlying Assets in Stable Value Funds (year end 2008):
Abbreviations:
CFTC: Commodity Futures Trading Commission:
CIF: collective investment fund:
EBSA: Employee Benefits Security Administration:
ERISA: Employee Retirement Income Security Act of 1974:
FDIC: Federal Deposit Insurance Corporation:
FINRA: Financial Industry Regulatory Authority:
FRB: Federal Reserve Board:
GIC: guaranteed investment contract:
OCC: Office of the Comptroller of the Currency:
PTE: prohibited transaction exemption:
SAI: Statement of Additional Information:
SEC: Securities and Exchange Commission:
[End of section]
United States Government Accountability Office:
GAO:
March 10, 2011:
The Honorable Herb Kohl:
Chairman:
Special Committee on Aging:
United States Senate:
Dear Mr. Chairman:
The recent problems in the U.S. mortgage market and subsequent
financial crisis revealed underlying weaknesses in the U.S. financial
system and illustrated the importance of due diligence in financial
matters. Investors, including 401(k) plan participants, experienced
large losses from their investments in 2008.[Footnote 1] There were
reports that some 401(k) participants experienced losses and were
restricted from accessing their plan assets in certain situations, and
that employers that sponsored 401(k) plans (plan sponsors) were also
restricted from withdrawing plan assets. Nearly 90 percent of all
401(k) plans are participant-directed, meaning they generally allow
participants to choose how much to invest, within federal limits, and
to select from a menu of diversified investment options chosen by the
plan sponsor. As such, most 401(k) plan participants expect to be able
to switch investment options or withdraw money from their accounts.
[Footnote 2] Similarly, plan sponsors also expect to be able to change
the investment options offered to their 401(k) plan participants
without significant restrictions and, in fact, have a duty under the
Employee Retirement Income Security Act of 1974 (ERISA) to act
prudently when selecting investment options for plan participants and
to act solely in the interest of the participants. The financial
crisis illustrated that withdrawal restrictions can be a condition of
certain investments, but they can also be a limitation of which some
plan participants and plan sponsors may not be aware.
Since it was unclear from the reports why certain types of investment
options restricted withdrawals and how and when withdrawal
restrictions were placed, we were asked to determine what happened
during the financial crisis to participant accounts and to plan
sponsors' control over the investment options offered to 401(k) plan
participants. To better understand the type of investments that were
offered to plan participants and whether plan participants and plan
sponsors were adequately informed about the potential for withdrawal
restrictions, we answered the following questions:
1. What are some of the specific investments and practices that
prevented plan sponsors and participants from accessing 401(k) plan
assets?
2. What changes, if any, could Labor make to assist plan sponsors in
understanding the challenges posed by certain investments and
practices?
To determine the specific practices that may have affected plan
sponsors' and participants' access to 401(k) plan assets during the
recent market downturn, we reviewed articles published by industry
experts, related documents from the Department of Labor (Labor), such
as published materials available to plan fiduciaries regarding plan
investment practices or suggested disclosures, and a report by Labor's
ERISA Advisory Council. We also conducted a short poll of plan
sponsors. The poll was conducted in coordination with Plansponsor
Magazine (Plansponsor) and asked plan sponsors about withdrawal
restrictions in their plans. The poll respondents were members of
Plansponsor's subscription list, and their responses cannot be
considered representative of the overall population of 401(k) plan
sponsors. Our main use of this information was to better inform our
understanding of these issues from a plan sponsor perspective and to
design our subsequent audit work. Because of the methodological
limitations and low response rate of this poll, this information is
anecdotal and represents only the views of the 74 members who
responded to our poll.
To demonstrate the scope of the potential effects of withdrawal
restrictions and risks to participants' earnings, we gathered data
from industry associations and private researchers; however, because
there was no comprehensive data source available, it was difficult to
determine how widespread the incidences of withdrawal restrictions
were and to quantify any losses to 401(k) participant accounts. We
also interviewed plan sponsors, plan service providers,
representatives from industry associations, researchers, and Labor
officials to determine the circumstances that led to withdrawal
restrictions during the recent market downturn, to get an
understanding of the advantages and disadvantages of investing in
certain investment options and engaging in certain investment
practices, and to determine the various relationships between 401(k)
plans and parties involved in these investment options and practices.
To examine how the oversight and regulatory requirements governing
withdrawal restrictions ensure that 401(k) plan sponsors and
participants are aware of the potential for restricted access to plan
investment options, we reviewed ERISA and Labor's related regulations,
guidance, and frequently asked questions to determine their specific
disclosure requirements and fiduciary responsibility standards. We
reviewed the relevant federal laws and regulations, including those
pertaining to disclosure requirements, of the Securities and Exchange
Commission (SEC), the Office of the Comptroller of the Currency (OCC),
the Federal Reserve Board (FRB), and the Federal Deposit Insurance
Corporation (FDIC), and interviewed officials at each of the federal
entities about how they govern withdrawal restrictions and other
investment practices. We reviewed Labor's, SEC's, and banking
regulators', requirements to see if changes to those requirements
could better inform plan sponsors and participants of the risks
associated with certain investments and investment practices. We also
collected and reviewed examples of disclosures from various investment
options offered by 401(k) plans to see if the disclosures were clear
and understandable and if they complied with current requirements. In
addition, we interviewed Labor officials about how they oversee
withdrawal restrictions and monitor disclosures to plan sponsors and
participants, and interviewed service providers, other industry and
participant organizations, and pension professionals to obtain their
views on current oversight, disclosure and fiduciary requirements.
We conducted this performance audit from November 2009 to March 2011,
in accordance with generally accepted government auditing standards.
Those standards require that we plan and perform the audit to obtain
sufficient, appropriate evidence to provide a reasonable basis for our
findings and conclusions based on our audit objectives. We believe
that the evidence obtained provides a reasonable basis for our
findings and conclusions based on our audit objectives.
Background:
Under Title I of ERISA, plan sponsors are permitted to offer their
employees two broad types of retirement plans, defined benefit and
defined contribution. Plan sponsors that offer defined benefit plans
typically invest their own money in the plan and, regardless of how
the plans' investments perform, promise to provide eligible employees
guaranteed retirement benefits, which are generally fixed levels of
monthly retirement income based on years of service, age at
retirement, and, frequently, earnings. In contrast, plan sponsors that
offer defined contribution plans do not promise employees a specific
benefit amount at retirement--instead, the employee and/or their plan
sponsor contribute money to an individual account held in trust for
the employee. The employee's retirement income from the defined
contribution plan is based on the value of their individual account at
retirement, which reflects the contributions to, performance of the
investments in, and any fees charged against their account. Over the
past three decades, there has been a general shift by plan sponsors
away from defined benefit plans to defined contribution plans.
The dominant and fastest growing defined contribution plan is the
401(k) plan, which allows workers to choose to contribute a portion of
their pretax compensation to the plan under section 401(k) of the
Internal Revenue Code.[Footnote 3] The use of 401(k) plans accelerated
in the 1980s after the U.S. Department of the Treasury (Treasury)
issued a ruling clarifying a new section of the tax code that allowed
employers and employees to make pretax contributions, up to certain
limits, to employees' individual accounts. According to estimates by
industry researchers, 49 million Americans were active 401(k) plan
participants in 2009 and, by year end, 401(k) plan assets amounted to
$2.8 trillion.[Footnote 4] In most 401(k) plans, participants bear the
risk of their investments' performance and the responsibility for
ensuring they have adequate savings in retirement. Participants may,
under certain circumstances, withdraw their retirement savings early
but may have to pay tax penalties for doing so. Current law limits
participant access to retirement savings in employer-sponsored
retirement plans although, in certain circumstances, 401(k) plan
sponsors may provide participants with access to their tax-deferred
retirement savings before retirement.[Footnote 5]
Plan sponsors that offer 401(k) plans have responsibilities under
ERISA. The law establishes that a plan fiduciary includes a person who
has discretionary control or authority over the management or
administration of the plan, including the plan's assets.[Footnote 6]
Typically, the plan sponsor is a fiduciary under this definition.
ERISA requires that plan fiduciaries carry out their responsibilities
prudently and do so solely in the interest of the plan's participants
and beneficiaries. In accordance with ERISA and related Labor
regulations and guidance, plan sponsors and other fiduciaries must
exercise an appropriate level of care and diligence given the scope of
the plan and act for the exclusive benefit of plan participants and
beneficiaries, rather than for their own or another party's gain.
Responsibilities of a fiduciary may include, but are not limited to:
* selecting and monitoring any service providers to the plan;
* reporting plan information to the federal government and to
participants;
* adhering to the plan documents, including any investment policy
statement;
* identifying parties-in-interest to the plan and taking steps to
monitor transactions with them;
* selecting and monitoring investment options the plan will offer and
diversifying plan investments; and:
* ensuring that the services provided to the plan are necessary and
that the cost of those services is reasonable.
Because 401(k) plans place the responsibility for ensuring adequate
retirement savings on participants and limit a fiduciary's liability
for investment decisions made by participants, Labor has placed
additional responsibilities on plan sponsors and their fiduciaries who
offer these plans. For participants to have control, they must be
given the opportunity to choose from a broad range of investment
alternatives. They must be allowed to give investment instructions at
least once a quarter and perhaps more often if the investment option
is volatile. In addition, participants must be given sufficient
information to make informed decisions about the investment options
offered under the plan.[Footnote 7]
ERISA allows plan sponsors to hire companies that will provide the
services necessary to operate their 401(k) plans. Service providers
are various outside entities, such as investment companies, banks, or
insurance companies that a plan sponsor hires to provide the services
necessary to operate the plan such as:
* investment management (e.g., selecting and managing the securities
included in a mutual fund);
* consulting and providing financial advice (e.g., selecting vendors
for investment options or other services);
* record keeping (e.g., tracking individual account contributions);
* custodial or trustee services for plan assets (e.g., holding the
plan assets in a bank); and:
* telephone or Web-based customer services for participants.
Labor's Employee Benefits Security Administration (EBSA) oversees
401(k) plans,[Footnote 8] educates and assists plan sponsors and
participants, investigates alleged violations of ERISA, responds to
requests for interpretations of ERISA through advisory opinions and
rulings, and makes determinations to exempt transactions that would
otherwise be prohibited under ERISA.[Footnote 9] However, the specific
investment products commonly offered in 401(k) plans fall under the
authority of the applicable securities, banking, or insurance
regulators. These regulators include SEC, federal and state banking
agencies, and state insurance commissioners as follows:
* SEC, among other responsibilities, regulates securities markets and
issuers, including mutual funds under various securities laws.
* Federal agencies charged with oversight of banks--primarily FRB,
OCC, FDIC, and state banking agencies--oversee bank investment
products, such as collective investment funds (CIF),[Footnote 10]
which are trusts that pool the investments of retirement plans or
other institutional investors.[Footnote 11]
* State insurance agencies generally regulate insurance products. Some
investment products may also include one or more insurance elements,
which are not present in other investment options. Generally, these
elements include an annuity feature and interest and expense
guarantees.[Footnote 12]
401(k) Investment Options:
ERISA does not prohibit a plan from offering any type of investment to
its participants, but gives plan sponsors flexibility to choose the
investments to be offered through their 401(k) plans.[Footnote 13]
There are many types of 401(k) investment options, including those
listed in table 1.
Table 1: Investment Options Typically Offered through a 401(k) Plan:
Type of investment option: Real estate accounts;
Description: Real estate accounts are open-ended, commingled accounts
that invest directly in real estate, such as funds that buy and manage
commercial properties. Real estate accounts are equity accounts
consisting primarily of high quality, well-leased real estate
properties in the industrial, office, retail, and hotel sectors. If
real estate accounts are offered by insurance companies as separate
accounts, they are regulated by the State Insurance Commissioner in
the state they are created.
Type of investment option: Mutual funds;
Description: A mutual fund, legally known as an open-end investment
company, is a company that pools money from many investors and invests
the money in stocks, bonds, short-term money market instruments, other
securities or assets, or some combination of these investments. These
investments comprise the fund's portfolio. Mutual funds are registered
and regulated under the Investment Company Act of 1940, and are
supervised by the SEC. Mutual funds sell shares to public investors.
Each share represents an investor's proportionate ownership in the
fund's holdings and the income those holdings generate. Mutual fund
shares are "redeemable," which means that when mutual fund investors
want to sell their shares, the investors sell them back to the fund,
or to a broker acting for the fund, at their current net asset value
per share, minus any fees the fund may charge.
Type of investment option: Money market funds;
Description: Money market funds are open-end management investment
companies that are registered under the Investment Company Act of
1940, and regulated under rule 2a-7 under that act. Money market funds
invest in high-quality, short-term debt instruments such as commercial
paper, treasury bills and repurchase agreements. Generally, these
funds, unlike other investment companies, seek to maintain a stable
net asset value per share (market value of assets minus liabilities
divided by number of shares outstanding), typically $1 per share.
Type of investment option: Collective Investment Funds (CIFs);
Description: A CIF is a bank-administered trust that holds commingled
assets that meet specific criteria. Each CIF is established under a
"plan" that details the terms under which the bank manages and
administers the fund's assets. The bank acts as a fiduciary for the
CIF and holds legal title to the fund's assets. Participants in a CIF
are the beneficial owners of the fund's assets. While each participant
owns an undivided interest in the aggregate assets of a CIF, a
participant does not directly own any specific asset held by a CIF.
CIFs are designed to enhance investment management by combining assets
from different accounts into a single fund with a specific investment
strategy. Many banks establish CIFs as an investment vehicle for
employee benefit accounts, including 401(k) plans.
Type of investment option: Balanced funds;
Description: Balanced funds are pooled accounts invested in stocks,
bonds, and often additional asset classes. They are classified into
two subcategories: target-date funds and nontarget-date balanced
funds. Target date funds are often registered mutual funds and hold a
mix of stocks, bonds, and other investments. Over time, the investment
allocation gradually shifts according to the fund's investment
strategy. Target date funds are designed to be investments for
individuals with particular retirement dates in mind. The name of the
fund often refers to its target date. For example, a fund with the
name "Target 2030" is designed for individuals who intend to retire in
or near the year 2030. Nontarget-date balanced funds include asset
allocation or hybrid funds.
Type of investment option: Stable value funds;
Description: Stable value funds are a fixed income investment option,
designed to preserve the total amount of participants' contributions,
or their principal, while also providing steady, positive returns set
in the contract. See below for more information.
Source: GAO.
Note: See [hyperlink, http://www.gao.gov/products/GAO-11-118] for more
information on target date funds.
[End of table]
Labor reports that, in recent years, there has been a dramatic
increase in the number of investment options typically offered under
401(k) plans. Many investments offered under 401(k) plans today pool
the money of a large number of individual investors into funds called
commingled or pooled accounts.[Footnote 14] However, larger plans are
more likely to structure their investments in separate accounts.
[Footnote 15] Both types of accounts may be invested in stocks, bonds,
or real estate, but the type and number of options plan sponsors offer
to participants in any given 401(k) plan vary based on a number of
factors, including the size of the plan and the chosen plan service
providers.
Results from a 2009 survey conducted by an industry consulting firm
show that the most commonly offered 401(k) investment options in 2009
were equity, bond, and stable value funds.[Footnote 16] Results from
the survey also indicated that the percentage of plans offering money
market funds significantly increased between 2007 and 2009. As shown
in figure 1, equity funds accounted for over 40 percent of the 401(k)
plan assets at the close of 2009. Other plan assets were invested in
company stock; stable value funds, including guaranteed investment
contracts; balanced funds; bond funds; and money funds.
Figure 1: Estimated Aggregate Asset Allocation of 401(k) Plan Assets,
2009:
[Refer to PDF for image: pie-chart]
Equity funds: 41% ($496.1 billion);
Balanced funds: 17% ($205.7 billion);
GICs and other stable value funds: 13% ($157.3 billion);
Bond funds: 11% ($133.1 billion);
Company stock: 9% ($108.9 billion);
Money funds: 5% ($60.5 billion);
Other: 4% ($48.4 billion).
Sources: Employee Benefit Research Institute and Investment Company
Institute.
Note: GAO analyzed data provided in the November 2010 EBRI Issue Brief
No. 350, in which EBRI and ICI summarize data from their 2009 EBRI/ICI
401(k) database. According to EBRI and ICI, at year end 2009, all
401(k) plans held a total of $2.8 trillion in assets, and that the
database is a representative sample of the estimated universe of
401(k) plans. EBRI and ICI state the database contains information on
over 51,000 401(k) plans (about 10 percent of plans) with $1.21
trillion in assets (about 44 percent of 401(k) plan assets) and about
20 million participants (about 42 percent of the universe of active
401(k) plan participants). The percentages presented in this figure
are estimates of 401(k) plan assets included in each investment type
based on the population covered in the database, or $1.21 trillion in
401(k) plan assets. The "Equity funds" and "Bond funds" categories
consist of pooled investments--including mutual funds and CIFs--that
are primarily invested in stocks and bonds, respectively. The "Other"
category is the residual for other investments, such as real estate
funds, and the "Money funds" category includes money market funds and
other funds that are designed to maintain a stable share price, other
than GICs and stable value funds. For definitions of key terms used in
the report, please see the glossary.
