On May 2, 2022, at approximately 6pm ET, this article was edited. The following sentence was added to the end of the second paragraph: "Note that 529 plans are subject to the anti-fraud provisions of the federal securities law."
Because 529 plans are exempt from SEC oversight, they can charge higher fees and use that revenue in ways that do not benefit plan participants. New research shows some states are guilty of this abuse.
By year-end 2021, total assets in 529 savings plans had grown to $480 billion (across more than 15 million accounts), up from $165 billion at the end of 2011 (across fewer than 11 million accounts). What most investors in these plans are probably unaware of is that the sponsors of the plans, which are state governments, are exempt from the Investment Company Act of 1940 and the Securities Act of 1933, important federal laws that protect the interests of investors. Without federal oversight and no mandated disclosure requirements, 529 college savings plans operate outside the jurisdiction of the Securities and Exchange Commission.1 Note that 529 plans are subject to the anti-fraud provisions of the federal securities law.
Justin Balthrop and Gjergji Cici, authors of the March 2022 study “Conflicting Incentives in the Management of 529 Plans,” examined how the involvement and incentives of state governments affected investors in 529 plans. They began by noting: “Most states collect asset-based fees from their 529 plans and their incentives may not perfectly align with those of plan participants. States face budgetary constraints, which might force them to view their 529 plans as a potential revenue source.” They added: “States outsourcing program management to external managers further complicates the incentive landscape” – 90% of the plans are outsourced. Complications arise because service providers face incentives to favor their own funds or the funds of other families with which they have revenue sharing arrangements for inclusion in the plan menus – about one-third of plans operate under revenue sharing arrangements, which they are not required to disclose.
A state’s revenues are a function of two factors: the state (trustee) fee, which is applied as a percentage of assets, and total plan assets. States that desire higher revenues can negotiate a higher state fee with the program manager and/or allow the program manager to pursue aggressive sales practices via sales incentives for plan distributors to increase plan assets. Variation in fees and practices identifies differential tendencies of states to extract revenue from their 529 plans, which the authors labeled as Tendency to Extract Revenue (TER).
Balthrop and Cici’s 529 plan data was from the College Saving Plans database in Morningstar Direct downloaded on March 30, 2021 and covered 86 Section 529 plans offered by 49 different states and the District of Columbia. Following is a summary of their findings:
- The state fee – the fee collected by the state (also known as the trustee fee) – for the average investment was 4 basis points (bps) and could be as high as 26 bps.
- Program managers in higher-TER plans were more likely to use revenue sharing arrangements, which result in investment menus with higher fees and weaker investment performance.
- Sponsors of funds with higher fees offered no other direct or indirect benefits (such as education and tax benefits) that offset these plans’ inferior investment menus.
Balthrop and Cici noted that some states use state fee revenue from their 529 plans to support other initiatives, effectively transferring wealth from their 529 plan participants to other state residents. For example, the State of Virginia used part of the $40 million in fees it collected from its CollegeAmerica 529 plan to cover the operating expenses of its prepaid tuition program. Similar practices of using state fee revenue to support other initiatives are currently or have been used in the past in other states, including New Jersey, Nevada and Washington.
Their findings led Balthrop and Cici to conclude that conflicts of interest faced by program managers and lack of investment sophistication of sponsoring states are the likely explanations for the higher fees and lack of offsetting benefits. The unfortunate result is inferior menus for plan participants.
Wide dispersion in 529 plan expenses
529 plan costs vary widely. There are multiple costs; thus, one has to look beyond just the expense ratios of the available fund choices. Almost every plan charges an administrative fee and expenses related to the underlying investments. And some plans charge an account maintenance fee, usually for non-residents and low balances. For example, at $30 per year, one of the highest maintenance fees is levied by the Washington state DreamAhead plan.
A helpful web site, SavingForCollege, does an annual review of the lowest-cost 529 plans. Not surprisingly, this is somewhat subjective because cost is largely driven by which investment options one chooses. For example, while many CD and savings options are advertised as having no cost, equity and bond mutual funds charge a wide range of expenses. Thus, a conservative account, invested mostly in CD or savings vehicles, will often have a much lower cost than an aggressive account, invested in equities, especially higher-cost small-cap and international stocks.
With that understanding, SavingForCollege named the Louisiana START Saving Program and the Florida 529 Savings Plan the lowest-cost plans. However, both plans require the account owner or beneficiary to be a resident of the respective states.
And cost is not everything. Aside from tax benefits offered by many states, the other major consideration is investment options. You should seek low-cost funds, such as the index funds of Vanguard and the systematic factor-based strategies of Dimensional, to avoid high-cost actively managed funds. The plans that offer the best combination of cost and investment options include Illinois’ Bright Start, New York’s Direct 529 Plan and Utah’s my529.
Investor takeaways
Balthrop and Cici’s findings demonstrate that states in need of revenue accept higher fees in return for more leeway for the program manager in setting menus and fees to the detriment of the end investor, typically its own residents. Program managers take advantage of the weak regulatory oversight by pursuing their own interests at the expense of plan investors. Doing your own due diligence in choosing the right 529 plan can make a major difference in your investment results. Performing that due diligence for you is another way a true wealth advisor can add value.
Larry Swedroe is the chief research officer for Buckingham Strategic Wealth and Buckingham Strategic Partners.
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1Interests in 529 savings plans are considered municipal securities under the federal securities laws, and are considered municipal fund securities under MSRB rules. MSRB rules apply to brokers, dealers and municipal securities dealers (collectively, “dealers”) that act in the capacity of underwriters of 529 savings plans, dealers that sell interests in 529 savings plans, and municipal advisors to those plans. The MSRB has adopted standards that govern municipal securities dealers and municipal advisor activities in connection with the sale of 529 savings plans, including requirements related to fair dealing, disclosure, suitability and professional qualification.
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On May 2, 2022, at approximately 6pm ET, this article was edited. The following sentence was added to the end of the second paragraph: "Note that 529 plans are subject to the anti-fraud provisions of the federal securities law."
