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States: The 529 Flaw

Christine Benz

Christine Benz: Hi, I am Christine Benz from Morningstar. We've just come out with our annual study of the Best and Worst 529 Plans, and I'm here today with the study's author Greg Brown. Greg thanks for being here.

Greg Brown: Thank you.

Christine Benz: Now, you've studied 529's extensively, and it's a confusing landscape because states are involved. States administer the plans. And you may also receive a state-tax deduction if you had opted for your in state plan. But, it's a confusing landscape, and its sounds like that's one reason you have some concerns about states being involved and states running these plans.

Greg Brown: Yeah, that's true, I think especially for newcomers. People that initially look into the 529's, they might question: "Why are states involved? Does that mean that I can only invest in my states plan? Does that mean my child can only go to the state where I've invested in?"

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Christine Benz: And that's not true, but people sometimes think that that's the case.

Greg Brown: Right, that's correct. It's not true. But I think that that actually goes out of prepaid tuition plans. Prepaid tuition plans, where you invest, it's very restricted as to where your child can go to school. And, prepaid tuition plans were a predecessor to 529. So I think that's where some of the confusion lies.

Christine Benz: So, another concern over state involvement, and obviously this a concept near and dear to our hearts at Morningstar, there's an extra layer of fees there because states are involved, right?

Greg Brown: That's correct, that's correct. You know some plans are reasonable, I mean, they add about 20 basis points or 0.2 percent, but some plans get as high as 70 basis points or 0.7 percent in additional fees, and that's in addition to the underline fund fee. So, you've got distribution fees, recording keeping fees, administration fees. And sometimes there's even a modest annual account maintenance fee, you know, a $10, $25 account maintenance fee.

And, those are unnecessary. I mean, if the state wasn't involved, there wouldn't need to be that middleman involved. Sometimes that's close to 50, 60 percent of the cost of the underlying funds. Sometimes it's a lot more.

Like with index funds, where you start with a very low base, you know, a 10 or 20 basis points, but then you've got these fees that can be as high as 70 basis points, that you got sometimes six or seven times the cost of the underlying holdings. So the cost is something that is a problem and it's unnecessary.

Christine Benz: And one other issue that you've identified as problematic and certainly came out loud and clear in your studies is that some of these plans are wedded to a single provider, maybe a lackluster provider. Can you talk about why you think that that's a big disadvantage?

Greg Brown: Yeah, that's a problem. I mean, these plans they have contracts with these mutual fund firms. They are typically five to 10 years. And when the states make these contracts, they are in contract with those firms.

There's examples like Ohio's advisor sold Putnam plan. You know, they are basically stuck with Putnam. They are doing the best they can. I mean, this year they've upgraded with some other non Putnam options. But at the end of the day, I mean, they are still in a contract with Putnam.

We have seen it with Oregon; Oregon's contracted with Oppenheimer. There contracts up at the end of this year. And there's been some real problems in Oppenheimer's domestic fixed-income products, and that's definitely a problem. These contracts really do lock the states in with the mutual fund firms. And, you know, markets change, things change and firms change, and it's not an ideal situation.

Christine Benz: So if you are looking at this and kind of put off by some of these issues that we have identified, do you think that should be a disincentive to invest in 529's, period? Should you look elsewhere, or do you think it's the best vehicle for people looking to save for college?

Greg Brown: Well, as it stand today--I mean for people that really do want to invest a significant sum of money, 529's today are the best vehicle to do that.

But there are other options, like the Coverdell Educational Savings Account. In my opinion, the actual structure I think is better than the 529. It's just that you are limited by how much you can put in those plans per year. You are limited right now to $2000. There's income limitations on people who can contribute.

But the actual vehicle itself, I think, is far better. I mean, it's very similar to a Roth IRA. You can choose whatever options you want as long as that mutual fund can sort of put it in that wrapper. And there is no state involvement. It's just a whole lot simpler. And I think, you know, we've seen with Roth IRAs, we've seen that those are very successful. So there's really no reason to question the Coverdell format.

Christine Benz: Except for the limited ability to make significant contributions.

Greg Brown: Yeah, that's true. I believe that 10 years ago that the 529's were really given the nod by the administration at the time. There's clear, clear advantages for the 529's right now, you know, just the large amounts of money you can contribute.

Christine Benz: Right.

Greg Brown: So, right now, 529's have the clear advantage. But I think they have grown into something that maybe wasn't anticipated. Originally, they were intended for lower and moderate income families, and they were intended for sort of the states to be overseer of these plans. But there's really no reason to say that the Coverdell won't be successful, I mean, if given more of the opportunities that 529's have.

Christine Benz: Well, thanks Greg. That's helpful background for people trying to navigate this complicated landscape. Thanks so much.

Greg Brown: Yeah, thank you.

Christine Benz: Thanks for being here. I am Christine Benz for Morningstar.

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