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May Restrict Withdrawals Not Widely Understood' which was released on 
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United States Government Accountability Office: 
GAO: 

Report to the Chairman, Special Committee on Aging, U.S. Senate: 

March 2011: 

401(K) Plans: 

Certain Investment Options and Practices That May Restrict Withdrawals 
Not Widely Understood: 

GAO-11-291: 

GAO Highlights: 

Highlights of GAO-11-291, a report to the Chairman, Special Committee 
on Aging, U.S. Senate. 

Why GAO Did This Study: 

401(k) plan sponsors are responsible for offering an array of 
appropriate investment options, and participants are responsible for 
directing their investments among those options. While participants 
expect to be able to switch investment options or withdraw money from 
their accounts, during the recent economic downturn, some 401(k) plan 
sponsors and participants found that they were restricted from doing 
so. 

GAO was asked to (1) identify some of the specific investments and 
practices that prevented plan sponsors and participants from accessing 
their 401(k) plan assets and (2) determine any changes the Department 
of Labor (Labor) could make to assist sponsors in understanding the 
challenges posed by the investments and practices that restricted 
withdrawals. To do this, GAO reviewed relevant federal laws and 
regulations and consulted with experts, federal officials, service 
providers, and plan sponsors. 

What GAO Found: 

Between 2007 and 2010, some 401(k) plan sponsors and participants were 
restricted from withdrawing their plan assets from certain 401(k) 
investment options, see figure, including real estate, money market, 
and stable value investment options, as well as other investment 
options that lent securities (the practice of lending plan assets to 
third parties in exchange for cash as collateral that a fund 
reinvests). In most cases, the withdrawal restrictions were caused by 
losses and illiquidity in the investment options’ underlying 
portfolios and sometimes contract constraints placed on plan sponsors 
by the investment options. For stable value funds, and also for those 
investment options that lent securities, the withdrawal restrictions 
and their causes highlight the risks that participants face when 
allocating their 401(k) plan assets to these investment options—and, 
that losses are borne by plan participants. In addition, participants 
often do not understand or may receive insufficient disclosures of the 
risks posed by these investments. Further, plan sponsors may be 
unaware or receive insufficient disclosures of the risks and 
challenges involved with those investment options and practices. 

Figure: Investments and Practices that Restricted Plan Sponsor and 
Participant Access to 401(k) Plan Assets: 

[Refer to PDF for image: illustration] 

Assets: 
Real estate accounts; 
Money market funds; 
Stable value funds; 
Securities lending; 
Release of assets. 

Source: GAO. 

[End of figure] 

Labor can take a variety of steps to help plan sponsors who offer 
stable value funds and investment options that lend securities. Many 
of these steps can draw upon the changes that the Securities and 
Exchange Commission and others have already made, or will make, 
regarding these investment options and recent suggestions from plan 
sponsors, industry service providers, and other key stakeholders. 
Specifically, Labor could identify and take action to address those 
stable value contract constraints that may hinder plan sponsors from 
performing their fiduciary responsibilities and provide better 
disclosures to plan sponsors about certain investment options to help 
sponsors make decisions on behalf of participants. Similarly, revising 
Labor’s prohibited transaction exemption for securities lending to 
restrict those securities lending arrangements that may pose 
unreasonable financial terms upon plans and providing more guidance, 
in general, about such transactions can also help plan sponsors and 
participants understand the risks that cash collateral reinvestment 
can pose to plan assets in investment options that lend securities and 
how to mitigate them. 

What GAO Recommends: 

GAO recommends Labor study stable value funds and the practice of 
securities lending with cash collateral reinvestment by 401(k) plans 
to identify situations or conditions where plan sponsors could be 
prevented from meeting their fiduciary obligations, revise one of its 
prohibited transaction exemptions, and provide better disclosures and 
guidance to plan sponsors and participants. Labor disagreed with three 
of GAO’s recommendations and stated that it will consider the 
remaining four. GAO continues to believe in its recommendations. 

View [hyperlink, http://www.gao.gov/products/GAO-11-291] or key 
components. For more information, contact Charles Jeszeck at (202) 512-
7215 or jeszeckc@gao.gov. 

[End of section] 

Contents: 

Letter: 

Background: 

Certain Investment Options Placed Withdrawal Restrictions on 401(k) 
Plan Sponsors and Participants: 

Labor Can Take Steps to Help Plan Sponsors Understand the Risks and 
Challenges Posed By Certain Investments and Practices: 

Conclusions: 

Recommendations For Executive Action: 

Agency Comments and Our Evaluation: 

Appendix I: Comments from the Department of Labor: 

Appendix II: GAO Contact and Staff Acknowledgments: 

Glossary: 

Tables: 

Table 1: Investment Options Typically Offered through a 401(k) Plan: 

Table 2: Descriptions of the Three Types of Stable Value Fund 
Contracts: 

Table 3: Various Parties Involved in a Typical Securities Lending 
Transaction with Cash Collateral Reinvestment: 

Table 4: Potential Effects on Participants if Market Value Is Below 
Book Value: 

Figures: 

Figure 1: Estimated Aggregate Asset Allocation of 401(k) Plan Assets, 
2009: 

Figure 2: Stable Value Fund Wrap Contract: 

Figure 3: Example of a Simple Securities Lending with Cash Collateral 
Reinvestment Transaction: 

Figure 4: Reasons Withdrawal Restrictions May Have Occurred Regarding 
401(k) Plan Assets: 

Figure 5: Potential Risks Associated with Stable Value Fund Wrap 
Contracts: 

Figure 6: Gain or Loss earned from Cash Collateral from Securities 
Lending in Differing Market Scenarios: 

Figure 7: Example of a Stable Value Fund Disclosure Provided to 401(k) 
Participants: 

Figure 8: Example of a Securities Lending Disclosure in Registered 
Investment Option's Required Disclosures: 

Figure 9: Underlying Assets in Stable Value Funds (year end 2008): 

Abbreviations: 

CFTC: Commodity Futures Trading Commission: 

CIF: collective investment fund: 

EBSA: Employee Benefits Security Administration: 

ERISA: Employee Retirement Income Security Act of 1974: 

FDIC: Federal Deposit Insurance Corporation: 

FINRA: Financial Industry Regulatory Authority: 

FRB: Federal Reserve Board: 

GIC: guaranteed investment contract: 

OCC: Office of the Comptroller of the Currency: 

PTE: prohibited transaction exemption: 

SAI: Statement of Additional Information: 

SEC: Securities and Exchange Commission: 

[End of section] 

United States Government Accountability Office: 
GAO: 

March 10, 2011: 

The Honorable Herb Kohl: 
Chairman: 
Special Committee on Aging: 
United States Senate: 

Dear Mr. Chairman: 

The recent problems in the U.S. mortgage market and subsequent 
financial crisis revealed underlying weaknesses in the U.S. financial 
system and illustrated the importance of due diligence in financial 
matters. Investors, including 401(k) plan participants, experienced 
large losses from their investments in 2008.[Footnote 1] There were 
reports that some 401(k) participants experienced losses and were 
restricted from accessing their plan assets in certain situations, and 
that employers that sponsored 401(k) plans (plan sponsors) were also 
restricted from withdrawing plan assets. Nearly 90 percent of all 
401(k) plans are participant-directed, meaning they generally allow 
participants to choose how much to invest, within federal limits, and 
to select from a menu of diversified investment options chosen by the 
plan sponsor. As such, most 401(k) plan participants expect to be able 
to switch investment options or withdraw money from their accounts. 
[Footnote 2] Similarly, plan sponsors also expect to be able to change 
the investment options offered to their 401(k) plan participants 
without significant restrictions and, in fact, have a duty under the 
Employee Retirement Income Security Act of 1974 (ERISA) to act 
prudently when selecting investment options for plan participants and 
to act solely in the interest of the participants. The financial 
crisis illustrated that withdrawal restrictions can be a condition of 
certain investments, but they can also be a limitation of which some 
plan participants and plan sponsors may not be aware. 

Since it was unclear from the reports why certain types of investment 
options restricted withdrawals and how and when withdrawal 
restrictions were placed, we were asked to determine what happened 
during the financial crisis to participant accounts and to plan 
sponsors' control over the investment options offered to 401(k) plan 
participants. To better understand the type of investments that were 
offered to plan participants and whether plan participants and plan 
sponsors were adequately informed about the potential for withdrawal 
restrictions, we answered the following questions: 

1. What are some of the specific investments and practices that 
prevented plan sponsors and participants from accessing 401(k) plan 
assets? 

2. What changes, if any, could Labor make to assist plan sponsors in 
understanding the challenges posed by certain investments and 
practices? 

To determine the specific practices that may have affected plan 
sponsors' and participants' access to 401(k) plan assets during the 
recent market downturn, we reviewed articles published by industry 
experts, related documents from the Department of Labor (Labor), such 
as published materials available to plan fiduciaries regarding plan 
investment practices or suggested disclosures, and a report by Labor's 
ERISA Advisory Council. We also conducted a short poll of plan 
sponsors. The poll was conducted in coordination with Plansponsor 
Magazine (Plansponsor) and asked plan sponsors about withdrawal 
restrictions in their plans. The poll respondents were members of 
Plansponsor's subscription list, and their responses cannot be 
considered representative of the overall population of 401(k) plan 
sponsors. Our main use of this information was to better inform our 
understanding of these issues from a plan sponsor perspective and to 
design our subsequent audit work. Because of the methodological 
limitations and low response rate of this poll, this information is 
anecdotal and represents only the views of the 74 members who 
responded to our poll. 

To demonstrate the scope of the potential effects of withdrawal 
restrictions and risks to participants' earnings, we gathered data 
from industry associations and private researchers; however, because 
there was no comprehensive data source available, it was difficult to 
determine how widespread the incidences of withdrawal restrictions 
were and to quantify any losses to 401(k) participant accounts. We 
also interviewed plan sponsors, plan service providers, 
representatives from industry associations, researchers, and Labor 
officials to determine the circumstances that led to withdrawal 
restrictions during the recent market downturn, to get an 
understanding of the advantages and disadvantages of investing in 
certain investment options and engaging in certain investment 
practices, and to determine the various relationships between 401(k) 
plans and parties involved in these investment options and practices. 

To examine how the oversight and regulatory requirements governing 
withdrawal restrictions ensure that 401(k) plan sponsors and 
participants are aware of the potential for restricted access to plan 
investment options, we reviewed ERISA and Labor's related regulations, 
guidance, and frequently asked questions to determine their specific 
disclosure requirements and fiduciary responsibility standards. We 
reviewed the relevant federal laws and regulations, including those 
pertaining to disclosure requirements, of the Securities and Exchange 
Commission (SEC), the Office of the Comptroller of the Currency (OCC), 
the Federal Reserve Board (FRB), and the Federal Deposit Insurance 
Corporation (FDIC), and interviewed officials at each of the federal 
entities about how they govern withdrawal restrictions and other 
investment practices. We reviewed Labor's, SEC's, and banking 
regulators', requirements to see if changes to those requirements 
could better inform plan sponsors and participants of the risks 
associated with certain investments and investment practices. We also 
collected and reviewed examples of disclosures from various investment 
options offered by 401(k) plans to see if the disclosures were clear 
and understandable and if they complied with current requirements. In 
addition, we interviewed Labor officials about how they oversee 
withdrawal restrictions and monitor disclosures to plan sponsors and 
participants, and interviewed service providers, other industry and 
participant organizations, and pension professionals to obtain their 
views on current oversight, disclosure and fiduciary requirements. 

We conducted this performance audit from November 2009 to March 2011, 
in accordance with generally accepted government auditing standards. 
Those standards require that we plan and perform the audit to obtain 
sufficient, appropriate evidence to provide a reasonable basis for our 
findings and conclusions based on our audit objectives. We believe 
that the evidence obtained provides a reasonable basis for our 
findings and conclusions based on our audit objectives. 

Background: 

Under Title I of ERISA, plan sponsors are permitted to offer their 
employees two broad types of retirement plans, defined benefit and 
defined contribution. Plan sponsors that offer defined benefit plans 
typically invest their own money in the plan and, regardless of how 
the plans' investments perform, promise to provide eligible employees 
guaranteed retirement benefits, which are generally fixed levels of 
monthly retirement income based on years of service, age at 
retirement, and, frequently, earnings. In contrast, plan sponsors that 
offer defined contribution plans do not promise employees a specific 
benefit amount at retirement--instead, the employee and/or their plan 
sponsor contribute money to an individual account held in trust for 
the employee. The employee's retirement income from the defined 
contribution plan is based on the value of their individual account at 
retirement, which reflects the contributions to, performance of the 
investments in, and any fees charged against their account. Over the 
past three decades, there has been a general shift by plan sponsors 
away from defined benefit plans to defined contribution plans. 

The dominant and fastest growing defined contribution plan is the 
401(k) plan, which allows workers to choose to contribute a portion of 
their pretax compensation to the plan under section 401(k) of the 
Internal Revenue Code.[Footnote 3] The use of 401(k) plans accelerated 
in the 1980s after the U.S. Department of the Treasury (Treasury) 
issued a ruling clarifying a new section of the tax code that allowed 
employers and employees to make pretax contributions, up to certain 
limits, to employees' individual accounts. According to estimates by 
industry researchers, 49 million Americans were active 401(k) plan 
participants in 2009 and, by year end, 401(k) plan assets amounted to 
$2.8 trillion.[Footnote 4] In most 401(k) plans, participants bear the 
risk of their investments' performance and the responsibility for 
ensuring they have adequate savings in retirement. Participants may, 
under certain circumstances, withdraw their retirement savings early 
but may have to pay tax penalties for doing so. Current law limits 
participant access to retirement savings in employer-sponsored 
retirement plans although, in certain circumstances, 401(k) plan 
sponsors may provide participants with access to their tax-deferred 
retirement savings before retirement.[Footnote 5] 

Plan sponsors that offer 401(k) plans have responsibilities under 
ERISA. The law establishes that a plan fiduciary includes a person who 
has discretionary control or authority over the management or 
administration of the plan, including the plan's assets.[Footnote 6] 
Typically, the plan sponsor is a fiduciary under this definition. 
ERISA requires that plan fiduciaries carry out their responsibilities 
prudently and do so solely in the interest of the plan's participants 
and beneficiaries. In accordance with ERISA and related Labor 
regulations and guidance, plan sponsors and other fiduciaries must 
exercise an appropriate level of care and diligence given the scope of 
the plan and act for the exclusive benefit of plan participants and 
beneficiaries, rather than for their own or another party's gain. 
Responsibilities of a fiduciary may include, but are not limited to: 

* selecting and monitoring any service providers to the plan; 

* reporting plan information to the federal government and to 
participants; 

* adhering to the plan documents, including any investment policy 
statement; 

* identifying parties-in-interest to the plan and taking steps to 
monitor transactions with them; 

* selecting and monitoring investment options the plan will offer and 
diversifying plan investments; and: 

* ensuring that the services provided to the plan are necessary and 
that the cost of those services is reasonable. 

Because 401(k) plans place the responsibility for ensuring adequate 
retirement savings on participants and limit a fiduciary's liability 
for investment decisions made by participants, Labor has placed 
additional responsibilities on plan sponsors and their fiduciaries who 
offer these plans. For participants to have control, they must be 
given the opportunity to choose from a broad range of investment 
alternatives. They must be allowed to give investment instructions at 
least once a quarter and perhaps more often if the investment option 
is volatile. In addition, participants must be given sufficient 
information to make informed decisions about the investment options 
offered under the plan.[Footnote 7] 

ERISA allows plan sponsors to hire companies that will provide the 
services necessary to operate their 401(k) plans. Service providers 
are various outside entities, such as investment companies, banks, or 
insurance companies that a plan sponsor hires to provide the services 
necessary to operate the plan such as: 

* investment management (e.g., selecting and managing the securities 
included in a mutual fund); 

* consulting and providing financial advice (e.g., selecting vendors 
for investment options or other services); 

* record keeping (e.g., tracking individual account contributions); 

* custodial or trustee services for plan assets (e.g., holding the 
plan assets in a bank); and: 

* telephone or Web-based customer services for participants. 

Labor's Employee Benefits Security Administration (EBSA) oversees 
401(k) plans,[Footnote 8] educates and assists plan sponsors and 
participants, investigates alleged violations of ERISA, responds to 
requests for interpretations of ERISA through advisory opinions and 
rulings, and makes determinations to exempt transactions that would 
otherwise be prohibited under ERISA.[Footnote 9] However, the specific 
investment products commonly offered in 401(k) plans fall under the 
authority of the applicable securities, banking, or insurance 
regulators. These regulators include SEC, federal and state banking 
agencies, and state insurance commissioners as follows: 

* SEC, among other responsibilities, regulates securities markets and 
issuers, including mutual funds under various securities laws. 

* Federal agencies charged with oversight of banks--primarily FRB, 
OCC, FDIC, and state banking agencies--oversee bank investment 
products, such as collective investment funds (CIF),[Footnote 10] 
which are trusts that pool the investments of retirement plans or 
other institutional investors.[Footnote 11] 

* State insurance agencies generally regulate insurance products. Some 
investment products may also include one or more insurance elements, 
which are not present in other investment options. Generally, these 
elements include an annuity feature and interest and expense 
guarantees.[Footnote 12] 

401(k) Investment Options: 

ERISA does not prohibit a plan from offering any type of investment to 
its participants, but gives plan sponsors flexibility to choose the 
investments to be offered through their 401(k) plans.[Footnote 13] 
There are many types of 401(k) investment options, including those 
listed in table 1. 

Table 1: Investment Options Typically Offered through a 401(k) Plan: 

Type of investment option: Real estate accounts; 
Description: Real estate accounts are open-ended, commingled accounts 
that invest directly in real estate, such as funds that buy and manage 
commercial properties. Real estate accounts are equity accounts 
consisting primarily of high quality, well-leased real estate 
properties in the industrial, office, retail, and hotel sectors. If 
real estate accounts are offered by insurance companies as separate 
accounts, they are regulated by the State Insurance Commissioner in 
the state they are created. 

