What to Look for in DC Securities Lending Funds

Securities Lending in US DC Funds What to Look For Securities Lending in US DC Funds: What to Look For

Asset management stakeholders are a meticulous bunch. Whether we are owners or managers of assets, we are invested in improving efficiency and we scrutinize risk and return. And in a continued environment of fee compression, we fixate over every basis point.

It is then understandable that securities lending has become with agreed terms; and 3.) Operational risk, which a focal point in our industry. On its own, adding basis points derives from the increased transaction volumes and of return to fund performance is a compelling proposition. management complexity associated with a lending program. Understanding a manager’s approach to these However, complexity and a lack of transparency can make risks is a critical step in ensuring a lending program an objective comparison difficult to achieve. To provide a aligns with an owner’s objectives. framework, there are three primary dimensions asset owners and consultants should understand and evaluate to • Costs: There can be significant costs associated determine the securities lending program most appropriate with managing a securities lending program, and it is for their investment objectives. important to understand where these costs are borne, and how the various parties are compensated. While the • Returns: Returns can be relatively straightforward to fee split is often the headline expense communicated by assess, though it is important to ensure that returns are an investment manager, there are multiple ways that this measured consistently. While not a guarantee of the fee split may be calculated, and often are not the only future, historical returns provide the strongest indicator expenses paid in a securities lending program. of comparative securities lending performance, and should be presented as a percentage of total fund assets, The world of securities lending is nuanced and can and net of all costs and fee splits. easily confuse even the most experienced of investment • Risk management: The risks associated with a professionals. The objective of this paper is to provide you, securities lending program can be complex to identify the reader, with information on how to evaluate securities and measure. Investors should understand and consider lending programs, and arm you with important questions three primary types of risk associated with securities to ask investment managers to make informed decisions. lending: 1.) Reinvestment risk, which derives from the We will also provide insight into how the State Street Global reinvestment of cash collateral received to secure a Advisors securities lending program seeks to optimize the loan; 2.) Borrower default risk, which derives from a balance of risk and return to provide a program that aligns borrower’s inability to return securities in accordance our investment solutions with the objectives of our clients.

State Street Global Advisors 2 Securities Lending in US DC Funds: What to Look For

Returns

Securities lending returns are relatively straightforward dividends, which counteracts the lower lending returns. and readily comparable across asset managers. As part of These tradeoffs of lower lending returns and higher an analysis of returns, there are a few items to keep in mind. dividend yields for tax-exempt funds do not necessarily equal and cancel each other out, but do add a layer of First, lending returns are generally stated in basis points complexity to the analysis. Therefore, when comparing and represent the net annual lending return to the fund returns between lending funds, it is critical to understand divided by net assets in the fund. This practice is relatively the funds’ tax status, and its impact on securities lending standard, but it is important to confirm that figures provided and dividend returns. Recognize that a taxable fund may are net of all costs and fee splits, and are provided relative to reflect a higher lending return, but the return may be more total assets of the fund as opposed to lendable assets or some than offset by a lower dividend realization rate. other measure.

Second, the tax status of a fund that invests in foreign Questions to Ask a Lending Manager securities can impact its lending returns. Generally, retirement funds1 are entitled to lower withholding tax 1. Are the returns you indicated net of all fees, and rates on foreign dividend income compared to taxable reflect returns realized by the fund? Are the returns funds. This translates into lower securities lending returns represented relative to total assets of the fund? than a taxable fund may otherwise achieve. On the other 2. Does the fund benefit from preferential withholding hand, the tax-exempt fund will receive a larger portion of tax rates for retirement funds on foreign dividends?