[End of figure]
Stable Value Funds:
A key type of investment commonly offered through 401(k) plans is the
stable value fund, which is a capital preservation investment option.
These funds are primarily offered to defined contribution plan
participants, including 401(k) plan participants.[Footnote 17] Stable
value funds are marketed as being invested in high-quality,
diversified fixed income investments that are protected against
interest rate volatility. According to the Stable Value Investment
Association, about 50 percent of 401(k) plans offer stable value funds
and when a stable value fund is offered, participants put about 15 to
20 percent of their plan assets, on average, into the investment
option. Stable value funds are designed to preserve the total amount
of participants' contributions, or their principal, while also
providing steady, positive returns.
While these funds attempt to maintain a stable return, actual return
could vary over time because of changes in the market value of the
underlying stable value portfolio assets, among other things.[Footnote
18] To protect the fund from interest rate volatility, an important
component of a stable value fund is the contract that plan sponsors or
stable value fund managers purchase from plan service providers,
including banks and insurers. The contract is a guarantee by a service
provider, in the event of participant withdrawals, to pay participants
at book value should the market value of the stable value portfolio be
worth less than the amount needed to pay that book value.[Footnote 19]
As part of the price of providing this guarantee, contract providers
typically require certain restrictions on plan sponsor and participant
withdrawals or transfers of plan assets from stable value funds.
[Footnote 20]
While the market value of a stable value fund fluctuates as market
prices of the underlying assets rise and fall, its book value
fluctuates much less often, if at all--the rate of return may be
fixed, indexed, or reset periodically based on certain factors,
including the actual performance of the underlying assets--depending
on the type of stable value fund contract obtained by the plan. Table
2 describes the three types of stable value fund contracts. Stable
value funds may hold one contract type or a combination of contracts.
Table 2: Descriptions of the Three Types of Stable Value Fund
Contracts:
Type of stable value fund: Traditional guaranteed investment contracts
(GIC);
Description: Plan sponsors contract with an insurance company to
guarantee participants principal protection and a rate of return
regardless of the performance of the underlying assets, which the
insurance company owns and holds within their general account.
Type of stable value fund: Separate account GICs;
Description: Plan sponsors contract with an insurance company to
guarantee participants principal protection and a rate of return,
which may be fixed, indexed, or reset periodically based on the actual
performance of the underlying assets. The insurance company owns and
holds the underlying assets in a separate, customized account for the
exclusive benefit of a single plan.
Type of stable value fund: Synthetic GICs;
Description: Plan sponsors contract with a bank or insurance company
to guarantee participants principal protection and a rate of return
relative to a portfolio of assets held in an external trust owned by
the plan. The rate of return, which is based on the actual performance
of the underlying assets, is reset periodically.
Source: GAO.
Note: For the purpose of this report, stable value funds described are
those typically categorized as synthetic guaranteed investment
contracts.
[End of table]
For synthetic GICs, contracts are called "wrap contracts." These
stable value funds may obtain multiple wrap contracts from wrap
contract providers to cover the underlying assets held in the stable
value portfolio. As shown in figure 2, if participants want to
withdraw funds when the value of a stable value portfolio falls below
the book value the wrap contract provider may make up the difference
for participants. In this situation, the wrap contract provider must
only cover the difference between market value and book value if the
total amount of participants' withdrawals exceeded the market value of
the underlying stable value portfolio.
Figure 2: Stable Value Fund Wrap Contract:
[Refer to PDF for image: line graph]
The graph charts Value of Investment against Duration of Time.
Represented on the graph are the following:
Market value of portfolio;
Book value of contract.
Under the conditions of the wrap contract, if the fund liquidates when
the book value of the portfolio is higher than its market value, the
insurer (wrap contract provider) pays the difference according to the
terms of the wrap contract.
Source: GAO presentation of Stable Value Investment Association
information.
[End of figure]
401(k) Investment Practice: Securities Lending with Cash Collateral
Reinvestment:
Many of the investment options offered by plan sponsors, including
money market funds, stable value funds, and equity funds, engage in a
practice called securities lending, where some of the assets held in
these investment options on behalf of plan participants are lent out
for a period of time to a third party, usually a broker-dealer.
[Footnote 21] In return, the broker-dealer provides collateral to the
securities lending agent to hold until the broker-dealer returns the
borrowed securities.[Footnote 22] For example, an S&P 500 index fund
will hold the same stocks in approximately the same ratio as they
comprise the S&P 500, in an attempt to approximate the return of the
S&P 500. There will always be a gap between the S&P 500 and an index
fund that tries to approximate the returns of the S&P 500, by buying
and selling stocks to maintain the same values as are held in the S&P
500. This gap, also known as "tracking error," is caused by, among
other things, fund expenses, such as investment advisory fees, and
brokerage expenses, that the index itself would not have. These index
funds may try to decrease the gap by earning greater return on the
stocks they hold by temporarily lending out the securities and then
investing the cash collateral they receive.[Footnote 23] Table 3
defines the various parties involved in a typical securities lending
transaction.
Table 3: Various Parties Involved in a Typical Securities Lending
Transaction with Cash Collateral Reinvestment:
Entity: Plan participants;
Role: Plan participants contribute to their 401(k) and direct that
contribution to certain investment options. In 401(k) plans, the
assets are held in trust for participants.
Entity: Plan sponsor;
Role: A plan sponsor chooses which investment options to offer to its
participants and, when making that choice, may decide whether to offer
investment options that engage in securities lending.
Entity: Plan service provider;
Role: A plan service provider purchases securities on behalf of 401(k)
plan participants. May act as securities lending agent.[A].
Entity: Securities lending agent;
Role: The securities lending agent may coordinate loans of securities,
hire a manager to invest cash collateral, and often takes on
counterparty risk--or the risk that the borrower will fail to return
the securities--on behalf of the plan. May be an affiliate of the
custodian, i.e., an entity, usually a bank, that has legal
responsibility for safekeeping a plan's securities.
Entity: Borrower;
Role: The borrower contracts with a broker-dealer to acquire the
securities it needs to cover its obligations. The broker-dealer can
also be the borrower. There are many reasons why an entity might seek
to borrow securities, including for "short" sales, i.e., borrowing a
security from a broker and selling it, with the understanding that it
must be bought back and returned to the broker. Short selling is a
technique used by investors who try to profit from the falling price
of a stock.
Entity: Broker-dealer;
Role: The broker-dealer borrows securities on behalf of its customers,
providing cash as collateral to the securities lending agent.[B] A
broker-dealer is a company or other organization that trades
securities for its own account or on behalf of its customers. Although
many broker-dealers are "independent" firms solely involved in broker-
dealer services, many others are business units or subsidiaries of
commercial banks, investment banks or investment companies. When
executing trade orders on behalf of a customer, the institution is
said to be acting as a broker. When executing trades for its own
account, the institution is said to be acting as a dealer.
Entity: Cash collateral pool manager;
Role: The cash collateral pool manager invests the cash provided as
collateral for the borrowed securities in order to earn additional
return for the securities lending agent during the period of time that
the securities are borrowed. The securities lending agent can be the
cash collateral pool manager, but usually it is an affiliate of the
securities lending agent.
Source: GAO.
[A] Custodial banks commonly provide securities lending services to
defined benefit and defined contribution plans. If the plan invests
plan assets in separate accounts, plan sponsors can choose whether or
not to participate directly in a securities lending program. If the
plan invests plan assets in commingled accounts--including mutual
funds and collective investment funds--it may also participate
indirectly in securities lending if those commingled accounts
participate in securities lending.
[B] The amount of collateral provided by the broker-dealer may depend
on the type of security being lent. For U.S. securities a typical
collateral rate is 102 percent, for international securities it is 105
percent, of the value of the securities being lent out.
[End of table]
Figure 3 shows how a simple securities lending transaction would work.
Figure 3: Example of a Simple Securities Lending with Cash Collateral
Reinvestment Transaction:
[Refer to PDF for image: illustration]
1. Participant sends cash to plan sponsor to be invested in a 401(k)
plan.
2. Plan sponsor, usually employer, sends cash to plan service provider
to purchase shares in 401(k) plan on behalf of participant.
3. Plan service provider buys securities on behalf of the plan and
holds these securities and those of other investors in a pool of
assets. Plan service provider can act as securities lending agent.
Lending shares for additional investment:
4. Acting as securities lending agent, plan service provider may lend
some of the pool's securities to a broker-dealer.
5. Broker-dealer borrows a needed security on behalf of a customer in
exchange for cash as collateral and a promise to return the security
at a future date.
6. Seeking additional return, the securities lending agent invests the
cash collateral.
7. Cash collateral pool manager, who is often working as an affiliate
of the securities lending agent, manages the investment of the cash
collateral. Gains or losses[A] to Plan service provider.
8. When the broker-dealer returns the security, the plan refunds the
cash used as collateral.
Source: GAO interviews and analysis of the practice of securities
lending with cash collateral reinvestment.
Note: When securities are on loan, the lenders, or plan participants,
retain all the benefits of ownership including rights to dividends,
interest payments, corporate actions (excluding proxy voting), and
market exposure to unrealized capital gains or losses.
[A] Participants earn additional return in this transaction when the
reinvested cash collateral earns more than the amounts owed to (1) the
cash collateral pool manager as a fee for managing the cash collateral
pool and (2) the broker-dealer as a "rebate." Generally the return
left over after these two entities are paid is split between the
securities lending agent and plan participants in varying percentages.
The proceeds from securities lending that plan participants receive
typically serves to offset custody fees and administrative expenses or
to simply enhance participants' portfolio returns.
[End of figure]
Institutions engaged in securities lending for a 401(k) plan subject
to ERISA are supposed to take all steps necessary to design and
maintain their programs to conform to an ERISA exemption that
authorizes securities lending transactions that might otherwise
constitute "prohibited transactions" under ERISA.[Footnote 24] In
general, ERISA prohibits parties-in-interest--such as service
providers, plan fiduciaries, the employer, the union, owners,
officers, and relatives of parties-in-interest--from doing business
with the plan[Footnote 25] but provides various exemptions to these
prohibited transactions.[Footnote 26] Some of the exemptions provide
for dealings with banks, insurance companies, and other financial
institutions essential to the ongoing operations of the plan. Labor
issued Prohibited Transaction Exemption (PTE) 2006-16 to allow the
lending of securities by employee benefit plans to certain banks and
broker-dealers and to permit the payment of compensation to a lending
fiduciary for services rendered in connection with loans of plan
assets that are securities.[Footnote 27]
Certain Investment Options Placed Withdrawal Restrictions on 401(k)
Plan Sponsors and Participants:
Between 2007 and 2010, some plan sponsors and participants were
restricted from withdrawing their plan assets from certain 401(k)
investment options, such as real estate, money market, and stable
value investment options.[Footnote 28] As shown in figure 4, beyond
elevated levels of withdrawal requests, there were various reasons why
certain investment options restricted withdrawals.[Footnote 29]
Figure 4: Reasons Withdrawal Restrictions May Have Occurred Regarding
401(k) Plan Assets:
[Refer to PDF for image: illustration]
Assets:
Real estate accounts:
Fund doesn‘t have enough cash and doesn‘t want to liquidate assets
that have declined in value or have become difficult to sell.
Money market funds:
Fund‘s assets have declined in value, and the fund has decided to
liquidate.
Stable value funds:
Fund doesn‘t have enough cash to pay all participants or sponsors who
want to withdraw at book value; and:
Fund is unable to liquidate assets that have declined in value or have
become difficult to sell for enough to pay out at book value; and:
Wrap contracts will be voided if sponsor or too many participants want
to withdraw or because of an employer-initiated event.
Securities lending:
Cash collateral pool assets have declined in value or have become
difficult to trade; and:
Unable to liquidate assets to obtain enough cash to unwind securities
lending transaction.
Source: GAO.
[End of figure]
Real Estate Accounts Restricted Withdrawals Because of Illiquid Assets:
Multiple real estate accounts placed restrictions on participant and
sponsor withdrawals in 2007 and 2008--some of which lasted into 2011.
[Footnote 30] Since these accounts buy and manage real estate, such as
commercial properties, which is inherently more illiquid than some
assets in other 401(k) investment options, industry experts we spoke
to told us that few plan sponsors tend to offer these investment
options in 401(k) plans. Nevertheless, some 401(k) plan participants
had invested some of their 401(k) plan assets with these types of
investment options and found those assets frozen during the last few
years because some of the investments in the real estate accounts--for
example, an investment by the real estate fund in a high-rise building
or other commercial property--had lost significant value and became
difficult to sell. As a result, participants' and plan sponsors'
withdrawals of their assets from the investment options were postponed
by managers of the accounts, sometimes for multiple years. [Footnote
31] While the number of 401(k) plan sponsors or participants whose
withdrawals were affected or who lost money as a result of withdrawal
restrictions is unknown, at least one lawsuit was filed on behalf of
ERISA plans, including 401(k) plan participants, alleging that a
service provider breached its fiduciary duties by managing a real
estate account that restricted withdrawals inconsistently with its
stated objective to maintain adequate liquidity to provide for daily
withdrawals.[Footnote 32] As of December 2010, some of the
restrictions that were placed on these real estate accounts had been
lifted, and some plan participants and sponsors had received their
requested plan assets.
Industry experts told us that withdrawal restrictions on real estate
accounts are not unusual--in fact such accounts have implemented
withdrawal restrictions in the past--and that, for this reason, these
investment options disclose to plan sponsors and participants in
account documentation that the real estate account manager may
temporarily freeze withdrawals. We found that plan sponsors generally
receive information about real estate accounts, including the maximum
number of days allowed to defer withdrawals from the account, in the
contract that they sign with their service provider. In addition, we
reviewed disclosures to participants that stated that the investment
option was subject to investment and liquidity risk and other risks
inherent in real estate such as those associated with general and
local economic conditions, and that payment of principal and earnings
may be delayed. However, some of the industry officials we spoke to
noted that, regardless of these disclosures, participants may not have
known that their plan assets could be frozen because they failed to
read or understand the disclosures.
One Money Market Fund Restricted Withdrawals Because of Losses and
Illiquid Assets, While Others Required Support to Prevent Potential
Restrictions:
While money market funds account for only a small portion of 401(k)
plan assets, during 2007 and 2008, many money market funds experienced
severe financial difficulties from exposure to losses from debt
securities issued by structured investment vehicles and Lehman
Brothers Holdings Inc. (Lehman), and one of them placed restrictions
on all withdrawals from the investment option. The once-more than $60
billion money market fund, the Reserve Primary Fund, "broke the buck"
on September 16, 2008, because its $785 million holdings of Lehman
debt securities had defaulted, causing a 3 percent loss to investors,
including 401(k) plan participants.[Footnote 33] As a result of
investor concern over Lehman's default, the Primary Fund faced a very
large number of withdrawal requests over a short period of time--or a
run on the fund--which the other Reserve funds also experienced.
[Footnote 34] The Primary Fund stopped satisfying redemption requests
and formally instituted withdrawal restrictions on all investors on
September 22, 2008, when it obtained an SEC order permitting the
suspension of redemptions in certain Reserve Funds, including the
Primary Fund, to permit their orderly liquidation.[Footnote 35]
With the exception of the Reserve Primary Fund, the money market funds
that were exposed to losses in 2007 and 2008 obtained support in some
form from their advisers or other affiliated service providers that
may have helped to avoid potential restrictions. This support either
absorbed the losses or provided a guarantee covering a sufficient
amount of losses to prevent the money market fund from breaking the
buck. In addition, these funds received support from federal
regulators to help them remain liquid and preserve their value.
Shortly after the Reserve Primary Fund began to experience
difficulties, on September 19, 2008, the Treasury announced the
Temporary Guarantee Program for Money Market Funds, which temporarily
guaranteed certain investments in money market funds that decided to
participate in the program.[Footnote 36] On the same day, the FRB
announced the creation of its Asset-Backed Commercial Paper Money
Market Mutual Fund Liquidity Facility, through which it extended
credit to U.S. banks and bank holding companies to finance their
purchases of high-quality asset-backed commercial paper from money
market funds.[Footnote 37] As a result of the service provider and
federal support that provided additional liquidity to money market
funds, additional redemption suspensions and liquidations may have
been prevented.
