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Gunning for College

College savings plans are getting the hairy eyeball from regulators: It's one of those things that was so easy to predict, it could hardly have surprised anyone. Indeed, the way scandals have piled up over the last year or so, it seems, at times, the regulators are just working their way down a list of investment products. Investment banking? Check. Stocks? Check. Mutual funds? Check. Annuities? Check.

College savings plans are getting the hairy eyeball from regulators: It's one of those things that was so easy to predict, it could hardly have surprised anyone.

Indeed, the way scandals have piled up over the last year or so, it seems, at times, the regulators are just working their way down a list of investment products. Investment banking? Check. Stocks? Check. Mutual funds? Check. Annuities? Check.

Now they've arrived at the complex college saving vehicles known as 529 plans, and early indications are that abuses in the patchwork system of state-sponsored programs are widespread.

Trouble is, the lack of jurisdictional definition has so far kept regulators from making any sweeping changes to the status quo. This leaves financial advisors who sell the products in a precarious situation. Should they keep selling 529s as they always have? Should they modify their habits based on preliminary signals the enforcers are sending? Or should they swear off 529s altogether until the final verdict is handed down?

Careful as You Go

For starters, most advisors are taking special care when discussing the plans with clients. At worst, some are considering stepping back (at least temporarily) from 529 programs, which let consumers save for college tuition by investing in a pool of mutual funds that are managed by a third party.

The plans were introduced about seven years ago, but total assets in the accounts have mushroomed in recent years. In 2003, there were $35.1 billion in assets in more than 80 plans, up from just $2.5 billion in 2000, according to Financial Research Corp., a market research firm in Boston.

This uptick has played no small role in the regulators' interest in 529 plans. As more investors put their faith in the plans, the stakes rise for those who are supposed to be protecting them, and agencies like the NASD and the SEC have jumped into the fray with gusto.

In March, the NASD revealed it had launched a hush-hush investigation the summer before into the practices of six national brokerage firms that sell 529 plans. Since then, the number of companies under investigation has increased to 20. About the same time, in response to a request by House Financial Services Committee Chairman Michael Oxley, the SEC announced it was forming a task force on 529 plans. Over the summer, the Congressman held hearings on the subject and came out with a new set of recommendations for the SEC. (So far, the SEC task force isn't giving out any hints about when its work might be done.) And, in late September, Sen. Peter Fitzgerald (R-Ill.), a major force in the mutual fund investigations, held his own hearing on the plans.

Unfortunately, the somewhat murky regulatory status of the plans has made the current investigatory efforts even more unwieldy than they might have been otherwise. Indeed, a number of agencies can potentially claim to regulate parts of the plans. Technically, they fall under the jurisdiction of the Municipal Securities Rulemaking Board. At the same time, the SEC, under anti-fraud provisions of the Federal Securities Act, can stop b/ds from selling 529 plans. Further, it has authority over the underlying mutual funds. Meanwhile, the NASD oversees the activities of reps selling the plans.

Abuses? What Abuses?

For the NASD, the primary issue is the suitability of the investments that advisors are recommending. About half of all states give residents a tax deduction if they invest in a plan run by their home state. But, according to NASD Vice Chairman Mary Schapiro, reps in the firms under investigation might have steered clients to other plans without adequately explaining the forfeited tax deduction. About 90 percent of 529 plan sales at these companies have come from plans not run by clients' home states. The presumption (or fear) is that reps are favoring out-of-state plans in order to ensure they would collect a fee (many plans in states that give tax deductions are direct-sold or not offered by those firms).

What changes the investigations will engender are unclear for now. Schapiro makes it clear the efforts are at an early stage, because the agency is still examining the documents they've gathered from the firms under investigation. She has declined to predict whether she will take further action although, in September, the agency issued an investor alert warning consumers to be wary of brokers who might try to steer them into the wrong plans.

“We can't tell if there will be any enforcement cases,” she says.

Still, Schapiro, who says she has opened 529 plans to save for her own children's education, has nothing but praise for the concept. “They're a wonderful product, a tremendous tool for people trying to save for college,” she says.

Oxley's hearings and the SEC task force have focused on what they see as exorbitantly high fees. Under current legislation, investors don't pay taxes on earnings or on qualified 529 withdrawals. But, according to a letter made public late last winter from SEC Chairman William Donaldson, high fees on the front end can significantly erode those tax advantages.

