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529 Plans Next in Line on Capitol Hill


State-sponsored 529 college savings plans are the latest investment vehicle to draw scrutiny from legislators, as Congress prepares for a series of hearings to examine their fees, broker commissions and tax efficiency.

Both the House and the Senate announced recently that they will convene in early June to discuss these issues and determine their impact on shareholders looking to save for their children's college education. The move comes on the heels of a regulatory probe launched by the National Association of Securities Dealers last summer. The NASD is currently investigating up to 15 securities firms for potential misconduct in the sale of 529 plans.

"We're concerned that a high percentage of the 529 plans sold are out-of-state plans, which may mean that investors may be losing out on the state tax deduction," said John Gannon, vice president of investor education at the NASD.

Indeed, more than 90% of the 529 dollars flowing into the firms being probed came from out-of-state residents, he noted. In-state tax deductions are arguably the most attractive benefits of 529 plans. Gannon also noted that there are issues that are similar to what regulators have dealt with in the mutual fund arena, in that there are "large discrepancies" between one plan and another as to how much investors pay.

Under the Hood

The Securities and Exchange Commission is also looking under the hood of 529 plans. In March, SEC Chairman William Donaldson established a special task force to look for potential pitfalls involving the state-sponsored college savings plans following an inquiry from House Financial Services Committee Chairman Michael Oxley (R-Ohio).

"We believe that the wide variations in disclosure among the various state 529 tuition savings plans we reviewed, as well as the absence of significant securities law protections, makes it difficult for investors to fully understand the options that are available to them with respect to these tax-advantaged college savings plans," Oxley wrote in a letter to Donaldson.

He highlighted two key areas that help illustrate some of the difficulties parents face in making informed investment decisions. The first is that there is less disclosure in 529s than in mutual funds. While mutual funds comprise an overwhelming majority of 529s, investors tend to receive limited information about the underlying investments. That's because 529s are largely an unregulated business and are not required by law to provide the same quality of information. The Municipal Securities Rulemaking Board is tasked with rulemaking responsibilities for 529s under the supervision of the SEC, but the Commission cannot bring enforcement actions unless there is fraud at the broker level.

Another flawed aspect of 529s, according to Oxley, is the lack of standardized disclosure. Since each state runs its own plan, the manner in which information is presented varies widely, which makes evaluating performance more difficult.

"Congress and the SEC seem to be concerned about investors understanding what they're paying for, recognizing that 529 plans are not consistent in how they structure their fees and expenses," said Joseph Hurley, chief executive officer and founder of SavingforCollege.com, an educational Web site devoted to 529 plans. When asked if he thought the probe would uncover widespread abusive behavior as with the mutual fund scandal, Hurley said. "I don't think it will be a big mess. The investigations will stimulate more coordination among the states to further improve and perhaps standardize their disclosure procedures."

Going For Broke

Still, regulators and Congress are keenly interested in delving deeper into broker sales practices, which has prompted California to junk efforts to offer a broker-sold 529 plan pending the outcome of the investigations. Some states sell directly to investors without a sales commission, whereas others sell through brokers and financial advisers, who charge fees up to 5.75%. Others offer both options. California's $1 billion Golden Gate Scholar share plan, managed by TIAA-CREF, ranks ninth in the U.S. in terms of total assets. Conversely, Rhode Island and Maine, whose populations are dwarfed by California, sponsor significantly larger plans because they market them nationwide to brokers.

"Some investors are better off going through a broker because 529s have unique tax rules," Hurley said. He further argued that 529s are more nuanced investment vehicles than mutual funds because there are many more factors to consider such as gift and estate tax consequences, so rather than bone up on all the nuts and bolts, less sophisticated investors are better off paying a broker or financial planner to do it for them. "Over time, more people will understand how they work, but certainly the nature of the beast is that there is a lot of confusion and incomplete understanding of how they work," Hurley said.

Sheryl Garrett, CFP and founder of The Garrett Planning Network of fee-only financial planners in Shawnee Mission, Kan., argues that the problem with 529s is that some of the states just don't have good options. "States are selling the 529 package through a high-cost investment company. and the end users are stuck paying their excessive fees," she said. "People are getting the short end of the stick in too many plans."

In fact, the fees in some plans can be a full 1% more than another state's. Garrett illustrated that one state could have a low-cost management expense through TIAA-CREF but then have extra built-in fees, such as a $20-a-year administrative fee that the state imposes. If an investor is not putting in much money, $2,000 a year for example, $20 equals 1% of that. If you add that to annual expenses of 1.3%, you're looking at 2.3% of the total investment.

"If that were a mutual fund, that would be terribly excessive," Garrett said. "On top of that, the fact is the fees are not nearly as transparent or fully disclosed as we would like them to be."

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