Note: This video is part of Morningstar's October 2014 College Planning Report Card special report.
Adam Zoll: For Morningstar, I'm Adam Zoll. Morningstar has released its updated ratings for 529 college-savings plans, and here to tell us what's new is Kathryn Spica, she is the senior fund analyst of 529 plans for Morningstar.
Kathryn, thanks for being with us.
Kathryn Spica: Thanks for having me.
Zoll: Kathryn, let's get right to it. What are some of the changes with this year's 529 plan ratings?
Spica: We've rated 64 plans this year, we had five upgrades and ten downgrades. And even though we've downgraded more plans this year, we still see the industry improving. There are a lot of positive trends. Program managers are improving their oversight. They are adding more impressive investments to the lineup. They are lowering fees. There are a lot of trends that are really benefiting college savers.
Zoll: Let's talk about the plans that were upgraded. Can you give us some examples of what the plans were and why they received upgrades?
Spica: For a couple of plans, we actually upgraded the parent rating. In the parent rating, we look at the program manager--typically an investment manager but sometimes a state-sponsored entity, for example--and we also look at the state. So, every 529 plan is sponsored by a state. They have to be run through a specific state. And we've seen a lot of good trends in oversight.
Virginia, for example: They have two plans and their direct-sold plan, Virginia InVest, got an upgrade this year. It went from a Bronze rating to a Silver rating. We've been really impressed with the team at Virginia. They keep an eye on fees. They have lowered their program-management fee this year. Their plan is competitively priced. They have a really great investment lineup, and they have really good oversight from the state.
Zoll: Great. Then, you mentioned the downgrades. What were some reasons that plans were downgraded this year?
Spica: We've seen a couple of plans introduce some newer themes to their portfolios, for example. As one example, Fidelity introduced tactical management. And so, while they have some experience on the institutional side, they don't have a public track record. So, what they are bringing to the table in these plans is relatively new and it's untested. We haven't actually seen how they can do. So, while they have made a lot of strides in the past--improving the quality of the active managers that are included in the lineup, producing competitive prices, for example--this new component just lowers our conviction a little bit. We just want to see how they play out in practice.
Zoll: So, when you say tactical management, you're talking about funds that move into and out of market positions based on the prevailing conditions?
Spica: Exactly. So, they have asset-allocation funds within their portfolios. Most 529s have age-based tracks where they vary the asset-allocation mix over time, and [Fidelity is] adding tactical components to that. They have also added that to their target-date series, which has a similar track, and it's just a new component and we want to see how they do.Read Full Transcript
Zoll: Let's talk for a moment about what the Medalist ratings actually mean. If I'm in a fund that's a Gold, Silver, or Bronze, I take it that's a good thing. If I'm in a Neutral fund, should I be worried?
Spica: You shouldn't necessarily be worried. That's a great question. If you're in a Neutral plan, we just don't have as much conviction there as we do in one of our Medalists--our Bronze-, Silver-, and Gold-rated plans. A Neutral plan, for example, could be a really great option if you get a state tax benefit, for example. Sometimes, our Neutral-rated plans have higher fees and while we know that's going to detract from performance, if you get a state tax benefit, you as an investor will have a bigger nest egg when it matters.
Zoll: And if you don't get that state tax break, maybe you want to cast your lot further afield and look for one of the Medalist funds you mentioned.
Spica: Absolutely. You have no incentive, really, to stay in-state, so you want to look nationwide, find the best plan that suits your needs, suits what type of risk tolerance you have, and has a strong investment lineup.
Zoll: One big story we've been following here at Morningstar has been the upheaval at PIMCO, including the departure of the firm's founder, Bill Gross--manager of their flagship PIMCO Total Return Fund (PTTRX). How has the upheaval at PIMCO affected the 529 space?
Spica: A lot of actively managed 529 plans use PIMCO for their bond exposure or for a significant portion of their bond exposure. So, we've seen changes at a number of plans. Two states in particular cut PIMCO from the lineup. One replaced it with the program manager TIAA-CREF (TBIIX) and another replaced it with an index fund. So, we've seen a couple of states pull the trigger pretty quickly to get rid of it. Other states are taking their time. They are evaluating their options. They are seeing what the liquidity inflows are like at the PIMCO Total Return Fund before making a decision.
Zoll: We have downgraded the PIMCO Medalist rating from Gold to Bronze. Has the Medalist rating of any of the 529 plans that were using PIMCO or are using PIMCO been affected?
Spica: That's another good question. The PIMCO fund itself still is a Medalist, still has a Bronze rating, but we have downgraded the South Dakota plan, the Allianz-sponsored plan. Allianz, the parent company of PIMCO, is the program manager for that state. And so, they have a lot of exposure to PIMCO from many different angles. A lot of the underlying funds are from PIMCO, including PIMCO Total Return. So, we expect the disruption at PIMCO as well as some other nuances about the plan to really detract from its future performance.
Zoll: Well, Kathryn, lots of interesting developments involving 529 plans. Thanks for sharing your thoughts with us today.
Spica: Thanks for your time.
Zoll: For Morningstar, I'm Adam Zoll. Thanks for watching.