Type of investment option: Mutual funds; 
Description: A mutual fund, legally known as an open-end investment 
company, is a company that pools money from many investors and invests 
the money in stocks, bonds, short-term money market instruments, other 
securities or assets, or some combination of these investments. These 
investments comprise the fund's portfolio. Mutual funds are registered 
and regulated under the Investment Company Act of 1940, and are 
supervised by the SEC. Mutual funds sell shares to public investors. 
Each share represents an investor's proportionate ownership in the 
fund's holdings and the income those holdings generate. Mutual fund 
shares are "redeemable," which means that when mutual fund investors 
want to sell their shares, the investors sell them back to the fund, 
or to a broker acting for the fund, at their current net asset value 
per share, minus any fees the fund may charge. 

Type of investment option: Money market funds; 
Description: Money market funds are open-end management investment 
companies that are registered under the Investment Company Act of 
1940, and regulated under rule 2a-7 under that act. Money market funds 
invest in high-quality, short-term debt instruments such as commercial 
paper, treasury bills and repurchase agreements. Generally, these 
funds, unlike other investment companies, seek to maintain a stable 
net asset value per share (market value of assets minus liabilities 
divided by number of shares outstanding), typically $1 per share. 

Type of investment option: Collective Investment Funds (CIFs); 
Description: A CIF is a bank-administered trust that holds commingled 
assets that meet specific criteria. Each CIF is established under a 
"plan" that details the terms under which the bank manages and 
administers the fund's assets. The bank acts as a fiduciary for the 
CIF and holds legal title to the fund's assets. Participants in a CIF 
are the beneficial owners of the fund's assets. While each participant 
owns an undivided interest in the aggregate assets of a CIF, a 
participant does not directly own any specific asset held by a CIF. 
CIFs are designed to enhance investment management by combining assets 
from different accounts into a single fund with a specific investment 
strategy. Many banks establish CIFs as an investment vehicle for 
employee benefit accounts, including 401(k) plans. 

Type of investment option: Balanced funds; 
Description: Balanced funds are pooled accounts invested in stocks, 
bonds, and often additional asset classes. They are classified into 
two subcategories: target-date funds and nontarget-date balanced 
funds. Target date funds are often registered mutual funds and hold a 
mix of stocks, bonds, and other investments. Over time, the investment 
allocation gradually shifts according to the fund's investment 
strategy. Target date funds are designed to be investments for 
individuals with particular retirement dates in mind. The name of the 
fund often refers to its target date. For example, a fund with the 
name "Target 2030" is designed for individuals who intend to retire in 
or near the year 2030. Nontarget-date balanced funds include asset 
allocation or hybrid funds. 

Type of investment option: Stable value funds; 
Description: Stable value funds are a fixed income investment option, 
designed to preserve the total amount of participants' contributions, 
or their principal, while also providing steady, positive returns set 
in the contract. See below for more information. 

Source: GAO. 

Note: See [hyperlink, http://www.gao.gov/products/GAO-11-118] for more 
information on target date funds. 

[End of table] 

Labor reports that, in recent years, there has been a dramatic 
increase in the number of investment options typically offered under 
401(k) plans. Many investments offered under 401(k) plans today pool 
the money of a large number of individual investors into funds called 
commingled or pooled accounts.[Footnote 14] However, larger plans are 
more likely to structure their investments in separate accounts. 
[Footnote 15] Both types of accounts may be invested in stocks, bonds, 
or real estate, but the type and number of options plan sponsors offer 
to participants in any given 401(k) plan vary based on a number of 
factors, including the size of the plan and the chosen plan service 
providers. 

Results from a 2009 survey conducted by an industry consulting firm 
show that the most commonly offered 401(k) investment options in 2009 
were equity, bond, and stable value funds.[Footnote 16] Results from 
the survey also indicated that the percentage of plans offering money 
market funds significantly increased between 2007 and 2009. As shown 
in figure 1, equity funds accounted for over 40 percent of the 401(k) 
plan assets at the close of 2009. Other plan assets were invested in 
company stock; stable value funds, including guaranteed investment 
contracts; balanced funds; bond funds; and money funds. 

Figure 1: Estimated Aggregate Asset Allocation of 401(k) Plan Assets, 
2009: 

[Refer to PDF for image: pie-chart] 

Equity funds: 41% ($496.1 billion); 
Balanced funds: 17% ($205.7 billion); 
GICs and other stable value funds: 13% ($157.3 billion); 
Bond funds: 11% ($133.1 billion); 
Company stock: 9% ($108.9 billion); 
Money funds: 5% ($60.5 billion); 
Other: 4% ($48.4 billion). 

Sources: Employee Benefit Research Institute and Investment Company 
Institute. 

Note: GAO analyzed data provided in the November 2010 EBRI Issue Brief 
No. 350, in which EBRI and ICI summarize data from their 2009 EBRI/ICI 
401(k) database. According to EBRI and ICI, at year end 2009, all 
401(k) plans held a total of $2.8 trillion in assets, and that the 
database is a representative sample of the estimated universe of 
401(k) plans. EBRI and ICI state the database contains information on 
over 51,000 401(k) plans (about 10 percent of plans) with $1.21 
trillion in assets (about 44 percent of 401(k) plan assets) and about 
20 million participants (about 42 percent of the universe of active 
401(k) plan participants). The percentages presented in this figure 
are estimates of 401(k) plan assets included in each investment type 
based on the population covered in the database, or $1.21 trillion in 
401(k) plan assets. The "Equity funds" and "Bond funds" categories 
consist of pooled investments--including mutual funds and CIFs--that 
are primarily invested in stocks and bonds, respectively. The "Other" 
category is the residual for other investments, such as real estate 
funds, and the "Money funds" category includes money market funds and 
other funds that are designed to maintain a stable share price, other 
than GICs and stable value funds. For definitions of key terms used in 
the report, please see the glossary. 

[End of figure] 

Stable Value Funds: 

A key type of investment commonly offered through 401(k) plans is the 
stable value fund, which is a capital preservation investment option. 
These funds are primarily offered to defined contribution plan 
participants, including 401(k) plan participants.[Footnote 17] Stable 
value funds are marketed as being invested in high-quality, 
diversified fixed income investments that are protected against 
interest rate volatility. According to the Stable Value Investment 
Association, about 50 percent of 401(k) plans offer stable value funds 
and when a stable value fund is offered, participants put about 15 to 
20 percent of their plan assets, on average, into the investment 
option. Stable value funds are designed to preserve the total amount 
of participants' contributions, or their principal, while also 
providing steady, positive returns. 

While these funds attempt to maintain a stable return, actual return 
could vary over time because of changes in the market value of the 
underlying stable value portfolio assets, among other things.[Footnote 
18] To protect the fund from interest rate volatility, an important 
component of a stable value fund is the contract that plan sponsors or 
stable value fund managers purchase from plan service providers, 
including banks and insurers. The contract is a guarantee by a service 
provider, in the event of participant withdrawals, to pay participants 
at book value should the market value of the stable value portfolio be 
worth less than the amount needed to pay that book value.[Footnote 19] 
As part of the price of providing this guarantee, contract providers 
typically require certain restrictions on plan sponsor and participant 
withdrawals or transfers of plan assets from stable value funds. 
[Footnote 20] 

While the market value of a stable value fund fluctuates as market 
prices of the underlying assets rise and fall, its book value 
fluctuates much less often, if at all--the rate of return may be 
fixed, indexed, or reset periodically based on certain factors, 
including the actual performance of the underlying assets--depending 
on the type of stable value fund contract obtained by the plan. Table 
2 describes the three types of stable value fund contracts. Stable 
value funds may hold one contract type or a combination of contracts. 

Table 2: Descriptions of the Three Types of Stable Value Fund 
Contracts: 

Type of stable value fund: Traditional guaranteed investment contracts 
(GIC); 
Description: Plan sponsors contract with an insurance company to 
guarantee participants principal protection and a rate of return 
regardless of the performance of the underlying assets, which the 
insurance company owns and holds within their general account. 

Type of stable value fund: Separate account GICs; 
Description: Plan sponsors contract with an insurance company to 
guarantee participants principal protection and a rate of return, 
which may be fixed, indexed, or reset periodically based on the actual 
performance of the underlying assets. The insurance company owns and 
holds the underlying assets in a separate, customized account for the 
exclusive benefit of a single plan. 

Type of stable value fund: Synthetic GICs; 
Description: Plan sponsors contract with a bank or insurance company 
to guarantee participants principal protection and a rate of return 
relative to a portfolio of assets held in an external trust owned by 
the plan. The rate of return, which is based on the actual performance 
of the underlying assets, is reset periodically. 

Source: GAO. 

Note: For the purpose of this report, stable value funds described are 
those typically categorized as synthetic guaranteed investment 
contracts. 

[End of table] 

For synthetic GICs, contracts are called "wrap contracts." These 
stable value funds may obtain multiple wrap contracts from wrap 
contract providers to cover the underlying assets held in the stable 
value portfolio. As shown in figure 2, if participants want to 
withdraw funds when the value of a stable value portfolio falls below 
the book value the wrap contract provider may make up the difference 
for participants. In this situation, the wrap contract provider must 
only cover the difference between market value and book value if the 
total amount of participants' withdrawals exceeded the market value of 
the underlying stable value portfolio. 

Figure 2: Stable Value Fund Wrap Contract: 

[Refer to PDF for image: line graph] 

The graph charts Value of Investment against Duration of Time. 
Represented on the graph are the following: 

Market value of portfolio; 
Book value of contract. 

Under the conditions of the wrap contract, if the fund liquidates when 
the book value of the portfolio is higher than its market value, the 
insurer (wrap contract provider) pays the difference according to the 
terms of the wrap contract. 

Source: GAO presentation of Stable Value Investment Association 
information. 

[End of figure] 

401(k) Investment Practice: Securities Lending with Cash Collateral 
Reinvestment: 

Many of the investment options offered by plan sponsors, including 
money market funds, stable value funds, and equity funds, engage in a 
practice called securities lending, where some of the assets held in 
these investment options on behalf of plan participants are lent out 
for a period of time to a third party, usually a broker-dealer. 
[Footnote 21] In return, the broker-dealer provides collateral to the 
securities lending agent to hold until the broker-dealer returns the 
borrowed securities.[Footnote 22] For example, an S&P 500 index fund 
will hold the same stocks in approximately the same ratio as they 
comprise the S&P 500, in an attempt to approximate the return of the 
S&P 500. There will always be a gap between the S&P 500 and an index 
fund that tries to approximate the returns of the S&P 500, by buying 
and selling stocks to maintain the same values as are held in the S&P 
500. This gap, also known as "tracking error," is caused by, among 
other things, fund expenses, such as investment advisory fees, and 
brokerage expenses, that the index itself would not have. These index 
funds may try to decrease the gap by earning greater return on the 
stocks they hold by temporarily lending out the securities and then 
investing the cash collateral they receive.[Footnote 23] Table 3 
defines the various parties involved in a typical securities lending 
transaction. 

Table 3: Various Parties Involved in a Typical Securities Lending 
Transaction with Cash Collateral Reinvestment: 

Entity: Plan participants; 
Role: Plan participants contribute to their 401(k) and direct that 
contribution to certain investment options. In 401(k) plans, the 
assets are held in trust for participants. 

Entity: Plan sponsor; 
Role: A plan sponsor chooses which investment options to offer to its 
participants and, when making that choice, may decide whether to offer 
investment options that engage in securities lending. 

Entity: Plan service provider; 
Role: A plan service provider purchases securities on behalf of 401(k) 
plan participants. May act as securities lending agent.[A]. 

Entity: Securities lending agent; 
Role: The securities lending agent may coordinate loans of securities, 
hire a manager to invest cash collateral, and often takes on 
counterparty risk--or the risk that the borrower will fail to return 
the securities--on behalf of the plan. May be an affiliate of the 
custodian, i.e., an entity, usually a bank, that has legal 
responsibility for safekeeping a plan's securities. 

Entity: Borrower; 
Role: The borrower contracts with a broker-dealer to acquire the 
securities it needs to cover its obligations. The broker-dealer can 
also be the borrower. There are many reasons why an entity might seek 
to borrow securities, including for "short" sales, i.e., borrowing a 
security from a broker and selling it, with the understanding that it 
must be bought back and returned to the broker. Short selling is a 
technique used by investors who try to profit from the falling price 
of a stock. 

Entity: Broker-dealer; 
Role: The broker-dealer borrows securities on behalf of its customers, 
providing cash as collateral to the securities lending agent.[B] A 
broker-dealer is a company or other organization that trades 
securities for its own account or on behalf of its customers. Although 
many broker-dealers are "independent" firms solely involved in broker-
dealer services, many others are business units or subsidiaries of 
commercial banks, investment banks or investment companies. When 
executing trade orders on behalf of a customer, the institution is 
said to be acting as a broker. When executing trades for its own 
account, the institution is said to be acting as a dealer. 

Entity: Cash collateral pool manager; 
Role: The cash collateral pool manager invests the cash provided as 
collateral for the borrowed securities in order to earn additional 
return for the securities lending agent during the period of time that 
the securities are borrowed. The securities lending agent can be the 
cash collateral pool manager, but usually it is an affiliate of the 
securities lending agent. 

Source: GAO. 

[A] Custodial banks commonly provide securities lending services to 
defined benefit and defined contribution plans. If the plan invests 
plan assets in separate accounts, plan sponsors can choose whether or 
not to participate directly in a securities lending program. If the 
plan invests plan assets in commingled accounts--including mutual 
funds and collective investment funds--it may also participate 
indirectly in securities lending if those commingled accounts 
participate in securities lending. 

[B] The amount of collateral provided by the broker-dealer may depend 
on the type of security being lent. For U.S. securities a typical 
collateral rate is 102 percent, for international securities it is 105 
percent, of the value of the securities being lent out. 

[End of table] 

Figure 3 shows how a simple securities lending transaction would work. 

Figure 3: Example of a Simple Securities Lending with Cash Collateral 
Reinvestment Transaction: 

[Refer to PDF for image: illustration] 

1. Participant sends cash to plan sponsor to be invested in a 401(k) 
plan. 

2. Plan sponsor, usually employer, sends cash to plan service provider 
to purchase shares in 401(k) plan on behalf of participant. 

3. Plan service provider buys securities on behalf of the plan and 
holds these securities and those of other investors in a pool of 
assets. Plan service provider can act as securities lending agent. 

Lending shares for additional investment: 

4. Acting as securities lending agent, plan service provider may lend 
some of the pool's securities to a broker-dealer. 

5. Broker-dealer borrows a needed security on behalf of a customer in 
exchange for cash as collateral and a promise to return the security 
at a future date. 

6. Seeking additional return, the securities lending agent invests the 
cash collateral. 

7. Cash collateral pool manager, who is often working as an affiliate 
of the securities lending agent, manages the investment of the cash 
collateral. Gains or losses[A] to Plan service provider. 

8. When the broker-dealer returns the security, the plan refunds the 
cash used as collateral. 

Source: GAO interviews and analysis of the practice of securities 
lending with cash collateral reinvestment. 

Note: When securities are on loan, the lenders, or plan participants, 
retain all the benefits of ownership including rights to dividends, 
interest payments, corporate actions (excluding proxy voting), and 
market exposure to unrealized capital gains or losses. 

[A] Participants earn additional return in this transaction when the 
reinvested cash collateral earns more than the amounts owed to (1) the 
cash collateral pool manager as a fee for managing the cash collateral 
pool and (2) the broker-dealer as a "rebate." Generally the return 
left over after these two entities are paid is split between the 
securities lending agent and plan participants in varying percentages. 
The proceeds from securities lending that plan participants receive 
typically serves to offset custody fees and administrative expenses or 
to simply enhance participants' portfolio returns. 

[End of figure] 

Institutions engaged in securities lending for a 401(k) plan subject 
to ERISA are supposed to take all steps necessary to design and 
maintain their programs to conform to an ERISA exemption that 
authorizes securities lending transactions that might otherwise 
constitute "prohibited transactions" under ERISA.[Footnote 24] In 
general, ERISA prohibits parties-in-interest--such as service 
providers, plan fiduciaries, the employer, the union, owners, 
officers, and relatives of parties-in-interest--from doing business 
with the plan[Footnote 25] but provides various exemptions to these 
prohibited transactions.[Footnote 26] Some of the exemptions provide 
for dealings with banks, insurance companies, and other financial 
institutions essential to the ongoing operations of the plan. Labor 
issued Prohibited Transaction Exemption (PTE) 2006-16 to allow the 
lending of securities by employee benefit plans to certain banks and 
broker-dealers and to permit the payment of compensation to a lending 
fiduciary for services rendered in connection with loans of plan 
assets that are securities.[Footnote 27] 

Certain Investment Options Placed Withdrawal Restrictions on 401(k) 
Plan Sponsors and Participants: 

Between 2007 and 2010, some plan sponsors and participants were 
restricted from withdrawing their plan assets from certain 401(k) 
investment options, such as real estate, money market, and stable 
value investment options.[Footnote 28] As shown in figure 4, beyond 
elevated levels of withdrawal requests, there were various reasons why 
certain investment options restricted withdrawals.[Footnote 29] 

Figure 4: Reasons Withdrawal Restrictions May Have Occurred Regarding 
401(k) Plan Assets: 

[Refer to PDF for image: illustration] 

Assets: 

Real estate accounts: 
Fund doesn’t have enough cash and doesn’t want to liquidate assets 
that have declined in value or have become difficult to sell. 

Money market funds: 
Fund’s assets have declined in value, and the fund has decided to 
liquidate. 

Stable value funds: 
Fund doesn’t have enough cash to pay all participants or sponsors who 
want to withdraw at book value; and: 
Fund is unable to liquidate assets that have declined in value or have 
become difficult to sell for enough to pay out at book value; and: 
Wrap contracts will be voided if sponsor or too many participants want 
to withdraw or because of an employer-initiated event. 

Securities lending: 
Cash collateral pool assets have declined in value or have become 
difficult to trade; and: 
Unable to liquidate assets to obtain enough cash to unwind securities 
lending transaction. 

Source: GAO. 