Critics contend that plans include a dizzying variety of expenses, including fees for the advisor, the state administrator and program manager — plus enrollment and annual maintenance fees. There are also asset-based expenses on the programs' underlying funds, which can range from less than half a percent to more than 2 percent for A shares, according to Dan McNeela, a senior analyst with Morningstar, who testified at Oxley's hearing. Plus, it's possible for investors to have money in the same plan, but pay different fees at different times. Since fees are based on the underlying funds cost, bond funds are cheaper than stock funds, for example. As a result, when the asset allocations change (as a child gets closer to college age), so will asset-based fees.

All this boils down to one big disclosure nightmare, and sorting it out seems to be a priority for the regulators taking aim at 529s.

Disclosure Discussion

Regulators specifically worry about the lack of uniform disclosure documents. Current 529 information seldom explains expenses clearly, and the lack of a standard for presenting that information makes it all the more difficult to understand. It also makes it easier for unscrupulous advisors to bamboozle their clients.

“Fees are generally buried at the back of a long program disclosure document,” says McNeela. “But only when you add up all these fees can you get a clear picture of what it's costing.”

But regulators are worried about other matters as well. In June, the MSRB called for comments on proposed rules regarding performance claims made in 529 promotional material. Final comments were due Sept. 15, and the last board meeting will be held in November. In September, Sen. Fitzgerald also held hearings, which arrived at similar conclusions — that 529 fees can potentially eliminate any tax savings.

“Too many middlemen, including state bureaucrats, are feeding off the trough,” he said in a statement, comparing the abuses to those in the mutual fund industry.

Not everyone sees what the fuss over fees is about.

“While some plans are way out there, most are generally in line with the norm,” says the head of 529 plans for one program provider.

The 5 to 15 basis points that states usually charge often is used solely for covering 529-related costs. “It doesn't generally generate revenue for the state,” says Whitney Dow, director of educational savings research at the FRC.

Some plans with the highest charges have lowered their fees over the past year, and, according to Dow, expenses are likely to come down industrywide as more plans become profitable.

There's more consensus on the issue of disclosure. Well before regulators started making noises about the matter, some insiders were pushing for increased standardization. Over a year ago, for example, the College Savings Plans Network, part of the National Association of State Treasurers, formed a committee to create guidelines for uniform documentation. Last May, it finalized a draft, which was submitted to the SEC to serve as an industry model. Those efforts are now aimed at convincing the industry to adopt the guidelines voluntarily, before regulators come up with something else.

“The industry is very interested in self-regulating,” says Bruce Harrington, vice president and director of product development and marketing at MFS Investment Management in Boston.

The Need for Education

Some industry analysts and participants express at least some skepticism about the regulators' involvement. For one thing, some suspect the regulators did not fully appreciate the intricacies of the 529 marketplace when they first got started.

“There's an inherent complexity when every state is going to design their own 529,” says Joe Hurley, the founder of, a 529 information resource. “I don't think they understood that originally.”

Others doubt that advisors would bother to steer clients away from state plans providing tax deductions, just to be able to get the business for themselves. Despite the large amount of total assets in 529 plans, the average individual balance is only about $8,000, and plan assets typically make up less than 5 percent of an advisor's total.

“Why would an advisor want to risk losing a client for such a small amount of money,” says Luis Fleites, senior analyst with Cerulli Associates, a market research firm in Boston.

A number of b/ds and wirehouses have started responding to the scrutiny. Notably, Merrill Lynch, which originally allowed advisors to sell only the company's Maine-based plan, recently added five others, including three in states that provide a tax deduction to residents investing in the plan. Wachovia, which asks clients to sign a disclosure form stating that they understand the tax implications of not investing in their state's 529 plan, says it's giving the document another look. The firm also recently introduced a 529 guide for investors on its Web site, discussing taxation issues, among others.

Advice to Advisors

Given all this, what should advisors do? Most reps tend to familiarize themselves with anywhere from three to five plans, according to Harrington. But they may not always understand all the intricacies of the fees and expenses and how they compare to other plans. One of the best things a rep can do to avoid trouble is to do his homework. It's not enough to rely on the due diligence done by a b/d.

“Your feet are going to be held to the fire if they audit you, and they want to know why you're recommending these things,” says Fred Siegel, who runs the Siegel Group in New Orleans.

Christopher Gullotti, a financial advisor with Canby Financial Advisors in Framingham, Mass., for example, follows the recommendations of Commonwealth Financial Network, his b/d. But he also does extensive digging on his own, on occasion calling appropriate state treasurers' offices to get answers to questions.

What's more, advisors also should get to know the workings of appropriate state plans. That includes whatever plans exist in states in which their clients reside, if those states give a tax deduction to investors. If most clients are in one state, of course, that's an easy process — especially if, like Thomas Jones, a partner with McConnell Jones Lanier & Murphy, a financial advisory firm in Houston, the rep is in a state that doesn't have a tax deduction.

