Monthly top tips

So Says the 529 Guru

No. 10
Joe Hurley
Monday, November 24th 2003

Question: The company that manages my 529 plan has been named in the mutual-fund scandal. What should I do now?

Answer: Naturally, youíre concerned about entrusting your college savings with a 529 plan using a fund manager whose trustworthiness has been called into question. Maybe itís time for you and/or your adviser to take a fresh look at your college savings account and determine if this is the right plan for you. In evaluating your options, stay mindful of the following considerations.

First, what do we know about the actions of the fund company Ė has it admitted or been proven to have done wrong or allowed activities that have cheated shareholders in such funds or has it merely been asked to forward information to the regulatory agencies as a seemingly industry-wide investigation occurs? Is it a one-day story or the tip of the iceberg? If one or more senior executives of the fund company has been dismissed or has resigned, thatís usually a telling sign.

Second, if the wrongdoing by the fund company is apparent, have you been directly affected by such actions, i.e., did your 529 plan invest in shares of such funds called into question and was your account actually a part of such investment? (Perhaps it doesnít matter and you simply feel the fund company no longer deserves to manage your money.) If the offending fund manager is intending on offering redress, it will most likely make whole those who were shareholders at the time of wrongdoing from gains lost and could possibly include some type of monetary penalty demanded by the state administrators. Since the 529 plan, not the participant, is the actual shareholder of the underlying mutual fund, you cannot be confident that you will participate in any such recovery if you bail out of the plan now. Perhaps before making any final decision, you should satisfy yourself as to whether you need to remain in plan in order to participate in such restitution.

Third, what is the state (responsible for maintaining the 529 plan) saying to us? Is it seeking redress? Is it seeking to supplement or replace the underlying investment managers of the program? Remember, the outside program manager typically does much more than place the planís assets in its own funds, and has a contract with the state under terms that may limit the stateís options. The state may be reluctant to replace the program manager if it has otherwise done a good job, but rather would want to ensure that the plan participants will not suffer in the future from any such improprieties. What, if anything is your adviser and/or your adviserís firm recommending with respect to such fund company?

Fourth, what has your experience with your 529 plan and the underlying mutual funds been to date? Have you had other experience with either the 529 plan manager or the underlying fund company outside the 529 plan? Has the performance been meeting your expectations or has it been lacking? Has the customer service been satisfactory? If you have had a satisfactory experience over recent years with such fund company, whether through the 529 plan or otherwise, you should not lightly dismiss such prior experience with such firm as you deliberate a future course of action with your 529 account.

Fifth, what is the best of your three options, namely - stay, roll over, or close your 529 account? Is there a better plan for you out there? Perhaps the state administering your 529 account offers more than one 529 savings program and will permit you to go from your current plan into another (note that an intrastate transfer falls under the investment change rules and not the rollover rules). If you wish to roll over to another stateís plan, will you be forfeiting a state tax deduction by having to add it back into your state taxable income? If so and you are rolling over anyway, are you better off rolling over in 2003 or 2004? Have you, or anyone else with a 529 account for the same beneficiary, rolled over in the last 12 months, in which case you must change beneficiaries when making the rollover in order to avoid tax and penalty? Or are there other advantages to staying with the current 529 plan? If you expect to begin withdrawing soon from your current 529 plan, perhaps staying put is a simpler option. Closing the 529 account as a non-qualified withdrawal is rarely a course of action that I would recommend unless you have a loss and can benefit by claiming the loss as a 2% miscellaneous itemized deduction.

In summary, you should give careful consideration as to how to proceed in light of recent revelations of alleged misdeeds by many fund companies used by 529 investment plans. While the affected states will be making their own decisions with respect to these firms, you as the participant should examine what is in your own best interest. Do not decide solely on the basis of media accounts, but give careful consideration to your own particular circumstances. Whatever decision you make, you should be satisfied it is the right one for something as important as your college savings account.

Question: Iíve noticed that many of the Vanguard 529 Plan choices have significantly underperformed their respective underlying mutual funds, year-to-date. This underperformance exists even after taking into account the higher fees of the 529 plan. Perhaps you can offer an explanation, and more importantly, explain how the problem will be corrected.

Answer: Your findings are correct, J.P. It is reasonable to expect that a 529 portfolio investing in a single mutual fund, as several now do, will closely track the performance of the mutual fund. However, you will find that reconciling the investment performance of the 529 portfolio to the performance of the underlying mutual fund may be difficult if not impossible. Simply adjusting for the 529 program management expenses will not do the trick.

In Nevadaís Vanguard 529 Savings Plan, as with most other 529 savings plans, a one-day lag exists between the day your contribution is received and credited to your account and the day that contribution is actually invested by the 529 plan in the underlying mutual fund. For that one day, your contribution, along with anyone elseís, is sitting in cash. Any market movement on that one day above or below the return on the cash will skew the performance numbers. With the market trending up, as it has over the last year, the 529 portfolio performance will trail the underlying mutual fund. If the market were to trend down, the result would be the opposite.

The effect of the one-day lag is much more pronounced in a new rapidly-growing 529 plan like Vanguard's. That's because the total daily contribution represents a significant portion of the portfolio. As the 529 plan fund balance gets larger, the cash lag becomes a smaller and smaller factor until the point where there will be little if any measurable differences in performance. So although you cannot expect any corrective action for past performance, in most cases the "problem" does eventually go away on its own.

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