State Street Global Advisors 3 Securities Lending in US DC Funds: What to Look For

Risk Management

While securities lending returns are generally well rise, corporate actions may become more complex to understood, securities lending risks can be more complex manage, and increased transaction volumes heighten to understand. There are three important types of risks traditional non-lending operational risks. that investors should consider: 1. Reinvestment risk derives from the reinvestment Reinvestment Risk Management of cash collateral received to secure a loan, and the risk that the reinvestment fund declines in value. Reinvestment risk is the most critical risk for an investor Borrowers generally post collateral in the form of to understand for three primary reasons: cash or other securities (non-cash). If the collateral is • First, reinvestment risk is generally not indemnified in a non-cash (example: US government bonds), a lender securities lending program, so the lending fund is usually will hold it for the duration of the loan and receive a not compensated if this risk is realized. fee without exposure to reinvestment risk. However, • Second, principal losses are commonly born entirely by if the collateral is cash, a lender reinvests the cash the lending fund and are not shared with the lending agent (often in a reinvestment fund) to generate returns.2 the way securities lending program revenues are. Reinvestment risk comes from this cash collateral exposure to the reinvestment fund, which typically • Third, reinvestment risk affects the entire cash collateral has traditional money market risks such as credit, pool and not just individual loan trades, thereby widening liquidity, and duration risk. the breadth of potential impact. 2. Borrower default risk derives from a borrower’s Cash collateral is typically managed similarly to a money- inability to return securities and close a loan upon market investment, where the primary objective is request, resulting in a default. In such a case, the safeguarding the principal. In this context, there are three lender would liquidate the pledged collateral and use primary types of reinvestment risk: credit risk, liquidity the proceeds to purchase replacement securities on risk, and duration risk of the underlying cash collateral pool. the open market. This means there remains a risk that the collateral is insufficient to repurchase the 1. Credit risk is the potential for loss due to a credit securities to make the lender whole. event on one or several of the investments in the reinvestment fund. This risk is largely managed 3. already present in the Operational risk, through diligent credit analysis of the investments management of an investment fund, increases with in the pool, selection of high credit-quality securities, securities lending: the frequency of sell-fails may and diversification of credit exposures.

The State Street Approach With more than $32.45 billion3 in cash assets under management, average life (WAL) guideline of 120 days, and a maximum final cash and collateral management is a core business for State maturity for all individual investments of 13 months. To best Street Global Advisors and not simply a byproduct of securities manage duration risk, our cash management team is also lending. This focus and scale of the business allows us to deploy integrally linked to, and in constant communication with, the resources and capabilities necessary to effectively prioritize the lending agent to manage asset- liability dynamics of the safety of principal as a primary objective of cash management securities lending program. Further, our collateral reinvestment along with liquidity and competitive returns. As such, we employ pools are also managed with a maximum 60-day weighted a prime reinvestment strategy that generally follows Rule 2a-7 average maturity (WAM) guideline. We do not believe that more guidelines with regard to quality, maturity, and diversification.4 aggressive reinvestment strategies align with our objective To manage the reinvestment pool’s credit risk, we employ a team of capturing intrinsic value in the securities lending program. of credit specialists dedicated to the analysis of underlying Instead, they expose investors to additional reinvestment risk instruments. As for liquidity risk management, the portfolio is which may not be fully appreciated, understood, or in line with actively managed for liquidity within a maximum weighted the investor’s objectives.

State Street Global Advisors 4 Securities Lending in US DC Funds: What to Look For

