    [Senate Hearing 112-62]
    [From the U.S. Government Publishing Office]

                                                             S. Hrg. 112-62

     SECURITIES LENDING IN RETIREMENT PLANS: WHY THE BANKS WIN, EVEN WHEN
                                    YOU LOSE

    =======================================================================

                                    HEARING

                                   BEFORE THE

                           SPECIAL COMMITTEE ON AGING

                              UNITED STATES SENATE

                          ONE HUNDRED TWELFTH CONGRESS

                                 FIRST SESSION

                                   __________

                                 WASHINGTON, DC

                                   __________

                                 MARCH 16, 2011

                                   __________

                                Serial No. 112-3

             Printed for the use of the Special Committee on Aging

             Available via the World Wide Web: http://www.fdsys.gov

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                           SPECIAL COMMITTEE ON AGING

                         HERB KOHL, Wisconsin, Chairman

    RON WYDEN, Oregon                    BOB CORKER, Tennessee
    BILL NELSON, Florida                 SUSAN COLLINS, Maine
    BOB CASEY, Pennsylvania              ORRIN HATCH, Utah
    CLAIRE McCASKILL, Missouri           MARK KIRK III, Illnois
    SHELDON WHITEHOUSE, Rhode Island     JERRY MORAN, Kansas
    MARK UDAL, Colorado                  RONALD H. JOHNSON, Wisconsin
    MICHAEL BENNET, Colorado             KELLY AYOTTE, New Hampshire
    KRISTEN GILLIBRAND, New York         RICHARD SHELBY, Alabama
    JOE MANCHIN III, West Virginia       LINDSEY GRAHAM, South Carolina
    RICHARD BLUMENTHAL, Connecticut      SAXBY CHAMBLISS, Georgia
                                  ----------
                     Debra Whitman, Majority Staff Director
                 Michael Bassett, Ranking Member Staff Director

                                    CONTENTS

                                  ----------

                                                                       Page

    Opening Statement of Senator Kohl................................     1
    Statement of Senator Corker......................................     2

                               PANEL OF WITNESSES

    Statement of Charles Jeszeck, Acting Director, Education,
      Workforce and Income Security, Government Accountability
      Office, Washington, DC.........................................     3
    Statement of Anthony Nazzaro, Principal, A. A. Nazzaro
      Associates, Yardley, PA........................................     5
    Statement of Ed Blount, Executive Director, Center for the Study
      of Financial Market Evolution, Washington, DC..................     7
    Statement of Allison Klausner, Assistant General Counsel-
      Benefits, Honeywell International, Inc., Morristown, NJ........     8
    Statement of Steven Meier, Chief Investment Officer, Global Cash
      Management, State Street Global Advisors, Boston, MA...........    10

                                    APPENDIX
                       Witness Statements for the Record:

    Charles A. Jeszeck, Acting Director, Education, Workforce and
      Income Security, Government Accountability Office, Washington,
      DC.............................................................    28
    Anthony Nazzaro, Principal, A. A. Nazzaro Associates, Yardley, PA    56
    Ed Blount, Executive Director, Center for the Study of Financial
      Market Evolution, Washington, DC...............................    59
    Allison Klausner, Assistant General Counsel - Benefits, Honeywell
      International, Inc., Morristown, NJ............................    70
    Steven Meier, Chief Investment Officer, Global Cash Management,
      State Street Global Advisors, Boston, MA.......................    74

                        Additional Committee Documents:

    Government Accountability Report to the Chairman: 401(k) Plans,
      Certain Investment Options and Practices That May Restrict
      Withdrawals Not Widely Understood..............................    82
    Summary of Committee Research: Securities Lending with Cash
      Collateral Reinvestment in Retirement Plans: Withdrawal
      Restrictions and Risk Raise Concerns...........................   155

                 Additional Statement Submitted for the Record:

    ING Investment Management-US.....................................   184

     SECURITIES LENDING IN RETIREMENT PLANS: WHY THE BANKS WIN, EVEN WHEN
                                    YOU LOSE

                                  ----------

                           WEDNESDAY, MARCH 16, 2011

                                           U.S. Senate,
                                    Special Committee on Aging,
                                                        Washington, DC.
        The Committee met, pursuant to notice, at 2:02 p.m. in Room
    SH-216, Dirksen Senate Office Building, Hon. Herb Kohl,
    Chairman of the Committee, presiding.
        Present: Senators Kohl [presiding], Manchin, Blumenthal,
    and Corker.

            OPENING STATEMENT OF SENATOR HERB KOHL, CHAIRMAN

        The Chairman. Good afternoon. I would like to welcome our
    witnesses and welcome everyone attending today's hearing.
        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.
        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.
        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.
        It was upsetting to hear reports about some 401(k)
    participants actually losing money within their 401(k) accounts
    due to these practices. Some employers were restricted from
    accessing their worker's retirement savings in investments that
    lent securities. This is troubling because employers are
    required by law to be able to change the investment options
    offered in their 401(k) plans.
        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.
        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.
        I hope today's hearing and our committee report will shed
    some light on securities lending within retirement plans, and
    the benefits and the risk associated with it.
        We'll start our hearing with a review of the findings of a
    new GAO report showing that securities lending is not widely
    understood by employers or workers. We'll then hear experts on
    securities lending and the reason why employers are
    reconsidering their participation in securities lending within
    their 401(k) plan. Finally, we'll hear from one of the major
    providers of securities lending services.
        We thank you all again for being here today. We look
    forward to your testimony and a productive dialogue.
        And at this point, we'll turn to my colleague, the ranking
    member, Senator Corker.

                      STATEMENT OF SENATOR CORKER

        Senator Corker. Thank you, Mr. Chairman, and thanks for
    calling this meeting. And to all of you who are going to
    educate us here in just a moment, we thank you for being here,
    and looking forward to your testimony.
        We are here today to talk about securities lending and
    401(k) plans and the events that occurred during the crisis of
    2008.
        Because of liquidity constraints in the marketplace, gates
    were put in place essentially to protect people from having
    immediate access to funds being held in 401(k) plans. And
    unfortunately some people did not understand why they could not
    access their funds when they wanted to.
        Defined contribution plans are taking over as a major
    source of revenue for our retiring Americans, and so it is
    important to understand how they work in a properly functioning
    marketplace, and also to understand what happened during the
    financial crisis to understand what may or may not have gone
    wrong.
        As is typical in the aftermath of a financial crisis, the
    industry has improved. The leading agents and collateral
    managers have largely self-adjusted since the crisis. They have
    learned to adjust client investment objectives in collateral so
    that they are more liquid, less exposed to interest rate and
    credit risk by using more conservative investment models.
        One of the things we need to be careful about is not to
    overregulate, but to preserve competition and choice in
    retirement savings plans for beneficiaries. If we overregulate,
    there is a danger that the only options for beneficiaries will
    be lower yielding options. And there is always risk obviously
    involved when you try to seek those higher returns.
        A better informed consumer is good, but we need to make
    sure that we are not just piling on more disclosures that
    consumers do not understand or read. We need to make sure that
    we are not needlessly regulating where the market is already
    corrected or where other laws and rules may be already
    addressing concerns. More disclosure is not always better, but
    certainly more meaningful disclosure could be very good.
        I am here today to learn from the witnesses testifying
    before us. I look forward to reading the majority report on
    securities lending. I think it is being released right now, as
    a matter of fact.
        I urge all of us to take time to consider the majority's
    report, the GAO report, being publicly released today, as well
    as all of the laws we recently passed as part of the Dodd-Frank
    Wall Street Reform and Consumer Protection Law.
        Securities lending may pose risk, but it can increase
    yield. So let us be careful about how we proceed forward in
    order to preserve competition in the marketplace, allow
    functioning markets to flourish, and promote choice for all
    participants.
        And, again, thank all of you for being here.
        The Chairman. Thank you very much, Senator Corker.
        Our first witness today will be Charlie Jeszeck, who is
    acting director in the Government Accountability Office,
    Education, Workforce and Income Security team. Throughout his
    26-year career at GAO, Mr. Jeszeck has focused on health care,
    unemployment insurance, private pensions, and social security.
        Next, we will be hearing from Anthony Nazzaro, who is
    principal of A.A. Nazzaro Associates, a securities lending
    manager and consulting firm in operation since 1987. Mr.
    Nazzaro has worked in the securities lending industry for 35
    years.
        The third witness will be Ed Blount, Executive Director of
    the Center for the Study of Financial Market Evolution. The
    organization works with practitioners, academics, trade groups,
    and regulators to analyze practices in capital market sectors
    that have developed ahead of formal disclosure and reporting
    standards.
        The fourth witness today will be Allison Klausner. Ms.
    Klausner is the Assistant General Counsel-Benefits for
    Honeywell International. Ms. Klausner is responsible for legal
    matters relating to employee benefits at Honeywell within the
    United States and also worldwide.
        Finally, we will be hearing from Steve Meier, Chief
    Investment Officer, Global Cash Management, for State Street
    Global Advisors. Mr. Meier joined State Street in 2003. He has
    more than 27 years of experience in the global cash and fixed
    income markets.
        We thank you all for being here today. And we will start
    with you, Mr. Jeszeck.

