VOL 59, ISSUE 5, MAY 1, 2005

Ivy-Covered Hall of Shame
by Kristin W. Davis

Our hall has three wings: The firs...
options and the performances of the plans that had investment selections with total annual fees of
2.5% or more. (Most pla...
Expenses are similar in the plan run by Pacific Funds, which offers a collection of uninspiring choic-
es save for a bond ...
able keeping their money there.

What about 529 plans run by fund companies that have been embroiled in the industry’s mar...
Our favorite plans

They’ve been put through the ringer by regulators, and most 529 plans have come out clean. If
your sta...
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Kiplinger's Personal Finance

  1. 1. VOL 59, ISSUE 5, MAY 1, 2005 529 PLANS Ivy-Covered Hall of Shame by Kristin W. Davis Our hall has three wings: The first holds five plans that clearly benefit financial companies more than investors. The second singles out states with unfriendly tax rules. In the third, Congress gets a rotten tomato for keeping investors in the dark about the tax status of withdrawals. Last year wasn’t a very good one for 529 plans. They ran the gauntlet of regulators, who poked, probed and peered at the state-sponsored college-savings programs. Congress held hearings on whether fees are too high and whether financial advisers steer customers to inappropriate plans. NASD examined 529-plan sales practices, and the Securities and Exchange Commission scrutinized the plans’ many layers of expenses. As if that weren’t enough, the mutual fund market-timing scan- dal tainted college-savings plans by association. It’s enough to make the 7.2 million people who have invested in 529 plans wonder if they’ve done the right thing. They have. As a whole, the plans continue to be a superb way to put college savings into appropri- ate investments and take advantage of valuable tax breaks. But all that scrutiny wasn’t misplaced. You’ll shoot yourself in the foot if you invest in one of the stinkers — a plan with egregiously high fees and lousy investment choices. To help protect you, we’re bestowing booby prizes on the worst offenders and corralling them in Kiplinger’s 529 Plan Hall of Shame. Our hall has three wings: The first holds five plans that clearly benefit financial companies and brokers more than investors. The second singles out states with tax rules that are unfriendly to 529-plan investors. In the third, Congress gets a rotten tomato for keeping investors in the dark about the tax status of withdrawals when it’s time to tap the accounts for college expenses. Fees, fees, fees Morningstar senior analyst Dan McNeela told Congress last year that “too many 529 plans are pro- hibitively expensive.” He’s right. Investors not only pay annual expenses for the funds they invest in, they also pony up administrative and management fees to the state and to the financial compa- ny that manages or distributes the plan. Now that 65% to 75% of the assets going into 529 plans are funneled through brokers, most investors pay sales charges as well. And you may also be charged an enrollment fee or a yearly account-maintenance fee. Many plans have annual charges exceeding 2%. That means underlying investments have to earn more than 5% to keep ahead of the fees and a modest 3% inflation rate. To find the worst offenders, we used Morningstar’s 529 Advisor database of 83 college-savings plans to screen for those with the highest expenses. Then we reviewed the overall investment
  2. 2. options and the performances of the plans that had investment selections with total annual fees of 2.5% or more. (Most plans have a range of charges based on the expense ratio of the investment you choose and the share class you buy. The highest annual totals are usually for a plan’s Class C shares, for which the broker earns an annual sales fee rather than a larger up-front commission.) Plans that don’t report any performance data to Morningstar were excluded from the screen. Among them is Wyoming’s 529 program, which Morningstar recently named one of the five worst. Maine. Lee and Dyana Rossignol of Gorham, Maine, have held accounts for their four young chil- dren in Maine’s NextGen College Investing Plan since shortly after it opened in 1999. But after enduring five years of disappointing returns, they transferred the accounts this year to South Dakota’s College Access plan. Maine’s plan “has done nothing for me,” Lee says, “and everything is very high-priced.” In fact, Maine’s fees are higher than most. Residents pay 0.5% per year (and nonresidents up to 1% per year) on top of fund expenses, which range from 0.7% to 1.8%, for a total of up to 2.8%. In 35 of the plan’s investment selections, C shares carry annual expenses of 2% or more. Even the direct- sold plan (with no broker’s commission) has total expenses that reach as high as 2%. In return for those high fees, investors in NextGen have been rewarded with mediocre performance, especially from its AIM and MFS funds. For their 8-year-old son, Mitchell, the Rossignols invested in Merrill Lynch’s age-based portfolio, which adjusts its mix of assets to become more conservative as a child gets older. That portfolio has returned a not-so-bad 5% per year over the past three years. Overall, the Merrill Lynch funds have done better than other funds in the plan. AIM’s age-based portfolio for the same group has had negative annual returns. For their 5-year-old triplets, Wilkins, Madeline and Bridget, the Rossignols invested in an AIM fund and two Franklin Templeton funds, which have returned a subpar 1% to 3% per year over the past five years. “Fees are part