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529 E-ditorials

04-6: Perspectives on the 529 debate
Joe Hurley
Tuesday, December 28th 2004

The following E-ditorial was contributed by Chris Stack, Esq., managing consultant with SFC Educational Services, LLC.

The year 2004 will be remembered as a challenging one for many states and their 529 plans. As noted in a Wall Street Journal article, there's been "a lot of talk" about 529 plans, including "criticism that some of these popular state-sponsored plans charge excessive fees."

One recent study by UNC-Wilmington accounting professors concluded that federal and state tax subsidies for 529 plan participants were accruing to the mutual fund distributors and brokers rather than benefiting the investor. Another recent article declared that 529 plans have become too complex: "What should be a consumer's paradise is, instead, a quagmire of investment funds, tax incentives and tangled rules and regulations, enough to confuse the most astute expert."

Such criticisms, having caught the attention of federal policy makers and regulators, are casting more than a passing cloud over 529 plans. We now see proposals for reform emanating from Washington that would severely impact them. A retiring U.S. Senator, Peter Fitzgerald from Illinois, has suggested that the states be removed as sponsors and administrators of these college savings plans. In his letter to U.S. Treasury officials, Sen. Fitzgerald wrote: "Having the state governments run section 529 plans serves no apparent purpose. With ordinary mutual funds, brokers and the fund companies charge fees. With section 529 plans, state governments interpose themselves as additional middlemen charging yet more fees."

Are these criticisms accurate and justified, or are 529 plans the victims of confusion perpetuated by those with less than a full understanding and appreciation for what 529 plans offer and how they operate?

As full-time observers of the 529 industry, we thought it appropriate to take a step back and comment on the controversy and perhaps lend some additional perspective. While we cannot respond to every point made in the debate on 529 plans, we can comment on the role of the states, the structure of 529 plans, so-called excessive fees, broker involvement, and the tax breaks available through these programs.

Some of the criticisms undoubtedly have merit, but we note that with more than 80 such different 529 "products" available, there is plenty of room for bad plans, as well as good ones, not unlike the more than 9,000 mutual funds available to investors today. Too often, outside observers have painted these plans with a broad brush and, at times, have contradicted themselves, perhaps without appreciating what they're saying.

First, addressing the role of the states begins with the recognition of those responsible for the very existence of these tax-advantaged college saving programs. States began formulating prepaid tuition plans and college savings plans in the 1980s. Congress entered the picture in 1996, essentially to preserve and protect what the states had already undertaken.

It has been the consistent goal of the states to make higher education affordable for their citizens. Tuition at public institutions rose 234% from 1980 to 1995, while median family income rose only 72% during the same period, according to the U.S. General Accounting Office. The early state programs were established to assist families combat this reality. Recent reports show the price spiral continues, as does the desire of the states to help families meet this challenge.

Thus, every state in the nation set out to establish an "affordable" 529 program for its residents. In pursuing this mission, many states have mandated that their program vendors, i.e., the mutual fund, insurance and broker companies, deviate from their normal business practices to offer and manage low-cost, easy-entry college savings programs, often on a money-losing basis. Participation can be had by a resident of any state in its own state 529 plan without paying any broker charges or commissions. Firms that offer mutual funds only through brokers have in several instances agreed to offer a 529 program to residents of the sponsoring state without any such charge. Many firms are also willing to offer other pricing and minimum contribution concessions. Consider the Vanguard Group, a company acclaimed by many as provider of low-cost mutual funds. To invest directly in Vanguard's Total Stock Market Index fund requires a $3,000 minimum investment, and you will pay a $10 annual account maintenance fee under certain low-balance conditions. For one to invest in the same Vanguard fund within New York's 529 plan requires as little as $15, and no annual account maintenance fee. It should also be noted that these concessions are typically achieved at no expense to the state taxpayer.

Additionally, the states have assumed a type of fiduciary duty with respect to these programs, not unlike what employers do for 401(k) programs, by performing due diligence on the firms providing the investment and other program services. Each state takes a different approach in its attempt to carry out its role and duty, and the result is the variety of 529 plans you see in the market.

What some call a major contributor to the confusion surrounding 529 plans, the state tax treatment of 529 plans, can instead be viewed as a further benefit to many participants. About one-half of all such states offer some type of up-front inducement to contribute to a 529 plan. Thus, the states do what they can to encourage would-be college savers.

It is true that states could further promote saving for college and reduce the complexity by making available for every 529 plan the state tax deduction and other incentives that they provide for their own plan. But states have valid reasons for resisting this idea. And given the choice between a state tax deduction limited to the in-state 529 plan and no tax deduction at all, most resident participants would want to have the deduction available, even if they elect not to utilize it. Sometimes the potential state tax benefit is not so significant as to always be the deciding factor. Program flexibility, quality of investment options, and availability of broker advice and services are all reasons that might convince an investor to join an out-of-state 529 plan.

While some programs impose fees and charges that may seem unnecessarily high, expenses of 529 plans in fact vary widely. Some of the earlier plans have evolved into lower cost plans, and others have reduced their expenses as they have gained more assets providing greater fees to offset the fixed costs. As with mutual funds, 529 plans with actively-managed investments are typically more expensive than 529 plans with passively-managed investments such as index funds. The variety of investment options across all 529 plans is impressive.

Given the wide array of choices of 529 plans to choose from, many parents and grandparents seek the help of a financial professional to identify the plan best suited for them. Advisers are familiar with numerous investment firms and products and can assist their clients with 529 plans depending on the need and preferences of the client. These financial professionals are often paid for their services by their clients through fees and commissions attached to the product, as they are and have been paid for working with mutual funds, annuities and other financial products. Fee-only advisers are another option. They do not receive commissions but instead charge the client a fee, and they typically recommend only non-broker 529 plans.

The age-old debate as to whether one should pay fees and commissions for a product when a no-fee alternative is available is not unique to 529 plans. People can also argue whether it's better to see a doctor or self-diagnose their ills, search for their dream house themselves or work with a real estate agent, prepare their own will or retain an attorney, and so forth and so on. Ultimately, the answer as to which is best for college savers lies in whether there is value added, and this is determined by the adviser-client relationship.

Given all the debate and scrutiny that 529 plans have encountered during the past year, it is important to recognize that millions of families have, in fact, benefited from participating in them. By becoming more familiar with 529 plans and the choices among the various programs, through our own research and efforts or through the trusted advice of an adviser, we can focus on how to best utilize all that these programs offer. Ultimately this will prove to be more effective for college savers and investors than imposing restrictions on these worthwhile programs.

» 05-4: The 529 marshals have arrived - 08/30/05
» Our 5.29th-year anniversary - 06/29/05
» 05-2: 529s and the new Bankruptcy Act - 04/28/05
» 05-1: Reform or Deform? - 02/27/05
» 04-6: Perspectives on the 529 debate - 12/28/04
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