The often-opaque world of securities lending may get clearer soon for retirement plan sponsors and participants.
Following a March 16 Congressional hearing on securities lending in retirement plans held by the Senate Special Committee on Aging, some changes appear likely. A committee majority staff investigation that surveyed the 30 largest 401(k) sponsors and the seven largest banks in the securities-lending market uncovered what its report called troubling results about restrictions on defined benefit and defined contribution plans’ ability to exit funds that do securities lending. And in 401(k) plans, the report says, “participants bear the ultimate risk of loss from the cash collateral pool investments,” but “in the event that there are gains from the investments of the cash collateral pool, participants generally share the gain with securities lending service providers, including broker-dealers and securities lending agents.” Two of the experts who testified talked subsequently about changes that may result from the hearing.
Most likely, new regulations could come out to help ensure that more people have a grasp of how these programs work. “For plan participants, that does not appear to be the case,” says Charles Jeszeck, acting director of education, workforce and income security at the Government Accountability Office (GAO). “And we were shocked that a number of plan sponsors who are otherwise very diligent did not realize that securities lending was going on with some of their plan’s investments.”
For plan sponsors, guidance could alert them to securities lending’s risks and tell them information they should seek when approaching securities-lending agents, Jeszeck says. And participants should get a very basic sense of securities lending and if their investments do it. “For a lot of participants, neither of these two conditions are present,” he says. “You could say, ‘These options in your plan engage in this,’ and explain that there is potential for greater gains and potential for losing money.”
But establishing strict parameters around these programs, such as limits on a specific percentage or dollar amount that a retirement plan can make available for securities lending, seems unlikely at this point. GAO favors the Labor Department modifying ERISA (Employee Retirement Income Security Act) prohibited-transaction rule guidelines as they apply to securities lending, so that providers do not gain unreasonably on securities lending at the expense of participants. But Jeszeck says Labor Department officials have not expressed much enthusiasm for changing the prohibited-transaction rules in this case.
“I do not think you can find a one-size-fits-all” for establishing strict parameters, says Anthony Nazzaro, principal at A.A. Nazzaro Associates, a securities lending manager and consultant. The prudent parameters vary depending on the size and sophistication of a sponsor’s plan and lending program, he adds.
Nazzaro has four recommendations for plan sponsors to help avoid problems with their securities-lending programs. First, in addition to a securities-lending agreement, have a written investment-manager agreement to cover securities lending. “I do not think that people realize what authority they are putting on this securities-lending agent” for investments, he says. This sets a higher duty and standard of care.
Second, have stringent guidelines for reinvestment of cash collateral, such as investment type and duration. “Typically, part of the securities-lending agreement may have an addendum with investment guidelines, but they often are very broadly drafted,” Nazzaro says. “Banks may buy four-, five-, or six-year paper for essentially overnight kinds of transactions. They are doing that to capture more yield, but they also are taking on more risk.” Third, put limits on the amount or value of securities that can be loaned, to limit the portfolio’s exposure. In many cases, sponsors’ lending programs have had no stated limits, he says.
Fourth, get daily reports on valuation of the cash collateral corresponding to the securities lending loan balances. “I do not think they do it on a daily basis,” Nazzaro says. “There have been cases where it was even quarterly. But the technology is there now, and the lending agent has daily reports on the cash collateral.” Sponsors should regularly track how much their program actually has on loan, and if the cash collateral value needed is being maintained, he says.
