Rating 529 College Savings Plans

EXECUTIVE SUMMARY

Section 529 college savings plans offer numerous advantages and have few disadvantages compared with other options. Their benefits include tax savings, estate planning benefits, high contribution limits and no income limitations. One of the few drawbacks to these plans is that investment products usually are chosen by the state treasurer’s office and the 529 program manager. Withdrawals used to pay for qualified educational expenses usually are free of federal taxes. With any other withdrawals, the earnings portion is subject to federal taxes and a 10% penalty. If a child doesn’t go to college, the funds generally can be used to pay for another family member. There are two types of plans: prepaid tuition plans and savings plans. The two most common asset-allocation options clients can choose for savings plans are age-based and static-investment allocation. Clients will want to consider which states have the best-performing plans. Unfortunately, because 529 savings plans are relatively new, it is difficult to determine their long-term investment performance. Because 529 plans invest in mutual funds, it is possible to use the long-term performance evaluations of these funds from a rating service such as Morningstar or Lipper in order to calculate weighted-average ratings for a state’s 529 portfolio options. Jan E. Eighme, CPA, PhD, is assistant professor, Department of Accountancy, Richard T. Farmer School of Business, Miami University, Oxford, Ohio. Her e-mail address is eighmeje@muohio.edu .

ollege expenses are increasing faster than the average paycheck, but IRC section 529 savings plans can narrow the gap. These plans provide numerous advantages and have few disadvantages compared with other options. They offer tax savings, estate planning benefits, high contribution limits and no income limitations. One of the few drawbacks is that investment decisions usually are made by the state treasurer’s office and the 529 program manager. As a result clients will want to know which states have the best-performing plans. CPAs offering financial planning services to their clients should be prepared to provide this information.

Unfortunately, because they are relatively new, it is difficult to determine the best-performing 529 savings plans using the most popular yardstick of comparison: long-term investment performance. However, the plans invest in mutual funds whose long-term performance evaluations are available from rating services such as Morningstar and Lipper. This article shows CPAs how to use Morningstar ratings of the underlying mutual funds to evaluate a state’s 529 portfolio options. These weighted-average ratings provide a long-term, risk-adjusted performance measure that can be used to compare 529 savings plans.

THE BASICS OF 529 SAVINGS PLANS
WIn qualified plans covered by section 529 of the Internal Revenue Code, withdrawals used to pay for qualified educational expenses usually are free of federal taxes. With any other withdrawals, the earnings portion is subject to federal taxes and a 10% penalty. If a child doesn’t go to college, the funds generally can be used to pay for another family member. (For more on investing in these plans, see “ The Best Use of Spare Cash, ” page 41.)

Section 529 authorizes two types of plan: prepaid tuition plans and savings plans. Generally, state-sponsored prepaid tuition plans offer tuition contracts that allow contributors to lock in the cost of tuition and mandatory fees at an in-state public college or university. Unlike these prepaid tuition plans, most 529 savings plans do not offer any guarantees. The 529 plan program manager, usually a large mutual fund company, collects contributions and invests them in funds or other financial instruments.

The two most common asset-allocation choices for 529 savings plan investors are age-based and static-investment allocation. With an age-based allocation, the assets are moved over time to portfolios with progressively lower percentages of stock and higher percentages of fixed-income securities to minimize risk as the child gets closer to college age. Conservative age-based options move out of equities quickly; aggressive ones move out more slowly.

Static-investment allocation options maintain a constant equity percentage as a beneficiary grows older. Many 529 plans offer low-, medium- and high-equity content options and most allow account owners to use more than one. By investing in multiple options, clients can create customized portfolios to match their risk preference. For example, if a 529 account owner wants a portfolio with 75% of its assets in equity funds and 25% in fixed-income funds, he or she can put $750 of each $1,000 contributed into a 100% equity option and $250 into a 100% fixed-income option.

CALCULATING WEIGHTED- AVERAGE MORNINGSTAR RATINGS
To determine its mutual fund star ratings, Morningstar classifies funds into 69 categories, then calculates risk-adjusted returns for each fund, taking into account asset-based expenses and loads. Morningstar rates the funds (from 1 to 5 stars— 5 being the best) in each category based on these risk-adjusted returns. In other words, funds

In the top 10% of their category receive five stars.
In the next 22.5% receive four stars.
In the middle 35% receive three stars.
In the next 22.5% receive two stars.
In the bottom 10% receive one star.

Morningstar calculates star ratings for 3-, 5- and 10-year periods and combines them to obtain a comprehensive star rating for each mutual fund. The online exhibit shows weighted-average Morningstar ratings for selected 529 options for each state that have been calculated using the comprehensive star ratings of the options’ underlying mutual funds.

The online exhibit provides age-group performance evaluations by giving weighted-average Morningstar ratings for a sample of age-group portfolios. This sample includes portfolios for newborns and children ages 6, 12 and 18. The weighted-average Morningstar ratings of these age-group portfolios have been used to calculate the overall age-based option ratings. The online exhibit also gives weighted-average Morningstar ratings for three types of static-investment option: growth, balanced and conservative.