Because of the severity of the problems experienced by money market
funds during 2007 and 2008, SEC reformed its regulations governing
money market funds. The new regulations are designed to make money
market funds more resilient, more liquid, and to reduce the chance of
runs on money market funds in the future.[Footnote 38] Among other
things, the new regulations now permit a money market fund that has
broken the buck, or that is at imminent risk of doing so, and that has
irrevocably decided to liquidate, to suspend redemptions without
obtaining an SEC order.[Footnote 39] These changes could permit
additional participant and sponsor withdrawal restrictions in the
future, if additional money market funds liquidate.
Some Stable Value Fund Assets Were Restricted Because of Losses,
Illiquid Assets, and Contract Constraints, Which Also Pose Risks to
Participants:
Some Stable Value Funds Restricted Plan Sponsor and Participant
Withdrawals, but the Extent Is Unknown:
Industry experts have noted that most stable value funds avoided
withdrawal restrictions in 2008 and 2009, but we found that the total
number of plan sponsors and participants affected by withdrawal
restrictions from stable value funds was unknown. Stable value funds
can place restrictions on plan sponsor and participant withdrawals in
some circumstances when the market value of the fund's underlying
assets is below the book value, and more participants want to cash out
than the fund's cash holdings can handle. According to the Stable
Value Investment Association and industry consultants, many stable
value funds were operating with market values below book values in
2008 and 2009 because of losses and illiquidity in their underlying
assets, but plan participants allocated increasing amounts of their
401(k) assets to stable value funds. An industry association indicated
that this increase in participants' contributions to stable value
funds likely allowed stable value funds to avoid liquidity problems
that could have caused withdrawal restrictions or losses for
participants.
However, when many stable value funds experienced market values below
book values during 2008 and 2009, some participants and plan sponsors
were restricted from withdrawing their plan assets from some stable
value portfolios because of stipulations in their wrap contracts. For
example, after their company's bankruptcy, participants in Mervyns
LLC's 401(k) plan were restricted from withdrawing their assets
invested in the stable value option. In this situation, the
protections that would have been afforded to the Mervyns participants
by the stable value fund's wrap contract were voided by the plan
sponsor's bankruptcy, since it was considered an "employer-initiated
event" in the contract. Similarly, some plan sponsors were restricted
from withdrawing plan assets from stable value funds because of
constraining language in the wrap contract that provided for
withdrawal restrictions in the case of employer-initiated events.
Specifically, wrap contracts typically stipulate that stable value
managers have the right to restrict plan sponsor withdrawals for
employer-initiated events for up to 12 months in order to unwind
investments and ensure that participants can be paid out at book
value, but during this time participants are generally able to make
withdrawals from the investment option at any time.[Footnote 40]
Employer-initiated events could include layoffs, bankruptcies, and
changing stable value fund providers and might include anything that
may cause withdrawals of a large plan asset amount from the investment
option in a short time frame. For example, one plan sponsor who
recently acquired another company noted that the acquisition took only
4.5 months, but it was restricted from withdrawing from the companies'
two stable value funds for nearly 2 years because the acquisition, as
an employer-initiated event, required a merger of the two existing
stable value funds, but existing contract providers refused to
accommodate the stable value fund merger without loss to participants.
Another plan sponsor we spoke to noted that its 401(k) plan switched
plan service providers and had to wait until the stable value fund
provider had come up with enough cash to implement the change. As of
the date of the switch, new contributions to the stable value option
were attributed directly to the new stable value fund at the new
provider, but the plan had to keep the past contributions on the
plan's records until the restriction was lifted.
Losses and Illiquidity in Stable Value Portfolios and Contract
Constraints Increase Participants' Risks for Restrictions and Losses:
The losses and illiquidity of the underlying assets of stable value
funds and contract constraints that led to the withdrawal restrictions
raised some concerns about the risks that these investment options
pose to participants. Specifically, the industry has documented that,
between 2005 and 2007, many stable value funds began including riskier
assets than had been traditionally included in stable value
portfolios--including highly rated corporate bonds, mortgage-backed
securities,[Footnote 41] and asset-backed securities,[Footnote 42] at
the expense of treasuries--in an effort to increase participants'
return and to attract more investors. However, many of these
securities suffered price declines, which contributed to the stable
value funds' market values falling below their book values and has
resulted in lower returns for participants. When the market value of
the stable value portfolio is above book value, participants who want
to withdraw their plan assets from the stable value fund receive book
value, and stable value fund providers retain the extra as profit and
as reimbursement for their costs to run the stable value fund.
[Footnote 43] However, as shown in table 4, when the market value of
the stable value portfolio's assets is below book value, and the
contract is voided by an employer-initiated event, plan participants
can face withdrawal restrictions until the stable value fund generates
enough cash from new contributions or by selling existing portfolio
assets.[Footnote 44]
Table 4: Potential Effects on Participants if Market Value Is Below
Book Value:
Wrap contract is:
Valid--withdrawals do not result from employer-initiated events;
What happens if many participants want to withdraw? Stable value fund
pays participants with cash holdings and proceeds from selling other
stable value holdings. Since the stable value holdings are not enough
to pay participants at book value, the wrap provider pays the
difference between market value and book value.[A]
Wrap contract is:
Void--withdrawals result from employer-initiated events that void the
contract;
What happens if many participants want to withdraw? Stable value fund
pays participants the market value of their investment in the fund
with cash holdings and proceeds from selling other stable value
holdings.
Or:
Stable value fund restricts withdrawals until the stable value fund
can provide participants with cash holdings and proceeds from selling
other stable value holdings.
Source: GAO.
[A] Wrap providers cover the difference between market value and book
value; not the full amount necessary to pay participants who request
withdrawals. For example, if the book value of a participant's plan
assets in the stable value fund is $100, but the market value of their
plan assets is only $97, then the wrap provider would pay $3, and the
stable value fund would pay $97 if the participant wanted to withdraw
their assets.
[End of table]
In addition to withdrawal restrictions, when the market value of the
stable value portfolio's assets is below book value, participants are
at risk for losses from the investment option. As noted above, in the
case of an employer-initiated event, the wrap contract protections
that would provide participants with book value could be voided,
thereby placing plan participants at risk for any losses of the
underlying assets.[Footnote 45] For example, when Lehman filed for
bankruptcy in September 2008, wrap contracts that covered portions of
the stable value fund in the Lehman 401(k) plan became void, which
resulted in losses for some plan participants who withdrew their plan
assets from the investment option. Furthermore, even if the wrap
contract remains valid, if more participants request transfers out of
the investment option when the market value of the fund is less than
book value than the fund's liquidity reserves can handle, new
participants and participants who remain in the fund could be at risk
for the losses from the investment option because the rate of return
earned on the stable value fund, going forward, will be adjusted
downward by the wrap contract provider to reflect the market losses
that were temporarily covered by the wrap provider.[Footnote 46] In
fact, industry experts note that wrap providers had never made a
payment in fulfillment of a wrap contract that they did not recoup. As
a result of the adjusted rate of return, future assets contributed to
the stable value fund, whether by current or new participants, will
earn less than the original assets that incurred the losses because
the wrap provider will guarantee a lower return for those future
contributions in order to make up for the market losses. Although one
of the reasons why stable value fund providers place restrictions on
plan sponsor and participant withdrawals is to limit these situations,
even unrestricted participant withdrawals could trigger an inequitable
distribution of risk and losses. This is of particular concern when
interest rates have risen sharply, and investors leave the stable
value fund in search of higher yields.
Stable Value Wrap Contracts Also Expose Participants to Other Risks:
In addition to causing potential losses for participants, wrap
contracts can also expose participants to other risks. Figure 5
illustrates some of the potential risks associated with stable value
fund wrap contracts.
Figure 5: Potential Risks Associated with Stable Value Fund Wrap
Contracts:
[Refer to PDF for image: illustration]
Stable Value Portfolio:
Wrap Contract:
* It is possible to lose money by investing in a fund that doesn‘t
maintain its net asset value;
* Participants are typically restricted from transferring their money
into competing funds for a period of time;
* Some portfolios could be left unwrapped if wrap contract providers
exit the business or experience credit downgrades;
* Some participants could receive market value if their wrap provider
defaults.[A]
Source: GAO interviews and analysis of stable value fund issues.
[A] One of the major wrap contract providers almost went bankrupt,
requiring a federal bailout.
[End of figure]
* "Competing" fund restrictions--If participants wish to withdraw
their assets from a stable value fund, the terms of the wrap contract
may prohibit them from transferring their assets into "competing"
investment options offered by the plan sponsor, as defined in the wrap
contract. Participants may instead be required to put their assets
into a noncompeting investment option for 90 days.[Footnote 47]
Because these funds are intended to be longer term investments, these
restrictions are typically included in the wrap contract to prevent
participants from taking of advantage of interest rate fluctuations;
however, they still represent a risk to participants since they are
prevented from directing their assets.
* Rising fees for wrap contracts--Industry experts note that wrap
contracts have gotten more expensive in recent years as wrap providers
also became aware of the significant risks taken in stable value fund
portfolios. For example, one stable value fund provider stated that,
as of March 2010, virtually all wrap providers had ceased accepting
new stable value portfolios unless the contracts stipulated new
contract terms--including tougher investment parameters and higher
fees--which were more favorable for wrap providers but could create
unwelcome inflexibility for plan sponsors.[Footnote 48] Such higher
fees for wrap providers, everything else equal, could also result in
lower returns for participants. Wrap capacity has also recently been
constrained because some wrap providers left the market, and others
saw decreases in their credit ratings. Because of this, some stable
value funds have had difficulty obtaining wrap contracts on portions
of their underlying stable value portfolios, which has increased the
likelihood that participants could bear potential losses from the
underlying investments in stable value funds. For example, AIG, one of
the major wrap providers, no longer provides wrap contracts.[Footnote
49] Similarly, according to industry reports, a few other firms,
including UBS and Rabobank, decided to stop providing wrap coverage.
These developments would also tend to place upward pressure on fees.
[Footnote 50] While some providers have entered the market, and other
stable value fund providers have agreed to provide this coverage for
their plan sponsors until they can obtain a wrap contract, wrap
capacity is not yet back to previous levels.
Certain Investment Options That Lent Securities Placed Restrictions on
Plan Sponsor Withdrawals Because of Losses and Illiquid Assets in the
Cash Collateral Pool, Which Also Posed Risks to Participants:
We also found that some restrictions were placed on investment options
that lent securities. Any number of 401(k) investment options can lend
securities, including index funds, money market funds, and stable
value funds. Some service providers that offered the investment
options that lent securities did not allow plan sponsors to withdraw
or transfer all of the 401(k) plans' investments in those investment
options because of collateral pool losses.[Footnote 51] These losses
occurred because the cash collateral pools had been invested in risky
assets that subsequently lost value and became difficult to trade.
[Footnote 52] As a result of the losses, the pools were not worth the
amount that the investment option needed to return the cash collateral
and pay rebates to borrowers.[Footnote 53] During the period of
withdrawal restrictions, some plan sponsors were allowed to withdraw
only a certain percentage of their plan's assets in the investment
option over a given time period--in many cases 2 to 4 percent--or they
were required to take their share of the cash collateral pool's
illiquid and devalued assets.[Footnote 54]
Similar to stable value funds, the losses and illiquid assets in the
cash collateral pools that led to these restrictions on plan sponsor
withdrawals raised concerns about the risks this practice poses to
participants' account balances, given the returns they receive. In the
case of securities lending with cash collateral, participants bear the
ultimate risk of loss from the cash collateral pool
investments.[Footnote 55] While securities lending agents may bear
counterparty risk from securities lending activities with cash
collateral--i.e., reimburse plan participants for losses caused by
borrower default--they generally do not reimburse plan participants
for losses that the cash collateral reinvestment pool may suffer,
which is the risk that remains with plan participants. However, in the
event that there were gains from the investments of the cash
collateral pool, participants only receive a portion of return, while
securities lending service providers, including broker-dealers and
securities lending agents, may obtain most of the gains earned on cash
collateral reinvestment.[Footnote 56] In addition, some securities
lending agents reported large portions of their annual revenues from
the returns earned by cash collateral reinvestment activities for
their institutional investors, including 401(k) plans.[Footnote 57] In
2008, one of the largest securities lending agents reported that its
revenues from such lending were over $1 billion. See figure 6 for a
breakdown on the return that participants can receive.
Figure 6: Gain or Loss Earned on Reinvestment of Cash Collateral from
Securities Lending in Differing Market Scenarios:
[Refer to PDF for image: illustration]
The profit or loss taken by plan participants on the same $2,500
investment varies with the annual return earned by cash collateral
pools.
Scenario 1: The cash collateral pool earns a 4 percent return over the
year (+$100):
$100 total return on investment:
$87.50 Rebate to broker-dealer (3.5% interest[A] on total cash
collateral);
$3.75 Fee to collateral pool manager (15 basis points)[B];
$8.75 profit;
$1.75 Profit to securities lending agent (20% of gross profit);
$7 Profit to participants (80% of gross profit).
Scenario 2: The cash collateral pool earns 3 percent interest over the
year (+$75):
$75 total return on investment:
$87.50 Rebate to broker-dealer (3.5% interest[A] on total cash
collateral);
$3.75 Fee to collateral pool manager (15 basis points);
$0 Profit to securities lending agent (0% of total loss);
$16.25 Loss to participants (100% of total loss).
Scenario 3: The cash collateral pool loses 3 percent over the year
(–$75):
$75 loss on investment:
$87.50 Rebate to broker-dealer (3.5% interest[A] on total cash
collateral);
$3.75 Fee to collateral pool manager (15 basis points);
$0 Profit to securities lending agent (0% of total loss);
$166.25 Loss to participants (100% of total loss).
Source: GAO interviews and analysis of the practice of securities
lending with cash collateral reinvestment.
Note: All of these scenarios are based on certain assumptions. The
rates were chosen to depict a situation that may have been in effect
in the years/months prior to and at the beginning of the crisis. While
today's rates may vary from the rates depicted here, the distribution
of gains/losses will not likely differ materially for the same type of
securities loan. Thus, in this example,
* The securities lending agent contracts with (1) the plan sponsor to
allow the plan's assets to be lent and (2) with the broker-dealer to
lend the assets,
* The security lent is not a "special" security--or a security that is
sought after in the market by borrowers,
* The total amount of cash collateral as a result of the securities
lending transaction, $2,500, is provided by the broker-dealer at the
beginning of the year and the securities lending transaction remains
in effect throughout the year,
* The securities lending agent reinvests all of the cash collateral
provided by the broker-dealer in a cash collateral pool managed by the
collateral pool manager, who charges 15 basis points of the total
amount of cash collateral to manage the pool ($3.75),
* The broker-dealer is promised a rebate--an annualized return of 3.5
percent interest on the total amount of cash collateral they provide
over the year ($87.50), and:
* The plan sponsor agrees to an 80/20 revenue sharing split between
plan participants and the securities lending agent, which means that
participants get 80 percent, and the lending agent gets 20 percent of
the revenue earned from the cash collateral pool after fees are paid.
[A] Typically, the rate promised to the broker-dealer as a rebate is
based on a benchmark rate, such as the federal funds rate or LIBOR and
is not typically provided in a one-time payment as shown in the
graphic, but more likely paid on a daily or monthly basis. The greater
the demand for the security being lent, the lower the rebate paid to
the broker-dealer. "Special" securities that have an extremely high
borrowing demand, or that are in short supply and therefore hard to
borrow, can obtain "negative" rebates, requiring the borrower to not
only pledge cash, but also pay a fee to plan participants.
[B] 15 basis points is the same as 0.15 percent.
[End of figure]
Because securities lending agents typically do not bear the risk of
loss of the collateral pool, yet gain when the collateral pool makes
money, they may be encouraged to take more risks with the underlying
assets of the investment options--both by investing in riskier assets
and by delaying the sale of those assets. Some cash collateral pool
managers invested in certain assets that increased the risk of the
pool. These assets were of questionable credit quality or required a
longer duration of investment than the typical plan assumed were in
the cash collateral pool. For example, prior to September 2008, some
pools had invested in Lehman Brothers Holdings, Inc., securities that
became almost worthless in 2008, making them too illiquid to pay all
withdrawal requests.[Footnote 58] Furthermore, we found that plan
sponsors may have also had the incentive to offer investment options
that lent securities more aggressively because those investment
options offered higher returns, yet were still marketed as relatively
"risk free." Thus, in trying to offer participants investment options
that provided competitive returns, plan sponsors may have searched out
investment options that may have, as a result of securities lending
with cash collateral, increased participant risks in the process of
seeking higher returns.[Footnote 59]
In addition to withdrawal restrictions, these risky assets in
securities lending cash collateral pools caused realized losses for
participants in the last few years.[Footnote 60] A recent industry
publication estimated that unrealized losses in securities lending
cash collateral pools affected most pension plans and many defined
contribution plans, but some 401(k) plans also experienced realized
cash collateral pool losses in 2008. In addition, some retirement
plans, including 401(k) plans, have recently filed lawsuits against
some of the larger securities lending agents as a result of these
losses.[Footnote 61] The litigation claims included allegations of
violations of the lending agents' fiduciary, contractual, and other
legal responsibilities in losing millions of dollars for the
investment funds in their securities lending contracts. In addition,
several securities lending agents have requested and received
individual prohibited transaction exemptions from Labor that have
allowed them to reduce some of the cash collateral pool losses.
