Parents worried about how they’re going to pay for college have been steering more and more money into college-saving plans, also known as 529 plans. Investment in such plans, which under federal law must be sponsored by states, grew from $18 billion in 2002 to $318 billion in 2018. They’re attractive because investment gains are shielded from federal taxes, and many states give tax breaks to residents who contribute to in-state funds.
No wonder so many of us have been writing checks for these accounts, in our children’s or grandchildren’s names.
The tax advantages are real, but investors should be cautious, because some of these plans are a worse deal than they at first appear. On average, according to my own research, contributors to 529 plans pay management fees that are twice as high as those for the typical large 401(k) tax-sheltered retirement plan— .6 percent versus .3 percent annually.
The worst offenders are plans sold by commission-compensated brokers. Investors in these plans are also more likely to pay brokerage fees, further offsetting the tax advantages.
States have significant conflicts of interest in this area, too. In some cases, private companies run the plans (meaning they collect checks and handle administration for an array of pre-existing mutual funds, from which investors choose). But the states still charge these companies for the privilege of working under their umbrella. States then steer some of the management fees they collect into other educational programs — notably scholarships and prepaid tuition plans. Such revenue-sharing reduces the incentive to keep costs down, and it means the states aren’t acting in the fiduciary interests of savers.
All of this means it might be time to rip up the rules for how 529 plans are managed — possibly ending the state monopoly system, which would force sttes to compete with private operators. But more modest reforms could eliminate the conflict-of-interest problems, and much of the overcharging.
By now, 49 states offer 529 plans — which are open to savers nationwide, though out-of-state residents often forego some tax breaks. (529 plans, incidentally, disproportionately benefit the upper-middle class: some surveys have found that fewer than a third of Americans over 20 years old have heard of them, although word may be spreading.) The largest is the CollegeAmerica plan, run out of Virginia and operated by American Funds, a sponsor of broker-sold mutual funds, which has more than $60 billion in assets. That represents fully 20 percent of the national 529 plan total. While it’s among the lower-priced broker-sold plans, CollegeAmerica is nevertheless more expensive than Virginia’s other college savings plan, which is sold directly to consumers.
CollegeAmerica offers dozens of fund options, but not a single index fund, which typically have lower fees than managed funds do. And though CollegeAmerica is run by American Funds, Virginia charges investors a fee to buy into the plan, generating $40 million annually. That’s enough for Virginia to fully cover the expenses of operating its other 529 programs, with millions left over.
What does the state do with that surplus? For each of the past several years, Virginia has made a deposit of more than $15 million into its prepaid tuition plan. Prepaid tuition programs promise investors that their investment returns will keep up with the pace of tuition increases at Virginia public universities. The income from CollegeAmerica has helped keep Virginia’s prepaid plan above water without putting Virginia public funds at risk, and the cost is borne by CollegeAmerica investors, who mostly live elsewhere.
Virginia is hardly alone in this approach. For example, Nevada subsidizes a prepaid tuition plan with 529-related revenue, and New Jersey runs a scholarship program. Across the country, 529 plans marketed nationally act as cash cows for the benefit of the states and some in-state investors. Consumers are told in plan disclosures that state fees cover “oversight” or “administration,” but a significant portion of fees are directly allocated to these other purposes. That’s a long way from the way an efficient savings plan should operate, and a far cry from how 401(k) plans work.
These inefficiencies and conflicts are important in themselves, but they have broader ramifications: Several states have entered the much larger retirement-savings market, offering Independent Retirement Account Plans (IRAs), typically aimed at low-income workers whose employers don’t provide a retirement plan. More are considering doing so. It would be a mistake to recreate the weaknesses of the 529 system in the much larger retirement-savings market.
If states are charging for the privilege of hosting plans, but aren’t delivering strong oversight, then the federally mandated state control starts to look less like a structure that ensures investor protection and more like a tax on investors. States should be free to offer plans (and, to be sure, some states provide decent, low cost options) but they should not have a monopoly.
A less dramatic reform would be to require states to provide individual oversight boards for each plan they sponsor, with each charged with getting the best possible deal for plan investors. People in a position to watch over others’ money are supposed to avoid conflicts of interest, not run one plan for the benefit of another. (401(k) plans are far from perfect, but investors can sue companies that administer the plans for breaches of fiduciary duty, and that’s helped to push fees down.) Requiring individual boards to oversee 529 plans would create an obstacle to schemes that work against investors’ interests.
In the meantime, consumers should act with caution. College savings plans remain a solid savings option, on the whole, but their quality varies widely. Investors should choose with care, keeping a close eye on fees. And they should know that the people charged with overseeing 529 plans may have ambitions that clash with their own financial goals.