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Lower Fees, Better Returns Help 529s Make the Grade

Still, college savers and advisors must do careful research to ensure that they know what they're buying.

Josh Charlson, 06/14/2011

This article first appeared in the June/July 2011 issue of Morningstar Advisor magazine. Get your free subscription here. 

With industry assets topping $120 billion, 529 plans have become an important tool for many Americans' college savings. The plans feature investments that grow tax-free and often are shielded from state taxes as well.

The 529 industry has matured considerably in recent years to feature more investment choices that are cheaper and easier to understand. Morningstar's analysis of these investments also has matured. After judging the best and worst in the industry for seven years, Morningstar issued its first-ever analyst ratings and reports on plans in 2010. We also created new categories specifically designated for investments in 529 plans, making it easier to compare risk-adjusted returns and fees among investments with similar mandates. Finally, Morningstar published an in-depth Industry Survey that cataloged significant features and trends across the broader 529-plan industry.

Through this extensive research, Morningstar's analysts picked up on a few trends that are particularly relevant to investors and advisors.

No Consensus on Asset Allocation
Age-based investment options--which investors choose based on the child's age or expected college matriculation date--have come to dominate the assets in 529 plans. Anecdotal evidence suggests that 40% to 50% of new assets in 529 plans flow to such investments.

Similar to target-date funds, 529 age-based options' asset allocation shifts from equity-heavy asset mixes when a child is young to mostly bonds and cash as college nears. The average 529 age-based option's glide path starts with 80% equities and dips down to 10% equities when the beneficiary is 19 years old (Exhibit 1). That drop--far more pronounced than target-date funds'--reflects the limited time that college investors have to recover from bad market conditions and the high fixed costs associated with a college education.

But not every plan or individual age-based investment becomes similarly conservative near the enrollment date. In fact, 529 options designed for 15-year-olds have a wide disparity in asset allocation, with some options' equity allocation higher than 50% for beneficiaries who are one year into high school (Exhibit 2).

Another difference between the glide paths of 529 plans and target-date series is that many 529 plans have multiple glide paths while target-date series have a single path. Several 529 plans, including those run by TIAA-CREF and Franklin Templeton, have added multiple glide paths since the 2008 market downturn. In 2010, 38 of the 82 529 plans nationwide contained multiple glide paths, often labeled "growth," "moderate," and "conservative" to more intuitively reflect the path's exposure to equities throughout the investment.

Ultimately, this range of choice in asset allocation is valuable for advisors who may be helping a client choose a 529 plan. Within a client's home state, the advisor may be able to select an appropriate glide path from among several. And once the state tax advantage is considered (or discarded), advisors can look to other states to seek an option suitable for the client's risk tolerance and financial situation.

Open vs. Closed Architecture
As the 529 industry has matured, an increasing number of plans feature money managers from more than one firm. These so-called "open architecture" plans usually mix unaffiliated managers in both distinct static options and within age-based options.

In theory, open-architecture plans confer an advantage because they can choose "best of breed" asset managers--just as an institutional money manager would. In reality, however, open-architecture plans have not outperformed closed-architecture plans on a risk-adjusted basis (as measured by the Morningstar Rating) (Exhibit 3). That's at least partly due to cost. On average, closed-architecture 529 plans have lower expense ratios than those that mix managers from multiple firms. This gives closed-architecture plans an immediate performance advantage.

Of the five 529 plans earning Morningstar's "Top" analyst rating, only Ohio CollegeAdvantage features an open architecture. More states and program managers may push for open architecture to give their plans better marketing cachet and avoid the single-firm risks that can vex closed-architecture programs.

Conservative Options Gain Traction
Both anecdotal evidence and some statistics suggest that the 529 industry has gotten more conservative on the investment front. States were chastened by their plans' performance in 2008, including several notable blowups.

As we mentioned, 38 529 plans now contain multiple glide paths and some large 529 managers have added age-based tracks with less equity exposure. Morningstar's new category system classifies age-based options by level of equity exposure and age. Although Morningstar hasn't tracked the holdings in those options historically, investors' current positioning is tilted toward conservative investments. In the Age 7-12 grouping of Age-Fixed 529 plans, for example, nearly 30% of assets are in Medium Equity options and another 57% in Low Equity.

In other cases, some states recently have added bank-guaranteed investment options; at last count, 15 plans offered such options.

As in other areas of the financial marketplace, there is some danger of an overreaction. It's likely that many college savers, mesmerized by the bull market of the 2000s, were overly committed to stocks when the market crashed. That does not mean that investors are better off squirreling away their college investments in low-yielding bank options, though the circumstances of college saving certainly encourage a conservative approach. Advisors can play a key role here, finding a risk level for clients that will allow for capital growth while protecting assets at the right time.PAGEBREAK

Performance Keeps Pace
There is a perception among some investors and advisors that 529 plans are a poor substitute for real mutual funds. Some of this may be a residual effect of the industry's early days, when investment options were more limited and fees more prohibitive.

In fact, Morningstar finds that performance of 529 options has generally kept pace with comparable open-end mutual fund investments. Morningstar's new categories for static 529 options--those with fixed asset allocations--are modeled after open-end categories, and in many cases, the static options are clones of open-end funds, making comparisons relatively straightforward. In cases where 529 investment options' average returns have lagged mutual funds', higher fees are likely to blame, especially among fixed-income options. Fortunately, those lower returns often can be offset by state income-tax benefits. This data should lend confidence that competitive returns can be earned in college-savings plans, especially given the tax benefits on contributions (in most states) and gains.

Expense Ratios Declining
Investment options in 529 plans remain more expensive on average than mutual funds, but fees are coming down. Since June 2009, more than 30 plans have cut their fees. Direct-sold plans tend to be significantly less expensive than advisor-sold plans.

Many of the recent cuts come from the program management fee, which is included in the investment options' total expense ratio. Management fees also vary widely among plans--from 0% to 0.7% on an asset-weighted basis, according to Morningstar's data. There are many layers to 529 fees, however, and they can be tricky to unwind, so it makes most sense to focus on the total expense ratio (Exhibit 4).

The growing use of index funds, as well as Vanguard's sizable presence in the 529 marketplace, also has exerted a strong downward impact on prices. The cheapest of indexed options now charge between 0.2% and 0.25% annually. Those relative bargains mean there's little incentive to pay for higher-cost index-based plans, some of which look downright expensive by comparison. Seeking out the lowest-cost 529 plans is no guarantee of outperformance, but it gives college savers a solid head start. Whether an advisor is helping a client build a portfolio of static options or selecting an appropriate age-based track, it pays to be cost-conscious.

All in All, 529s Have Appeal
College-savings plans are far from perfect, and not every state is on equal footing. But there have been enough improvements, and investors have enough choices nationwide, to make 529 plans an appealing way to save for college given their tax advantages. Low-cost indexed options abound, diversified age-based options make choosing an investment relatively easy, and advisors who want to help investors assemble a custom portfolio have a solid set of options at hand--though certainly not to the extent available in a taxable account. As states and program managers continue to incorporate asset-allocation best practices and market pressures push costs lower, we expect to see even brighter prospects for 529 plans.

Josh Charlson is a senior mutual fund analyst with Morningstar.

Josh Charlson is a senior fund analyst with Morningstar.
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