[Footnote 62] Specifically, these exemptions allowed securities
lending agents either to buy the problematic securities from a number
of cash collateral pools that held pension plan and 401(k) plans
assets or to shore up those pools with cash in an attempt to create
liquidity in the otherwise cash-strapped collateral pools.[Footnote 63]
Disclosures about Stable Value Funds and Securities Lending Are
Limited and Difficult for Participants to Understand:
Given the risk and limitations that participants are exposed to when
investing in stable value funds, information provided to participants
may be difficult for them to understand and may not fully explain the
risks taken on their behalf by stable value funds, including the
variety of events that could affect participants' withdrawals or that
could cause losses. See figure 7. While participants receive some
disclosures about stable value funds and some of the risks associated
with investing in them, industry experts found in 2009 that
participants often are not able to understand those disclosures.
[Footnote 64] For example, a defined contribution consulting firm
recently expressed concern over participants' perception that these
investment options are risk-free and recommended that stable value
funds should be required to make a statement explaining how such a
fund is managed and identifying the risks associated with the fund,
such as the underlying assets, the wrap providers, and the wrap
contract.
Figure 7: Example of a Stable Value Fund Disclosure Provided to 401(k)
Participants:
[Refer to PDF for image: illustration]
Excerpts from a two-page stable value fund fact sheet (text shown
actual size):
Risk Management:
* Issuer exposure is constrained to minimize issuer credit risk and
increase diversification.
* Duration target is managed at portfolio and product levels to
provide consistent income from interest and principal repayments while
minimizing convexity risk.
* A tiered liquidity protocol and laddered portfolio maturity
structure are utilized to minimize liquidity risk.
Smaller text:
...actual investment advisory fees incurred by clients may vary
depending on account size and other account-specific factors...
...It should not be assumed that any of the securities transactions or
holdings listed or discussed were or will be profitable, or that the
investment recommendations or decisions we will make in the future
will be profitable or will equal the investment performance of the
securities listed or discussed herein....
Source: GAO presentation of a private investment company‘s fact sheet
for a stable value fund.
[End of figure]
Furthermore, it is unclear to what extent stable value fund
disclosures include a discussion of all of the risks that participants
could be exposed to and all of the information participants need to
evaluate the benefits and risks of the investment option. Labor
published final participant disclosure regulations in October 2010
that will affect the disclosures participants receive about investment
options, including stable value funds.[Footnote 65] One industry
expert we spoke to said that while the newly required disclosures
clearly include participant restrictions defined in the stable value
contracts, such as restrictions on transferring plan assets into
competing funds, the expert did not believe that the potential for
restrictions of stable value withdrawals based on employer-initiated
events would be included in these new disclosures to participants. In
addition, industry experts we talked to said that participants were
frequently not given an important piece of information--the market to
book value of the stable value portfolio--unless they asked for it. In
fact, some experts said that plan sponsors may not be inclined to
provide this information to participants for fear that it would cause
what would be deemed an employer-initiated event.[Footnote 66] While
one expert believed that participants would continue to receive
disclosures from stable value funds about the stable value funds' book
values, the expert did not believe that the market value of the stable
value portfolio would be required by Labor's recently published
participant disclosure regulations. One industry expert stated that
the ratio of market to book value of the stable value portfolio was
the summary statistic that would help plan participants understand
whether their investments are at risk if the other participants in
their plan withdraw from the fund. While Labor's recent regulations
may address some of these risks in a requirement that the participant
disclosures include an Internet Web site address that provides
participants access to the investment option's principal strategies
and principal risks, it is unclear whether participants will find this
method of disclosure useful in understanding the specific risks
associated with stable value funds and comparing those risks with the
risks posed by other investments.
Participants may also be unaware of the risks taken on their behalf by
investment options that lend securities, including the complex
compensation structures and variety of events that could affect
participants' withdrawals or that could cause losses. As with stable
value fund disclosures, disclosures regarding the risks associated
with engaging in securities lending with cash collateral reinvestment
are generally also buried deeply within the pages of investment option
documents and, as written, may give the incorrect impression that any
financial risk to plan assets is low. In one mutual fund's annual
report, the fact that the investment option engages in securities
lending is disclosed on page 68 of the 90 page document.[Footnote 67]
Figure 8 shows pertinent information about securities lending that
would be provided to a plan participant from another investment
option, an index fund, registered with the SEC. The figure shows page
14 of a 52-page document. The 52-page document is the "Statement of
Additional Information" (SAI) which is a supplementary document to a
mutual fund's prospectus that contains additional information about
the mutual fund and includes further disclosure regarding its
operations. There is also a 37-page annual report, as well as a 40-
page prospectus for the index fund.
Figure 8: Example of a Securities Lending Disclosure in Registered
Investment Option's Required Disclosures:
[Refer to PDF for image: illustration]
Excerpt from page B-14 of one 52-page "Statement of Additional
Information" (text shown actual size):
Securities Lending. A fund may lend its investment securities to
qualified institutional investors (typically brokers, dealers, banks,
or other financial institutions) who may need to borrow securities in
order to complete certain transactions, such as covering short sales,
avoiding failures to deliver securities, or completing arbitrage
operations. By lending its investment securities, a fund attempts to
increase its net investment income through the receipt of interest on
the securities lent. Any gain or loss in the market price of the
securities lent that might occur during the term of the loan would be
for the account of the fund. If the borrower defaults on its
obligation to return the securities lent because of insolvency or
other reasons, a fund could experience delays and costs in recovering
the securities lent or in gaining access to the collateral. These
delays and costs could be greater for foreign securities. If a fund is
not able to recover the securities lent, a fund may sell the
collateral and purchase a replacement investment in the market. The
value of the collateral could decrease below the value of the
replacement investment by the time the replacement investment is
purchased. Cash received as collateral through loan transactions may
be invested in other eligible securities.
this cash subjects that investment to market appreciation or
depreciation.
The terms and the structure of the loan arrangements, as well as the
aggregate amount of securities loans, must be consistent with the 1940
Act, and the rules or interpretations of the SEC thereunder. These
provisions limit the amount of securities a fund may lend to 33 1/3%
of the fund's total assets, and require that (1) the borrower pledge
and maintain with the fund collateral consisting of cash, an
irrevocable letter of credit, or securities issued or guaranteed by
the U.S. government having at all times not less than 100% of the
value of the securities lent; (2) the borrower add to such collateral
whenever the price of the securities lent rises (i.e., the borrower
"marks-to-market" on a daily basis); (3) the loan be made subject to
termination by the fund at any time; and (4) the fund receive
reasonable interest on the loan (which may include the fund's
investing any cash collateral in interest bearing short-term
investments), any distribution on the lent securities, and any
increase in their market value. Loan arrangements made by each fund
will comply with all other applicable regulatory requirements,
including the rules of the New York Stock Exchange, which presently
require the borrower, after notice, to redeliver the securities within
the normal settlement time of three business days. The advisor will
consider the creditworthiness of the borrower, among other things, in
making decisions with respect to the lending of securities, subject to
oversight by the board of trustees. At the present time, the SEC does
not object if an investment company pays reasonable negotiated fees in
connection with lent securities, so long as such fees are set forth in
a written contract and approved by the investment company's trustees.
In addition, voting rights pass with the lent securities, but if a
fund has knowledge that a material event will occur affecting
securities on loan, and in respect of which the holder of the
securities will be entitled to vote or consent, the lender must be
entitled to call the loaned securities in time to vote or consent.
Source: GAO presentation of a private investment company‘s Statement
of Additional Information for an index fund.
[End of figure]
In general, 401(k) participants do not receive the SAI or the
prospectus automatically, although plan sponsors do receive a
prospectus, and so do retail investors. Therefore, participants may
never see this disclosure on securities lending. One plan sponsor we
spoke to, described the SAI as an attachment to the prospectus. The
sponsor told us that it is necessary to know where to find this
information and then work through the details. All disclosure
information is embedded in massive documents of varying degrees of
importance. Labor's recently issued participant disclosure regulations
will undoubtedly affect the disclosures participants receive.
Participants will receive core information about investments available
under the plan, including performance and fee information, in a chart
or similar format designed to facilitate investment comparisons.
However, since these regulations require only disclosure of investment
options, and not all practices utilized by those investment options--
of which securities lending is one practice--it is unclear how much or
to what extent securities lending fees and risks will be discussed in
these disclosures.[Footnote 68] There is nothing in the regulations
that explicitly requires plan sponsors to disclose information on the
risks of securities lending with cash collateral reinvestment or
withdrawal restrictions that can result from securities lending.
Without better disclosures on securities lending with cash collateral,
participants may continue to be unaware of the practice of cash
collateral reinvestment and the risk it poses to plan participants, as
well as the potential for withdrawal restrictions resulting from such
practices.
Labor Can Take Steps to Help Plan Sponsors Understand the Risks and
Challenges Posed By Certain Investments and Practices:
Eliminating Stable Value Fund Restrictions That Can Compromise
Sponsors' Fulfillment of Their Fiduciary Obligations and Providing
Better Information Can Help Plan Sponsors:
Stable value funds are typically subject to restrictions and wrap
contracts that may prevent plan sponsors or fiduciaries from meeting
their fiduciary obligations when choosing to offer a stable value
fund.[Footnote 69] A stable value fund contract can constrain a plan
sponsor's ability to add investment options or communicate information
about the basic health of the investment option to participants. In
addition, stable value fund contractual arrangements can discourage
plan sponsors from communicating with their plan participants about
the levels of risk the particular investment options were assuming.
These types of arrangements that limit sponsor behavior and that may
void the stable value contract, however, are not prohibited by current
regulation, and experts told us that they are commonly accepted
industry practices.
The wrap contracts associated with stable value funds may cause
problems for plan sponsors because they typically limit the type of
information that can be shared with participants. Wrap contracts
typically prohibit sponsors from making any communication that may
result in fund redemptions. This can complicate the plan sponsor's
role in administering the plan. For example, in a situation where a
sponsor becomes aware that the market value of the stable value fund's
underlying assets has fallen below book value, which could put
participant assets at risk, the sponsor is in a unique position--if
the sponsor communicates this information to participants, it would
likely void an insurance contract that could be valuable to the plan's
participants. However, failing to communicate this information to
participants may compromise the plan sponsor's role as a fiduciary
with respect to the plan.
During our review, industry experts told us that sponsors of varying
plan sizes often lacked an understanding of the underlying investments
and the features of stable value funds. Stable value funds are
marketed to plan sponsors as low-risk investments that provide
consistent stable returns, protection of the invested principal, and
immediate liquidity, characteristics that have attracted many sponsors
and participants to stable value funds. Stable value funds are also
considered to be invested in high-credit quality, fixed income
securities, such as low-risk, government and corporate bonds with
short-to medium-term maturities. Yet, as shown in figure 9, as of the
end of 2008, nearly 50 percent of the underlying assets in stable
value funds were asset-backed or mortgage-backed securities.
Figure 9: Underlying Assets in Stable Value Funds (year end 2008):
[Refer to PDF for image: pie-chart]
Mortgage-backed: 26%;
Publicly traded bonds: 19%;
Treasuries: 10%;
Commercial mortgage-backed securities: 9%;
Cash: 7%;
Asset-backed securities: 7%;
Private placement bonds[B]: 5%;
Commercial mortgages: 5%;
Federal agency securities[A]: 4%;
Guaranteed investment contracts: 3%;
Other: 5%.
Source: Stable Value Investment Association's 13th Annual Stable Value
Investment and Policy Survey.
[A] Federal agency securities are debt instruments issued by federal
credit agencies.
[B] A private placement is a direct offering of securities directly to
an institutional investor, such as a bank, mutual fund, insurance
company, pension fund, or foundation.
[End of figure]
Given their mix of underlying assets, many stable value funds' credit
rates dropped sharply in 2008 and 2009 because of lower returns on
their underlying bond holdings and market conditions that prompted
stable value managers to put more money into cash during the financial
crisis. Despite the problems that stable value funds experienced
during 2008 and 2009, investors continued to put money into stable
value funds as they sought a less risky investment which helped to
shore up stable value returns.
Labor's ERISA Advisory Council reported in 2009 that plan sponsors
need, among other things, a better understanding of a stable value
fund's portfolio composition, the current financial condition of fund
issuers and wrap providers, and the safeguards they each have in place
in the event of default.[Footnote 70] The council reported that only
with this critical information can plan sponsors adequately determine
the appropriateness of selecting a particular stable value fund or
whether such an investment meets the needs of the plan. The council
heard testimony that such information may either not be readily
available from wrap providers or stable value fund managers or that
plans sponsors do not know to ask for, or do not understand, the
information that might be made available. Without this information,
plan sponsors may continue to offer stable value funds to plan
participants, the associated risks of which they and plan participants
may not clearly understand.
[Side bar:
Example of an Employer-Initiated Event That Could Void the Stable
Value Wrap Contract:
A common sponsor response to an underperforming fund is to replace it
with another fund. However, in the case of a stable value fund that
has a market value below book value, replacing the stable value fund
could invalidate the wrap protection, or at least trigger clauses in
the contract that might delay the liquidation of the fund. Some funds
allow the option of a ’12-month put,“ in other words, a 1-year advance
notice required to terminate a fund, while others may not allow
termination of the fund until market value and book value converge. A
sponsor may be faced with the difficult choice of either maintaining
an underperforming stable value fund or voiding an insurance contract
that may be potentially valuable to their plan participants.
End of side bar]
Labor's ERISA Advisory Council also reported that plan sponsors need
more information with regard to a stable value fund's underlying
assets, including how those funds are valued, its wrap provider, and a
fund's costs and fees.[Footnote 71] In addition, understanding the
events that could void a wrap contract could help plan sponsors make
strategic decisions. The stress of the market volatility in 2008 and
2009 (which led to lower market values for many stable value funds)
has placed increased scrutiny on sponsor behavior that might be
considered an employer-initiated event according to the terms of wrap
contracts and highlighted the need for plan sponsors to have a better
understanding of all the implications of their decisions regarding the
wrap provisions of their stable value funds.
According to industry reports, some plan sponsors are now asking for
more flexibility in their wrap contract provisions and, as a result,
some stable value fund providers are starting to offer options that
might provide that flexibility. One stable value fund provider stated
that one of the concerns about stable value funds that came to light
as a result of the 2008 financial crisis was that wrap contracts may
have been too inflexible to provide plan sponsors with the ability to
make necessary business decisions, such as closing a plant or layoffs,
without affecting their stable value fund options in their 401(k)
plans. The stable value fund provider stated that plan sponsors may
view the embedded protections in wrap contracts that would preclude
them from making these decisions as too constraining and has thus
begun to offer some plan sponsors with choices that provide greater
flexibility. For example, the stable value fund provider is offering
its plan sponsors two stable value fund choices that seek to provide
them with flexibility for employer-initiated events or participant
communications and a greater likelihood that they will not void the
contract if they make changes to their plans. While these
flexibilities in the terms of wrap contracts may be offered to some
plan sponsors, not all plan sponsors are able to negotiate special
terms to protect their plan participants or themselves.[Footnote 72]
Recently enacted legislation requires Labor and other regulators to
review various aspects of stable value fund contracts, providing Labor
an opportunity to aid plan sponsors and participants in better
understanding stable value funds. Specifically, the Dodd-Frank Wall
Street Reform and Consumer Protection Act (Dodd-Frank),[Footnote 73]
prescribes that the SEC and the Commodity Futures Trading Commission
(CFTC) jointly conduct a study to determine whether stable value
contracts fall within the definition of a swap.[Footnote 74] Given
that Labor will be required to inform the study, the agency is in a
unique position to focus on ways to help plan sponsors better
understand stable value funds.
