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.
Influencing Asset Allocation
When states choose program managers to run their 529 plans, some take the investment options and asset allocations that the money manager suggests. These off-the-shelf solutions have been featured in 529 plans run by Fidelity in states such as California, Massachusetts, and New Hampshire.
Other states, however, have customized the 529 plan's investment lineup or the asset allocation within them. Such alterations can be based on suggestions from officials running other state assets, like a public-employee pension fund, or from consultants that the states hire to oversee or improve their investment choices. New York and Utah, for example, both have 529 plans featuring Vanguard funds, but their investment lineup is different from that in the Vanguard 529 College Savings Plan, a nationally marketed plan based in Nevada. Vanguard's Nevada plan features three tracks of age-based options that vary their approaches to satisfy college savers with different tolerances for risk. Those three tracks change their asset allocation in step, every five years. Meanwhile, the Utah Education Savings Plan has five age-based options that shift their asset allocations at varying intervals, between three and seven years.
Elsewhere, states have taken different approaches when it comes to international exposure. TIAA-CREF, which is the program manager to 529 plans in nine states, has noted that state officials in Michigan were more apprehensive about foreign exposure in their state's 529 plan than were the 529 plan leaders in Oregon. Indeed, the non-U.S. equity weighting in the age-based investment option designed for 12- to 14-year-olds was 15.5% for the Oregon College Savings Plan and 12.1% for a similar option at the Michigan Education Savings Program.
These differences in asset allocation are perhaps most relevant to 529 college savers who are shopping nationally for a plan. They shouldn't assume that the same asset-management company is investing its assets similarly among plans. It's important to dig into the portfolio details of every plan they consider.
It's also worth noting that the asset manager running the 529 plan may or may not be involved in the college-savings plan's record-keeping. Some states, like Utah and Virginia, do their own record-keeping to keep costs down; others outsource to a third-party program manager, like Upromise.
We know of no incidents of sloppy 529 record-keeping, either by the do-it-themselves states or the big asset managers that track millions of accounts and transactions each day. But this fragmented approach can make it more difficult to track 529 college-savings assets along with other savings accounts. There may be more competitive pressure on the 529 industry to make its record-keeping more user-friendly: Putnam's new Nevada-based 529 plan, Putnam 529 for America, allows advisors to view all of their clients' investments in one web-based interface.
The states each oversee and administer their 529 plans differently, but state politics are a common backdrop to all plans. Many state treasurers have some hand in running their local plans, and they're not shy about associating themselves with their constituents' college savings. If treasurers view their work on the states' 529 plan as a plus for their political careers, they have notable incentive to manage the funds thoughtfully.
But there's a downside to politicizing 529s. Some treasurers may play it too safe in their hiring of an asset manager or by sticking with investment options that are not best in class. Others get caught up in controversies. Kansas' state treasurer was criticized in 2008 after she was featured in television ads for the 529 plan paid for by the plan's program manager, American Century. In Illinois, things got even uglier when the state's treasurer sought a U.S. Senate seat in 2010. Attack ads accused the treasurer of mismanaging Illinois' Oppenheimer-run 529 plan because of its steep 2008 losses. The treasurer vigorously denied his opponent's allegations, but his colleagues in other states likely noted that there can be a potential career cost associated with overseeing a 529 plan.
The good news for 529 account holders is that the states' oversight jobs are getting easier. Today, the plans typically feature well-regarded investments from some of the money-management industry's top firms. Contracts are getting more competitive as fees have come down, and performance has improved to be on par with similar mutual funds. That's not to say that every state's approach to 529 governance is equally strong, but the states have raised their game.
Laura Pavlenko Lutton is an editorial director in Morningstar's fund research group.
Further Reading: State Budgets Should Have Little Impact on 529s
States' budget woes have been getting a lot of attention from the media and municipal investors, but 529 college-savings plans should remain above the fray.
To be sure, 529 plans are municipal securities, but unlike a traditional municipal bond, there's no debt associated with a 529 plan, so the plans don't face default risk should the states' finances worsen. 529 plan assets are similar to those in mutual funds--they remain the property of the college saver's beneficiary, not an asset of the state offering the plan.
A 529 plan also is insulated from state budget woes because it has its own revenue stream, which is generated from the asset-based fees that the plans charge college savers each year. As such, 529 plans probably felt more of a squeeze in 2009, on the heels of 2008's market decline. Total assets in many 529 plans declined at a double-digit rate in 2008, so the same was true of the plan's fee revenue, which supports the operations behind the plan.
Where 529 plans may be affected by states' fiscal problems is among the personnel running them. Many of the individuals overseeing the 529 plan are state employees who would be subject to a state's cuts in pay or benefits.
There also are signs that some prepaid-tuition plans are under pressure. With a prepaid-tuition plan, college savers pay into the program under an agreement that the program will then pay a college-going beneficiary's tuition and expenses. Problems can set in, however, if the prepaid-tuition plan isn't fully funded or doesn't appreciate as much as its administrators anticipate. In Illinois, for example, lawmakers are investigating the state's prepaid-tuition plan after local media reported that the plan was more than 30% underfunded.
Although some prepaid tuition plans and 529 plans are run by the same state personnel, the programs are entirely separate. Difficulties in a state's prepaid plan will not have an impact on its 529 plans.