529 College-Savings Plans Lag, But Don't Count Them Out

College savers choosing 529 plans often give up some investment performance in exchange for the plans' tax savings, a new Morningstar study has shown.

As part of its annual study of the 529 college-savings plan industry, Morningstar's team of analysts dissected the performance of the 529 plans. On average, the long-term performance of 529 investment options continues to look unimpressive relative to that of similar peers in the broader mutual fund universe.

Over the five-year period through Dec. 31, 2013, five of the eight most-prominent static Morningstar 529 categories trail their respective open-end fund categories on an annualized basis. For the most part, the gap was relatively narrow. For example, among large-blend investments, the average 529 option trailed the analogous open-end mutual fund by roughly 0.30 percentage points per year. The largest gaps are with the large-value and conservative-allocation categories, in which the average 529 investment trailed its average open-end peer by more than 1 percentage point per year.

In a few cases, however, 529 categories have outperformed their mutual fund categories. For the five-year period ended in 2012, 529 investment options in the short-term bond category again edged past their average open-end rival. For the past five years through Dec. 31, 2013, the 529 investment options in the intermediate-term bond and aggressive-allocation categories also earned a slight performance edge over similar mutual funds.

Headwinds for 529s
Several structural features of 529 investment options can lead to performance differentials relative to their open-end peers. For one, most 529 investment options carry heftier price tags than similar mutual funds, creating a constant headwind for their returns.

In addition, within equity categories, the typical 529 investment option has a larger stake in international stocks than does the typical mutual fund. For example, in Morningstar's 529 static large-blend category, the average 529 invests 16% in international stocks, while the typical traditional large-blend mutual fund has only 5% invested abroad. With U.S. stocks on a tear during 2013, traditional mutual funds received a relative boost. 

Also, 529 investments tend to take on more passive exposure than their mutual fund counterparts. In markets where active management shines, investors can reasonably expect index-heavy 529 investments to lag. In markets where active management suffers, 529 investments may do better on average (assuming they can overcome the higher 529 fee hurdle). For example, many active large-blend managers have had trouble beating the S&P 500 Index since 2010, which allowed indexed options' returns to exceed the 529 large-blend category average. The opposite was true in 2009, when active managers outperformed.

More so, 529 bond-heavy categories frequently take less credit risk than their open-end counterparts. Fear of losses, particularly in the wake of 2008, has led plan managers to select options with higher credit quality or more cash. Indeed, the intermediate-term bond category for 529 investment options has an average credit quality of A and 15% of assets in cash, while the same category for traditional mutual funds has an average credit quality of BBB and doesn't hold any cash. Holding more cash and shorter-term debt helped 529 bond categories earn a slight edge recently relative to their respective mutual fund categories. Understandably, the same cautious approach may likely hold 529 bond categories back when riskier bonds rally.

529s Continue to Lag Blended Benchmarks
Comparing performance among Morningstar categories for 529 investments and traditional open-end investments can provide helpful insight for college savers considering various vehicles for their college savings. To be sure, the majority of college savers in 529s choose an age-based track as the anchor of their investment, and there isn't a directly comparable mutual fund category to use to evaluate the typical 529 category's performance. Therefore, it can be informative to evaluate the performance of 529 investments relative to a corresponding benchmark that matches the average asset allocation to equities, bonds, and cash to see how the investments' results compare.

Using this lens, 529 age-based plans fall short across the board. The blended benchmark weights the returns of the S&P 500 Index, the Barclays U.S. Aggregate Bond Index, and the three-month U.S. Treasury bill according to each category's average allocation to stocks, bonds, and cash to determine benchmark performance. While a few 529 categories outperformed the blended benchmark over the past five years (notably, the US 529 age 19+ high equity category comes out ahead by nearly 2 percentage points per year), every category lags during the trailing three- and 10-year periods.

As was the case for the comparison of 529 static categories with traditional mutual funds, the performance gap within the age-based 529s can be attributed to structural differences between 529 investments and the benchmarks. For one, expenses continue to be a drag on returns for 529 investments. In addition, age-based 529s tend to be more diversified across asset classes and geographies, including investments such as international stocks and Treasury Inflation-Protected Securities, which can affect performance.

In early 2014, Morningstar launched a series of 529 indexes that provide a diversified benchmark for 529 investment options. Similar to the Morningstar 529 age-based categories that reflect high-, medium-, or low-equity tracks, the Morningstar 529 indexes have three different risk tracks--aggressive, moderate, and conservative--to correspond to investors' varying risk preferences. Each benchmark invests in between six and 18 underlying Morningstar indexes, providing a wide array of exposure to different broad and subasset classes.

Morningstar's 529 indexes are more diversified than most 529 plans' age-based options, and, at times, that mix of asset classes boosts relative returns. Indeed, 529 age-based investments have lagged. Over the 10-year period, the 529 options fall short by an average of 2.3 percentage points per year. For college savers socking away $1,200 per year during the period, that difference would work out to an approximate gap of $1,600.

Expenses are to blame for many of these shortfalls. Neither the blended benchmark nor the Morningstar indexes include expenses, although a basket of comparable open-end indexed mutual funds or similar exchange-traded funds is cheaply available.

However, it is also worth noting that 529 investors don't pay federal taxes on their investments' gains when used for qualified higher education expenses, so their actual proceeds may be higher than what they would get on an aftertax basis with a passive portfolio of investments mimicking the benchmarks. In addition, many states offer tax deductions (and two states offer even more generous tax credits) that can significantly boost aftertax results. Several states also offer matching grants and scholarships, which can further increase the home-state plan's appeal for qualified college savers. For more information on each state's tax and grant policy for 529 plans, see this article.