401(k) Plans
Issues Involving Securities Lending in Plan Investments Gao ID: GAO-11-359T March 16, 2011Securities lending can be a relatively straightforward way for plan sponsors and participants to increase their return on 401(k) investments. However, securities lending can also present a number of challenges to plan participants and plan sponsors. GAO was asked to explain how securities lending with cash collateral reinvestment works in relation to 401(k) plan investments, who bears the risks, and what are some of the challenges plan participants and plan sponsors face in understanding securities lending with cash collateral reinvestment. In this testimony, GAO discusses its recent work regarding securities lending with cash collateral reinvestment. GAO is making no new recommendations in this statement but continues to believe that the Department of Labor (Labor) can take action to help plan sponsors of 401(k) plans and plan participants to understand the role, risk, and benefits of securities lending with cash collateral reinvestment in relation to 401(k) plan investments. Specifically, GAO recommended that Labor provide more guidance to plan sponsors about fees and returns when plan assets are utilized in securities lending with cash collateral reinvestment, amend its participant disclosure regulation to include provisions specific to securities lending with cash collateral reinvestment information, and make cash collateral reinvestment a prohibited transaction unless the gains and losses for participants are more symmetrical.
Some 401(k) investment options that hold assets on behalf of plan participants lend out those assets for a period of time to a third party in exchange for collateral. In the United States, cash is the primary form of collateral taken in these securities lending transactions. When cash is received it is typically reinvested in a cash collateral pool to earn a greater return for participants. Many investment options offered by 401(k) plans engage in securities lending with cash collateral reinvestment, and the structure of the investment options offered by the plan affects the type of securities lending the plan engages in--direct or indirect securities lending--and the way the gains and losses are allocated to plan participants. 401(k) plan participants share any gains but fully bear any losses from cash collateral pool investments in the case of securities lending with cash collateral reinvestment. 401(k) plan participants only receive a portion of the return when the reinvested cash collateral earns more than the amounts owed to others engaged in the transaction. In the past few years, risky assets in the cash collateral pool, which lost value and were difficult to trade, caused realized and unrealized losses to 401(k) plan participants. Participants and some plan sponsors are often unaware that 401(k) plan investment options are engaged in securities lending with cash collateral reinvestment and that these arrangements can pose risks to plan participants. Current disclosures on these transactions are often not transparent, although certain government and private sector entities are taking steps to make these arrangements more transparent and less risky. GAO recommended that Labor also take action to assist plan sponsors in understanding, among other things, the potential gains and losses associated with the cash collateral pools, and to provide better guidance to plan sponsors and participants.
GAO-11-359T, 401(k) Plans: Issues Involving Securities Lending in Plan Investments
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United States Government Accountability Office:
GAO:
Testimony:
Before the Special Committee on Aging, U.S. Senate:
For Release on Delivery:
Expected at 2:00 p.m. EDT:
Wednesday, March 16, 2011:
401(K) Plans:
Issues Involving Securities Lending in Plan Investments:
Statement of Charles A. Jeszeck, Acting Director: Education,
Workforce, and Income Security:
GAO-11-359T:
GAO Highlights:
Highlights of GAO-11-359T, a testimony before the Special Committee on
Aging, U.S. Senate.
Why GAO Did This Study:
Securities lending can be a relatively straightforward way for plan
sponsors and participants to increase their return on 401(k)
investments. However, securities lending can also present a number of
challenges to plan participants and plan sponsors. GAO was asked to
explain how securities lending with cash collateral reinvestment works
in relation to 401(k) plan investments, who bears the risks, and what
are some of the challenges plan participants and plan sponsors face in
understanding securities lending with cash collateral reinvestment. In
this testimony, GAO discusses its recent work regarding securities
lending with cash collateral reinvestment. GAO is making no new
recommendations in this statement but continues to believe that the
Department of Labor (Labor) can take action to help plan sponsors of
401(k) plans and plan participants to understand the role, risk, and
benefits of securities lending with cash collateral reinvestment in
relation to 401(k) plan investments. Specifically, GAO recommended
that Labor provide more guidance to plan sponsors about fees and
returns when plan assets are utilized in securities lending with cash
collateral reinvestment, amend its participant disclosure regulation
to include provisions specific to securities lending with cash
collateral reinvestment information, and make cash collateral
reinvestment a prohibited transaction unless the gains and losses for
participants are more symmetrical.
