What Our New Approach Means for 529 Plan Ratings

Executive Summary In July we announced our plans to update the Morningstar Analyst Rating methodology for 529 plans. You can find a comprehensive summary of the changes here, but to recap: The modifications include removing the Performance Pillar as a standalone assessment; refocusing the Parent Pillar to reflect only our assessment of the plan's state trustee; increasing our emphasis on the investment manager in the People Pillar; and assessing a plan's fees irrespective of its underlying investment approach (active versus passive) or how it's distributed (advisor-sold versus direct-sold). In this piece we'll examine the potential impact of the methodology enhancements on the future Morningstar Analyst Ratings, using the current pillar assessments and the current fees of plans' age-based options. We plan to publish our new ratings, with updated pillar evaluations, later this month.

Key Takeaways From Our Pro Forma Analysis

• Up to 53% of plans could see a rating change. Downgrades and upgrades are likely to balance out, and we expect most ratings to move up or down by only one notch.
• Ratings changes are most likely to affect plans currently rated Neutral (32% of all changes), Silver (26%), or Bronze (also 26%).
• The new methodology compares a plan's price with all plans, irrespective of distribution channel. In general, this means that advisor-sold plans with share classes that embed advice and sales fees could see more downgrades than upgrades. Plans that offer more "unbundled" share classes, such as those sold directly to investors, have a price advantage.
• Plans that use higher-cost actively managed funds could see their ratings fall, while plans that use lower-cost index funds may see their ratings rise.
• Today, Morningstar analysts don't confer any Gold, Silver, or Bronze ratings to plans with above-average or high fees, which receive Negative Price Pillar ratings. While the group of plans whose fees are rated Above Average or High will likely change, the probability of a plan with High fees achieving a Morningstar Medalist designation remains small.

Study Approach To analyze the potential impact of the ratings enhancement, we applied the updated methodology pro forma to plans that we currently cover and intend to cover again this year, a universe of 58 plans. We did so by taking the plans' current People, Process, and Parent Pillar ratings and running them through the updated methodology. (You can access the updated methodology document here.) Given how fast fees fall in the industry, we estimated plans' Price Pillar ratings using a straight average of their current age-based options' expense ratios.

A few factors will underpin additional differences between this application of the enhanced ratings methodology to forthcoming ratings. Notably, (and good news for 529 investors broadly), the typical plan has improved its lineup in recent years. This results in a higher standard for the strategies comprising plans’ investment menus across the board, but it can also mean that it is more difficult for an investment manager to stand out simply through the strategies chosen. Subsequently, to differentiate across plans that have increasingly employed similar strategies, the impending People Pillar ratings more strongly recognize the team assembling and monitoring the lineup. A compelling lineup in and of itself is no longer sufficient for an Above Average or High People Pillar rating. In addition, our analysts consider other data, such as asset-weighted fees and maintenance fees, when determining Price Pillar ratings, whereas this pro forma analysis estimated plans’ Price Pillar rating using a simple average of the age-based portfolios’ fees. Finally, analysts reserve the right to override a plan’s suggested score, and we anticipate that there may be several instances where that judgment is exercised.

Below, we compare the pro forma ratings against the existing Analyst Ratings.

Impact Analysis: Downgrades and Upgrades Wash Out Our pro forma analysis suggests that overall, Analyst Ratings are not likely to shift drastically. In aggregate, the ratings may shift slightly in favor of Bronze ratings from Neutral under the new methodology, with upgrades outnumbering downgrades by about three plans, or 6.9%. That said, ratings distributions for 529 plans are often lumpy, as investment managers may build several identical or nearly identical plans offered by different states. That tight margin means it's too close to predict whether upgrades will outnumber downgrades, or vice versa.

Similar trends hold when splicing plans by the type of underlying investments they hold. Some plans favor active underlying managers, some prefer passive underlying strategies, while others use a mix of both. Typically, active management increases fees. Plans generally give themselves a higher expense hurdle to clear when investing in primarily active underlying strategies, and under the enhanced methodology these plans will require a greater degree of analyst conviction to earn the same ratings as cheaper plans, whose cost advantages are often persistent and reliable contributors to performance over longer time periods.