of the equation, along with the value of the adviser, the investment choices and the ability to move your money around,” says Charles Toth, director of education savings at Merrill Lynch. With portfolios and stand-alone mutual funds from five fund families, including newly added Oppenheimer funds, Toth argues that NextGen allows investors plentiful choices. Merrill Lynch has also added a low-cost index fund for direct investors; however, it’s not available in broker-sold accounts. But it’s mainly broker-sold accounts that have driven this expensive plan to become the nation’s eighth-largest, with $2.9 billion in assets. Residents and nonresidents alike can do better. Arizona. None of the three broker-sold plans that Arizona offers is attractive. The Waddell & Reed InvestEd Plan is among the nation’s most expensive, with total fees running as high as 2.6% per year. The company does not report complete investment returns to Morningstar, but annualized three-year returns on the Waddell & Reed Web site range from 0.6% to 4.6% in the fund’s three portfolios. In the Securities Management & Research Family College Savings Plan, some funds carry expense ratios exceeding 2.5%. There are no age-based portfolios. At the end of 2004, all eight portfolios holding a fixed mix of stocks had below-average returns compared with their peer groups — some by substantial margins.
  3. 3. Expenses are similar in the plan run by Pacific Funds, which offers a collection of uninspiring choic- es save for a bond fund run by Pimco’s Bill Gross. The SM&R and Pacific Funds plans have direct- sold versions with no sales fees (but still the high expense ratios). There’s no state-tax deduction, so Arizona residents sacrifice nothing by looking elsewhere. Pennsylvania. High fees plague the Keystone State’s TAP 529 Investment Plan as well. Expenses for broker-sold shares range from 1.2% (plus an up-front load) to 2.6%. Performance in most of the investment choices has been dismal. With the exception of some bond-heavy portfolios for older children, nearly all of the age-based choices have underperformed their peers by significant mar- gins. Among the fixed-investment portfolios, Calvert’s socially conscious funds have done well, but those managed by Delaware Funds are duds. Steer clear. Nebraska. Although state residents have three plans to choose from, the AIM College Savings plan stands out for off-the-chart annual expenses — as high as 2.2% plus an up-front load for A shares, and 2.8% for B shares — and poor returns. Every one of the age-based choices has lagged its peers by one to two percentage points, and many of the fixed portfolios and individual fund choices have done worse. Ohio. The state has vastly improved the plan it offers directly to investors (it added a slate of low- cost Vanguard funds last year), but the broker-sold version, managed by Putnam, is still pricey, with expenses ranging as high as 2.7%. Meanwhile, it has delivered only average performance — below- average when you factor in sales fees. The plan is widely sold: It is the fourth-largest college-sav- ings program, with $3.5 billion in assets. Although many plans clearly need to improve, there’s good news about fees overall: Some plans have trimmed their expenses, and states such as Ohio and Maine have added low-cost index funds to their menu of investments. It’s also getting easier to compare one 529 plan’s costs with anoth- er’s. Although 529 plans are not subject to the same disclosure rules as mutual funds, the industry is voluntarily adopting the practice of showing total expenses as an annual dollar amount per $10,000 invested. By year-end, you should be able to find that comparative information in nearly all plan prospectuses. Plans come clean College plans haven’t been immune to scandal. Last July, the Utah Educational Savings Plan fired its director, Dale Hatch, accusing him of breach of trust and misappropriation of funds. Hatch has been charged with second-degree felony theft. He declines to comment. Utah should have had better internal controls, but the state gets credit for cracking down after an employee noticed suspicious transactions and for coming clean with investors about the breach. Account holders of record in March were reimbursed for missing funds, which came to about 62 cents per $1,000 invested. And the plan’s new director has introduced record-keeping systems to prevent cheating. Kiplinger’s has consistently recommended Utah’s plan for its super-low expenses and for its sensi- ble selection of age-based and fixed portfolios of Vanguard funds. Investors should feel comfort-
  4. 4. able keeping their money there. What about 529 plans run by fund companies that have been embroiled in the industry’s market- timing scandal? They, too, might have been contestants for entry into the Hall of Shame, but most states have acted quickly to replace tainted fund families or to offer alternatives. When Richard Strong and Strong Capital Management were cited for market-timing violations, Oregon and Wisconsin both replaced Strong funds or added alternatives. “These are very good examples of states exercising their fiduciary duty,” says Andrea Feirstein, a New York City consultant to 529 plans. Harsh treatment In about half the states and the District of Columbia, residents have an incentive to keep their money close to home: a state-tax deduction for part or all of the money they invest in the state plan. If your state’s plan is reasonably good, that tax break can be the sweetener that keeps you from investing elsewhere. If your plan has steep annual expenses or underwhelming