Today's Lesson: Consolidation

For the little commissions they generate, 529 plans have required quite a lot of effort on the part of financial advisors. When the business got started nearly a decade ago, states contracted with money managers to administer the tax-free investment programs. By 2002, there were plans sponsored by all the states except Washington, which does not have a savings plan (just a prepaid offering). Today there are 80 money managers offering 529 options, each with its own investment options, managers and fees.

The bad news for some managers is that a shakeout, which will force some vendors out of the business and leave a landscape with fewer but stronger plan marketers, is unfolding. That's good news for advisors, who can now quickly narrow the choices for their clients.

As in any industry consolidation, a handful of dominant companies is emerging. Plans with large marketing machines behind them, brand familiarity in the broker/dealer world and those that have managed to get the business of several states are emerging as the heavy hitters who are positioned to survive. The top 10 players in the 529 marketplace control nearly 80 percent of the assets invested in these college savings plans — $47.7 billion out of approximately $59.1 billion. A common trait among these successful managers is getting shelf space on b/d platforms, the largest channel through which 529 plans are sold. “This really is a distribution story,” says Bruce Harrington, vice president and director of product development at MFS. “529 plans are sold not bought.”

Advisors have handled about 82 percent of all investments made into 529 plans this year, according to Financial Research Corp. (FRC). That's up from 75 percent in 2003, and a little more than 60 percent in 2004, says FRC. “There's a fair number of clients who would never invest in a 529 plan unless it were offered through a broker,” says Joe Hurley, founder of Savingforcollege.com, a Web site and seminar business meant to educate both consumers and advisors on the 529 industry.

Many plans that came to the game late — or failed to get the attention of the broker community — are finding it harder now to grab a profitable slice of the pie. More importantly, brokers themselves are steering clients away from the smaller plans, concerned that they may not be around for the duration.

Concerns about the survivability of smaller players are well founded. The larger plans can more efficiently support the small account balances normal for such a nascent industry. With the average balance in a 529 plan just $9,209, according to the FRC, there's very little profit to be made as of yet. More established money management firms like American Funds and Alliance Capital are accustomed to dealing with small investors with mass-market mutual funds. Smaller firms may not have the wherewithal.

How the Top Survive

The biggest money manager in the 529 game, not surprisingly, is also one of the top mutual fund companies. American Funds, the Santa Ana, Calif., giant with $600 billion under management, has more than $11 billion in 529s. American manages the Virginia state plan, and remains a perennial favorite among brokers. “American Funds is selling an incredible share of mutual fund shares,” says Chuck Toth, director of the education savings program at Merrill Lynch, and an executive committee member of the College Savings Foundation, a nonprofit group whose members are firms that sell 529 plans. “So when you look at their spot in the 529 plan industry, you would expect that level of participation. They get good market share in mutual funds, so it makes sense they would get a good share with 529 plans.”

The other big names in 529s include Fidelity, Merrill Lynch, Putnam and T. Rowe Price (see table, p. 136). The No. 2 is not a money management veteran, though. It's Upromise, a four-year-old company that got into education savings through a program that lets consumers earn college-funding money when they make purchases at certain vendors. The actual money management of the Upromise program (now in five states) is subadvised by Vanguard, the index-fund giant.

At this point, it's worth asking why smaller players thought that they had a shot at the 529 business. States began offering tax-advantaged, college savings accounts in the 1980s, but in 1996, the bill establishing Section 529 of the Internal Revenue code, which set up rules for establishing tax-deferred college savings plans, passed Congress. By 2002, there were plans in all the states (except for Washington), and in 2001 and 2002, Congress sweetened the incentives, making distributions tax-free and loosening rules on how 529 funds can be used, for example, by extending the type of family members (nieces, nephews) who could be beneficiaries.

Overnight, the 529 business began to mushroom and some small firms saw this as an opening. They believed a new savings vehicle might lure new money to the investment table — from consumers who had not been mutual fund investors before. These managers figured that if they got in early, they could compete with fund giants like American and Alliance.

“It was almost a land grab,” says MFS' Harrington. “Everyone scrambled to get a relationship with a state. But you need a certain level of scale to get profitable.”

Smaller plans may now be running out of time. Brian Boswell, a research analyst with FRC, believes Calvert, which manages the Washington, D.C., plan with $48 million in assets, may drop out completely. Laurent Ross, manager of the college savings program with Calvert, says that the firm is definitely not going to look for additional states to run, but is instead looking to grow its 529 business by subadvising funds for other fund companies. “Client servicing is too much work,” he says.