Changes to Labor's Disclosure Regulations Can Also Help Plan Sponsors
Become Aware of the Risks Associated with Investment Options That Lend
Securities:
Industry experts told us that many plan sponsors are unaware of the
risks involved with the cash collateral reinvestment portion of their
service providers' securities lending programs, or may not fully
understand the risks. Other plan sponsors may not know whether their
investment options engage in such lending at all. For example, 17 of
the 74 plan sponsors who responded to our brief poll responded "no" to
our question about whether their investments that engage in securities
lending had disclosed to them that this investment practice was a
possibility. An additional 20 plan sponsors responded that they were
not sure whether this information had been disclosed.[Footnote 75]
Other industry officials have expressed similar concerns. One large
investment consulting firm has stated that many of its plan sponsor
clients may not be aware that their investment options utilize
securities lending programs. An industry expert we spoke to, who is
also a 401(k) plan sponsor, admitted that he did not know whether the
investment options offered through his plan engaged in securities
lending. Another industry expert told us that there were poor
communications between investment option managers and lending agents
(e.g., custodial banks)--investment option managers did not ask the
right questions about how the cash collateral was being invested, and
custodian banks who acted on behalf of investment options' managers
thought their customers were educated enough to understand that the
cash collateral posted by borrowers was invested in collective
investment pools.
Recent litigation involving banks that engage plan assets in their
securities lending programs illustrates instances where plan sponsors
may not have understood the practice of securities lending, and where
parties involved, under minimal scrutiny, may have taken additional
risks with plans' assets. Over the past few years, plan sponsors and
others filed lawsuits against Northern Trust, State Street, JP Morgan,
Bank of New York Mellon, Wells Fargo, U.S. Bank, and Wachovia for
allegedly violating their fiduciary, contractual, and other legal
responsibilities in losing millions of dollars for the investment
funds in their securities lending contracts. Most of the lawsuits
involve the loss of cash collateral invested by the custodian banks in
their securities lending programs. Plan sponsors allege that they were
intentionally misled by their custodian banks as to where their cash
collateral was being invested. Critics of these plaintiff's lawsuits
say that the plan sponsors are simply disgruntled customers seeking to
recoup unavoidable investment losses from banks that have profited
from their plans' assets.[Footnote 76]
One way industry experts have suggested to help protect participants'
401(k) retirement savings when placed in investments that utilize
securities lending with cash collateral reinvestment is by limiting
the percentage of 401(k) plan assets that could potentially be loaned
out at any one time. Industry experts we talked to stressed the
importance of limiting the amount of 401(k) assets that can be subject
to securities lending, similar to SEC staff's limits on lending by
mutual funds. SEC staff no-action letters effectively limit the amount
of assets that can be lent from a mutual fund at one time to one-third
of the fund's total asset value. Furthermore, SEC limits the amount of
total mutual fund assets and money market fund assets to 15 percent
and 5 percent, respectively, that can be invested in illiquid
securities, such as some asset-backed securities that do not trade on
exchanges and do not have an accessible market for buyers and sellers.
[Footnote 77] However, there are no comparable limitations on the
total amount of 401(k) plan assets that can be lent or invested in
illiquid securities.
SEC and Others Are Taking Steps to Improve Transparency and
Disclosures on Securities Lending, and Labor Can Also Require Better
Disclosures for Plan Sponsors:
SEC and others in industry are already taking steps to address certain
issues related to securities lending. SEC and the Financial Industry
Regulatory Authority (FINRA)[Footnote 78] are working on proposals for
additional disclosure on securities lending. The Dodd-Frank Act calls
for the SEC to promulgate rules no later than July 21, 2012, that are
designed to increase the transparency of information available to
brokers, dealers, and investors with respect to the loan or borrowing
of securities.[Footnote 79] FINRA is also looking at promulgating
rules that will ensure that broker-dealers allow customers to fully
understand all the risks involved and that will focus on disclosing
things from potential conflicts to restrictions firms may have on
liquidating securities.[Footnote 80]
It is unclear whether the improved disclosures will provide
information about the gains and losses from securities lending to
investors and other stakeholders. Currently, banking regulators do not
require banks to report gains or losses from their securities lending
programs. Although the Financial Accounting Standards Board requires
banks to make publicly available this information in their financial
statements, the information is not reported to any federal regulator
and is also not broken out by type of plan. The Federal Financial
Institutions Examination Council[Footnote 81] supervisory policy on
securities lending stipulates that information on securities borrowing
and lending transactions should be made publicly available by
commercial banks in their financial statements. However, banks do not
break out this information by type of plan and may only provide the
information as a summary total that includes other revenue streams,
such as investment advisory and administration fees, making it
difficult to determine revenue specific to securities lending.
Some securities lending agents have already begun to implement various
changes to their securities lending programs and the way they manage
cash collateral. These changes have come as a result of securities
lending agents, who have recently reported that some plan sponsors
that they service have not only requested more disclosure about
securities lending and cash collateral pools but have also requested
that their securities lending programs take on less risk. For example,
one securities lending agent is calling for a "back to basics
approach" with the focus on protecting principal and maintaining
liquidity while generating incremental returns for participants.
Securities lending agents stated that going forward, cash collateral
pools would likely be of shorter duration and have more standardized
guidelines of what they could invest in. They also said that these
guidelines could possibly be structured along the lines of SEC's
liquidity requirements for money market funds, under which, among
other things, money market funds must maintain minimum daily and
weekly asset positions.[Footnote 82] With these changes, they believe
that 401(k) plan participants could receive some protection from the
losses and withdrawal restrictions that they recently experienced.
Labor could also take steps to improve transparency on the practice of
securities lending by amending its prohibited transaction exemption
regarding the practice of securities lending. Labor's PTE 2006-16,
authorizes securities lending transactions that might otherwise
constitute "prohibited transactions" under ERISA, but the exemption
currently lacks specifics on the utilization of 401(k) plan assets in
the practice of securities lending. In addition, according to Labor,
the exemption does not address or provide any relief for the
reinvestment of cash collateral.[Footnote 83] Without such
information, plan sponsors do not have the information they need to
assess the potential gains and losses from cash collateral
reinvestments, since other regulators that oversee the financial
entities involved in securities lending also do not require that such
information be explicitly disclosed to plan sponsors. By revising the
existing exemption, Labor can ensure that plan sponsors who enter into
securities lending arrangements with cash collateral reinvestment are
not prevented from meeting their fiduciary obligations when doing so.
Labor can also help to ensure that plan sponsors clearly understand
the gains and losses associated with securities lending by amending
its two recently issued rules, one regarding service provider
disclosure to plan sponsors,[Footnote 84] and one regarding plan
sponsor disclosure to participants, to include information specific to
securities lending. The recent amendment to the interim final rule,
which affects the "up-front" or "point of sale" disclosure, i.e., when
a service provider and a plan sponsor enter into a service agreement
or contract, enhances disclosure to fiduciaries of 401(k) and other
retirement plans. It requires service providers to disclose, among
other things, a description of the services to be provided; a
statement that the covered service provider will provide its services
as a fiduciary to the covered plan; a description of all "direct
compensation" (i.e., compensation received directly from the covered
plan) and "indirect compensation" (i.e., compensation that is received
from any source other than the covered plan, plan sponsor, covered
service provider, an affiliate, or a subcontractor) that the covered
service provider reasonably expects to receive in connection with the
disclosed services. The regulation is meant to assist fiduciaries in
determining both the reasonableness of compensation paid to plan
service providers and any conflicts of interest that may impact a
service provider's performance under a service contract or arrangement.
With regard to the practice of securities lending, the regulation
would presumably require a custodian to disclose the fact that it
receives compensation from its role in the investment strategy of
securities lending. However, it is unclear how much assistance it
would provide to plan sponsors in understanding securities lending
with cash collateral reinvestment or the gains and losses associated
with that practice. For example, as currently written, it is unclear
whether it would be obvious to the plan sponsor how much of a profit
the custodian would take compared with the profit the plan would
receive. It is also unclear whether the custodian would have to reveal
exactly how it used the plan's profit, such as to reduce plan fees, or
whether the custodian would disclose that the other service providers
involved in the transaction received their compensation, in the form
of fees and rebates, regardless of the performance of the cash
collateral reinvestment pool. Labor's regulations, as currently
written, will not assist plan sponsors in understanding the mechanics
of a securities lending transaction and how the entities involved in
the transaction, specifically those involved in the cash collateral
reinvestment activity, are paid. Plan sponsors need to know that the
profit they make is a net return after everyone else is paid for their
role and that any loss from the cash collateral pool comes out of
their plans' assets. The current regulations also do not contain
specific provisions requiring disclosure of the potential for
withdrawal restrictions, which could assist plan sponsors in their
decision-making process when selecting investment options to offer
through their 401(k) plans.
Conclusions:
For a growing number of American workers, their prospects for a secure
retirement increasingly rest on the retirement savings they accumulate
in their 401(k) plans. One of the touted benefits of 401(k) plans was
their transparency to and control by participants. Participants could
see their accounts grow and control how much to contribute and where
to invest those contributions. Yet, it is becoming increasingly
obvious that saving for retirement is not as simple as it appeared 30
years ago when 401(k) plans were first created. As this report shows,
and as our past report on undisclosed fees and more recent reports on
target date funds and conflicted investment advice illustrate,
managing the risks faced in savings for retirement through 401(k)
plans today can be complicated and pose significant challenges for
participants and sponsors alike.
At a minimum, greater transparency and disclosure are necessary to
help plan sponsors and participants understand the restrictions and
limitations they could face with certain 401(k) investment options and
the risk of loss to plan participants' investments in 401(k) plans.
The recent financial crisis vividly illustrated the importance of
transparency when dealing with complex financial instruments. What
seems like an optimal way to make money off of 401(k) plan assets,
such as through securities lending with cash collateral reinvestment,
can appear to be straightforward until the scope of the risks and
complexities of the cash collateral reinvestment transaction have to
be explained to investors, plans sponsors, and plan participants.
Expecting plan sponsors and plan participants to understand the
intricacies of today's many investment options without sufficient
guidance and information is unrealistic.
Without more explicit and accessible information on stable value funds
and securities lending with cash collateral reinvestment, participants
are unknowingly bearing a greater risk of loss than they are currently
aware of and, more importantly, have no control over. Labor has
already provided much needed disclosure requirements for plan sponsors
to give to plan participants. Amending those regulations to include
disclosure explicitly targeted to the risks of investing in stable
value funds and provisions on securities lending will help to ensure
that plan participants, like plan sponsors, are informed about stable
value funds and securities lending with cash collateral reinvestment
and are able to make the best decisions to save for their retirement.
The maturation of the 401(k) system, coupled with the increased
complexity of the financial markets, is posing new challenges for
Labor, financial regulators, plan sponsors, and participants. Changes
called for in the Dodd-Frank Act are likely to clarify stable value
contracts and provide more disclosure on securities lending. Because
of the statutory requirements in the Dodd-Frank Act, Labor has an
opportunity to assist plan sponsors and participants with two complex
areas, stable value fund contracts and securities lending with cash
collateral reinvestment. Such careful, thoughtful action to facilitate
prudent decision making on the part of sponsors and participants can
bolster retirement security and avoid the long-term loss of
participant confidence in the 401(k) system.
Recommendations For Executive Action:
The recently enacted Dodd-Frank Wall Street Reform and Consumer
Protection Act includes requirements that will affect deliberations
about stable value funds and requires that the SEC and the CFTC, in
consultation with Labor and Treasury, conduct a study of stable value
funds. To ensure additional protection for plan participants,
appropriate information for plan sponsors, and to better inform the
study required by the Dodd-Frank Act, we recommend that Labor take the
following actions:
* As it conducts its consultative analysis to assist the SEC and CFTC,
also analyze stable value funds specifically in a 401(k) investment
context to identify those situations or conditions that prevented plan
sponsors from withdrawing from stable value funds, such as contract
restrictions, and take appropriate regulatory steps to assist plan
sponsors in fulfilling their fiduciary responsibilities.
* Amend its regulation on plan sponsor disclosure to participants to
include a specific requirement for plan sponsors to provide
information to participants that discloses the risks of investing in
stable value funds.
* Provide guidance to plan sponsors on the risks, structure, and
dynamics of stable value funds, consistent with the recommendations
proposed by the ERISA Advisory Council regarding the disclosure of
information about stable value funds.
Given the current practice of securities lending with cash collateral
reinvestment, its role in 401(k) plan investments, and our findings
that plans and plan participants can bear a disproportionate amount of
any loss associated with the practice, Labor should take action to
help plan sponsors of 401(k) plans and plan participants understand
the role, risk, and benefits of securities lending with cash
collateral reinvestment in relation to 401(k) plan investments. ERISA
requires that the fees paid to plan service providers be reasonable
with respect to the services performed and Labor, in its
implementation of PTE 2006-16, its prohibited transaction class
exemption for securities lending, specifically requires that
compensation received by the parties involved in the securities
lending transaction should be reasonable. According to Labor, PTE 2006-
16 does not cover cash collateral reinvestment. Therefore, we
recommend that Labor also take the following actions:
* Review the practice of securities lending with cash collateral
reinvestment, to provide guidance to plan sponsors as to what would be
reasonable levels of fees and reasonable distributions of returns when
401(k) plan assets are utilized in this practice.
* Revise PTE 2006-16 to include the practice of cash collateral
reinvestment by requiring that plan sponsors who enter into securities
lending arrangements utilizing cash collateral reinvestment on behalf
of 401(k) plan participants not do so unless they ensure the
reasonableness of the distributions of expected returns associated
with this arrangement.
* Amend its regulation on plan sponsor disclosure to participants to
include provisions specific to (1) the practice of cash collateral
reinvestment utilized by fund providers' securities lending programs
and (2) disclosing the potential for withdrawal restrictions.
* Provide plan sponsors with guidance alerting them to the risks of
engaging in securities lending with cash collateral reinvestment and
the types of information they should seek from their service providers
about these investments.
Agency Comments and Our Evaluation:
We provided a draft of this report to the Department of Labor, the
Securities and Exchange Commission, the Federal Reserve Board, the
Office of the Comptroller of the Currency, and the Federal Deposit
Insurance Corporation for review and comment. Labor's formal comments
are reproduced in appendix I of this report. We did not receive formal
comments from the Securities and Exchange Commission, the Federal
Reserve Board, the Office of the Comptroller of the Currency, or the
Federal Deposit Insurance Corporation, but received technical comments
from four of the five agencies, which we incorporated as appropriate.
In its agency response letter, the Department of Labor agreed with our
conclusions concerning the importance of transparency and disclosure.
Consistent with our conclusions, Labor noted that it is committed to
ensuring that participants have the information they need to make
informed decisions about their retirement savings and that plan
sponsors receive the information they need to assess the
reasonableness of contracts or arrangements. Labor also noted that it
has recently devoted significant resources to ensure that plan
sponsors and participants have the information they need. Labor has
agreed to consider amending PTE 2006-16 to require the securities
lending agreement to provide enhanced disclosures to plan fiduciaries
and to consider providing plan sponsors with guidance alerting them to
the risks of engaging in securities lending and the types of
information they should seek from their service providers about these
investments. Labor disagreed with three of our recommendations.
Labor disagreed with our recommendation to amend its participant
disclosure regulations to provide information disclosing the risks of
investing in stable value funds. It stated that without further study
and review, the department is not prepared to conclude that its
participant disclosure regulations should be amended to specifically
address stable value funds. Given the complexity of the issues
involving stable value funds, we encourage Labor to initiate the
study, review what it deems necessary, and to amend its disclosure
regulations as appropriate. We note Labor's additional consideration
to the recommendations proposed by the ERISA Advisory Council
regarding information provided to plan sponsors and participants
concerning stable value funds, and we believe that plan sponsors and
participants would benefit from such guidance being issued in a
prudent but expeditious manner. Given that the ERISA Advisory Council
report on stable value funds was posted in April 2010, without
additional guidance or assistance, plan sponsors may remain unaware of
the risks and challenges associated with this investment option.
Furthermore, because Labor will be consulting with SEC and CFTC with
regard to their study of stable value funds, Labor has a unique
opportunity to assist participants in their understanding of the
restrictions, limitations, and risks of investing in such funds. We
look forward to the findings, conclusions and proposed actions of
Labor's consultation and believe that this effort represents a great
opportunity for Labor to assist plan sponsors and participants in
building retirement security.
Labor disagreed with our recommendation to amend its participant
disclosure regulations regarding the practice of securities lending
with cash collateral reinvestment and the potential for withdrawal
restrictions. The Department stated that without further study and
review, it is not prepared to conclude that its participant disclosure
regulations should be amended to specifically address securities
lending-related issues. While we believe that the evidence provided in
our report is particularly compelling with regard to this
recommendation, we strongly encourage Labor to initiate the study and
review what it deems necessary, and, to amend its disclosure
regulations as appropriate. As demonstrated in our report, securities
lending with cash collateral reinvestment arrangements can be very
complex transactions. Further, as we reported, Labor's participant
disclosure regulations do not explicitly require plan sponsors to
disclose information on the risks of securities lending with cash
collateral reinvestment or withdrawal restrictions that can result
from securities lending. We acknowledge Labor's comment that the
current participant disclosure regulations require that information
pertaining to investment risks and investment strategies be available
to plan participants. However, as we reported, these regulations
require only disclosure of investment options, and not all practices
utilized by those investment options--of which securities lending is
one practice--and it is unclear how much or to what extent securities
lending fees and risks will be discussed in these disclosures.
