The Biggest Thing Since the 401(k)?

It has never been hard to convince parents and grandparents that they should put some money into the market now so that when that adorable little bundle from heaven is ready to get his first tattoo and body-piercing, the money will be there for him to get a decent college education, too. Congress made the sell even easier in 1996 when it approved Section 529 of the IRS code, creating college savings accounts that, like Individual Retirement Accounts, allow money to build up untaxed until distribution. Last year, Congress sweetened the deal by eliminating taxes on the withdrawals, too. And, to ice that cake, more than 20 states are giving tax breaks to residents who make 529 contributions.

A Media Darling

All this has generated so much media attention that 80 percent of parents with pre-college age children have heard of 529 plans, according to the Spectrem Group, a Chicago-based consultant specializing in retirement issues. And, according to Alliance Capital, which operates the popular Rhode Island plan, 65 percent of investors who are told about the opportunity say they would invest in a 529.

Indeed, the public knows a good deal when it sees it. At the end of 2000, about $2.5 billion in assets were parked in 529 plans. By last December, that had quadrupled to some $10 billion and, according to Cerulli Associates, the number will hit $51 billion by 2006. Inspiring those rosy projections are the new rules, in effect as of Jan. 1, which, among other things, permit donors to put aside money for more-distant relatives, such as nephews and nieces.

Todd Taskey, a planner in Bethesda, Md., was so excited by the improvements that he began dialing clients as soon as the bill passed last June to spread the news. “We bring 529s up with all of our clients,” he says. “It makes sense for most people and the negatives are so small.”

Family Ties

So, is this a bonanza for brokers and investment advisors, too? Yes and no. Yes, because there are so many variations among the 36 different plans (each is sponsored by a state and each has its own rules and choices of investments) that consumers can use the help of a knowledgeable advisor. And yes, because the advisor who helps a client solve the college-funding problem stands to get other business, too.

“It connects us to the rest of a customer's family,” says Judith McGee, who runs McGee Financial Strategies in Portland, Ore., and has built a specialty in 529 sales. “We have grandpa and grandma, and we use the 529 account to get a chance to talk to the kids.” Or, if you have the kids, 529 can be your route to the grandparents, who can use 529s as part of their estate planning. In terms of creating new sales opportunities, the 529 is “the best thing to come along since the Roth,” says Ray Jensen, a financial planner with Raymond James in Louisville, Ohio.

And the “no”? The 529 business itself does not have a lot of dollars attached. In most states, an account cannot exceed $250,000 and most will never approach that. Customers can start accounts with as little as $25 and many start with a few hundred dollars. So, while sales commissions on some plans can run as high as 5.75 percent, a broker isn't going to get rich on 529s alone. “The 529s haven't really been a gold mine by any stretch of the imagination,” says Joe Thompson, a first vice president of Morgan Keegan & Co. in Memphis, who, along with partner Charles Hardee, manages $100 million in assets.

But it is early days and Thompson has a plan: He and Hardee have begun pitching 529 plans as a corporate benefit. Think of it as stepping up from selling IRAs to 401(k)s. “It's a numbers game,” Thompson says. “Our goal is to get $1 million a month through payroll deductions,” says Thompson. He has already lined up one corporate client that brings in about $50,000 a month.

And the numbers are beginning to run in favor of advisors: About 80 percent of the assets that went into 529 plans in 2000 were placed directly by consumers, according to Cerulli. In 2001, that had dropped to only about 55 percent. By the end of 2002, the percentage of 529 money invested directly by do-it-yourselfers will decline to 40 percent, Cerulli forecasts.

One reason for the change: Sponsors have made the plans more broker-friendly. “The problem was when these things were first launched in 1998, they weren't priced in a conventional, familiar structure that brokers could understand,” says Ralph Constantino, CEO of Schoolhouse Capital, a 529 vendor. “They realized to sell these plans, they're going to have to incent the broker. Now that they have familiar loads, much like the A, B and C structure that brokers understand, sales have been spectacular.”