On the other hand, about six of the 28 states Siegel's clients reside in have deductions. He has an assistant research each state plan before he decides which option is the best choice.

“If a broker recommends an outside plan, they better have a very good reason,” he says. At the same time, investing in a state plan simply because of a tax deduction often turns out not to be the wisest move.

“Just because a state has a state tax advantage doesn't mean it's the best plan,” says Fleites. That's because, especially in states with low income tax rates or limits on the amount eligible for a deduction, the total tax savings may not come to a lot of money. In Illinois, for example, with a top income tax rate of 3 percent, the most any client would save would be $300, according to William Raynor, first vice president and director of education savings and sales for AIM Investments. Most advisors say the deduction should be just one component in the planning process, along with size of fees, the reputation of program managers and performance history.

The tax issue is even more complex for advisors in certain states, like New York, where residents who transfer funds from the plan into another out-of-state option have to pay back the tax deduction they previously received.

Although married couples filing jointly can get deductions for contributions of $10,000 a year, “I would never recommend that a client with young children put themselves in a box for that long,” says Edward Neugroschl, an advisor with Finesco Associates in Brewster, N.Y.

Even so, some analysts speculate that advisors, fearing regulatory scrutiny, may feel forced to make the wrong choice.

“I think this will put pressure on the financial advisor to put the client automatically in a state plan that isn't really the best choice for him,” says a 529 specialist at one b/d.

Thanks, I'll Wait

Already, there are signs that the regulatory attention is discouraging advisors from entering the 529 marketplace. Even before the investigations, understanding the workings of 529 plans took a lot of work. Now some advisors are wondering whether it's worth the effort. For most reps, 529 sales are a door-opener or a value-added service, not a big moneymaker.

Keith Snyder, an advisor with Personal Financial Management, in Redding, Pa., for example, recently attended a 529 seminar held by, to learn more about the plans. His firm has been considering making a bigger push into 529s, but, thanks to the NASD investigation, he says, “It makes me a little hesitant to get in too deep. Will we get in trouble if we end up recommending the wrong one? To make sure we don't, is that a full-time job?”

It's certainly possible some big changes are in the offing. In his final recommendations to the SEC, Congressman Oxley specifically included a suggestion that the SEC increase its regulatory powers over 529 plans. At Sen. Fitzgerald's hearing, there were questions raised about whether the plans should be federalized.

Then there's the tax parity question — the idea that it's unfair for some states only to give deductions to residents who invest in their plans, and not in plans outside the state, creating an uneven playing field. Oxley, for his part, suggested changing the 529 code so that qualified plans would include only those that “don't discriminate against out-of-state investors.”

While waiting for all the regulators to finish their investigating, however, the best advisors can do is continue their research, maintain good records and keep their noses clean — until the next investigation rears it head.


Year-to-year growth in total assets invested in 529 plans has been nothing short of explosive, one reason why regulators have started to pay attention to the programs.

Year Assets
2000 $2.5 billion
2001 9.2 billion
2002 19.2 billion
2003 35.1 billion
Source: Financial Research Corp.

State deductions

The following 25 states, plus the District of Columbia, provide tax benefits to residents who invest in their 529 plans. Like most everything else that pertains to 529s, the specifics vary, literally, all over the map.

State Maximum Deduction
Colorado Contributions are fully deductible
District of Columbia $3,000 for single filers, $6,000 married couples filing jointly
Georgia $2,000
Idaho $4,000 single filers, $8,000 joint filers
Illinois Contributions are fully deductible; $10,000, as of 2005
Iowa $2,290
Kansas $2,000 single filers, $4,000 joint filers
Louisiana $2,400
Maryland $2,500
Michigan $5,000 single filers, $10,000 joint filers
Mississippi $10,000 single filers, $20,000 joint filers
Missouri $8,000
Montana $3,000 single filers, $6,000 joint filers
Nebraska $1,000
New Mexico Contributions are fully deductible
New York $5,000 for single filers, $10,000 joint filers
Ohio $2,000
Oklahoma $2,500
Oregon $2,000
Rhode Island $500 single filers, $1,000 joint filers
South Carolina Contributions are fully deductible
Utah $1,410 for single filers, $2,820 joint filers
Vermont Credit of 5% of up to $2,000 in contributions
Virginia $2,000, unlimited for contributors 70 years and older
West Virginia Contributions are fully deductible
Wisconsin $3,000
Source:, Morningstar
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