What Is Securities Lending in a 401(k) Fund?

Securities lending lets an investment portfolio earn incremental income from assets it already intends to own. The portfolio temporarily lends a stock or bond to an approved borrower, receives collateral, and earns compensation until equivalent securities are returned. The extra return can benefit 401(k) investors, but it comes with borrower, collateral, operational and sometimes reinvestment risk.

The legal analysis depends on one question that is often skipped:

Whose securities are actually being lent?

If a 401(k) owns shares of a registered mutual fund, the fund's underlying securities generally do not become ERISA plan assets merely because the plan owns fund shares.^[3][5]

If a CIT, separate account or another plan-asset vehicle holds the securities, the underlying assets can be plan assets and ERISA's prohibited-transaction rules can apply directly to the loan.^[4]

That distinction matters before discussing collateral percentages or PTE 2006-16.

What Happens in a Securities Loan?

Assume a portfolio owns:

100,000 shares of Company X.

A broker-dealer wants temporary access to:

20,000 shares.

The portfolio can lend those shares under a securities-lending agreement.

Typical sequence:

1. borrower receives the securities
2. lender receives collateral
3. borrower pays economic compensation
4. collateral is maintained during the loan
5. borrower later returns equivalent securities
6. collateral is returned.

The lender remains economically exposed to the security's price movement because it expects equivalent securities back.

The position was loaned.

It was not sold as an investment decision.

Why Does Anyone Borrow Securities?

Common reasons include:

• short selling
• avoiding settlement failures
• market making
• financing
• hedging
• arbitrage.

The borrower values access to a particular security.

That demand creates a price for the loan.

Some securities are easy to borrow.

Others are:

special

because supply is limited relative to borrowing demand.

Hard-to-borrow assets can command much higher lending fees.

Securities Lending Monetizes Scarcity

Suppose an index portfolio expects to hold a stock for years.

The manager does not need the physical security sitting idle at every moment.

If a qualified borrower will pay to use it temporarily—and the risk controls are acceptable—the portfolio can monetize that demand.

Conceptually:

same long-term investment exposure + temporary lending revenue.

That sounds like free money.

It is not.

The revenue exists because the borrower values something the lender is temporarily giving up or exposing to risk.

Two Main Revenue Paths

The economics depend partly on collateral.

Noncash collateral

Borrower posts approved securities or another acceptable noncash form.

Borrower can pay a direct fee for the loan.

Cash collateral

Borrower posts cash.

The lender invests the cash.

The borrower can receive a:

rebate

and the lender keeps the remaining spread after costs.

The mechanics differ.

Both can create incremental return.

Example: Direct Lending Fee

Portfolio lends:

$20 million

of securities.

Annualized lending fee:

0.35%.

If the loan remains outstanding for one year:

$20,000,000 × 0.35% = $70,000

gross lending income.

If lending agent receives:

20%

of the revenue:

Agent:

$14,000

Portfolio:

$56,000

before any other costs.

The participant benefit is not the headline $70,000.

It is the amount retained after the lending program's economics.

Cash Collateral Creates a Spread

Assume borrower posts cash collateral.

Collateral reinvestment earns:

4.80%.

Borrower rebate:

4.50%.

Gross spread:

0.30%.

On:

$20 million

the annualized gross spread is:

$60,000.

If the lending agent receives 20%:

• agent: $12,000
• portfolio: $48,000

before other expenses and losses.

A higher collateral yield can increase the spread.

It can also mean the cash was invested differently.

That can increase risk.

The Lending Agent Is Not Free

Funds and institutional portfolios often use:

• custodian bank
• specialist lending agent
• investment manager

to administer the program.

Functions can include:

• borrower selection
• loan negotiation
• collateral management
• daily mark-to-market
• recalls
• settlement
• reporting.

SEC guidance notes that funds commonly compensate lending agents with a portion of lending revenue and may pay separate compensation for collateral-reinvestment management.^[10]

The revenue split belongs in the comparison.

Gross Lending Yield Can Be Misleading

Fund A reports:

0.12% gross lending revenue.

Fund B reports:

0.10%.

Fund A gives 30% of gross revenue to its agent.

Fund B gives 10%.

Approximate retained revenue:

Fund A

0.12% × 70% = 0.084%

Fund B

0.10% × 90% = 0.090%

The lower gross program benefits investors more before other costs.

Compare net economics.

Lending Revenue Can Help Offset Expenses

Suppose index fund expense ratio:

0.05%.

Net securities-lending benefit:

0.03%.

All else equal, the lending program can offset much of the drag created by the stated fund expense.

That is one reason two index funds tracking the same benchmark can produce slightly different net returns.

But the result depends on:

• lending utilization
• borrower demand
• revenue split
• collateral
• reinvestment
• transaction costs.