2. Liquidity risk is the potential for loss from the Reinvestment risk can be avoided entirely through the use forced liquidation of an investment, or even worse, of non-cash collateral, which has been gaining acceptance the inability to liquidate a term investment. The in the market. However, the overwhelming majority of investment may be of sound credit, but a forced collateral in the US is still cash.6 If a manager rejects or sale at an inopportune time can realize a mark-to- minimizes non- cash collateral in the lending program, it market loss and make it unrecoverable. Liquidity could indicate a misalignment of interests: the manager may risk in a cash collateral lending program requires be seeking to maximize returns from the lending program an asset-liability management process because loan in spite of the incremental risk which is born by the lending portfolios often have different maturity profiles than funds, or may be motivated by fees from the management of the reinvestment portfolio, and because the flow of the cash collateral (more on this under the Costs section). loans can impact liquidity therein. Liquidity risk is largely managed through investment maturity Borrower Default Risk Management laddering, weighted average life (WAL) guidelines, and maximum investment maturity guidelines. Generally, lending funds may call a loan at a time of their Liquidity may also be managed through holdings choosing, and the borrower is expected to be able to return of readily saleable assets and latent liquidity in the the loaned securities upon demand. If a borrower is of low lending fund,5 but these are suboptimal methods creditworthiness or experiences a credit event, they may not of obtaining liquidity when needed. It is important be able to return the securities to the lending fund. Industry to have experienced active cash portfolio managers standard practices are designed to ensure that the lending familiar with the characteristics of lending programs fund is sufficiently collateralized so that collateral may be to manage liquidity effectively in a collateral liquidated to purchase replacement securities. However, reinvestment fund. there is always a risk that transaction costs and price movements of the loaned securities or collateral result 3. Duration risk is the potential for loss due to an in a shortfall. unexpected change in interest rates or forecasts, and derives from the asset-liability dynamic To protect against borrower default, lenders utilize the when accepting cash collateral. There is potential following techniques: exposure if the interest rates move and the duration • Careful screening of approved borrowers to mitigate the of the loan portfolio is different from the duration risk of a borrower default. of the reinvestment fund. Therefore, consistent communication between the lending agent overseeing • Acceptance of high quality collateral and excess the loan portfolio and the investment manager collateralization to provide sufficient protection against overseeing the reinvestment fund is paramount to price fluctuations and transaction costs. managing duration risk. This risk is measured by • Indemnification against borrower default, to protect the duration mismatch of the loan and reinvestment the lending funds and align interests between the lending portfolios. Weighted average maturity (WAM) is one funds and the lending agent. Note that indemnification common measure of duration that can be used to against borrower default is a common protection assess risk exposure. provided by many lending agents. In the case of borrower default, it requires the lending agent to make up for any shortfall in the cost to replace securities on loan to a The State Street Approach defaulting borrower. However, not all lending programs We accept non-cash collateral (in the form of US Treasury are covered by borrower indemnification, and not all and Agency securities) specifically because it can place our indemnifications are equal. If an indemnification is lending funds and our investors in a return-generating provided, it is important to review what potential events position without incremental reinvestment risk exposure. of loss are covered, and whether the provider of the indemnification has sufficient capital and balance-sheet strength to honor the indemnification.

State Street Global Advisors 5 Securities Lending in US DC Funds: What to Look For

There is a balance between lending revenue-generation The State Street Approach and operational risk mitigation. This balance depends on ever-changing market dynamics, so we believe that a State Street Global Advisors has the scale to support a lending fund should not rely solely on regulatory limits dedicated team of counterparty risk analysts to screen and when making these determinations because regulatory monitor approved counterparties. We do not rely solely on limits are static and do not respond to changes in market third-party rating agencies or our lending agent to evaluate dynamics or investor behavior. and approve the borrowers in our program. A lending program’s risk is not captured by traditional Additionally, our lending funds benefit from full borrower level measures such as standard deviation, and aggressive indemnification for both cash and non-cash loans. This means managers can go undetected as they increase risk in the that our lending agent funds any shortfall if a liquidation of lending program. Investors need to be vigilant on risk collateral due to borrower default is insufficient to purchase management because the incentive structure in most replacement securities. The indemnification protects the lending programs rewards lending agents for assuming more lending fund and, just as importantly, aligns the interests of risk. This incentive misalignment is driven by the lending the lending funds and the lending agent. If the agent is liable agent receiving a percentage of the program revenues while for a shortfall, they are incentivized to ensure tight controls reinvestment losses are often born solely by the lending on collateralization levels and collateral quality.7 This fund. Ask the questions below to understand the true risk ultimately reduces risk to the lending fund and its investors. profile of your securities lending program. When you ask us these questions, you’ll find a securities lending program optimized on a risk/return balance, designed to extract the Operational Risk Management intrinsic value of lending while avoiding excessive risks. Securities lending inherently adds operational risk to a fund through increased transaction volumes and complexity. It is therefore important to have an experienced The State Street Approach lending agent equipped to manage this complexity. The At State Street Global Advisors, we have developed a investment manager itself also plays a part in operational proprietary, dynamic, risk-based model that sets the lending risk management by imposing lending limits on funds as limits at the fund level and at the security level for all of our well as individual security positions. For example, holding lending funds within regulatory limits. Our model functions back a portion of each position as part of the program design by conducting a quantitative analysis of fund flows and ensures the receipt of corporate action notifications and collateral pool liquidity, and is updated regularly to reflect the limits the frequency of failures-to-deliver on sell trades. dynamic nature of the collateral reinvestment funds, lending While these are relatively minor issues, a sell fail can cost fund flows, and the markets. A securities lending program the fund unnecessary overdraft fees and create other that does not set well-informed limits at the fund and security complications. Additionally, excessive lending can expose levels may be opening itself to operational risks, or worse yet, the fund to high fluctuations in balances on loan which may not be aware of those risks altogether as they change can strain liquidity in the collateral pools. over time.

