Today's 529 Plan Landscape

Karen Wallace: For Morningstar, I'm Karen Wallace. We recently released our annual study on 529 college savings plans. Here to discuss the report's findings is the report's lead author, Leo Acheson. He's a senior analyst in Morningstar's manager research group focusing on multiasset strategies.

Leo, thanks so much for being here.

Leo Acheson: Sure; thanks for having me.

Wallace: So, first off I want to discuss age-based 529 plans, which is where most of the assets are invested. You make a distinction in the report between a sort of dynamically changing portfolio allocation and a static, age-based allocation. What are the differences there?

Acheson: Sure. So within the age-based portfolios, plans can follow either progressive or static approaches. A progressive approach gradually shifts from equities to bonds over time perhaps a couple of percentage points a year. So it’s a really smooth rebalancing process. Whereas static portfolios tend to make more abrupt shifts, sometimes reducing equities by more than 10 percentage points in a single day. We prefer the more progressive approach because that courts less market-timing risk.

Wallace: You've also identified that there is a range of experience among the teams running these plans. What are some things that you looked out there?

Acheson: So we do find that there are certainly differences behind the resources and asset allocation within these 529 plans. Some plans use really experienced asset allocation investors who have strong track records running similar types of strategies, such as target-date retirement funds, whereas other plans use less-proven asset allocators. So we think it's really important for investors to understand the differences behind those teams, as they are really driving the decisions behind the age-based portfolios, which are the most popular options within 529 plans.

Wallace: You make a comparison a few times in the paper between target-date funds and 529 plans. Why make that comparison? What are the similarities and what are the differences?

Acheson: Sure. So I'll begin with the similarities. Both 529 plans and target-date strategies offer investors a single, all-in-one investment option that shifts from primarily equities to bonds over time. However, there are legitimate reasons why they would also be different. Investors in target-date retirement funds have more than four decades to save for retirement, whereas 529 investors have about half as much time to grow capital. Meanwhile target-date retirement funds have a much longer withdrawal phase. As a result, 529 plans tend to take a little bit less risk.

Wallace: And do the portfolio allocations differ between 529 plans and target-date funds?

Acheson: The main difference that we have seen between the two is that 529 plans tend to use less-common asset classes such as high-yield bonds, commodities, alternatives a little bit less than target-date strategies.

Wallace: It can be difficult to evaluate a 529 plan's past performance, especially considering that the allocations are designed to shift to become more conservative. How would you suggest investors go about evaluating the past performance of a 529 plan?

Acheson: So there definitely are challenges when evaluating performance of 529 plans. Specifically, when looking at age-based fixed portfolios, there are certain things that investors would have to do. The majority of plans use age-based fixed portfolios and an investor in those strategies actually shifts from one portfolio to the next over time. So for instance a common approach is that an investor would hold one portfolio from ages 0 to 5, and then at age 6 they would switch to another portfolio and hold it from age 6 to 10. So to understand how the performance would have been over that 10-year period you have to actually link the returns of those two portfolios. Overall it can become a pretty cumbersome process. However, to help investors compare returns between 529 plans, we actually ran that analysis for all 529 plans and included it in our report.

Wallace: You mentioned in the report that the asset-weighted expense ratio has declined for 529 plans. What are some factors you've identified there?

Acheson: Sure. So for one, 529 plans continue to reduce fees to become more competitive relative to one another. So that has driven expenses down. But also you've seen investors favoring less-expensive options within 529 plans more and more. So often you are seeing investors favoring passive strategies that come with obviously much lower fees, which has overall driven down the asset-weighted expense ratio.

Wallace: Lastly I wanted to talk about some industry best practices that you've identified. How do Morningstar analysts go about assigning an analyst rating to a 529 plan?

Acheson: When looking at 529 plans we consider, we evaluate them based on a five-pillar approach, which is process, people, parent, performance, and price. Looking at the process, we are looking at the design of the investment options in the age-based portfolios and the asset allocation within them. Looking at the people we are considering the quality of the underlying managers used within the plan. As far as parent we evaluate the oversight from both the state and the program manager. For performance we are looking at past returns on both the total and risk-adjusted basis as well as forward-looking prospects. And finally price, we look at the cost of the investment options.

Wallace: It’s an interesting report. Thanks so much for being here to discuss it.

Acheson: Of course. Thanks for having me.

Wallace: For Morningstar, I'm Karen Wallace. Thanks for watching.