Conflicting Incentives in 529 Plans Harm Plan Participants
On May 2, 2022, at approximately 6pm ET, this article was edited. The following sentence was added to the end of the second paragraph: "Note that 529 plans are subject to the anti-fraud provisions of the federal securities law."
Because 529 plans are exempt from SEC oversight, they can charge higher fees and use that revenue in ways that do not benefit plan participants. New research shows some states are guilty of this abuse.
By year-end 2021, total assets in 529 savings plans had grown to $480 billion (across more than 15 million accounts), up from $165 billion at the end of 2011 (across fewer than 11 million accounts). What most investors in these plans are probably unaware of is that the sponsors of the plans, which are state governments, are exempt from the Investment Company Act of 1940 and the Securities Act of 1933, important federal laws that protect the interests of investors. Without federal oversight and no mandated disclosure requirements, 529 college savings plans operate outside the jurisdiction of the Securities and Exchange Commission.1 Note that 529 plans are subject to the anti-fraud provisions of the federal securities law.
Justin Balthrop and Gjergji Cici, authors of the March 2022 study “Conflicting Incentives in the Management of 529 Plans,” examined how the involvement and incentives of state governments affected investors in 529 plans. They began by noting: “Most states collect asset-based fees from their 529 plans and their incentives may not perfectly align with those of plan participants. States face budgetary constraints, which might force them to view their 529 plans as a potential revenue source.” They added: “States outsourcing program management to external managers further complicates the incentive landscape” – 90% of the plans are outsourced. Complications arise because service providers face incentives to favor their own funds or the funds of other families with which they have revenue sharing arrangements for inclusion in the plan menus – about one-third of plans operate under revenue sharing arrangements, which they are not required to disclose.
A state’s revenues are a function of two factors: the state (trustee) fee, which is applied as a percentage of assets, and total plan assets. States that desire higher revenues can negotiate a higher state fee with the program manager and/or allow the program manager to pursue aggressive sales practices via sales incentives for plan distributors to increase plan assets. Variation in fees and practices identifies differential tendencies of states to extract revenue from their 529 plans, which the authors labeled as Tendency to Extract Revenue (TER).
Balthrop and Cici’s 529 plan data was from the College Saving Plans database in Morningstar Direct downloaded on March 30, 2021 and covered 86 Section 529 plans offered by 49 different states and the District of Columbia. Following is a summary of their findings:
- The state fee – the fee collected by the state (also known as the trustee fee) – for the average investment was 4 basis points (bps) and could be as high as 26 bps.