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Key Findings From Our 529 Industry Study

Adam Zoll
Kailin Liu

Adam Zoll: For Morningstar, I'm Adam Zoll. This week Morningstar's fund-of-funds team released its annual survey about the 529 industry. 

Here to talk about that survey and some of the findings is Kailin Liu; she is an analyst on Morningstar's fund-of-funds team.

Kailin, thanks for being here. 

Kailin Liu: Thank you.

Zoll: So, can you talk a little about what's in the survey, how your team goes about compiling it? 

Liu: Absolutely. I think it's important to make the distinction that this survey, which was recently released, is distinct from our plan ratings, which we released in October 2012. For the industry survey, we dig into some of the industry data and plan-specific data that we, the analysts, used to assign these ratings.

Zoll: And one the findings, for example, is about asset flows into 529s, which seem to be on the upswing? 

Liu: That's definitely true. Assets into 529 grew 25% from the end of 2012 compared to the end of 2011. This is due to a couple of things. For one, it's because of contributions, which is great. People are feeling more confident about putting money in college savings, and they are doing it, which is a good thing for college savers. Asset growth has also been helped by the growth of the market in 2012 as well.

Zoll: I thought there was some interesting findings regarding asset allocation within 529 plans. For example, in the broader mutual fund market, we're finding that asset flows continue to be drawn to safer fixed-income investments and that's reflected in the 529 asset flows as well, isn't it? 

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Liu: That is correct. The top assets flows for static 529 categories are in conservative allocation and a bond category.

Zoll: Another interesting finding in the report is that funds held in 529 plans tend to underperform versus similar funds outside of 529 plans. Can you explain why that would be? 

Liu: Definitely. So, 529 plans are sort of distinctive for mutual funds in a handful of different ways. The first is that they do tend to run more expensive. The prices in the 529 industry have come down considerably in the past several years, but broadly they’re still not as price competitive as mutual funds. This is because of the different layers of fees that you would have to pay in a 529 plan that you would not have to pay in an open-end fund.

For example, 529 plans frequently charge program management fees and state administration fees that a regular mutual fund would not need. 

Zoll: And has that gap narrowed in recent years between what funds are charging in 529 versus outside of those plans?

Liu: Yes. The gap most certainly has narrowed. 

Zoll: OK. So, Aside from fees what are some other contributing factors to that gap?

Liu: I think that one big contributing factor is that the underlying investments in 529 funds are different in some pretty substantial ways for mutual funds. For example, 529 funds tend to have a much higher weighting to index funds than mutual funds. So, in markets where active management outperforms, 529 plans are understandably left behind. 

Additionally, on the fixed-income side, 529 plans … are a bit more shy about taking credit risk. In the intermediate-bond category you find that their weighting to credit exposure is pretty low as compared to intermediate-term bond mutual funds.

Zoll: But for an individual investor who may be hearing this and saying, why should I invest in a 529 when I can invest outside of a 529 in a comparable mutual fund and probably outperform, there are still advantages to the 529 structure for an individual investor, correct? 

Liu: That's correct. For one, I think that one of the big benefits of 529 plans is that the investment minimums tend to be much lower than for mutual funds. For example, if you were interested in buying some sort of index investment, you need a couple of thousand dollars to invest in a Vanguard fund whereas it's pretty easy to just have a couple hundred dollars, even as low as $25, to invest in a 529 plan. So, investment minimums are very attractive for families that maybe don't have thousands of dollars just to place into college savings at one time.

Additionally, growth in 529 plan accounts are tax sheltered, and many families are also eligible for state income tax deductions. 

Zoll: Another finding in the study involves open versus closed architecture funds. Can you speak a little to what that distinction means, and what you found in terms of performance?

Liu: The distinction between open and closed architecture is who the underlying managers are that's running the money in the 529 plan. An example of the closed architecture plan would be the T. Rowe price savings plan in Maryland, where every underlying investment is run by T. Rowe Price. An example of an open architecture fund would be the Bright Directions plan in Illinois, where they have a number of different managers running different subsets of the plan. 

In terms of the performance differential, we actually found that open architecture tends to run more expensive than closed architecture, and closed architecture, possibly because of this performance differential, has tended to outperform open architecture on a risk-adjusted basis.

Zoll: In terms of the people running these funds, the survey found that generally these are people who Morningstar analysts regarded as good managers, correct? 

Liu: That's definitely true, yes. So, when we looked at the distribution of funds that had an existing People rating in the 529 universe, we found that no plans had underlying funds that had a negative People rating. Additionally, many of them had funds that had positive People ratings, and the average manager tenure, which is something that we look at when evaluating funds, is quite high in the 529 industry compared to regular mutual funds.

Zoll: Kailin, thanks for stopping by today to talk about changes in the 529 industry in this new report. 

Liu: Thank you.

Zoll: Thanks. For Morningstar, I'm Adam Zoll. Thanks for watching.