Gross-to-Net pricing versus “Fee Normalization”

1. Gross-to-Net pricing versus “Fee Normalization” A superior new solution from BPAS A presentation for Plan Sponsors, Trustees and Advisors prepared by BPAS

2. The concern of Congress and the DOL in proposed fee regulations? It is impossible to be objective when a provider is paid like this: = Mutual fund revenue sharing (basis points) This “incurable conflict of interest” will impact:  fund selection  fund monitoring, recommendations over time  participant education and advisory services

3. What is ‘gross to net pricing’ (a.k.a., the ERISA budget approach) ? • A methodology for handling retirement plan fees • Has been in use since 1997 (initially contemplated in DOL Advisory Opinion 15A to Frost Bank, which required a dollar-for-dollar offset of revenue sharing against the provider’s fee schedule to eliminate any conflicts of interest) • The concept: • Most mutual funds feature various forms of “revenue sharing” • As plan assets increase, revenue sharing dollars also increase • At some point, revenue sharing may exceed the providers’ aggregate costs for servicing a plan • The concept: identify and isolate excess revenue sharing, then allocate it back to the participants in the form of enhanced earnings • Goal is to achieve more value for plan participants, maximize wealth creation

4. What is the basic math used in gross-to-net pricing (GTNP)? • Identify the total revenue sharing that is generated by a plan’s funds (A) • Identify the total costs of servicing the plan (B) • Recordkeeping fees • Clearing and custodial fees • Trustee or Advisory Fees • Fees for additional education services or communication tools • Other plan-eligible expenses (audit costs, legal fees, consulting, etc) • Note: Together, these amount to a considerably larger figure than plan sponsors are used to seeing since there are no asset-based subsidies • Deposit all revenue sharing to a segregated trust account in the name of the Plan. Pay all expenses from this account. • A – B = C. • At the end of the year, if C > 0, a surplusexists. This would be allocated back to participants in the form of enhanced earnings (similar to a profit sharing allocation, but pro-rata based on account balances) • At the end of the year, if C < 0, a deficitexists. This can either be paid by the plan sponsor or charged to the plan as a fee allocation (e.g., a negative allocation of earnings, based on account balances)

5. An illustration of GTNPa hypothetical plan with 9 funds, 420 participants, $13.6 million in assets Total revenue sharing generated = $53,235 / year (A). Total revenuesharing paidby each fundin the plan inbasis points(from allsources) Assets in each fund: $1.75M $2.9M $2.85M $1.65M $650k $1.4M $910k $950k $550k (VanguardFund) (VanguardFund) • Total revenue sharing = $53,235 / year (A). (This equals 39.1 basis points on $13.1 million of assets) • Assume annual servicing costs are $40,000 (B) • 53,235 – 40,000 = $13,235, which is a surplus (C) • After paying expenses, this surplus would be applied to all participants as an additional earnings credit of 9.72 basis points on account balances ($13,325 / $13,600,000)

6. Unfortunately, there is a critical problem with GTNP Total revenue sharing = $53,235 / year (A). Total revenuesharing paidby each fundin the plan inbasis points(from allsources) Assets in each fund: $1.75M $2.9M $2.85M $1.65M $650k $1.4M $910k $950k $550k (VanguardFund) (VanguardFund) • If a surplus of $13,235 exists: a participant with $50,000 in fund F paid $0 in fees, then receives an earnings allocation from other participants of $48.62, while a participant with $50,000 in Fund C paid $300 in fees then receives an earnings allocation of $48.62. This $300 difference in fees (60 basis points) is significant, and very difficult to justify from an ERISA perspective. • If a deficit of $20,000 exists: a participant with $50,000 in fund F paid $0 in fees, then is charged $73.47 or 14.7 basis points in the year-end fee allocation, while a participant with $50,000 in Fund C paid $300 in fees during the year plus $73.47 in the year-end fee allocation, for total fees of $373.47. This $300 difference in fees (60 basis points) is significant, and very difficult to justify from an ERISA perspective.