[End of figure] 

Real Estate Accounts Restricted Withdrawals Because of Illiquid Assets: 

Multiple real estate accounts placed restrictions on participant and 
sponsor withdrawals in 2007 and 2008--some of which lasted into 2011. 
[Footnote 30] Since these accounts buy and manage real estate, such as 
commercial properties, which is inherently more illiquid than some 
assets in other 401(k) investment options, industry experts we spoke 
to told us that few plan sponsors tend to offer these investment 
options in 401(k) plans. Nevertheless, some 401(k) plan participants 
had invested some of their 401(k) plan assets with these types of 
investment options and found those assets frozen during the last few 
years because some of the investments in the real estate accounts--for 
example, an investment by the real estate fund in a high-rise building 
or other commercial property--had lost significant value and became 
difficult to sell. As a result, participants' and plan sponsors' 
withdrawals of their assets from the investment options were postponed 
by managers of the accounts, sometimes for multiple years. [Footnote 
31] While the number of 401(k) plan sponsors or participants whose 
withdrawals were affected or who lost money as a result of withdrawal 
restrictions is unknown, at least one lawsuit was filed on behalf of 
ERISA plans, including 401(k) plan participants, alleging that a 
service provider breached its fiduciary duties by managing a real 
estate account that restricted withdrawals inconsistently with its 
stated objective to maintain adequate liquidity to provide for daily 
withdrawals.[Footnote 32] As of December 2010, some of the 
restrictions that were placed on these real estate accounts had been 
lifted, and some plan participants and sponsors had received their 
requested plan assets. 

Industry experts told us that withdrawal restrictions on real estate 
accounts are not unusual--in fact such accounts have implemented 
withdrawal restrictions in the past--and that, for this reason, these 
investment options disclose to plan sponsors and participants in 
account documentation that the real estate account manager may 
temporarily freeze withdrawals. We found that plan sponsors generally 
receive information about real estate accounts, including the maximum 
number of days allowed to defer withdrawals from the account, in the 
contract that they sign with their service provider. In addition, we 
reviewed disclosures to participants that stated that the investment 
option was subject to investment and liquidity risk and other risks 
inherent in real estate such as those associated with general and 
local economic conditions, and that payment of principal and earnings 
may be delayed. However, some of the industry officials we spoke to 
noted that, regardless of these disclosures, participants may not have 
known that their plan assets could be frozen because they failed to 
read or understand the disclosures. 

One Money Market Fund Restricted Withdrawals Because of Losses and 
Illiquid Assets, While Others Required Support to Prevent Potential 
Restrictions: 

While money market funds account for only a small portion of 401(k) 
plan assets, during 2007 and 2008, many money market funds experienced 
severe financial difficulties from exposure to losses from debt 
securities issued by structured investment vehicles and Lehman 
Brothers Holdings Inc. (Lehman), and one of them placed restrictions 
on all withdrawals from the investment option. The once-more than $60 
billion money market fund, the Reserve Primary Fund, "broke the buck" 
on September 16, 2008, because its $785 million holdings of Lehman 
debt securities had defaulted, causing a 3 percent loss to investors, 
including 401(k) plan participants.[Footnote 33] As a result of 
investor concern over Lehman's default, the Primary Fund faced a very 
large number of withdrawal requests over a short period of time--or a 
run on the fund--which the other Reserve funds also experienced. 
[Footnote 34] The Primary Fund stopped satisfying redemption requests 
and formally instituted withdrawal restrictions on all investors on 
September 22, 2008, when it obtained an SEC order permitting the 
suspension of redemptions in certain Reserve Funds, including the 
Primary Fund, to permit their orderly liquidation.[Footnote 35] 

With the exception of the Reserve Primary Fund, the money market funds 
that were exposed to losses in 2007 and 2008 obtained support in some 
form from their advisers or other affiliated service providers that 
may have helped to avoid potential restrictions. This support either 
absorbed the losses or provided a guarantee covering a sufficient 
amount of losses to prevent the money market fund from breaking the 
buck. In addition, these funds received support from federal 
regulators to help them remain liquid and preserve their value. 
Shortly after the Reserve Primary Fund began to experience 
difficulties, on September 19, 2008, the Treasury announced the 
Temporary Guarantee Program for Money Market Funds, which temporarily 
guaranteed certain investments in money market funds that decided to 
participate in the program.[Footnote 36] On the same day, the FRB 
announced the creation of its Asset-Backed Commercial Paper Money 
Market Mutual Fund Liquidity Facility, through which it extended 
credit to U.S. banks and bank holding companies to finance their 
purchases of high-quality asset-backed commercial paper from money 
market funds.[Footnote 37] As a result of the service provider and 
federal support that provided additional liquidity to money market 
funds, additional redemption suspensions and liquidations may have 
been prevented. 

Because of the severity of the problems experienced by money market 
funds during 2007 and 2008, SEC reformed its regulations governing 
money market funds. The new regulations are designed to make money 
market funds more resilient, more liquid, and to reduce the chance of 
runs on money market funds in the future.[Footnote 38] Among other 
things, the new regulations now permit a money market fund that has 
broken the buck, or that is at imminent risk of doing so, and that has 
irrevocably decided to liquidate, to suspend redemptions without 
obtaining an SEC order.[Footnote 39] These changes could permit 
additional participant and sponsor withdrawal restrictions in the 
future, if additional money market funds liquidate. 

Some Stable Value Fund Assets Were Restricted Because of Losses, 
Illiquid Assets, and Contract Constraints, Which Also Pose Risks to 
Participants: 

Some Stable Value Funds Restricted Plan Sponsor and Participant 
Withdrawals, but the Extent Is Unknown: 

Industry experts have noted that most stable value funds avoided 
withdrawal restrictions in 2008 and 2009, but we found that the total 
number of plan sponsors and participants affected by withdrawal 
restrictions from stable value funds was unknown. Stable value funds 
can place restrictions on plan sponsor and participant withdrawals in 
some circumstances when the market value of the fund's underlying 
assets is below the book value, and more participants want to cash out 
than the fund's cash holdings can handle. According to the Stable 
Value Investment Association and industry consultants, many stable 
value funds were operating with market values below book values in 
2008 and 2009 because of losses and illiquidity in their underlying 
assets, but plan participants allocated increasing amounts of their 
401(k) assets to stable value funds. An industry association indicated 
that this increase in participants' contributions to stable value 
funds likely allowed stable value funds to avoid liquidity problems 
that could have caused withdrawal restrictions or losses for 
participants. 

However, when many stable value funds experienced market values below 
book values during 2008 and 2009, some participants and plan sponsors 
were restricted from withdrawing their plan assets from some stable 
value portfolios because of stipulations in their wrap contracts. For 
example, after their company's bankruptcy, participants in Mervyns 
LLC's 401(k) plan were restricted from withdrawing their assets 
invested in the stable value option. In this situation, the 
protections that would have been afforded to the Mervyns participants 
by the stable value fund's wrap contract were voided by the plan 
sponsor's bankruptcy, since it was considered an "employer-initiated 
event" in the contract. Similarly, some plan sponsors were restricted 
from withdrawing plan assets from stable value funds because of 
constraining language in the wrap contract that provided for 
withdrawal restrictions in the case of employer-initiated events. 
Specifically, wrap contracts typically stipulate that stable value 
managers have the right to restrict plan sponsor withdrawals for 
employer-initiated events for up to 12 months in order to unwind 
investments and ensure that participants can be paid out at book 
value, but during this time participants are generally able to make 
withdrawals from the investment option at any time.[Footnote 40] 
Employer-initiated events could include layoffs, bankruptcies, and 
changing stable value fund providers and might include anything that 
may cause withdrawals of a large plan asset amount from the investment 
option in a short time frame. For example, one plan sponsor who 
recently acquired another company noted that the acquisition took only 
4.5 months, but it was restricted from withdrawing from the companies' 
two stable value funds for nearly 2 years because the acquisition, as 
an employer-initiated event, required a merger of the two existing 
stable value funds, but existing contract providers refused to 
accommodate the stable value fund merger without loss to participants. 
Another plan sponsor we spoke to noted that its 401(k) plan switched 
plan service providers and had to wait until the stable value fund 
provider had come up with enough cash to implement the change. As of 
the date of the switch, new contributions to the stable value option 
were attributed directly to the new stable value fund at the new 
provider, but the plan had to keep the past contributions on the 
plan's records until the restriction was lifted. 

Losses and Illiquidity in Stable Value Portfolios and Contract 
Constraints Increase Participants' Risks for Restrictions and Losses: 

The losses and illiquidity of the underlying assets of stable value 
funds and contract constraints that led to the withdrawal restrictions 
raised some concerns about the risks that these investment options 
pose to participants. Specifically, the industry has documented that, 
between 2005 and 2007, many stable value funds began including riskier 
assets than had been traditionally included in stable value 
portfolios--including highly rated corporate bonds, mortgage-backed 
securities,[Footnote 41] and asset-backed securities,[Footnote 42] at 
the expense of treasuries--in an effort to increase participants' 
return and to attract more investors. However, many of these 
securities suffered price declines, which contributed to the stable 
value funds' market values falling below their book values and has 
resulted in lower returns for participants. When the market value of 
the stable value portfolio is above book value, participants who want 
to withdraw their plan assets from the stable value fund receive book 
value, and stable value fund providers retain the extra as profit and 
as reimbursement for their costs to run the stable value fund. 
[Footnote 43] However, as shown in table 4, when the market value of 
the stable value portfolio's assets is below book value, and the 
contract is voided by an employer-initiated event, plan participants 
can face withdrawal restrictions until the stable value fund generates 
enough cash from new contributions or by selling existing portfolio 
assets.[Footnote 44] 

Table 4: Potential Effects on Participants if Market Value Is Below 
Book Value: 

Wrap contract is: 
Valid--withdrawals do not result from employer-initiated events; 
What happens if many participants want to withdraw? Stable value fund 
pays participants with cash holdings and proceeds from selling other 
stable value holdings. Since the stable value holdings are not enough 
to pay participants at book value, the wrap provider pays the 
difference between market value and book value.[A] 

Wrap contract is: 
Void--withdrawals result from employer-initiated events that void the 
contract; 
What happens if many participants want to withdraw? Stable value fund 
pays participants the market value of their investment in the fund 
with cash holdings and proceeds from selling other stable value 
holdings. 
Or: 
Stable value fund restricts withdrawals until the stable value fund 
can provide participants with cash holdings and proceeds from selling 
other stable value holdings. 

Source: GAO. 

[A] Wrap providers cover the difference between market value and book 
value; not the full amount necessary to pay participants who request 
withdrawals. For example, if the book value of a participant's plan 
assets in the stable value fund is $100, but the market value of their 
plan assets is only $97, then the wrap provider would pay $3, and the 
stable value fund would pay $97 if the participant wanted to withdraw 
their assets. 

[End of table] 

In addition to withdrawal restrictions, when the market value of the 
stable value portfolio's assets is below book value, participants are 
at risk for losses from the investment option. As noted above, in the 
case of an employer-initiated event, the wrap contract protections 
that would provide participants with book value could be voided, 
thereby placing plan participants at risk for any losses of the 
underlying assets.[Footnote 45] For example, when Lehman filed for 
bankruptcy in September 2008, wrap contracts that covered portions of 
the stable value fund in the Lehman 401(k) plan became void, which 
resulted in losses for some plan participants who withdrew their plan 
assets from the investment option. Furthermore, even if the wrap 
contract remains valid, if more participants request transfers out of 
the investment option when the market value of the fund is less than 
book value than the fund's liquidity reserves can handle, new 
participants and participants who remain in the fund could be at risk 
for the losses from the investment option because the rate of return 
earned on the stable value fund, going forward, will be adjusted 
downward by the wrap contract provider to reflect the market losses 
that were temporarily covered by the wrap provider.[Footnote 46] In 
fact, industry experts note that wrap providers had never made a 
payment in fulfillment of a wrap contract that they did not recoup. As 
a result of the adjusted rate of return, future assets contributed to 
the stable value fund, whether by current or new participants, will 
earn less than the original assets that incurred the losses because 
the wrap provider will guarantee a lower return for those future 
contributions in order to make up for the market losses. Although one 
of the reasons why stable value fund providers place restrictions on 
plan sponsor and participant withdrawals is to limit these situations, 
even unrestricted participant withdrawals could trigger an inequitable 
distribution of risk and losses. This is of particular concern when 
interest rates have risen sharply, and investors leave the stable 
value fund in search of higher yields. 

Stable Value Wrap Contracts Also Expose Participants to Other Risks: 

In addition to causing potential losses for participants, wrap 
contracts can also expose participants to other risks. Figure 5 
illustrates some of the potential risks associated with stable value 
fund wrap contracts. 

Figure 5: Potential Risks Associated with Stable Value Fund Wrap 
Contracts: 

[Refer to PDF for image: illustration] 

Stable Value Portfolio: 

Wrap Contract: 
* It is possible to lose money by investing in a fund that doesn’t 
maintain its net asset value; 
* Participants are typically restricted from transferring their money 
into competing funds for a period of time; 
* Some portfolios could be left unwrapped if wrap contract providers 
exit the business or experience credit downgrades; 
* Some participants could receive market value if their wrap provider 
defaults.[A] 

Source: GAO interviews and analysis of stable value fund issues. 

[A] One of the major wrap contract providers almost went bankrupt, 
requiring a federal bailout. 

[End of figure] 

* "Competing" fund restrictions--If participants wish to withdraw 
their assets from a stable value fund, the terms of the wrap contract 
may prohibit them from transferring their assets into "competing" 
investment options offered by the plan sponsor, as defined in the wrap 
contract. Participants may instead be required to put their assets 
into a noncompeting investment option for 90 days.[Footnote 47] 
Because these funds are intended to be longer term investments, these 
restrictions are typically included in the wrap contract to prevent 
participants from taking of advantage of interest rate fluctuations; 
however, they still represent a risk to participants since they are 
prevented from directing their assets. 

* Rising fees for wrap contracts--Industry experts note that wrap 
contracts have gotten more expensive in recent years as wrap providers 
also became aware of the significant risks taken in stable value fund 
portfolios. For example, one stable value fund provider stated that, 
as of March 2010, virtually all wrap providers had ceased accepting 
new stable value portfolios unless the contracts stipulated new 
contract terms--including tougher investment parameters and higher 
fees--which were more favorable for wrap providers but could create 
unwelcome inflexibility for plan sponsors.[Footnote 48] Such higher 
fees for wrap providers, everything else equal, could also result in 
lower returns for participants. Wrap capacity has also recently been 
constrained because some wrap providers left the market, and others 
saw decreases in their credit ratings. Because of this, some stable 
value funds have had difficulty obtaining wrap contracts on portions 
of their underlying stable value portfolios, which has increased the 
likelihood that participants could bear potential losses from the 
underlying investments in stable value funds. For example, AIG, one of 
the major wrap providers, no longer provides wrap contracts.[Footnote 
49] Similarly, according to industry reports, a few other firms, 
including UBS and Rabobank, decided to stop providing wrap coverage. 
These developments would also tend to place upward pressure on fees. 
[Footnote 50] While some providers have entered the market, and other 
stable value fund providers have agreed to provide this coverage for 
their plan sponsors until they can obtain a wrap contract, wrap 
capacity is not yet back to previous levels. 

Certain Investment Options That Lent Securities Placed Restrictions on 
Plan Sponsor Withdrawals Because of Losses and Illiquid Assets in the 
Cash Collateral Pool, Which Also Posed Risks to Participants: 

We also found that some restrictions were placed on investment options 
that lent securities. Any number of 401(k) investment options can lend 
securities, including index funds, money market funds, and stable 
value funds. Some service providers that offered the investment 
options that lent securities did not allow plan sponsors to withdraw 
or transfer all of the 401(k) plans' investments in those investment 
options because of collateral pool losses.[Footnote 51] These losses 
occurred because the cash collateral pools had been invested in risky 
assets that subsequently lost value and became difficult to trade. 
[Footnote 52] As a result of the losses, the pools were not worth the 
amount that the investment option needed to return the cash collateral 
and pay rebates to borrowers.[Footnote 53] During the period of 
withdrawal restrictions, some plan sponsors were allowed to withdraw 
only a certain percentage of their plan's assets in the investment 
option over a given time period--in many cases 2 to 4 percent--or they 
were required to take their share of the cash collateral pool's 
illiquid and devalued assets.[Footnote 54] 

Similar to stable value funds, the losses and illiquid assets in the 
cash collateral pools that led to these restrictions on plan sponsor 
withdrawals raised concerns about the risks this practice poses to 
participants' account balances, given the returns they receive. In the 
case of securities lending with cash collateral, participants bear the 
ultimate risk of loss from the cash collateral pool 
investments.[Footnote 55] While securities lending agents may bear 
counterparty risk from securities lending activities with cash 
collateral--i.e., reimburse plan participants for losses caused by 
borrower default--they generally do not reimburse plan participants 
for losses that the cash collateral reinvestment pool may suffer, 
which is the risk that remains with plan participants. However, in the 
event that there were gains from the investments of the cash 
collateral pool, participants only receive a portion of return, while 
securities lending service providers, including broker-dealers and 
securities lending agents, may obtain most of the gains earned on cash 
collateral reinvestment.[Footnote 56] In addition, some securities 
lending agents reported large portions of their annual revenues from 
the returns earned by cash collateral reinvestment activities for 
their institutional investors, including 401(k) plans.[Footnote 57] In 
2008, one of the largest securities lending agents reported that its 
revenues from such lending were over $1 billion. See figure 6 for a 
breakdown on the return that participants can receive. 

Figure 6: Gain or Loss Earned on Reinvestment of Cash Collateral from 
Securities Lending in Differing Market Scenarios: 

[Refer to PDF for image: illustration] 

The profit or loss taken by plan participants on the same $2,500 
investment varies with the annual return earned by cash collateral 
pools. 

Scenario 1: The cash collateral pool earns a 4 percent return over the 
year (+$100): 

$100 total return on investment: 
$87.50 Rebate to broker-dealer (3.5% interest[A] on total cash 
collateral); 
$3.75 Fee to collateral pool manager (15 basis points)[B]; 
$8.75 profit; 
$1.75 Profit to securities lending agent (20% of gross profit); 
$7 Profit to participants (80% of gross profit). 

Scenario 2: The cash collateral pool earns 3 percent interest over the 
year (+$75): 

$75 total return on investment: 
$87.50 Rebate to broker-dealer (3.5% interest[A] on total cash 
collateral); 
$3.75 Fee to collateral pool manager (15 basis points); 
$0 Profit to securities lending agent (0% of total loss); 
$16.25 Loss to participants (100% of total loss). 

