On 12 January the Pensions Regulator issued a statement: Understanding and Managing the Risks of Securities Lending. The statement is aimed at trustees of both defined benefit and defined contribution schemes and was issued in response to concerns expressed in the pensions industry about the risks to scheme assets from stock lending. The statement does not condemn or criticise its practice by pension schemes; it focuses on the need for trustees to have full knowledge of the terms, circumstances, risks and effects of stock lending.
Broadly, stock lending entails the transfer of securities (or other assets), on a temporary basis, by a lender to a borrower, with the borrower agreeing to return the equivalent securities to the lender at an agreed time. It is, the Regulator acknowledges, "widely practised" by pension schemes as it allows schemes to generate an income to enhance returns on ownership of particular assets or to offset the costs of fund management. Despite certain advantages with the practice, the Regulator notes that stock lending will not be appropriate for all schemes; the decision is in the hands of the trustees, who need to identify and control the risks involved.
The Regulator is particularly concerned that trustees may be unaware that fund managers are lending scheme assets in this way, with fund managers retaining the majority of the investment return and the scheme retaining all of the risk. There may also be inadequate collateral in place to cover this risk. Hence, in its statement, the Regulator suggests that trustees should:
- Ensure that they are aware of whether their fund managers are lending assets and that the scheme is receiving due benefit. In particular, trustees should ensure that they are aware of the proportion of income derived from the securities lent that is not passed on to the scheme (including where assets are invested in pooled funds).
- Ensure they understand the arrangements and financial terms in place between the scheme, the fund manager and borrower.
- Be fully aware of the risks of stock lending and of the nature of the collateral covering these risks; this should be sufficient and appropriate.
- Ensure that the controls they have in place allow them to monitor the appropriateness of these arrangements in the context of their overall investment strategy.
The Regulator also sets out certain key questions for trustees to consider:
- Do the scheme's arrangements with fund managers provide clarity about whether (and which) scheme assets may be lent, and the terms on which they may be lent?
- Do trustees have a good understanding of the proportion of scheme assets which may be lent?
- Do trustees have an up-to-date knowledge of how much stock lending has taken place and is currently taking place?
- Does the fund manager have appropriate legal agreements in place which make clear the obligations of the borrower and the lender?
- Do trustees have appropriate controls and expertise to understand and monitor the risks and to ensure that collateral is appropriate and properly secured?
The upshot of the statement is that, whilst stock lending is a legitimate and often appropriate activity for pension schemes, the trustees should be fully aware of its extent and the terms on which it is conducted by their fund manager. In particular, trustees should be aware of the risks and benefits to the scheme.