Mercury, a subsidiary of Merrill Lynch, may be trying to drop its management of Wyoming's plan completely — and with the state's blessing, according to Wyoming's State Treasurer Cynthia Lummis. Instead, Wyoming is considering merging its state plan with another state plan to increase the total assets in a combined plan. “Mercury Funds would like to get out of the contract,” Lummis says. “We feel the fees are too high.” Nothing will be done before Wyoming's legislature meets again in February 2006. A spokeswoman from Merrill Lynch declined to comment. Merrill wouldn't be alone: State Street got out of its 529 contracts with New Mexico and Oregon in 2004, says Hurley. Oppenheimer now manages both of those plans.

Overhead Eating Profits

The 529 business has not proved to be an easy entry-point for ambitious money managers. These accounts bring special problems, including the need for extensive customer service, and they have structural limitations. For example, contributions are limited to $55,000 per account every five years. The maximum that can be placed in a 529 account differs — some allow more than $300,000, for example. Still, most clients don't come close to those numbers, creating an ocean of small-fry investors. Merrill Lynch's NextGen Program, sponsored by the state of Maine, has the largest average account balance — $19,947. Oppenheimer's Oregon College Savings Plan has an average balance of $6,626.

On top of the small account sizes, plan managers also face the demands of the states that sponsor the programs. The states often seek additional contract fees. And the marketing arrangements between the states and the managers are often costlier than with a traditional mutual fund sold through a b/d. Indeed, the mutual fund industry rarely passes on those fees (at least not directly) to the consumer. But in 529 plans, it is not uncommon for consumers to get hit with extra basis points to cover state fees. Large money managers can eat some of that cost and keep their fees low for the consumer. But smaller firms have less of a cushion and end up having to pass the cost along, making them less attractive to an advisor trying to find a good deal for his client.

As state contracts come up for renewal, managers can be fired. Significant changes have occurred in about a dozen states because of poor performance, or firms not seeing a working business model for them. With consumers reading stories of high fees and concerns over disclosures in 529 plans, more weak performers may be forced out.

Brokers who recommend 529 plans are paying attention: Nobody wants to put a client's funds with a manager that is likely to disappear. “You do worry that the newer players are going to want to keep doing this for the long run,” says Lynne Sebastian, a vice president in investments with UBS, who wants to make sure that her clients with young children can look forward to a long relationship with the plan she puts them in. As FRC's Boswell says: “It's hard to believe that some of the programs with smaller accounts will stay in the industry.”

Trying Other Tactics

Brokers, of course, have a role to play in deciding which plans thrive. So, how do they choose which 529s to sell their clients? There are a lot of factors, including performance and price. But, in this product category, little things mean a lot. Brokers say they like plans that offer features like calculators on Web sites to help clients project investment returns. They like vendors that supply prompt and accurate telephone support for reps. That group, says Hurley of Savingforcollege.com, includes John Hancock, which has its funds in the Arkansas state plan. MFS, also highly regarded by brokers, offers outreach educational calls to advisors that sell their brand. A recent telephone seminar, “Advanced College Funding,” had 200 advisors calling in, says Harrington. And the firm is planning other call-in seminars for later this fall to tutor advisors on using the 529 plans in estate planning, an increasingly popular technique.

As with other categories of financial products, there are too many permutations for most reps to really master — they will invest the time to learn about a handful and then stick to those products for years. “The typical advisor only works with three to five mutual fund firms,” says Harrington. UBS' Sebastian concurs. She has access to 15 plans on her platform, but tends to sell the three that she likes best: Alliance Capital, which was an early mover into the space; John Hancock; and American Funds. She likes American Funds, she says, because she can choose her own asset allocation, rather than locking into age-based formulas.

“It's very competitive to get shelf space with brokers,” says Hurley. “You also have to make it easy for them to understand your product so they can sell them.”

That applies to the states, too, as they shop for plan administrators. Brands that are familiar and have more longevity in the investment space tend to do well, Hurley says. “The states like having a sizeable organization that already has a reputation in the 529 field,” he says.

While consolidation may eventually make the broker's life easier, the process of winnowing out weak players may take years. In the meantime, it behooves advisors to keep a sharp eye on not only how a plan performs and how easy it is for them to understand, but also how it is faring in the war of attrition. “What you're really looking for is consistency,” says Sebastian. “After all, this money is earmarked for college funds. And you want to know it's going to be there for the client.” That's what the client is paying for.