       STATEMENT OF CHARLES JESZECK, ACTING DIRECTOR, EDUCATION,
       WORKFORCE AND INCOME SECURITY, GOVERNMENT ACCOUNTABILITY
                         OFFICE, WASHINGTON, DC

        Mr. Jeszeck. Mr. Chairman and members of the committee,
    thank you for inviting me here today to discuss the practice of
    securities lending with cash collateral reinvestment. My
    comments will focus on how these transactions occur in the
    context of 401(k) plans. While this practice appears to be an
    easy way for plans to make money, these transactions are
    complex and pose challenges both to plan sponsors and
    participants.
        Before I continue, it is important to note that 401(k)
    plans are now the dominant retirement savings plan in the
    United States with over 49 million participants and plan assets
    of $2.8 trillion. In our view, to foster national retirement
    security in the 401(k) model, both sponsors and participants,
    at a minimum, need to have the information necessary to enable
    sound, prudent decision making.
        Securities lending in 401(k) plans is a transaction where
    assets held in 401(k) investment options are lent to third
    parties, typically in return for cash, which is held as
    collateral. The idea is that by reinvesting this cash, greater
    returns can be earned for plan participants.
        Many 401(k) investments that engage in securities lending
    pool their money into commingled or pooled accounts. These
    accounts are designed to combine assets of unrelated plans to
    facilitate diversification and gain the cost advantages of
    larger plans. While larger 401(k) plan sponsors may maintain
    separate investment accounts and can choose directly to
    participate in securities lending, it is the commingled account
    manager, not the plan sponsor, that makes that decision for
    commingled funds.
        The figure to my left provides a basic example of a
    securities lending transaction with a commingled account.
    First, a plan sponsor sends contributions to the service
    provider or account manager administering a commingled account.
    The account manager then negotiates with the securities lending
    agent the terms of the transaction, including the split of any
    gains. The securities lending agent then negotiates with a
    broker-dealer who is seeking to borrow securities for a client.
    The broker-dealer provides cash as collateral for the borrowed
    security to the securities lending agent for the length of the
    agreement. The broker-dealer earns a rebate or interest on the
    cash collateral being lent.
        The securities lending agent then works with a cash
    collateral pool manager, who may be affiliated with the lending
    agent, to reinvest the cash. The pool manager earns a fee for
    investing this cash. When the transaction is completed, the
    assets are returned to the original parties.
        As shown in the figure on my right, after the broker-dealer
    and the cash collateral pool manager have received their fees,
    the securities lending agent and the commingled fund split any
    gains from the transaction. For the participants, these gains
    are reflected directly in the values of the shares in the
    commingled account.
        It is important to note that the split is asymmetric. While
    the gains are shared between the plan participant and the
    securities lending agent--in our example, the split is 80/20 in
    favor of the participant--the investment losses are borne only
    by the participant; thus, a symmetry can also create an
    incentive for the cash collateral pool manager to seek riskier
    investments as they do not bear the investment loss.
        Securities lending transactions poses challenges for plan
    participants and sponsors alike. Participants may be unaware
    that their plan investments are utilized in securities lending
    transactions. We found that information about such transactions
    is often buried deeply within investment option documents,
    documents which, in many cases, may not even be received by
    participants. New disclosure regulations by Labor may not be
    helpful because they focus on information about investment
    options, such as information on fees paid, and not the
    practices employed by those options, like securities lending.
        Plan sponsors may also be unaware or not fully understand
    the risks involved in securities lending transactions. This
    might be particularly the case for smaller plans with
    commingled funds who may not be as sophisticated as larger plan
    sponsors. This view is echoed by industry experts with whom we
    spoke.
        The SEC, FINRA, and the industry itself are already taking
    steps to address issues related to securities lending. GAO has
    made recommendations to Labor that we believe will enhance
    disclosure and transparency for both sponsors and participants,
    and assist in a negotiation of these transactions.
        That concludes my statement, Mr. Chairman. I am happy to
    answer any questions that you or other members may have.
        [The prepared statement of Mr. Jeszeck appears in the
    Appendix on page 28.]
        The Chairman. Thank you very much, Mr. Jeszeck.
        Now we'll hear from Mr. Nazzaro.

        STATEMENT OF ANTHONY NAZZARO, PRINCIPAL, A. A. NAZZARO
                        ASSOCIATES, YARDLEY, PA

        Mr. Nazzaro. Good afternoon. My name is Anthony Nazzaro. I
    am the principal and owner of A. A. Nazzaro Associates. We are
    a securities lending manager and consulting group in operation
    since 1987.
        I would first like to thank Chairman Kohl, Ranking Member
    Corker, and the members of the committee for the opportunity to
    appear before you today. It is a wonderful honor and a
    privilege for me to do so.
        I believe I was invited to appear and give testimony
    because of my experience and the longevity of my career in the
    securities lending industry. My participation in this industry
    spans some 35 years in roles ranging from an in-house lender at
    Yale University, to a custodian agent lender for the pension
    funds of the Commonwealth of Pennsylvania, to a present status
    as an independent manager for university and foundation
    endowments. It is my hope that I can offer some perspective,
    insight, and constructive counsel for pension funds, which
    represent a large segment of the beneficial owners
    participating as lenders of securities.
        Many large pension funds that participate in securities
    lending choose to do so through an agent lender, such as their
    custodian bank. It is my sense that, when a fund enters into an
    agreement with its agent lender, the fund may not fully
    appreciate or understand that it has also hired an investment
    manager. Many times the fund may be focused upon the lending of
    securities side of the equation and less upon the reinvestment
    of cash collateral. As a result, the focus or scrutiny is more
    heavily weighted toward the counterparty risk of the borrower
    and overshadows or obscures the reinvestment risk. This may
    result in less scrutiny of the cash collateral investment
    guidelines proffered by the agent lender. In addition, given
    the wide ranging of authority of the agent lender over all
    lendable assets and the reinvestment of cash collateral, the
    size of the assets held in the cash collateral portfolio may
    grow to become the largest portfolio in the funds universe, and
    the agent lender may become its largest investment manager.
        The omission or failure to perceive an agent lender as an
    investment manager may result in a lack of sufficient reporting
    and oversight of the cash collateral portfolio, and an
    assumption that the reinvestment of cash is part of the agent's
    custodial function in the management of the securities lending
    program. The danger and risk in this perception was brought to
    light and exposed during the recent financial crisis and brings
    us here today.
        The reason I'm highlighting this issue is because I believe
    there are some basic steps that can be taken to protect pension
    funds and limit their risk.
        Step one, documentation. In addition to the execution of a
    securities lending agency agreement, which is standard
    documentation, pension funds should execute an investment
    manager agreement. This elevates the duty and standard of care
    by the agent lender/investment manager. The investment reports
    would receive a heightened degree of visibility and are more
    likely to come within the purview of those persons or
    committees with oversight at the pension fund.
        Step two, investment guidelines for cash collateral.
    Implementation of stringent guidelines for the reinvestment of
    cash collateral similar to those of a Rule 2a-7 money market
    fund. This would limit holdings in the portfolio to only
    securities of high credit quality, high liquidity, shortened
    duration, or weighted average maturity.
        Step three, reporting and valuation. Receipt of daily
    reports as to the valuation of the cash collateral
    corresponding to the securities lending loan balances. The
    value of the cash collateral portfolio report should be equal
    to or close to the 102 percent collateralization required for
    loans and received from counterparty borrowers.
        Step four, limits upon program participation.
    Implementation of a limit or cap upon the amount or value of
    securities which may be loaned in order to reduce exposure of a
    portfolio. This limit may be expressed as a specific dollar
    amount or as a percentage of the total assets.
        The above recommendations are four steps that pension funds
    can implement that I believe would be both constructive and
    prudent. It is my opinion that implementation of some or all of
    these steps could have mitigated the problems that funds
    experienced during the financial crisis.
        Thank you.
        [The prepared statement of Mr. Nazzaro appears in the
    Appendix on page 56.]
        The Chairman. Thank you very much, Mr. Nazzaro.
        Mr. Blount, we would like to hear from you.

