Et Tu, 529 Plans

Just when you thought the news couldn't possibly get worse, it has. Both the NASD and the SEC have revealed they are separately investigating yet another area within the financial services sector: 529 college savings plans. The state-sponsored, tax-advantaged college savings programs have been around since 1997, so why the trouble now? For starters, 529s have now finally gathered enough critical mass

Just when you thought the news couldn't possibly get worse, it has. Both the NASD and the SEC have revealed they are separately investigating yet another area within the financial services sector: 529 college savings plans.

The state-sponsored, tax-advantaged college savings programs have been around since 1997, so why the trouble now? For starters, 529s have now finally gathered enough critical mass to attract regulators' attention. There are about 70 plans in existence with more than $35 billion in assets at the end of 2003, up 85 percent from the year before, according to Cerulli Associates.

In early March, the NASD disclosed a formerly secretive investigation, begun last summer, into six large securities firms that sell 529 plans. (The agency declines to reveal the names of the firms.) The overarching concern, according to an NASD spokesman, is that firms have been selling plans sponsored by states other than the clients' home states without explaining the sizeable tax deduction those customers might then forfeit. Typically, more than 90 percent of the money made from sales of programs in the firms under investigation has gone to nonresident state plans. The investigation may expand to other firms, as well.

The NASD actions were followed by a letter from SEC Chairman William Donaldson, saying the commission was forming a task force to investigate high fees in 529 plans. Investors don't pay taxes on contributions to 529 plans, nor do they pay federal or, in many cases, state taxes, on qualified withdrawals. But, according to the letter, high fees sometimes eat severely into the plans' tax benefits. In addition, different states may charge different fees for exactly the same underlying mutual fund investment. The result: Investors in one state program end up with significantly more money than those who chose another state's plan, even though the investments were identical.

Stated Interest

Bear in mind that state governments may also have a vested interest in high charges. Most states get an asset-based fee for 529 plans of anywhere from 10 to 50 basis points, depending on whether they act as the administrator or not, according to Dan McNeela, a 529 specialist and senior analyst at Morningstar.

“There is a potential conflict,” he says. “States getting sizeable cuts have reasons to have high fees, because their cuts might be bigger. It really points to the need for more disclosure, so investors know where their money is going and what they're paying for.”

Indeed, 529 disclosure documents are not only complex, they are unstandardized. Federal securities laws don't require that 529 investors receive the same periodic reporting that mutual funds must make, nor do they mandate the same quality of information. “The level of disclosure, the type of information disclosed and the manner in which the information is presented to investors varies among states and among different plans offered by the same state,” writes Donaldson. “This lack of standardization makes it difficult for parents to compare various 529 plans.”

There's more. House Financial Services Committee Chairman Michael Oxley, who had originally asked the SEC to look into 529s, may also hold hearings on the plans. They would probably take place before the summer, according to spokeswoman Peggy Peterson.

Technically, 529 plans are municipal securities under the jurisdiction of the Municipal Securities Rulemaking Board. Even so, the SEC and NASD have plenty of regulatory sway at their disposal. For example, under anti-fraud provisions of federal securities law, the SEC can stop broker/dealers from selling 529 plans. And, of course, the underlying mutual funds are regulated by the SEC.

It isn't only regulators who think something has to change. Many advisors and industry observers find the 529 landscape increasingly confusing. They point to the wide variation in asset-based expenses of the programs' underlying funds, which can range from less than half a percent to more than 2 percent, according to Morningstar's McNeela. In addition there are typically enrollment and annual maintenance fees of $10 to $50 and fees to cover administrative costs. On top of that, about 75 percent of plans are sold through advisors, and these have a crazy quilt of A, B or C loads.

Unfortunately, says McNeela, plan documents “don't always add up the costs for you, so the investor must do the math to get the total cost on his own.”

Some advisors and experts have long advocated standardizing 529 documentation. About a year ago, the College Savings Plan Network, part of the National Association of State Treasurers, created a committee to look at 529 disclosure methods and come up with guidelines for presenting information “in a way that potential investors can understand,” says Diana Cantor, executive director of the Virginia College Savings Plan and chairman of the College Savings Plan Network. She expects to announce results and recommendations at the group's annual conference in May. The group has also asked to be able to participate in the SEC's proceedings.

How Much is Too Much?

At the same time, Cantor and other observers are wary of overstandardization. Because these are state-sponsored programs, they feel, one size cannot possibly fit all. “I'm not sure you can put every 529 plan in a few standard boxes,” says Joe Hurley, a 529 expert who runs Savingforcollege.com, in Pittsford, N.Y. “These are individually crafted programs subject to individual contracts with vendors in what is, essentially, a negotiated process.”

What do the investigations mean for advisors? For now, all's quiet.

“I haven't had any feedback,” says Howard Gartenhaus, a financial advisor with Gartenhaus Financial in Rockville, Md., who says about one-quarter of his business comes from 529 plans.

Still, in the short term, according to many advisors, the moves could mean even more uncertainty — and that could discourage investor interest. “Virtually everyone who talks to me is totally confused about 529 plans,” says Randy Fox, an advisor with Wealth Strategies Counselors in Naperville, Ill. “And when there's too much confusion, people just don't want to have anything to do with it.”

What's more, Hurley fears the chaos will keep more advisors from working with 529s, despite their obvious tax benefits. In the current environment of corporate and Wall Street scandals, that's especially true if press reports emphasize the more sensationalistic aspects of the investigations.

“People will think there's just another thing that's crooked,” says Fox. And that also means the potential loss of a useful marketing tool. Sales of 529 plans account for only a small part of Fox's revenue — he's not alone there — the industry average account balance is $8,078, according to Cerulli — but they are helpful in landing and keeping clients.

Ultimately, though, if the investigations yield a more coherent disclosure system and standardization of fees, it could make the plans an easier sell for advisors.

“Purchasers will know what they're paying for and advisors will be able to more clearly explain to their clients what they're paying for,” says Tim Hoffman, a financial advisor with Raymond James in Sterling, Va. Plus, reps will be able to assess plans more easily and figure out which best suit their clients' needs.

How long it takes to reach that point, however, is anybody's guess. But expect a fair amount of confusion en route.

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