The tax break is good for Grandma. It also works for Mom and Dad and even an old family friend. Anyone who wants to save money for a child's college tuition can do so in a state-sponsored, tax-free 529 plan. Assets of such plans increased from less than $3.3 billion at the end of 1997 -- their first year -- to $72 billion at the end of last year, according to the National Association of State Treasurers. Every state and the District of Columbia offers a 529 program. The largest, Virginia's, reports assets of $14.1 billion.
A state will choose one or more money managers to run its plan, usually offering a contract lasting three to five years. When those contracts come up for renewal, as several will this year, money managers will compete to replace the incumbent and win the right to manage the growing pool of assets. Plans in at least seven states, including California ($1.7 billion in assets), Idaho ($75 million), Michigan ($1.2 billion) and Tennessee ($28 million), are up for bid.
Still, net inflows into the plans fell to $13.69 billion in 2005 from $13.72 billion the previous year, according to Boston-based Financial Research Corp. That reflects some uncertainty on the part of investors about the future of the plans' federal tax advantage: It is one of the tax breaks in the Bush administration's Economic Growth and Tax Relief Reconciliation Act of 2001 that is set to expire in 2011. Whether Congress will preserve the 529 provision remains to be seen.
Money managers face a more nagging problem: Profit margins are modest or nonexistent. "T. Rowe Price is making a profit on some of the plans," says Renee Boyd, the firm's senior college savings plan manager. Which means, of course, that the Baltimore money manager is not making a profit on other 529 plans. At TIAA-CREF, says Phillip Rollock, vice president of education savings, "close to half" of the programs are covering costs or are "in the ballpark."
What's more, margins are getting thinner as fees continue to fall. Investors pay on average 53 basis points a year for state administrative fees, on top of regular mutual fund charges, according to Morningstar. Mercer Investment Consulting estimates that asset management fees are falling about 5 basis points a year with new contract renewals.
Even so, critics of 529 plans argue, the double layer of fees means that consumers are paying too much for the product. Last year Congressional hearings on 529 plans considered this issue.
But money managers remain committed to the market. Increased economies of scale will help bolster margins, they believe. Moreover, they hope to build relationships with the parents and grandparents who set up the 529 accounts, so that they can cross-sell other products, such as IRAs.
"There's a significant opportunity to cross-market financial services products," notes Bruce Harrington, director of product development at MFS Investment Management. Robert Corcoran, vice president of college planning at Fidelity Investments, concurs: "We look at it holistically. We hope to do retirement accounts for our clients as well."
Less populous states, which have fewer assets to offer potential money managers, worry that they may have trouble finding new providers when their 529 contracts come up for bid.
Although the market has grown rapidly, the pace has not quite met expectations. "Overall it has been disappointing," says Troy Saharic, a principal in Mercer's Seattle office. "People initially thought there would be an enormous flow of assets into these plans."
"When 529s first started to take off, everyone wanted a piece of the market," notes Luis Fleites, a senior analyst at Boston-based consulting firm Cerulli Associates. "Expectations were set too high. I think reality has set in."
In 2002, Financial Research predicted that 529 assets would reach $100 billion by the end of 2005, about $30 billion more than the current total. According to Saharic and other industry observers, several factors explain the disappointing growth: Investment choices can be confusing, considerably more so than with an IRA. Few companies include the plans as an employee benefit. Last, there's that perennial problem: Americans don't like to save.
Since 529 plans debuted -- they are named after the section of the tax code that created them -- the roster of dominant players has shifted. From the start, TIAA-CREF has run the largest number of state plans; its total today is 12. That reflects the manager's traditional lock on retirement plans for educational institutions. But when ranked by 529 assets under management, TIAA-CREF was overtaken by American Funds in 2003. The top five as of year-end 2005: American Funds, with $12.2 billion; an alliance between Vanguard Group and Needham, Massachusettsbased Upromise Investments, a broker-dealer that specializes in helping families save for college, with $7.7 billion; Alliance Capital Management, with $6 billion; Fidelity Investments, with $5.5 billion; and TIAA-CREF, with $5.2 billion.