      STATEMENT OF ED BLOUNT, EXECUTIVE DIRECTOR, CENTER FOR THE
          STUDY OF FINANCIAL MARKET EVOLUTION, WASHINGTON, DC

        Mr. Blount. Chairman Kohl, Ranking Member Corker, and
    members of the committee, thank you for the opportunity to
    share a few thoughts with you today.
        I approach this issue with the perspective gained from 35
    years of varied roles in the securities lending community, and
    the experience gained from having built and then sold a
    profitable business that pioneered the analysis of performance
    measurement for securities lending programs.
        On the surface, the problems cited by the GAO report appear
    to be a lender side issue; that is, the cash collateral lock
    ups that froze the assets of 401(k) defined contribution
    participants and others during and for up to a year after the
    crisis. However, this is really an issue for the entire
    investment community.
        The effect of restrictions on the supply of lendable
    securities could quickly degrade the liquidity and efficiency
    of U.S. capital markets by raising the risks of settlement
    failures and increasing the capital charges for brokers with
    customer segregation deficits.
        In particular, restrictive actions of regulators affecting
    the lendable supply of securities could well impair the ability
    of pension plan sponsors to offer passive index funds and to
    hedge actively managed portfolios. The reduced availability of
    index funds and hedges in turn would increase portfolio risks
    and threaten the investment returns that pension beneficiaries
    need and expect.
        At a very fundamental level, securities lenders help to
    make the markets more efficient. This has been documented in a
    number of reports by international regulators.
        And the supply of lendable securities is highly sensitive
    to the actions of Federal regulators. I would cite the 1981
    decision of the Department of Labor to amend the prohibited
    transactions exemption as one example of this.
        But let me pause here for a minute. If I say that
    securities lending is important, I do not mean to say that
    problems do not exist in the lending community, nor do I intend
    my comments to be taken as a defense of the status quo such
    that pensioners might once again be deprived of access to their
    own funds in the uncertain days of financial crisis.
        However, the cause of the lockups was the illiquidity of
    certain asset-backed securities, which were included in the
    cash collateral pools of those funds that lent out their
    securities. In that regard, the problems of securities lenders
    and their investor beneficiaries are the same as those of many
    other commingled funds in the United States during the recent
    market crisis. During that crisis, the suddenly illiquid
    individual beneficiaries of defined contribution plan accounts
    absorbed the effects of investment choices made by others; that
    is, their plan sponsors and cash managers. Unfortunately, DC
    plan sponsors, unlike defined benefit plan sponsors, have no
    financial incentive to increase investment revenue, such as
    securities lending income for their participants.
        Plan participants gained the income from securities lending
    while their administrators merely gain more work and more risk.
    As a result, it is easier for DC plan sponsors to simply reject
    as investment options those mutual funds which lend rather than
    learn how to evaluate the ways in which risks and securities
    lending evolve as market conditions change, so as to help
    participants fine tune their exposures.
        Such a decision appears now to have been made by many plan
    sponsors, whose management mandates routinely reject the
    possibility of income from securities lending services. As a
    result, the investment performance of DB plans is exceeding
    that of DC plans, even when offered by the same corporate plan
    sponsor. In effect, we are creating a yield deviation between
    DC and DB plans where there is not a good reason for it.
        Going forward, however, it will be necessary to construct a
    framework which more closely aligns the interests and
    responsibilities of all those in the DC plan securities lending
    community without unnecessarily impairing the ability of the
    market system to contribute to the welfare of both DC and DB
    plan beneficiaries.
        Among the changes that I believe are necessary are an
    improvement and extension of the disclosure regime for
    securities lending cash managers. Furthermore, I believe that
    an expert council should be established to define the limits of
    prudence for collateral cash managers, one that is based on
    close monitoring of changing market conditions. I do not--or I
    do believe that educational programs should be funded by the
    securities lending community, not the government, through
    incentives, such as capital charge credits, and then provide it
    to DC plan sponsors and participants as a way of improving the
    awareness of their own responsibilities and those of their
    service providers.
        In conclusion, if all members of the service provider
    community fulfill their responsibilities, I do not believe that
    new legislation or regulatory actions will be necessary. The
    cash lockups of the financial crisis were not attributable to a
    failure of securities lending.
        Thank you.
        [The prepared statement of Mr. Blount appears in the
    Appendix on page 59.]
        The Chairman. Thank you very much, Mr. Blount.
        Ms. Klausner.

       STATEMENT OF ALLISON KLAUSNER, ASSISTANT GENERAL COUNSEL-
        BENEFITS, HONEYWELL INTERNATIONAL, INC., MORRISTOWN, NJ

        Ms. Klausner. Thank you.
        My name is Allison Klausner, and I am the Assistant General
    Counsel-Benefits for Honeywell. On behalf of Honeywell, a
    Fortune 50 company, I want to express Honeywell's appreciation
    of Chairman Kohl's and Senator Corker's desire to understand
    the practice of securities lending in the context of employer-
    sponsored defined contribution plans.
        I understand that my testimony today has been requested to
    provide the Senate Special Committee on Aging with insight into
    how one plan sponsor's fiduciary committee has addressed
    securities lending issues.
        Over the years, securities lending has provided tremendous
    value to participants and beneficiaries of employer-sponsored
    DC plans, including those with employee deferrals and
    contributions. I encourage the Senate Special Committee on
    Aging to recognize that, if unnecessary actions are taken to
    restrict fiduciaries from offering securities lending funds in
    defined contribution plans, plan participants and retirees may
    lose valuable opportunities, now and in the future, as they
    strive to maximize retirement security.
        Honeywell's primary defined contribution plan is a fairly
    typical 401(k) plan. Participants are permitted to direct the
    investment of their deferrals and contributions, as well as
    their vested matching contributions. They have the opportunity
    to select from a robust range of asset classes with varying
    potential risks and rewards.
        The Honeywell Savings Plan Investment Committee is a
    fiduciary committee consisting of five professionals at
    Honeywell. Two of the current committee members dedicate
    significantly all of their time addressing issues relating to
    ERISA plan assets, one of whom does exclusively for the
    company's defined contribution plans. All the members have
    fiduciary education and are counseled on an ongoing basis with
    regard to their fiduciary duties.
        The Honeywell committee members understand that
    satisfaction of their fiduciary duties is critical to
    supporting a long-term retirement security of the plan's
    participants and the company's retirees. The company members
    recognize they must engage in a prudent process, which
    considers many factors when selecting and evaluating investment
    funds, including, but not limited to, whether it has a
    securities lending component.
        I encourage the Senate committee to consider that the
    matter of whether defined contribution plan assets are invested
    in securities lending funds is one that should be evaluated in
    the context of the fiduciary process.
        A fiduciary's process in selecting a fund will be based on
    many considerations: fees to be charged by the investment
    manager, the type of fund, the asset class, the past
    performance, and the plan's complete fund line-up.
        Securities lending funds in the Honeywell defined
    contribution plans fund line-up has in fact supported many
    participants' retirement goals as those investment funds
    typically charge lower fees than comparable non-securities
    lending funds and historically had investment gains that
    contributed to the investment returns for the assets invested
    in such funds.
        The take away is that, depending upon facts and
    circumstances, offering defined contribution plan participants
    the opportunity to invest in securities lending funds can
    indeed be a prudent decision.
        Notwithstanding the potential benefits, the Honeywell
    Savings Investment Committee did determine in October of 2008
    to transition from securities lending funds to nonsecurities
    lending funds. The committee recognized that the then economic
    climate, and that which was anticipated in the then near
    future, and the gatekeeping measures which were being
    implemented, weighed against continuing to offer securities
    lending funds for investment of defined contribution plan
    assets.
        Although the plan's fiduciaries understood that the
    gatekeeping measures were purportedly designed to stem the
    possibility that there would be a run on the bank within the
    sec lending programs, and that the gatekeeping measures did, in
    fact, achieve such goal, the gatekeeping measures did handcuff
    plan fiduciaries and restricted them from making decisions,
    which could have impacted plan participants' opportunity to
    maximize retirement security.
        Today's legislative and regulatory framework permits
    fiduciaries to offer defined contribution plan participants
    access to investment funds with securities lending features. I
    encourage the Senate committee to recognize the importance of
    maintaining the flexibility currently available. Fiduciaries
    should not be required to operate in a rigid environment which
    prohibits them from providing plan participants and retirees
    with valuable opportunities to achieve retirement security.
        Securities lending employer-sponsored DC plans is a topic
    that is worthy of your attention. However, we must take care
    not to study the issue in a vacuum or elevate the matter of
    securities lending over other issues of equal or greater
    importance to define contribution plan participants and
    retirees.
        Plan administrators and fiduciaries, as well as third party
    providers, are in the process of implementing new legislation
    and regulation, all designed to protect participants. But there
    does not appear to be an urgent need to address the issue of
    employer-sponsored defined contribution plans and securities
    lending features. Perhaps this is a time to rest and allow the
    new rules to take hold before we consider any new rules or
    requirements.
        I want to thank you for asking me to be a witness today,
    and I would be happy to address any questions you may have.
        [The prepared statement of Ms. Klausner appears in the
    Appendix on page 70.]
        The Chairman. Thank you, Ms. Klausner.
        Mr. Meier, we would like to hear from you.

