Allan Tomlinson wanted to give money to his three grandchildren, but he also wanted control over how the funds would be spent.
By Jinny St. Goar
February 2001
Institutional Investor Magazine
The 68-year-old former oil industry executive was looking, too, to minimize the size of his estate. The result: Beginning in 1998, when his first grandchild was born, Tomlinson set up three college savings funds, one of the latest wrinkles in the market for defined contribution plans.
“These kids will have to do some work for their education,” says the Dallas resident, who retired as the CEO of Champlin Refining in 1990 and previously was president of Diamond Shamrock. “But this will help them out.”
Over the next five years, Tomlinson is considering putting aside up to $50,000 for each grandchild, the maximum allowed without incurring the federal gift tax. Those funds will grow with their federal income taxes deferred until withdrawal, when they will be taxed at the college student’s rate. The money can be used to pay tuition for any U.S. college or university, private or public.
Tomlinson joins a growing roster of investors in 529 college savings plans, named for the section of the Internal Revenue code that went into effect with the passage of the Small Business Jobs Protection Act of 1996. Facing a mature market for corporate 401(k)s - some 90 percent of large companies already have a plan in place - providers are naturally enthusiastic about the prospects for this new business. “We have every reason to believe that the three numbers ‘5-2-9' will eventually be as well known as ‘4-0-1-k,’” says Richard Davies, who is overseeing Alliance Capital Management’s 529 program.
“Within two or three years, we expect the overall market for 529 plans to be about $20 billion in assets,” says Timothy Lane, vice president for tuition financing at TIAA-CREF, which with $930 million under management currently has the largest market share of 529 assets.
Since July 1998, when the first college savings product was launched by Fidelity Investments, the plans have amassed approximately $4 billion in assets, according to Joseph Hurley, an accountant who runs a Web site called SavingForCollege.com. That success follows substantial marketing campaigns by the usual suspects: Alliance Capital, Fidelity, Merrill Lynch & Co., Morgan Stanley Dean Witter, Putnam Investments, Salomon Smith Barney, State Street Global Advisors and TIAA-CREF.
Even in a low-inflation economy, college costs have risen through the 1990s, and further increases are inevitable. According to the College Board, a nonprofit association of higher educational institutions, the tab for four years of tuition, room and board now runs about $90,000 for a four-year private college and $34,000 for a public institution. In the 1995-'96 academic year, those averages stood at $69,500 and $27,000, respectively. The four-year cost of a college education for a freshman entering in 2018 is projected to be $235,000 at a private school and $100,000 at a public school, according to TIAA-CREF’s Lane.
At the same time, the financial value of a college education has steadily increased. In 2000 the average annual income of college-educated Americans was about 80 percent higher than that of high school graduates, according to the College Board. In 1995 college graduates earned 50 percent more per year, on average, than their high school counterparts. Such statistics make for a natural sales pitch for the financial services industry.
Before college savings plans came into play, states did offer a sort of defined benefit plan for college savings - state-sponsored prepaid tuition programs, first established in the mid-1980s. These plans have also fallen under the 529 umbrella since 1997, and the majority allow investors to lock in tuition at a fixed cost. But most cover tuition at only a few public and private schools in the sponsoring state. The states assume the risk of the rising cost of college education and offer a “defined benefit” - the commitment to tuition at a qualified college.
These prepaid tuition plans are restricted to in-state schools, but some state programs are substantial nonetheless. Florida, for example, has about $3 billion in assets in its prepaid tuition plan and has only recently started to set up a college savings plan. The drawback to the prepaid plans has always been the lack of flexibility. “What if you lived in Michigan and it turned out your kid likes to surf and wants to go to college in Florida?” says Edward O’Connor, director of retirement and education savings at Merrill Lynch. (Merrill enjoys relationships with state-sponsored 529 plans in Maine, Arkansas and Wyoming, with total assets under management of just less than $500 million.)
So far 44 states have set up 529 plans, 27 of which are open to out-of-state residents. Withdrawals from all 529 plans can be used to pay college tuitions anywhere. Georgia and South Dakota have not yet joined the club; four states have legislation on the table.