In fact, it helps to think of the entire 529 phenomenon like the 401(k) business — circa 1985. It started out small and the products were not terribly sophisticated. But as the market grew and there was more competition for the assets, there were more innovations and more ways to make money. And, the brokers who developed an expertise in 401(k) plans reaped the rewards.

Do Your Homework

So, it's time to crack the books and learn about 529s. That, says Jensen, the Raymond James advisor, is not so easy. Figuring out the ins and outs and tradeoffs among the plans can be “like getting Jell-O to stop wiggling,” he says. “Once you learn all the ins and outs, something else changes.”

What makes 529s so complicated is that they are created by the state governments. “Because they are a creature of state law, the law behind each is different,” notes Joseph Hurley, a Pittsford, Mass.-based CPA who has become an authority on 529s and runs savingforcollege.com, a 529 Web site. And the variables are only going to multiply: The 14 states that don't have plans now are working on them for launch by yearend. Such details as terms of contract with the vendor and level of asset protection vary with each plan because each state crafted its own law concerning 529s. “Even if there are two states managed by the same company, there are differences,” Hurley says.

Further complicating matters is the fragmented nature of the 529 fund manager market. TIAA-CREF is the industry leader, managing 12 state plans, says Spectrem. Merrill Lynch and Fidelity each manage three. T. Rowe Price, Salomon Smith Barney and the College Savings Bank manage two. (See chart on page 32.)

Eventually, the experts say, the state-by-state idiosyncrasies will fade and there will be big national vendors providing the kind of custom solutions that 401(k) suppliers have developed. Already, some fund companies have created, in essence, a fund of funds, with different money managers from different companies. Schoolhouse Capital, for example, offers three such plans (one is no-load) and is rolling out a fourth.

Schoolhouse, a unit of State Street Corp., which owns the money manager State Street Global Advisors, will launch its Arrive Plan this spring with four investment managers: Evergreen Investments, Prudential Financial, State Street Global Advisors and SunAmerica Mutual Funds. With the help of financial advisors, donors will be able to create custom combinations of funds. The funds will be sold by Evergreen, Prudential and SunAmerica through their own sales teams. The plan will feature traditional multi-share class pricing.

Until the products evolve, however, there may be more confusion — not less. And that's a good thing. Complexity spells opportunity for advisors. “There are so many variables that consumers have to think about, they need to turn to somebody to ask for advice,” says J. Scott Slater, of Spectrem. And it pays to be the “go-to” person in the emerging 529 field. “I want to be the local expert on 529 plans,” Jensen says. “That's nice to be able to tell a client.”

And, at this point, there may still be an opening for a 529 guru in most towns. “I think that not too many people understand them right now, based on the calls I'm getting from places I wouldn't expect to get calls from,” says William Neely, partner at Neely, Cashdollar. “I'm getting calls from Georgia, Philly, New York, New Jersey, wherever, and I'm in Grove City, Pa.”

So, how does an advisor go about getting educated? “Like anything else, you dig in and figure out where your resources are and how you can use them,” says McGee, the Portland advisor.

The Basics

First, the basics: For starters, these are not mutual funds, but, technically, unregistered municipal securities that hold mutual funds, says Constantino. And it's important to realize that the state plan you choose basically dictates the style of investment you are wedded to. In fact, until this year, once you chose a plan, you were locked in — unless the client changed beneficiaries. Now, a donor can change his plan manager once a year or roll over to another style within the same plan.

There is a wide variation between the state plans. New York has a broad palate of styles from which to choose: from money market funds to aggressive equity growth. But in Montana, managed by the College Savings Bank, there is at present but one option and one option only: an FDIC-insured CD that offers a variable interest rate, pegged to a national index of private college costs (but yielding no lower than 4 percent). Then there is Kentucky, which now only offers a prepaid savings vehicle and is only open to Kentucky residents or other who have “ties” to the state.