What GAO Found:
Some 401(k) investment options that hold assets on behalf of plan
participants lend out those assets for a period of time to a third
party in exchange for collateral. In the United States, cash is the
primary form of collateral taken in these securities lending
transactions. When cash is received it is typically reinvested in a
cash collateral pool to earn a greater return for participants. Many
investment options offered by 401(k) plans engage in securities
lending with cash collateral reinvestment, and the structure of the
investment options offered by the plan affects the type of securities
lending the plan engages in”direct or indirect securities lending”and
the way the gains and losses are allocated to plan participants.
401(k) plan participants share any gains but fully bear any losses
from cash collateral pool investments in the case of securities
lending with cash collateral reinvestment. As shown in the figure
below, 401(k) plan participants only receive a portion of the return
when the reinvested cash collateral earns more than the amounts owed
to others engaged in the transaction. In the past few years, risky
assets in the cash collateral pool, which lost value and were
difficult to trade, caused realized and unrealized losses to 401(k)
plan participants.
Participants and some plan sponsors are often unaware that 401(k) plan
investment options are engaged in securities lending with cash
collateral reinvestment and that these arrangements can pose risks to
plan participants. Current disclosures on these transactions are often
not transparent, although certain government and private sector
entities are taking steps to make these arrangements more transparent
and less risky. GAO recommended that Labor also take action to assist
plan sponsors in understanding, among other things, the potential
gains and losses associated with the cash collateral pools, and to
provide better guidance to plan sponsors and participants.
Figure: Example of a Separate Account Securities Lending with Cash
Collateral Reinvestment Transaction:
[Refer to PDF for image: illustration]
The illustration depicts a circular flow of lending as follows:
401(k) plan owns assets:
Security:
Securities lending agent lends securities on behalf of plan and
reinvests cash collateral.
Security:
Broker-dealer borrows securities in exchange for cash collateral.
Cash collateral:
Cash collateral pool manager invests cash collateral.
Profit (or loss):
To 401(k) plan owner.
Source: GAO interviews and analysis of the practice of securities
lending with cash collateral reinvestment.
[End of figure]
[End of section]
Mr. Chairman and Members of the Committee:
I am pleased to be here today to discuss securities lending with cash
collateral reinvestment in the context of 401(k) plans. Many of the
investment options offered by 401(k) plan sponsors, including money
market funds,[Footnote 1] stable value funds,[Footnote 2] and equity
funds,[Footnote 3] engage in 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. In the United
States, cash is the primary form of collateral taken in securities
lending transactions, and in this testimony, I will be discussing
investment options that lend plan assets to third parties in exchange
for cash as collateral that a fund reinvests, or securities lending
with cash collateral reinvestment. At first glance, the practice of
securities lending with cash collateral reinvestment appears to be a
relatively straightforward and potentially easy way for plan sponsors
and participants to increase their return on 401(k) plan investment
options. But beneath the surface, securities lending with cash
collateral reinvestment can also pose challenges and risks to both
plan sponsors and plan participants. In our view, transparency and
disclosure are important preconditions to assist plan sponsors and
participants in understanding the risks and rewards of such
transactions and in making prudent decisions about them.
My statement will focus on the practice of securities lending with
cash collateral reinvestment in relation to 401(k) plan investments.
