Michelle Singletary, a Washington Post writer, reviewed a Morningstar report titled “Which States Have the Best College-Savings Plans?” In the report, Morningstar released its 2018 rankings of the best and worst 529 college savings plans. I find it curious that Michelle would quote Morningstar on the performance of sixty-two 529 plans (representing 95% of the estimated $300 billion in 529 plans) nationwide. Why? Compare it to letting the fox watch the henhouse. Morningstar makes money primarily from the mutual fund industry. If Morningstar can encourage more people to invest in mutual funds (or simply invest more money if they already have money invested) then the better off Morningstar becomes.

Morningstar also makes money by having more money under management themselves. Michelle goes on to quote Steve Wordell, Morningstar’s head of behavioral science. She repeats, “We estimate that families leave over $200 billion on the table by not using 529’s for college savings”. The biased, behavioral scientist’s message is an emotional hook to the average consumer indicating to the public that they are missing out on any chance of tax savings when they send their kid to college without using a 529 plan. 529 plans primarily invest in mutual funds which indirectly or possibly directly pads Morningstar’s pocket. One might also ask why Morningstar has a behavioral scientist in the first place if they are neutral on managing money (which they are not) and only evaluate mutual fund performance.

Besides having the “the fox watch the henhouse,” there are several items of misleading information in her article.

FUZZY MATH

According to the Morningstar report, “Families could save 25% less and still have the same amount of money available when their child is ready for college….” WOW, what kind of calculator do you use to arrive at that statement? At best, the math is an appalling stretch. Who gives the families the extra 25%? If they are suggesting that all families in the 25% tax bracket are going to religiously take their tax savings and apply it to the cost of college, they are yet again pitching a sales ploy to get people to put more money into college savings plans.

Another part of the fuzzy math here is the 25% figure should only be based on the tax savings on the gains achieved from the investments. So, the math is flat out wrong because having an extra 25% does not represent the non-deductible amount saved or the amount you would contribute to a 529 college savings plan. Stating to the 529 plan investor that they can save “25% less and still have the same amount of money” is VERY misleading. 

Other Factors to Consider When Investing in 529 College Plans

529 college plans

Besides the factors mentioned above one should consider several other items when investing in 529 plans as follows: 

  1. Risk.  
  2. Expenses
  3. Diversification by asset class
  4. Manager diversification
  5. Advisors interest in 529 plans
  6. Tax savings

Morningstar rated the sixty-two state 529 college savings plan based on “low fees, exceptional investment options, strong state oversight and a good asset-allocation approach for the popular age-based portfolios.” These portfolios invest more aggressively when beneficiaries are younger, increasingly moving to more conservative options as the child gets closer to attending college.” Morningstar’s rating system awarded plans either a gold, silver, bronze, neutral, or negative rating based on the above criteria. Four plans received gold, nine got silver, eighteen bronze, 26 neutral, and 5 plans got a negative rating. I can only imagine the extra money that is now flowing into the four plans that got a gold rating.

So, let’s evaluate 529 college savings plans based on the six criteria stated above. You should consider these criteria before deciding if a 529 plan is right for you.

1. Risk

While it is apparent that Michelle is a fan of 529 plans, one might find it interesting to note that she described her own roller coaster experience using 529 plans for her own children in a previous article. Risk is equivalent to volatility and investing in 529 plans and the underlying mutual funds are certainly capable of giving you a roller coaster ride.

Most 529 college savings plans are invested in mutual funds. The mutual funds invest in stocks and bonds traded on the various exchanges. No one will dispute that there is significantly more risk investing in stocks and bonds than there is in CDs or treasury instruments. The stock and bond markets consistently go up and down over time. However, over time, bonds and stocks have outperformed CDs or short- term treasuries. If stocks and bonds outperform over time, why should you even consider CDs or treasuries over stocks and bond mutual funds? Let me give you a few reasons. 

a. First

Let’s say you had a student starting college in 2008 after 9-11. Whatever money you had invested in stocks or stock mutual funds at that time could have lost almost 40% of its value. 

b. Second

One should especially consider the risk when withdrawing money at a time (ie. years like 2008) when your student starts school and you have lost money in the market. Over the following four-year period of your student’s educational expense would make it extremely difficult to recover your previous gains or for that matter, some of your lost contributions. If you were left with only 60% of your money when you would typically use 25% of the value before the loss to help offset your student’s college expenses that year of school would deplete the 529 college savings plan that much faster. The market would have to have enormous returns in order for you to get back what you lost with less principal to work with in the plan. 

