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Conflicts of interest in 529 plans emphasize need for oversight

Two researchers at the University of Kansas School of Business have identified problems in how some states manage their savings plans for 529 colleges. They suggest that these problems are caused by conflicts of interest, insufficient supervision and a lack of sophisticated investment by the state sponsors.

According to the College Savings Plan Network, as of December 31, 2021, a total of $480 billion has been invested in 15.7 million 529 college savings plans.

As a result, consumers using 529 plans in certain states may be overcharged (as a result of these conflicts of interest), reducing their investment returns over time. Given a choice, consumers should opt for the lowest possible subscription cost to maximize return.

You can find your state’s plan and see costs in our 529 Plan guide by state.

Features of 529 subscription fee

Justin Balthrop and Gjergji Cici of the University of Kansas analyzed 5,339 unique investment options in 86 state 529 college savings plans for their paper, Conflicting Incentives in the Management of 529 Plans.

Two-thirds of the 529 plans are sold directly and a third are sold through advisors. Only 10% of plans are managed internally, the rest are outsourced to external program managers. A third has income-sharing agreements with the underlying mutual funds.

About half of the total compensation of 529 plans goes to the state, the program managers and various intermediaries.

The administrative asset-based fees for 529 plans are five times higher than the comparable fees for managing a retirement plan.

The 529 average subscription cost includes the following:

State Fees: 0.04%, but can be up to 0.26% Program Manager Fees: 0.16%, but can be up to 1.15% Distribution Fees: 0.23%, but can be up to 1.10% Underlying Fund Fees: 0 .38%, but can go up to 1.29%

The total expense ratio – the sum of all asset-based fees – averages 0.81% with a standard deviation of 0.53%. The expense ratio can be up to 2.49%.

Since the average return on investment for a 529 plan is about 6% based on historical performance data, some states and program managers take a significant portion of investor returns for their own benefit.

In some cases, families are better off saving in taxable accounts.

States with the highest 529 subscription costs

According to the most recent Saving For College 529 Plan Fee Study, here are the states with the highest fees. This study looks at the 10-year cost of a $10,000 investment for directly sold plans. It is important to note that subscriptions sold by advisors can have a much higher cost.

Comparing the most expensive subscription option to the cheapest option, South Dakota College Access 529 charges more than 10x the cost of the Lousiana START savings program.

The 10 most expensive 529 plans in the United States all charge nearly 3x the cost of the 10 cheapest plans in the United States.

Here are the 10 most expensive 529 plans in the United States (remember, each state can and does have multiple subscription options):

USAA 529 College Savings Plan

Texas College Savings Plan

Fidelity Arizona College Savings Plan

Connecticut Higher Education Confidence (CHET)

DE529 Education savings plan

U.Fund College Investment Plan

UNIQUE college investment plan

CollegeChoice 529 Instant Savings Plan

You can compare the above states and plans with the options below. We emphasize the HIGHEST cost option in the state. Louisiana does offer a $0 fee plan, which is a fixed-income plan administered directly by the state treasurer, but this plan is only open to state residents.

Education Savings Program in Michigan

New York’s 529 College Savings Program

SMART529 WV Direct College Savings Plan

Future Scholar 529 College Savings Plan

Minnesota College Savings Plan

Pennsylvania 529 Investment Plan

Trade-off between state revenue and program quality

Some states charge higher fees than others, but this generally does not improve the quality of the program. In fact, quite the opposite.

The 529 plans in states that get more revenue from the 529 plans offer more limited investment options that charge higher costs and deliver inferior net performance. The increase in underlying fund fees is about a quarter of the average fees for mutual funds.

The more expensive 529 plans offer fewer investment options and are less likely to offer low-cost index funds. These states also do not provide additional or better state tax benefits.

The University of Kansas researchers found that investment options from plans where states generate the most income have an average underlying fund expense ratio of 0.506%, while investment options from states that generate the least income have an average underlying expense ratio of 0.219%. So when a state gets more revenue from the state’s 529 plan, the expense ratio is more than twice as high (2.3x higher).

The University of Kansas researchers also used Sharpe ratios calculated by Morningstar for all 529 plans, showing that investors in these more expensive 529 plans underperform.