Scenario 3: The cash collateral pool loses 3 percent over the year 
(–$75): 

$75 loss on investment: 
$87.50 Rebate to broker-dealer (3.5% interest[A] on total cash 
collateral); 
$3.75 Fee to collateral pool manager (15 basis points); 
$0 Profit to securities lending agent (0% of total loss); 
$166.25 Loss to participants (100% of total loss). 

Source: GAO interviews and analysis of the practice of securities 
lending with cash collateral reinvestment. 

Note: All of these scenarios are based on certain assumptions. The 
rates were chosen to depict a situation that may have been in effect 
in the years/months prior to and at the beginning of the crisis. While 
today's rates may vary from the rates depicted here, the distribution 
of gains/losses will not likely differ materially for the same type of 
securities loan. Thus, in this example, 

* The securities lending agent contracts with (1) the plan sponsor to 
allow the plan's assets to be lent and (2) with the broker-dealer to 
lend the assets, 

* The security lent is not a "special" security--or a security that is 
sought after in the market by borrowers, 

* The total amount of cash collateral as a result of the securities 
lending transaction, $2,500, is provided by the broker-dealer at the 
beginning of the year and the securities lending transaction remains 
in effect throughout the year, 

* The securities lending agent reinvests all of the cash collateral 
provided by the broker-dealer in a cash collateral pool managed by the 
collateral pool manager, who charges 15 basis points of the total 
amount of cash collateral to manage the pool ($3.75), 

* The broker-dealer is promised a rebate--an annualized return of 3.5 
percent interest on the total amount of cash collateral they provide 
over the year ($87.50), and: 

* The plan sponsor agrees to an 80/20 revenue sharing split between 
plan participants and the securities lending agent, which means that 
participants get 80 percent, and the lending agent gets 20 percent of 
the revenue earned from the cash collateral pool after fees are paid. 

[A] Typically, the rate promised to the broker-dealer as a rebate is 
based on a benchmark rate, such as the federal funds rate or LIBOR and 
is not typically provided in a one-time payment as shown in the 
graphic, but more likely paid on a daily or monthly basis. The greater 
the demand for the security being lent, the lower the rebate paid to 
the broker-dealer. "Special" securities that have an extremely high 
borrowing demand, or that are in short supply and therefore hard to 
borrow, can obtain "negative" rebates, requiring the borrower to not 
only pledge cash, but also pay a fee to plan participants. 

[B] 15 basis points is the same as 0.15 percent. 

[End of figure] 

Because securities lending agents typically do not bear the risk of 
loss of the collateral pool, yet gain when the collateral pool makes 
money, they may be encouraged to take more risks with the underlying 
assets of the investment options--both by investing in riskier assets 
and by delaying the sale of those assets. Some cash collateral pool 
managers invested in certain assets that increased the risk of the 
pool. These assets were of questionable credit quality or required a 
longer duration of investment than the typical plan assumed were in 
the cash collateral pool. For example, prior to September 2008, some 
pools had invested in Lehman Brothers Holdings, Inc., securities that 
became almost worthless in 2008, making them too illiquid to pay all 
withdrawal requests.[Footnote 58] Furthermore, we found that plan 
sponsors may have also had the incentive to offer investment options 
that lent securities more aggressively because those investment 
options offered higher returns, yet were still marketed as relatively 
"risk free." Thus, in trying to offer participants investment options 
that provided competitive returns, plan sponsors may have searched out 
investment options that may have, as a result of securities lending 
with cash collateral, increased participant risks in the process of 
seeking higher returns.[Footnote 59] 

In addition to withdrawal restrictions, these risky assets in 
securities lending cash collateral pools caused realized losses for 
participants in the last few years.[Footnote 60] A recent industry 
publication estimated that unrealized losses in securities lending 
cash collateral pools affected most pension plans and many defined 
contribution plans, but some 401(k) plans also experienced realized 
cash collateral pool losses in 2008. In addition, some retirement 
plans, including 401(k) plans, have recently filed lawsuits against 
some of the larger securities lending agents as a result of these 
losses.[Footnote 61] The litigation claims included allegations of 
violations of the lending agents' fiduciary, contractual, and other 
legal responsibilities in losing millions of dollars for the 
investment funds in their securities lending contracts. In addition, 
several securities lending agents have requested and received 
individual prohibited transaction exemptions from Labor that have 
allowed them to reduce some of the cash collateral pool losses. 
[Footnote 62] Specifically, these exemptions allowed securities 
lending agents either to buy the problematic securities from a number 
of cash collateral pools that held pension plan and 401(k) plans 
assets or to shore up those pools with cash in an attempt to create 
liquidity in the otherwise cash-strapped collateral pools.[Footnote 63] 

Disclosures about Stable Value Funds and Securities Lending Are 
Limited and Difficult for Participants to Understand: 

Given the risk and limitations that participants are exposed to when 
investing in stable value funds, information provided to participants 
may be difficult for them to understand and may not fully explain the 
risks taken on their behalf by stable value funds, including the 
variety of events that could affect participants' withdrawals or that 
could cause losses. See figure 7. While participants receive some 
disclosures about stable value funds and some of the risks associated 
with investing in them, industry experts found in 2009 that 
participants often are not able to understand those disclosures. 
[Footnote 64] For example, a defined contribution consulting firm 
recently expressed concern over participants' perception that these 
investment options are risk-free and recommended that stable value 
funds should be required to make a statement explaining how such a 
fund is managed and identifying the risks associated with the fund, 
such as the underlying assets, the wrap providers, and the wrap 
contract. 

Figure 7: Example of a Stable Value Fund Disclosure Provided to 401(k) 
Participants: 

[Refer to PDF for image: illustration] 

Excerpts from a two-page stable value fund fact sheet (text shown 
actual size): 

Risk Management: 

* Issuer exposure is constrained to minimize issuer credit risk and 
increase diversification. 

* Duration target is managed at portfolio and product levels to 
provide consistent income from interest and principal repayments while 
minimizing convexity risk. 

* A tiered liquidity protocol and laddered portfolio maturity 
structure are utilized to minimize liquidity risk. 

Smaller text: 

...actual investment advisory fees incurred by clients may vary 
depending on account size and other account-specific factors... 

...It should not be assumed that any of the securities transactions or 
holdings listed or discussed were or will be profitable, or that the 
investment recommendations or decisions we will make in the future 
will be profitable or will equal the investment performance of the 
securities listed or discussed herein.... 

Source: GAO presentation of a private investment company’s fact sheet 
for a stable value fund. 

[End of figure] 

Furthermore, it is unclear to what extent stable value fund 
disclosures include a discussion of all of the risks that participants 
could be exposed to and all of the information participants need to 
evaluate the benefits and risks of the investment option. Labor 
published final participant disclosure regulations in October 2010 
that will affect the disclosures participants receive about investment 
options, including stable value funds.[Footnote 65] One industry 
expert we spoke to said that while the newly required disclosures 
clearly include participant restrictions defined in the stable value 
contracts, such as restrictions on transferring plan assets into 
competing funds, the expert did not believe that the potential for 
restrictions of stable value withdrawals based on employer-initiated 
events would be included in these new disclosures to participants. In 
addition, industry experts we talked to said that participants were 
frequently not given an important piece of information--the market to 
book value of the stable value portfolio--unless they asked for it. In 
fact, some experts said that plan sponsors may not be inclined to 
provide this information to participants for fear that it would cause 
what would be deemed an employer-initiated event.[Footnote 66] While 
one expert believed that participants would continue to receive 
disclosures from stable value funds about the stable value funds' book 
values, the expert did not believe that the market value of the stable 
value portfolio would be required by Labor's recently published 
participant disclosure regulations. One industry expert stated that 
the ratio of market to book value of the stable value portfolio was 
the summary statistic that would help plan participants understand 
whether their investments are at risk if the other participants in 
their plan withdraw from the fund. While Labor's recent regulations 
may address some of these risks in a requirement that the participant 
disclosures include an Internet Web site address that provides 
participants access to the investment option's principal strategies 
and principal risks, it is unclear whether participants will find this 
method of disclosure useful in understanding the specific risks 
associated with stable value funds and comparing those risks with the 
risks posed by other investments. 

Participants may also be unaware of the risks taken on their behalf by 
investment options that lend securities, including the complex 
compensation structures and variety of events that could affect 
participants' withdrawals or that could cause losses. As with stable 
value fund disclosures, disclosures regarding the risks associated 
with engaging in securities lending with cash collateral reinvestment 
are generally also buried deeply within the pages of investment option 
documents and, as written, may give the incorrect impression that any 
financial risk to plan assets is low. In one mutual fund's annual 
report, the fact that the investment option engages in securities 
lending is disclosed on page 68 of the 90 page document.[Footnote 67] 
Figure 8 shows pertinent information about securities lending that 
would be provided to a plan participant from another investment 
option, an index fund, registered with the SEC. The figure shows page 
14 of a 52-page document. The 52-page document is the "Statement of 
Additional Information" (SAI) which is a supplementary document to a 
mutual fund's prospectus that contains additional information about 
the mutual fund and includes further disclosure regarding its 
operations. There is also a 37-page annual report, as well as a 40-
page prospectus for the index fund. 

Figure 8: Example of a Securities Lending Disclosure in Registered 
Investment Option's Required Disclosures: 

[Refer to PDF for image: illustration] 

Excerpt from page B-14 of one 52-page "Statement of Additional 
Information" (text shown actual size): 

Securities Lending. A fund may lend its investment securities to 
qualified institutional investors (typically brokers, dealers, banks, 
or other financial institutions) who may need to borrow securities in 
order to complete certain transactions, such as covering short sales, 
avoiding failures to deliver securities, or completing arbitrage 
operations. By lending its investment securities, a fund attempts to 
increase its net investment income through the receipt of interest on 
the securities lent. Any gain or loss in the market price of the 
securities lent that might occur during the term of the loan would be 
for the account of the fund. If the borrower defaults on its 
obligation to return the securities lent because of insolvency or 
other reasons, a fund could experience delays and costs in recovering 
the securities lent or in gaining access to the collateral. These 
delays and costs could be greater for foreign securities. If a fund is 
not able to recover the securities lent, a fund may sell the 
collateral and purchase a replacement investment in the market. The 
value of the collateral could decrease below the value of the 
replacement investment by the time the replacement investment is 
purchased. Cash received as collateral through loan transactions may 
be invested in other eligible securities. 
this cash subjects that investment to market appreciation or 
depreciation. 

The terms and the structure of the loan arrangements, as well as the 
aggregate amount of securities loans, must be consistent with the 1940 
Act, and the rules or interpretations of the SEC thereunder. These 
provisions limit the amount of securities a fund may lend to 33 1/3% 
of the fund's total assets, and require that (1) the borrower pledge 
and maintain with the fund collateral consisting of cash, an 
irrevocable letter of credit, or securities issued or guaranteed by 
the U.S. government having at all times not less than 100% of the 
value of the securities lent; (2) the borrower add to such collateral 
whenever the price of the securities lent rises (i.e., the borrower 
"marks-to-market" on a daily basis); (3) the loan be made subject to 
termination by the fund at any time; and (4) the fund receive 
reasonable interest on the loan (which may include the fund's 
investing any cash collateral in interest bearing short-term 
investments), any distribution on the lent securities, and any 
increase in their market value. Loan arrangements made by each fund 
will comply with all other applicable regulatory requirements, 
including the rules of the New York Stock Exchange, which presently 
require the borrower, after notice, to redeliver the securities within 
the normal settlement time of three business days. The advisor will 
consider the creditworthiness of the borrower, among other things, in 
making decisions with respect to the lending of securities, subject to 
oversight by the board of trustees. At the present time, the SEC does 
not object if an investment company pays reasonable negotiated fees in 
connection with lent securities, so long as such fees are set forth in 
a written contract and approved by the investment company's trustees. 
In addition, voting rights pass with the lent securities, but if a 
fund has knowledge that a material event will occur affecting 
securities on loan, and in respect of which the holder of the 
securities will be entitled to vote or consent, the lender must be 
entitled to call the loaned securities in time to vote or consent. 

Source: GAO presentation of a private investment company’s Statement 
of Additional Information for an index fund. 

[End of figure] 

In general, 401(k) participants do not receive the SAI or the 
prospectus automatically, although plan sponsors do receive a 
prospectus, and so do retail investors. Therefore, participants may 
never see this disclosure on securities lending. One plan sponsor we 
spoke to, described the SAI as an attachment to the prospectus. The 
sponsor told us that it is necessary to know where to find this 
information and then work through the details. All disclosure 
information is embedded in massive documents of varying degrees of 
importance. Labor's recently issued participant disclosure regulations 
will undoubtedly affect the disclosures participants receive. 
Participants will receive core information about investments available 
under the plan, including performance and fee information, in a chart 
or similar format designed to facilitate investment comparisons. 
However, since these regulations require only disclosure of investment 
options, and not all practices utilized by those investment options--
of which securities lending is one practice--it is unclear how much or 
to what extent securities lending fees and risks will be discussed in 
these disclosures.[Footnote 68] There is nothing in the regulations 
that explicitly requires plan sponsors to disclose information on the 
risks of securities lending with cash collateral reinvestment or 
withdrawal restrictions that can result from securities lending. 
Without better disclosures on securities lending with cash collateral, 
participants may continue to be unaware of the practice of cash 
collateral reinvestment and the risk it poses to plan participants, as 
well as the potential for withdrawal restrictions resulting from such 
practices. 

Labor Can Take Steps to Help Plan Sponsors Understand the Risks and 
Challenges Posed By Certain Investments and Practices: 

Eliminating Stable Value Fund Restrictions That Can Compromise 
Sponsors' Fulfillment of Their Fiduciary Obligations and Providing 
Better Information Can Help Plan Sponsors: 

Stable value funds are typically subject to restrictions and wrap 
contracts that may prevent plan sponsors or fiduciaries from meeting 
their fiduciary obligations when choosing to offer a stable value 
fund.[Footnote 69] A stable value fund contract can constrain a plan 
sponsor's ability to add investment options or communicate information 
about the basic health of the investment option to participants. In 
addition, stable value fund contractual arrangements can discourage 
plan sponsors from communicating with their plan participants about 
the levels of risk the particular investment options were assuming. 
These types of arrangements that limit sponsor behavior and that may 
void the stable value contract, however, are not prohibited by current 
regulation, and experts told us that they are commonly accepted 
industry practices. 

The wrap contracts associated with stable value funds may cause 
problems for plan sponsors because they typically limit the type of 
information that can be shared with participants. Wrap contracts 
typically prohibit sponsors from making any communication that may 
result in fund redemptions. This can complicate the plan sponsor's 
role in administering the plan. For example, in a situation where a 
sponsor becomes aware that the market value of the stable value fund's 
underlying assets has fallen below book value, which could put 
participant assets at risk, the sponsor is in a unique position--if 
the sponsor communicates this information to participants, it would 
likely void an insurance contract that could be valuable to the plan's 
participants. However, failing to communicate this information to 
participants may compromise the plan sponsor's role as a fiduciary 
with respect to the plan. 

During our review, industry experts told us that sponsors of varying 
plan sizes often lacked an understanding of the underlying investments 
and the features of stable value funds. Stable value funds are 
marketed to plan sponsors as low-risk investments that provide 
consistent stable returns, protection of the invested principal, and 
immediate liquidity, characteristics that have attracted many sponsors 
and participants to stable value funds. Stable value funds are also 
considered to be invested in high-credit quality, fixed income 
securities, such as low-risk, government and corporate bonds with 
short-to medium-term maturities. Yet, as shown in figure 9, as of the 
end of 2008, nearly 50 percent of the underlying assets in stable 
value funds were asset-backed or mortgage-backed securities. 

Figure 9: Underlying Assets in Stable Value Funds (year end 2008): 

[Refer to PDF for image: pie-chart] 

Mortgage-backed: 26%; 
Publicly traded bonds: 19%; 
Treasuries: 10%; 
Commercial mortgage-backed securities: 9%; 
Cash: 7%; 
Asset-backed securities: 7%; 
Private placement bonds[B]: 5%; 
Commercial mortgages: 5%; 
Federal agency securities[A]: 4%; 
Guaranteed investment contracts: 3%; 
Other: 5%. 

Source: Stable Value Investment Association's 13th Annual Stable Value 
Investment and Policy Survey. 

[A] Federal agency securities are debt instruments issued by federal 
credit agencies. 

[B] A private placement is a direct offering of securities directly to 
an institutional investor, such as a bank, mutual fund, insurance 
company, pension fund, or foundation. 

[End of figure] 

Given their mix of underlying assets, many stable value funds' credit 
rates dropped sharply in 2008 and 2009 because of lower returns on 
their underlying bond holdings and market conditions that prompted 
stable value managers to put more money into cash during the financial 
crisis. Despite the problems that stable value funds experienced 
during 2008 and 2009, investors continued to put money into stable 
value funds as they sought a less risky investment which helped to 
shore up stable value returns. 

Labor's ERISA Advisory Council reported in 2009 that plan sponsors 
need, among other things, a better understanding of a stable value 
fund's portfolio composition, the current financial condition of fund 
issuers and wrap providers, and the safeguards they each have in place 
in the event of default.[Footnote 70] The council reported that only 
with this critical information can plan sponsors adequately determine 
the appropriateness of selecting a particular stable value fund or 
whether such an investment meets the needs of the plan. The council 
heard testimony that such information may either not be readily 
available from wrap providers or stable value fund managers or that 
plans sponsors do not know to ask for, or do not understand, the 
information that might be made available. Without this information, 
plan sponsors may continue to offer stable value funds to plan 
participants, the associated risks of which they and plan participants 
may not clearly understand. 

