OHIO PUBLIC EMPLOYEES RETIREMENT SYSTEM 277 EAST TOWN STREET, COLUMBUS, OH 43215-4642 1-800-222-PERS (7377) www.opers.org MEMORANDUM DATE: September 13, 2005 TO: FROM: RE: OPERS Retirement Board Members Jerry May, Securities Lending Officer Securities Lending Policy Revision Purpose This memorandum highlights the changes made to the Securities Lending Policy, which was most recently updated in July of 2003. Background In July of 2003, staff prepared a securities lending policy revision in conjunction with the securities lending consultant, Bill Pridmore. This policy provided the framework for the changes that have taken place over the past few years. The current policy has proven to be broad enough to incorporate the changes that were necessary in the securities lending program, while still offering risk controls to operate the program in a prudent manner. The policy that is being presented today refines the areas in which the industry and our program have evolved. Today s policy also attempts to conform to the standard format that has been adopted with the rest of the OPERS investment policies. Issues This Securities Lending Policy follows the same format that has been presented in the Master Plan Polices and the Asset Class Policies with minor changes where the subject matter deviated. The major sections are highlighted here with a brief description of the material included. 1
I. SCOPE This section is new for the Securities Lending Policy and specifies that the policy applies to all assets that are loaned out by OPERS for both the Defined Benefit and Health Care plans. II. PURPOSE This section is given its own heading with the wording from the previous policy basically intact. III. INVESTMENT PHILOSOPHY This section borrows some language from the previous policy providing some framework upon which the securities lending program is administered. The section addresses the investment of the cash collateral provided by the borrowers of OPERS securities. IV. INVESTABLE INSTRUMENTS AND RESTRICTED INVESTMENTS This section points to the cash guidelines for those securities that are eligible to purchase. V. PERFORMANCE OBJECTIVES This section is the same as the previous Performance Assessment with a change in the frequency of the performance evaluation to quarterly from annually. The benchmark or composite to be used in assessing performance has never been established in the securities lending industry. There are some advantages and disadvantages with each standard currently available. Staff is currently working with peers in the industry to establish a benchmark that provides flexibility and integrity to all participants. In the interim, staff is currently using two composites to compare performance. VI. RISK MANAGEMENT This section is based upon language from the previous policy and highlights the main risks from securities lending, and the means by which those risks are being addressed in OPERS securities lending program. Staff monitors these risks closely on a regular basis. VII. ROLES AND RESPONSIBILITIES This section has changed to reflect the current format of the OPERS plan policies. The role of the staff has been supplemented with more detail, as well as the role of the investment advisor to the Board. The formal role of the Director of Investments is now a function of the line of reporting, while staff s responsibilities, as well as the Board s, have broadened in scope for administration and oversight of the program. VIII. MONITORING AND REPORTING This section has been modified only slightly, to reflect the frequency of reporting that is done for the Board. 2
Next Steps Staff will incorporate feedback and bring those changes to the October Investment Committee meeting, or accept approval of the suggested changes and finalize the policy. Jerry May 3
MEMORANDUM To: Investment Committee Ohio Public Employees Retirement System From: Brady O Connell, CFA Date: September 2, 2005 Re: Securities Lending Policy EnnisKnupp has reviewed the proposed Securities Lending Policy and is comfortable endorsing it for Investment Committee approval. In addition to the formatting changes that make this policy look like other OPERS policies, other noteworthy changes have been made: The definition and strategic objective of the securities lending program have been changed. The detailed definition of securities lending was removed. We are comfortable with these changes given that a more concise definition for the program is contained in the Investment Philosophy section. Clarification of the risks associated with a securities lending program. Too often investors take securities lending revenue as a source of income that does not have substantial risks. This policy rightly identifies the risks involved (cash reinvestment, counterparty and liquidity) and discusses how those risks will be managed. The Director of Investments has been removed as one of the roles identified under Roles and Responsibilities. Staff involved in the securities lending program will still ultimately be responsible to the Director of Investments, but staff (broadly) and the Board are assuming the responsibilities for monitoring performance and compliance of the securities lending program on a quarterly basis. These tasks had previously been assigned to the Director of Investments. Ennis Knupp + Associates vox 312 715 1700 10 South Riverside Plaza, Suite 1600 fax 312 715 1952 Chicago, Illinois 60606-3709 www.ennisknupp.com
Ohio Public Employees Retirement System Securities Lending Policy July 2003September 2005