Specifically, I will discuss (1) how it works with 401(k) plan
investments, (2) who bears the risk of loss, and (3) what are some of
the challenges plan participants and plan sponsors face and actions
that can be taken. My testimony is based on our March 2011 report,
which is being released today.[Footnote 4] Our work was conducted 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 objective. 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 the Employee Retirement Income Security Act of 1974
(ERISA), plan sponsors are permitted to offer their employees two
broad types of retirement plans, defined benefit and defined
contribution.[Footnote 5] Plan sponsors that offer defined
contribution plans do not promise employees a specific benefit amount
at retirement--instead, the employee and/or his or her 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 his or her individual
account at retirement, which reflects the contributions to,
performance of the investments in, and any fees charged against the
account.
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 6] 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 7] In most 401(k) plans, participants bear the risk
of their investments' performance and the responsibility for ensuring
they have adequate savings in retirement.
Plan sponsors that offer 401(k) plans have responsibilities under
ERISA, which 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 8]
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.
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 9] 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 10] 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 the Securities and
Exchange Commission (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 the
Federal Reserve Board (FRB), the Office of the Comptroller of the
Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC),
and state banking agencies--oversee bank investment products, such as
collective investment funds (CIF),[Footnote 11] which are trusts that
pool the investments of retirement plans or other institutional
investors.[Footnote 12]
* 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 13]
Investment options offered by 401(k) plan sponsors, including money
market funds, stable value funds, and equity funds, may engage in
securities lending with cash collateral reinvestment.[Footnote 14] SEC
staff, by no action letters, effectively 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.
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 15] 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 16] but provides various exemptions to these
prohibited transactions.[Footnote 17] 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 18]
Securities Lending with Cash Collateral Reinvestment Is Utilized with
401(k) Plan Investments:
Securities lending is a transaction where some of the assets held in
401(k) investment options on behalf of plan participants are lent out
for a period of time to a third party.[Footnote 19] Investment options
offered to 401(k) plan participants can earn greater returns if these
investment options temporarily lend out their underlying securities
and invest the cash received as collateral for the loan.[Footnote 20]
For example, a 401(k) investment option that mimics the S&P 500 index
fund will hold the same stocks in approximately the same ratio as they
are included in 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 a
401(k) 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.[Footnote 21] These index funds may try to decrease the
gap by earning a greater return on the stocks they hold by temporarily
lending out the securities and then investing the cash collateral they
receive. Table 1 defines the various parties involved in a typical
securities lending transaction.
Table 1: 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.
[B] If the price of the lent security increases while the loan is
outstanding, the borrower will be required to increase the
corresponding amount of cash collateral in order to ensure a certain
percentage coverage of the security's value. The lender also has
responsibilities with respect to the cash collateral. These terms are
generally described in a Master Securities Lending Agreement, which is
entered into between the lending agent and the broker-dealer.
[End of table]
Securities lending with cash collateral reinvestment can be done
through separate or commingled funds. Many investments offered under
401(k) plans pool the money of a large number of individual investors
into funds called commingled or pooled accounts, which include CIFs or
mutual funds, which are designed to combine the assets of unrelated
retirement plans to enable participants to diversify and gain the
advantages that being part of a larger fund affords, such as greater
profits and lower costs. With these accounts, the manager of the
commingled account makes the decision to engage in securities lending,
so the plan participates in the lending activities indirectly. Larger
401(k) plans, however, are more likely to structure their investments
as separate accounts. With separate accounts, it is the plan sponsor
who chooses whether or not to participate directly in a securities
lending program by lending out the plan assets held in the separate
account. Figure 1 shows how securities lending with cash collateral
reinvestment is done through a commingled fund, or when the plan
sponsor is not directly engaging in securities lending. A securities
lending arrangement follows certain steps:
1. Plan participants invest in a CIF or mutual fund. With these
commingled accounts, the plan participants own a share in a pool of
assets held in the account, and the commingled account owns the assets
in the account. The commingled account manager (or mutual fund
provider in the case of a mutual fund) makes the decision about
whether to engage securities lending.
