[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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