Securities lending is one implementation variable among several.

Borrower Default Is the Obvious Risk

The borrower is obligated to return equivalent securities.

Suppose:

• portfolio lends stock worth $10 million
• borrower defaults
• replacement stock now costs $10.5 million
• available collateral after liquidation is $10.3 million.

Shortfall:

$200,000

before other costs.

Collateral reduces loss severity.

It does not make default mathematically impossible.

Why Collateral Is Marked to Market

The value of loaned securities changes.

A stock lent at:

$100

can rise to:

$120.

If collateral stayed fixed while the security rose, protection would shrink.

Lending programs therefore monitor collateral continuously or daily under applicable rules and agreements.

PTE 2006-16 requires specified collateral maintenance for covered plan-asset loans.^[2]

If collateral falls below the applicable level at the close of trading, the borrower must provide additional collateral under the exemption's conditions.^[2]

Overcollateralization Is a Buffer

Imagine:

Loaned securities:

$10 million

Collateral:

$10.2 million

Collateralization:

102%.

The extra:

$200,000

creates a buffer for market movement and replacement costs.

It is useful protection.

It is not enough to say:

102% collateral means zero risk.

A large overnight price move, collateral impairment, insolvency delay or operational failure can consume the buffer.

PTE 2006-16 Does Not Use One Universal 102% Rule

This is an important technical point.

The current exemption contains different requirements depending on:

• U.S. vs. foreign collateral
• currency relationship
• lending-fiduciary status
• borrower-default indemnification.^[2]

For example, the exemption states a minimum of:

100%

for specified U.S. collateral in the general condition.

Certain foreign collateral requires:

102%

when denominated in the same currency as the lent security and:

105%

when denominated in a different currency, subject to the exemption's detailed rules.^[2]

Do not reduce PTE 2006-16 to:

"ERISA always requires 102%."

It does not.

Operational Programs Can Require More Than the Exemption Minimum

A fiduciary or lending program can require stronger collateralization than the class exemption's floor.

DOL audits of the Thrift Savings Plan's lending operations have described program procedures using at least:

• 102% for U.S. securities
• 105% for international securities

with daily mark-to-market.^[11]

That is a program design.

It should not be confused with a universal statutory formula applying identically to every loan.

Cash Collateral Has Its Own Investment Risk

Suppose borrower posts:

$10.2 million cash.

The lender invests that cash.

If the reinvestment vehicle loses:

1%

the collateral pool loses approximately:

$102,000.

The borrower can still return the securities exactly as promised.

The lending program can still lose money.

This is why:

borrower-default risk ≠ cash-collateral reinvestment risk.

Collateral Is Not the Same as a Guarantee

Collateral can:

• absorb default loss
• reduce replacement risk.

But cash collateral can itself be invested in assets that:

• decline
• become illiquid
• experience credit problems.

SEC guidance specifically identifies losses from cash-collateral investment as a securities-lending risk.^[10]

GAO also highlighted cash-collateral reinvestment risk in 401(k)-related investment structures.^[12]

The quality of the collateral program matters as much as the headline collateral amount.

Indemnification Has Boundaries

A lending agent can indemnify the lender against borrower default.

That can be valuable.

But indemnification should be read literally.

SEC guidance notes that lending agents often indemnify against borrower failure to return securities where collateral is insufficient, while collateral-reinvestment losses are typically not covered by that borrower-default indemnity.^[10]

Ask:

• What event triggers indemnification?
• What losses are covered?
• What losses are excluded?
• Who is the indemnitor?
• How strong is that entity?

"Indemnified" is not a complete risk description.

Counterparty Selection Matters

A collateralized loan is still a credit exposure.

A lending program should evaluate borrowers based on factors such as:

• capitalization
• liquidity
• credit quality
• financial condition
• jurisdiction
• operational capacity.

PTE 2006-16 requires covered borrowers to provide the lending fiduciary with their most recent available audited financial statement and, when applicable, a more recent unaudited statement.^[2]

The borrower must also address material adverse changes in financial condition under the exemption's terms.^[2]

That is not paperwork for its own sake.

Borrower quality is part of the risk control.

Loans Need Written Agreements

Under PTE 2006-16, covered securities loans must be made pursuant to a written agreement whose terms are at least as favorable to the plan as an arm's-length transaction with an unrelated party.^[2]

The agreement must address the plan's rights in the collateral.

A master agreement can cover a series of loans.^[2]

Important operating terms include:

• eligible borrowers
• collateral
• valuation
• margin calls
• fees
• rebates
• distributions
• recalls
• default remedies.

The legal agreement is part of the investment infrastructure.