State Street Global Advisors 6 Securities Lending in US DC Funds: What to Look For

Questions to Ask a Lending Manager • Do you accept non-cash collateral? If so, how much of your collateral is cash vs. non-cash? What types of non-cash • Do your collateral reinvestment funds adhere to certain collateral does the lending program accept? quality, maturity, and diversification requirements set forth in Rule 2a-7? • Do the lending funds benefit from full borrower indemnification? What entity provides the • What are the maximum WAL, maturity, and WAM indemnification, and is the entity sufficiently capitalized? guidelines for the collateral reinvestment pools? What are the credit quality guidelines and permissible instruments • Do you have dynamic lending limits at the fund and for the reinvestment pool? position level? If so, what determines those limits?

The State Street Approach8

Inherent Risk Program Control Design

• Cash collateral invested in funds similar to Rule 2a-7 strategy guidelines

• Short weighted average life and maturity to control liquidity and duration exposure Reinvestment Risk • Credit team focused on safety of principal

• Utilization of non cash collateral to avoid reinvestment risk

• Full borrower-level indemnification provided by lending agent for both cash and non-cash collateral loans Borrower Default Risk • High-quality borrower selection from dedicated credit team • Over-collateralization/Daily market-to-market

• Only USD, US Treasury and agency securities accepted as collateral

• Lending limits set by dynamic risk-based model at both the fund and position level on a fund-by-fund Operational Risk basis to increase returns while managing risk

State Street Global Advisors 7 Securities Lending in US DC Funds: What to Look For

Costs

While returns and risk management are important Without a thorough understanding and accounting considerations in selecting a lending program, fees and of all fees and expenses charged to a lending program, expenses should also be considered. There are significant a comparison among programs may be ineffective. costs to running a lending program, and investors should You might come across a claim of a 100% return of lending be aware of both the structure and magnitude of the fees. revenues or income to the fund; quite a catchy headline. Understanding a lending program’s fees enables an informed However, view such claims with skepticism because assessment of whether the interests of the investors in managing a lending program is a costly and risky the lending fund are aligned with that of the investment undertaking that is usually pursued for compensation. manager, lending agent, and reinvestment fund manager, and Instead, pose the supplied questions to bring to light all the whether the fund is appropriately compensated for the risk it material information. Above all, be wary of suggestions of assumes. Fees can be obscured due to the complicated nature confidentiality of this material information; you have a right of this activity, so it is important to understand them fully. to know.

