Later this year, we will enhance the methodology of our forward-looking Morningstar Analyst Rating for 529 plans. We believe the changes accomplish three key objectives: simplify the overall framework, streamline our pillar assessments, and make our ratings more useful. Our new methodology document details the enhancements, which we'll summarize here. We'll also explain how these enhancements will work in practice and lay out a timeline for the debut of the new methodology.
The changes are as follows:
- We're removing the Performance Pillar and refocusing on the other four pillars: People, Process, Price, and Parent.
- We're increasing transparency by transitioning from a three-point pillar ratings scale (Positive. Neutral, Negative) to a five-point pillar ratings scale (High, Above Average, Average, Below Average, Low).
- We're disclosing pillar weightings: 30% for People, Process, and Price, and 10% for Parent.
- We're calculating scores for all plans based on their pillar ratings and pillar weightings, disclosing the equation to calculate those scores, and unveiling the thresholds for Gold, Silver, Bronze, Neutral, and Negative ratings based on those scores. However, analysts retain discretion to override a rating suggested by the score if deemed appropriate.
- We're refocusing the Parent Pillar to only reflect our assessment of the state's stewardship; it historically also involved our assessment of the program and/or investment manager's stewardship, which will now roll up under the People rating.
- Our Price Pillar will now convey our assessment of a plan's fees, irrespective of its distribution channel or the strategy of the underlying investment options.
- State tax benefits will no longer impact our Analyst Ratings, though we will continue to highlight them in our written analysis.
- We've slightly expanded the meaning of our Analyst Rating, which aims to identify plans that feature investments we expect to collectively outperform peers and adhere to industry best practices.
Simplifying the Framework Our new methodology simplifies the ratings framework in multiple ways. We're reducing the number of pillars from five to four by removing the Performance Pillar and refocusing the assessment around its more predictive elements--People, Process, Parent, and Price. Morningstar analysts will score the pillars on a 1 to 5 basis (the scores must be approved by the relevant Morningstar ratings committee).
We're also increasing transparency by describing these scores along a five-point pillar ratings range (High, Above Average, Average, Below Average, and Low) in our written analysis; we've used a three-point pillar scale (Positive, Neutral, and Negative) since 2012. For People, Process and Parent, the scores will be expressed in our written analysis as follows: 5 (High), 4 (Above Average), 3 (Average), 2 (Below Average), and 1 (Low). For Price, the scores will be 5 (Low), 4 (Below Average), 3 (Average), 2 (Above Average), and 1 (High). That should make it easier to map a plan's pillar ratings to its overall Analyst Rating and compare between plans. Going forward, we will weight the pillar scores as follows:
- People 30%
- Process 30%
- Price 30%
- Parent 10%
- Performance 0%
Then, an overall score is determined for each plan, using the following equation:
Score = (0.3*People Score) + (0.3*Process Score) + (0.3*Price Score) + (0.1*Parent Score)
We will typically assign ratings according to the following scores:
- Gold ≥ 4.5
- Silver = 4.0 to < 4.5
- Bronze = 3.5 to < 4.0
- Neutral = 2.5 to < 3.5
- Negative < 2.5
However, our analysts retain discretion to override these scores if they believe a unique characteristic justifies a different rating than the score suggests, though we expect relatively few overrides.
Streamlining Our Pillar Assessments
From Five Pillars to Four: People, Process, Parent, and Price Since 2012, we've expressed our assessment of a plan across five pillars--People, Process, Parent, Performance, and Price. Going forward, we will only assign pillar ratings to People, Process, Parent, and Price. Morningstar manager research has found that these four elements are the best predictors of future performance of investment strategies, net of fees. While our 529 plan ratings span more than just a strict evaluation of a plan's underlying investment strategies, we believe it's prudent to focus on these four elements to derive a plan's rating.
Although we will no longer assign a Performance rating, we will still analyze the past performance of a plan's strategies by weaving our evaluation of performance into People, Process, and Parent.
Paring Our Parent Assessment Parent has been a critical driver of our Analyst Ratings since we debuted them in 2012. Our new framework continues to prize robust oversight, but we are adjusting how we express our views by shifting the focus of our Parent rating.
Currently, the Parent Pillar reflects our evaluation of the partnership between the state, the program manager, and the investment manager for each individual plan. However, because the state and its supporting staff retain final say over its plans as the trustee, in recent years we've placed greater emphasis on state oversight within our Parent Pillar. Going forward, the Parent Pillar will only reflect our view of the state's stewardship, including the state entity overseeing the plan and, if applicable, consultants or governing boards involved. As a result of this shift, in most cases we expect to assign one common Parent Pillar rating to all the plans under a state's watch based on the quality of the oversight of all of its plans. A state that exhibits poor oversight of one of its plans may receive a Parent Pillar downgrade across the board. Likewise, a state exhibiting exemplary oversight of one of its plans may earn a Parent Pillar upgrade.
Although the Parent Pillar receives a smaller weighting of 10%, as compared with 30% for each of the other pillars, robust oversight remains critical. The state ultimately is responsible for ensuring that its 529 plans have strong investment teams implementing sound investment strategies at a reasonable cost--all factors that drive the People, Process, and Price Pillars.
We will continue to evaluate the stewardship of program and/or investment managers, but that will roll up into the People Pillar, as the cultures of these firms influence the investment teams. Among the elements of a plan that we consider in the People evaluation, we expect to take a more encompassing approach that includes an evaluation of the investment management team overseeing the investment options and asset allocation of the age-based portfolios along with an assessment of the quality of the underlying holdings; we have more heavily emphasized the latter in recent years. 529 plans have made significant improvements in the quality of their underlying holdings, making that measure an important though less differentiating aspect among plans, so we expect this more encompassing approach to better serve investors.