      STATEMENT OF STEVEN MEIER, CHIEF INVESTMENT OFFICER, GLOBAL
       CASH MANAGEMENT, STATE STREET GLOBAL ADVISORS, BOSTON, MA

        Mr. Meier. Chairman Kohl, Ranking Member Corker, and
    members of the Special Committee, thank you for the opportunity
    to appear today.
        My name is Steven Meier, and I am the Chief Investment
    Officer of Global Cash Management at State Street Global
    Advisors, the investment management arm of State Street
    Corporation. I hope my testimony will assist you in your
    important work.
        At State Street, we believe that securities lending can
    play an important role in a balanced investment program for
    professionally managed retirement plans. As you know, employee
    retirement plans typically earn dividends and interest income
    from the plan's investment portfolio.
        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 income
    varies by portfolio and depends upon a number of factors, it
    can be significant and may be used to either offset expenses or
    supplement the plan's investment return.
        An investor like a 401(k) plan can earn this incremental
    income when it lends a security it owns to a borrower, who uses
    the security to settle another transaction, often in connection
    with a short sale. The borrower provides collateral to the
    lender for the borrowed security, typically in the form of
    cash. During the course of the loan, as the market value of the
    borrowed security changes, the lender either collects or
    returns collateral based on changes in the value of the
    security. If the lender has received cash collateral, it
    invests the cash to earn investment income. When the loan
    terminates, the lender returns the borrower's collateral, along
    with an additional payment known as a ``rebate.'' The lender
    shares the remaining income with the securities lending agent
    as compensation for its services administering the program,
    such as matching lenders to borrowers, reassigning loans when
    the lender sells a security, and revaluing the securities on
    loan and marking to market the collateral daily.
        The lending agent's share of the securities lending income
    also compensates it for indemnifying lenders against the
    failure of a borrower to return a security if the borrower
    defaults on its obligations.
        As this Committee is aware, the events of the recent global
    financial crisis were unprecedented and created challenges for
    the securities lending business. State Street acted cautiously
    and thoughtfully before and during the financial crisis to
    protect the interests of our securities lending clients. Due to
    our prudent management, none of our cash collateral pools
    realized credit losses.
        In addition, we maintained 401(k) plan participants' full,
    unrestricted ability to make withdrawals from our lending
    funds. Investors in our lending funds 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.
        State Street believes that it acted in the best interest of
    our securities lending clients and significantly mitigated the
    potential adverse impacts from the financial crisis.
        Our securities lending clients are generally long-standing
    clients for whom securities lending is just one of many
    services State Street provides. We believe our interests are
    appropriately aligned with those of our clients. We are
    committed to best practices in disclosure and risk management.
    We also welcome the opportunity to learn more from you today
    about how the industry can better serve its clients, and
    particularly retirement plans.
        Thank you for the opportunity to be here today. I will be
    pleased to answer any of the Committee's questions.
        [The prepared statement of Mr. Meier appears in the
    Appendix on page 74.]
        The Chairman. Thank you, Mr. Meier.
        I would like to start out with a question and ask for a
    response from each of you.
        What are the risks for both the retirement plan and the
    individual participants of participating in a securities
    lending program? Do you think that both employers and their
    workers are aware of the risks? We will start with Mr. Jeszeck
    and then move to his left.
        Mr. Jeszeck. In our firm, what we have found is that there
    is an asymmetry. While the gains are shared between the
    securities agent and the lending agent and the plan, the losses
    are completely borne by the participant. So in that sense,
    there is an asymmetry there, and, as I mentioned earlier, we
    think it also creates an incentive for pool managers, because
    they do not bear any of the loss, to possibly invest in more
    risky assets.
        As to whether participants and sponsors are aware of
    securities lending with cash collateral reinvestment, our work
    has found that in general there may be some savvy participants
    who know, but in general, participants, frankly, have no idea
    what securities lending is, much less whether they are aware of
    whether it is going on in their 401(k) plan.
        The other area, while an argument could be made that plan
    sponsors should be aware of securities lending, during our work
    in our report, we found a number of plan sponsors who were not
    aware of securities lending with cash collateral reinvestment,
    or securities lending at all going on in their plan. So that
    was a disturbing finding.
        The Chairman. Thank you.
        Does anybody substantially disagree with Mr. Jeszeck's
    description? Yes, Ms. Klausner.
        Ms. Klausner. Thank you, Chairman.
        In our experience at Honeywell, the fiduciaries are
    extremely well aware of which funds are able to have securities
    lending activity in the fund. We also are aware that we have
    disclosure in our summary plan description and in other places,
    perhaps like on our website and in other informal
    communications, that identify in their description of the funds
    that securities lending does in fact exist. So I would not
    necessarily characterize all plan participants as not being
    aware. I understand that disclosure doesn't always bring
    awareness, but there are certain populations in Honeywell, as
    well perhaps in other organizations where the sophisticated
    professionals and other well-educated individuals do know that
    it exists and understand it.
        In terms of loss and risk, I also think they understand
    that the varying funds that are available all have the
    opportunity to go down in their account balance and not just
    up. And so, this is something that I think in terms of
    recognizing the variation between what is available to
    individuals is true, and perhaps the bar needs to be raised.
    But I would not characterize our plan participants as not
    having the information readily available.
        The Chairman. Does your company, Honeywell, take time and
    make the effort to see to it that everybody involved
    understands this transaction?
        Ms. Klausner. May I ask, when you ask everybody involved,
    do you mean at the plan sponsor/plan fiduciary level?
        The Chairman. Yes, as well as those who are in the plan
    itself.
        Ms. Klausner. At the plan sponsor/plan fiduciary level, the
    answer is absolutely yes. As to the plan participants at that
    granular level, I would hesitate to say yes. Just like with all
    aspects of the investment, they have high-level information
    about the character of the asset class and the different
    activities that might go on in terms of the fund. As to whether
    or not they understand the granular level of securities
    lending, I would say that is probably not likely.
        The Chairman. Okay. Yes, sir, Mr. Blount.
        Mr. Blount. Senator, I think the issue of comprehension by
    participants and the disclosure by their service providers is
    complicated. The service providers, I believe, attempt to
    provide as much information as possible. Plan participants in
    many cases are no different from the board members of defined
    benefits plans. And I find when meeting with plan sponsors that
    there are different levels of comprehension even at the board
    level. There are members of the investment committee that might
    have an extremely good understanding. Others are more concerned
    with retirement issues and leave the investment matters to
    other board members and directors.
        I think when you start to talk about individuals who are
    investing in any investment program, there is a presumption of
    trust that they believe protects them. They will assume that if
    they are being offered a program--an option--that it has been
    thoroughly vetted, and there is, in effect, an imprimatur to
    it. Whether they fully understand the details, I think, is
    actually impossible for most of them. There are many--and I say
    this with a smile--there are many contemporaries of mine who
    have been in the business for three decades or more, very
    closely in the securities lending world, and still don't
    understand it all. It is an extremely complex and opaque area,
    so there is a level of trust that I think goes beyond that.
        The Chairman. Thank you. Mr. Meier.
        Mr. Meier. Senator, at State Street, we are completely
    committed to transparency in terms of all of our investment
    strategies, including our securities lending activities, as
    well as our cash collateral reinvestment pools.
        In terms of our outreach, we tend to spend a lot of time
    with plan sponsors and their consultants to go through our
    program to make sure that there is that level of understanding.
        I would say from an industry perspective, one of the
    frustrations may be that we do not have the ability to actually
    reach down and communicate directly with the plan participants.
    Again, our activities are with the plan sponsors and their
    consultants.
        In terms of the characterization about a potential
    misalignment of interests, I will say that our interests at
    State Street are completely aligned with those of our clients.
    We have been in the securities lending business since 1974. It
    is a core competency of ours as a custodial bank, and we have
    committed many resources to making sure that we continue to