The Retirement Plan Must Receive Economic Value

The exemption requires the retirement plan to receive:

• a reasonable lending fee
• and/or an opportunity to derive compensation through investment of cash collateral.^[2]

Where cash collateral is invested, a rebate or similar fee can be paid to the borrower subject to the exemption's conditions.^[2]

All fees and other consideration received in connection with the loan must also be reasonable under the exemption.^[2]

A lending program should therefore answer:

What compensation is being earned for the risk and operational burden?

Equivalent Distributions Still Belong Economically to the Lender

When securities are on loan, the borrower temporarily holds them.

The class exemption requires the lender to receive the equivalent of distributions made to holders during the loan, including:

• dividends
• interest
• stock-split shares
• rights to acquire additional securities.^[2]

The securities are temporarily elsewhere.

The economic entitlement to those distributions is contractually preserved.

Tax Character Can Differ Outside Qualified Plans

In taxable investing, payments in lieu of dividends can have different tax treatment from qualified dividends.

Inside a tax-qualified 401(k), current participant-level income-tax treatment is generally different because investment gains are held within the retirement plan.

The important 401(k) issue is not usually current dividend tax classification.

It is whether the fund receives the economic equivalent and accounts for it correctly.

Voting Rights Can Leave With the Security

When securities are lent, voting rights generally pass with the borrowed securities while the loan remains open.^[10]

That creates a trade-off.

The portfolio earns lending income.

But it may lose the ability to vote those securities unless the loan is recalled in time.

For routine votes, the economic value of keeping the loan open can exceed the perceived voting value.

For material votes, the analysis can change.

A Material Vote Can Trigger Recall Analysis

Suppose a portfolio has lent shares of a company facing:

• merger vote
• contested director election
• major governance proposal.

The investment manager may conclude that voting is economically important.

The fund can recall the securities, terminate the loan and regain voting rights if operational timing permits.

SEC guidance discusses recalling loaned securities when management knows of a material vote.^[10]

The decision has an opportunity cost:

lost lending revenue during the recall.

Securities Lending Can Conflict With Stewardship

A portfolio manager can want two things:

1. maximize lending revenue
2. exercise shareholder voting rights.

They cannot always be maximized simultaneously for the same security.

A strong policy should define:

• materiality
• recall criteria
• who decides
• timing.

Otherwise the lending desk can unintentionally control voting outcomes through operational inertia.

The Mutual-Fund ERISA Boundary Is Crucial

Suppose a 401(k) invests:

$50 million

in a registered index mutual fund.

The fund lends:

$5 billion

of securities across its entire portfolio complex.

Are those underlying securities automatically assets of the 401(k) plan?

No.

ERISA Section 401(b)(1) says that when a plan invests in a security issued by a registered investment company, the plan owns that security but does not, solely because of the investment, own the investment company's underlying assets as plan assets.^[3]

DOL Advisory Opinion 2009-04A confirms that principle.^[5]

Mutual-Fund Lending Is Therefore Not Automatically a Plan Loan

The 401(k) plan owns:

mutual-fund shares.

The mutual fund owns:

portfolio securities.

If the mutual fund lends its securities, it is the registered investment company engaging in lending.

PTE 2006-16 is not automatically the direct legal basis for that loan merely because a retirement plan owns the mutual fund.

The fund operates under:

• Investment Company Act framework
• SEC guidance
• its governing documents
• board/adviser oversight.^[10]

That separation is often missed.

The Sponsor Still Has a Mutual-Fund Fiduciary Decision

The plan-level exclusion does not mean:

"The sponsor can ignore securities lending."

DOL Advisory Opinion 2009-04A notes that ERISA's mutual-fund exclusion does not eliminate fiduciary responsibility for the decision to invest plan assets in the mutual fund.^[5]

A prudent review can consider:

• total returns
• fees
• risk
• lending practices
• revenue retention
• operational quality

when material to the investment decision.

The sponsor does not become the lending desk.

It still selects and monitors the fund.

CITs Can Produce a Different Answer

A bank collective investment trust is not a registered mutual fund.

Under the plan-asset regulation, an investing plan can have an undivided interest in the underlying assets of specified pooled entities, including bank common or collective trusts, subject to the regulation's framework.^[4]

That means securities inside a CIT can be:

plan assets

for ERISA purposes.

If the CIT lends those securities to parties in interest, PTE 2006-16 can become directly relevant.

INV-139 covers CIT structure.

Separate Accounts Make the Link Even Clearer

In a dedicated separate-account mandate, the plan trust can own:

• stocks
• bonds

directly.

If those plan-owned securities are lent to a covered bank or broker-dealer that is a party in interest, the prohibited-transaction analysis is directly at the plan-asset level.

PTE 2006-16 exists to provide specified relief when its conditions are satisfied.^[1][2]

INV-146 explains the separate-account structure.