Greater Emphasis on Fees We're placing greater emphasis on fees and will no longer take into account a plan's distribution channel (advisor-sold versus direct-sold) or the strategy of its underlying investments (active or passive) when determining Price ratings.
Historically, we've determined Price ratings by comparing direct-sold plan fees versus one another and advisor-sold plan fees versus one another. Within those distribution channels, we go a step further by comparing plans that use primarily passive strategies relative to one another, plans the use primarily active strategies versus one another, and plans that blend the two. Because we're aiming to identify plans that will outperform peers, and price is a strong predictor of future performance, our enhanced methodology will remove the distribution channel and active/passive/blend distinctions and instead will compare all plans' fees versus one another. This will better align our Price Pillar ratings with the fees that investors are paying.
This change means plans will no longer receive positive marks for being the cheapest option in an expensive lot. Instead, cheaper plans will receive better Price ratings than more expensive plans. Consequently, advisor-sold plans, which bundle advice and sales fees, and plans that favor more-expensive active underlying strategies over passive ones could see downgrades to their Price Pillar ratings.
Making Ratings More Useful for Investors
A More Encompassing Assessment Our current methodology document focuses on identifying plans with investment options that will collectively outperform peers and/or relevant indexes on a risk-adjusted basis over the long haul. We have removed benchmark comparisons from our methodology, given that 529 plans are a captive universe--investors seeking to reap the tax benefits offered by 529 plans lack alternative investment options with commensurate tax benefits.
Our 529 ratings aren't just performance-based, though. Because we rate entire plans that offer a plethora of investment options, other less tangible considerations can affect investor outcomes and influence a plan's rating. For instance, the investment menu design represents one input into our 529 plan ratings, an element that's often reflected in the Process Pillar. We can't know which investment option an education saver will wind up in, so offering an easy-to-navigate investment menu is important to the investor experience. Therefore, we slightly expanded the methodology so our Analyst Ratings also signify which plans adhere to industry best practices, which has begun to influence our ratings in recent years. Best practices include but are not limited to:
- Ensuring that the age-based or target-enrollment options utilize a well-researched asset-allocation approach and a robust process for selecting underlying investments.
- Offering an appropriate set of options to meet investor needs.
- Hiring a skilled investment management team to oversee the lineup.
- Utilizing talented investment managers that underpin the investment options.
- Tapping investment managers with exemplary stewardship practices.
- Strong oversight from the state.
- Keeping fees low relative to peers.
In summary we're setting clearer expectations for Gold, Silver, and Bronze ratings; for a plan to earn these ratings, our research must convince us the plan both follows best practices and offers investments that will collectively outperform relevant peer-groups after fees and accounting for risk.
Excluding Potential State Tax Benefits From Our Evaluation Our new methodology also establishes that state tax benefits will not influence our ratings. Each saver's tax situation is unique, depending on his or her state of residency, income level, and size and frequency of contributions. Plus, more than half of the country's population has no incentive to stay in state. As of December 2019, 42% of Americans live in states with no state income tax or state income tax benefit, and 12% receive state income tax benefits regardless of the plan they select. So, we've gradually phased state tax benefits out of our 529 plan ratings. Formally removing them from our evaluations puts all plans on a level playing field and increases the comparability of our ratings across the country. That said, in our written analysis, we will continue to identify potential state tax benefits that each plan offers to its investors.
How It Will Work Our approach to determining Analyst Ratings can be thought of in three steps. We already follow this process to a large extent, but the enhancements will further systematize the process by which we form expectations about a plan's potential and translate those expectations into an Analyst Rating.
1) Assess a plan's ability to adhere to best practices and deliver outperformance before fees. In this step, we evaluate the People, Process, and Parent Pillars. This assessment determines how much conviction we have in the plan's potential to serve investors well in the future. The more conviction we have--for instance, if we rate People, Process, and Parent as High across the board--the more of that potential we'll assume that plan can deliver, and vice versa when we have low conviction. Our evaluation of the teams and processes behind the age-based or target-enrollment options tends to influence the People and Process ratings, since these options typically have the most assets.
2) Evaluate a plan's expenses. Unlike Morningstar's mutual fund ratings, we will continue to assign Price ratings for 529 plans. The Price rating is driven by a quantitative assessment of fees, though because plans offer many investment options, sometimes across multiple share classes, there's a qualitative element involved. Ultimately, our Price Pillar represents a comprehensive assessment of the expenses levied by all the vehicles on offer. We typically place greater emphasis on the age-based options, since those often have the most assets. We have chosen this approach as our ratings apply to entire plans, rather than unique investment strategies or vehicles.
3) Translate a plan's potential, in light of its fees, into an Analyst Rating. For a plan to be eligible to receive a Gold, Silver, or Bronze rating, our assessment must convince us that the plan's options can collectively beat its peers and that the plan can adhere to best practices.
As previously mentioned, we will usually assign Gold ratings to plans that achieve a weighted average score of 4.5 or better across the four pillars that we evaluate, Silver ratings to plans between 4.0 and 4.4, and Bronze ratings to plans between 3.5 and 3.9. Of those plans that we do not believe can deliver meaningfully better investment experiences--in the form of following best practices and offering investment options likely to outperform peers--we will typically apply Negative ratings to those that score less than 2.5 and Neutral ratings to those that score between 2.5 and 3.4. However, our analysts may override this overall score when assigning a rating.
Timeline Morningstar plans to update all of our 529 plan Analyst Ratings under this enhanced framework in October 2020. In the meantime, investors can remain confident in the current ratings we've assigned to 529 plans.