Forming a partnership with state governments carries its own set of challenges and quirks.
This article first appeared in the June/July 2011 issue of Morningstar Advisor magazine. Get your free subscription here.
When you invest in a mutual fund, the name on the prospectus makes it clear with whom you're forming a partnership. But with a 529 college-savings plan, the marketing brochure often features a grinning state treasurer more prominently than the asset-management company's logo.
By design, 529 plans are municipal securities, so a 529 account is a partnership first with state government and second with the asset manager running the 529 plan's assets. No two states run their 529 plans the same way, and that can lead to interesting results for college savers.
Wooing State Government
A 529 plan usually starts with a Request for Proposals; a state government asks money-management firms to bid to run its 529 plan assets. The RFP lists its 529 plan requirements, and firms submit proposals outlining exactly how they would run the plan's assets. In March, California issued a 148-page RFP for its ScholarShare 529 plans, giving money managers a chance to win the state's contracts away from Fidelity, California's 529 program manager since 2006.
After asset managers submit their bids, the state selects a winner and negotiates a management contract. Some of these contracts have relatively long terms--five years or more, though the states have found some creative ways to improve 529 investment options in the meantime, should trouble hit. Ohio, for example, started a new 529 plan in 2009 after its Putnam-run, advisor-sold 529 plan badly underperformed. Because Ohio couldn't terminate its contract with Putnam, it hired BlackRock to run a separate plan. In October, BlackRock absorbed the Putnam-run assets when Putnam's contract expired.
Similarly, Illinois couldn't fire Oppenheimer when its Core Bond fund sunk the 2008 returns of many of the state's age-based investment options. Instead, Illinois sued Oppenheimer and insisted that other third-party investment options be included in the plan, including a raft of ultracheap Vanguard indexes. Such performance disasters have prompted some states to include investment-performance reviews as part of their contracts with the program managers.
States have other recourse as well. Some have used the RFP process--or the threat of putting a plan's program-management contract up for bid--to secure lower fees within the 529 plan. New York announced lower fees in its Vanguard-run plan in August, just before the contract was up for renewal. Elsewhere, the College Savings Plan of Nebraska hired a local company, First National Bank of Omaha, to replace Union Bank & Trust Co. as its program manager in late 2010. Along with that switch came much lower fees for investors.
All told, more than 30 529 plans have lowered their fees over the past two years; this is a direct benefit to college savers and reflects a more-competitive landscape for asset managers running 529 accounts.