White-Label Funds Can Contain Both Types

A custom white-label equity fund might hold:

• 50% registered mutual fund
• 30% CIT
• 20% dedicated separate account.

Securities lending could occur:

• inside the mutual fund
• inside the CIT
• inside the separate account.

Those three programs can sit behind one participant-facing line.

The legal analysis is not necessarily the same for each sleeve.

INV-147 explains why the wrapper must be mapped before applying rules.

The Class Exemption Solves a Prohibited-Transaction Problem

ERISA Section 406 restricts transactions between a plan and parties in interest.^[7]

Banks and broker-dealers can be parties in interest to a plan.

A securities loan to such a counterparty can therefore create a prohibited-transaction issue.

The 2006 class exemption provides relief for specified lending transactions involving employee-benefit-plan securities when its conditions are met.^[1][2]

The exemption also covers specified compensation arrangements for fiduciaries providing lending services.^[2]

The Exemption Is Not a Prudence Safe Harbor

This distinction matters.

The class exemption answers:

Can an otherwise prohibited transaction receive exemptive relief if the conditions are satisfied?

It does not answer:

Was entering the lending program prudent under ERISA Section 404?

ERISA's prudence and loyalty duties still apply.^[6]

A loan can satisfy the exemption and still be a poor fiduciary decision if:

• expected compensation is inadequate
• collateral policy is weak
• borrower concentration is excessive
• agent fees are unreasonable
• cash reinvestment is imprudent.

Exempt does not mean wise.

The Current Exemption Reflects a 2022 Amendment

DOL amended several class exemptions in 2022 to remove specified reliance on credit ratings under Dodd-Frank.^[2]

For the securities-lending exemption, the change affected certain definitions of:

Foreign Collateral.

Effective:

May 9, 2022

foreign sovereign debt used under the relevant provision must satisfy standards involving:

• minimal credit risk
• sufficient liquidity to be sold at or near fair market value in the ordinary course within seven calendar days.^[2]

The old specified rating-category test was removed.

Foreign Letters of Credit Also Changed

The 2022 amendment also changed the PTE's treatment of qualifying foreign-bank letters of credit.

The current language requires the issuing foreign bank's ability to honor the commitment to be subject to:

no greater than moderate credit risk^[2]

rather than relying on the prior specified rating formulation.

Credit ratings can still be relevant information.

They are not the prescribed sole test in the amended provisions.

PTE 2006-16 Is Still Current

DOL's current class-exemption page lists PTE 2006-16 under:

Securities Lending

and identifies the 2022 final amendment.^[1]

The Department's current page also shows the associated OMB information-collection approval extending through:

September 30, 2028.^[1]

That matters because some older securities-lending summaries still describe the pre-2022 credit-rating language as if it were current.

A Plan Can Terminate a Covered Loan

PTE 2006-16 provides that the plan can terminate a covered loan at any time.^[2]

The borrower then must return identical securities—or the specified equivalent after certain corporate events—within the lesser of:

• customary delivery period
• five business days
• negotiated delivery period.^[2]

That termination right supports:

• liquidity
• portfolio management
• proxy recalls
• risk control.

The operational ability to execute the recall still matters.

Default Remedies Are Written Into the Structure

If a borrower fails to return securities within the applicable period, PTE 2006-16 provides for remedies under the loan agreement that can include:

• purchasing replacement securities
• applying collateral
• recovering remaining obligations and expenses.^[2]

The legal right is important.

So is execution speed.

A right to collateral has less value if:

• collateral is hard to liquidate
• market prices gap sharply
• insolvency blocks access.

Operational enforceability belongs in due diligence.

Lending-Agent Compensation Has Additional Conditions

PTE 2006-16 also addresses compensation paid to a fiduciary for securities-lending services.^[2]

Among the conditions:

• the lending fiduciary must be authorized
• compensation must be reasonable
• payment must follow a written instrument
• the arrangement generally requires prior written authorization by an independent authorizing fiduciary
• termination rights apply.^[2]

For certain commingled funds, the exemption contains a special rule with notice and withdrawal mechanics.^[2]

The fee split is therefore more than a commercial negotiation when ERISA plan assets and fiduciary compensation are involved.

A Commingled-Fund Rule Handles Scale

A bank CIT or insurance pooled separate account can contain assets from many plans.

Obtaining a separate fresh approval from every investor for every compensation change can be operationally difficult.

PTE 2006-16's special commingled-fund rule provides a structure involving:

• advance information
• notice of material changes
• an opportunity for an objecting plan to withdraw without penalty under the exemption's terms.^[2]

The rule reflects the economics of pooled institutional investing.

It does not remove fiduciary review.