The funds invested generate federal estate tax exclusion and, in a few cases, a state income tax deduction as well. Initial investment minimums tend to be low - $250 or even $50. The lifetime contribution cap varies by state-sponsored program and can run as high as $250,000. The Internal Revenue Service has yet to finalize regulations for these plans, so the lifetime contribution cap could change. If there is more money in the account than is necessary to pay for college, the owner can take it out with a 10 percent penalty on the earnings or transfer it to a beneficiary who is related to the original student.
Technically, 529 plans are municipal trusts administered by the individual states, with mutual funds, or some other investment product, used as their trusts’ underlying securities. The mutual fund companies and brokerage houses that have competed for these state contracts are hired to manage, administer and distribute the plans. Many state-sponsored plans are being marketed nationally, allowing California residents, for example, to choose among California’s plan (offered by TIAA-CREF), Rhode Island’s (Alliance), New Hampshire’s (Fidelity) and Ohio’s (Putnam).
Unlike their 401(k) counterparts, Tomlinson and other 529 account holders cannot shift their funds’ investments, and the initial choice is generally limited. Tomlinson, for example, chose Fidelity as his 529 provider, and his funds are automatically invested in a series of eight age-based mutual fund portfolios. Like a life-cycle fund, the Fidelity 529 assets start at a mix of 88 percent equities and 12 percent fixed income for a newborn beneficiary, shifting gradually to just less than 20 percent equities by the time the beneficiary reaches age 18.
Market leader TIAA-CREF began its 529 business with New York State in September 1998 and has since added 11 states to its roster of sponsor relationships. Fidelity is second in market share, with about $730 million in assets since it launched its first 529 fund in New Hampshire in July 1998. Fidelity also counts Delaware and Massachusetts among its 529 clients, while TIAA-CREF serves California, Connecticut, Missouri and Tennessee.
Most 529 plans are sold directly. TIAA-CREF, for example, airs television ads in New York, one of which features Governor George Pataki and State Comptroller H. Carl McCall. But TIAA-CREF is also starting to crack the corporate market, counting MasterCard International (based in St. Louis) and Oracle Corp. (headquartered in Redwood Shores, California) among the handful of corporations that offer these savings plans as an employee benefit. “At this point, 90 percent of our 529 assets under management are retail and 10 percent corporate, but we expect that split to reverse as these plans catch on,” says TIAA-CREF’s Lane.
A few government entities have started offering payroll deductions for 529 plans as an aftertax employee benefit. The Albuquerque Public Schools made State Street’s New Mexico plan available on December 1 to 10,000 people - teachers and other school employees. “This is a no-brainer when you are talking to educators,” says Nancy Bearce, the benefits manager for the school system. “As soon as we start our communication effort about this, we expect to see people enroll,” she says, explaining the four enrollees in the program’s first month.
“The complexities of these plans aren’t good for direct selling,” contends Alliance Capital’s Davies, whose plan was launched in Rhode Island in October. Davies reports that Alliance collected 7,500 accounts and $70 million in assets within the program’s first six weeks of marketing, from mid-November until early January 2001. Almost all of Alliance’s 529 accounts were sold through brokers.
To win the states’ contracts, the fund companies have had to promise substantial marketing budgets. TIAA-CREF pledged to spend about $50 million on advertising over the first five years of its 529 plan contracts with the five states.
One unanswered question could prove troublesome for the industry: Might a change in state government affect which companies are permitted to administer these plans? Would the 529 plan become, in effect, more like a municipal finance contract than a 401(k)?
“Are these [529 plan contracts] political?” asks mutual fund industry consultant Geoff Bobroff, rhetorically. “I hope not, but a change in a state administration could bring a change of vendor.” Collegiate Capital’s three-year contracts in Connecticut and Rhode Island expired and were not renewed at the end of 1999. TIAA-CREF then picked up Connecticut, and Alliance Capital snared Rhode Island.
In addition, all the plans are competitive, with nothing to prevent account holders from opening a 529 fund in their home state to collect the state tax deduction and then moving the account to another vendor for better pricing or performance. In that respect, 529 assets could be “leakier” than 401(k) assets, which move from one administrator to another when a plan sponsor decides to jump ship.
Providers accept that these plans will be costly to administer at the outset, simply because account balances will start out small. But TIAA-CREF, Merrill Lynch, Putnam, Fidelity and State Street predict that those balances - and their firms’ total 529 assets under management - will quickly grow.