c. Third

Finally, and certainly not the least important risk to consider, is the loss of one of the reasons you buy a 529 plan: tax savings. If the market retreats and you end up with very little in the way of gains, your tax savings component will be severely diminished. Not to mention, it could potentially erode need-based funds (free money) you could receive, based on your EFC (expected family contribution) from the government or the university of choice. Under FAFSA, 529 savings plans add just under 6% of the value of your 529 account value to your family’s EFC thus potentially reducing the amount of free aid a family could receive.

2. Expenses

Morningstar does use cost evaluation as a component of its rankings of 529 college savings plans. Anyone considering a 529 plan should ask or research the 529 plan for the expenses related to plans they are comparing. The higher the cost, the lower amount of money you will have in your 529 plan, should you decide to use one.

3. Diversification of asset class

529 college plans

Diversifying by asset class before needing the funds is an important strategy. Asset classes would include the following: Bonds (US or foreign), large cap stocks, mid cap stocks, small cap stocks, international stocks, and alternative asset classes like real estate stocks. One way to evaluate a 529 plan is to consider whether they offer as many of these asset classes as possible. It is the prudent investor that diversifies by asset class. To give an example, portfolios with international stocks overtime reduce risk (measured by volatility) and increases returns when combined with other asset classes.

4. Manager diversification

Typically, a sponsoring state 529 plan will choose one mutual fund management company. This is another risk you should consider because no one manager outperforms the market consistently over any length of time. It is a proven statistic that a manager who makes it into the top 25% of his asset class will not continue to be ranked in the top 25% over a five-year period. Therefore, a prudent investor will look to diversify across several different money managers.

It is also true that more money pours into funds ranked with five stars by Morningstar for performance. This is a financial boom to the money manager who make the cut because lucrative amounts of money follow the Morningstar rankings. Seriously consider that higher risk usually means higher returns. Because of this, managers wanting to hit the top quartile of returns are going to take higher risks to get more money flowing into their mutual funds. More assets under management means more money to the money manager. This higher risk profile should be weighed against the knowledge that it is highly unlikely that the manager will be able to repeat the performance going forward.

5. Advisor interests in recommending 529 plans

Brokers who recommend 529 plans typically recommend 529 college savings plans that they can get paid for. As mentioned in #2 above, the greater the expense, the lower accumulation you will have in the end. You should make sure your broker or advisor is bringing added value to your choices if you’re going to be paying them. This could include making recommendations as to asset class or manager diversification as noted above.

6. Tax savings

Most people who start a 529 plan don’t have a big lump sum to dump into a college savings plan at the beginning. They have to contribute monthly to their plans. Why is this important? It means that the money you contribute today (vs. tomorrow or down the road) has the greatest chance to produce the greatest return. Look at the following numbers: $100 invested for 10 years compounded at 8% turns into $215.89 whereas, $100 invested for 1 year compounded at 8% turns into $108. Therefore, to take advantage of the tax savings component of a 529 plan, you should front load it. Get as much money in it as early as possible, giving the early money the greatest chance for gain over time. The greater the gain, the more tax savings you’ll reap when the funds are used for qualified college expenses.

Though the tax savings component sounds enticing, make sure you do the math to calculate which would be greater: your tax savings vs. investing your college savings someplace where it doesn’t count against you in qualifying for free money from the government or university. This should also be weighed against the risks of a downside market when you need the money to pay for college expenses. 

Another consideration!

Recent legislation allows you to use 529 funds to pay for private K through 12 education. It seems to me that unless you dumped a ton of money into a 529 plan, there wouldn’t be time to generate much in gains before you needed the money to pay for private K through 12 school tuition. That recent change allowing families to use 529 money for private K through 12 tuition doesn’t make a lot of sense to me. Maybe it is another emotional hook to get people to put more money into mutual funds!

In any case, if you are considering a 529 college savings plan, you should seriously consider the above factors before deciding whether a 529 college savings plan is right for you. It’s not just about whether the 529 plan received a gold, silver, bronze or other ranking from Morningstar. Make sure to do your own research! Consider more than just Michele’s recommendations or the Morningstar rankings.

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