Best Practices for College-Savings Plans
Morningstar highlights what moves a 529 plan from good to great.
College savers have no shortage of choice when it comes to 529 college-savings plans, and picking one plan over another can be difficult. In a new industry study out today, we focus on the industry's best practices in five key areas: Process, People, Parent, Price, and Performance. By highlighting some of the leaders in each of those areas, we give college savers more context with which to evaluate 529 programs.
Intro to 529 plans
The 529 industry consists of college-savings plans and prepaid-tuition plans. The former serve as a tax-favored means to invest money for use toward future qualified education expenses; the latter allow college savers to purchase contracts covering years of tuition or course credits. Morningstar’s analysis focuses on 529 college-savings plans.
The industry sponsors two types of college-savings plans: direct-sold plans, where college savers can invest directly in the plan and select their own investment options, and advisor-sold plans, which are distributed through financial advisors. Many states sponsor two 529 plans so residents have an in-state option whether they invest on their own or with an advisor. Investors have no obligation to stay with their state's plan(s), and savings can be used to pay for qualified expenses at colleges across the nation.
All 529 investors skip federal taxes on growth and distributions to pay for beneficiaries' higher-education costs. About 45% of the U.S. population lives in states that offer their residents additional state-specific tax benefits for investing within the state's 529 plan; 10% enjoy state tax benefits regardless of the state 529 plan used (commonly referred to as tax-parity states), and 45% reside in states that offer no additional tax benefits (either because the state has no state income tax or no 529-specific tax benefit). Some plans generously offer additional incentives, such as savings matches, outright grants, or scholarships.
Process: Morningstar evaluates the design of the plan’s investment options, including the glide path followed by the age-based portfolios and the suite of investment options available.
· Feature diversified age-based tracks designed by well-resourced asset allocators with strong track records running similar investments.
· Glide paths follow either fixed tracks with moderate steps or progressive tracks.
Age-based options have attracted the lion’s share of 529 assets; thus, as part of a plan’s Process rating, Morningstar emphasizes glide-path design to ensure it follows a sensible approach. The hiring of experienced asset allocators with strong track records to design thoughtful, well-diversified glide paths for age-based portfolios bodes well for investors. For example, New York’s 529 Advisor-Guided Program hired J.P. Morgan’s global multiasset group, winner of Morningstar’s 2014 Allocation Fund Manager of the Year award, to manage its age-based portfolios. The group built a well-diversified track that includes dedicated allocations to asset classes beyond traditional stocks and bonds.
Similarly, T. Rowe Price uses a sensible approach in designing enrollment-based portfolios--another name for age-based portfolios--within the Maryland College Investment Plan. Those portfolios rebalance often and shift out of equities in small increments rather than steps, reducing market-timing risk.
People: Morningstar considers the underlying money managers used in the plan.
· Showcase Morningstar Medalists and/or investments from asset managers with Positive Parent pillar ratings.
Very few 529 plans include untested investment providers, and the quality of people behind a plan is strong overall. But a few plans stand out from the crowd. American Funds, for example, serves as the program manager for Virginia’s advisor-sold CollegeAmerica plan and manages all of the plan’s underlying portfolios. This plan’s lineup is exceptional. Morningstar rates 18 of its underlying funds, and 10 of those earn ratings of Gold, which reflects analysts' highest conviction in the funds' potential to deliver strong results.
Other program managers have had success by looking beyond their internal capabilities and assembling a sound investment lineup of outside managers. For instance, Union Bank & Trust (based out of Lincoln, Nebraska) serves as the program manager for Alabama’s advisor-sold CollegeCounts 529 Fund Advisor Plan and Illinois’ advisor-sold Bright Directions College Savings Program. It draws on an external consultant’s research in an attempt to select best-in-class strategies across the board. Both these plans offer solid stand-alone strategies.
Parent: Morningstar analyzes stewardship and oversight practices of those running and governing 529 plans.
· States--Informed and engaged oversight, with staff focused solely or primarily on administering the state's 529 plan and relatively independent of political influence.
· Program Managers and Asset Managers--Attractive investment cultures with long-tenured portfolio managers, low fees, and incentive structures that align firms' interests with fund shareholders'.
Unlike the Morningstar Analyst Rating for individual mutual funds, where the Parent rating hinges on the asset manager’s stewardship profile, the 529 Parent rating assesses multiple parties--the state and the entity responsible for the investments in the plan, either the program manager or asset manager. A few program managers don’t manage assets, and, in those cases, Morningstar analysts take another layer into account in the Parent evaluation.
The strongest state stewards include Massachusetts, Ohio, Utah, and Virginia. Those states’ 529 plans are housed under entities that remain relatively insulated from changing political tides. Moreover, the staff members’ sole or primary responsibilities center on the state's 529 program. Meanwhile, Vanguard, American Funds, and T. Rowe Price boast Morningstar Stewardship Grades of A, owing to their long histories of putting investors first. Plans that use those firms as program managers or asset managers are generally in good hands.
Price: Morningstar measures the cost of the plan’s investment options.
· Offer attractively priced investment options.
· Scheduled reduction in program management fees as a plan’s asset base increases.
One of the best ways 529 plans can distance themselves from the competition is on price. Several 529 plans and program managers have aggressively cut expenses across all of their portfolio offerings in recent years. In fact, 40 of the 85 529 plans in Morningstar's database reduced fees in 2014, on average by 3.8 basis points. Notably, Minnesota’s College Savings plan lowered fees by more than 20 basis points in 2014 following contract renegotiations. Meanwhile, South Carolina’s Future Scholar (Direct) plan offers passive options for an average cost of 13 basis points; California’s ScholarShare program provides active strategies for 52.
Performance: Morningstar considers the plan’s risk-adjusted track record and forward-looking return expectations.
· Investments have delivered strong risk-adjusted results and appear well-equipped to repeat past successes.
Morningstar measures how 529 investments have fared relative to expectations and similar peers, especially within the framework of risks taken. A plan’s average Morningstar Rating, better known as the star rating, on 529 portfolios serves as one tool to gauge past performance. Those boasting superior returns in relation to volatility earn 4- and 5-star ratings; investments that have landed near the middle of the pack receive 3-star ratings; and strategies that have delivered poor risk-adjusted results garner 1- and 2-star ratings.
While a plan’s past performance certainly plays a role in its Performance rating, its ability to outperform going forward also carries weight. For instance, Morningstar has strong conviction that Virginia’s CollegeAmerica plan will outpace competitors because of its attractive underlying investment lineup. Indeed, the plan boasts an average star rating of 3.38, the highest among advisor-sold competitors, and it appears well equipped to repeat past successes.
Incentives such as state tax benefits, savings matches, outright grants, or scholarships do not have a direct impact on plans’ pillar ratings and thus are not included in the best practices outlined above, but Morningstar certainly considers those benefits and factors them into a plan’s overall rating. To find out how your 529 plan and its investment options rate with Morningstar's analysts, click here.