529 plans begin to employ sophisticated asset management

Like the customers they are designed for, college savings plans are growing up.

The largest 529 plans had $193 billion as of Nov. 30, according to new research by Chicago-based Morningstar Inc. for 63 plans that represent 98% of the market. That is up from $166 billion in 2012, when plan assets grew by 25%.

The numbers represent plans sold directly and through advisers, but do not include prepaid college-tuition plans. While 529 plans have higher expense ratios than similar mutual funds, the tax benefits for investors close much of the gap.

The pace of growth is attracting more interest from money managers, while the dollar amounts are leading some asset owners to think more creatively about their investment options, and to rely more on professionals for help.

“It's gone from a big focus on how to sell them to "let's get the investment part of right,'” said Jeremy Thiessen, managing director of Pension Consulting Alliance Inc. in Portland, Ore., who works with 10 states and 20 college savings programs. He sees more knowledgeable 529 plan board members getting more involved in hiring investment expertise, including consultants.

Like their public pension fund counterparts, “boards are starting to recognize the benefit of outside investment expertise from a governance perspective,” said Andrea Feirstein, managing director of AKF Consulting Group in New York, which advises state 529 plan administrators on plan design and structure. “We see more investment consulting engagements enhancing the 529 boards' important decisions.”

The increased sophistication can cut both ways, noted Laura Lutton, director of Morningstar's funds of funds research. “I think the states feel more empowered with the advice of the investment consultant to come back on underperforming options. Most states have investment consultants who come in to scrub, or are on retainer. We think that's a good trend because it's good to have an extra set of eyes,” said Ms. Lutton, whose firm evaluates and rates 529 plan managers each year (see sidebar on Page 14).

Today, top 529 managers include T. Rowe Price Group Inc., TIAA-CREF, Vanguard Group Inc. and American Funds.

According to Morningstar, two of the top-rated plans are Alaska's $2.2 billion plan and Maryland's $3.8 billion plan, both managed by T. Rowe Price. The other two top-rated plans are Nevada's $9.1 billion plan, managed by Upromise Investments Inc., and the internally managed $6.5 billion Utah Educational Savings Plan. All four are sold directly to consumers.

In direct-sold plans, which rely more on index funds, “when an active manager performs, you automatically leapfrog ahead,” said Tom Kazmierczak, head of retirement and college products and vice president at T. Rowe Price in Baltimore. “Some of the state treasurers want the lowest cost; others think about what is best net-of-fees performance,” said Mr. Kazmierczak.

At T. Rowe Price, where 529 managers rely heavily on the firm's internal asset allocation committee, the past year has brought increases in international exposure and holdings in real assets. Michael Conrath, 529 program director at J.P. Morgan Asset Management, agrees. He sees movement “away from plain vanilla, especially fixed income, and toward considering emerging markets, high yield, inflation protection. We think this is the right way to invest. It's a trend we're starting to see more and more, especially adviser-sold.”

John Heywood, principal with Vanguard Group's retail investor group in Valley Forge, Pa., and head of the education savings group, said the firm has made changes to fund lineups only around the edges so far.

But “we are talking with a number of state plans about including our global non-U.S. bond fund, designed to reduce risk,” he said. While the 529 plan board members are not ready to talk about alternatives, “there is certainly a lot of interest. It depends on how (the inclusion of alternatives) goes in the defined contribution space. A lot of what happens in the investment world spills over into the 529 world,” said Mr. Heywood. Relationships and performance also carry weight with institutional buyers, he noted.

At least half of the dollars are now going to age-based programs, including target-date strategies, “which are a natural evolution to 529s,” said Mr. Thiessen of PCA. One of the newest 529 entrants is J.P. Morgan Asset Management, which in 2012 decided that its solid footing in the target-date space made it the right time to get in, said Mr. Conrath of J.P. Morgan Asset Management, where 529 assets have grown to $2.8 billion from $1.9 billion in less than two years through the plan.

The next challenge will be more dynamic asset classes within target date strategies, said Mr. Thiessen. “As you roll down the age-based path, they need to be set up to include subasset classes that will deal with risk, either interest rate or inflation risk.

“I think there are a lot of good shops working on that now, on how do we put those in and not make it too complex or drive up costs,” he said.

American Funds' $43 billion CollegeAmerica 529 Savings Plan program in Richmond, Va. — the largest 529 plan — sees growth in employer-sponsored 529 plans, which are gaining in popularity, said spokesman Chuck Freadhoff, spokesman for the 529 plan manager, Capital Group of Companies Inc. in Los Angeles.

“I think the employer understands, or advisers are helping employers understand, that employees need a holistic approach” to investing, similar to retirement savings, he said.

The recent market growth is also bringing downward pressure on fees, which suffer in comparison to mutual funds. “A lot of it is scale, and part of it is competitive pressure,” said Mr. Kazmierczak of T. Rowe Price. “We are constantly looking at our fee structure.”

Despite the pressure on fees and the complexity of dealing with 50 states' tax incentives and investment goals, solid growth is expected, especially as more investment advisers are convinced of the value of 529 plans for their clients.

“I think the dynamic is changing,” said Mr. Conrath of J.P. Morgan.“It's not a mature market, and trying to think of new ways to approach it has been well received. The investment piece is where there is still the biggest opportunity to evolve.”