Jason Stipp: I'm Jason Stipp for Morningstar.
Morningstar has released its 2011 529 College Savings Plan Research Study today. I am checking in with editorial director Laura Lutton to learn a little bit about their findings in the study, and also what that might mean for college savings investors.
Thanks for joining me, Laura.
Laura Lutton: Thanks for having me.
Stipp: So I looked over your study and one of the first things that you mention is that 529 plans are getting better, which seems to be, obviously, a very positive thing for investors. What's behind that?
Lutton: Well, I think we are seeing a couple of good trends in terms of helping college savers. Number 1, we are seeing fees come down particularly among plans that are direct sold. So where a parent or a grandparent goes directly to the plan and signs up, we have seen fees coming down.
The other thing we are seeing is better investment choices. I think the industry is maturing, and we are seeing a lot of plans improve the lineup of investment options within their offerings.
Stipp: So I know we have talked in the past about how 529 plans have performed against other benchmarks, or similar mutual funds. A couple of years ago, we talked about how they performed in the downturn of 2008. We had some market volatility over the summer; I know that you folks looked at 529 plan performance. What did you see, and how did those plans come through that period of disruption?
Lutton: We saw a lot of losses in the categories that are equity-heavy, which isn't a surprise given the downturn that we saw in the equity markets in general. So 529 options are going to look a lot like the market, and they do so. So, we saw some losses over that period, but when you look out over the longer-term returns five, 10 years, particularly that 10-year period, it looks pretty good. Parents and grandparents who have held these for the long term have done all right
Stipp: So given that there are some, obviously, tax benefits in investing in 529 plans, when you're thinking about where are your other options to put money, these are over the long term going to give you similar performance with those benefits than just going outside the plans.
Lutton: Right, and not having to pay taxes on the gains that you get from a 529 plan really gives them a huge boost from a performance standpoint. So it is important to keep that in mind when you're looking at these return numbers. You're doing much better, thanks to this tax benefit, than you would if you were saving through a traditional mutual fund.
Stipp: So, Laura, you mentioned about the performance that the more equity-heavy 529 plans suffered more volatility during the turmoil. You folks look at the glide path, what you call the glide path, of these funds and how they allocate for different age bands. Have you noticed any changes in how 529 plans are putting their money across stocks and bonds for example?
Lutton: So we just started collecting this data at Morningstar about a year ago. So it is relatively new, but between last year and this year, we have seen a slight tip in that asset allocation between stocks and bonds. We see a little heavier industrywide, a little heavier in equity when children are very young, and a little less equity exposure as they are getting close to college.
So this is just a broad look at the industry, and there are many plans that have made no changes at all to their glide paths, but on the margin we are seeing a little more risk when kids are young and a little less risk when they're getting ready to go to college.
Stipp: Would you say that that's a good trend, just given that by the time your son or daughter is going to college you need that money over a pretty compressed period. Would you say that overall investors really are a bit less risk tolerant as the child gets closer to age 18?
Lutton: Well, I think the industry is responding to that very narrow drawdown period. In retirement, you are accessing your capital over decades perhaps. With a 529 account, it is often four years, five years, six years you're going to zero. So there is this desire, I think, to make sure that when you're nest egg is the largest, which is right before your child enrolls, that that savings is a little bit more protected from volatility in the equity market.
Stipp: You mentioned earlier that there were some lineup changes that improved the options that investors have in these plans. Are there any fund families that are coming in and having much more availability in these plans? What are you seeing as far as the underlying providers?
Lutton: Well we are seeing a little bit more Vanguard on the margin, I would say, in some plans. That was the case in Rhode Island. They added a few more Vanguard indexes for in-state residents only to that plan.
I guess the other broad trend that we are seeing is open architectures, is how we talk about it in the fund industry, but where you are including money managers from more than one firm in the lineup. We saw several examples of that. In California, for example, TIAA-CREF just won that 529 contract, and they have an open architecture plan. And then Fidelity, interestingly, they run plans in four states. They added an open architecture, a multi-manager/multi-firmed suite of options within that plan as well. So that is a trend we are seeing.
Stipp: So it would seem logically that that could be a good trend because then you could pick a best of breed option from fixed income and from equity. Do we have enough history and track record of these open architecture plans to say whether they have a leg-up on a plan that is all from one fund family, for example?
Lutton: Well I think the catch with these open architecture plans is they often come with higher expense ratios. And one of the things that we looked at in our study is whether these open architecture plans then get a performance advantage. You would hope that a best-in-class fund would be able to outperform, but with this higher expense ratio, we are not really seeing that. So, I think that is the catch for some of these plans is, if we want to include managers from a variety of firms, can we do that at a price that is not going to hamstring the manager to the point that the fund can't outperform.
Stipp: So you mentioned fees, obviously one of the important things you look at with the plans. Can you talk briefly about the ways that you assess these 529 plans--because one of the results in the study is a list of highly rated plans and then on down in your rating scale. How do you come up with those?
Lutton: It is a very comprehensive look at the plan. Fees are a huge piece of it, and that is because Morningstar's research has shown year-in and year-out that the less you pay for an investment, the more likely it is to outperform over the long term, and with a 529 investment where parents are holding these funds for often a decade or longer, that fee becomes very important. So fees are baked in there.
We look at the portfolio, the quality of those underlying options. Who is running them? Are these folks we know? Are they going to do a good job, do we think, over that period?
We also look at the stewardship characteristics of the folks who are involved in running the plan. Historically, we have looked mostly at the program managers, so the money management firm, the asset management firm that is running the plan. But more and more we are layering in the states' oversight. We have been getting to know the folks from the states who are running these plans. So that is becoming more important in our analysis as well.
Stipp: Another big consideration for investors in 529 plans are their own in-state tax benefits and breaks. To what extent do you look at that and how does that factor into the way that recommend these plans to investors?
Lutton: We look at these in-state tax benefits really carefully, because that's a first check that a parent or a grandparent can do; am I getting any kind of goodies for staying in-state, and if you're not, then really the world is your oyster. You can look nationally for a 529 plan, and we come to the analysis with that assumption. If there are no state tax benefits or those tax benefits are portable, then we would expect this plan to compete nationally. So it's a little bit of a tougher standard. If there are some very generous tax benefits in place, but a plan has some things that we wish were a little better, we may go a little bit easier on the rating because the tax benefits help offset some of those things that we wish weren't there.
Stipp: All right, Laura, some great insights from this recent study. Thanks for sharing the highlights today.
Lutton: Thanks for having me.
Stipp: To see Morningstar's highest-rated 529 plans, full research on over 50 plans, comprehensive plan data, and the full study results for 2011, see the related links in this video or visit Morningstar's College Savings Center.