2. The securities lending agent, the keeper of the commingled
account's securities (sometimes the plan's service provider), sets up
an agreement with the account manager of the commingled account (or
the mutual fund provider in the case of a mutual fund) specifying many
things, including the split of the gains from the transactions.
3. The securities lending agent also sets up a Master Securities
Lending Agreement with a broker-dealer, who is seeking to borrow
securities on behalf of a client.
4. The broker-dealer provides cash as collateral to the securities
lending agent, for the length of the agreement, which would specify,
among other things, that the lending agent has responsibility with
respect to the cash collateral.[Footnote 22]
5. The securities lending agent, then, reinvests the cash received
from the broker-dealer to earn an additional return. The lending agent
selects and purchases investments within any guidelines set out in its
lending agreement with the commingled fund. Guidelines for
reinvestment of cash collateral could include the types of investments
allowed and other parameters, such as the credit quality of those
investments. The securities lending agent may reinvest the cash in a
separate account that it or an affiliate manages, or it may reinvest
the cash in a commingled collateral pool managed by a cash collateral
pool manager, which could also be an affiliate of the securities
lending agent. If the lending agent chooses to reinvest the cash in a
commingled collateral pool, the cash collateral pool manager chooses
the investments included in the pool within the investment parameters
of the pool. However, plan sponsors that offer investment options that
engage in securities lending with cash collateral reinvestment are
responsible for ensuring that the investment option is prudent for
their participants and may take steps to monitor the gains and losses.
6. When the broker-dealer returns the security, the lending agent
returns the funds to the broker-dealer on behalf of the plan. Any
gains from the cash collateral reinvestment are split between the
securities lending agent and the plan participant. With a commingled
account, gains and losses from cash collateral reinvestment are passed
through to the participant by increases and decreases in the value of
the participant's shares in the commingled account (i.e., through the
net asset value of the mutual fund shares in the case of a mutual
fund). Before the plan participant receives any return from the cash
collateral pool investments, however, the securities lending agent,
broker-dealer, and cash collateral pool manager will each receive
either a fee or a rebate for their part of the transaction.
Figure 1: Example of a Simple Securities Lending with Cash Collateral
Reinvestment Transaction:
[Refer to PDF for image: illustration]
1) Participant send 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.
Lending shares for additional investment:
4) Acting as a 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.
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.
[End of figure]
A direct securities lending arrangement works in a similar manner as
an indirect securities lending arrangement, except that the plan
sponsor or designated fiduciary has a more direct role. In a direct
securities lending arrangement, such as when a plan offers an index
fund through a separate account for its 401(k) plan participants, the
plan sponsor engages directly with the securities lending agent,
selects investment guidelines for the cash collateral reinvestment,
and monitors the securities lending agent and the gains and losses
from cash collateral reinvestment. Also, the gains and losses are
realized directly by participants, since they own the assets of the
separate account, again after the securities lending agent, broker-
dealer, and cash collateral pool manager have received their fees or
rebates.
Cash Collateral Pool Losses Are Borne By Plan Participants in
Securities Lending Programs While Gains Are Shared:
Participants bear the ultimate risk of loss from the cash collateral
pool investments in the case of securities lending with cash
collateral reinvestment.[Footnote 23] While securities lending agents
may bear counterparty risk from securities lending activities with
cash collateral--i.e., they may 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. This risk remains with plan participants. Figure 2 illustrates
a breakdown of the losses and returns that participants receive, as
well as how and when the securities lending agent, broker-dealer, and
cash collateral pool manager are paid.