    manage those programs in a prudent manner.
        We at State Street actually have a little bit of a unique
    business structure in that we have a division of
    responsibilities. For example, we have one division that is
    responsible for lending the securities, and another division,
    the investment managing arm that I work for, that actually
    manages the cash collateral. In terms of the fee structure and
    the revenue sharing, we actually work for a modest set fee on
    the investment management side, of typically anywhere between
    one to three basis points, to manage those portfolios.
        We are acting as a fiduciary. We are not incented to take
    on additional risk to increase the return so that State Street
    Bank, for example, would earn a higher level of income off of
    those activities.
        The Chairman. Thank you. I will ask Mr. Jeszeck a question,
    and then we'll turn to Senator Corker. And I think you have
    alluded to it, but I would like to ask you directly.
        Your report shows that the risk of securities lending with
    cash collateral reinvestments are all borne by the
    participants, while the rewards are spread around, as you
    indicated. In fact, some of those involved in the transaction,
    including securities lending agents, broker-dealers, and
    collateral pool managers always win and never lose. Does that
    make you nervous?
        Mr. Jeszeck. Well, certainly from our work we have found
    that participants and sponsors are not favored compared to
    other actors in these transactions. Having said that, we
    continue to believe that securities lending with cash
    collateral reinvestment could benefit 401(k) participants if it
    is managed responsibly. And I think that means getting more
    information to plan sponsors so that they can negotiate these
    transactions more prudently, for plan participants to be aware
    of the existence of securities lending, the implications of
    securities lending with cash collateral reinvestment for their
    portfolios so they can make an informed decision consistent
    with their general preference towards risk. Some individual
    participants like risk. They like more risk and will be
    comfortable with securities lending transactions. Others may
    not like risk as much. And so for these reasons and others, we
    made the recommendations in our report to the Department of
    Labor.
        The Chairman. Okay. Senator Corker.
        Senator Corker. Thank you, Mr. Chairman.
        Mr. Jeszeck, I am not the most sophisticated investor in
    the world, but I have been fortunate and do do some investing.
    I do not know if I have ever seen a scenario where it was
    different than what you just said. I mean, typically when
    investments are made, the investment manager participates in
    the gain, and they do not participate--I mean, that is the way
    hedge funds operate. It is the way most funds operate. I have
    not been aware of managers who participate in gains as a way of
    making fees, participating in losses. So I do not find anything
    unique about that. Is there something--I could ask Mr. Blount--
    but is that not standard that usually when people are making
    investments, they participate in gains and incentive, but do
    not participate in the losses? As a manager, is that not kind
    of standard/typical in the industry?
        Mr. Blount. I would say it is, Senator, yes.
        Senator Corker. I know you have to have had involvement in
    this industry other than just this report, right?
        Mr. Jeszeck. Well, Senator, I--I've been at the Government
    Accounting Office for the last 26 years, so in that sense I
    have worked on pension issues. I have worked on issues
    involving the industry. I have had interactions with the
    industry, but I have not had any direct involvement myself in
    the industry.
        Senator Corker. Well, let me just state that as a guy who
    is certainly no professional that it is a very standard typical
    arrangement that you are describing, and there is nothing--I
    mean, that is typical of the way it is. It is very asymmetric.
    Is there anybody that disagrees with that? I mean, so I just
    find you making a point out of that odd when, you know, just
    for the little bit of looking into what is happening in the
    industry you would understand that that is the way the industry
    operates.
        Mr. Jeszeck. Well, sir, I think the point--what we come
    away from here is that it is unclear whether plan sponsors know
    that there is an asymmetry here. In some other cases----
        Senator Corker. Yes. Yes.
        Mr. Jeszeck [continuing]. Many other transactions there may
    be--both sides may have some skin in the game. When we looked
    at these transactions in this instance, in the case dealing
    with cash collateral reinvestment, the losses are borne by the
    participants.
        Now, the other issue here is, is that the participants, at
    least from the work that we have done, are not aware--they are
    not even aware of securities lending in general, much less the
    fact that they are bearing an additional risk here. And I think
    that is the issue. It may be typical in the industry, but I
    think in general, it would be--I think it would be more--I
    think it would be nice--I think it would be helpful for plan
    participants, who, after all, it is their money, and we are
    placing the responsibility on plan participants to invest
    prudently, to have information about these transactions and the
    implications of these transactions. And it may be in that case
    that many plan participants may choose to assume the risk of
    these transactions and go forward. We know that risk
    preferences for individuals vary across the board. But I think
    for us, the key thing is that plan participants should be aware
    of the particular relationship--the dynamics of these
    agreements.
        Senator Corker. I appreciate what you are saying. I have to
    tell you that I would go back to one of the earlier witnesses.
    I think plan participants sign up more on a sort of global
    basis of what they think the fund does. I would assume that
    Honeywell has hedge funds in their fund, and I would assume
    that there is all kind of long, short, all kinds of activities
    taking place that a standard typical plan participant would
    have no idea what that means, nor the risk involved in that.
    But they would assume that the plan sponsor is making a prudent
    allocation of resources there.
        I can assure you that if I had to know all of those things
    myself--signing up for a defined contribution plan--again, I am
    not the most sophisticated person. I do not want to know all
    that, and I do not know that you are really doing the
    participant a lot of good in knowing that. I assume a long
    disclosure form would be okay, but, again, I do not see--I
    think we are barking up the tree.
        Mr. Blount, do you want to add to that?
        Mr. Blount. Senator, I think we can even go beyond the
    mutual fund or the investment world. People buy stocks for
    airlines, and airlines engage in hedging strategies to protect
    their cost as fuel prices change. Some do, some do not. If you
    buy an airline stock, you do not necessarily understand what
    the hedging strategy is.
        Senator Corker. You might not know that Southwest made
    inordinate profit for years because they had a great hedge that
    was going to disappear in a month, right?
        Yes, ma'am.
        Ms. Klausner. Thank you. I just wanted to make sure I made
    sure the record was correct. I am not confident that we
    actually have hedging or hedge funds specifically in our
    Honeywell 401(k) plan funds.
        Senator Corker. But you might.
        Ms. Klausner. We clearly--it is possible. What I wanted to
    note was that we certainly have many funds that are index based
    and some that are actively managed. And our participants do
    understand, through a lot of disclosure, not only through our
    summary plan description, which I discussed or noted before,
    but through what we call our fund fact sheets, which are very
    dense pieces of information about all aspects of each fund,
    including with charts so that those that are better to
    understand things through, you know, a description of whereas
    others through an illustration. There are varying ways to
    understand what is there.
        In terms of getting to the granular level of talking about
    securities lending and how that may or may not impact the fees
    of a fund manager, I think that goes to your earlier question,
    does that provide meaningful information to the individual, or
    is it just piling on additional information so that the salient
    points that you want them to know about actually get lost in
    the density and the volume of information being provided.
        Senator Corker. Now, I know that I have used a lot of time.
    I just--we did some calculations yesterday, and for a young
    person beginning to invest in a defined contribution plan and
    not having the option of lending securities as part of that
    portfolio, it makes a huge difference at their time of
    retirement. We looked just on a sort of an ordinary, very
    conservative basis that if that option were not available to an
    individual starting out at age 25 and working, that it is
    likely they would actually have to work a minimum of a year
    longer, if not more, if that option is not readily available to
    them. Would any of you all like to comment on that? So, in
    essence, if we sort of regulate it out and make it so it is
    very difficult for that to occur, what we are really doing is
    hurting individuals from the standpoint of amassing a
    retirement that allows them to retire at an age they would like
    to retire.
        Yes, sir.
        Mr. Nazzaro. Senator, I would say that just by that fact,
    securities lending has merit. The issue before me as I looked
    at this is really about how much risk one is willing to accept.
    Done in its basic form, it should be as low risk as possible,
    and that is how securities lending has always been. I think it
    got away from us a little bit in the 2003 to 2008 period. All
    we are really talking about, from my perspective, is reining