408(b)(2) Can Add Another Compensation Lens

Covered service-provider disclosure under 29 CFR 2550.408b-2 can require plan fiduciaries to receive information about:

• services
• fiduciary status
• direct compensation
• indirect compensation
• related-party compensation

when the arrangement falls within the rule.^[9]

A lending agent or asset manager can therefore have compensation obligations under more than one legal framework.

PTE 2006-16 focuses on exemptive conditions.

408(b)(2) focuses on service-provider disclosure and reasonable arrangement analysis.

High Lending Revenue Can Signal Valuable Inventory

Suppose two small-cap funds own different stocks.

Fund A earns:

0.02%

from lending.

Fund B earns:

0.25%.

Fund B's portfolio may contain securities that are:

• harder to borrow
• more heavily shorted
• less available in lending markets.

That can make the inventory more valuable to borrowers.

It can also indicate different underlying portfolio characteristics.

Lending revenue should not be analyzed separately from investment strategy.

Utilization Matters

A portfolio owns:

$1 billion

of securities eligible for lending.

Average amount actually on loan:

$100 million.

Utilization:

10%.

Another fund lends:

$400 million

of the same eligible base.

Utilization:

40%.

Higher utilization can produce more revenue.

It can also increase:

• counterparty exposure
• recall activity
• operational volume.

The relevant question is not maximum utilization.

It is whether incremental lending is economically attractive after risk.

Fee Rate and Utilization Work Together

Fund A

Average on loan:

10%

Average lending fee:

1.00%

Gross portfolio-level contribution:

approximately 0.10%.

Fund B

Average on loan:

40%

Average fee:

0.20%

Gross contribution:

approximately 0.08%.

Fund A lends much less inventory.

Its harder-to-borrow securities earn more.

A single headline number can hide the source of revenue.

Borrower Concentration Matters

Suppose 80% of outstanding loans are with one broker-dealer.

Even with collateral, that concentration increases exposure to:

• one default event
• one operational failure
• one legal proceeding.

A diversified borrower roster can reduce concentration.

But using more borrowers can add:

• monitoring
• settlement
• documentation complexity.

Borrower diversification is not free.

It is another risk-control choice.

Collateral Type Matters Too

Cash collateral creates:

• reinvestment opportunity
• reinvestment risk.

Noncash collateral can avoid that reinvestment layer but has its own:

• market risk
• liquidity
• custody
• valuation considerations.

The optimal collateral structure depends on:

• lending market
• borrower
• security
• legal rules
• portfolio liquidity.

A program should not chase the highest gross spread without considering what collateral makes that spread possible.

The Collateral Portfolio Can Become the Hidden Risk

A conservative index strategy can have a risky lending program if cash collateral is invested aggressively.

That creates an odd result:

the stock portfolio can be simple while the collateral portfolio becomes complex.

A fiduciary reviewing a plan-asset lending program should ask:

• permitted collateral investments
• maturity
• credit quality
• liquidity
• concentration
• stress behavior.

Collateral reinvestment is a second portfolio.

Treat it that way.

Gap Risk Is Real

Assume:

• borrower rebate adjusts quickly with market rates
• cash-collateral portfolio holds longer-duration instruments.

Rates move.

Collateral investments fall in value or fail to earn enough to cover the rebate.

The lending spread compresses or turns negative.

SEC filings commonly describe this as:

gap risk.

The loaned security can be returned on time.

The collateral economics can still lose money.

Liquidity Risk Can Appear During Heavy Redemptions

A fund may need to:

• recall securities
• unwind collateral investments
• raise cash

at the same time.

If the collateral pool holds less-liquid instruments, a normally stable lending program can become difficult during market stress.

This matters most when liquidity is needed quickly.

A strategy that looks profitable in ordinary markets should be stress-tested for:

• borrower failure
• participant withdrawals
• collateral losses
• market volatility

occurring together.

Lending Can Create Operational Risk

A securities loan requires correct processing of:

• trade date
• collateral
• margin
• income payments
• recalls
• corporate actions
• return settlement.

Errors can create real economic loss.

Examples:

• collateral call missed
• dividend equivalent omitted
• security not recalled before vote
• loan not closed after sale instruction
• borrower exposure reported incorrectly.

Automation reduces manual work.

It does not remove operational risk.

Corporate Actions Require Special Handling

Suppose lent stock undergoes:

• split
• merger
• tender offer
• rights offering.

The agreement and operations process must preserve the lender's economic entitlement.

PTE 2006-16 expressly addresses equivalent securities in certain reorganizations and equivalent distributions during the loan.^[2]

Corporate-action complexity is one reason securities lending needs specialized infrastructure.

