529 Plans

529 Plan Crash Course

Sales of state-sponsored 529 college savings plans have never been higher.

Last year, reports Cerulli Associates, a Boston research firm, Americans invested $35 billion in 529 plans, up from $20 billion in 2002, and they are expected to put in $145 billion by 2008. If that prediction holds, it would represent a 40% compound annual growth rate between 2002 and 2008.

While that’s a huge leap, what is surprising is that sales of these tax-advantaged investment plans aren’t significantly higher.

College costs are rising at a gut-wrenching rate; the College Board reports that for the 2003-2004 academic year, the average annual total cost of attending a four-year public college increased nearly 10% to $10,363, while the cost of a private college costs jumped 5.7% to $26,854. Assuming such costs increase by 5% a year, the projected cost of one year of college in 2019 – when today’s preschoolers are enrolling – will be more than $100,000 for a four-year public college and more than $200,000 for a four-year private college, says William Raynor, secretary for the College Savings Foundation in Washington, D.C.

Despite the obvious need for college savings by parents, financial experts say that the market for 529 plans has barely been tapped. There are 72 million children under the age of 18 in the United States, but only 3.7 million 529 accounts have been opened, reports the Financial Research Corp.

According to the sixth annual College Financial Preparedness Study, conducted by Harris Interactive for Alliance Bernstein Investment Research and Management, nearly two-thirds of parents (64%) and grandparents (65%) are unfamiliar with 529 plans and just 15% of those polled were actively investing or considering investing in them.

Why the lack of knowledge of or interest in 529 plans? One reason, according to a recent article in Money Management Executive, is that several years ago, states began turning the marketing of 529s over to financial advisers and brokers. However, with the equity market booming, these professionals had little financial incentive to promote the plans.

“Low account balances and “paltry” commissions aroused little broker interest,” the magazine states. “Even with commissions up to 4.69% at the end of 2002 and rising, the relative newness of the product and consequent lack of awareness among [financial] professionals thwarts the best efforts of marketing gurus to get out the word.”

That’s changing, however. The Wall Street Journal found that mutual fund companies and investment advisers hired by states to market their 529 plans have been increasing their brokerage commission fees to entice more financial advisers to sell the products. This, in turn, has piqued the interest of Congress and securities regulators.

Congress concerned

In February, House Financial Services Chairman Michael G. Oxley (R-Ohio) asked the Securities and Exchange Commission to look into “the current state of affairs with respect to 529 plans.

“Perhaps most troubling,” Oxley said, “a Newsday article that appeared in late December suggested that the fees charged by these state-sponsored plans are so exorbitant that they may actually outstrip the tax benefits that Congress has attempted to provide to hard-working families through the plans. This same article indicated that states are not putting in place adequate procedures to monitor the performance and operation of the investment managers they hire to run their plans.

“I am also concerned about the tremendous differences in overall fees and other costs among what appear to be similar 529 plans,” he added.

Peggy Peterson, deputy staff director for the House Financial Services Committee, says the overall concern is transparency. “We want to know whether fees and expenses outpace the tax advantages of these plans, and how easy or difficult it is for consumers to compare plans.”

SEC Chairman William Donaldson has created an internal task force to investigate 529 plan marketing and regulation, which he agrees is “complicated and likely difficult for parents to understand.” This, he says, is because:

* The law does not require as much disclosure to 529 investors as to other mutual fund investors, and less information typically is provided.

* The level of disclosure and type of information provided on fees and plan administration is not standardized, and therefore varies.

According to the SEC, as on any investment, fees charged by a stockbroker or financial planner on 529 plans will reduce investors’ returns. However, “It is important to note that many 529 plans, in particular direct-sold plans and broker-sold plans that waive loads, offer lower-cost options which may well preserve the tax benefit Congress intended to grant to investing parents,” SEC explains.

The House Financial Services Committee will wait for the SEC task force report before deciding what, if anything, to do about tightening the laws governing 529s. “We’re not ready to find fault with anyone,” Peterson commented. “[This bears scrutiny because] these plans are growing extremely quickly, and there is confusion about them.”