[Side bar: 
Example of an Employer-Initiated Event That Could Void the Stable 
Value Wrap Contract: 
A common sponsor response to an underperforming fund is to replace it 
with another fund. However, in the case of a stable value fund that 
has a market value below book value, replacing the stable value fund 
could invalidate the wrap protection, or at least trigger clauses in 
the contract that might delay the liquidation of the fund. Some funds 
allow the option of a “12-month put,” in other words, a 1-year advance 
notice required to terminate a fund, while others may not allow 
termination of the fund until market value and book value converge. A 
sponsor may be faced with the difficult choice of either maintaining 
an underperforming stable value fund or voiding an insurance contract 
that may be potentially valuable to their plan participants. 
End of side bar] 

Labor's ERISA Advisory Council also reported that plan sponsors need 
more information with regard to a stable value fund's underlying 
assets, including how those funds are valued, its wrap provider, and a 
fund's costs and fees.[Footnote 71] In addition, understanding the 
events that could void a wrap contract could help plan sponsors make 
strategic decisions. The stress of the market volatility in 2008 and 
2009 (which led to lower market values for many stable value funds) 
has placed increased scrutiny on sponsor behavior that might be 
considered an employer-initiated event according to the terms of wrap 
contracts and highlighted the need for plan sponsors to have a better 
understanding of all the implications of their decisions regarding the 
wrap provisions of their stable value funds. 

According to industry reports, some plan sponsors are now asking for 
more flexibility in their wrap contract provisions and, as a result, 
some stable value fund providers are starting to offer options that 
might provide that flexibility. One stable value fund provider stated 
that one of the concerns about stable value funds that came to light 
as a result of the 2008 financial crisis was that wrap contracts may 
have been too inflexible to provide plan sponsors with the ability to 
make necessary business decisions, such as closing a plant or layoffs, 
without affecting their stable value fund options in their 401(k) 
plans. The stable value fund provider stated that plan sponsors may 
view the embedded protections in wrap contracts that would preclude 
them from making these decisions as too constraining and has thus 
begun to offer some plan sponsors with choices that provide greater 
flexibility. For example, the stable value fund provider is offering 
its plan sponsors two stable value fund choices that seek to provide 
them with flexibility for employer-initiated events or participant 
communications and a greater likelihood that they will not void the 
contract if they make changes to their plans. While these 
flexibilities in the terms of wrap contracts may be offered to some 
plan sponsors, not all plan sponsors are able to negotiate special 
terms to protect their plan participants or themselves.[Footnote 72] 

Recently enacted legislation requires Labor and other regulators to 
review various aspects of stable value fund contracts, providing Labor 
an opportunity to aid plan sponsors and participants in better 
understanding stable value funds. Specifically, the Dodd-Frank Wall 
Street Reform and Consumer Protection Act (Dodd-Frank),[Footnote 73] 
prescribes that the SEC and the Commodity Futures Trading Commission 
(CFTC) jointly conduct a study to determine whether stable value 
contracts fall within the definition of a swap.[Footnote 74] Given 
that Labor will be required to inform the study, the agency is in a 
unique position to focus on ways to help plan sponsors better 
understand stable value funds. 

Changes to Labor's Disclosure Regulations Can Also Help Plan Sponsors 
Become Aware of the Risks Associated with Investment Options That Lend 
Securities: 

Industry experts told us that many plan sponsors are unaware of the 
risks involved with the cash collateral reinvestment portion of their 
service providers' securities lending programs, or may not fully 
understand the risks. Other plan sponsors may not know whether their 
investment options engage in such lending at all. For example, 17 of 
the 74 plan sponsors who responded to our brief poll responded "no" to 
our question about whether their investments that engage in securities 
lending had disclosed to them that this investment practice was a 
possibility. An additional 20 plan sponsors responded that they were 
not sure whether this information had been disclosed.[Footnote 75] 

Other industry officials have expressed similar concerns. One large 
investment consulting firm has stated that many of its plan sponsor 
clients may not be aware that their investment options utilize 
securities lending programs. An industry expert we spoke to, who is 
also a 401(k) plan sponsor, admitted that he did not know whether the 
investment options offered through his plan engaged in securities 
lending. Another industry expert told us that there were poor 
communications between investment option managers and lending agents 
(e.g., custodial banks)--investment option managers did not ask the 
right questions about how the cash collateral was being invested, and 
custodian banks who acted on behalf of investment options' managers 
thought their customers were educated enough to understand that the 
cash collateral posted by borrowers was invested in collective 
investment pools. 

Recent litigation involving banks that engage plan assets in their 
securities lending programs illustrates instances where plan sponsors 
may not have understood the practice of securities lending, and where 
parties involved, under minimal scrutiny, may have taken additional 
risks with plans' assets. Over the past few years, plan sponsors and 
others filed lawsuits against Northern Trust, State Street, JP Morgan, 
Bank of New York Mellon, Wells Fargo, U.S. Bank, and Wachovia for 
allegedly violating their fiduciary, contractual, and other legal 
responsibilities in losing millions of dollars for the investment 
funds in their securities lending contracts. Most of the lawsuits 
involve the loss of cash collateral invested by the custodian banks in 
their securities lending programs. Plan sponsors allege that they were 
intentionally misled by their custodian banks as to where their cash 
collateral was being invested. Critics of these plaintiff's lawsuits 
say that the plan sponsors are simply disgruntled customers seeking to 
recoup unavoidable investment losses from banks that have profited 
from their plans' assets.[Footnote 76] 

One way industry experts have suggested to help protect participants' 
401(k) retirement savings when placed in investments that utilize 
securities lending with cash collateral reinvestment is by limiting 
the percentage of 401(k) plan assets that could potentially be loaned 
out at any one time. Industry experts we talked to stressed the 
importance of limiting the amount of 401(k) assets that can be subject 
to securities lending, similar to SEC staff's limits on lending by 
mutual funds. SEC staff no-action letters effectively limit the amount 
of assets that can be lent from a mutual fund at one time to one-third 
of the fund's total asset value. Furthermore, SEC limits the amount of 
total mutual fund assets and money market fund assets to 15 percent 
and 5 percent, respectively, that can be invested in illiquid 
securities, such as some asset-backed securities that do not trade on 
exchanges and do not have an accessible market for buyers and sellers. 
[Footnote 77] However, there are no comparable limitations on the 
total amount of 401(k) plan assets that can be lent or invested in 
illiquid securities. 

SEC and Others Are Taking Steps to Improve Transparency and 
Disclosures on Securities Lending, and Labor Can Also Require Better 
Disclosures for Plan Sponsors: 

SEC and others in industry are already taking steps to address certain 
issues related to securities lending. SEC and the Financial Industry 
Regulatory Authority (FINRA)[Footnote 78] are working on proposals for 
additional disclosure on securities lending. The Dodd-Frank Act calls 
for the SEC to promulgate rules no later than July 21, 2012, that are 
designed to increase the transparency of information available to 
brokers, dealers, and investors with respect to the loan or borrowing 
of securities.[Footnote 79] FINRA is also looking at promulgating 
rules that will ensure that broker-dealers allow customers to fully 
understand all the risks involved and that will focus on disclosing 
things from potential conflicts to restrictions firms may have on 
liquidating securities.[Footnote 80] 

It is unclear whether the improved disclosures will provide 
information about the gains and losses from securities lending to 
investors and other stakeholders. Currently, banking regulators do not 
require banks to report gains or losses from their securities lending 
programs. Although the Financial Accounting Standards Board requires 
banks to make publicly available this information in their financial 
statements, the information is not reported to any federal regulator 
and is also not broken out by type of plan. The Federal Financial 
Institutions Examination Council[Footnote 81] supervisory policy on 
securities lending stipulates that information on securities borrowing 
and lending transactions should be made publicly available by 
commercial banks in their financial statements. However, banks do not 
break out this information by type of plan and may only provide the 
information as a summary total that includes other revenue streams, 
such as investment advisory and administration fees, making it 
difficult to determine revenue specific to securities lending. 

Some securities lending agents have already begun to implement various 
changes to their securities lending programs and the way they manage 
cash collateral. These changes have come as a result of securities 
lending agents, who have recently reported that some plan sponsors 
that they service have not only requested more disclosure about 
securities lending and cash collateral pools but have also requested 
that their securities lending programs take on less risk. For example, 
one securities lending agent is calling for a "back to basics 
approach" with the focus on protecting principal and maintaining 
liquidity while generating incremental returns for participants. 
Securities lending agents stated that going forward, cash collateral 
pools would likely be of shorter duration and have more standardized 
guidelines of what they could invest in. They also said that these 
guidelines could possibly be structured along the lines of SEC's 
liquidity requirements for money market funds, under which, among 
other things, money market funds must maintain minimum daily and 
weekly asset positions.[Footnote 82] With these changes, they believe 
that 401(k) plan participants could receive some protection from the 
losses and withdrawal restrictions that they recently experienced. 

Labor could also take steps to improve transparency on the practice of 
securities lending by amending its prohibited transaction exemption 
regarding the practice of securities lending. Labor's PTE 2006-16, 
authorizes securities lending transactions that might otherwise 
constitute "prohibited transactions" under ERISA, but the exemption 
currently lacks specifics on the utilization of 401(k) plan assets in 
the practice of securities lending. In addition, according to Labor, 
the exemption does not address or provide any relief for the 
reinvestment of cash collateral.[Footnote 83] Without such 
information, plan sponsors do not have the information they need to 
assess the potential gains and losses from cash collateral 
reinvestments, since other regulators that oversee the financial 
entities involved in securities lending also do not require that such 
information be explicitly disclosed to plan sponsors. By revising the 
existing exemption, Labor can ensure that plan sponsors who enter into 
securities lending arrangements with cash collateral reinvestment are 
not prevented from meeting their fiduciary obligations when doing so. 

Labor can also help to ensure that plan sponsors clearly understand 
the gains and losses associated with securities lending by amending 
its two recently issued rules, one regarding service provider 
disclosure to plan sponsors,[Footnote 84] and one regarding plan 
sponsor disclosure to participants, to include information specific to 
securities lending. The recent amendment to the interim final rule, 
which affects the "up-front" or "point of sale" disclosure, i.e., when 
a service provider and a plan sponsor enter into a service agreement 
or contract, enhances disclosure to fiduciaries of 401(k) and other 
retirement plans. It requires service providers to disclose, among 
other things, a description of the services to be provided; a 
statement that the covered service provider will provide its services 
as a fiduciary to the covered plan; a description of all "direct 
compensation" (i.e., compensation received directly from the covered 
plan) and "indirect compensation" (i.e., compensation that is received 
from any source other than the covered plan, plan sponsor, covered 
service provider, an affiliate, or a subcontractor) that the covered 
service provider reasonably expects to receive in connection with the 
disclosed services. The regulation is meant to assist fiduciaries in 
determining both the reasonableness of compensation paid to plan 
service providers and any conflicts of interest that may impact a 
service provider's performance under a service contract or arrangement. 

With regard to the practice of securities lending, the regulation 
would presumably require a custodian to disclose the fact that it 
receives compensation from its role in the investment strategy of 
securities lending. However, it is unclear how much assistance it 
would provide to plan sponsors in understanding securities lending 
with cash collateral reinvestment or the gains and losses associated 
with that practice. For example, as currently written, it is unclear 
whether it would be obvious to the plan sponsor how much of a profit 
the custodian would take compared with the profit the plan would 
receive. It is also unclear whether the custodian would have to reveal 
exactly how it used the plan's profit, such as to reduce plan fees, or 
whether the custodian would disclose that the other service providers 
involved in the transaction received their compensation, in the form 
of fees and rebates, regardless of the performance of the cash 
collateral reinvestment pool. Labor's regulations, as currently 
written, will not assist plan sponsors in understanding the mechanics 
of a securities lending transaction and how the entities involved in 
the transaction, specifically those involved in the cash collateral 
reinvestment activity, are paid. Plan sponsors need to know that the 
profit they make is a net return after everyone else is paid for their 
role and that any loss from the cash collateral pool comes out of 
their plans' assets. The current regulations also do not contain 
specific provisions requiring disclosure of the potential for 
withdrawal restrictions, which could assist plan sponsors in their 
decision-making process when selecting investment options to offer 
through their 401(k) plans. 

Conclusions: 

For a growing number of American workers, their prospects for a secure 
retirement increasingly rest on the retirement savings they accumulate 
in their 401(k) plans. One of the touted benefits of 401(k) plans was 
their transparency to and control by participants. Participants could 
see their accounts grow and control how much to contribute and where 
to invest those contributions. Yet, it is becoming increasingly 
obvious that saving for retirement is not as simple as it appeared 30 
years ago when 401(k) plans were first created. As this report shows, 
and as our past report on undisclosed fees and more recent reports on 
target date funds and conflicted investment advice illustrate, 
managing the risks faced in savings for retirement through 401(k) 
plans today can be complicated and pose significant challenges for 
participants and sponsors alike. 

At a minimum, greater transparency and disclosure are necessary to 
help plan sponsors and participants understand the restrictions and 
limitations they could face with certain 401(k) investment options and 
the risk of loss to plan participants' investments in 401(k) plans. 
The recent financial crisis vividly illustrated the importance of 
transparency when dealing with complex financial instruments. What 
seems like an optimal way to make money off of 401(k) plan assets, 
such as through securities lending with cash collateral reinvestment, 
can appear to be straightforward until the scope of the risks and 
complexities of the cash collateral reinvestment transaction have to 
be explained to investors, plans sponsors, and plan participants. 
Expecting plan sponsors and plan participants to understand the 
intricacies of today's many investment options without sufficient 
guidance and information is unrealistic. 

Without more explicit and accessible information on stable value funds 
and securities lending with cash collateral reinvestment, participants 
are unknowingly bearing a greater risk of loss than they are currently 
aware of and, more importantly, have no control over. Labor has 
already provided much needed disclosure requirements for plan sponsors 
to give to plan participants. Amending those regulations to include 
disclosure explicitly targeted to the risks of investing in stable 
value funds and provisions on securities lending will help to ensure 
that plan participants, like plan sponsors, are informed about stable 
value funds and securities lending with cash collateral reinvestment 
and are able to make the best decisions to save for their retirement. 

The maturation of the 401(k) system, coupled with the increased 
complexity of the financial markets, is posing new challenges for 
Labor, financial regulators, plan sponsors, and participants. Changes 
called for in the Dodd-Frank Act are likely to clarify stable value 
contracts and provide more disclosure on securities lending. Because 
of the statutory requirements in the Dodd-Frank Act, Labor has an 
opportunity to assist plan sponsors and participants with two complex 
areas, stable value fund contracts and securities lending with cash 
collateral reinvestment. Such careful, thoughtful action to facilitate 
prudent decision making on the part of sponsors and participants can 
bolster retirement security and avoid the long-term loss of 
participant confidence in the 401(k) system. 

Recommendations For Executive Action: 

The recently enacted Dodd-Frank Wall Street Reform and Consumer 
Protection Act includes requirements that will affect deliberations 
about stable value funds and requires that the SEC and the CFTC, in 
consultation with Labor and Treasury, conduct a study of stable value 
funds. To ensure additional protection for plan participants, 
appropriate information for plan sponsors, and to better inform the 
study required by the Dodd-Frank Act, we recommend that Labor take the 
following actions: 

* As it conducts its consultative analysis to assist the SEC and CFTC, 
also analyze stable value funds specifically in a 401(k) investment 
context to identify those situations or conditions that prevented plan 
sponsors from withdrawing from stable value funds, such as contract 
restrictions, and take appropriate regulatory steps to assist plan 
sponsors in fulfilling their fiduciary responsibilities. 

* Amend its regulation on plan sponsor disclosure to participants to 
include a specific requirement for plan sponsors to provide 
information to participants that discloses the risks of investing in 
stable value funds. 

* Provide guidance to plan sponsors on the risks, structure, and 
dynamics of stable value funds, consistent with the recommendations 
proposed by the ERISA Advisory Council regarding the disclosure of 
information about stable value funds. 

Given the current practice of securities lending with cash collateral 
reinvestment, its role in 401(k) plan investments, and our findings 
that plans and plan participants can bear a disproportionate amount of 
any loss associated with the practice, Labor should take action to 
help plan sponsors of 401(k) plans and plan participants understand 
the role, risk, and benefits of securities lending with cash 
collateral reinvestment in relation to 401(k) plan investments. ERISA 
requires that the fees paid to plan service providers be reasonable 
with respect to the services performed and Labor, in its 
implementation of PTE 2006-16, its prohibited transaction class 
exemption for securities lending, specifically requires that 
compensation received by the parties involved in the securities 
lending transaction should be reasonable. According to Labor, PTE 2006-
16 does not cover cash collateral reinvestment. Therefore, we 
recommend that Labor also take the following actions: 

* Review the practice of securities lending with cash collateral 
reinvestment, to provide guidance to plan sponsors as to what would be 
reasonable levels of fees and reasonable distributions of returns when 
401(k) plan assets are utilized in this practice. 

* Revise PTE 2006-16 to include the practice of cash collateral 
reinvestment by requiring that plan sponsors who enter into securities 
lending arrangements utilizing cash collateral reinvestment on behalf 
of 401(k) plan participants not do so unless they ensure the 
reasonableness of the distributions of expected returns associated 
with this arrangement. 

* Amend its regulation on plan sponsor disclosure to participants to 
include provisions specific to (1) the practice of cash collateral 
reinvestment utilized by fund providers' securities lending programs 
and (2) disclosing the potential for withdrawal restrictions. 

* Provide plan sponsors with guidance alerting them to the risks of 
engaging in securities lending with cash collateral reinvestment and 
the types of information they should seek from their service providers 
about these investments. 

Agency Comments and Our Evaluation: 

We provided a draft of this report to the Department of Labor, the 
Securities and Exchange Commission, the Federal Reserve Board, the 
Office of the Comptroller of the Currency, and the Federal Deposit 
Insurance Corporation for review and comment. Labor's formal comments 
are reproduced in appendix I of this report. We did not receive formal 
comments from the Securities and Exchange Commission, the Federal 
Reserve Board, the Office of the Comptroller of the Currency, or the 
Federal Deposit Insurance Corporation, but received technical comments 
from four of the five agencies, which we incorporated as appropriate. 

In its agency response letter, the Department of Labor agreed with our 
conclusions concerning the importance of transparency and disclosure. 
Consistent with our conclusions, Labor noted that it is committed to 
ensuring that participants have the information they need to make 
informed decisions about their retirement savings and that plan 
sponsors receive the information they need to assess the 
reasonableness of contracts or arrangements. Labor also noted that it 
has recently devoted significant resources to ensure that plan 
sponsors and participants have the information they need. Labor has 
agreed to consider amending PTE 2006-16 to require the securities 
lending agreement to provide enhanced disclosures to plan fiduciaries 
and to consider providing plan sponsors with guidance alerting them to 
the risks of engaging in securities lending and the types of 
information they should seek from their service providers about these 
investments. Labor disagreed with three of our recommendations. 

