Adam Zoll: I'm Adam Zoll. Morningstar's annual 529 survey has just been released and here to talk about some of the key findings is Kathryn Spica. She is a senior fund analyst here at Morningstar and a co-author of the report.
Kathryn, thanks for being here.
Kathryn Spica: Thanks for having me.
Zoll: In your analysis, you compare the performance of 529 portfolios versus comparable traditional mutual funds. What did you find with regard to how they compared?
Spica: It's an really important comparison to make because as a college saver those are the investment vehicles you have available to you. You can choose a 529 option in most cases or an open-end mutual fund, for example. So looking at those two categories and their differentials in performance can really be insightful.
We looked across the categories of static 529 plan investments, such as large plan, conservative allocation, large value, et cetera, and compared them with the open-end categories, and we saw a pretty big gap across some of the categories.
Zoll: Which categories in particular seemed to lag when you invest via a 529 plan?
Spica: The majority of them did. The larger gaps were in the large-value categories and the conservative-allocation category.
Zoll: You mentioned that these are for static portfolios. Those are the portfolios that never change and keep the allocation set. What about the age-based portfolios? These are the portfolios that change as the beneficiary ages, so they may be stock-heavy when the beneficiary is younger, more bond-heavy as they approach college age. What did you find with regard to performance there?
Spica: Exactly. So it's another good point. A lot of investors are choosing these age-based options. They're a little bit of an easier default investment. They're kind of like a target-date fund in that they change their allocation as they mature. With these assets they also trail their counterparts.
We don't have analogous open-end categories to compare them with, but we can look at blended benchmarks. So, in our study, we looked at two different benchmarks. One, just an allocation of stocks, bonds, and cash at appropriate allocations, and then we also looked at blended benchmarks from Morningstar. So within both cases, 529 plans also fell short.
Zoll: And is there any way to describe why exactly there was that shortfall, not only in the age-based allocation, but also in the static allocation?
Spica: Sure. There are a couple different ways to look at it. One is expenses. So, 529 plans have a little bit heftier expenses than their open-end counterparts, and there are a couple of reasons for that. It's a smaller asset base. There are multiple levels of oversight and marketing and administrative expenses. So the costs go a little bit higher in 529 plans.
Also, when you are comparing to blended benchmarks, there aren't expenses. So, even though you could find a basket of open-end funds or ETFs that are pretty inexpensively available, there is the reason of fees why they trail a blended benchmark.
Zoll: For someone who is watching us, who may say, "529 funds are underperforming the traditional funds; why bother with investing in a 529 fund?" What are the advantages of staying with the 529?
Spica: There are still a couple of reasons to consider a 529 plan. One is the tax benefit. So those are huge. The performance numbers that we're looking at are purely on a before-tax basis. But because you have generous federal- and state-level tax deductions as well as credits in some cases, it can really make a significant difference on an aftertax basis.
Another reason is that 529 program managers, in general, are gravitating toward high-quality investments. American Funds, Vanguard, and Fidelity are the top asset managers that are being chosen by program managers. So, I think they're providing a good set of investments for investors.
Zoll: You mentioned, for example, the state tax incentives, so in many states you are offered a state income tax deduction on your contribution to an in-state 529 plan. So, if you are in one of those states, especially this performance gap you may more than make up for that by using a 529. If you're in a state that doesn't give you that in-state income tax incentive, maybe you want to look at an alternative vehicle? Would it make some sense to look at a traditional mutual fund or maybe a Coverdell Educational Savings Account?
Spica: In some cases, it would. It's always worth looking across the board at all of your options. So we have some highly rated plans that distribute their plans nationally. So if you're in a state without generous tax breaks, for example, you might want to look at a Gold-rated plan sold elsewhere.
Zoll: Great. Kathryn, thanks so much for being with us today and sharing your insights on the new report.
Spica: Thanks. My pleasure.
Zoll: For Morningstar, I'm Adam Zoll. Thanks for watching.