    that in a little so that it becomes the modest, low-risk
    activity that it should be. It is only meant to hit singles,
    not home runs, and that is what I would like to see it get back
    to.
        Senator Corker. Do you think the industry, as Mr. Blount
    mentioned, has the ability to take care of that themselves and
    learn from what has just occurred?
        Mr. Nazzaro. Yes, Senator, I do, and I think they are
    already moving in that direction, to their credit.
        Senator Corker. Thank you. Somebody wants to speak. I do
    not know if I have taken too much time.
        The Chairman. No, go right ahead.
        Senator Corker. Thank you. Mr. Meier.
        Mr. Meier. Thank you, Senators.
        I would just like to comment. I agree. I do think that
    securities lending is a very viable, long-term strategy. I
    think it is an excellent source of low-risk incremental income.
    I think you have to look at the risks associated with
    securities lending in light of the unprecedented financial
    crisis that we have been through and potentially are still in,
    hopefully at the tail end of it.
        But I think what we saw over the last three and a half to
    four years is really a perfect storm in terms of excess
    leverage in the marketplace. Credit spreads are very tight. I
    do not think what we saw happen over the last few years is
    going to happen again, and I would hate to see us eliminate
    securities lending as a viable investment strategy for
    individual plan participants as a result of that. And, again, I
    would agree with your assessment. It can make a significant
    difference in a young person's retirement savings over a period
    of time.
        Senator Corker. Thank you, Mr. Chairman. Thank you.
        The Chairman. Thank you, Senator Corker.
        Senator Blumenthal.
        Senator Blumenthal. Thank you, Mr. Chairman. And I want to
    express my appreciation to you for holding this hearing on a
    very profoundly important topic. And I apologize for my
    lateness, but like many of us, I had several hearings and
    meetings at the same time, and I have been following your
    testimony. I want to thank everyone who is here today to
    educate us for the very important testimony that you have
    given.
        And it is important because obviously this issue is of
    profound and growing importance. We have made great progress in
    fighting poverty among our seniors. The rate is down from 50
    percent in 1939 to 10 percent now, largely because of Social
    Security, which is one of the reasons why I have strongly
    opposed any measures to cut Social Security. But in 2009, 49
    million Americans were active 401(k) plan participants--many
    thousands in Connecticut as well--dependent on these plans for
    their financial well-being, and, in fact, for many of them, a
    primary way to save for retirement. And I understand your
    point, Mr. Meier, and others here, that the recent crisis--the
    near collapse of our economy--may have been a perfect storm,
    but there remains the possibility that there may be similar
    storms, perhaps not of the same severity, but equally impactful
    on the lives and livelihoods of people saving for their
    retirement.
        So, my first question is to you. I understand that State
    Street has effectively managed securities lending funds during
    even this very difficult time. In terms of disclosure, you
    mentioned that you went above and beyond the Federal guidelines
    to keep your clients informed. But do you believe that more
    clear Federal banking regulations are appropriate and necessary
    to assure that others--other service providers follow that
    lead?
        Mr. Meier. Thank you for that question, Senator. As I
    intimated earlier, we are completely committed to transparency.
    And I do think transparency certainly helps level set
    expectations. I think as an investment manager, it sets for a
    clear discussion around investment goals and objectives. I, for
    one, do not want to be in a conversation with a client that is
    suddenly surprised at the outcome. So, again, we are committed
    to transparency.
        In terms of the specific Federal regulations or changes
    that you are talking about, Senator, I am not familiar with
    those. I would be happy to look at them and perhaps come back,
    if that is appropriate, and give you some feedback on whether I
    think that would help the situation. But I just have not seen
    them at this point.
        Senator Blumenthal. So, your answer would presumably be--
    and I do not mean to put words in your mouth, but what I hear
    you saying is in spirit, yes, and you would want to see the
    specifics before you either approve or disapprove of the
    particular regulation.
        Mr. Meier. Yes, sir. That is correct.
        Senator Blumenthal. Anyone else have a--yes, sir.
        Mr. Blount. Senator, I think that if we draw a line between
    the crisis problems that we are discussing here and Federal
    banking regulations, at the moment--and I am not a lawyer, so
    there this probably needs to be vetted--if a bank were to
    guarantee the investments of any securities lending pool, there
    would be 100 percent risk capital charge to the bank, which
    would basically put it off the table. It would make it too
    expensive. But when the banks--State Street, I think, in
    particular--applied for a work around to that, the FED was
    pretty flexible in saying, well, it depends on what you invest
    in. If you were to invest in overnight treasury repos, then
    there is a way to reduce those capital charges.
        Now, the unfortunate part of that is that you really cannot
    make any money in the securities lending pool if that is what
    you are investing in. But the concept of reducing the capital
    charges as a result of a more conservative investment strategy
    is, I think, a direction that might be explored further. And I
    believe that it is possible to create incentives for the banks
    and brokers relative to their capital charges, especially as
    Basel III comes in, that would encourage either more
    conservative--not implying that the current strategy is too
    aggressive--but more conservative implementation of strategies,
    as well as disclosures that help cash managers themselves know
    where they are.
        One of the problems in the securities lending cash
    management world is there is virtually no contemporaneous
    information. You do not know what is happening at other pools,
    so if you are to protect your competitive position, there is an
    incentive to try to be a little bit more aggressive. So a
    little bit more information perhaps combined with an incentive
    in the capital charges might be worth exploring.
        Senator Blumenthal. Well, I really welcome that comment
    insofar as it says that more information, in effect, more
    education might be welcome and specific incentives for the kind
    of steps that you would recommend. Do you have more specifics
    about the kinds of incentives, to use your word, that might be
    provided?
        Mr. Blount. Well, I tend to think in terms of metrics,
    having run a data business, rather than information. So I
    would--which is a calibrated form of information--write the
    metrics that allow you to compare where you are to others.
        I think the SEC looks at these matters, among other
    directions, in terms of systemic risk. So the capital charge
    credits or the capital credits might be somehow tied to some
    reduction and overall systemic risk through a conversation
    between the FED and the SEC, but that is beyond my pay grade.
        Senator Blumenthal. Well, whether it is within your pay
    grade or outside it, I would welcome additional specific
    thoughts you may have. You may want to consult with some of
    your colleagues and anyone else now or afterward. I think
    normally we keep open the record for additional comments, so I
    would welcome specific responses, both Mr. Meier, to the
    question I asked you and others. We do not always have all of
    the answers at our fingertips, as I know from having been on
    your side of the table. So if you want to follow up, we would
    welcome it.
        Mr. Blount. I would be happy to do that, Senator.
        Senator Blumenthal. Thank you very much, Mr. Blount.
        Mr. Nazzaro, your suggestions to protect pension funds and
    limit their risk include increased documentation, and more
    stringent guidelines for cash collateral reinvestment, and more
    reporting requirements and loan limits. What do you think the
    effect would be on loan servicers? And I apologize if you may
    have covered this point in part. And would that kind of
    increased regulation be too much of a burden, in your view?
        Mr. Nazzaro. I do not know if it would be too much of a
    burden on loan servicers. What I am trying to--the message that
    I am trying to get across is that securities lending is a
    short-term, overnight, week, day activity, and there is an
    imbalance when corresponding cash collateral investments are
    five, six, and seven years. There is no correlation there. So
    what I am suggesting is the maturity ranges of the cash
    collateral portfolio should be much shorter than the broader
    guidelines that had been in place. But as we mentioned a few
    minutes ago, the industry has recognized that because of what
    has happened in 2008, and I believe there has been self-
    correcting in that regard. So I think the large providers of
    this service are shortening their maturity guidelines and
    tightening up their regulations and their investment portfolio,
    and that is what I think is important to protect retirees and
    pension plans.
        Senator Blumenthal. Do you think the self-correcting has
    been sufficient?
        Mr. Nazzaro. That I don't know because it is not possible
    for me to monitor industrywide the banks. But some of the
    larger providers, I believe, have moved in that direction, but
    I cannot speak for all of them.
        Senator Blumenthal. Where would be the best place to get
    that information?
        Mr. Nazzaro. I don't have the answer to that. I do not
    know. You would have to be privy to the programs within each
    individual provider. I am not privy to that.
        Senator Blumenthal. So if we asked each individual