Taking one state as an example, exhibits 1 and 2 use Connecticut’s age-based option to illustrate the method used to calculate the weighted-average Morningstar ratings in the online exhibit . (Practitioners can follow the example in these exhibits to make their own calculations for different states, keeping in mind that fund ratings may need to be updated since they can change over time. More information can be found at www.morningstar.com .) A portfolio’s weighted-average Morningstar rating is based only on its rated funds. If an age-group or static portfolio does not have at least 75% of its non-money-market assets in Morningstar-rated funds, the portfolio is not given a weighted-average Morningstar rating. If an age-group portfolio is unrated, an overall rating is not calculated for the age-based option.

Connecticut’s Age-Based Option     Asset Allocation     Percentage Funds Used in Connecticut’s Age-Based Option Morningstar Star Rating 1 Newborn Age 6 Age 12 Age 18 TIAA-CREF Equity Index 4 60 52 32 16 TIAA-CREF International Equity 4 7.5 6.5 4 2 TIAA-CREF Inflation-Linked Bond 4 6.25 8.75 15 8.75 TIAA-CREF Real Estate Securities 3 7.5 6.5 4 2 TIAA-CREF Bond 3 18.75 26.25 45 26.25 TIAA-CREF Money Market 0 0 0 0 45 Total Assets   100 100 100 100 Percentage of total assets in Morningstar-rated mutual funds   100 100 100 55 Percentage of non-money-market assets in Morningstar-rated mutual funds   100 100 100 100 Is the percentage of non-money-market assets in Morningstar-rated mutual funds greater than 75%?   Yes Yes Yes Yes 1 Star ratings as of June 12, 2006. Note : The money market fund in this exhibit does not have a Morningstar rating because Morningstar does not rate money market funds or any funds less than three years old.

In addition to weighted-average Morningstar ratings, the online exhibit provides the total asset-based expense for each 529 option and the portion of this expense accounted for in the option’s weighted-average Morningstar rating. A 529 option’s total asset-based expense is usually made up of two parts: the asset-based expense charged by the 529 program manager and the asset-based expense charged by the option’s underlying mutual funds. The asset-based expense charged by the program manager is not accounted for in the option’s weighted-average Morningstar rating. On the other hand, most of the asset-based expense charged by the option’s underlying mutual funds is accounted for in the rating.

INVESTING IN OUT-OF-STATE 529 PLANS
Of course, CPAs should remind clients that investment returns and ratings are only part of the puzzle. When deciding whether to invest in an out-of-state plan, clients should consider other issues, such as expenses and tax consequences. Out-of-state 529 account owners sometimes pay higher expenses than state residents do. For example, some 529 plans require out-of-state account owners to invest in load-based funds resulting in additional asset-based expense. If this is the case, the online exhibit assumes, for rating purposes, that class A shares are purchased. Class A usually is the most advantageous load share class for long-term investors.

Owners of an out-of-state 529 account might lose a state income tax deduction or tax credit for contributions to the account and, in a few states, do not receive an exemption from state income tax for qualified withdrawals. About half of the states allow their residents a state income tax deduction for some or all of a contribution to an in-state 529 account, but not for contributions to an out-of-state account. If an out-of-state investment seems attractive, the client might consider funding an in-state 529 account to the maximum deductible amount and putting any further contributions into an out-of-state account. A client in a state that taxes qualified withdrawals from out-of-state 529 accounts should consider rolling an out-of-state 529 account into an in-state account before withdrawals begin to avoid these taxes. (To learn more about plan details, go to www.savingforcollege.com/529_plan_details .)

Calculation of Weighted-Average Morningstar Ratings Using Connecticut’s Age-Based Option Newborn (.60*4 stars) + (.075*4 stars) + (.0625*4 stars) + (.075*3 stars) + (.1875*3 stars) = 3.74 stars Age 6 (.52*4 stars) + (.065*4 stars) + (.0875*4 stars) + (.065*3 stars) + (.2625*3 stars) = 3.67 stars Age 12 (.32*4 stars) + (.04*4 stars) + (.15*4 stars) + (.04*3 stars) + (.45*3 stars) = 3.51 stars Age 18 (16/55*4 stars) + (2/55*4 stars) + (8.75/55*4 stars) + (2/55*3 stars) + (26.25/55*3 stars) = 3.49 stars Overall [(100*3.74) + (100*3.67) + (100*3.51) + (55*3.49)] = 3.62 stars [(100 + 100 + 100 + 55)]

A VALUABLE COMPARISON TECHNIQUE
For many 529 account owners, the advantages of investing in an out-of-state 529 plan outweigh the possible disadvantages. An out-of-state plan may provide diversification benefits, be better-suited to an account owner’s investment style and be more compatible with an owner’s non-529 investments. Clients who invest in an out-of-state 529 plan, regardless of the reason, share a common goal: obtaining good investment performance at a fair expense. The weighted-average Morningstar ratings and expense figures in the online exhibit can help CPAs and their clients identify the 529 plans that will allow them to achieve this goal.

Most 529 account owners are investing for the long term and, as part of their overall decision-making process, would find it useful to compare the long-term performance history of various 529 plans. Because of the newness of most 529 plans, long-term performance measures are not commonly available. Until they are, using the procedure outlined in this article to determine weighted-average Morningstar ratings for a 529 plan’s portfolio options is a good alternative.