Figure 2: 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 in
2008. 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]
In the last few years, risky assets in securities lending cash
collateral pools caused realized losses for participants.[Footnote 24]
These losses occurred because the cash collateral pools' assets lost
value and became difficult to trade.[Footnote 25] As a result of the
losses in the cash collateral pool investments, the pools were not
worth the amount that the investment option needed to return the cash
collateral and pay rebates to borrowers.[Footnote 26] 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.[Footnote 27] For
example, some 401(k) investment options that were registered with SEC,
such as mutual funds, experienced realized and unrealized cash
collateral pool losses, where the realized losses were included in the
net asset value of the registered investment option.
In addition, some cash collateral pool managers invested in assets
that increased the risk of the cash collateral pool investments. 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.[Footnote 28] 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 seeking higher
returns.[Footnote 29]
Securities lending agents also typically do not bear the risk of loss
of the collateral pool, yet they gain when the collateral pool makes
money and, as a result, may have been 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.
Broad cash collateral reinvestment guidelines specified by the plan
sponsor or commingled account manager in the lending agreement with
the securities lending agent may have allowed some securities lending
agents to choose more aggressive reinvestment strategies when more
conservative approaches were available. Some securities lending agents
have 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 30] For
example, in 2008, one of the largest securities lending agents
reported that its revenues from such lending were over $1 billion.
Participants can also earn a return in a securities lending
transaction with cash collateral, but it is not symmetrical to the
loss that participants can incur from cash collateral pool investment
losses. As shown in figure 2, participants only receive a portion of
return, while broker-dealers and securities lending agents may obtain
most of the gains earned on cash collateral reinvestment.[Footnote 31]
Participants also only receive a return 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, if any,
and (2) the broker-dealer as a "rebate." The plan sponsor agrees to a
split of the remaining return between the securities lending agent and
the plan participants in various proportions, such as 80 percent to
the participants, and 20 percent to the securities lending agent. The
amount that the plan receives can serve to offset custody fees and
administrative expenses or to simply enhance participants' portfolio
returns.
More Transparency and Disclosure May Help Plan Participants and Plan
Sponsors Face Challenges with Securities Lending with Cash Collateral
Reinvestment:
Participants Are Unaware of Securities Lending with Cash Collateral
Reinvestment Arrangements and the Risks Such Arrangements Pose to Them:
Participants may be unaware that their 401(k) plan's investments are
utilizing securities lending with cash collateral reinvestment.
Information regarding securities lending with cash collateral
reinvestment is generally buried deeply within the pages of investment
option documents that participants receive. For example, we found, in
one mutual fund's annual report, the fact that the investment option
engages in securities lending was disclosed on page 68 of a 90-page
document. Moreover, as shown in figure 3, documents from an index fund
registered with SEC, disclosed pertinent information about securities
lending on page 14 of a 52-page document of a supplementary document
to a mutual fund's prospectus, which 401(k) plan participants do not
receive automatically.[Footnote 32] Therefore, participants may never
see information on securities lending, and the disclosed information
on securities lending may be embedded in massive documents of varying
degrees in which they would have to know what to look for and also
understand what the documents are disclosing about securities lending.
Furthermore, as written, information regarding securities lending with
cash collateral reinvestment may give the impression that any
financial risk to plan assets is low when this may not be the case.
Figure 3: 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]
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.[Footnote 33]
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. There is nothing in these 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.[Footnote 34]
Without better disclosures about securities lending with cash
collateral reinvestment, participants may continue to be unaware of
the practice of cash collateral reinvestment and the risk it poses to
their 401(k) balances, such as ultimately being responsible for the
risk of loss of the cash collateral pool investments.
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 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, to 15 percent and 5 percent, respectively.
[Footnote 35] However, there are no comparable regulations that limit
the total amount of 401(k) plan assets that can be lent or invested in
illiquid securities.
Plan Sponsors May Not be Aware That Investment Options Utilize
Securities Lending Arrangements or of the Risks Such Arrangements Pose:
Plan sponsors may not know whether their investment options offered to
plan participants engage in securities lending with cash collateral
reinvestment. For example, 17 of the 74 plan sponsors who responded to
our brief poll[Footnote 36] 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. Other industry officials have
expressed similar concerns. One large investment consulting firm
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.
