College Savers Pay a Premium for 529s

While the gap is shrinking, the costs of 529 college savings plans continue to create a tough hurdle when compared with traditional mutual funds.

As part of its annual study of the 529 college-savings-plan industry, Morningstar's team of analysts dug into the costs associated with 529 plans. Because of many factors, including smaller asset bases and costs associated with state-level administration and marketing, 529 investment options typically carry more-expensive price tags than comparable traditional open-end mutual funds.

Fortunately for college savers, costs across the industry have come down in recent years. Since Morningstar began tracking the movements in 529 investments' fees in 2010 through the end of 2013, the cost gap between the average 529 category expense ratio and that of the analogous open-end mutual fund category has shrunk to 21 basis points from 40 basis points. 

The lower-cost trend is due to a number of factors, including a growing use of low-cost passive mutual funds and exchange-traded funds for age-based and stand-alone investment options. In addition, several plan sponsors and program managers have aggressively cut administration and maintenance costs. For example, Fidelity is the program manager of four direct-sold plans and, along with its state sponsors, cut fees at each of the plans' index-based options below most peers'.

Costs have decreased on average, although all but one of Morningstar's 529 categories still cost more than their respective open-end category. The largest gap is among aggressive-allocation investments, in which the typical 529 aggressive-allocation option costs 35 basis points more than the typical open-end mutual fund. The only category to reverse this trend is large blend, in which the average 529 option costs 5 basis points less. The large-blend category is home to index funds that track prominent U.S. stock indexes, such as the S&P 500, and passive investments cost less than most category peers. As passive investments have taken up a prominent position in many 529 plans, it makes sense that this category carries a generally lower price tag.

The Method Matters
To better compare 529 expenses across plans, Morningstar divided 529 age-based options into groups based on their distribution channel and underlying investment types. After dividing the age-based options by whether they are direct- or advisor-sold, Morningstar categorizes the options into one of three groups: actively managed, passively managed, or a blend of the two. (The "blend" groups are defined as having between 20% and 80% in active management.) Morningstar then determines the average total expense ratio for each age-based track.

Passively managed age-based tracks tend to cost less than those that blend active and passive investments, which in turn are typically less expensive than those entirely composed of active managers. Direct-sold plans tend to be populated with index funds, as these low-cost and broad-based investments provide straightforward exposure to various asset classes and are generally easy to use. In turn, direct-sold plans on average cost less than advisor-sold plans, which tend to offer a larger number of actively managed funds and include the compensation for advisors giving financial guidance and navigating the more complex lineup. 

The cost differential between direct-sold and advisor-sold investments is notable even for similar investments. The typical passively managed age-based option within an advisor-sold plan charges roughly double the 0.37% of a passively managed age-based option within the typical direct-sold plan. A more expensive passively managed fund has no opportunity to outperform a cheaper alternative.

Comparing the absolute costs across the degree of active management and distribution channel can be informative for investors weighing whether they prefer active or passive investments and if they would like to work with an advisor; it can also be helpful to compare costs within each subset. 

There is a wide range of fees charged within each group. For example, among direct-sold, passively managed age-based options, fees range from 8 to 85 basis points, a meaningful difference that can have a significant effect on performance. That wide gap holds true even among plans using similar underlying investments, such as North Dakota's College SAVE and New York's 529 Program (Direct), both of which use well-regarded Vanguard index funds to populate their age-based tracks. Despite this similarity, the North Dakota plan's three age-based tracks charge the highest levy (85 basis points) among direct-sold, passively managed options, while the options within New York's plan cost a mere 17 basis points. To be sure, New York has a much larger participant base and asset pool, but it's disappointing that states and program managers continue to allow for such large price discrepancies.

Don't Ignore the Dollar-Based Fees
Another way investors can evaluate the costs of a 529 plan is by looking at the dollar-based fees charged for maintenance expenses. These fees generally cover the program manager's administrative costs associated with mailing paper statements or offsetting the relatively high cost of accounts with low balances. Roughly half of all 529 plans charge a maintenance fee, though some may be waived under certain circumstances. The average levy charged by plans with a maintenance fee is $20, although it can range as high as $50 per year, as in the case of Maine's NextGen College Investing Plan Select. These costs eat away at returns: A $10,000 account with a $20 annual fee equals 20 basis points in costs added to its expense ratio. Account owners with low balances are particularly punished by these recurring charges.

Investors have plenty of decisions to make when it comes to choosing a 529 plan, from whether to work with an advisor or go it alone. They also must decide whether they will be best served by a plan that offers actively or passively managed investments, or a blend of both. 

Regardless of those inputs, it's worthwhile for college savers to shop around and find the most competitively priced investment that fits their needs. To see whether your 529 investment options are priced competitively, click here to find your plan, investment options, and fees. Keep in mind that the benefits of certain in-state grants or tax breaks can make a home-state plan more attractive than a less expensive out-of-state plan. College savers are wise to evaluate the overall costs and benefits of their options accordingly.