Multiple choice

In the fast-growing market for college savings plans, fund companies increasingly rely on brokers to close a complicated sale.

In the fast-growing market for college savings plans, fund companies increasingly rely on brokers to close a complicated sale.

By Jinny St. Goar
July 2002
Institutional Investor Magazine

College savings plans are: (a) a good deal for parents; (b) an attractive form of estate planning for grandparents; (c) a rather complicated investment product; (d) popular with brokers; (e) all of the above.

The answer is (e) -- all of the above.

When investment providers began aggressively selling college savings plans two years ago, they were working off the educated assumption that the plans would be an easy sell. That’s because the money in these defined contribution accounts grows on a tax-deferred basis
until withdrawal. At that point contributions to the funds are free of federal income taxes, while a portion of the earnings are treated as ordinary income. With annual tuition, room and board at a four-year private college running about $35,000, what parent wouldn’t be interested in such a savings plan? And since anyone can set aside money to fund a student’s education, the plans have become an appealing estate planning vehicle for many grandparents.

Assets in these savings plans, named “529" to avoid misread for the section of the Internal Revenue code that defines their tax treatment, have grown from about $4 billion at the end of 2000 to some $15 billion. Of that total, some 90 percent is invested in mutual funds.

Though the industry’s initial assumption about the program’s appeal was
correct, sales have been anything but simple. Technically, 529 plans are municipal trusts, administered by states, with mutual funds, annuities or other investment products used as the trusts’ underlying securities. Although plans are marketed nationwide, each state imposes its own particular tax treatment,
hiring a provider like Alliance Capital Management or Fidelity Investments to manage and distribute them.

There are additional wrinkles. The plans cover educational expenses anywhere in the country -- a New York family can finance a California education -- but states set their own contribution limits, which can range anywhere from $15,000 to $305,000 per student. In all states money can only be withdrawn for what the tax code defines as “legitimate” educational expenses -- tuition, room, board and books.

To explain the finer points of these plans, more and more direct sellers, including traditional no-load stalwarts like TIAA-CREF, now rely on brokers and financial advisers. According to, a nonprofit company that tracks the market, broker-sold funds accounted for 30 percent of 529 plan assets two years ago. Today, the firm estimates, that share is up to 70 percent.

Back in 1998 when TIAA-CREF and Fidelity pioneered the 529 arena, they sold their plans exclusively through direct channels. A year ago Fidelity launched its broker-sold 529 product; the big mutual fund company’s 529 sales recently totaled about $1.75 billion. “We had started hearing from our advisers in significant numbers in early 2001 that they were eager to market 529 plans,” reports Edward Nigro, Fidelity’s vice president for product development.

Now TIAA-CREF, which has about $2 billion in 529 assets, is planning to launch its broker-sold 529 product in the third quarter of this year. Until now the company has sold no financial products through brokers. “We’re not turning our backs on the direct-sales channel,” insists Timothy Lane, vice president of tuition financing at TIAA-CREF, which has about $270 billion in assets under
management. “This is not a sea change for TIAA-CREF.”

Because of broker interest, new players are jumping into the marketplace. In April Delaware Investments started up its first 529 plan, sponsored by the state of Hawaii. “We would not have entered this market if direct sales were the only option,” says Daniel Carlson, the Delaware vice president who is managing the new product.

Delaware, which uses A.G. Edwards & Sons and Merrill Lynch & Co., among others, to sell its mutual funds, reports that the brokers themselves urged them to enter the college savings plan market. “They wanted something to sell. We simply needed to have a 529 plan in our stable of products,” says Carlson.

Similarly, American Funds Group, a large, Texas-based wholesaler, started marketing its first 529 product a few months earlier, in mid-February. The company has had significant success selling the plans exclusively through brokers: close to $350 million so far.

In July 2000 the American Century Investments fund family began selling 529 plans directly to the public; in April 2002 it started marketing through brokers. (The company recently had $246.6 million in 529 assets under management.) “We knew we were missing investors who are only willing to buy through brokers,” says senior vice president David Larrabee.