Index Funds Can Benefit—but Tracking Can Change

Securities-lending revenue can help an index fund outperform its benchmark before expenses or offset some management cost.

But lending can also introduce small differences through:

• cash
• recalls
• collateral investment
• fees
• operational timing.

A fund with better lending economics can track its benchmark more tightly net of expenses.

A poorly managed program can do the opposite.

Two Identical Expense Ratios Can Hide Different Net Economics

Fund A:

• expense ratio: 0.05%
• net lending benefit: 0.04%.

Fund B:

• expense ratio: 0.05%
• net lending benefit: 0.01%.

All else equal, Fund A has a:

3 basis point

implementation advantage.

That does not prove Fund A is universally better.

It shows why expense ratio alone does not capture every source of net fund return.

Revenue-Sharing Percentage Is Not Enough

Suppose:

Program A

Fund retains:

90%

of lending revenue.

Gross revenue:

0.03%.

Net retained:

0.027%.

Program B

Fund retains:

70%.

Gross revenue:

0.10%.

Net retained:

0.070%.

The lower percentage split produces more participant value.

Compare:

dollars or basis points retained

not just:

percentage of revenue retained.

Indemnification Should Be Priced Too

A lending agent offering strong borrower-default indemnity can retain more revenue than an unindemnified agent.

That higher fee can be reasonable if the indemnity has real economic value.

The comparison should include:

• indemnitor credit strength
• scope
• exclusions
• claim process
• collateral policy
• fee difference.

Cheapest agent does not automatically mean best net lending arrangement.

Securities Lending and Participant Disclosure

A participant generally does not choose each individual loan.

The participant chooses the investment option, not the individual loans.

For a participant-directed designated investment alternative, 404a-5 disclosure focuses on:

• investment objective
• strategy
• risk
• performance
• benchmark
• fees
• website information.

Where lending materially affects strategy, risk or return, the investment's disclosure materials should describe it appropriately.

The participant needs to understand the investment.

Not the daily borrower list.

Investment Documents Can Reveal More Detail

For a registered mutual fund, securities-lending information can appear in:

• prospectus
• statement of additional information
• shareholder reports
• SEC filings.

For CITs and custom plan investments, details can appear in:

• declaration/trust materials
• investment guidelines
• fact sheets
• service agreements
• lending-agent reports.

A serious fiduciary review should go beyond the participant fact sheet.

What Should a Participant Look For?

Participants comparing funds can reasonably ask:

1. Does the investment lend securities?
2. How material is lending income to net return?
3. What lending risks are disclosed?
4. How does total return compare with the benchmark after expenses?
5. Is cash collateral used?
6. Does the lending agent receive a material share of revenue?
7. Is borrower-default indemnification described?

Most participants do not need to audit collateral daily.

They should understand whether lending is a meaningful source of return or risk.

What Should a Plan Fiduciary Review?

Legal vehicle

• registered mutual fund?
• CIT?
• separate account?
• white-label structure?

Plan-asset status

• are the securities being lent plan assets?
• is PTE 2006-16 directly relevant?

Borrowers

• eligibility
• credit review
• concentration
• jurisdiction.

Collateral

• type
• haircut
• daily mark-to-market
• liquidity
• reinvestment.

Economics

• gross lending revenue
• borrower rebate
• agent split
• collateral-management fee
• net retained revenue.

Protection

• default indemnity
• exclusions
• collateral access
• legal enforceability.

Governance

• proxy recall
• corporate actions
• reporting
• stress testing
• escalation.

The important comparison is net risk-adjusted value.

A Lending Program Should Be Evaluated in Basis Points

Example:

Portfolio assets:

$500 million

Gross lending income:

$750,000

Gross contribution:

0.15%.

Borrower rebates/collateral costs:

$300,000

Agent compensation:

$150,000

Net benefit:

$300,000

Net contribution:

0.06%.

That:

6 basis points

is the number most relevant to investment results before any other effects.

The gross 15 basis points sounds much larger.

Risk Should Be Measured Against the 6 Basis Points

Suppose the program adds:

6 bps annually.

A severe collateral-reinvestment loss could cost:

50 bps

in one event.

That does not automatically make lending imprudent.

It means risk controls need to be evaluated relative to expected compensation.

A small recurring gain does not justify unlimited tail risk.

Lending Should Not Be Judged Only by Whether Losses Happened

A program can run for ten years without a default.

That does not prove the controls were good.

Likewise, a well-run program can experience loss during an extreme event.

Process review should examine:

• borrower standards
• collateral
• concentration
• liquidity
• agent incentives
• stress testing.

Outcome alone is not a prudence test.

The Agent's Incentive Can Differ From the Fund's

If an agent receives:

20% of gross lending revenue

then more loans can mean more agent compensation.