In New York, the largest plan (as of the second quarter of 2001) with more than $700 million invested, the manager is TIAA-CREF, which sells directly to investors and has funds covering four broad investing style options. They range from aggressive to conservative. A client can choose his own allocation or opt for a managed allocation option, in both “moderate” or “aggressive” flavors, or simply choose the “high equity” option, which keeps a minimum 75 percent exposure to stocks with a potential to have a maximum of 100 percent invested in U.S. stocks. Or you can choose a plan that guarantees your client's principle and pays out a fixed amount of income.

The managed allocation option and the aggressive managed allocation option are both age-based strategies that aim to use a mix of domestic stocks, bonds and money market instruments in an effort to achieve an appropriate balance of growth and safety. In both strategies, the closer the beneficiary gets to college age, the more conservative the mix becomes. The aggressive version of this option simply maintains a greater exposure to equities than the moderate model.

Ohio, the fifth-largest plan sponsor with around $375 million, offers not only domestic growth funds and value funds (in age-based mixes, naturally), but a large-cap international growth fund. It also offers an intermediate bond fund and a high-yield fund. Putnam is the manager.

Little Giants

Then there is the Rhode Island plan, managed by Alliance Capital. With a strong distribution network, including UBS PaineWebber, it was the fourth-largest plan last year with more than $400 million in mid-2001, and it has a similar age-driven line-up as New York. Alliance is pushing hard and might have pulled ahead of TIAA-CREF by now, says Cerulli, which is working on its year-end report.

As you can see, the size of the state has little to do with the size of the 529 program, because most states open their plans to residents of other states. Tiny New Hampshire has about $563 million, managed by Fidelity. Maine, with just 1.3 million residents, has $570 million under management with Merrill Lynch. Nearly all of that money is from out of state and politicians love this: Plan administrators commonly send half a basis point or more of their management fee back into state treasuries.

As investments, 529 plans have not been great. They have the disadvantage of being born at the wrong time. Most have been open for about two years and many early investors watched their college savings accounts take the same kind of beating as their retirement accounts.

The most conservative funds have posted single-digit gains. But those who availed themselves of the more aggressive 529 options took a major hit. One indication of how the age-based allocations work is their relative performance in the market downturn. Growth-oriented funds for kids born in 1984 have lost less than 1 percent since inception; the aggressive growth funds for kids born after 1999 are down about 20 percent. Oregon's years-to-college options are all currently underwater, down 1 percent for conservative funds; the aggressive funds are down about 14 percent.

The New York moderate managed allocation option lost 24.7 percent between its inception on Jan. 1, 2000, and through Dec. 31, 2001. The aggressive managed allocation option was off by 30.1 percent since its inception on Nov. 15, 2000. The high equity option was off by just under 10 percent since inception on Nov. 15, 2000 while the “Guaranteed Style” was up by 4.5 percent in that same period.

On the brighter side, many of the funds posted excellent gains in the fourth quarter of last year, when the market climbed back from its Sept. 21 bottom. New York state's most aggressive option, for a child born in 2000 or 2001, jumped by 11 percent in the fourth quarter.

So, the first step for brokers is analyzing the plans available in each state. Spectrem's Slater says, “Once you've made your choice, you have to remember that somebody else is making the investment decisions for you. It's almost like a traditional pension plan offered by a company that you can't control.” Except once a year. “Now, if you don't like the style offered by the plan or your needs change, you can move it.”

Think Performance

To do right by your client there is much to consider: expenses, enrollment fees, whether out-of-state residents qualify for particular plans, mutual fund load expenses, maintenance fees and the nature of the underlying asset management that's associated with the program. Is the state offering a value fund or a growth fund? How have these managers done in other types of funds? Does the in-state tax break justify going with a plan that has produced smaller returns? About 90 percent of planner Jensen's clients live in Ohio, for example, but he rarely puts customers into the state's plan, whose managerial track record he finds disappointing. “I'd rather have a stronger performer than slightly greater tax benefits,” he says. “In the long run, it's the performance that's going to make a difference.”