7. Aside from the “fee fairness problem”, what other problems does GNTP present? • Timing problems from participants coming and going; the allocation is only performed periodically (typically annually), based on a snapshot • New participants receive undue share of earnings or fees from prior period • Participants who take distribution before end of year do not participate in earnings or fee allocation if they are no longer in the Plan when the ‘snapshot’ is taken • Added cost of accounting for all 12b-1s, shareholder servicing fees and sub-transfer agent fees (requires plan-level registration), then performing additional earnings or fee allocation at year end • Audit risk – revenue sharing must be handled with extreme care; since these are plan assets, improper use can give rise to Prohibited Transaction • Annual plan audit must include this process. Also, existing trust statements may now be inaccurate since they do not cover activity in the ‘recapture account’. • Relies entirely on 12b-1s to generate revenue sharing for use in the process; this is a very arbitrary way to cover plan expenses. This philosophy would eliminate many funds from consideration simply because they don’t offer revenue sharing (institutional share classes, Vanguard, Dodge & Cox, T. Rowe institutional, and many others). • Communicating all of this to participants

8. Is there a better answer? Absolutely. “Fee Normalization” from BPAS • Can cover recordkeeping, clearing and custodial, and Trustee / Advisor fees in a single, automated process • Eliminates all fairness problems of GTNP – all participants pay the same percentage of total costs, regardless of their asset allocation • Allows a plan to use any combination of funds or share classes, including pure institutional funds, getting the best deal for participants • Eliminates timing problems from participants coming and going • No quarterly, semi-annual or annual true-up (one automated monthly routine) • No after-the-fact allocation of earnings or expenses • No outside trust or set of records for revenue recapture account • Very little audit risk – entire process is consistent and automated • BPAS’ certified trust statements cover all activity • BPAS is responsible for all accounting, revenue collection and payment functions (plan sponsors and financial intermediaries like this) • Can be reviewed every 12, 18 or 24 months for any macro-level adjustments; keeping it competitive and equitable for all parties

9. How normalization worksa hypothetical plan with 9 funds, 420 participants, $13.6 million in assets.Assume that BPAS needs 30 bps, Trustee / Advisor needs 30 bps to support plan 10 10 20 = revenue sharing (including sub TA’s) 25 25 45 = custodial fee added by BPAS 60 60 60 50 50 35 40 35 15 Assets in each fund: $1.75M $2.9M $2.85M $1.65M $650k $1.4M $910k $950k $550k (VanguardFund) (VanguardFund) A fee is applied at the fund level to “normalize” plan-level revenues at 60 basis points across all funds. The custodial fee is applied in even monthly increments. Assets in Fund A would be charged 2.08 basis points / month (25 / 12); assets in Fund C would not have an additional charge; and assets in Funds F and I would be charged 5 basis points / month (60 / 12). BPAS would collect all revenues, pay the Trustee / Advisor 7.5 basis points per quarter (30 bps / year), and retain the remainder as its fee. Other costs can be included in the “funnel” as well. The normalization level be reduced by a corresponding amount if the plan sponsor wishes to have part of the fees invoiced; therefore, this approach is both accurate and flexible.

10. Why is this the best approach? • Accomplishes the goals of GTNP pricing without all the downsides • Eliminates all conflicts of interest, for all parties, initially and ongoing • Makes the entire universe of funds available for consideration, not just A, R, R4 or other funds with revenue sharing (true open architecture) • All participants pay the same portion of fees, regardless of asset allocation decisions • 100% consistent with new regulatory environment on fees through level compensation • Accomplished in one pass without timing problems or a separate trust account • Automatically adjusted when individual fund revenue sharing levels change or more revenue is negotiated • Does not impact audit or certified trust statements • Keeps the plan sponsor, participants and providers on the same page at all times • Can be provided as part of an overall fee schedule that includes fixed dollar fees (e.g., annual base fee, per participant charge, etc). Therefore, some fees could be asset-based while others are fixed dollar.

11. Other issues to consider • If fee inequities exist within a plan, it will become a glaring problem under 404(a)(5) when participants with a similar balance compare their statements • Six major court cases have been brought by Schlichter Bogard & Denton (St. Louis) in regards to retirement plan fees (General Dynamics: $15.1 million settlement, Caterpillar $16 million settlement, etc) • Edison International is most glaring example: $1 billion plan used three retail mutual funds alongside institutional share classes, apparently to generate enough revenue to cover fees. Judge ruled in plaintiffs’ favor. Damages have not yet been determined. • Read Reish white paper for more on this topic

12. The best solution for large plans • Relying on revenue sharing is a very arbitrary way to cover costs • Think of a lamp with “off, medium and high” settings versus a dimmer switch • For a $30 million plan with 600 participants, a hypothetical fee might be 22 basis points for recordkeeper, 21 basis points for the advisor • Through this approach, revenue can be normalized exactly at 43 basis points for each fund • “Dial up exactly the revenue that is needed to service the plan, without overshooting the target or having to plow back excess revenue sharing. Do it in one pass with no audit, timing or fairness issues among participants.”