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529 Plans Struggle With Costs

John Rekenthaler

Raising Questions
Ron Estes isn't happy with Morningstar.

Ron Estes being the Kansas State Treasurer, and in charge of the state's 529 program. Kansas offers three 529 plans, and one of them received a Negative Morningstar Analyst Rating. In response, Estes has posted a letter on Kansas' website, contending that Morningstar's approach to rating 529 plans contains "blatant inconsistencies" that "misguide the investing public, damage the reputation of 529 higher education savings plans, and discredit their [sic] own reputation."

Not for me to say. I'll discuss Morningstar decisions that I helped to make, but I have not been involved with the company's 529 research.

I was, however, struck by one line of Estes' argument, in which he writes that "Morningstar's misguided bias toward 'low fees' also fails to account for the benefits investors obtain when working through an actively-managed 529 account."

Wait. What? A misguided bias toward low fees? (And why does the term low fees need quotation marks?)

What's more, a trade-industry story in Ignites (the story is paywalled) about the Kansas letter quotes a 529 consultant stating that Morningstar's preference for low-cost funds "perpetuates a 'race to the bottom' in fees."

Encouraging a race to the bottom in fees is bad for 529 investors?

Those quotes got me thinking. If a State Treasurer and industry consultant are seemingly so cavalier about expenses, what does that imply about 529 funds' costs?

The High-Cost Answer
My fears were confirmed. On an equal-weighted basis, the average 529 balanced fund (moderate allocation in Morningstar's lingo) has an annual expense ratio of 1.22%, as opposed to 0.99% for the average retail mutual fund. For intermediate-term bonds, the comparison is 1.14% to 0.90%. Aside from large-blend stock funds, which are cheaper for 529 plans, annual expenses in the 529 industry tend to be about 0.25% higher than those of a standard mutual fund.

I expected to see the opposite pattern. These are institutional plans, after all. A single, informed party negotiates on behalf of a state's worth of assets, pitting many vendors against each other. The vendors are selling what is largely a commodity product. Per standard economic theories, the power would seem to lie almost entirely with the buyer and very little with the seller.

It's sure not working out that way. Much of the problem is because the assets are divided into 84 plans, among the 50 states and the District of Columbia. (Recall that Kansas alone has three plans.) The $200 billion collectively invested in 529 plans would carry tremendous negotiating weight if it were assembled into a single place. For example, Boeing's $40 billion 401(k) plan offers an actively managed Large Companies fund with 0.36% of annual expenses--one third the cost of the typical similar offering in 529 plans. Boeing's balanced funds cost 0.08% for the index option and 0.35% to 0.40% for the actively managed flavors. In all, the asset-weighted expenses for Boeing come in at less than 0.20% per annum.

In this application, states' rights don't appear to be helpful. I understand the desire to give local autonomy and, perhaps, to create best practices by permitting the states to experiment. However, it's hard to avoid the conclusion that the opposite is occurring, that pushing 529 plans down to the state level adds extra costs by preventing concerted action on behalf of shareholders. (Living in Illinois, a state that has sent four of its past seven governors to prison, I am well acquainted with the cons of states' rights.)

One also wonders if, per the quotes in this column, the 529 industry is fully on board with today's investment trends. In most of the mutual fund industry, as well as with brokerage commissions, the overwhelming trend among buyers is to insist upon lower costs. It appears that 529 plans do not consistently have that mind-set.

As for Kansas, its Negative-rated plan's equal-weighted expense ratio checks in at 1.02% per year, with (surprisingly) the asset-weighted costs running higher, at 1.22%. On average, then, Kansans who are saving for their children's college education by using that officially sanctioned 529 plan are paying 6 times as many fees per dollar invested as are Boeing's employees in preparing for their retirement.

Too high? Again, that is not for me to say. Morningstar's researchers believe so; the State of Kansas does not. However, I am comfortable writing that the difference between that 529 plan's costs and Boeing's 401(k) fund expenses does not feel right. College savings and retirement planning are critical national items. To give different U.S. citizens such different experiences, depending on where they live and work, seems ... amateurish. Arbitrary.

In the 529 marketplace, I suspect, the race to the bottom has only begun.

Back in the U.S.A.
I've been back in the States now for two weeks. The return has mostly been good. I appreciate many European ways, and I understand after a month in France and Germany why the locals are delighted, but I have been a Yank for 52 years now and the habit is hard to break. Give me big coffees, clean streets, and good ventilation, thanks very much. As well as NBA basketball.

American drivers, on the other hand, you can have.

For those of you who have not driven on European highways, let me explain how things are done.

If there are three lanes, and you are driving at a moderate speed, you drive in the right lane and the right lane only. Never any other lane. When you approach a car that is driving slowly, you move to the middle lane, pass, and then move back to the right lane.

If you are driving at a high speed, you drive in the middle lane. You do not move into the left lane except to pass, then you move back to the middle lane.

You do not drive in the left lane except to pass.

If anybody ever passes you on the right--ever, under any circumstances--you have been daydreaming, and if there were any justice on this planet you would receive a traffic ticket.

Read up, fellow Americans. You do so very much so very well. Highway driving ... well ... that would not be one of your strengths. (To put the matter much more mildly than I do when I encounter you on the roads.)

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.