Labor disagreed with our recommendation to amend its participant 
disclosure regulations to provide information disclosing the risks of 
investing in stable value funds. It stated that without further study 
and review, the department is not prepared to conclude that its 
participant disclosure regulations should be amended to specifically 
address stable value funds. Given the complexity of the issues 
involving stable value funds, we encourage Labor to initiate the 
study, review what it deems necessary, and to amend its disclosure 
regulations as appropriate. We note Labor's additional consideration 
to the recommendations proposed by the ERISA Advisory Council 
regarding information provided to plan sponsors and participants 
concerning stable value funds, and we believe that plan sponsors and 
participants would benefit from such guidance being issued in a 
prudent but expeditious manner. Given that the ERISA Advisory Council 
report on stable value funds was posted in April 2010, without 
additional guidance or assistance, plan sponsors may remain unaware of 
the risks and challenges associated with this investment option. 
Furthermore, because Labor will be consulting with SEC and CFTC with 
regard to their study of stable value funds, Labor has a unique 
opportunity to assist participants in their understanding of the 
restrictions, limitations, and risks of investing in such funds. We 
look forward to the findings, conclusions and proposed actions of 
Labor's consultation and believe that this effort represents a great 
opportunity for Labor to assist plan sponsors and participants in 
building retirement security. 

Labor disagreed with our recommendation to amend its participant 
disclosure regulations regarding the practice of securities lending 
with cash collateral reinvestment and the potential for withdrawal 
restrictions. The Department stated that without further study and 
review, it is not prepared to conclude that its participant disclosure 
regulations should be amended to specifically address securities 
lending-related issues. While we believe that the evidence provided in 
our report is particularly compelling with regard to this 
recommendation, we strongly encourage Labor to initiate the study and 
review what it deems necessary, and, to amend its disclosure 
regulations as appropriate. As demonstrated in our report, securities 
lending with cash collateral reinvestment arrangements can be very 
complex transactions. Further, as we reported, Labor's participant 
disclosure regulations do not explicitly require plan sponsors to 
disclose information on the risks of securities lending with cash 
collateral reinvestment or withdrawal restrictions that can result 
from securities lending. We acknowledge Labor's comment that the 
current participant disclosure regulations require that information 
pertaining to investment risks and investment strategies be available 
to plan participants. However, as we reported, these regulations 
require only disclosure of investment options, and not all practices 
utilized by those investment options--of which securities lending is 
one practice--and it is unclear how much or to what extent securities 
lending fees and risks will be discussed in these disclosures. 
Furthermore, Labor only requires that information be made available to 
plan participants, not disclosed, which would require plan 
participants to know what information they need to avail themselves of 
in order to understand the fees and risks of securities lending. 
Without better disclosures on securities lending with cash collateral, 
participants may continue to be unaware of the practice of cash 
collateral reinvestment and the risks it poses, as well as the 
potential for withdrawal restrictions resulting from such practices. 

Labor also did not agree with our recommendation to review the 
practice of securities lending with cash collateral reinvestment to 
provide guidance to plan sponsors as to what would be reasonable 
levels of fees and reasonable distributions of returns when 401(k) 
assets are utilized in this practice. Labor noted that a plan sponsor, 
in deciding to offer any investment option, must make that decision in 
accordance with its fiduciary responsibility under ERISA, and that it 
would not be possible for Labor to provide specific guidance on 
reasonable levels of fees and reasonable distributions of returns in 
connection with any particular securities lending cash collateral 
reinvestment. We recognize the complexity of these transactions and 
the diligence that should be taken in developing such guidance. 
Nevertheless, key participants in securities lending transactions are 
already moving in the direction of providing additional guidance to 
plan sponsors. For example, as we reported, some securities lending 
agents have already begun to make changes to their securities lending 
programs in response to plan sponsors who have requested more 
disclosure about securities lending and cash collateral pools and have 
also requested that their securities lending programs take on less 
risk. In addition, securities lending agents are beginning to 
standardize guidelines for cash collateral pool investments, changes 
which they think would provide participants with some protection from 
losses. These industry driven developments clearly suggest that not 
only is such guidance possible, but that it is in the best interest of 
plan sponsors for Labor to provide some assistance on this issue. 

Finally, Labor disagreed with our recommendation regarding the 
inclusion of cash collateral reinvestment into PTE 2006-16, regarding 
the reasonableness of expected returns associated with this 
arrangement. Labor believes that it is not feasible to ensure a 
certain level of expected return on any particular investment. It is 
not our intent that rates of return should be ensured in such 
transactions, but that the reasonableness of the distributions of 
expected returns be ensured. We note, however, that under ERISA, Labor 
is already responsible for enforcing the requirements that plan 
sponsors ensure that the fees paid with plan assets are reasonable and 
for necessary services. Applying the same standard to the parameters 
of transactions involving securities lending with cash collateral can 
help reduce the risk of loss to plan participants. As we note in our 
report, securities lenders are already implementing changes that could 
redefine the potential of loss and return to plan participants from 
these transactions. Action by Labor can help to ensure that it will 
not only be sophisticated plan sponsors who are likely to get the 
disclosures they need, while other plans sponsors continue to be 
unaware of what they need to ask for and understand regarding 
securities lending with cash collateral reinvestment. 

As agreed with your office, unless you publicly announce the contents 
of this report earlier, we plan no further distribution until 6 days 
from the report date. At that time, we will send copies of this report 
to the appropriate congressional committees, the Secretary of Labor, 
the Chairman of the Securities and Exchange Commission, and other 
interested parties. The report also will be available at no charge on 
the GAO Web site at [hyperlink, http://www.gao.gov]. 

If you or your staff members have any questions concerning this 
report, please contact Charles Jeszeck at (202) 512-7215. Contact 
points for our Office of Congressional Relations and Public Affairs 
may be found on the last page of this report. GAO staff who made major 
contributions to this report are listed in appendix II. 

Sincerely yours, 

Signed by: 

Charles A. Jeszeck: 
Director, Education, Workforce, and Income Security Issues: 

[End of section] 

Appendix I: Comments from the Department of Labor: 

U.S. Department of Labor: 
Assistant Secretary for	Employee Benefits Security Administration: 
Washington, D.C. 20210: 

February 25, 2011: 

Mr. Charles A. Jeszeck: 
Director, Education, Workforce, and Income Security Issues: 
United States Government Accountability Office: 
Washington, DC 20548: 

Dear Mr. Jeszeck: 

Thank you for the opportunity to review the Government Accountability 
Office's (GAO) draft report entitled "401(k) PLANS: Certain Investment 
Options and Practices That May Restrict Withdrawals Not Widely 
Understood" (GA0-11-291). Based on our review of the report, below are 
our comments and observations. 

The draft report finds that during the recent financial crisis, plan 
sponsors and participants faced unexpected restrictions on withdrawals 
of plan assets from certain 401(k) investment options, specifically 
real estate accounts, money market funds, stable value funds and 
investment options that lend securities. It concludes, among other 
things, that greater transparency and disclosure are necessary to 
assist plan sponsors and plan participants in understanding 
restrictions, limitations, and risk of loss to plan participants 
associated with investment in stable value funds and investment 
options that lend securities. 

In this regard, the Department has recently devoted significant 
resources to ensuring that all participants and beneficiaries in 
participant-directed individual account plans (e.g., 401(k) plans) 
have the information they need to make informed decisions about the 
management of their individual accounts and the investment of their 
retirement savings, and to ensuring that plan fiduciaries receive 
disclosures from service providers to assist the fiduciaries in 
assessing the reasonableness of contracts or arrangements, including 
the reasonableness of the service providers' compensation and 
potential conflicts of interest that may affect the service providers' 
performance.[Footnote 1] 

Recommendation 1: The recently enacted Dodd-Frank Wall Street Reform 
and Consumer Protection Act includes requirements that will affect 
deliberations about stable value funds and requires that the SEC and 
CFTC, in consultation with Labor and Treasury, conduct a study of 
stable value funds. To ensure additional protection for plan 
participants, appropriate information for plan sponsors, and to better 
inform the study required by the Dodd-Frank Act, we recommend that 
Labor: 

* As it conducts its consultative analysis to assist the Securities 
and Exchange Commission and the Commodity Futures Trading Commission, 
also analyze stable value funds specifically in a 401(k) investment 
context to identify those situations or conditions that prevented plan 
sponsors from withdrawing from stable value funds, such as contract 
restrictions, and take appropriate regulatory steps to assist plan 
sponsors in fulfilling their fiduciary responsibilities. 

The Department will consider whether further action would be 
appropriate after consulting with the SEC and the CFTC upon completion 
of their study as mandated by the Dodd-Frank Wall Street Reform and 
Consumer Protection Act. 

* Amend its regulation on plan sponsor disclosure to participants to 
include a specific requirement for plan sponsors to provide 
information to participants that discloses the risks of investing in 
stable value funds. 

The Department disagrees with this recommendation. Without further 
study and review, the Department is not prepared to conclude that the 
regulations governing the disclosure of investment-related information 
to participants and beneficiaries must be amended to specifically 
address stable value funds. The current regulation specifically 
requires that information pertaining to investment risks, as well as 
investment strategies, be available to plan participants with respect 
to all investment alternatives offered under a participant-directed 
individual account plan, including stable value funds. 

* Provide guidance to plan sponsors on the risks, structure, and 
dynamics of stable value funds, consistent with the recommendations 
proposed by the ERISA Advisory Council regarding the disclosure of 
information about stable value funds. 

While the Department is not prepared at this time to commit to 
providing the recommended guidance, the Department will pursue further 
consideration of the recommendations prepared by the ERISA Advisory 
Council regarding stable value funds. 

Recommendation 2: Given the current practice of securities lending 
with cash collateral reinvestment, its role in 401(k) plan 
investments, and our findings that plans and plan participants can 
bear a disproportionate amount of any loss associated with the 
practice, Labor should take action to help plan sponsors of 401(k) 
plans and plan participants understand the role, risk, and benefits of 
securities lending with cash collateral reinvestment in relation to 
401(k) investments. ERISA requires that the fees paid to the plan 
service providers be reasonable with respect to the services performed 
and Labor, in its implementation of PTE 2006-16, its prohibited 
transaction class exemption for securities lending, specifically 
requires that compensation received by the parties involved in the 
securities lending transaction should be reasonable. According to 
Labor, PTE 200616 does not cover cash collateral reinvestment. 
Therefore we recommend Labor: 

* Review the practice of securities lending with cash collateral 
reinvestment, to provide guidance to plan sponsors as to what would be 
reasonable levels of fees and reasonable distributions of returns when 
401(k) plan assets are utilized in this practice. 

The Department disagrees with this recommendation. The Department 
notes that a plan sponsor's decision to offer any investment option, 
which may engage in securities lending, is a decision that must be 
made in accordance with the fiduciary responsibility provisions of 
ERISA, based on all relevant facts and circumstances. Because each 
decision is made based on a number of variables, it would not be 
possible for the Department to provide specific guidance on reasonable 
levels of fees and reasonable distributions of returns in connection 
with any particular securities lending cash collateral reinvestment. 

* Revise PTE 2006-16 to include the practice of cash collateral 
reinvestment by requiring that plan sponsors who enter into securities 
lending arrangements utilizing cash collateral reinvestment on behalf 
of 401(k) plan participants not do so unless they ensure the 
reasonableness of the expected returns associated with this 
arrangement. 

A plan sponsor's decision to engage in securities lending is a 
decision that must be made in accordance with the fiduciary 
responsibility provisions of ERISA, based on all relevant facts and 
circumstances. These provisions require, among other things, that a 
plan receive reasonable compensation for the level of risk associated 
with the investment. The Department's PTE 2006-16 provides relief from 
ERISA's prohibited transaction provisions for both the lending of 
securities by employee benefit plans to banks and broker-dealers and 
the receipt of compensation by a securities lending fiduciary in 
connection with services provided to a plan. As currently granted, the 
exemption does not address or provide relief for the reinvestment of 
the cash collateral. 

Currently, section II(g) of the exemption requires that all fees and 
other consideration received by the plan in connection with the loan 
of securities arc reasonable. The Department does not believe it is 
feasible to require additionally that plan sponsors ensure a certain 
level of expected return on any particular investment. Market forces 
and the choice of investments for the cash collateral will impact the 
return to the plan. However, the Department will consider whether to 
amend PTE 2006-16 to require the securities lending agreement 
described therein to provide enhanced disclosures to plan fiduciaries. 

* Amend its regulation on plan sponsor disclosure to participants to 
include provisions specific to (1) the practice of cash collateral 
reinvestment utilized by fund providers' securities lending programs 
and (2) disclosing the potential for withdrawal restrictions. 

The Department disagrees with this recommendation. Without further 
study and review, the Department is not prepared to conclude that the 
regulations governing the disclosure of investment-related information 
to participants and beneficiaries must be amended to specifically 
address securities lending-related issues. 

* Provide plan sponsors with guidance alerting them to the risks of 
engaging in securities lending with cash collateral reinvestment and 
the types of information they should seek from their service providers 
about these investments. 

The Department will consider this recommendation in light of its 
experience with security lending practices. 

EBSA is committed to protecting the employer-sponsored benefits of 
American workers, retirees, and their families. Again, thank you for 
the opportunity to review the draft report. Please do not hesitate to 
contact us if you have questions concerning this response or if we can 
be of further assistance. 

Sincerely, 

Signed by: 

Phyllis C. Borzi: 
Assistant Secretary: 

Appendix I Footnote: 

[1] See Fiduciary Requirements for Disclosure in Participant-Directed 
Individual Account Plans; Final Rule, 75 FR 64910 (October 20, 2010); 
Reasonable Contract or Arrangement Under Section 408(b)(2) — Fee 
Disclosure; Interim Final Rule, 75 FR 41600 (July 16, 2010). 

[End of section] 

Appendix II: GAO Contact and Staff Acknowledgments: 

GAO Contact: 

Charles Jeszeck, (202) 512-7215, or jeszeckc@gao.gov: 

Staff Acknowledgments: 

In addition to the individual named above, the following team members 
made significant contributions to this report: Tamara Cross, Assistant 
Director; Monika Gomez, Analyst-in-Charge; Jessica Gray; James 
Bennett; Susannah Compton; Sheila McCoy; Roger Thomas; and Walter 
Vance. 

[End of section] 

Glossary: 

The terms below are defined for the purposes of this GAO report. 

Asset-Backed Security:
An asset-backed security is a security whose value and income payments 
are derived from and collateralized (or "backed") by a specified pool 
of underlying assets. The pool of assets is typically a group of small 
and illiquid assets that are unable to be sold individually. Pooling 
the assets into financial instruments allows them to be sold to 
general investors, a process called securitization, and allows the 
risk of investing in the underlying assets to be diversified because 
each security will represent a fraction of the total value of the 
diverse pool of underlying assets. 

Balanced Fund:
Balanced funds are pooled accounts invested in stocks, bonds, and 
often additional asset classes. They are classified into two 
subcategories: target-date funds and non-target-date balanced funds. 

Book Value:
The book value of a stable value fund is the principal contributed to 
the investment option, plus accrued interest, minus withdrawals and 
fees. Accrued interest, minus withdrawals and fees, is calculated 
based on a methodology specified in the stable value fund contract and 
is reset on a periodic basis, which is usually quarterly or 
semiannually. 

Broker-Dealer:
The broker-dealer borrows securities on behalf of its customers, 
providing cash as collateral to the securities lending agent. A broker-
dealer is a company or other organization that trades securities for 
its own account or on behalf of its customers. Although many broker- 
dealers are "independent" firms solely involved in broker-dealer 
services, many others are business units or subsidiaries of commercial 
banks, investment banks or investment companies. When executing trade 
orders on behalf of a customer, the institution is said to be acting 
as a broker. When executing trades for its own account, the 
institution is said to be acting as a dealer. 

Cash Collateral Pool Manager:
The cash collateral pool manager invests the cash provided as 
collateral for the borrowed securities in order to earn additional 
return for the securities lending agent during the period of time that 
the securities are borrowed. The securities lending agent can be the 
cash collateral pool manager, but usually it is an affiliate of the 
securities lending agent. 

Collateral Deficiency:
A situation when the securities lending agent determines that a 
substantial portion of the invested collateral is so impaired that it 
will be insufficient to repay borrowers upon redemption. 

Collective Investment Fund:
Collective investment funds (CIF) are bank investment trusts that pool 
the investments of retirement plans or other institutional investors. 

Commingled Fund:
Commingled or collective funds are designed to combine the assets of 
unrelated retirement plans, enabling participants to diversify and 
gain the economies of scale, i.e., the advantages that being part of a 
larger fund affords, such as greater profits and less cost. 

Counterparty Risk:
The risk to each party of a contract that the counterparty will not 
live up to its contractual obligations. In a securities lending 
transaction, this is the risk to the lender that the borrower will 
fail to return the securities. 

Federal Agency Securities:
Federal agency securities are debt instruments issued by federal 
credit agencies. 

Illiquid Security:
The term "illiquid security" generally includes any security which 
cannot be sold or disposed of promptly and in the ordinary course of 
business without taking a reduced price. A security is considered 
illiquid if a fund cannot receive the amount at which it values the 
instrument within seven days. 

Institutional Investor:
An institutional investor is an organization that pools large sums of 
money and invests those sums in securities, real property and other 
investment assets. Institutional investors are typically banks, 
insurance companies, retirement or pension funds, hedge funds, 
foundations and mutual funds. 

Intrinsic Value:
Intrinsic value refers to the return on a securities loan excluding 
the benefit of active collateral management. It is the spread between 
the rebate rate and the benchmark rate, e.g. federal funds rate. 

Market Risk:
The potential for portfolio losses resulting from the change in value 
of stock prices of the portfolio's assets, interest rates, foreign 
exchange rates, and commodity prices. 

Market Value:
The market value of a stable value fund is the price at which the 
underlying assets of the fund are trading in the market at a given 
time. 

