The story behind individual funds and 529 plans

http://www.savingforcollege.com/articles/the-story-behind-individual-funds-and-529-plans

One need only point to the phenomenal success of American Funds in launching its CollegeAmerica 529 Savings Plan this past February to argue that there must be a secret formula for success in the 529 savings market. Witness the growth of this particular program: In less than five months’ time CollegeAmerica grew to over one billion in assets, making it the fastest-growing 529 plan in the country and the sixth-largest program overall as of June 30, 2002 (Alliance Capital’s CollegeBoundfund was number one at over $2.2 billion). Why the attraction to CollegeAmerica? Beyond the well-known strengths of Capital Research and its American Funds mutual fund family—strong performance, low expenses, and widespread broker loyalty—this 529 program brought something new to the 529 marketplace: a menu of individual mutual funds. In fact, that is all it is: A lineup of 21 American Funds offered under the 529 umbrella. The standard 529 offering up to this point was a menu of blended-fund portfolios, with each portfolio designed for a particular college investment objective through asset class allocation and diversification. This “funds of funds” approach leaves the responsibility for appropriate investment selection largely to the program investment manager. The individual fund approach, on the other hand, permits the investor (and adviser) to select his or her own blend of mutual funds. Industry observers used to think that the individual fund approach was not going to pass muster with the IRS. Section 529 of the Code prohibits a 529 program participant from exercising investment direction. And when the IRS loosened up the rules by permitting annual switches among investment options within a program, it did so only for changes between “broad-based investment strategies designed exclusively by the program.” A custom-built fund of funds clearly fits that definition, but does an individual mutual fund? The 529 program managers apparently think so. You will now find individual mutual funds featured in an increasing number broker-sold 529 plans. These include the programs distributed through Alliance Capital, Fidelity, Hartford, MFS, Pacific Life, PIMCO, and Putnam. (You can argue that CollegeAmerica was not the first 529 plan to feature individual mutual funds. Aware of what was coming down the pike, both Putnam and Alliance Capital beat American Funds to the street by adding individual funds to their existing 529 plans shortly before CollegeAmerica was launched. And truth be told, Arizona was the real trailblazer. In 1999, it launched a 529 savings program comprised of a simple menu of SM&R mutual funds. This fact is obscured by the reality that the Arizona 529 plan through Securities Management and Research has attracted less than $10 million in assets.) Your client’s ability to choose between individual funds and funds of funds is good news for you. It also distinguishes broker-sold 529 product from direct-sold plans which currently do not offer individual funds. As long as tax law contains the general prohibition against self-direction of investments within 529 plans, many states will be reluctant to offer individual fund choices in direct-sold plans. Whether or not individual funds are best for your client is up to you to decide. Some advisers will still prefer portfolios under an age-based investment approach that automatically adjusts as the beneficiary nears college age (especially for small accounts that do not warrant a large investment of adviser time). Others will feel more comfortable creating their own blend of individual mutual funds and taking a look every year to determine the need for rebalancing. It can be a great excuse for scheduling a periodic investment check-up with your client."