TABLE OF CONTENTS I. GENERAL PROVISIONS...1 A. Purpose...1 B. Definition...1 II. STRATEGIC OBJECTIVES...2 A. Risk...2 B. Performance Assessment...2 III. RESPONSIBILITIES AND REPORTING...2 A. Board...2 B. Director of Investments...3 C. Staff Duties...3 I. Scope.. 2 II. Purpose... 2 III. Investment Philosophy.. 2 IV. Investable Instruments and Restricted Investments. 2 V. Performance Objectives 2 VI. Risk Management.. 3 A. Cash Reinvestment Risk... 3 B. Counterparty Risk. 3 C. Liquidity Risk 3 VII. Roles and Responsibilities. 3 A. Board of Trustees.. 3 B. Investment Staff. 3 C. Investment Advisor 4 VIII. Monitoring and Reporting. 4 Annually... 4 Quarterly. 4
Revision History Date Approved Policy Established December 7, 2001 Policy Revised June 19, 2002 Policy Revised July 15, 2003 Policy Revised September 2005
I. GENERAL PROVISIONS SCOPE This policy applies to all assets eligible for loan of Ohio Public Employees Retirement System ( OPERS ) for the Defined Benefit and Health Care funds. A.II. PurposeURPOSE The purpose of this document is to establish the policies that govern the securities lending activities of OPERS Ohio Public Employees Retirement System (System). This policy applies to the securities lending of all asset class portfolios. These policies have been adopted by, and can be changed only by, the Board of the Ohio Public Employees Retirement System. The guidance set forth herein is to be strictly followed by all those responsible for any aspect of the management or administration of these funds. All participants in the securities lending process shall act responsibly as custodians of the public trust. III. INVESTMENT PHILOSOPHY The securities lending program actively lends securities through various programs to qualified borrowers in order to provide incremental income to the respective asset classes. Borrowers provide liquid collateral in exchange for the right to borrow securities. Cash collateral investment shall follow the Cash Policy and Guidelines. IV. INVESTABLE INSTRUMENTS AND RESTRICTED INVESTMENTS Eligible and restricted short-term investment vehicles are provided in the cash collateral guidelines. B. Definition Securities lending is an agreement between a lender (e.g. OPERS) and a borrower (e.g. broker/dealer) to transfer ownership of a security temporarily in order to earn additional income. The lender retains economic benefits of the security and is entitled to any distributions that occur with respect to that security during the life of the loan, such as coupon interest and dividend payments. The lender, however, transfers ownership rights such as the right to vote proxies unless the lending agreement specifically states that securities are not to be loaned over proxy record 1
date. The borrower backs the agreement by delivering collateral to the lender, either in the form of cash, which is currently the dominant form of collateral in securities lending transactions, or other liquid securities, in an amount that exceeds the market value of the securities borrowed. Both the collateral and loan are marked-to-market on a daily basis. There are two aspects to the return earned from securities lending. One part of the return represents the intrinsic lending value of the loaned securities. The other part of the return represents the yield one earns from investing the cash collateral. The higher the proportion of the return that is due to the yield earned on reinvestment of cash collateral, the higher is one s reliance on a limited form of leverage to generate the return. This is a higher risk strategy than allowing the intrinsic value of the loaned securities to generate most of the return. II.STRATEGIC OBJECTIVES Generating incremental income by lending securities to qualified borrowers is the strategic objective of the System s Program. Borrowers provide liquid collateral in exchange for the right to borrow securities. Cash collateral investment shall follow the System s Guidelines and Procedures. It is intended that securities lending generate income primarily from the intrinsic lending value of the loaned securities and secondarily through a moderate-risk cash collateral investment strategy. The securities lending program will be conducted in such a manner as to not interfere with the management of the OPERS portfolios. A.Risk There are two key risks associated with securities lending: counterparty risk and cash collateral reinvestment risk. Counterparty risk refers to the possibility that the borrower will fail to return the security. Cash collateral reinvestment risk refers to the possibility that one could suffer a loss on the short-term investments purchased with the cash collateral. Staff will develop measures to minimize to an acceptable degree OPERS exposure to these risks. These measures will be specified in the Securities Lending Guidelines. 2