Self-regulation expected

In addition to Congress and the SEC, industry self-regulatory groups also are looking at 529 plans.

The National Association of Securities Dealers revealed in March that it is investigating six major securities firms for possible misconduct involving the sale of “out-of-state” 529 plans, and it says the probe may spread. NASD suspects that consumers may have been directed to purchase plans other than those sponsored by their home states, which would have caused them to lose significant tax advantages.

“Suitability determination [on out-of-state plans] is important,” says Joseph Hurley, an expert on college-savings investments who provides online research tools for 529 plan buyers and sellers at Savingforcollege.com. If brokers are selling out-of-state plans without assessing the tax situation, that’s a problem. “I don’t know if that’s widespread,” Hurley indicates.

Meanwhile, spurred by revelations of market timing by mutual fund managers, the College Savings Plan Network, the affiliate of the National Association of State Treasurers whose members run state 529 plans, last summer began reviewing plan disclosure documents. Apparently, the group did not like what it saw, because by the end of the year it plans to release guidelines for plan marketers detailing what information they should be giving to consumers.

The Municipal Securities Rulemaking Board, which is active in regulating broker-dealers, has gone through a lengthy review of conduct over the past three years, says Hurley, and the industry “has been sensitive” to its findings and recommendations. “Broker-dealers for the most part are following suit.”

Nevertheless, Hurley maintains the attention being paid to the lack of investor information and the wide-ranging fees on 529 plans is long overdue. “Since day one, everyone should have recognized” that varied fees could be a problem, he says. “Most brokers do charge extra fees; it costs more to invest in 529s than mutual funds.”

However, he is quick to add that “in most cases, the tax benefits of 529 plans far outweigh the costs.”

For consumers and professionals who want to find out exactly what they will be earning on a plan investment, Savingforcollege.com will soon be providing online calculators. The tools will assess the value of the instate tax deduction for every state, not just in gross dollars, but as annual return on investment.

Due diligence important

The best thing that 529 plan consumers can do is to learn all they can about 529 plans so that they’ll be able to make an informed decision about the cost versus benefits, Hurley notes.

“The employer plays a critical role in this because employees tend to trust that, in offering a plan, the employer has researched [the market] and made the proper decision,” says Hurley. “That may or may not be the case. It is important that employers understand how 529s work. They’re different animals.”

“Most organizations that include a 529 plan as a benefit believe that the instate plan should be one of the options,” he continues. “It is certainly more difficult for employers with facilities in multiple states; they have to decide how many and which should be on the platform.”

Hurley encourages employers to contact their brokers or plan providers for information that they can then share with employees. Brokers and providers also may be willing to hold information sessions onsite for workers. On request, Hurley will conduct onsite workshops that provide employees with an independent assessment of 529 plan investing.

For do-it-yourselfers, Hurley writes bi-monthly newsletters and recommends his book, The Best Way to Save for College – A Complete Guide to 529 Plans, available at Savingforcollege.com.

“It comes down to employee education,” he summarizes. “Whether or not the company offers a 529 plan as part of their benefit program, it is very important to inform employees about the importance of college planning and the vehicles that are available.”

Rules for 529 investors

1. Learn all you can about Section 529 plans before you buy. Compare plans and fees at Savingforcollege.com.

2. Instate plans provide a state tax break. However, it may be worth forgoing that if an out-of-state plan provides more or better investing options. Talk with your adviser.

3. Look at brokers’ fees and examine fees charged by the mutual funds you’re invested in. Ask about program fees, which typically range from seven-tenths of a percent to one percent. There may also be annual account maintenance fees; an expense ratio of more than one percent a year is too high.

4. Once you’ve invested in a plan, keep on contributing. Many state plans allow contributions over $230,000. Yet the average account has a balance of less than $7,000.

5. Diversify. Don’t put your child’s education nest egg in just the 529 basket since the tax rules on these plans can always change.