    provider, that would be the best way.
        Mr. Nazzaro. I suppose so. Yes, Senator.
        Senator Blumenthal. Thank you.
        Thank you, Mr. Chairman.
        The Chairman. Thank you, Senator Blumenthal.
        To Mr. Nazzaro and Mr. Blount, both of you have been in the
    securities lending business for over 30 years. Could you
    explain some of the problems that pension funds experienced
    during the financial crisis with respect to their securities
    lending programs? And based on that experience, what might you
    recommend that we do to prevent these things from happening
    again?
        Mr. Nazzaro. I would be happy to start.
        The Chairman. Mr. Nazzaro.
        Mr. Nazzaro. As I stated in my prepared remarks, Chairman,
    the guidelines are the first place I would start. I think that
    the large providers of securities lending services to the plan
    sponsors and pension funds, because it is a worthwhile
    activity, as we have agreed upon, but I think because of the
    profit that has been in there from 2003 to 2008, I think it was
    easy to extend maturity guidelines and to just go a little bit
    far out on the risk curve and the yield curve, and I think that
    needs to be reined in a bit. So, the shorter the maturity of
    these investments would reduce the risk and exposure. I think
    that is probably the single most important point.
        Also I would--many times it is easier to think about this
    as an equation. You have the securities lending side of the
    equation, then you have the cash collateral reinvestment side
    of the equation. Banks, custodian lenders, very large entities
    have done a wonderful job on the securities lending side of the
    equation. They have protected their clients' assets. They have
    demanded 102 percent from the counterparty borrowers and marked
    that to the market every single day. That side of the equation
    I think has done extremely well. What I am talking about is now
    that you have the 102 percent from counterparty borrowers, it
    is the preservation of that 102 percent at all times. And I
    think you can do that well as long as your maturity range is
    short. If you are going to then take that cash collateral and
    go out three years, four years, five years, six years, I think
    you are adding risk as you go further out with those
    investments. That was the lesson, I believe, we learned a
    couple of years ago, and that is why it is part of my
    recommendation.
        The Chairman. Thank you. Mr. Blount.
        Mr. Blount. Senator, I would affirm what Mr. Nazzaro says
    in general. But I think there are a couple of lessons that can
    be taken from the crisis. I think historically it has been very
    easy for pension funds and their consultants to look at income
    projections expected from securities lending programs and the
    revenue split as the primary metrics when you evaluate
    different service providers. Those are easy, either 70/30 split
    or 80/20. You take the 80/20. Sounds great. Income of an
    expected $10 million a year versus $5 million a year, take the
    10. But there has to be a greater focus on what I call a
    holistic review of the risk within a lending program.
        Historically the industry has corrected very well. In 1982,
    there was a default by a firm called Drysdale, which caused
    Chase Manhattan to step up and write a $200 million check to
    cover its customers. After that, the industry decided that they
    had to market all the loans, so that was a self-correction.
    There were several others, and I will not go through all the
    details. But the industry corrects constantly.
        Holistically, the big risks in a lending program, if you
    assume that the collateral margin of 102 percent is enough to
    cover defaults, the big risks come from the difference between
    the assets and the liabilities, just like a bank. So on the
    liabilities side, it is what the lending program owes to the
    borrowers because the borrowers, being brokers, will return the
    securities that they have borrowed and say, give me back my
    cash collateral. That is a huge risk. That is like the risk of
    depositors coming to a bank and saying, give me back all the
    money that I have deposited.
        Just like a bank, securities lending programs have invested
    with a gap--a maturity gap that generates a profit, so pensions
    have to look at what those redemption patterns are, the
    possibility that depositors may come back. The consultants have
    to take this look, too. They have to look at the assets, so not
    just focusing on the assets and the quality of the assets, but
    the potential for a run on the bank, the risk of the
    liabilities coming in and making it illiquid. And I think that
    has been missing by most of the pension funds and their
    consultants up till now.
        I think the service providers have been saying it, but most
    of the focus from the consultants to the pension community has
    been on give me a better split and come up with a better income
    projection, and really now has to be given more balance
    holistically.
        The Chairman. Yes, Mr. Nazzaro.
        Mr. Nazzaro. I think we are saying the same thing on that
    side--securities lending side of the equation. If all of the
    counterparty borrowers were to return the securities at the
    same time, i.e., a run on the bank, you would have to have the
    liquidity in that cash collateral portfolio to repay all the
    counterparty borrowers. If you did not, you would be in default
    and it would be a huge default. So if your collateral portfolio
    had to be liquidated quickly, unless it were in short-term
    securities or longer-dated securities, such as we found in
    2008, large losses would have been realized.
        And, Chairman, we only look to the example of AIG. That
    was, in fact, what happened. All of the counterparty borrowers
    wanted their money back at the same time. AIG did not have the
    liquidity to give them their money back; hence, the bailout and
    the $20 some odd billion infusion that went to cover
    counterparty collateral. So we know what that looks like, and
    that is a very--that is a doomsday scenario. And Mr. Blount is
    right; we want to learn from that.
        The Chairman. Mr. Meier.
        Mr. Meier. Senator, if I can comment. I work at a very
    conservative firm. We manage our assets prudently. We managed
    through this crisis. If I can give you a couple of data points.
    From June of 2008 to December of 2008, we saw a 50 percent
    reduction in our securities lending balances. We were not a
    forced seller of any securities and in the liquid market
    throughout the crisis. And I think it is important to remember
    that prudent management doesn't mean taking unnecessary risks.
        If you look at our portfolios, irrespective of whether they
    can invest a little further out on the curve, certainly not
    five or six years, at the heart, all of our portfolios--our
    cash collateral portfolios or money market portfolios--was what
    I refer to as a spread product overlay where we might buy
    unsecured debt in a 1- to 3-year space or asset-backed
    securities in the 1- to 3-year space. And those investments
    typically provide diversification benefits away from unsecured
    credits, away from M&A risk, and risks of downgrades associated
    with rating actions.
        So I do think when you look at risks, you look at the
    management of these portfolios, they need to be managed
    prudently. They do need to be managed to a very high standard
    of liquidity.
        There is also the concept in these portfolios of latent
    liquidity, where a lender has the ability to simply put out
    more loans as opposed to sell assets in a declining market.
    And, again, we use those tools in terms of managing that very
    important asset liability mismatch.
        Mr. Blount. And I think there is one more point, to extend
    Mr. Meier's point, that it has been overlooked that during the
    fourth quarter of 2008, which was the worst of the crisis, that
    the securities lenders recognized the risk that they were
    dealing with, and they increased the rebates to the borrowers
    in order to hold those balances in place. And it got to a point
    where they were paying out what amounted to negative rebates.
    They were encouraging the broker-dealers to keep the funds in
    place, and it was pretty effective. It kept the balances until
    the worst of the crisis was over. So it was a holistic
    approach.
        The Chairman. Yes, Ms. Klausner.
        Ms. Klausner. I would just like to add a comment to try and
    maybe put this all in a bit of perspective. Clearly I am not an
    investment specialist, and my knowledge is based upon my
    personal experience in being counsel to the Savings Investment
    Committee and learning a great deal from them.
        However, we are talking about liquidity, and we are talking
    about whether or not there should be potentially new rules or
    new guidance in terms of how the securities lending funds
    should be managed in terms of their liquidity, and whether or
    not, you know, there is undue risk in the event of certain
    doomsday events occurring and there being a potential run on
    the bank.
        But those concepts exist at varying levels in a defined
    contribution plan. So, again, just to put this in perspective,
    here's my example. We have a Honeywell common stock fund. Now,
    we are very clear that it is not 100 percent stock. There is a
    cash buffer there. I believe our cash buffer is targeted to be
    about 3 percent. It allows that there would be daily trades and
    to be liquidity.
        There are some individuals who actually will be
    disappointed that there is cash in the fund in order to allow
    for liquidity and daily trades because they caught a drag on
    the market when the Honeywell common stock is going up. On the
    other hand, there are people who are disappointed that there is
    not enough cash when stock is going down.
        The point here is that at all levels, not just with regard
    to the small portion of the fund that has securities lending,
    is liquidity issue. It is an issue that we look at as a
    fiduciary at a larger level as well. So, in terms of take-