Fee 1: Fee Split The fee split is usually the cost headliner. The split is The State Street Approach typically the division of gross lending revenue between the State Street Global Advisors employs a simple and clear fee lending fund and the lending agent. Gross lending income split to promote transparency. Generally, the lending agent commonly consists of all fees earned on non-cash collateral applies a 70–3010 fee split on the gross lending revenue of the loans plus the spread earned on cash loans.9 This concept funds in the defined contribution lending program, which seems straightforward, but identifying embedded fees means that 70% of the gross revenue is returned to the fund requires a more thorough inspection. Take these examples: with no additional operating, transaction, or administration fees. All expenses of managing and executing the program • A manager might advertise a “50-50 split” between the are borne by the lending agent from their share of the split. fund and the lending agent, but not clarify if there are other administrative, operational, or transactional fees associated with the program that are charged before or after the split is calculated. These costs and fees can Fee 2: Management Fees on misalign interests if they are volume based and not income or profit based. Cash Reinvestment • An investment manager might also reference the split as Another fee often overlooked is the management and applying to the net revenue or net income after the lending operating fees associated with the reinvestment of cash 11 agent’s split is applied, indicating that the investment collateral. Cash collateral may be reinvested by the lending manager is taking a portion of income on top of that agent directly, but is most frequently invested into a fund apportioned to the lending agent, which could imply fees sponsored by the lending agent, its affiliated investment for oversight or administration of the program. manager, or third party cash manager. These fees are usually calculated and are charged even before determining the gross revenue for purposes of the fee split above.

State Street Global Advisors 8 Securities Lending in US DC Funds: What to Look For

Surprisingly, asset owners are frequently unfamiliar with these fees and rarely evaluate them when choosing lending The State Street Approach programs, despite the direct and potentially sizable impact State Street Global Advisors’ investment management they have on lending income. fees for collateral reinvestment are on the low end of the Understanding and measuring these fees depends on the spectrum, at 1.75 basis points of cash collateral assets under structure of the collateral reinvestment fund. For registered management. Other reinvestment fund expenses may collateral reinvestment funds, the total expense ratio (TER) generally amount to 0.1–0.2 basis points, resulting in a total is generally the best measure to use. A little more work reinvestment fund expense of approximately 2 basis points. may be necessary when dealing with private collateral Other reinvestment fund managers may charge as high as 5, reinvestment funds: all expenses should be considered, 10, or 20 basis points in total expenses, significantly impacting including investment management fees, custodial fees, lending program revenues. This is in addition to the fees paid administration fees, accounting fees, operation fees, audit to the lending agent. fees, etc. In addition to their erosive effect on securities lending program returns, higher management fees on cash Questions to Ask a Lending Manager reinvestment funds can skew a manager’s incentives by • What is the fee split with the lending agent? Are there rewarding cash collateral loans and higher loan balances, any additional fees charged to the lending program by both of which funnel more assets into reinvestment the agent? funds, thereby increasing the reinvestment manager • Are all transactional costs of the program borne by the compensation. As noted in the risk management discussion, lending agent? Does the lending fund manager charge any this misalignment of interests may increase a manager’s fees in addition to those paid to the lending agent? compensation while adding risk to the lending program. To avoid this misalignment of incentives, select a lending • What are the total expenses of the cash collateral program with low investment management fees on the reinvestment vehicle? collateral reinvestment fund, disciplined consideration • Does the lending fund manager or an affiliate benefit of the lending limits, and an active acceptance of from fees charged to the reinvestment fund, or by the non-cash collateral. lending agent? A lending program’s total costs are frequently not limited • Are there any other conflicts of interest inherent in the to the program’s headline fee split. A robust discussion lending program? regarding all potential fees is necessary to uncover conflicts of interest and understand when the lending fund is earning a reasonable return. Ask the questions provided to understand the cost profile of your securities lending program.

State Street Global Advisors 9 Securities Lending in US DC Funds: What to Look For

Example Consider all costs, not just the headline fee split

Fees on Cash Reinvestment Pool

REINVESTMENT FEES Investment Management Fee Reinvestment fund expenses are rarely Administration Fee considered despite having a direct and Audit Fee potentially sizeable impact on lending program returns. Custodial Fee Accounting Fee

OPERATING FEES

Other Fees by Lending Agent

Gross Revenue*

The Headliner Fee Split When assessing the costs of lending % to the Lending Fund % to the Lending Agent programs, understand the percent of revenue going to the lending fund and to the lending agent.