A Sharpe ratio is a risk-adjusted return on investment. It is the 529 plan’s return on investment minus the risk-free return and divided by the standard deviation of the excess return. A higher Sharpe ratio is better.

The 529 plans from states that earn more revenue from the 529 plans have a lower Sharpe ratio than 529 plans from states that earn less revenue, a sign that the investment plan’s performance, excluding fees, is inferior. The Sharpe ratios in the 529 plans in the states with high income extraction are 20% lower than the Sharpe ratios in the states with the least income from the 529 plans.

Conflict of interest

Since 529 plans generate revenue for the states and program managers, there is potential for a conflict of interest.

State incentives are not necessarily in line with the interests of plan participants.

States receive higher fees in exchange for offering program managers greater flexibility to generate more revenue, directly and indirectly, from plan participants.

529 plans often include investment options from the program manager’s own mutual funds and from investment firms with which the program manager has revenue sharing agreements.

529 plans with income-sharing agreements have underlying fund fees and total expense ratios that are 0.08% and 0.18% higher than other 529 plans.

Some examples that emerged in the report were plans where excess fees were used to fund other state initiatives. Or there is a disincentive to negotiate better compensation for investors as states enjoy the excess income. In its most blatant form, 529 subscription fees can be used to fund ad campaigns that some critics have called political campaigns, rather than investor education.

Lax supervision

There is very little effective oversight of the management of 529 plans.

529 plans are exempt from the Investment Company Act of 1940 and Securities Act of 1933. They are not required to register with the Securities and Exchange Commission (SEC), so the SEC is not a source of investor protection. SEC rules regarding investment disclosure do not apply to the 529 plans.

529 plans are not subject to a fiduciary standard. However, SEC regulations do require investment advisors, such as those who recommend 529 plans sold by advisors, to disclose conflicts of interest and consider costs when recommending products. The SEC’s Regulation Best Interest (Reg BI) isn’t really a fiduciary standard, just an eligibility standard. It does not apply to the 529 plans themselves, only the investment advisors.

The states provide some oversight by establishing advisory councils. However, the politically appointed advisory boards may lack the financial sophistication needed to align the 529 plan with investor interests.

Program managers often offer more fee income to states with weaker oversight.

Inadequate disclosures make it more difficult for investors to make informed decisions. There are no unified disclosure practices that are standardized across all 529 plans.

States that charge higher fees, which affect the net return on investment, do not provide better benefits to investors.

The states provide some oversight by establishing advisory councils. However, the politically appointed advisory boards often lack the financial sophistication needed to align the 529 plan with investor interests.

States that charge higher fees, which affect the grid, do not offer investors better benefits.

Program managers often offer more fee income to states with weaker oversight.

Inadequate disclosures make it more difficult for investors to make informed decisions. There are no unified disclosure practices that are standardized across all 529 plans.

Tips for investors

Minimizing costs is key to maximizing net returns.

Higher fees are not associated with better net performance after deducting the fees from investment returns. The investment options do not necessarily provide a better return on investment. Even if they do, the higher returns are not enough to offset the higher costs.

So, investors should choose the lowest cost state 529 plans.

There is often a tradeoff between low benefits in an out-of-state 529 plan and state tax benefits for contributions to the state’s own 529 plan. There is an inflection point between choosing low cost and state tax breaks when the child enters high school. Keep the following in mind if you choose a 529 plan going forward:

When the child is young, the families should focus on 529 lower cost plans. When the child enters high school, new contributions must be made to that state’s 529 plan if the state offers a state tax benefit on contributions to the state’s 529 plan.

Low fees apply to the entire 529 plan balance, while the state tax benefit only applies to each year’s new contributions.

Morningstar.com and Savingforcollege.com provide ratings of 529 plans that consider net return on investment after expenses. Savingforcollege.com also publishes one that evaluates the impact of the array of fees through the investment options of each 529 plan sold directly.

Check out our full 529 guide to better understand contributing to a 529 subscription in your country and the costs involved.

This post Conflicts of interest in 529 plans emphasize need for oversight

was original published at “https://thecollegeinvestor.com/39863/conflicts-of-interest-in-529-plan-management/”

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