College-Savings Outlook: Cloudy With a Chance of High Fees

If you've found it tough to decide on a college-savings plan for your child, you're in good company. It's difficult to evaluate the college-savings vehicles known as 529 plans--those state-administered investments that provide tax breaks for savers. They're complex, opaque, and often expensive. Add extreme ups and downs in the market, higher unemployment rates, and rising tuition costs, and the stakes seem higher now than ever.

Indeed, Morningstar's research into 529s has found that plans have grown more complex in recent years as they have added more investment options to their menus and diversified assets among multiple asset managers. With all of this variety has come variable performance, and investments designed for students nearing their college enrollment have produced a wide spectrum of returns. Finally, there also is a broad disparity when it comes to cost.

Because it's increasingly harder to compare 529s, Morningstar is developing new tools to help investors evaluate these plans both quantitatively and qualitatively. We plan to release our expanded research this fall in lieu of the "Best & Worst" list that we've published in April each year.

Are Four Heads Better Than One?
The market slide of 2008 was a test of any investment thesis, and many 529 plans didn't make the grade. Plans run by Oppenheimer were particularly hard hit because they invested in  Oppenheimer Core Bond (OPIGX), a fund that was billed as relatively staid but in fact was economically levered up and owned lots of risky bonds that posted huge losses in 2008. This episode highlighted for plan administrators the risk of hiring a single manager to run all of a 529 plan's assets. Some states, including Illinois, now feature managers from multiple firms rather than hire a single manager across strategies.

Diversity can be a great thing. After all, few firms are best-in-class managers across all of the asset classes typically represented in a 529 college-savings plan. But now 529 investors are left with the complicated task of evaluating multiple managers across several options within the same plan. Take Wisconsin's two 529 plans--EdVest College Savings Program and Tomorrow's Scholar mix managers from firms such as Columbia, Legg Mason, Mutual Series, Wells Fargo, and Vanguard across 19 fixed-allocation and 10 age-based options. Evaluating the investment merit of each of those options is a tall order.

It's also necessary to compare the various approaches to asset allocation within a plan. Some 529 plans include options for which the asset allocation remains fixed through the years. Others are structured around the child's age and shift the asset allocation from a heavy stake in equities when the child is young to more cash and bonds in the years leading up to college.

There is tremendous variety in the asset allocation of these dynamic, age-based offerings, especially as the child approaches college age. Those aimed toward very young children--ages 0 to 3--tend to be stock-heavy. But among 249 distinct offerings designed for children ages 16 to 18, about 10% have at least half of the assets invested in stocks when the child is 16, while others are stock-free.

That disparity in asset allocation has led to a wide spread of returns among these peer funds over the past three years. One Oppenheimer option lost 8.11% per year on average for the three-year period while more than a dozen bond-heavy 529 plans have gained more than 4% annually on average over the period.

An Expensive Proposition
College costs are high, and the fees charged on many of the 529 plans designed to help you save for it are no bargain either. The costs of owning a 529 plan vary widely. The cheapest age-based option charges 0.20% while the most expensive is an advisor-sold plan charging more than 10 times that at 2.27%. Fixed-allocation options fall in a similar expense range with the cheapest at 0.10% and the most expensive share classes carrying nearly a 2.00% price tag.

To gauge the investor experience in 529 plans, we took a look at asset-weighted expenses and saw that investors aren't always getting the best deal. The average investor in a 529 plan is paying 1.09% per year on an asset-weighted basis. By contrast, the asset-weighted average expense for a target-date fund is 0.68% and for all other mutual funds is 0.80%. It's unclear why investors are paying so much more for college savings, but it is clear that the states could do a better job negotiating lower fees for their constituents just as plan sponsors have done with target-date funds in retirement plans. We think that with improved data, analysis, and tools, investors would be better equipped to find their way into cheaper plans.

In a strange twist on the fee debate, the industry could also benefit from charging less. 529 plans have struggled to take off. At the end of March, industry assets stood at approximately $117 billion. That's not petty cash, but it's a lot less than many projected for 529s when they were first introduced in 1996. Morningstar's fund-flow data shows that investors have been gravitating to cheaper funds over the past decade and shunning expensive ones, all which suggests that lower fees could be a boon for the 529 industry and investors alike.

More Tools in the Toolbox
To better help investors evaluate 529 plans, Morningstar is working on some new quantitative and qualitative measures designed to more-easily compare them. The team is drawing heavily on research it recently completed on target-date funds, which are geared for retirement savings but share many of the same attributes as 529s, such as asset allocation that changes over the life of the investment.

For example, Morningstar plans to revamp its peer groups for 529 options so that it's easier to compare the performance and fees of investments that have similar investment goals and asset allocations. Morningstar also is designing new graphics to illustrate the asset allocations across 529 plans so that one can clearly determine how a particular option's asset allocation compares with similar peers'. Finally, Morningstar's analysts are preparing qualitative ratings on many of the largest 529 plans. To arrive at these ratings, analysts will evaluate factors such as the plans' performances, fees, managers, and underlying funds.