October 19, 2012
The quest by states and mutual fund companies to capture the $179 billion that people are saving for college in 529 plans has led to improved investments and more reasonable fees for college savers.
In a study of the plans offered by states throughout the nation, Morningstar analyst Laura Pavlenko Lutton concluded: "The days of plans being chock-full of poor investments that were really expensive are over."
States have become more picky when evaluating funds they offer because of disasters like the 38 percent loss in an Illinois' Bright Start Oppenheimer bond fund in 2008.
Despite improvements, there remain significant differences in quality and expenses. Those differences can affect how much money you will have to send a child to college. So if you are starting to save for college, or have been using a 529 plan for a while, it's worth examining your choices. You are entitled to make a move within a 529 plan or to another state once a year.
You don't have to pick a fund offered by the state where you live, although you might miss out on a tax deduction for your contributions if you go elsewhere. You also don't need to invest in a 529 plan offered by a financial adviser. You can go directly to most states, without the help of an adviser; investing on your own is usually cheaper.
While fees have come down, some are still too high, and Lutton suggests screening for fees that erode performance. Funds with lower fees often perform better than those with higher fees.
Yet Morningstar ranks the T. Rowe Price Alaska and Maryland 529 plans among its top "gold"-rated picks despite relatively higher fees than its other two favorites, offered by Vanguard in Nevada and Utah.
The T. Rowe Price option for children 7 to 12 years old charges 0.87 percent, said Lutton, and the Vanguard option for the same age group charges 0.23 percent.
People sometimes assume such small numbers mean little, but that's not the case. If a person invests $10,000 and earns 7 percent on their investments in each, they will end up after 10 years with $19,224 in the low-cost 0.23 percent fund and about $18,026 in the higher fee fund. Examine 529 options at 529.morningstar.com/state-map.action? with a free 14-day trial and compare fees at dinkytown.net/java/FundExpense.html. Keep in mind that a load, or sales charge to compensate an adviser, increases your expenses.
T. Rowe Price's fees are higher than Vanguard's because T. Rowe employs fund managers, while Vanguard simply uses index funds. An index fund mimics the stock or bond market and is relatively cheap to operate. While having stock pickers often makes people feel like they have a better chance of success, fees for the fund manager's expertise can become a high hurdle. For the last five years, Lutton said, the T. Rowe 529 option provided families an average annual return of 1.8 percent, while the cheaper-to-operate Vanguard option provided 3.62 percent.
Lutton suggests that people selecting 529 plans pay attention to investment choices to make sure they are comfortable with the amount of stock exposure a fund offers. People have grown nervous about stocks since 2008, and some states have cut back exposure to stocks in 529 plans.
But typically plans investing money for babies and young children hold significant amounts of stock so that savings grow. As the child ages and gets closer to needing money, the 529 gets more conservative, putting most money into bonds or even safer money market funds.
The average 529 plan invests just 24 percent of a 16-year-old's college money in stocks and at age 18 that drops to 14 percent on average, said Lutton. Other 529 plans, sensitive to concerns about losses in the aftermath of the 57 percent decline in the stock market from late 2007 to March 2009, let families keep 100 percent of their savings invested in FDIC-insured CDs or uninsured money market funds.
Lutton doesn't suggest such an approach for young children because the safe investments earn almost no interest. She notes that college costs have been increasing 7 percent a year, so 1 or 2 percent interest isn't going to grow savings adequately to meet skyrocketing costs.
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