Money Market Funds:
Money market funds are open-end management investment companies that 
are registered under the Investment Company Act of 1940 and regulated 
under rule 2a-7 under that Act. Money market funds invest in high- 
quality, short-term debt instruments such as commercial paper, 
treasury bills and repurchase agreements. Generally, these funds, 
unlike other investment companies, seek to maintain a stable net asset 
value per share (market value of assets minus liabilities divided by 
number of shares outstanding), typically $1 per share. 

Mortgage-Backed Securities:
Mortgage-backed securities are securities whose value and income 
payments are derived from and collateralized (or "backed") by a 
specified pool of underlying mortgage loans, most commonly on 
residential propertyshares of a home loan sold to investors. For 
example, aA bank or other entity lends a borrower the money to buy a 
house and collects monthly payments on the loan. This loan and a 
number of others, perhaps hundreds, are sold to a larger bank that 
packages the loans together into a mortgage-backed security. The 
larger bank then issues shares of this security to investors who buy 
them and ultimately collect the dividends in the form of the monthly 
mortgage payments. 

Mutual Fund:
A mutual fund, legally known as an open-end investment company, is a 
company that pools money from many investors and invests the money in 
stocks, bonds, short-term money-market instruments, other securities 
or assets, or some combination of these investments. These investments 
comprise the fund's portfolio. Mutual funds are registered and 
regulated under the Investment Company Act of 1940, and are supervised 
by the SEC. Mutual funds sell shares to public investors. Each share 
represents an investor's proportionate ownership in the fund's 
holdings and the income those holdings generate. Mutual fund shares 
are "redeemable," which means that when mutual fund investors want to 
sell their shares, the investors sell them back to the fund, or to a 
broker acting for the fund, at their current net asset value per 
share, minus any fees the fund may charge. 

Participant-Directed 401(k) Plan:
A 401(k) plan that generally allows a participant to choose how much 
to invest, within federal limits, and to select from a menu of 
diversified investment options chosen by the plan sponsor. 

Nontarget-Date Balanced Funds:
Nontarget-date balanced funds include asset allocation or hybrid funds. 

Plan Participants:
Plan participants contribute to their 401(k) and direct that 
contribution to certain investment options. In 401(k) plans the assets 
are held in trust for participants. 

Plan Sponsor:
A plan sponsor chooses which investment options to offer to its 
participants, and when making that choice, decides on whether to offer 
investments that engage in securities lending. 

Plan Service Provider:
A plan service provider purchases securities on behalf of 401(k) plan 
participants. A plan service provider may act as securities lending 
agent. 

Private Placements:
A private placement is a direct offering of securities directly to an 
institutional investor, such as a bank, mutual fund, insurance 
company, pension fund, or foundation. 

Prohibited Transaction:
Prohibited transactions under ERISA include a sale, exchange, or lease 
between a plan and a party-in-interest; lending money or other 
extension of credit between the plan and party-in-interest; and 
furnishing goods, services, or facilities between the plan and party- 
in-interest, among other prohibited transactions. 

Real Estate Accounts:
Real estate accounts are open-ended, commingled accounts that invest 
directly in real estate, such as funds that buy and manage commercial 
properties. Real estate accounts are equity accounts consisting 
primarily of high quality, well-leased real estate properties in the 
industrial, office, retail and hotel sectors. Real estate accounts may 
be offered by insurance companies as separate accounts, and are 
regulated by the state insurance commissioner in the state they are 
created. 

Rebate:
A payment to the broker-dealer, as they would have earned a short-term 
rate of return on the cash they provided as collateral if they had 
kept it in their possession. The greater the demand for the security 
being lent, the lower the rebate paid to the broker-dealer by the 
securities lending agent. Securities that have an extremely high 
borrowing demand, or that are in short supply and therefore hard to 
borrow, can obtain "negative" rebates, requiring the borrower to not 
only pledge cash, but also pay a fee to plan participants. 

Securities Lending:
The lending of some of the assets held in investment options, on 
behalf of plan participants, to third parties, usually broker-dealers, 
for a period of time. In return, broker-dealers provide collateral to 
securities lending agents that they hold until broker-dealers return 
the borrowed securities. Collateral for the loan can be either cash or 
securities, such as bonds or stocks. If securities lending agents 
accept securities as collateral for the loan, broker-dealers will 
typically pay a fee to borrow the securities. However, in the U.S., 
cash is the primary form of collateral taken in securities lending 
transactions and if cash is taken as collateral, the securities 
lending agent does not receive a fee, but, instead, has the right to 
reinvest the cash to earn an additional return. This is sometimes 
called "cash collateral reinvestment," and is typically considered a 
separate, but related, activity to the securities lending transaction. 

Securities Lending Agent:
The securities lending agent coordinates loans of securities, hires a 
manager to invest cash collateral and may take on counterparty risk--
or the risk that the borrower will not return the securities--on 
behalf of the plan. May be an affiliate of the custodian, i.e., an 
entity, usually a bank, that has legal responsibility for safekeeping 
a plan's securities. 

Separate account GICs:
Plan sponsors contract with an insurance company to guarantee 
participants principal protection and a rate of return, which may be 
fixed, indexed, or reset periodically based on the actual performance 
of the underlying assets. The insurance company owns and holds the 
underlying assets in a separate, customized account for the exclusive 
benefit of a single plan. 

Stable Value Fund:
Stable value funds are a fixed income investment option, designed to 
preserve the total amount of participants' contributions, or their 
principal, while also providing steady, positive returns set in the 
contract. 

Statement of Additional Information:
A Statement of Additional Information (SAI) is a supplementary 
document to a mutual fund's prospectus that contains additional 
information about the mutual fund and includes further disclosure 
regarding its operations. 

Synthetic Guaranteed Investment Contracts:
Plan sponsors contract with a bank or insurance company to guarantee 
participants principal protection and a rate of return relative to a 
portfolio of assets held in an external trust owned by the plan. The 
rate of return, which is based on the actual performance of the 
underlying assets, is reset periodically. 

Target Date Funds:
Target date funds are often mutual funds and hold a mix of stocks, 
bonds, and other investments. Over time, the investment allocation 
gradually shifts according to the fund's investment strategy. Target 
date funds are designed to be investments for individuals with 
particular retirement dates in mind. 

Traditional Guaranteed Investment Contracts:
Plan sponsors contract with an insurance company to guarantee 
participants principal protection and a rate of return regardless of 
the performance of the underlying assets, which the insurance company 
owns and holds within their general account. 

Trustee-Directed 401(k) Plan:
A 401(k) plan wherein an employer appoints trustees who decide how the 
plan's assets will be invested. 

[End of section] 

Footnotes: 

[1] Industry researchers have estimated that the average 401(k) 
retirement account balance declined 27.8 percent in 2008, before 
rising 31.9 percent in 2009. Thus, over this 2-year period, the 
average retirement account balance lost 4.8 percent. For example, if 
the average 401(k) retirement account balance was $100, a decline of 
27.8 percent would bring the balance to $72.20 at the end of 2008. 
Then, an increase of 31.9 percent would bring the balance to $95.20 at 
the end of 2009. According to an industry association, the average 
401(k) retirement account balance outperformed the S&P 500 Index in 
both 2008 and 2009. 

[2] Other 401(k) plans are trustee-directed, wherein an employer 
appoints trustees who decide how the plan's assets will be invested. 
For the purposes of this report, we are discussing participant-
directed 401(k) plans. 

[3] In 2010, the federal limit for pretax contributions to 401(k) 
accounts was $16,500. Participants aged 50 and over were eligible for 
an additional $5,500 in "catch-up" contributions. 

[4] Employee Benefit Research Institute. 401(k) Plan Asset Allocation, 
Account Balances, and Loan Activity in 2009, Issue Brief No. 350 
(Washington D.C.: November 2010). 

[5] Plan sponsors may provide participants access to their retirement 
savings in the form of a participant loan, a hardship withdrawal, or a 
lump-sum distribution when the participant separates from the plan 
sponsor. Participants who take an early distribution generally pay a 
10 percent early withdrawal penalty and income taxes on the 
distribution amount and may face other restrictions and fees, such as 
loan origination fees. 

[6] Labor's proposed regulations of October 2010, would amend the 
definition of an ERISA fiduciary, reducing the number of conditions 
that need to be met to be deemed an ERISA fiduciary. As such, the 
proposed regulation, if finalized, would encompass a greater number of 
entities assisting plan sponsors with selecting investment options. 
Definition of the Term "Fiduciary," 75 Fed. Reg. 65,263 (proposed Oct. 
22, 2010) (to be codified at 29 C.F.R. pt. 2510). 

[7] Our recent reports on target date funds and conflicted investment 
advice illustrate that managing the risks faced in saving for 
retirement through 401(k) plans today can be complicated and pose 
significant challenges for participants and sponsors alike. See GAO, 
Defined Contribution Plans: Key Information on Target Date Funds as 
Default Investments Should Be Provided to Plan Sponsors and 
Participants, [hyperlink, http://www.gao.gov/products/GAO-11-118] 
(Washington, D.C.: Jan. 31, 2011); and GAO, 401(k) Plans: Improved 
Regulation Could Better Protect Participants from Conflicts of 
Interest, [hyperlink, http://www.gao.gov/products/GAO-11-119] 
(Washington, D.C.: Jan. 28, 2011). 

[8] IRS also oversees various aspects of 401(k) contributions under 
the Internal Revenue Code. 

[9] Labor regulations specify that participants must be offered at 
least three different investment options so that they can diversify 
investments within an investment category, such as through a mutual 
fund, and diversify among the investment alternatives offered. 

[10] The operation of CIFs by national banks is subject to regulation 
under OCC regulations. While certain CIFs offered by state banks must 
comply with OCC regulations in order to qualify for tax-exempt 
treatment (See 26 U.S.C. § 584) these CIFs generally are not limited 
to employee benefit assets. CIFs offered by state banks that consist 
solely of employee benefit assets such as retirement, pension, profit 
sharing, stock bonus, or other trusts that are exempt from federal 
income tax must only comply with applicable state law requirements 
(which may include a cross-reference to OCC regulations) and are not 
required under the tax code to comply with OCC regulations. 12 C.F.R. 
§ 9.18(a)(2). 

[11] An institutional investor is an organization that pools large 
sums of money and invests those sums in securities, real property and 
other investment assets. Institutional investors include banks, 
insurance companies, retirement or pension funds, hedge funds, 
foundations and mutual funds. 

[12] In the United States, an annuity contract is created when an 
insured party, usually an individual, gives an insurance company money 
that will later be distributed back to the insured party over time. 
Annuity contracts traditionally provide a guaranteed distribution of 
income over time, until the death of the person or persons named in 
the contract or until a final date, whichever comes first. 

[13] Title I of ERISA does not proscribe or prohibit particular types 
of investment products or options, but plan sponsors must conduct due 
diligence and prudently select the investment options they want to 
offer to their participants. 

[14] Commingled or collective funds are designed to combine the assets 
of unrelated retirement plans, enabling participants to diversify and 
gain the economies of scale, i.e., the advantages that being part of a 
larger fund affords, such as greater profits and less cost. 
Participants own a share in a pool of assets. 

[15] For plans that offer separate accounts, participants own the 
assets in the pool. 

[16] Hewitt Associates, Trends and Experience in 401(k) Plans 
(Lincolnshire, IL: 2009). 

[17] The stable value fund industry used to offer "stable value mutual 
funds" to investors who invested in Individual Retirement Accounts; 
however, after SEC staff raised concerns about the funds' accounting 
methods, stable value mutual funds were terminated. 

[18] The market value of a stable value fund is the collective prices 
at which the underlying assets of the fund are trading in the market 
at a given time. 

[19] The book value of a stable value fund is the principal 
contributed to the investment option, plus accrued interest, minus 
withdrawals and fees. Accrued interest, minus withdrawals and fees, is 
calculated based on a methodology specified in the stable value fund 
contract and is reset on a periodic basis, which is usually quarterly 
or semiannually. 

[20] In fact, according to a stable value fund provider, plan sponsor 
restrictions are necessary to provide the fund manager with a tool to 
protect the remaining investors in the fund and to protect the issuers 
of wrap contracts used by the funds. Similarly, in a 2006 Akron Law 
Review publication, an industry expert notes that, in order for a wrap 
contract to be a financially sound product, wrap contract providers 
nearly universally insist that plan participants not be allowed to 
make direct transfers from a stable value fund into a money market 
fund. The author argues that these participant restrictions are not 
only necessary to maintain favorable returns above those of other low-
risk investments, but also to ensure that less financially 
sophisticated plan participants are not disadvantaged by financially 
sophisticated, market-timing plan participants. Paul J. Donahue, "Plan 
Sponsor Fiduciary Duty for the Selection of Options in Participant-
Directed Defined Contribution Plans and the Choice Between Stable 
Value and Money Market," Akron Law Review 39, No. 1 (2005-2006). 

[21] Some of the $2.8 trillion in assets held in 401(k) plans at the 
end of 2009 were utilized in securities lending programs, but the 
specific percentage is unknown. The percentage of assets lent out at 
any given time varies by type of 401(k) investment option. While SEC 
staff, by no-action letters, limit the percentage of assets in mutual 
funds and money market funds that can be utilized in securities 
lending programs, other 401(k) investment options that are not 
registered with SEC, such as some equity, bond, and stable value 
funds, are generally not limited in the percentage of assets that can 
be utilized by securities lending programs. 

[22] The securities lending agent takes collateral for the loan that 
can be either cash or securities, such as bonds or stocks. However, in 
the United States, cash is the primary form of collateral taken in 
securities lending transactions and, thus, for the purpose of this 
report, investment options that lend securities are those investment 
options that participate in the practice of lending plan assets to 
third parties in exchange for cash as collateral that a fund 
reinvests, or securities lending with cash collateral reinvestment. 

[23] If the investment option takes cash as collateral, the lender has 
the right to reinvest that cash to earn an additional return. The 
borrower does not pay an additional fee to borrow the securities, 
called a "negative rebate," unless the security is in extremely high 
borrowing demand. If the investment option takes securities as 
collateral, the borrower will pay the lender a fee. 

[24] Prohibited Transaction Exemption (PTE) 2006-16; Class Exemption 
to Permit Certain Loans of Securities by Employee Benefit Plans, 71 
Fed. Reg. 63,786 (Oct. 31, 2006). 

[25] 29 U.S.C. § 1106. Prohibited transactions under ERISA include a 
sale, exchange, or lease between the plan and party-in-interest; 
lending money or other extension of credit between the plan and party-
in-interest; and furnishing goods, services, or facilities between the 
plan and party-in-interest, among other prohibited transactions. Labor 
may grant administrative exemptions from the prohibited transaction 
provisions of ERISA. 

[26] ERISA provides a number of detailed exemptions to its prohibited 
transaction provisions and permits Labor to establish additional ones. 
29 U.S.C. §1108. 

[27] Prohibited Transaction Exemption (PTE) 2006-16. This exemption 
permits the lending of securities owned by an employee benefit plan to 
persons who would otherwise constitute a "party in interest" with 
respect to such plans, provided certain conditions specified in the 
exemption are met. Under those conditions neither the borrower nor an 
affiliate of the borrower can have discretionary control over the 
investment of plan assets, or offer investment advice concerning the 
assets, and the loan must be made pursuant to a written agreement. The 
exemption also establishes a minimum acceptable level for collateral 
based on the market value of the loaned securities and permits 
compensation of a fiduciary for services rendered in connection with 
loans of plan assets that are securities. 

[28] There are a number of reasons why plan sponsors and participants 
may want to withdraw their assets. For example, plan sponsors can 
switch investment options because they want to offer different 
investment options or because fees are too high at their current 
service provider. Participants often transfer their plan assets into 
riskier or safer investment options or may withdraw their 401(k) 
assets because they are experiencing a personal hardship. Participants 
are also allowed to withdraw their assets when they retire. Between 
2007 and 2010, while some investment options placed restrictions on 
participants and sponsors who wanted to withdraw to move their plan 
assets into other investments, investment options generally did not 
restrict certain withdrawals that were defined by plan sponsors. This 
included hardship withdrawals and withdrawals at retirement, if 
applicable. 

[29] Withdrawal restrictions, in general, may have prevented some 
realized losses during the period of the restrictions. 

[30] Generally, defined benefit plans are more likely to invest in 
real estate than defined contribution plans. As such, public reports 
of redemption restrictions noted that numerous defined benefit plans 
also experienced withdrawal restrictions from these investment options. 

[31] While restrictions were placed on participants and sponsors who 
wanted to withdraw to move their plan assets into other investments, a 
representative of the real estate accounts that we spoke to told us 
that, despite the restrictions, it continued to pay benefits for 
certain withdrawals that were defined by plan sponsors, including 
hardship withdrawals and withdrawals at retirement at normal age, if 
applicable. 

[32] Mullaney v. Principal Global Investors, LLC et al. No.4:10-cv- 
00199-RP-TJS (U.S. Dist. Ct., So. Dist. Of Iowa)(April 30, 2010). 

[33] Money market funds must operate in accordance with rule 2a-7 
under the Investment Company Act of 1940. Under rule 2a-7, as in 
effect in 2008, money market funds were permitted to maintain a stable 
net asset value, usually $1.00, by using the "amortized cost" 
valuation method. Under this valuation method, securities are valued 
at acquisition cost, with certain adjustments, instead of fair market 
value. If there is a difference of more than one-half of 1 percent 
($.005 per share) between amortized cost and net asset value, the fund 
is deemed to have "broken the buck," and must reprice its shares. The 
Primary Fund's Lehman holdings were valued at zero in September 2008 
which led to a repriced net asset value of $0.97 per share. However, 
these Lehman holdings were subsequently sold for around 22 cents on 
the dollar and thus, as of approximately July 16, 2010, Primary Fund 
investors had been paid 99 cents on the dollar. 

[34] According to the "Report of the President's Working Group on 
Financial Markets: Money Market Reform Options," October 2010, money 
market funds are vulnerable to runs because shareholders have an 
incentive to redeem their shares before others do when there is a 
perception the fund might suffer a loss. Even when the fund suffers a 
small loss, shareholders who choose to redeem may do so at the expense 
of the remaining shareholders. 