Fees can vary as much as performance. New York, for example, has a relatively low maintenance fee of 0.65 percent and no sales charges. It allows its residents to withdraw the money tax free (so long as it's for school-related expenses). There is a $10,000 maximum state tax deduction per couple, per year. Rhode Island's plan, on the other hand, which is also sold nationwide, has management fees of 90 basis points to 110 basis point and a load paid by the investor to the broker of 3.25 percent. State residents don't get a tax deduction. McGee often recommends the Rhode Island offering to her Portland-area clients.

Why? Oregon's plan, managed by Strong, has no enrollment fees and no account maintenance fees, and only the barest of management fees — 0.325 percent, plus an additional 0.65 percent if a broker opened the account. Fund expenses are 0.77 percent to 1.32 percent, depending on the fund. “It's a matter of showing the different plusses and minuses of various plans, and fitting them into the family's overall financial strategy,” says McGee. “Oregon offers tax credits up to $2,000 if you use the Strong fund. But I found Strong has more limited returns and not as many choices as TIAA-CREF and some of the others.” On the other hand, she adds, “A more conservative client might be fine with Strong.”

If you think there are too many variables, the expert, Hurley, agrees. “You can never know everything,” he says. His advice: master a couple of the states and become familiar with a few others. “No rep will know every program. That's impossible.”

Sweet Spot

Also, don't forget about other options. With all the advantages that 529s now provide, they are not the only alternatives that brokers should know about for clients with college funding needs, says Glenn Pape of Ernst & Young in Chicago. Other vehicles, such as education IRAs, since renamed the Coverdell Education Savings Accounts, and the Uniform Gift to Minors Act will continue to have their uses, he says.

He points out, for example, that the current sweet deal for 529s — like the rollback of the federal estate tax — is set to expire at the end of 2010. Many people assume that Congress will extend the 529 breaks, Pape says. “But you don't want to rely on somebody else's crystal ball.”

Of course, it's tough to beat the 529. The problem with the Coverdell is that you may only contribute $2,000 a year to it. And like the UGMA, the money is turned over to the beneficiary irrevocably between the ages of 18 and 25, depending on the state, whether the beneficiary can handle it or not. And neither enjoys a state tax deduction. In fact, for financial aid purposes, the UGMA, which are assets of the beneficiary, can reduce the amount of available aid. (For more on UGMAs and trust alternatives, see Roy Adams' column, beginning on page 66.)

Besides the tax incentives, there are a few other reasons why 529s are a reasonable choice for most families with children. There are no income or age limitations; you can accumulate more money; and, perhaps best of all, the donor keeps control of the assets. In effect, the 529 is a revocable gift. That donor control is a popular feature for parents, grandparents and other would-be donors, says McGee. “Everybody always loves a new baby, but sometimes the child doesn't grow up as planned,” she notes. “With a 529, you can take the money back if you don't like the kid at age 18. You don't need to feed a vice or buy the new Porsche.”

As of now, the penalty for taking the money for non-educational purposes is 10 percent off the top in federal taxes. The money can be taken out for a sudden emergency or any other “non-qualified expense.” And, if Junior isn't college material, the client can reassign a 529 account to his smarter little sister. If she wins a scholarship, the cash can even be withdrawn without penalty.

The 529 is also emerging as a powerful estate planning tool for grandparents. The money can grow tax deferred, and a big gift on behalf of each child can significantly reduce the taxable estate later. In most cases, the maximum contribution the couple can make in a year would be $110,000 per beneficiary (that's $11,000 per donor, with an accelerated 5-year gift). In addition, a 529 gift “hits many emotional triggers,” says McGee. “What grandparents don't idolize their grandkids?” Gift and estate tax features of 529s are “really exceptional,” McGee says.

Fishing for Business

It's not surprising that so many advisors use the 529 as the hook to drive a discussion of larger planning goals. Parents and grandparents understand they need to amass substantial sums to pay for college, so education planning itself is a natural conversation starter. The advantageous new structure of the 529, then, has a natural appeal. “It fills a basic need for people,” says McGee. “Grandparents in particular love it.”