That can create incentive to:

• increase utilization
• lend harder-to-borrow assets
• keep loans open.

The portfolio's objective should be:

maximize appropriate net risk-adjusted return

not:

maximize gross lending volume.

Compensation design belongs in governance.

An Agent Affiliation Raises Another Question

Suppose:

• custodian affiliate is lending agent
• affiliate manages cash collateral vehicle.

Now the corporate group can earn:

• lending-agent fee
• collateral-management fee.

That does not make the arrangement improper.

It makes:

• compensation
• conflicts
• alternatives

important to evaluate.

408(b)(2) and applicable prohibited-transaction relief can matter depending on the structure.^[9]

Securities Lending Can Affect Manager Comparisons

Two managers can produce nearly identical security-selection performance.

Manager A's program adds:

4 bps net.

Manager B adds:

9 bps net.

If the additional five basis points are generated with:

• similar borrower risk
• similar collateral quality
• similar indemnification

that is a real implementation advantage.

If Manager B reaches 9 bps by taking materially greater collateral risk, the comparison changes.

Return without risk context is incomplete.

Securities Lending Is Not a Standalone Reason to Select a Fund

A fund should not be chosen because:

it lends more aggressively.

Core selection factors remain:

• investment objective
• portfolio construction
• benchmark
• fees
• risk
• manager quality
• operational execution.

Lending can improve implementation.

It cannot rescue a bad investment strategy.

Mutual-Fund vs. CIT/Separate-Account Lending

The legal wrapper changes the ERISA path.

Cash vs. Noncash Collateral

Neither type is automatically safer in every circumstance.

Gross vs. Net Lending Economics

A fund comparison should use the bottom line.

Indemnity vs. Risk

Read the contract.

The word:

indemnified

is too broad by itself.

PTE 2006-16 Conditions and Their Purpose

The exemption is a risk-control framework around an otherwise problematic transaction.

What Should Ongoing Monitoring Test?

• securities available to lend
• average utilization
• average fee
• net revenue
• borrower concentration
• collateral concentration
• cash reinvestment duration
• credit quality
• liquidity
• margin calls
• defaults
• indemnification claims
• proxy recalls
• operational breaks
• agent compensation
• benchmark impact.

A useful trend is:

net basis points earned per unit of operational and counterparty risk.

Not simply gross dollars.

Frequently Asked Questions

Does securities lending mean the fund sold the stock?

No.

The security is temporarily lent, and the borrower is obligated to return equivalent securities under the loan terms.

Why does the borrower pay for the loan?

The borrower values temporary access to the security for activities such as short selling, settlement or hedging.

What protects the lender?

Collateral, daily valuation/margining, borrower standards, contractual rights and sometimes indemnification.

Is collateral risk-free?

No.

Collateral can decline, become illiquid or be insufficient after rapid market moves. Cash collateral can also lose value when invested.

How does the fund earn money?

Through a direct lending fee, cash-collateral investment spread, or both, depending on the arrangement.

What is a borrower rebate?

In a cash-collateral loan, part of the income associated with the collateral can be paid back to the borrower as a rebate. The remaining spread contributes to lending revenue.

Does the lending agent keep part of the revenue?

Often yes.

The split depends on the arrangement.

Does PTE 2006-16 apply to every mutual-fund securities loan held in a 401(k)?

No.

ERISA Section 401(b)(1) generally provides that a plan's investment in registered mutual-fund shares does not, solely by reason of that investment, make the fund's underlying assets plan assets.^[3][5]

Can PTE 2006-16 apply to a CIT?

Yes, depending on the structure and facts, because underlying CIT assets can be plan assets under ERISA's plan-asset rules.^[4]

What does PTE 2006-16 do?

It provides prohibited-transaction relief for specified securities loans of plan assets to covered banks and broker-dealers and for certain lending-fiduciary compensation arrangements, subject to detailed conditions.^[1][2]

Does the exemption mean the lending program is prudent?

No.

ERISA Section 404 fiduciary duties remain separate.^[6]

Does PTE 2006-16 always require 102% collateral?

No.

The exemption contains different collateral requirements depending on the type of collateral, currency and other conditions.^[2]

Were the collateral rules changed recently?

The exemption was amended in 2022 to replace specified credit-rating requirements for certain foreign collateral with current credit-risk and liquidity standards.^[2]

Can the lender vote securities while they are on loan?

Voting rights generally travel with the loaned securities while the loan remains outstanding. The lender can need to recall securities in time to vote a material matter.^[10]

Does borrower-default indemnification cover cash-collateral losses?

Not necessarily. SEC guidance notes that such indemnification commonly addresses borrower default and typically does not cover collateral-reinvestment losses.^[10]

Can lending help an index fund outperform its benchmark?