Furthermore, Labor only requires that information be made available to
plan participants, not disclosed, which would require plan
participants to know what information they need to avail themselves of
in order to understand the fees and risks of securities lending.
Without better disclosures on securities lending with cash collateral,
participants may continue to be unaware of the practice of cash
collateral reinvestment and the risks it poses, as well as the
potential for withdrawal restrictions resulting from such practices.
Labor also did not agree with our recommendation to review the
practice of securities lending with cash collateral reinvestment to
provide guidance to plan sponsors as to what would be reasonable
levels of fees and reasonable distributions of returns when 401(k)
assets are utilized in this practice. Labor noted that a plan sponsor,
in deciding to offer any investment option, must make that decision in
accordance with its fiduciary responsibility under ERISA, and that it
would not be possible for Labor to provide specific guidance on
reasonable levels of fees and reasonable distributions of returns in
connection with any particular securities lending cash collateral
reinvestment. We recognize the complexity of these transactions and
the diligence that should be taken in developing such guidance.
Nevertheless, key participants in securities lending transactions are
already moving in the direction of providing additional guidance to
plan sponsors. For example, as we reported, some securities lending
agents have already begun to make changes to their securities lending
programs in response to plan sponsors who have requested more
disclosure about securities lending and cash collateral pools and have
also requested that their securities lending programs take on less
risk. In addition, securities lending agents are beginning to
standardize guidelines for cash collateral pool investments, changes
which they think would provide participants with some protection from
losses. These industry driven developments clearly suggest that not
only is such guidance possible, but that it is in the best interest of
plan sponsors for Labor to provide some assistance on this issue.
Finally, Labor disagreed with our recommendation regarding the
inclusion of cash collateral reinvestment into PTE 2006-16, regarding
the reasonableness of expected returns associated with this
arrangement. Labor believes that it is not feasible to ensure a
certain level of expected return on any particular investment. It is
not our intent that rates of return should be ensured in such
transactions, but that the reasonableness of the distributions of
expected returns be ensured. We note, however, that under ERISA, Labor
is already responsible for enforcing the requirements that plan
sponsors ensure that the fees paid with plan assets are reasonable and
for necessary services. Applying the same standard to the parameters
of transactions involving securities lending with cash collateral can
help reduce the risk of loss to plan participants. As we note in our
report, securities lenders are already implementing changes that could
redefine the potential of loss and return to plan participants from
these transactions. Action by Labor can help to ensure that it will
not only be sophisticated plan sponsors who are likely to get the
disclosures they need, while other plans sponsors continue to be
unaware of what they need to ask for and understand regarding
securities lending with cash collateral reinvestment.
As agreed with your office, unless you publicly announce the contents
of this report earlier, we plan no further distribution until 6 days
from the report date. At that time, we will send copies of this report
to the appropriate congressional committees, the Secretary of Labor,
the Chairman of the Securities and Exchange Commission, and other
interested parties. The report also will be available at no charge on
the GAO Web site at [hyperlink, http://www.gao.gov].
If you or your staff members have any questions concerning this
report, please contact Charles Jeszeck at (202) 512-7215. Contact
points for our Office of Congressional Relations and Public Affairs
may be found on the last page of this report. GAO staff who made major
contributions to this report are listed in appendix II.
Sincerely yours,
Signed by:
Charles A. Jeszeck:
Director, Education, Workforce, and Income Security Issues:
[End of section]
Appendix I: Comments from the Department of Labor:
U.S. Department of Labor:
Assistant Secretary for Employee Benefits Security Administration:
Washington, D.C. 20210:
February 25, 2011:
Mr. Charles A. Jeszeck:
Director, Education, Workforce, and Income Security Issues:
United States Government Accountability Office:
Washington, DC 20548:
Dear Mr. Jeszeck:
Thank you for the opportunity to review the Government Accountability
Office's (GAO) draft report entitled "401(k) PLANS: Certain Investment
Options and Practices That May Restrict Withdrawals Not Widely
Understood" (GA0-11-291). Based on our review of the report, below are
our comments and observations.
The draft report finds that during the recent financial crisis, plan
sponsors and participants faced unexpected restrictions on withdrawals
of plan assets from certain 401(k) investment options, specifically
real estate accounts, money market funds, stable value funds and
investment options that lend securities. It concludes, among other
things, that greater transparency and disclosure are necessary to
assist plan sponsors and plan participants in understanding
restrictions, limitations, and risk of loss to plan participants
associated with investment in stable value funds and investment
options that lend securities.
In this regard, the Department has recently devoted significant
resources to ensuring that all participants and beneficiaries in
participant-directed individual account plans (e.g., 401(k) plans)
have the information they need to make informed decisions about the
management of their individual accounts and the investment of their
retirement savings, and to ensuring that plan fiduciaries receive
disclosures from service providers to assist the fiduciaries in
assessing the reasonableness of contracts or arrangements, including
the reasonableness of the service providers' compensation and
potential conflicts of interest that may affect the service providers'
performance.[Footnote 1]
Recommendation 1: The recently enacted Dodd-Frank Wall Street Reform
and Consumer Protection Act includes requirements that will affect
deliberations about stable value funds and requires that the SEC and
CFTC, in consultation with Labor and Treasury, conduct a study of
stable value funds. To ensure additional protection for plan
participants, appropriate information for plan sponsors, and to better
inform the study required by the Dodd-Frank Act, we recommend that
Labor:
* As it conducts its consultative analysis to assist the Securities
and Exchange Commission and the Commodity Futures Trading Commission,
also analyze stable value funds specifically in a 401(k) investment
context to identify those situations or conditions that prevented plan
sponsors from withdrawing from stable value funds, such as contract
restrictions, and take appropriate regulatory steps to assist plan
sponsors in fulfilling their fiduciary responsibilities.
The Department will consider whether further action would be
appropriate after consulting with the SEC and the CFTC upon completion
of their study as mandated by the Dodd-Frank Wall Street Reform and
Consumer Protection Act.
* Amend its regulation on plan sponsor disclosure to participants to
include a specific requirement for plan sponsors to provide
information to participants that discloses the risks of investing in
stable value funds.
The Department disagrees with this recommendation. Without further
study and review, the Department is not prepared to conclude that the
regulations governing the disclosure of investment-related information
to participants and beneficiaries must be amended to specifically
address stable value funds. The current regulation specifically
requires that information pertaining to investment risks, as well as
investment strategies, be available to plan participants with respect
to all investment alternatives offered under a participant-directed
individual account plan, including stable value funds.
* Provide guidance to plan sponsors on the risks, structure, and
dynamics of stable value funds, consistent with the recommendations
proposed by the ERISA Advisory Council regarding the disclosure of
information about stable value funds.
While the Department is not prepared at this time to commit to
providing the recommended guidance, the Department will pursue further
consideration of the recommendations prepared by the ERISA Advisory
Council regarding stable value funds.
Recommendation 2: Given the current practice of securities lending
with cash collateral reinvestment, its role in 401(k) plan
investments, and our findings that plans and plan participants can
bear a disproportionate amount of any loss associated with the
practice, Labor should take action to help plan sponsors of 401(k)
plans and plan participants understand the role, risk, and benefits of
securities lending with cash collateral reinvestment in relation to
401(k) investments. ERISA requires that the fees paid to the plan
service providers be reasonable with respect to the services performed
and Labor, in its implementation of PTE 2006-16, its prohibited
transaction class exemption for securities lending, specifically
requires that compensation received by the parties involved in the
securities lending transaction should be reasonable. According to
Labor, PTE 200616 does not cover cash collateral reinvestment.
Therefore we recommend Labor:
* Review the practice of securities lending with cash collateral
reinvestment, to provide guidance to plan sponsors as to what would be
reasonable levels of fees and reasonable distributions of returns when
401(k) plan assets are utilized in this practice.
The Department disagrees with this recommendation. The Department
notes that a plan sponsor's decision to offer any investment option,
which may engage in securities lending, is a decision that must be
made in accordance with the fiduciary responsibility provisions of
ERISA, based on all relevant facts and circumstances. Because each
decision is made based on a number of variables, it would not be
possible for the Department to provide specific guidance on reasonable
levels of fees and reasonable distributions of returns in connection
with any particular securities lending cash collateral reinvestment.
* Revise PTE 2006-16 to include the practice of cash collateral
reinvestment by requiring that plan sponsors who enter into securities
lending arrangements utilizing cash collateral reinvestment on behalf
of 401(k) plan participants not do so unless they ensure the
reasonableness of the expected returns associated with this
arrangement.
A plan sponsor's decision to engage in securities lending is a
decision that must be made in accordance with the fiduciary
responsibility provisions of ERISA, based on all relevant facts and
circumstances. These provisions require, among other things, that a
plan receive reasonable compensation for the level of risk associated
with the investment. The Department's PTE 2006-16 provides relief from
ERISA's prohibited transaction provisions for both the lending of
securities by employee benefit plans to banks and broker-dealers and
the receipt of compensation by a securities lending fiduciary in
connection with services provided to a plan. As currently granted, the
exemption does not address or provide relief for the reinvestment of
the cash collateral.
Currently, section II(g) of the exemption requires that all fees and
other consideration received by the plan in connection with the loan
of securities arc reasonable. The Department does not believe it is
feasible to require additionally that plan sponsors ensure a certain
level of expected return on any particular investment. Market forces
and the choice of investments for the cash collateral will impact the
return to the plan. However, the Department will consider whether to
amend PTE 2006-16 to require the securities lending agreement
described therein to provide enhanced disclosures to plan fiduciaries.
* Amend its regulation on plan sponsor disclosure to participants to
include provisions specific to (1) the practice of cash collateral
reinvestment utilized by fund providers' securities lending programs
and (2) disclosing the potential for withdrawal restrictions.
The Department disagrees with this recommendation. Without further
study and review, the Department is not prepared to conclude that the
regulations governing the disclosure of investment-related information
to participants and beneficiaries must be amended to specifically
address securities lending-related issues.
* Provide plan sponsors with guidance alerting them to the risks of
engaging in securities lending with cash collateral reinvestment and
the types of information they should seek from their service providers
about these investments.
The Department will consider this recommendation in light of its
experience with security lending practices.
EBSA is committed to protecting the employer-sponsored benefits of
American workers, retirees, and their families. Again, thank you for
the opportunity to review the draft report. Please do not hesitate to
contact us if you have questions concerning this response or if we can
be of further assistance.
Sincerely,
Signed by:
Phyllis C. Borzi:
Assistant Secretary:
Appendix I Footnote:
[1] See Fiduciary Requirements for Disclosure in Participant-Directed
Individual Account Plans; Final Rule, 75 FR 64910 (October 20, 2010);
Reasonable Contract or Arrangement Under Section 408(b)(2) ” Fee
Disclosure; Interim Final Rule, 75 FR 41600 (July 16, 2010).
[End of section]
Appendix II: GAO Contact and Staff Acknowledgments:
GAO Contact:
Charles Jeszeck, (202) 512-7215, or jeszeckc@gao.gov:
Staff Acknowledgments:
In addition to the individual named above, the following team members
made significant contributions to this report: Tamara Cross, Assistant
Director; Monika Gomez, Analyst-in-Charge; Jessica Gray; James
Bennett; Susannah Compton; Sheila McCoy; Roger Thomas; and Walter
Vance.
[End of section]
Glossary:
The terms below are defined for the purposes of this GAO report.
Asset-Backed Security:
An asset-backed security is a security whose value and income payments
are derived from and collateralized (or "backed") by a specified pool
of underlying assets. The pool of assets is typically a group of small
and illiquid assets that are unable to be sold individually. Pooling
the assets into financial instruments allows them to be sold to
general investors, a process called securitization, and allows the
risk of investing in the underlying assets to be diversified because
each security will represent a fraction of the total value of the
diverse pool of underlying assets.
Balanced Fund:
Balanced funds are pooled accounts invested in stocks, bonds, and
often additional asset classes. They are classified into two
subcategories: target-date funds and non-target-date balanced funds.
Book Value:
The book value of a stable value fund is the principal contributed to
the investment option, plus accrued interest, minus withdrawals and
fees. Accrued interest, minus withdrawals and fees, is calculated
based on a methodology specified in the stable value fund contract and
is reset on a periodic basis, which is usually quarterly or
semiannually.
Broker-Dealer:
The broker-dealer borrows securities on behalf of its customers,
providing cash as collateral to the securities lending agent. A broker-
dealer is a company or other organization that trades securities for
its own account or on behalf of its customers. Although many broker-
dealers are "independent" firms solely involved in broker-dealer
services, many others are business units or subsidiaries of commercial
banks, investment banks or investment companies. When executing trade
orders on behalf of a customer, the institution is said to be acting
as a broker. When executing trades for its own account, the
institution is said to be acting as a dealer.
Cash Collateral Pool Manager:
The cash collateral pool manager invests the cash provided as
collateral for the borrowed securities in order to earn additional
return for the securities lending agent during the period of time that
the securities are borrowed. The securities lending agent can be the
cash collateral pool manager, but usually it is an affiliate of the
securities lending agent.
Collateral Deficiency:
A situation when the securities lending agent determines that a
substantial portion of the invested collateral is so impaired that it
will be insufficient to repay borrowers upon redemption.
Collective Investment Fund:
Collective investment funds (CIF) are bank investment trusts that pool
the investments of retirement plans or other institutional investors.
Commingled Fund:
Commingled or collective funds are designed to combine the assets of
unrelated retirement plans, enabling participants to diversify and
gain the economies of scale, i.e., the advantages that being part of a
larger fund affords, such as greater profits and less cost.
Counterparty Risk:
The risk to each party of a contract that the counterparty will not
live up to its contractual obligations. In a securities lending
transaction, this is the risk to the lender that the borrower will
fail to return the securities.
Federal Agency Securities:
Federal agency securities are debt instruments issued by federal
credit agencies.
Illiquid Security:
The term "illiquid security" generally includes any security which
cannot be sold or disposed of promptly and in the ordinary course of
business without taking a reduced price. A security is considered
illiquid if a fund cannot receive the amount at which it values the
instrument within seven days.
Institutional Investor:
An institutional investor is an organization that pools large sums of
money and invests those sums in securities, real property and other
investment assets. Institutional investors are typically banks,
insurance companies, retirement or pension funds, hedge funds,
foundations and mutual funds.
Intrinsic Value:
Intrinsic value refers to the return on a securities loan excluding
the benefit of active collateral management. It is the spread between
the rebate rate and the benchmark rate, e.g. federal funds rate.
Market Risk:
The potential for portfolio losses resulting from the change in value
of stock prices of the portfolio's assets, interest rates, foreign
exchange rates, and commodity prices.
Market Value:
The market value of a stable value fund is the price at which the
underlying assets of the fund are trading in the market at a given
time.
Money Market Funds:
Money market funds are open-end management investment companies that
are registered under the Investment Company Act of 1940 and regulated
under rule 2a-7 under that Act. Money market funds invest in high-
quality, short-term debt instruments such as commercial paper,
treasury bills and repurchase agreements. Generally, these funds,
unlike other investment companies, seek to maintain a stable net asset
value per share (market value of assets minus liabilities divided by
number of shares outstanding), typically $1 per share.
Mortgage-Backed Securities:
Mortgage-backed securities are securities whose value and income
payments are derived from and collateralized (or "backed") by a
specified pool of underlying mortgage loans, most commonly on
residential propertyshares of a home loan sold to investors. For
example, aA bank or other entity lends a borrower the money to buy a
house and collects monthly payments on the loan. This loan and a
number of others, perhaps hundreds, are sold to a larger bank that
packages the loans together into a mortgage-backed security. The
larger bank then issues shares of this security to investors who buy
them and ultimately collect the dividends in the form of the monthly
mortgage payments.
Mutual Fund:
A mutual fund, legally known as an open-end investment company, is a
company that pools money from many investors and invests the money in
stocks, bonds, short-term money-market instruments, other securities
or assets, or some combination of these investments. These investments
comprise the fund's portfolio. Mutual funds are registered and
regulated under the Investment Company Act of 1940, and are supervised
by the SEC. Mutual funds sell shares to public investors. Each share
represents an investor's proportionate ownership in the fund's
holdings and the income those holdings generate. Mutual fund shares
are "redeemable," which means that when mutual fund investors want to
sell their shares, the investors sell them back to the fund, or to a
broker acting for the fund, at their current net asset value per
share, minus any fees the fund may charge.