The notion of an educational savings vehicle began to take shape in the mid-1980s, when states introduced prepaid tuition plans. Typically, they covered tuition at only a handful of private and public colleges in the sponsoring state. The vehicles functioned like defined benefit plans, with the states assuming the risk of rising tuition as part of the plan’s promise to fund a student’s college costs. Since 1997 assets in these plans have fallen under the 529 umbrella.

The Small Business Jobs Protection Act of 1996 authorized defined contribution plans for college savings, with the money invested at the fundholder’s discretion and used to pay for tuition at any accredited college or university in the U.S. The legislation created a new section of the tax code -- section 529 -- and instituted a federal tax deferral on savers’ undistributed earnings. Additional changes to the tax code in 1997 spurred the further development of the marketplace.

The June 2001 Economic Growth and Tax Relief Reconciliation Act clearly stated that distributions from these savings plans would also be exempt from federal taxation. This, not surprisingly, was the clarion call that the financial services industry had been waiting to hear.

“Marrying the phrase ‘tax-free growth’ with ‘tax-free distribution’ made all the difference to brokers,” says Fidelity’s Nigro. Last September the IRS decided that it would be permissible for 529 savers to switch their investment options more than once a year, eliminating a previous constraint of the plans.

“The switching made 529 plans much more popular with brokers,” says Luis Fleites, a consultant with Cerulli Associates. He predicts that the total college savings market -- including 529 savings plans, 529 prepaid plans and educational savings accounts -- will grow from
$22 billion in total assets at year-end 2001 to more than $100 billion by 2006. For brokers, the investors’ opportunity to move their funds more than once a year now justifies the brokers’ ongoing fees.

Though it is sponsored by the small state of Rhode Island, Alliance’s 529 program ranks as one of the largest in the country, with about $2.2 billion in assets. Alliance helped blaze the trail for 529 sales, in part by being one of the first to enter the market, with a broker-sold product launched in November 2000. Initially, Alliance offered investors the standard fare of the 529 industry: an array of asset allocation portfolios through which an investor would migrate during the life cycles of the investment -- with a heavy stock exposure giving way to a fixed-income weighting when the student was a few years away from college. (Alliance’s portfolios were built by Ibbotson Associates.) More recently, Alliance has offered investors individual mutual funds.

Alliance 529 sales have been running at about six times anticipated volume, reports Richard Davies, the Alliance vice president who manages 529 sales.

At about the same time as Alliance’s debut, Putnam Investments entered the 529 marketplace with a plan that was sponsored by Ohio. Launched in October 2000, Putnam’s wholesaling reaped $1.5 billion in 529 assets in its first 19 months. “Brokers are now using 529 plans as a foot in the door to sell other retirement benefits to employees,” reports Elaine Sullivan, a Putnam senior vice president.

Of course, direct-sold 529 plans have much lower fees than broker-sold plans. They typically charge an administrative fee of 10 basis points and an additional 65 to 95 basis points in annual expense ratios.

In the first few years of 529 plans, some providers and brokers thought the employer-sponsored marketplace would prove to be fertile selling ground. The plans could be offered as voluntary benefits, the providers imagined. They were certainly simpler to administer than 401(k)s, since a corporation does not assume the responsibility for tax compliance in a 529 plan, as it does in a 401(k).

Ford Motor Co. is considering offering payroll deduction for 529 plans to its 165,000 U.S.-based employees. But most companies are taking a pass. One reason: Contributions to 529 plans cannot be made on a pretax basis, which is what many employees want.

TIAA-CREF’s employer-offered 529 plans account for just 10 percent of the company’s college savings assets. But since the start of the year, growth in the employer-sponsored market for 529 plans has been “explosive,” Lane says. TIAA-CREF would never have predicted that growth rate a few years ago. But the college savings market, it turns out, has more than a few trick questions.