It can add incremental income that offsets expenses or other implementation drag. The result depends on net revenue and program costs.

Is more lending income always better?

No.

Higher revenue can reflect more valuable inventory, higher utilization, stronger execution or greater risk. Compare net return and risk together.

Securities-Lending Review Test

Identify the investment vehicle → determine whether the securities being lent are ERISA plan assets → if a registered mutual fund owns them, distinguish fund-level lending from the plan's ownership of fund shares → if plan assets are involved, identify the prohibited-transaction route and whether PTE 2006-16 applies → identify eligible borrowers and credit-review process → map collateral type, initial margin and daily maintenance → distinguish borrower-default risk from collateral-reinvestment risk → identify the lending agent and every form of compensation → calculate gross lending revenue → subtract borrower rebates, agent share and other program costs → calculate net basis points retained by the investment → review indemnification scope and indemnitor strength → examine borrower and collateral concentration → inspect liquidity and collateral-reinvestment duration → define proxy-recall and corporate-action procedures → verify written agreements, termination rights and default remedies → review 408(b)(2) and other service-provider disclosures where applicable → stress-test default, market gap and heavy-withdrawal scenarios → compare incremental net return with the risks taken to earn it

The right question is not:

"How much did securities lending earn?"

It is:

"How much net value reached the investment after rebates and agent costs, and what counterparty, collateral, liquidity and governance risk was taken to earn it?"

A lending program is useful when the answer is favorable.

It is not free return.

Sources & References

1. U.S. Department of Labor — Employee Benefits Security Administration: Class Exemptions — PTE 2006-16 — https://www.dol.gov/agencies/ebsa/laws-and-regulations/rules-and-regulations/exemptions/class
2. U.S. Department of Labor / Federal Register: Amendments to Class Prohibited Transaction Exemptions To Remove Credit Ratings, 87 FR 12985 (March 8, 2022), including amended PTE 2006-16 — https://www.govinfo.gov/content/pkg/FR-2022-03-08/pdf/FR-2022-03-08.pdf
3. Legal Information Institute / U.S. Code: 29 U.S.C. §1101 — ERISA Coverage and Registered Investment Company Assets — https://www.law.cornell.edu/uscode/text/29/1101
4. Electronic Code of Federal Regulations / Legal Information Institute: 29 CFR §2510.3-101 — Definition of Plan Assets—Plan Investments — https://www.law.cornell.edu/cfr/text/29/2510.3-101
5. U.S. Department of Labor — Employee Benefits Security Administration: Advisory Opinion 2009-04A — https://www.dol.gov/agencies/ebsa/about-ebsa/our-activities/resource-center/advisory-opinions/2009-04a
6. Legal Information Institute / U.S. Code: 29 U.S.C. §1104 — Fiduciary Duties — https://www.law.cornell.edu/uscode/text/29/1104
7. Legal Information Institute / U.S. Code: 29 U.S.C. §1106 — Prohibited Transactions — https://www.law.cornell.edu/uscode/text/29/1106
8. Legal Information Institute / U.S. Code: 29 U.S.C. §1108 — Exemptions From Prohibited Transaction Rules — https://www.law.cornell.edu/uscode/text/29/1108
9. Electronic Code of Federal Regulations / Legal Information Institute: 29 CFR §2550.408b-2 — Covered Service Provider Disclosure — https://www.law.cornell.edu/cfr/text/29/2550.408b-2
10. U.S. Securities and Exchange Commission: Securities Lending by U.S. Open-End and Closed-End Investment Companies — https://www.sec.gov/investment/divisionsinvestmentsecurities-lending-open-closed-end-investment-companieshtm
11. U.S. Department of Labor — Employee Benefits Security Administration: Performance Audit of TSP Investment Management Operations — https://www.dol.gov/sites/dolgov/files/EBSA/about-ebsa/our-activities/resource-center/reports/thrift-savings-plan-audit/state-street-global-advisors-trust-company-tsp-investment-management-operations-2023.pdf
12. U.S. Government Accountability Office: 401(k) Plans: Certain Investment Options and Practices That May Restrict Withdrawals Not Widely Understood, GAO-11-291 — https://www.gao.gov/products/gao-11-291

Educational Disclaimer

ROIStreet publishes educational content about retirement-plan investments, securities lending, collateral, pooled funds, separate accounts and ERISA fiduciary duties. This article is not legal, fiduciary, tax, securities, investment or plan-administration advice. Securities-lending arrangements vary materially by legal vehicle, borrower, collateral, lending agent, indemnification, reinvestment policy and governing agreement. PTE 2006-16 is a conditional prohibited-transaction exemption, not a general prudence safe harbor. Current plan documents, investment agreements, service-provider disclosures and applicable law control.

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