Source: State Street Global Advisors. *Consists of all fees earned on non-cash collateral loans plus the spread earned on cash loans. The spread is the difference between the reinvestment yield received on cash collateral loans, and a rebate rate paid to the borrower providing cash as collateral. A rebate is effectively an interest rate paid to a borrower, and can be negative in cases of very hard-to-borrow securities.

State Street Global Advisors 10 1 This is true of USERISA-qualified collective investment trusts as well as various similar funds promulgated under developed-market regulations. 2 The lender may sometimes have to rebate some of the returns generated from the collateral reinvestment back to the borrower. This depends on what arrangement the parties have agreed to. 3 As of December 2018. 4 Investments purchased in the collateral reinvestment fund are required to satisfy certain quality, maturity, and diversification requirements set forth in Rule 2a-7 of the US Investment Company Act of 1940; however, the cash collateral pools are not registered investment companies, and as such are not required to strictly comply with Rule 2a-7. Therefore the investment guidelines for the cash collateral pools do not incorporate all of the requirements of Rule 2a-7, providing the Funds with greater flexibility in responding to market conditions. 5 Latent liquidity refers to securities available to lend but are not currently on loan. 6 The Growing Prominence of Non-Cash Collateral, State Street Global Markets, March 2014. 7 State Street Bank and Trust (SSBT), our lending agent, provides our lending funds with full borrower-level indemnification. SSBT is among the world’s largest and most experienced lending agents. SSBT was recently ranked #1 globally by beneficial owners in the 2018 ISF Beneficial Owner’s Survey of lending agents. More at Global Investor/ISF Magazine Spring 2018 issue. 8 Investments purchased in the collateral reinvestment fund are required to satisfy certain quality, maturity, and diversification requirements set forth in Rule 2a-7 of the US Investment Company Act of 1940; however, the cash collateral pools are not registered investment companies, and as such are not required to strictly comply with Rule 2a-7. Therefore the investment guidelines for the cash collateral pools do not incorporate all of the requirements of Rule 2a-7, providing the Funds with greater flexibility in responding to market conditions. 9 The spread is the difference between the reinvestment yield received on cash collateral loans, and a rebate rate paid to the borrower providing cash as collateral. A rebate is effectively an interest rate paid to a borrower, and can be negative in cases of very hard-to- borrow securities. 10 Other kinds of funds, such as ETFs, may have a different split. 11 Non-cash collateral loans are generally not subjected to reinvestment fund management fees.

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State Street Global Advisors One Iron Street, Boston MA 02210. by issuers with higher coupon or interest rates; and/or the risk of low income due T: +1 617 786 3000. to falling interest rates. To the extent that interest rates rise, certain underlying Important Information: obligations may be paid off substantially slower than originally anticipated and the value of those securities may fall sharply. This may result in a reduction in income Investing involves risk including the risk of loss of principal. from debt securities income. Securities lending programs and the subsequent reinvestment of the posted collateral The information provided does not constitute investment advice and it should not be are subject to a number of risks, including the risk that the value of the investments relied on as such. held in the collateral may decline in value and may at any point be worth less than the original cost of that investment. All information has been obtained from sources believed to be reliable, but its accuracy is not guaranteed. There is no representation or warranty as to the current The value of the debt securities may increase or decrease as a result of the following: accuracy, reliability or completeness of, nor liability for, decisions based on such market fluctuations, increases in interest rates, inability of issuers to repay principal information and it should not be relied on as such. and interest or illiquidity in the debt securities markets; the risk of low rates of return due to reinvestment of securities during periods of falling interest rates or repayment The whole or any part of this work may not be reproduced, copied or transmitted or any of its contents disclosed to third parties without SSGA’s express written consent.