Industry experts told us that many plan sponsors are also 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. 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 37]
SEC and Private Sector Entities Are Seeking to Make Securities Lending
Arrangements More Transparent:
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 38] 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 39] Such rules would result in improved
disclosure in connection with securities lending. 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 40]
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 41] With these changes, they believe
that 401(k) plan participants could receive some protection from the
losses and withdrawal restrictions that they recently experienced.
Despite these efforts, it is unclear whether the improved disclosures
will provide information about the gains and losses from securities
lending to investors and other stakeholders, including plan
participants and plan sponsors. Currently, banking regulators do not
require banks, who are often securities lending agents, 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 42] 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, as we found, revenue specific to securities lending.
GAO Has Recommended Changes Labor Can Make to Help Plan Sponsors and
Participants Better Understand Securities Lending with Cash Collateral
Reinvestment:
In our recently issued report on withdrawal restrictions, GAO made
several recommendations to Labor about actions the Department could
take to help improve transparency on the practice of securities
lending arrangements and assist plan sponsors and participants in
understanding the role, risk, and benefits associated with securities
lending with cash collateral reinvestment. Specifically, we
recommended that Labor:
1. Amend its regulations on plan sponsor disclosure to participants to
include provisions specific to the practice of cash collateral
reinvestment utilized by fund providers' securities lending programs
and provide plan sponsors with guidance alerting them to the risks of
engaging in securities lending with cash collateral reinvestment and
the type of information they should seek from their service providers
about these investments.
2. 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. ERISA already
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.
3. Revise its 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. 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 43] 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 has agreed to consider amending its 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.
Concluding Observations:
Securities lending with cash collateral reinvestment is a complex
arrangement, made all the more so because of the lack of transparency
of how it is done. What at a surface level seems like an easy way to
make money utilizing securities in 401(k) plan assets turns out to be
profitable to plan participants only after there is a positive return
on the cash collateral pool investments and everyone engaged in the
transaction is paid. Not only is the risk of loss unclear to plan
participants, but plan sponsors may also not understand the risks of
these types of arrangements for plan participants. This can be the
case particularly with indirect securities lending arrangements, such
as through a mutual fund, as plan sponsors never see the gains or
losses of such arrangements because they are passed along to
participants through the net asset value of the mutual funds shares.
Currently, plan sponsors and participants are minor participants in
securities lending arrangements, yet ultimately bear the risk of loss
from the cash collateral reinvestment.
It is clear that plan sponsors and participants need more transparent
information about how securities lending arrangements work and a
better understanding of the gains and losses from cash collateral pool
investments that affect plan assets, and ultimately plan participants.
Financial regulators and industry participants are beginning to make
changes that can help plan sponsors fulfill their obligations. Labor
can also takes steps to assist plan sponsors. Without more
transparency and better understanding, securities lending arrangements
with cash collateral reinvestment will continue as is, whereas plan
sponsors and participants will remain, in some cases, unaware of these
arrangements and the risk of loss they pose.
Mr. Chairman and Members of the Committee, this concludes my prepared
statement. I would be happy to respond to any questions.
GAO Contact and Staff Acknowledgments:
For further information about this testimony, please contact Charles
A. Jeszeck at (202) 512-7215 or jeszeckc@gao.gov. Contact points for
our Offices of Congressional Relations and Public Affairs may be found
on the last page of this testimony. Tamara Cross, Assistant Director;
Monika Gomez; Jessica Gray; James Bennett; Susannah Compton; Sheila
McCoy; Roger Thomas; and Walter Vance were key contributors to this
testimony.
[End of section]
Footnotes:
[1] 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.
[2] 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.
[3] Equity funds consist of pooled investments--including mutual funds
and collective investment funds (a bank-administered trust that holds
commingled assets that meet specific criteria)--that are primarily
invested in stocks.
