Yesterday, the Senate Panel on Aging held a hearing entitled, "Securities Lending in Retirement Plans: Why the Banks Win, Even When You Lose," which interviewed market participants and which discussed the results of a report, "Securities Lending with Cash Collateral Reinvestment in Retirement Plans: Withdrawal Restrictions and Risk Raise Concerns". Senator Herb Kohl, Chairman of the panel, introduced the topic, saying, "In recent years, most workers have seen their savings take a hit, leaving many to wonder if they will ever be able to retire. The gap between what Americans will need in retirement and what they will actually have saved is estimated to be a staggering 6.6 trillion dollars. Now more than ever, we need to strengthen and protect our pension and 401(k) systems. That is why we are examining securities lending within retirement plans."

He explains, "In simple terms, securities lending is when a plan lends some of its stocks and bonds to a third party in exchange for cash as collateral that is then reinvested. Many plans participate in securities lending to generate a little extra revenue. For many years it seemed that there were only benefits to these arrangements for all sides. The economic downturn showed that securities lending is not a free lunch.... Securities lending is a complex financial transaction that goes on every day, often without employers and employees even knowing it is going on within their plans. And if they are aware, many do not understand the added risk. And ultimately that risk lies with 401(k) participants because banks share the cash collateral profits but not the losses -- so the banks always win."

Kohl adds, "Last November, this Committee began an investigation of the securities lending market which is being released today. We surveyed employers that sponsored the 30 largest 401(k) plans and found that all had at least one investment option that engaged in securities lending at some time in the previous five years. However, after the downturn, five of these employers stopped participating in securities lending. The Committee also surveyed the seven largest banks in the securities lending market. In 2010, these seven banks provided services to 570 different employer-sponsored plans with a total, of roughly $1.3 trillion in assets."

A separate GAO Report, "401k Plans: Issues Involving Securities Lending in Plan Investments,", explains, "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."

Their report concludes, "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."

Steven Meier, Chief Investment Officer of Global Cash Management for State Street Global Advisors, told the panel in his testimony, "At State Street, we believe that securities lending can play a role in the development of a balanced investment program for professionally managed retirement plans. As you know, employee retirement plans typically earn dividends and interest from the plan's investment portfolio. However, if participants choose to invest in a plan option that engages in securities lending, the investment portfolio can earn additional incremental income. While the amount of this incremental income varies by portfolio and depends upon a number of factors such as prevailing interest rates and spreads between Federal funds and other credits, this incremental income can be significant."

He explains, "As this Committee is aware, the events of the recent global financial crisis that began in 2007 and worsened in 2008 were unprecedented. Our nation experienced a liquidity crisis in the fixed income sector as the secondary market for such securities essentially ceased functioning. Within the span of a few days in September 2008, we witnessed the failure of long-standing financial institutions and a large SEC-registered money market fund.... These events impacted lenders of securities in several ways, including a significant drain of liquidity from their cash collateral investment pools.... [D]uring the period from June 2008 to December 2008, State Street managed a nearly 50% decline in outstanding loan balances without any 401(k) plan investor invested in a Lending Fund realizing a loss due to a lack of cash collateral pool liquidity. However, this series of events caused significant impacts on cash collateral vehicles."

Meier adds, "Depending on their risk profiles and return objectives, collateral vehicles own assets of varying levels of liquidity, ranging from short-term cash and cash equivalents to high quality medium and long-term assets such as asset-backed securities and unsecured debt. If redemptions from a cash collateral vehicle (due to ongoing legal obligations to borrowers under the securities lending arrangement) exceed the vehicle's cash and cash equivalents and additional liquidity is required to meet its participants' obligations, the manager of the cash collateral vehicle will be forced to sell medium- and long-term assets to raise liquidity. In the market environment of 2008, such an imbalance made it virtually impossible to sell these assets, and if sales were possible, would have caused managers to sell assets at a substantial loss that did not reflect the intrinsic value of those securities, but rather reflected short-term illiquidity and unprecedented spread volatility in the markets."

Finally, he says, "State Street acted cautiously and thoughtfully to protect the interests of all of our securities lending clients. As a result, our Lending Fund investors did not incur any realized losses in connection with cash collateral reinvestment, unless they chose to take an in-kind distribution of securities and sell them at a loss. We are particularly proud of the way State Street has managed its securities lending program during the financial crisis over the last several years: We maintained 401(k) plan participants' full, unrestricted rights to make withdrawals from their retirement savings invested in Lending Funds; Due to our prudent management, none of the cash collateral pools realized material credit losses. As Chief Investment Officer, Global Cash management, I am particularly proud of this fact. We avoided the sale of strong credits into a distressed market and reinvested cash flow in highly liquid, short-term securities for a period of approximately one year before Lehman's default, building up the short-term liquidity in our cash collateral vehicles and managing the vehicles in an increasingly conservative manner."

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