As John Heywood, head of Vanguard's education markets group, sees it, "The watershed event" in the market share shift occurred in 2004. That year the Vanguard-Upromise partnership won New York's $1.8 billion 529 account away from TIAA-CREF with a 60-basis-point fee that was reportedly 5 basis points lower than TIAA-CREF's.
In late December the Vanguard-Upromise group also won the $827 million Missouri contract away from TIAA-CREF. Vanguard-Upromise now runs plans with a total of $8.1 billion in Colorado, Iowa, Nevada and New York, to which it will add those Missouri assets in May.
As for TIAA-CREF, how does the premier money manager for educational institutions view its setbacks? Says Rollock: "People should expect that, given the growth in the industry, programs will change hands from time to time. TIAA-CREF still maintains a leadership position in the industry."
That industry is getting tougher for all asset managers as many states push hard to hold down fees. Last year, when Maryland's $830 million 529 contract came up for bid, incumbent T. Rowe eliminated a $75 enrollment fee and lowered its management fee from 38 basis points to 30; the firm kept the contract.
Although Citigroup Asset Management held on to the bulk of Colorado's $2 billion in assets when the state's 529 contract came up in December 2004, Colorado split off one $360 million plan because Vanguard-Upromise underbid Citigroup by 34 basis points, charging just 75 basis points.
Some states are also asking bidders to pledge more resources to market the 529 program. In Maryland, T. Rowe will have to spend $750,000 more on marketing during the first year, with further increases in subsequent years. Vanguard-Upromise will double what TIAA-CREF spent on marketing for Missouri, to an average of at least $2 million per year.
"The 529 industry has evolved significantly since we first signed the contract [in December 2001]," says Joan Marshall, executive director of the Maryland plan. "We wanted to give our account holders the best set of prices."
T. Rowe's Boyd shrugs off the cuts in Maryland's fees. "When we bid on the business originally, we were uncertain how it was going to grow," she says. "Now we have enjoyed significant growth in the plan, and we have been able to pass some of the economies of that growth back to the investors in the form of reduced fees." (T. Rowe Price also runs three plans in Alaska, one of which is marketed nationally. Assets total about $1.7 billion.)
Managers can pick up extra assets if their funds are offered as investment options in state plans they don't manage or if a state whose plan they do manage is willing to market its program to out-of-state residents, which most are. But administering the programs is complex. Managers have to keep track of all of an investor's plans (which may include one for each child) to make sure they don't violate strict federal limits on the number of withdrawals and total contributions per year. Administrative rules can vary from state to state. Boyd estimates that T. Rowe spent several million dollars to set up a new recordkeeping system when it got the Maryland contract.
Financial Research estimates that money managers probably won't see a profit on plans with less than $500 million in assets or whose average account balance is less than $15,000. Industrywide the average balance is slightly less than $10,000.
Those calculations could leave smaller states out in the cold. Liza Carberry, investment manager for the state treasurer's office in Idaho -- whose $75 million in 529 assets reflects an average account balance of less than $6,000 -- worries that TIAA-CREF will not rebid when its five-year contract expires in March. (So far the two sides are "continuing our conversation," says TIAA-CREF's Rollock.) Carberry notes that "there's a program in every state, and there's somebody running and doing it. There are plenty of people out there interested in the business."
Small states might need to market their plans more aggressively, playing up their returns and their competitive fees, to draw in more out-of-state investors. Diana Cantor, executive director of the $14.1 billion Virginia College Savings Plan, suggests one potential solution. "There has been some discussion that the smaller plans might want to partner with another state," she says.
A few small money managers might abandon the 529 business, but the leading names are probably in it for the long haul. "It's such an important market for us," says T. Rowe's Boyd, "because it's such an important need for our customers."