    aways, the question might be, do we have to or should we create
    a situation where we are creating rules about liquidity
    specifically only for securities lending feature, or are there
    basically prudent rules that are already out there today with
    regard to the investment funds as a whole, including the
    securities lending feature.
        And so, I caution, again, not to look necessarily in a
    vacuum----
        The Chairman. Sure.
        Ms. Klausner [continuing]. But to look at the larger
    picture as well.
        The Chairman. Well, that brings me to a question for you,
    Ms. Klausner. When your company, Honeywell, reviewed the
    securities lending practices within your own 401(k) plan,
    Honeywell decided to transition out of securities lending
    within your plan. What happened?
        Ms. Klausner. A couple of things. One is we had our
    doomsday. We had our crisis, so there were a lot more issues to
    be reviewed at a very high level. When we were looking at what
    was going on with Lehman Brothers and all of the other players
    that were showing signs of collapse, one of the things that we
    looked at was whether or not the securities lending funds and
    the collateral there were at risk. Not my personal review, but
    the review of the investment managers who brought the
    information back to us, said the answer was no. As long as we
    allowed the collateral to stay put and we did not try and cash
    in on it and then ultimately realize a loss, we would not be at
    risk.
        So why did we move out? We recognized that because
    securities lending relationships were going to change, we would
    no longer in the future have an opportunity to get the benefit
    in the same manner as we did before. Securities lending would
    no longer be as--I do not want to use the word aggressive--but
    maybe not as conservative. We knew that the fees that were
    going to be charged and the differentials between non-
    securities lending funds and securities lending funds would be
    a smaller differential.
        And so at some point, the potential benefits of having
    those funds would not really necessarily outweigh the risks,
    coupled with the idea that we were in a gatekeeping situation,
    as Mr. Meier pointed out, not at a participant-directed level.
    Participants at each level were able to make their daily trades
    if they so chose or if they wanted to rebalance on a quarterly
    basis. They were welcome to do that, and there was no impact to
    them.
        But should we want to, from a fiduciary perspective, add
    perhaps a different investment manager in the same asset class,
    or if we wanted to put a competing one, which was a nonsec
    lending fund, we would have had adverse impact because of the
    gatekeeping measures.
        So given that then economic environment and the one that we
    expected in the then near future, we really believed it was not
    going to be in the best interests of our plan participants. We
    do, however, want to have the door open because, as with
    everything, there is a lot of learning that goes on. There is
    change in our economic environment, our financial environment,
    as well as our regulatory and legislative. And we want to leave
    open the door that should it be prudent to allow people to get
    the benefit as the landscape continues to change, to go back in
    and provide that opportunity to our participants and our
    retirees so they can maximize retirement security.
        The Chairman. Okay. Senator Blumenthal, any other thoughts?
        Senator Blumenthal. No thank you, Mr. Chairman.
        The Chairman. I would like to thank all of our witnesses
    for your presence here today and for your very informative
    testimony. I think we have had a very productive conversation.
    In light of today's hearing and the findings of our committee
    investigation on securities lending, I would like to make some
    common sense recommendations.
        First, employers, I believe, should increase their
    knowledge on securities lending within their defined
    contribution plans. The committee report outlines a few simple
    questions that all employers should know the answer to. For
    example, employers should ask their fund manager, ``Do the
    investment options within my plan participate in securities
    lending?'' They should. I'm not saying we should have a law.
    They should know.
        Number two, the Labor Department should help employers
    better understand this practice by developing basic information
    and tools for them on securities lending within their
    retirement plans.
        Three, participants should be given easy to understand
    information about securities lending to help them make informed
    decisions when selecting investments within their plans.
        And, four, there is currently no comprehensive public data
    available about securities lending, including securities
    lending in retirement plans.
        Therefore, we recommend that companies in the business of
    securities lending report information about their business
    practices to the Federal Government.
        I notice you were all writing it down as I was talking.
    Before we conclude the hearing, would anybody have any
    disagreement on those recommendations?
        Yes, Mr. Blount.
        Mr. Blount. Senator, just to reiterate a point I made
    earlier, I think the--if I was an editor, I would offer
    changing the word information into metrics.
        The Chairman. Okay.
        Mr. Blount. Something that is a little bit more precise,
    relative rather than piling on information.
        The Chairman. Good suggestion.
        Mr. Blount. Thank you.
        The Chairman. Yes, Ms. Klausner.
        Ms. Klausner. The only additional comment I would make is
    when you talk about giving participants easy to understand
    information, and I completely concur that any information they
    are provided must be easily understood.
        I have suggested in other hearings and platforms, I think
    that there is an opportunity here, even as an aging committee,
    to recognize that there should be some coordination so that
    employers, employer plans, employer sponsors, third party
    administrators, you know, do not bear the full brunt on
    educating our community--our society--on what it means to
    invest, whether it's invest through a plan, invest a plan with
    assets that are or are not with a securities lending feature.
        And if there is an opportunity here to recognize, as you
    said before, that our youngest workers need to understand from
    the first day they start working and the first day they start
    earning pay, an opportunity to make investments. You know what
    is out there in terms of the current landscape. And that that
    opportunity is not something that should be a burden on
    employers, plan sponsors, third party providers, that we should
    be players in that opportunity. But perhaps, you know, other
    departments and other regulatory agencies could participate in
    getting individuals in society prepared so that, when we give
    them information or disclose to them information as workers,
    they are ready to receive it.
        The Chairman. Well said.
        Mr. Jeszeck. Senator, I would say----
        The Chairman. Yes, Mr. Jeszeck.
        Mr. Jeszeck [continuing]. This would be consistent with the
    findings of our report. We would support all of those
    suggestions. I think in particular, something we did not talk a
    lot about in the report, but the issue of data. One of the
    handicaps we had in doing our work here was the lack of data,
    really getting our arms around the world of securities lending.
    How much is going on? Who does it involve? How much does it
    involve defined contribution plans? And I think that would be--
    data in this would certainly, I think, make our understanding
    of the issue and coming out with some solutions to the extent
    that there are problems there much more easy.
        The Chairman. Yes, you are right. As I am sure you know, we
    refer and cover that in our final recommendation, the
    accumulation of data, so we understand what the dimensions of
    this whole issue are.
        Yes, Mr. Meier.
        Mr. Meier. Senator, my only comment or suggestion would be,
    to focus on informed disclosure or data information with
    context, because I do think it is dangerous, for example, to
    simply publish a list of holdings without context in terms of
    the benefits of the portfolio, or the structures that underlie
    those specific securities.
        I can give you an example, the Rule 2a-7 disclosure
    requirement. We are required to post our holdings in a money
    market fund on a weekly basis. We do it on a daily basis. But
    the issue is, if a client looks at a holdings report and sees
    an asset-backed commercial paper conduit, they do not
    necessarily know who the liquidity support provider is, or the
    due diligence that we have done in the assets. They do not
    understand whether it is an appropriate and reasonable
    investment. And, frankly, that was what, I believe, started or
    was a considerable contributing factor, to the liquidity crisis
    in August of 2007. It was investors in money funds pulling out
    of money funds because of asset-backed commercial paper
    holdings without context--they had knowledge that they had
    those holdings, but they didn't have context around the risks
    associated with those conduits.
        The Chairman. Thank you. Good comment.
        Mr. Meier. Thank you.
        The Chairman. Yes, Senator Blumenthal.
        Senator Blumenthal. Yes. Thank you, Mr. Chairman. I think
    those suggestions or recommendations are excellent as a
    starting point, and certainly we may want to consider going
    beyond them based on what we've heard and what we may find out.
    But I think the Staff Report, combined with the GAO Report,
    provide a really important source of information and a
    beginning point. And I would support those recommendations as
    well.
        Thank you.
        The Chairman. Thank you very much, guys. You have been
    great.
        [Whereupon, at 3:20 p.m., the hearing was adjourned.]

                                    APPENDIX

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