Formerly, we determined Price Pillar ratings based on a plan’s distribution channel and the underlying strategy of its holdings. Going forward, we’ll assess the absolute value of a plan’s fees irrespective of these differences. A pro forma estimate of our Price Pillar rating indicates how the average cost of a plan’s age-based portfolios ranks within the context of its broad peer group. It takes the form of Low (cheapest 20% of share classes), Below Average (next 20%), Average (middle 20%), Above Average (next 20%), or High (priciest 20%).

Exhibit 1 below reveals that the cheaper a plan’s portfolios, the more likely it is to receive a Gold, Silver, or Bronze rating. Given that some of the cheapest age-based portfolios now cost less than 0.10% on average, a Price Pillar rating of Low is an all-but-undeniable advantage over plans that charge more.

It’s also likely that under the enhanced methodology, plans’ ratings won’t stray far from their prior ratings. More than 85% of plans would experience either no move or a one-rung move, with changes between Silver and Bronze and Bronze and Neutral representing the majority of changes.

Exhibit 1: Distribution of Analyst Ratings: All Plans

Still, our analysis suggests that, with current pillar ratings, 53% of plans would see a rating change under our new methodology.

Impact Analysis: Low-Cost Options Rise to the Occasion When we start to parse apart the universe, ratings trends become clearer. Notably, advisor-sold plans would see downgrades outnumbering upgrades under the pro forma Analyst Ratings. In this system, it will not suffice to be the cheapest in an expensive lot: The updated methodology puts greater emphasis on price as a driver of future results, and advisor-sold plans often layer on commission fees that dim their appeal on this measure.

Exhibit 2: Distribution of Analyst Ratings Changes: All Plans

Exhibit 3: Distribution of Analyst Ratings: Advisor-Sold Plans

Meanwhile, increased emphasis on fees would benefit direct-sold plans, which generally have lower expense ratios than advisor-sold plans. Overall, our analysis indicates that upgrades will outnumber downgrades for direct-sold plans, which in aggregate make up about 70% of our 529 coverage universe.

Exhibit 4: Distribution of Analyst Ratings: Direct-Sold Plans

Similar trends hold when splicing plans by the type of underlying investments they hold. Some plans favor active underlying managers, some prefer passive underlying strategies, while others use a mix of both. Typically, active management increases fees. Plans generally give themselves a higher expense hurdle to clear when investing in primarily active underlying strategies, and under the enhanced methodology these plans will require a greater degree of analyst conviction to earn the same ratings as cheaper plans, whose cost advantages are often persistent and reliable contributors to performance over longer time periods.

Formerly, we determined Price Pillar ratings based on a plan’s distribution channel and the underlying strategy of its holdings. Going forward, we’ll assess the absolute value of a plan’s fees irrespective of these differences. A pro forma estimate of our Price Pillar rating indicates how the average cost of a plan’s age-based portfolios ranks within the context of its broad peer group. It takes the form of Low (cheapest 20% of share classes), Below Average (next 20%), Average (middle 20%), Above Average (next 20%), or High (priciest 20%).

The exhibit below reveals that the cheaper a plan’s portfolios, the more likely it is to receive a Gold, Silver, or Bronze rating. Given that some of the cheapest age-based portfolios now cost less than 0.10% on average, a Price Pillar rating of Low is an all-but-undeniable advantage over plans that charge more.

Exhibit 5: Percentage of Plans That Would Receive a Medal

Exhibit 6: Distribution of Average Age-Based Expense Ratios

Conclusion: Ratings Are as Much an Art as a Science This analysis is pro forma, as it takes the People, Process, and Parent Pillar ratings analysts have already assigned to 529 plans, in conjunction with the current fees charged by the plans' age-based options, and runs them through the updated methodology. It goes without saying, though, that with every annual review analysts take into consideration the evolving contours and standards of the 529 plan universe (ratings are relative after all), in addition to their ever-deepening knowledge of a plan's structure. Every year is a fresh review, and one can't ignore that to stay competitive, a plan must continue looking for ways to improve the investor experience via fee cuts, improved investment options, and strong oversight.