[35] Subject to certain exceptions, Section 22(e) of the Investment 
Company Act of 1940 prohibits mutual funds, including money market 
funds, from (i) suspending the right of redemption, or (ii) postponing 
payment upon redemption of any redeemable security in accordance with 
its terms for more than seven days after the tender of the security to 
the fund or its agent. One of the exceptions is by order of the SEC 
for the protection of the fund's security holders. SEC issued an order 
covering the Reserve Primary Fund and the U.S. Government Fund on 
September 22, 2008, and an order covering additional Reserve money 
market funds on October 24, 2008. 

[36] Treasury's Temporary Guarantee Program for Money Market Funds 
expired on September 18, 2009. Treasury guaranteed that upon 
liquidation of a participating money market fund, the fund's 
shareholders would receive the fund's stable share price of $1.00 for 
each fund share owned as of September 19, 2008. Participating funds 
were required to agree to liquidate and to suspend shareholder 
redemptions if they broke the buck. Most money market funds elected to 
participate in the program. On November 20, 2008, SEC adopted an 
interim final temporary rule under section 22(e) of the Investment 
Company Act that permitted investment companies that commenced 
liquidation under the Guarantee Program to suspend redemptions of 
outstanding shares and postpone payment of redemption proceeds. 17 
C.F.R. § 270.22e-3T. According to SEC staff, none did. 

[37] FRB's Asset-Backed Commercial Paper Money Market Mutual Fund 
Liquidity Facility expired on February 1, 2010. 

[38] Money Market Reform, 75 Fed. Reg. 10,060 (Mar. 4, 2010) (codified 
at 17 C.F.R. pt. 270 and 274). The new rules were effective May 5, 
2010. 

[39] Specifically, the new rule (rule 22e-3) permits a money market 
fund to suspend redemptions and postpone payment of redemption 
proceeds to facilitate an orderly liquidation of the fund if: (1) the 
fund's board, including a majority of the disinterested directors, 
determines that the deviation between the fund's amortized cost price 
per share and the market-based net asset value per share may result in 
material dilution or other unfair results to investors, (2) the board, 
including a majority of the disinterested directors, irrevocably has 
approved liquidation of the fund, and (3) the fund has notified SEC 
prior to suspending redemptions. 

[40] Restrictions may vary depending on the way the stable value fund 
is structured. 12-month restrictions, such as the restrictions 
described above, are generally stipulated in contracts where the 
stable value fund is structured as a commingled investment option. For 
plan sponsors who offer stable value funds as separate account 
investment options, there is generally no exit option, per se. 
Instead, for stable value funds that are operated as separate account 
investment options, plan sponsors generally cannot exit at book value 
until market values recover to that amount. 

[41] Mortgage-backed securities are securities whose value and income 
payments are derived from and collateralized (or "backed") by a 
specified pool of underlying mortgage loans, most commonly on 
residential property. For example, a bank or other entity lends a 
borrower the money to buy a house and collects monthly payments on the 
loan. This loan and a number of others, perhaps hundreds, are sold to 
a larger bank that packages the loans together into a mortgage-backed 
security. The larger bank then issues shares of this security to 
investors who buy them and ultimately collect the dividends in the 
form of the monthly mortgage payments. 

[42] An asset-backed security is a security whose value and income 
payments are derived from and collateralized (or "backed") by a 
specified pool of underlying assets. The pool of assets is typically a 
group of small and illiquid assets that are unable to be sold 
individually. Pooling the assets into financial instruments allows 
them to be sold to general investors, a process called securitization, 
and allows the risk of investing in the underlying assets to be 
diversified because each security will represent a fraction of the 
total value of the diverse pool of underlying assets. The pools of 
underlying assets can include common payments from credit cards, auto 
loans, and mortgage loans, to esoteric cash flows from aircraft 
leases, royalty payments and movie revenues. 

[43] Some of the amount that the provider retains may be paid back to 
existing or new participants through small increases in their future 
book value. 

[44] Such restrictions are likely to occur in this situation if the 
stable value fund was structured as a commingled investment option. 

[45] Depending on the specific situation, some plan sponsors may be 
able to negotiate with the stable value fund provider to continue to 
provide book value to participants, even though an employer-initiated 
event has occurred. However, if the plan sponsor is able to negotiate 
with the wrap provider or find a new wrap provider who will accept the 
losses on the original contract, participants who are covered under 
the renegotiated or new contract will likely be charged a higher fee 
to make up for the losses. 

[46] If participants request transfers out when the market value of 
the fund is less than book value, the cash held by the stable value 
fund has been exhausted, and the withdrawal requests are not related 
to an employer-initiated event, the wrap contract will partially cover 
the difference between the market value and book value of the 
withdrawals. The wrap provider pays participants only if there is a 
deficit between book value and market value after all participants 
have left the plan. 

[47] These wrap contract restrictions are sometimes called "equity 
wash provisions" because once the participant transfers their plan 
assets out of the stable value fund, they are precluded by the 
contract from investing their plan assets directly into "competing" 
investment options, which could include money market funds or other 
short-term fixed income funds, and instead are required to put their 
money in a non-competing investment option, such as an equity fund. 

[48] Some plan sponsors have also called for less risk to be taken in 
the stable value portfolio. 

[49] According to a Congressional Oversight Panel June 10, 2010 
report, The AIG Rescue, Its Impact on Markets, and the Government's 
Exit Strategy, on the day that AIG was poised to fail, it had $38 
billion in stable value wrap contracts. 

[50] The combined effects of wrap providers exiting the business, 
credit downgrades in the insurance industry, and reevaluations of risk 
in the historically "low-risk" wrap contract business caused the 
majority of remaining wrap providers to significantly reduce their 
risk exposure, triggering much tighter investment restrictions on the 
underlying stable value portfolio and increasing fees. 

[51] Some investment options that were registered with SEC, such as 
mutual funds, also experienced realized and unrealized cash collateral 
pool losses but did not place restrictions on plan sponsors' 
withdrawals because of the losses. Instead, realized cash collateral 
pool losses were included in the net asset value of the registered 
investment option. 

[52] These assets may not have been perceived as risky when they were 
acquired and, in fact, may have complied with the plans' or the 
investment options managers' investment guidelines covering cash 
collateral reinvestment. Some investment guidelines were very broad 
and therefore provided some discretion to the lending agent. As a 
result, some lenders may have chosen more aggressive reinvestment 
strategies when more conservative approaches were available. 

[53] This is known as a "collateral deficiency" and, as used here, 
occurs when the securities lending agent determines that a substantial 
portion of the invested collateral is so impaired that it will be 
insufficient to repay borrowers upon redemption. 

[54] Securities lending agents had differing experiences in their 
respective cash collateral pools, and managed their clients' realized 
and unrealized losses differently--some placed restrictions on plan 
sponsor withdrawals. In addition, the restrictions varied by the type 
of investment options that plan sponsors offered. On one hand, 
investment options that were separate accounts required that a minimum 
percentage of the account's securities had to be lent out. However, 
investment options that were commingled accounts virtually eliminated 
plan sponsors' abilities to withdraw from the commingled accounts, 
limiting withdrawals to between 2 and 4 percent of their assets per 
month. 

[55] Participants ultimately bore the risk of loss from market risks 
of the cash collateral portfolio--the potential for portfolio losses 
resulting from the change in value of stock prices of the portfolio's 
assets, interest rates, foreign exchange rates, and commodity prices-- 
but were only provided with a portion of the return generated as a 
result of the risks taken on their behalf. 

[56] According to individuals we interviewed, broker-dealers may 
negotiate to receive a rebate from the securities lending agent of 
some of the return earned on the reinvestment of cash collateral 
because they would have earned a short-term rate of return on the cash 
they provided as collateral if they had kept it in their possession. 
However, since they are providing the cash as collateral, they are not 
able to earn interest on it. 

[57] The lending agent typically absorbs the operational expenses 
associated with providing the service. 

[58] While Lehman may have had a high credit rating immediately prior 
to its bankruptcy, that rating may have been based on materially 
misleading periodic reports. In fact, the report of the Examiner in 
Lehman's bankruptcy proceedings stated that "unbeknownst to the 
investing public, rating agencies, Government regulators, and Lehman's 
Board of Directors, Lehman reverse-engineered the firm's net leverage 
ratio for public consumption." 

[59] Many investment options, by design, invest in securities with 
some risk. If the securities are lent out and the cash collateral is 
then invested in risky securities, it creates a leveraged situation 
where $1 invested in the fund is exposed to more than $1 of risk. To 
the extent that returns on the two sets of risky assets are 
correlated, a market downturn could result in both the lent 
securities, and the collateral investments suffering losses at the 
same time. 

[60] Losses may have been realized or unrealized. Realized losses 
caused the value of the investment option to decline and were less 
likely to cause withdrawal restrictions, whereas unrealized losses did 
not cause the value of the investment option to decline and were more 
likely to cause withdrawal restrictions. 

[61] For example, BP Corporation pension plan committee filed suit in 
October 2008 against Northern Trust Company, asserting multiple causes 
of action grounded in the fiduciary obligations prescribed by §§ 404, 
409, and 502 of ERISA. This case is still pending, and no rulings have 
been made. BP Corporation North America, Inc. Savings Plan Investment 
Oversight Committee v. Northern Trust Investments N.A., No. 1: 08-cv- 
6029 (N.D. Ill.)(October 21, 2008). Other cases include: Public School 
Teachers' Pension & Retirement Fund of Chicago et.al. and City of 
Atlanta Firefighters' Pension Plan, v. Northern Trust Investments, No. 
1:10-cv-00619 (N.D. Ill.)(January 29, 2010); Board of Trustees of the 
AFTRA Retirement Fund et.al. v. J.P. Morgan Chase Bank N.A., No. 1:09- 
cv-00686-SAS-DCF (S.D. N.Y.)(January 23, 2009); and Diebold v. 
Northern Trust Investments N.A. et.al., No. 1:09-cv-01934 (N.D. 
Ill.)(March 30, 2009). We did not verify the status of these cases. 

[62] Individual exemptions relating to actions taken by service 
providers to ensure liquidity of cash collateral pools were granted by 
Labor in 2009 and 2010, including PTE 2009-11, JP Morgan Chase Bank, 
National Association; PTE 2009-27, Bank of New York Mellon 
Corporation; and PTE 2010-25, State Street Bank and Trust Company. 

[63] For example, one securities lending agent contributed cash to one 
of their cash collateral pools that experienced losses as a result of 
the Lehman default--in accordance with their portion of the split on 
gross profit--but sponsors that withdraw from the cash collateral pool 
within three years will forfeit this loss sharing. Another securities 
lending agent contributed cash representing 20 percent--or the loss 
from a Lehman security--of the unrealized and realized losses in one 
of their collateral pools. 

[64] ERISA Advisory Council. Report on Stable Value Funds and 
Retirement Security in the Current Economic Conditions (2009). 

[65] Fiduciary Requirements for Disclosure in Participant-Directed 
Individual Account Plans; Final Rule, 75 Fed. Reg. 64,910 (Oct. 20, 
2010)(codified at 29 C.F.R. pt. 2550). As a result of these 
regulations, which became effective on December 20, 2010, participants 
will receive core information about investments available under the 
plan, including performance and fee information, prior to investing 
and on an annual basis, in a chart or similar format designed to 
facilitate investment comparisons. Participants will also receive 
quarterly statements on plan fees and expenses deducted from their 
accounts along with a description of the services for which the charge 
or deduction was made. 29 C.F.R. § 2550.404a-5 and § 2550.404c-1. 

[66] Wrap contracts may stipulate plan sponsor communications with 
participants that induce transfers from the funds as employer-
initiated events. 

[67] The placement of this information in disclosure documents depends 
on the investment option's approach to securities lending. If, for 
example, the investment option only lends on an intrinsic value basis, 
and only reinvests cash to preserve principal, their risk may in fact 
be low. Since the economic crisis, securities lenders are calling for 
a move towards an intrinsic value lending approach, rather than a 
focus on cash collateral reinvestment to generate additional returns. 

[68] 29 C.F.R. § 2550.404c-1. 

[69] Section 404(a)(1) of Title I of ERISA provides a "prudent man 
standard of care" that a fiduciary must observe in meeting his or her 
duties with respect to the plan. As such, the fiduciary must act 
solely in the interests of plan participants and beneficiaries and for 
the exclusive purpose of providing benefits and defraying reasonable 
expenses of administering the plan. Among other requirements, the 
fiduciary must discharge his responsibilities with the appropriate 
care, skill, prudence, and diligence that similarly situated 
fiduciaries acting in a like capacity and familiar with such matters 
would use in a similarly situated enterprise of a like character and 
with like aims. 29 U.S.C. § 1104(a)(1). 

[70] An asset in a stable value fund can potentially default, for 
example, if the loan underlying an interest-only bond defaults or 
prepays. A wrap provider can potentially default on its "guarantee" or 
its obligation to cover any gap between market value and book value of 
a stable value fund's assets. 

[71] According to the ERISA Advisory Council, plan sponsors need (1) 
issuer specific information regarding the underlying assets of a 
stable value fund for insight into the risk/reward characteristics 
that will result in any variance between the fair market value and the 
book value; (2) issuer specific information regarding the wrap 
contract provider, since the financial stability of the wrap contract 
provider(s) may be a factor in the ability of the fund to be able to 
continue to make payments at book value when book value is greater 
than the fair market value of the underlying assets; (3) information 
on the administrative cost and other fees related to the fund, to aid 
in determining the efficiency and prudence of the investment; and (4) 
information concerning the periodic fair market valuation of the fund 
as compared with book value that would allow them to evaluate any risk 
of a market value adjustment. 

[72] Industry experts who testified before the ERISA Advisory Council 
stated that the level of due diligence for stable value fund selection 
is qualitatively different from the due diligence in selecting a 
mutual fund. Unlike mutual funds, where there are a variety of sources 
regarding their current and historic value, the only source of stable 
value fund information is the stable value fund provider. Thus, some 
plan sponsors are in a position where they not only do not understand 
the composition and diversification of the underlying portfolio of 
stable value funds, but they also do not understand how the market to 
book value of their plan's stable value fund compares to other stable 
value funds. 

[73] Pub. L. No. 111-203, §719, 124 Stat. 1377, 1656 (2010). The Dodd- 
Frank Act was signed into law on July 21, 2010. The stated intent of 
the new law is to promote the financial stability of the United States 
by improving the accountability and transparency in the financial 
system and protecting consumers from abusive financial services 
practices. 

[74] Swaps are one of the financial transactions addressed by the Dodd-
Frank Act. Normally, the vast majority of retirement plans do not 
directly employ swaps. However, the Dodd-Frank Act's definition of 
swap could include components of stable value fund products because 
the Dodd-Frank Act defines "swap" broadly to include certain 
agreements where the value is determined by reference to an underlying 
asset (subject to certain exclusions). The investments underlying a 
stable value fund are protected by the issuer's guarantee to pay the 
book value of the investments if the market value is depleted. It is 
this protective wrap contract that could be considered a swap under 
the Dodd-Frank Act. SEC and CFTC are to consult with Labor, Treasury, 
and state regulators who regulate the issuers of stable value 
contracts and issue a report by October 11, 2011. If they determine 
that stable value contracts fall within the definition of a swap, they 
are to determine if an exemption is in the public interest. Until such 
time, the requirements of the act are not to apply to stable value 
contracts and stable value contracts in effect prior to the adoption 
of any regulations are not to be considered swaps. Section 719(d) of 
Dodd-Frank 15 U.S.C. § 8307. 

[75] Our poll respondents' responses cannot be considered 
representative of the overall population of 401(k) plan sponsors. 
Because of the methodological limitations of this poll, this 
information is anecdotal and represents only the views of the 74 
members who responded to our poll. 

[76] We have not verified the status of any of these cases. 

[77] The term "illiquid security" generally includes any security that 
cannot be sold or disposed of promptly and in the ordinary course of 
business without taking a reduced price. A security is considered 
illiquid if a fund cannot receive the amount at which it values the 
instrument within 7 days. 

[78] FINRA is the largest independent regulator for all securities 
firms doing business in the United States. It oversees nearly 4,600 
brokerage firms, 163,000 branch offices, and 631,000 registered 
securities representatives. Its chief role is to protect investors by 
maintaining the fairness of the U.S. capital markets. 

[79] Section 984(b) of Dodd-Frank, 15 U.S.C. § 78j. The new act does 
not limit the authority of the federal banking agencies to also 
prescribe rules regarding the loan or borrowing of securities. 

[80] FINRA has also asked for input on how to create an ADV-like form 
for broker-dealers, which is the key disclosure document used by 
investment advisers that requires detailed disclosures of services, 
conflicts, and fees. 

[81] The council is a formal interagency body empowered to prescribe 
uniform principles, standards, and report forms for the federal 
examination of financial institutions by FRB, FDIC, the National 
Credit Union Administration, OCC, and the Office of Thrift 
Supervision, and to make recommendations to promote uniformity in the 
supervision of financial institutions. 

[82] SEC's rule 2a-7, which governs money market funds, requires that 
all taxable money market funds maintain at least 10 percent of their 
assets in cash, U.S. Treasury securities, or securities that mature or 
can be converted to cash within one business day, and that all money 
market funds hold at least 30 percent of their assets in cash, U.S. 
Treasury securities, certain other government securities with 
remaining maturities of 60 days or less, or securities that mature or 
can be converted to cash within a week. 

[83] Labor's PTE 2006-16 does state, however, that, in return for 
lending securities, the plan may receive a reasonable fee (in 
connection with the securities lending transaction) and/or have the 
opportunity to earn additional compensation through the investment of 
cash collateral. It further states that all fees and other 
consideration received by the plan in connection with the loan of 
securities should be reasonable. 

[84] Reasonable Contract or Arrangement Under Section 408(b)(2)-Fee 
Disclosure; Interim Final Rule, 75 Fed. Reg. 41,600 (July 16, 2010)(to 
be codified at 29 C.F.R. § 2550.408b-2). 

[85] A statement is also required when the covered service provider 
provides their services as a registered investment advisor. A "covered 
service provider" is a provider that enters into a contract or 
arrangement with the retirement plan and expects to receive $1,000 or 
more in direct or indirect compensation for services to the plan, 
regardless of whether the services are performed by the covered 
service provider, an affiliate, or a subcontractor, or as a registered 
investment advisor registered under the Advisors Act or under state 
law providing services directly to the plan. 

[End of section] 

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