Participant-Directed 401(k) Plan:
A 401(k) plan that generally allows a participant to choose how much
to invest, within federal limits, and to select from a menu of
diversified investment options chosen by the plan sponsor.
Nontarget-Date Balanced Funds:
Nontarget-date balanced funds include asset allocation or hybrid funds.
Plan Participants:
Plan participants contribute to their 401(k) and direct that
contribution to certain investment options. In 401(k) plans the assets
are held in trust for participants.
Plan Sponsor:
A plan sponsor chooses which investment options to offer to its
participants, and when making that choice, decides on whether to offer
investments that engage in securities lending.
Plan Service Provider:
A plan service provider purchases securities on behalf of 401(k) plan
participants. A plan service provider may act as securities lending
agent.
Private Placements:
A private placement is a direct offering of securities directly to an
institutional investor, such as a bank, mutual fund, insurance
company, pension fund, or foundation.
Prohibited Transaction:
Prohibited transactions under ERISA include a sale, exchange, or lease
between a plan and a party-in-interest; lending money or other
extension of credit between the plan and party-in-interest; and
furnishing goods, services, or facilities between the plan and party-
in-interest, among other prohibited transactions.
Real Estate Accounts:
Real estate accounts are open-ended, commingled accounts that invest
directly in real estate, such as funds that buy and manage commercial
properties. Real estate accounts are equity accounts consisting
primarily of high quality, well-leased real estate properties in the
industrial, office, retail and hotel sectors. Real estate accounts may
be offered by insurance companies as separate accounts, and are
regulated by the state insurance commissioner in the state they are
created.
Rebate:
A payment to the broker-dealer, as they would have earned a short-term
rate of return on the cash they provided as collateral if they had
kept it in their possession. The greater the demand for the security
being lent, the lower the rebate paid to the broker-dealer by the
securities lending agent. Securities that have an extremely high
borrowing demand, or that are in short supply and therefore hard to
borrow, can obtain "negative" rebates, requiring the borrower to not
only pledge cash, but also pay a fee to plan participants.
Securities Lending:
The lending of some of the assets held in investment options, on
behalf of plan participants, to third parties, usually broker-dealers,
for a period of time. In return, broker-dealers provide collateral to
securities lending agents that they hold until broker-dealers return
the borrowed securities. Collateral for the loan can be either cash or
securities, such as bonds or stocks. If securities lending agents
accept securities as collateral for the loan, broker-dealers will
typically pay a fee to borrow the securities. However, in the U.S.,
cash is the primary form of collateral taken in securities lending
transactions and if cash is taken as collateral, the securities
lending agent does not receive a fee, but, instead, has the right to
reinvest the cash to earn an additional return. This is sometimes
called "cash collateral reinvestment," and is typically considered a
separate, but related, activity to the securities lending transaction.
Securities Lending Agent:
The securities lending agent coordinates loans of securities, hires a
manager to invest cash collateral and may take on counterparty risk--
or the risk that the borrower will not return the securities--on
behalf of the plan. May be an affiliate of the custodian, i.e., an
entity, usually a bank, that has legal responsibility for safekeeping
a plan's securities.
Separate account GICs:
Plan sponsors contract with an insurance company to guarantee
participants principal protection and a rate of return, which may be
fixed, indexed, or reset periodically based on the actual performance
of the underlying assets. The insurance company owns and holds the
underlying assets in a separate, customized account for the exclusive
benefit of a single plan.
Stable Value Fund:
Stable value funds are a fixed income investment option, designed to
preserve the total amount of participants' contributions, or their
principal, while also providing steady, positive returns set in the
contract.
Statement of Additional Information:
A Statement of Additional Information (SAI) is a supplementary
document to a mutual fund's prospectus that contains additional
information about the mutual fund and includes further disclosure
regarding its operations.
Synthetic Guaranteed Investment Contracts:
Plan sponsors contract with a bank or insurance company to guarantee
participants principal protection and a rate of return relative to a
portfolio of assets held in an external trust owned by the plan. The
rate of return, which is based on the actual performance of the
underlying assets, is reset periodically.
Target Date Funds:
Target date funds are often mutual funds and hold a mix of stocks,
bonds, and other investments. Over time, the investment allocation
gradually shifts according to the fund's investment strategy. Target
date funds are designed to be investments for individuals with
particular retirement dates in mind.
Traditional Guaranteed Investment Contracts:
Plan sponsors contract with an insurance company to guarantee
participants principal protection and a rate of return regardless of
the performance of the underlying assets, which the insurance company
owns and holds within their general account.
Trustee-Directed 401(k) Plan:
A 401(k) plan wherein an employer appoints trustees who decide how the
plan's assets will be invested.
[End of section]
Footnotes:
[1] Industry researchers have estimated that the average 401(k)
retirement account balance declined 27.8 percent in 2008, before
rising 31.9 percent in 2009. Thus, over this 2-year period, the
average retirement account balance lost 4.8 percent. For example, if
the average 401(k) retirement account balance was $100, a decline of
27.8 percent would bring the balance to $72.20 at the end of 2008.
Then, an increase of 31.9 percent would bring the balance to $95.20 at
the end of 2009. According to an industry association, the average
401(k) retirement account balance outperformed the S&P 500 Index in
both 2008 and 2009.
[2] Other 401(k) plans are trustee-directed, wherein an employer
appoints trustees who decide how the plan's assets will be invested.
For the purposes of this report, we are discussing participant-
directed 401(k) plans.
[3] In 2010, the federal limit for pretax contributions to 401(k)
accounts was $16,500. Participants aged 50 and over were eligible for
an additional $5,500 in "catch-up" contributions.
[4] Employee Benefit Research Institute. 401(k) Plan Asset Allocation,
Account Balances, and Loan Activity in 2009, Issue Brief No. 350
(Washington D.C.: November 2010).
[5] Plan sponsors may provide participants access to their retirement
savings in the form of a participant loan, a hardship withdrawal, or a
lump-sum distribution when the participant separates from the plan
sponsor. Participants who take an early distribution generally pay a
10 percent early withdrawal penalty and income taxes on the
distribution amount and may face other restrictions and fees, such as
loan origination fees.
[6] Labor's proposed regulations of October 2010, would amend the
definition of an ERISA fiduciary, reducing the number of conditions
that need to be met to be deemed an ERISA fiduciary. As such, the
proposed regulation, if finalized, would encompass a greater number of
entities assisting plan sponsors with selecting investment options.
Definition of the Term "Fiduciary," 75 Fed. Reg. 65,263 (proposed Oct.
22, 2010) (to be codified at 29 C.F.R. pt. 2510).
[7] Our recent reports on target date funds and conflicted investment
advice illustrate that managing the risks faced in saving for
retirement through 401(k) plans today can be complicated and pose
significant challenges for participants and sponsors alike. See GAO,
Defined Contribution Plans: Key Information on Target Date Funds as
Default Investments Should Be Provided to Plan Sponsors and
Participants, [hyperlink, http://www.gao.gov/products/GAO-11-118]
(Washington, D.C.: Jan. 31, 2011); and GAO, 401(k) Plans: Improved
Regulation Could Better Protect Participants from Conflicts of
Interest, [hyperlink, http://www.gao.gov/products/GAO-11-119]
(Washington, D.C.: Jan. 28, 2011).
[8] IRS also oversees various aspects of 401(k) contributions under
the Internal Revenue Code.
[9] Labor regulations specify that participants must be offered at
least three different investment options so that they can diversify
investments within an investment category, such as through a mutual
fund, and diversify among the investment alternatives offered.
[10] The operation of CIFs by national banks is subject to regulation
under OCC regulations. While certain CIFs offered by state banks must
comply with OCC regulations in order to qualify for tax-exempt
treatment (See 26 U.S.C. § 584) these CIFs generally are not limited
to employee benefit assets. CIFs offered by state banks that consist
solely of employee benefit assets such as retirement, pension, profit
sharing, stock bonus, or other trusts that are exempt from federal
income tax must only comply with applicable state law requirements
(which may include a cross-reference to OCC regulations) and are not
required under the tax code to comply with OCC regulations. 12 C.F.R.
§ 9.18(a)(2).
[11] An institutional investor is an organization that pools large
sums of money and invests those sums in securities, real property and
other investment assets. Institutional investors include banks,
insurance companies, retirement or pension funds, hedge funds,
foundations and mutual funds.
[12] In the United States, an annuity contract is created when an
insured party, usually an individual, gives an insurance company money
that will later be distributed back to the insured party over time.
Annuity contracts traditionally provide a guaranteed distribution of
income over time, until the death of the person or persons named in
the contract or until a final date, whichever comes first.
[13] Title I of ERISA does not proscribe or prohibit particular types
of investment products or options, but plan sponsors must conduct due
diligence and prudently select the investment options they want to
offer to their participants.
[14] Commingled or collective funds are designed to combine the assets
of unrelated retirement plans, enabling participants to diversify and
gain the economies of scale, i.e., the advantages that being part of a
larger fund affords, such as greater profits and less cost.
Participants own a share in a pool of assets.
[15] For plans that offer separate accounts, participants own the
assets in the pool.
[16] Hewitt Associates, Trends and Experience in 401(k) Plans
(Lincolnshire, IL: 2009).
[17] The stable value fund industry used to offer "stable value mutual
funds" to investors who invested in Individual Retirement Accounts;
however, after SEC staff raised concerns about the funds' accounting
methods, stable value mutual funds were terminated.
[18] The market value of a stable value fund is the collective prices
at which the underlying assets of the fund are trading in the market
at a given time.
[19] The book value of a stable value fund is the principal
contributed to the investment option, plus accrued interest, minus
withdrawals and fees. Accrued interest, minus withdrawals and fees, is
calculated based on a methodology specified in the stable value fund
contract and is reset on a periodic basis, which is usually quarterly
or semiannually.
[20] In fact, according to a stable value fund provider, plan sponsor
restrictions are necessary to provide the fund manager with a tool to
protect the remaining investors in the fund and to protect the issuers
of wrap contracts used by the funds. Similarly, in a 2006 Akron Law
Review publication, an industry expert notes that, in order for a wrap
contract to be a financially sound product, wrap contract providers
nearly universally insist that plan participants not be allowed to
make direct transfers from a stable value fund into a money market
fund. The author argues that these participant restrictions are not
only necessary to maintain favorable returns above those of other low-
risk investments, but also to ensure that less financially
sophisticated plan participants are not disadvantaged by financially
sophisticated, market-timing plan participants. Paul J. Donahue, "Plan
Sponsor Fiduciary Duty for the Selection of Options in Participant-
Directed Defined Contribution Plans and the Choice Between Stable
Value and Money Market," Akron Law Review 39, No. 1 (2005-2006).
[21] Some of the $2.8 trillion in assets held in 401(k) plans at the
end of 2009 were utilized in securities lending programs, but the
specific percentage is unknown. The percentage of assets lent out at
any given time varies by type of 401(k) investment option. While SEC
staff, by no-action letters, limit the percentage of assets in mutual
funds and money market funds that can be utilized in securities
lending programs, other 401(k) investment options that are not
registered with SEC, such as some equity, bond, and stable value
funds, are generally not limited in the percentage of assets that can
be utilized by securities lending programs.
[22] The securities lending agent takes collateral for the loan that
can be either cash or securities, such as bonds or stocks. However, in
the United States, cash is the primary form of collateral taken in
securities lending transactions and, thus, for the purpose of this
report, investment options that lend securities are those investment
options that participate in the practice of lending plan assets to
third parties in exchange for cash as collateral that a fund
reinvests, or securities lending with cash collateral reinvestment.
[23] If the investment option takes cash as collateral, the lender has
the right to reinvest that cash to earn an additional return. The
borrower does not pay an additional fee to borrow the securities,
called a "negative rebate," unless the security is in extremely high
borrowing demand. If the investment option takes securities as
collateral, the borrower will pay the lender a fee.
[24] Prohibited Transaction Exemption (PTE) 2006-16; Class Exemption
to Permit Certain Loans of Securities by Employee Benefit Plans, 71
Fed. Reg. 63,786 (Oct. 31, 2006).
[25] 29 U.S.C. § 1106. Prohibited transactions under ERISA include a
sale, exchange, or lease between the plan and party-in-interest;
lending money or other extension of credit between the plan and party-
in-interest; and furnishing goods, services, or facilities between the
plan and party-in-interest, among other prohibited transactions. Labor
may grant administrative exemptions from the prohibited transaction
provisions of ERISA.
[26] ERISA provides a number of detailed exemptions to its prohibited
transaction provisions and permits Labor to establish additional ones.
29 U.S.C. §1108.
[27] Prohibited Transaction Exemption (PTE) 2006-16. This exemption
permits the lending of securities owned by an employee benefit plan to
persons who would otherwise constitute a "party in interest" with
respect to such plans, provided certain conditions specified in the
exemption are met. Under those conditions neither the borrower nor an
affiliate of the borrower can have discretionary control over the
investment of plan assets, or offer investment advice concerning the
assets, and the loan must be made pursuant to a written agreement. The
exemption also establishes a minimum acceptable level for collateral
based on the market value of the loaned securities and permits
compensation of a fiduciary for services rendered in connection with
loans of plan assets that are securities.
[28] There are a number of reasons why plan sponsors and participants
may want to withdraw their assets. For example, plan sponsors can
switch investment options because they want to offer different
investment options or because fees are too high at their current
service provider. Participants often transfer their plan assets into
riskier or safer investment options or may withdraw their 401(k)
assets because they are experiencing a personal hardship. Participants
are also allowed to withdraw their assets when they retire. Between
2007 and 2010, while some investment options placed restrictions on
participants and sponsors who wanted to withdraw to move their plan
assets into other investments, investment options generally did not
restrict certain withdrawals that were defined by plan sponsors. This
included hardship withdrawals and withdrawals at retirement, if
applicable.
[29] Withdrawal restrictions, in general, may have prevented some
realized losses during the period of the restrictions.
[30] Generally, defined benefit plans are more likely to invest in
real estate than defined contribution plans. As such, public reports
of redemption restrictions noted that numerous defined benefit plans
also experienced withdrawal restrictions from these investment options.
[31] While restrictions were placed on participants and sponsors who
wanted to withdraw to move their plan assets into other investments, a
representative of the real estate accounts that we spoke to told us
that, despite the restrictions, it continued to pay benefits for
certain withdrawals that were defined by plan sponsors, including
hardship withdrawals and withdrawals at retirement at normal age, if
applicable.
[32] Mullaney v. Principal Global Investors, LLC et al. No.4:10-cv-
00199-RP-TJS (U.S. Dist. Ct., So. Dist. Of Iowa)(April 30, 2010).
[33] Money market funds must operate in accordance with rule 2a-7
under the Investment Company Act of 1940. Under rule 2a-7, as in
effect in 2008, money market funds were permitted to maintain a stable
net asset value, usually $1.00, by using the "amortized cost"
valuation method. Under this valuation method, securities are valued
at acquisition cost, with certain adjustments, instead of fair market
value. If there is a difference of more than one-half of 1 percent
($.005 per share) between amortized cost and net asset value, the fund
is deemed to have "broken the buck," and must reprice its shares. The
Primary Fund's Lehman holdings were valued at zero in September 2008
which led to a repriced net asset value of $0.97 per share. However,
these Lehman holdings were subsequently sold for around 22 cents on
the dollar and thus, as of approximately July 16, 2010, Primary Fund
investors had been paid 99 cents on the dollar.
[34] According to the "Report of the President's Working Group on
Financial Markets: Money Market Reform Options," October 2010, money
market funds are vulnerable to runs because shareholders have an
incentive to redeem their shares before others do when there is a
perception the fund might suffer a loss. Even when the fund suffers a
small loss, shareholders who choose to redeem may do so at the expense
of the remaining shareholders.
[35] Subject to certain exceptions, Section 22(e) of the Investment
Company Act of 1940 prohibits mutual funds, including money market
funds, from (i) suspending the right of redemption, or (ii) postponing
payment upon redemption of any redeemable security in accordance with
its terms for more than seven days after the tender of the security to
the fund or its agent. One of the exceptions is by order of the SEC
for the protection of the fund's security holders. SEC issued an order
covering the Reserve Primary Fund and the U.S. Government Fund on
September 22, 2008, and an order covering additional Reserve money
market funds on October 24, 2008.