[4] GAO, 401(k) Plans: Certain Investment Options and Practices That
May Restrict Withdrawals Not Widely Understood, [hyperlink,
http://www.gao.gov/products/GAO-11-291] (Washington, D.C.: Mar. 10,
2011).
[5] 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.
[6] In 2010, the federal limit for pretax contributions to 401(k)
accounts was $16,500, and for those 50 and over, an additional $5,500
"catch-up" contribution.
[7] 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).
[8] Labor's proposed regulations, as 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).
[9] IRS also oversees various aspects of 401(k) contributions under
the Internal Revenue Code.
[10] 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.
[11] 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 owner 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 investment vehicles for
employee benefit accounts, including 401(k) plans. 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).
[12] 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.
[13] 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.
[14] There are many types of 401(k) investment options, including real
estate, mutual funds, money market funds, CIFs, balanced funds, and
stable value funds. Labor reports that, in recent years, there has
been a dramatic increase in the number of investment options typically
offered under 401(k) plans. ERISA does not prohibit a plan from
offering any type of investment to its participants, but it gives plan
sponsors flexibility to choose the investments to be offered through
their 401(k) plans. Specifically, Title I of ERISA does not proscribe
or prohibit types of investment products or options, but plan sponsors
must conduct due diligence and prudently select the investment options
they want to offer their participants.
[15] 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).
[16] 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.
[17] ERISA provides a number of detailed exemptions to its prohibited
transaction provisions and permits Labor to establish additional ones.
29 U.S.C. §1108.
[18] 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. However, according to Labor, the exemption does not
address or provide any relief for the reinvestment of cash collateral.
[19] Participants also still retain all the benefits of ownership of
the lent securities, including rights to dividends, interest payments,
corporate actions (excluding proxy voting), and market exposure to
unrealized capital gains or losses.
[20] Collateral for the loan could also be securities; however,
throughout the testimony we describe securities lending when cash is
taken as collateral for the loan since it is the primary form of
collateral accepted in the United States.
[21] 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.
[22] 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.
[23] 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.
[24] 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. While lending agreements between sponsors and
securities lending agents are typically set up to specify investment
guidelines for investing the cash collateral, some investment
guidelines were very broad and therefore provided some discretion to
the lending agent or cash collateral pool manager.
[25] Losses may have been realized or unrealized. Realized losses are
generally reflected as a decline in the value of the investment
option, whereas unrealized losses are generally not reflected in the
value of the investment option until realized.
[26] 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.
[27] Christine Williamson, "Pension Funds Stung By Securities Lending
Mess," Pensions and Investments (New York, N.Y.: Feb. 9, 2009).
[28] 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."
[29] 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.
[30] The lending agent typically absorbs the operational expenses
associated with providing the service.
[31] 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.
[32] 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. In general,
401(k) plan participants do not receive the SAI or the prospectus
automatically, although plan sponsors do receive a prospectus, as do
retail investors. There was also a 37-page annual report, as well as a
40-page prospectus for the index fund.
[33] 29 C.F.R. § 2550.404c-1.
[34] Between 2007 and 2010, some plan sponsors and participants were
restricted from withdrawing their plan assets from certain 401(k)
investment options, for various reasons. Withdrawal restrictions, in
general, may have prevented some realized losses during the period of
the restrictions.
[35] 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.
[36] GAO conducted a poll 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 74 members who responded to our poll.
[37] We have not verified the status of any of these cases.
[38] 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.
[39] Pub. L. No. 111-203, § 984(b), 124 Stat. 1376, 1933 (2010),
codified at 15 U.S.C. § 78j note. The new act does not limit the
authority of the federal banking agencies to also prescribe rules
regarding the loan or borrowing of securities.
[40] 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.
[41] SEC's rule 2a-7, which governs money market funds, requires that
these 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 1 business day, and 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.
[42] 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.
[43] 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.
[End of section]
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