Indeed, a Spectrem survey found that 12 percent of affluent households older than age 65 and 21 percent of those aged 55 to 64 supported a college student. In fact, it can be easier to get the grandparents than the parents — or at least at the right moment. Todd Taskey says his biggest problem is getting parents to start accounts when their kids are little because younger families often have less to put aside. But his plea worked with client Bob Mannon, a Marriott executive, who realized he needed the market's help to get his three kids through school. “I was very much aware of how much less value savings plans like this have the longer you wait to start,” he says.

And, it's not just financial planning types like Taskey who are learning the 529 ropes, Marcie Behman is a Merrill Lynch vice president in Boston, who is one of four financial consultants and six associates in a partnership managing about $2 billion for institutional and retail clients. She figures that between 40 percent and 50 percent of the clients require some sort of college saving plan. And it is foolish not to serve that customer need. “It really has opened up doors to meeting and forming relationships with clients whose children have children,” she says. “I think a financial advisor who hasn't embraced the strategy is missing out,” she says.

Behman has professional and personal investments in the 529 business. She opened 529 plans for her own three boys, aged 19 months to 7 years — and is expecting her fourth 529 beneficiary later this year.

As the business gets bigger, so do the incentives for brokers. In general, 529s carry sales loads that mirror the normal ‘A’, ‘B’, ‘C’ class structure. The A share load is typically around 3.5 percent, and there are too many B shares to enumerate. In general, though, the plan sponsors and vendors have aligned themselves with the financial intermediary, a trend that is happening throughout the industry. Many new offerings are approaching a load of 5.75 percent, which is the most common load in the mutual fund world. In part to entice brokers to promote its 529 offerings (which, incidentally, are top rated for performance, choice and flexibility), Nebraska recently introduced new plans carrying higher sales loads.

Heightened competition between plan administrators benefits everybody, because it should create more choice and, eventually, should lower marginal expenses for clients. Most states and their financial services company partners are now in full-tilt marketing mode, in a drive to attract evermore assets. So much so, that we should see an evolution of product offerings and service much like savers enjoyed in the 401(k) market.

Take the Offensive

As occured with 401(k) plans, third-party distribution alliances are springing up to capture some space in the 529 market. Fidelity signed on RBC Dain Rauscher to distribute its New Hampshire plan in parts of the country and is looking for other regional brokerages. American Century signed on Schwab to sell its Kansas plan, and State Street Global Advisors has teamed up with E-Trade. So, look at it this way: Learn the 529 basics or your clients will turn to Schwab for help. And then once Schwab has the 529 assets, it will go on the attack for the rest of your client's assets.

“When 401(k) plans first started, generally one provider offered all the services, from trustee to record-keeper to investment management,” says Spectrem's Slater. “Investment choices were limited to four to six funds from that single provider. Now participants expect investment choice, advice and easy access to their account information.” The same evolution is now under way in 529 plans. The brokers and advisors who keep up with this new business could go to the head of the class.

How Washington Sweetened the 529

“God bless George W. Look what he's done.” That was the message that Todd Taskey, a certified financial planner at Solutions Planning Group in Bethesda, Md., conveyed to his clients when he learned that the tax-reform bill had passed last summer. Here's why Taskey, who does a brisk business in 529s, is so excited.

Tax-free withdrawals

Previously, assets grew tax deferred but were generally subject to federal and state income tax upon distribution. Now, qualified withdrawals are not subject to federal income tax.

Easier rollovers

Under the old rules, rollovers from one state's plan to another required changing beneficiaries. Now, a client can move the assets in a 529 once every 12 months, without tax or penalty.

Higher gift maximums

Federal tax reform raises the annual tax-free gift limit from $10,000 to $11,000 per beneficiary this year, or $22,000 per couple.

More flexibility

Now, it's possible to set up accounts for nieces, nephews and other relations beyond a client's immediate family. Also, it's now easier to shift the account from one beneficiary to another.

529 Savings Plan Financial Service Providers