Karen Wallace: Morningstar released a new 529 plan landscape report. It studies the industry in broad strokes and in fine detail. Here to discuss the paper is one of its lead authors, Madeline Hume. She is an analyst in our manager research group, focusing on multi-asset strategies.
Madeline, thanks so much for being here.
Madeline Hume: Absolutely. Thank you for having me.
Wallace: So, in your report, you mentioned that there are $280 billion invested in 529 plans. And plans sold directly to college savers sort of account for a lot of that growth. Have you noticed any other trends in the past 10 years or so that you can speak on?
Hume: Yeah, absolutely. You're totally right about the direct-sold plans. They've seen growth of about 9.9% over the past five years as opposed to plans that are sold through a financial intermediary, which have only grown by about 4.4% over that same time period. We're watching really closely the trends in asset allocation among 529 plans. So, pretty much every 529 plan has at least one option that shifts between stocks and bonds on behalf of investors as they age. But as 529 plans have grown and increased in prominence, they are starting to get a little more sophisticated with how they approach that asset allocation. So, they are doing that in one of two ways. They are either creating portfolios that investors are buying into and selling out of and physically moving into different portfolios as they age, or they are invested in one option statically, but that option de-risks as investor approach college. So, there's no selling out and there's no buying into, which reduces the impact of market risk. And about 40% of portfolios that are currently in an age-based track take a step of equity reduction of 10% or less over the college-savings time horizon as opposed to only about 10% two years ago. So, it's a pretty dramatic change.
Wallace: And we've actually reorganized our categories to better reflect the landscape of 529s available. Can you discuss that a little bit?
Hume: Absolutely, yeah. So, our categories were created in 2010 when the typical 529 plan took an equity step every three to four years. And so, that no longer holds true for most of the plans in the industry. The categories also formerly bracketed between high, medium, and low equity. But since we've seen such a progression towards these narrower age bands, we've decided to modify our existing categories to reflect those two-year increments. We've also launched new target enrollment categories because more and more plans are embracing the target enrollment model. So, we have portfolios all the way from 2039-plus to a 2015 in three-year increments so that we can more closely analyze the performance of those portfolios.
Wallace: One of the areas that Morningstar analysts look at is the quality of the underlying investments. Can you speak a little bit about changes there?
Hume: Absolutely. We've seen a huge pickup in the quality of the investment options in 529 plans, which is a great win for college savers. So, we evaluate the quality of the investments through our Morningstar Analyst Ratings for mutual funds--most 529 investment options are composed of mutual funds, so this is a really great way to analyze whether these funds will deliver for college savers over the long term. About four years ago, 33% of investment options were Morningstar Medalists, and today, it's more than 66%. So, we've seen a huge pickup in quality in these 529 plans over that time horizon.
Wallace: That's great. And fees are another area of good news, is that right?
Hume: Yes, that's true. So, advisor-sold plans, which are typically the more expensive of the two distribution types, have a 0.93% expense ratio on average, which is a 0.06% reduction year-over-year. And direct-sold plans: They fell a little bit slower at 0.03%. But the all-in expense ratio on average is about 0.39%. So, college savers have a lot to look forward to in terms of affordability. That said, however, there are still some areas where 529 plans have room for improvement. There are a lot of underlying fees that limit the ability of 529 plans to reach the fees that would make them comparable to mutual funds. So, we are watching very closely those types of fees and trying to compare them as best we can, but the cost structures vary from plan to plan.
Wallace: And recently, there were some tax law changes that allowed 529s tax benefits to extend to K-12 private school. What kind of changes have you noticed based on that?
Hume: I would say the majority of 529 plans are still kind of absorbing the implications of the legislation, and they've reacted in several different ways. So, some states like Missouri automatically conform to Federal tax law, which meant that there was an equal tax benefit at the state level as compared to the Federal level where the capital gains taxes are waived for 529 savers. So, they are right in lock step with each other. Other states have tried to pass legislation to conform to Federal legislation on the 529 tax benefits but have failed to do so. That would include New York and Colorado. And finally, some states like Massachusetts and Illinois, our home state, have actually come out and said that these plans are exclusively for college savers and are not recognizing any state-level tax benefits to match the Federal tax benefits.
Wallace: So, you'd have to check with your state.
Hume: Absolutely. Yes.
Wallace: All right. This is a great report. It's got a ton of great information. Thanks so much for being here to discuss it.
Hume: Thank you so much for having me.
Wallace: For Morningstar, I'm Karen Wallace.