investment choices, you can always forgo the tax break and enroll in an out-of-state plan. But Hall of Shame citations go to Alabama, Illinois, Mississippi and Pennsylvania, which penalize their residents for shopping around. If residents choose an out-of-state plan, they not only give up the up-front tax deduction, but they must also pay state taxes on the earnings when they withdraw the money for college expenses. Illinois and Mississippi have attractive 529 plans, so their residents aren’t stuck with lemons. Mississippi has a low-cost plan run by TIAA-CREF with solid choices. The Bright Start plan in Illinois, run by Citigroup, also has reasonable expenses (just under 1%) and a good selection of Smith Barney funds. Alabama’s and Pennsylvania’s plans, on the other hand, have high expenses and decent but not stellar inevstments. (Morningstar chose Alabama as one of its five worst plans.) Runner-up in this category is New York. Its Vanguard plan is a good one, but residents who enroll and later change their minds pay dearly. Like some other states, New York recaptures the state-tax deduction residents received on their contributions. But it also taxes the earnings portion of the amount rolled into another state’s plan. That’s harsh. Shame on Uncle Sam Congress popularized 529 plans in 2001 when it blessed tax-free withdrawals for education. But there’s a catch: The tax-free status “sunsets” in 2010 unless Congress acts before then to extend it. With the deadline looming, millions of families with students younger than high school age may be putting off saving because they’re uncertain about whether withdrawals will be tax-free. States and the mutual fund industry have been lobbying hard to get the tax break extended, and President Bush’s budget calls for making it permanent. But Congress keeps putting off legislative action. “It’s a matter of competing for scarce tax resources rather than a lack of support for the programs,” says David Pearlman, vice-chairman of the College Savings Foundation, which repre- sents financial companies that manage 529 plans.
  5. 5. Our favorite plans They’ve been put through the ringer by regulators, and most 529 plans have come out clean. If your state has a plan with attractive investments, reasonable expenses and a state-tax break, you needn’t expand your search. But if you’re looking for alternatives, these are our favorites: College Savings Iowa. Iowa and the other seven states that partner with Vanguard — Arkansas, Colorado, Kansas, Nevada, New York, Ohio and Utah — offer low-cost plans with solid investment choices that combine various Vanguard index funds. Total expenses in Iowa’s plan are 0.65% per year, with no annual account-maintenance fee. The minimum investment is $25. Four age-based “tracks” allow investors to choose an aggressive or conservative progression from stocks to bonds as the beneficiary gets older. And eight fixed-investment choices range from a riskier aggressive- growth portfolio to a money-market fund. Performance across the board has been above average over the past three years. Michigan Education Savings Program and Minnesota College Savings Plan. These two virtual- ly identical plans are among 14 similar ones run by TIAA-CREF. Expenses are low, at 0.65% per year, and the minimum investment is $25. Investment choices are simple: one age-based series of portfolios, a 100%-stock portfolio and a guaranteed fixed-rate portfolio with a minimum return of 3% — a darn good parking place for college money you’ll be tapping soon. Performance in all of the selections has been solidly above average over the past three years. Virginia’s College America. The Iowa, Michigan and Minnesota plans are sold directly to investors rather than through brokers. If you’re not the do-it-yourself type, Virginia’s plan is our top choice among adviser-sold plans. Total expenses in most of the stock funds tend to be about 1.6% (for C shares); one emerging-markets fund breaks 2%. The plan has no age-based portfolios; your adviser can help you tailor your own mix from 21 American funds, most of which are top-notch. —Research: Joan Goldwasser All contents © 2005 The Kiplinger Washington Editors Inc. Reprinted with permission. The information contained in this article was compiled by Kiplinger Personal Finance Magazine. The article does not contain all pertinent information relating to the 529 programs described and certain program details may have changed since the date of the article. The program disclosure booklet should be read carefully before opening an account. The states, their agencies, TIAA-CREF Tuition Financing, Inc. (TFI), Teachers Insurance and Annuity Association of America and its affiliates do not insure any account or guarantee its principal or investment return. Account value will fluctuate based upon a number of factors, including general market conditions. State sponsored plans managed by TFI are distributed by Teachers Personal Investors Services, Inc., or TIAA-CREF Individual & Institutional Services, LLC. Consider the investment objectives, risks, charges and expense before investing in a 529 plan. For information on a specific 529 plan managed by TFI, visit one of the following websites for a Disclosure Booklet containing this information. Read it carefully: Michigan Education Savings Program: www.misaves.com Before investing in a 529 plan, you should consider whether the state you or your designated beneficiary reside in or have taxable income in has a 529 plan that offers favorable state income tax or other benefits that are only available if you invest in that state’s 529 plan. C34781