[36] Treasury's Temporary Guarantee Program for Money Market Funds
expired on September 18, 2009. Treasury guaranteed that upon
liquidation of a participating money market fund, the fund's
shareholders would receive the fund's stable share price of $1.00 for
each fund share owned as of September 19, 2008. Participating funds
were required to agree to liquidate and to suspend shareholder
redemptions if they broke the buck. Most money market funds elected to
participate in the program. On November 20, 2008, SEC adopted an
interim final temporary rule under section 22(e) of the Investment
Company Act that permitted investment companies that commenced
liquidation under the Guarantee Program to suspend redemptions of
outstanding shares and postpone payment of redemption proceeds. 17
C.F.R. § 270.22e-3T. According to SEC staff, none did.
[37] FRB's Asset-Backed Commercial Paper Money Market Mutual Fund
Liquidity Facility expired on February 1, 2010.
[38] Money Market Reform, 75 Fed. Reg. 10,060 (Mar. 4, 2010) (codified
at 17 C.F.R. pt. 270 and 274). The new rules were effective May 5,
2010.
[39] Specifically, the new rule (rule 22e-3) permits a money market
fund to suspend redemptions and postpone payment of redemption
proceeds to facilitate an orderly liquidation of the fund if: (1) the
fund's board, including a majority of the disinterested directors,
determines that the deviation between the fund's amortized cost price
per share and the market-based net asset value per share may result in
material dilution or other unfair results to investors, (2) the board,
including a majority of the disinterested directors, irrevocably has
approved liquidation of the fund, and (3) the fund has notified SEC
prior to suspending redemptions.
[40] Restrictions may vary depending on the way the stable value fund
is structured. 12-month restrictions, such as the restrictions
described above, are generally stipulated in contracts where the
stable value fund is structured as a commingled investment option. For
plan sponsors who offer stable value funds as separate account
investment options, there is generally no exit option, per se.
Instead, for stable value funds that are operated as separate account
investment options, plan sponsors generally cannot exit at book value
until market values recover to that amount.
[41] Mortgage-backed securities are securities whose value and income
payments are derived from and collateralized (or "backed") by a
specified pool of underlying mortgage loans, most commonly on
residential property. For example, a bank or other entity lends a
borrower the money to buy a house and collects monthly payments on the
loan. This loan and a number of others, perhaps hundreds, are sold to
a larger bank that packages the loans together into a mortgage-backed
security. The larger bank then issues shares of this security to
investors who buy them and ultimately collect the dividends in the
form of the monthly mortgage payments.
[42] An asset-backed security is a security whose value and income
payments are derived from and collateralized (or "backed") by a
specified pool of underlying assets. The pool of assets is typically a
group of small and illiquid assets that are unable to be sold
individually. Pooling the assets into financial instruments allows
them to be sold to general investors, a process called securitization,
and allows the risk of investing in the underlying assets to be
diversified because each security will represent a fraction of the
total value of the diverse pool of underlying assets. The pools of
underlying assets can include common payments from credit cards, auto
loans, and mortgage loans, to esoteric cash flows from aircraft
leases, royalty payments and movie revenues.
[43] Some of the amount that the provider retains may be paid back to
existing or new participants through small increases in their future
book value.
[44] Such restrictions are likely to occur in this situation if the
stable value fund was structured as a commingled investment option.
[45] Depending on the specific situation, some plan sponsors may be
able to negotiate with the stable value fund provider to continue to
provide book value to participants, even though an employer-initiated
event has occurred. However, if the plan sponsor is able to negotiate
with the wrap provider or find a new wrap provider who will accept the
losses on the original contract, participants who are covered under
the renegotiated or new contract will likely be charged a higher fee
to make up for the losses.
[46] If participants request transfers out when the market value of
the fund is less than book value, the cash held by the stable value
fund has been exhausted, and the withdrawal requests are not related
to an employer-initiated event, the wrap contract will partially cover
the difference between the market value and book value of the
withdrawals. The wrap provider pays participants only if there is a
deficit between book value and market value after all participants
have left the plan.
[47] These wrap contract restrictions are sometimes called "equity
wash provisions" because once the participant transfers their plan
assets out of the stable value fund, they are precluded by the
contract from investing their plan assets directly into "competing"
investment options, which could include money market funds or other
short-term fixed income funds, and instead are required to put their
money in a non-competing investment option, such as an equity fund.
[48] Some plan sponsors have also called for less risk to be taken in
the stable value portfolio.
[49] According to a Congressional Oversight Panel June 10, 2010
report, The AIG Rescue, Its Impact on Markets, and the Government's
Exit Strategy, on the day that AIG was poised to fail, it had $38
billion in stable value wrap contracts.
[50] The combined effects of wrap providers exiting the business,
credit downgrades in the insurance industry, and reevaluations of risk
in the historically "low-risk" wrap contract business caused the
majority of remaining wrap providers to significantly reduce their
risk exposure, triggering much tighter investment restrictions on the
underlying stable value portfolio and increasing fees.
[51] Some investment options that were registered with SEC, such as
mutual funds, also experienced realized and unrealized cash collateral
pool losses but did not place restrictions on plan sponsors'
withdrawals because of the losses. Instead, realized cash collateral
pool losses were included in the net asset value of the registered
investment option.
[52] These assets may not have been perceived as risky when they were
acquired and, in fact, may have complied with the plans' or the
investment options managers' investment guidelines covering cash
collateral reinvestment. Some investment guidelines were very broad
and therefore provided some discretion to the lending agent. As a
result, some lenders may have chosen more aggressive reinvestment
strategies when more conservative approaches were available.
[53] This is known as a "collateral deficiency" and, as used here,
occurs when the securities lending agent determines that a substantial
portion of the invested collateral is so impaired that it will be
insufficient to repay borrowers upon redemption.
[54] Securities lending agents had differing experiences in their
respective cash collateral pools, and managed their clients' realized
and unrealized losses differently--some placed restrictions on plan
sponsor withdrawals. In addition, the restrictions varied by the type
of investment options that plan sponsors offered. On one hand,
investment options that were separate accounts required that a minimum
percentage of the account's securities had to be lent out. However,
investment options that were commingled accounts virtually eliminated
plan sponsors' abilities to withdraw from the commingled accounts,
limiting withdrawals to between 2 and 4 percent of their assets per
month.
[55] Participants ultimately bore the risk of loss from market risks
of the cash collateral portfolio--the potential for portfolio losses
resulting from the change in value of stock prices of the portfolio's
assets, interest rates, foreign exchange rates, and commodity prices--
but were only provided with a portion of the return generated as a
result of the risks taken on their behalf.
[56] According to individuals we interviewed, broker-dealers may
negotiate to receive a rebate from the securities lending agent of
some of the return earned on the reinvestment of cash collateral
because they would have earned a short-term rate of return on the cash
they provided as collateral if they had kept it in their possession.
However, since they are providing the cash as collateral, they are not
able to earn interest on it.
[57] The lending agent typically absorbs the operational expenses
associated with providing the service.
[58] While Lehman may have had a high credit rating immediately prior
to its bankruptcy, that rating may have been based on materially
misleading periodic reports. In fact, the report of the Examiner in
Lehman's bankruptcy proceedings stated that "unbeknownst to the
investing public, rating agencies, Government regulators, and Lehman's
Board of Directors, Lehman reverse-engineered the firm's net leverage
ratio for public consumption."
[59] Many investment options, by design, invest in securities with
some risk. If the securities are lent out and the cash collateral is
then invested in risky securities, it creates a leveraged situation
where $1 invested in the fund is exposed to more than $1 of risk. To
the extent that returns on the two sets of risky assets are
correlated, a market downturn could result in both the lent
securities, and the collateral investments suffering losses at the
same time.
[60] Losses may have been realized or unrealized. Realized losses
caused the value of the investment option to decline and were less
likely to cause withdrawal restrictions, whereas unrealized losses did
not cause the value of the investment option to decline and were more
likely to cause withdrawal restrictions.
[61] For example, BP Corporation pension plan committee filed suit in
October 2008 against Northern Trust Company, asserting multiple causes
of action grounded in the fiduciary obligations prescribed by §§ 404,
409, and 502 of ERISA. This case is still pending, and no rulings have
been made. BP Corporation North America, Inc. Savings Plan Investment
Oversight Committee v. Northern Trust Investments N.A., No. 1: 08-cv-
6029 (N.D. Ill.)(October 21, 2008). Other cases include: Public School
Teachers' Pension & Retirement Fund of Chicago et.al. and City of
Atlanta Firefighters' Pension Plan, v. Northern Trust Investments, No.
1:10-cv-00619 (N.D. Ill.)(January 29, 2010); Board of Trustees of the
AFTRA Retirement Fund et.al. v. J.P. Morgan Chase Bank N.A., No. 1:09-
cv-00686-SAS-DCF (S.D. N.Y.)(January 23, 2009); and Diebold v.
Northern Trust Investments N.A. et.al., No. 1:09-cv-01934 (N.D.
Ill.)(March 30, 2009). We did not verify the status of these cases.
[62] Individual exemptions relating to actions taken by service
providers to ensure liquidity of cash collateral pools were granted by
Labor in 2009 and 2010, including PTE 2009-11, JP Morgan Chase Bank,
National Association; PTE 2009-27, Bank of New York Mellon
Corporation; and PTE 2010-25, State Street Bank and Trust Company.
[63] For example, one securities lending agent contributed cash to one
of their cash collateral pools that experienced losses as a result of
the Lehman default--in accordance with their portion of the split on
gross profit--but sponsors that withdraw from the cash collateral pool
within three years will forfeit this loss sharing. Another securities
lending agent contributed cash representing 20 percent--or the loss
from a Lehman security--of the unrealized and realized losses in one
of their collateral pools.
[64] ERISA Advisory Council. Report on Stable Value Funds and
Retirement Security in the Current Economic Conditions (2009).
[65] Fiduciary Requirements for Disclosure in Participant-Directed
Individual Account Plans; Final Rule, 75 Fed. Reg. 64,910 (Oct. 20,
2010)(codified at 29 C.F.R. pt. 2550). As a result of these
regulations, which became effective on December 20, 2010, participants
will receive core information about investments available under the
plan, including performance and fee information, prior to investing
and on an annual basis, in a chart or similar format designed to
facilitate investment comparisons. Participants will also receive
quarterly statements on plan fees and expenses deducted from their
accounts along with a description of the services for which the charge
or deduction was made. 29 C.F.R. § 2550.404a-5 and § 2550.404c-1.
[66] Wrap contracts may stipulate plan sponsor communications with
participants that induce transfers from the funds as employer-
initiated events.
[67] The placement of this information in disclosure documents depends
on the investment option's approach to securities lending. If, for
example, the investment option only lends on an intrinsic value basis,
and only reinvests cash to preserve principal, their risk may in fact
be low. Since the economic crisis, securities lenders are calling for
a move towards an intrinsic value lending approach, rather than a
focus on cash collateral reinvestment to generate additional returns.
[68] 29 C.F.R. § 2550.404c-1.
[69] Section 404(a)(1) of Title I of ERISA provides a "prudent man
standard of care" that a fiduciary must observe in meeting his or her
duties with respect to the plan. As such, the fiduciary must act
solely in the interests of plan participants and beneficiaries and for
the exclusive purpose of providing benefits and defraying reasonable
expenses of administering the plan. Among other requirements, the
fiduciary must discharge his responsibilities with the appropriate
care, skill, prudence, and diligence that similarly situated
fiduciaries acting in a like capacity and familiar with such matters
would use in a similarly situated enterprise of a like character and
with like aims. 29 U.S.C. § 1104(a)(1).
[70] An asset in a stable value fund can potentially default, for
example, if the loan underlying an interest-only bond defaults or
prepays. A wrap provider can potentially default on its "guarantee" or
its obligation to cover any gap between market value and book value of
a stable value fund's assets.
[71] According to the ERISA Advisory Council, plan sponsors need (1)
issuer specific information regarding the underlying assets of a
stable value fund for insight into the risk/reward characteristics
that will result in any variance between the fair market value and the
book value; (2) issuer specific information regarding the wrap
contract provider, since the financial stability of the wrap contract
provider(s) may be a factor in the ability of the fund to be able to
continue to make payments at book value when book value is greater
than the fair market value of the underlying assets; (3) information
on the administrative cost and other fees related to the fund, to aid
in determining the efficiency and prudence of the investment; and (4)
information concerning the periodic fair market valuation of the fund
as compared with book value that would allow them to evaluate any risk
of a market value adjustment.
[72] Industry experts who testified before the ERISA Advisory Council
stated that the level of due diligence for stable value fund selection
is qualitatively different from the due diligence in selecting a
mutual fund. Unlike mutual funds, where there are a variety of sources
regarding their current and historic value, the only source of stable
value fund information is the stable value fund provider. Thus, some
plan sponsors are in a position where they not only do not understand
the composition and diversification of the underlying portfolio of
stable value funds, but they also do not understand how the market to
book value of their plan's stable value fund compares to other stable
value funds.
[73] Pub. L. No. 111-203, §719, 124 Stat. 1377, 1656 (2010). The Dodd-
Frank Act was signed into law on July 21, 2010. The stated intent of
the new law is to promote the financial stability of the United States
by improving the accountability and transparency in the financial
system and protecting consumers from abusive financial services
practices.
[74] Swaps are one of the financial transactions addressed by the Dodd-
Frank Act. Normally, the vast majority of retirement plans do not
directly employ swaps. However, the Dodd-Frank Act's definition of
swap could include components of stable value fund products because
the Dodd-Frank Act defines "swap" broadly to include certain
agreements where the value is determined by reference to an underlying
asset (subject to certain exclusions). The investments underlying a
stable value fund are protected by the issuer's guarantee to pay the
book value of the investments if the market value is depleted. It is
this protective wrap contract that could be considered a swap under
the Dodd-Frank Act. SEC and CFTC are to consult with Labor, Treasury,
and state regulators who regulate the issuers of stable value
contracts and issue a report by October 11, 2011. If they determine
that stable value contracts fall within the definition of a swap, they
are to determine if an exemption is in the public interest. Until such
time, the requirements of the act are not to apply to stable value
contracts and stable value contracts in effect prior to the adoption
of any regulations are not to be considered swaps. Section 719(d) of
Dodd-Frank 15 U.S.C. § 8307.
[75] Our poll respondents' responses cannot be considered
representative of the overall population of 401(k) plan sponsors.
Because of the methodological limitations of this poll, this
information is anecdotal and represents only the views of the 74
members who responded to our poll.
[76] We have not verified the status of any of these cases.
[77] The term "illiquid security" generally includes any security that
cannot be sold or disposed of promptly and in the ordinary course of
business without taking a reduced price. A security is considered
illiquid if a fund cannot receive the amount at which it values the
instrument within 7 days.
[78] FINRA is the largest independent regulator for all securities
firms doing business in the United States. It oversees nearly 4,600
brokerage firms, 163,000 branch offices, and 631,000 registered
securities representatives. Its chief role is to protect investors by
maintaining the fairness of the U.S. capital markets.
[79] Section 984(b) of Dodd-Frank, 15 U.S.C. § 78j. The new act does
not limit the authority of the federal banking agencies to also
prescribe rules regarding the loan or borrowing of securities.
[80] FINRA has also asked for input on how to create an ADV-like form
for broker-dealers, which is the key disclosure document used by
investment advisers that requires detailed disclosures of services,
conflicts, and fees.
[81] The council is a formal interagency body empowered to prescribe
uniform principles, standards, and report forms for the federal
examination of financial institutions by FRB, FDIC, the National
Credit Union Administration, OCC, and the Office of Thrift
Supervision, and to make recommendations to promote uniformity in the
supervision of financial institutions.
[82] SEC's rule 2a-7, which governs money market funds, requires that
all taxable money market funds maintain at least 10 percent of their
assets in cash, U.S. Treasury securities, or securities that mature or
can be converted to cash within one business day, and that all money
market funds hold at least 30 percent of their assets in cash, U.S.
Treasury securities, certain other government securities with
remaining maturities of 60 days or less, or securities that mature or
can be converted to cash within a week.
[83] Labor's PTE 2006-16 does state, however, that, in return for
lending securities, the plan may receive a reasonable fee (in
connection with the securities lending transaction) and/or have the
opportunity to earn additional compensation through the investment of
cash collateral. It further states that all fees and other
consideration received by the plan in connection with the loan of
securities should be reasonable.
[84] Reasonable Contract or Arrangement Under Section 408(b)(2)-Fee
Disclosure; Interim Final Rule, 75 Fed. Reg. 41,600 (July 16, 2010)(to
be codified at 29 C.F.R. § 2550.408b-2).
[85] A statement is also required when the covered service provider
provides their services as a registered investment advisor. A "covered
service provider" is a provider that enters into a contract or
arrangement with the retirement plan and expects to receive $1,000 or
more in direct or indirect compensation for services to the plan,
regardless of whether the services are performed by the covered
service provider, an affiliate, or a subcontractor, or as a registered
investment advisor registered under the Advisors Act or under state
law providing services directly to the plan.
[End of section]
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