B.V. Performance AssessmentERFORMANCE OBJECTIVES Staff will assess the performance of the securities lending program on a quarterly annual basis by comparing it to an appropriate benchmark or industry composite as determined by staff. Staff will address any shortcomings in performance with recommendations to the Director of Investments. VI. RISK MANAGEMENT Risk is managed through a combination of quantitative and qualitative constraints. The following sections identify the significant elements of risk associated with securities lending. Staff shall establish reasonable parameters to control such risks. Staff will monitor agents and/or principals compliance with OPERS Securities Lending Policy on a regular basis. A. Cash Reinvestment Risk The primary risk associated with securities lending is the risk that the cash reinvestment assets would not be sufficient to cover the liabilities due the borrowing brokers. This risk is addressed for all of our lending agents and cash collateral managers by the prudent observation of the OPERS Cash Policy and Guidelines. B. Counterparty Risk The risk that a borrowing broker would not return a security from loan is managed through several factors. Staff regularly monitors amounts on loan to each borrowing broker. Excess collateral is held for each loan in the amount of 102% for domestic securities, and 105% for international securities. These collateral amounts are marked to market daily, should there ever be a need to liquidate collateral for a loan that cannot be returned. In order to further control potential risk associated with securities lending, the maximum amount that may be on loan with any one borrower is 10% of the total plan assets. C. Liquidity Risk The risk that assets may be on loan at a time when liquidity is needed. This risk is addressed by our legal agreement that mandates our legal right to recall any security at any time. In addition, the maximum percentage of assets that may be on loan is 50% of the total plan. III.VII. ROLES AND RESPONSIBILITIES AND REPORTING 3
A. Board of Trustees The Board shall have the following responsibilities and duties: 1. Approveing securities lending policy. 2. Reviewing securities lending performance quarterly.annually with the Staff. B.Director of Investments The Director of Investments shall have the following responsibilities and duties: 1. Reviewing and approving securities lending guidelines. 2. Approving process for selection of securities lending agents. 3. Reporting to the Board both quarterly and annually about the performance and compliance of the securities lending program. B. Staff DutiesInvestment Staff 1. Developing the securities lending policy. 2. Developing the securities lending procedures and guidelines. 3.3.Handleing the day-to-day administration of the securities lending program. 4. Contract with any agents and/or principals in executing the securities lending program. 5. Reporting to the Director of Investments both quarterly and annually about the performance and compliance of the securities lending programmonitor the performance of the securities lending program and report results to the Board quarterly. C. Investment Advisor 1. Review and comment on the policy and guidelines developed by staff. 2. Report to the Board independently in accordance with OPERS funds policies. VIII. MONITORING AND REPORTING The following monitoring and reporting procedures are to be followed: Annually Memo prepared by staff for Board reporting on performance of securities lending for the past year Quarterly Investment performance report prepared by staff Compliance report prepared by staff 4
OPERS Securities Lending Policy September 2005 By Jerry May
What is Securities Lending? OPERS contracts with agents to lend assets to borrowers In return OPERS and its agents receive cash collateral which is invested in short-term assets OPERS/ Lending Agent Securities Cash Borrowing Broker 2 2
What Is Securities Lending? (cont.) OPERS and its agents are required by the borrowing broker to pay a rebate to the broker on cash that has been submitted as collateral That rebate rate is based on the demand for the assets being borrowed the more special the asset the lower the rebate required from the borrower RELATIVE REBATE AMOUNTS FED FUNDS 3.50 TREASURIES 3.45 AGENCIES 3.50 U.S. EQUITIES 3.35 INT L EQUITIES 3.00 3 3
Scope (New) OPERS lends securities for the DB and Healthcare Plans in the following asset classes: Global Bonds U.S. Equity Non-U.S. Equity 4 4
Investment Philosophy (New) Loans to borrowers provide incremental income to the plan All cash collateral will be invested according to the OPERS Cash Policy and Guidelines 5 5
Performance Objectives (New) Performance is to be compared to a benchmark or composite annually There is no current industry wide benchmark that has been accepted. OPERS continues to work with other beneficial owners in development of an effective benchmark. Staff currently looks at three different composites to assess performance. 6 6
Risk Management (New) Cash Reinvestment Risk Risk of assets insufficient to cover liabilities Addressed by prudent observation of OPERS Cash Policy and Guidelines Liquidity Risk Risk of assets on loan when liquidity is needed. Addressed through legal contracts allowing for recalls of securities at any time, and a maximum percentage allowed on loan at any time capped at 50% of plan assets Counterparty Risk Risk of borrowing broker not being able to return a loaned security Addressed through excess collateral, monitoring broker exposures, and daily mark to market 102% excess collateral on US securities 105% excess collateral on international securities 10% cap to any one borrower 7 7
Roles and Responsibilities Board Approve lending policy Review lending performance annually with staff Staff Recommend lending policy Maintain procedures Administer program Contract with agents and principals Monitor program performance and report to Board Investment Advisor Review and comment on policy Report independently to Board 8 8
Annually Monitoring and Reporting Memo on yearly performance Quarterly Investment performance report Compliance report 9 9