College savings plans are enjoying another major cash infusion. Cash flows into 529 plans grew by more than $4 billion from 2011 to 2012, according to Morningstar data, the highest year-to-year increase since 2009-2010, when inflows more than doubled. Last year, assets in the plans rose by 25% to $166 billion, despite their five-year underperformance when compared with equivalent open-end mutual funds.

The drag on performance is partially attributed to the behavior of certain bond funds and to the higher expense ratios typical of 529 plans over the past five years. Kailin Liu, a mutual fund analyst for Morningstar, pointed out in the 2013 edition of the “529 College Savings Plan Industry Survey,” which she co-authored with Morningstar’s director of fund of funds research, Laura Pavlenko Lutton, that this spring intermediate-term bond funds held by 529 plans trailed open-end funds. Yet short-term bonds “bucked the trend” by outperforming open-end short-term bond funds.

There’s no doubt that plan cost declines are drawing more assets to 529s. Liu noted in a June 11 report that the gap between 529 investment fees and that of similar mutual funds in 2010 was on average 40 basis points. That difference shrunk to 31 basis points in 2011, and average expense ratios are even lower this year. Liu credited indexed fund alternatives for declining expenses in the typical large-blend 529 investment in 2011—a decline from 1.13% to 1.05%. It helped that the average open-end mutual fund expense ratio actually rose to 1.27% this year, from 1.14% in 2011.

Even the expense ratios of 529 plans offered by Vanguard, the household name synonymous with indexed and low-cost funds, have gone down.
Typically, 75 basis points are coming out of your return if you are invested in an actively managed 529 plan, says Liu, while the average is only 25 to 33 basis points in index-based plans. The trend toward passive from active management has also helped reduce costs. “While the perception is that you have to pick the right managers, some advisors and planners find it easier to just avoid the issue with indexed plans,” Liu says. 

Morningstar’s annual report also confirms a steady march from 529 plans sold by advisors to those sold directly to participants. On December 31, 2012, advisor-sold plans held $81.8 billion in assets while plans sold directly totaled $85.1 billion. Those plans sold through advisors are normally more expensive (though the ones sold directly have a wide fee range).

Advisors needn’t worry. Researchers point out that the growth of directly sold plans probably threatens brokers more than advisors, since brokers operate on commissions for investment transactions. Advisors, who obtain their revenue from a percentage of clients’ portfolios, would likely use the plans sold directly anyway in order to keep costs down, and that’s one of the things likely sparking the demand.

“Our research and that of others shows that low costs will be the driver of long-term outperformance, especially in indexed portfolios,” says Maria Bruno, a senior investment analyst at Vanguard, which oversees funds in state 529 plans. From December 2002, the company’s various funds dropped expense ratios in its 529 plan funds from a high of 65 basis points to a low of 25 basis points in December 2010, partly thanks to a growth in economies of scale, says Bruno. “Reduced fees are very positive for the industry as a whole,” she adds.

In late July, college lender Sallie Mae released a survey of parents with children under age 18 called, “How America Saves for College 2013.” The interviews showed that 17% of these parents would be motivated to invest or increase savings in a dedicated college fund if the fees were low, and the same percentage would do it for the tax benefits. The top incentive (among 21% of the respondents) was a guaranteed interest rate.

Most investors choose index funds when it comes to 529 plans. When investors or advisors choose active managers in these plans (and show willingness to pay the higher fees), they do it in classes like small-cap stocks and emerging market equities, what Liu calls, “satellite asset classes.” These tend to be less efficient, less liquid and can afford more chance for alpha.  

There are some companies that specialize in active management in 529 plans, such as the College America Plan from American Funds, offered by Los Angeles’ Capital Group. This advisor-sold plan, which is directed by the state of Virginia, is also sold nationally and has garnered Morningstar’s coveted “Silver” category. “The expenses [1.07% plus a $10 annual maintenance fee] are very reasonable among competitors in the advisor-sold, active management plans,” Liu says. “And its three-year average return [10.99%] is very good.”

College America’s expense ratios have steadily declined since the plan’s launch 11 years ago, says Kris Spazafumo, the Capital Group business development manager focused on the 529 plan, which at $38 billion in assets is, she says, the largest in the nation. Its size and the breadth of American Funds’ mutual funds (with $1 trillion in assets) give the plan the economies of scale to keep costs down, she says.

“Expenses go down as the assets go up.

“Also, the fee we pay to the Commonwealth of Virginia for management fees is 10 basis points,” she notes. “Other plans may pay higher fees to states for sponsorship.” (Advisors can access educational materials at the Web site for state-specific tax issues, expense ratios and long-term investment options.)

College Advantage Ohio, another Morningstar “Silver” 529, which is sold directly to consumers, also employs some active management. The Ohio Tuition Trust Authority manages the plan, which has an 11.92% average three-year return and a 0.35% average expense ratio. “Active management is not an automatic death knell for 529 plans,” says Liu.

T. Rowe Price also runs two 529 plans sold directly, and reserves the right to use active management when necessary (these two “Gold”-rated plans are directed by Alaska and Maryland and both have average three-year returns of more than 12%). But the active strategy also means elevated expense ratios (0.75% for the plan directed by Alaska and 0.76% for the one directed by Maryland). They also charge annual maintenance fees of $20.

Advisors catering to low- and middle-income clients may face a different problem this year. Fifty-five percent of parents with annual incomes of less than $35,000 said to Sallie Mae that the major reason they hadn’t saved for their children’s college was a lack of money. That sentiment was shared by 59% of those who earned $35,000 to $100,000 annually. Since many of these parents already perceive investable income shortages for their own retirement savings, advisors may have to strain their creativity to find new arguments for college saving.

“Middle-class Americans often juggle their financial demands with their savings goals, one of the most significant of which is saving for college,” says Esther Stearns, the CEO of NestWise, a San Francisco financial advisory firm and a unit of LPL Financial. “In our experience, one of the most important advantages of 529 plans, besides their obvious tax benefits, is their single-purpose design, which allows families to create accounts specifically earmarked for college savings.”

But only 10% of the families responding to the Sallie Mae survey said they cared that the 529 plan was designed especially for college. Overall, the researchers found, Americans were focusing more on “rainy day” savings and retirement.

Twenty-three percent of the Sallie Mae respondents expect to use a combination of student and parent borrowing. About half (731 households) said that scholarships and student loans would be part of the discussion.

Student loan applications rose from 19,486,280 in the 2009-2010 school year to 21,111,766 in the 2010-2011 school year, according to the U.S. Department of Education’s federal student aid records.

T. Rowe Price has crunched the numbers for clients. Its researchers considered what would happen for a student who had to pay a hypothetical tuition of $40,000 per year, then compared investing in a 529 plan over 18 years with the repayment costs of a 14-year college loan at an interest rate of 8% repaid over 10 years. The firm argues that the loan would accrue interest over the four school years and grow to about $55,000 even before the student could begin repaying.

The company concluded that borrowing increases the monthly costs of college sixfold, says Stuart Ritter, a financial planner and T. Rowe Price vice president. “We took a blended rate of all borrowing options: private loans, government loans, student loans, subsidized loans. We found that borrowing instead of saving can double the cost for what is already a very expensive purpose. People should take advantage of the opportunity to save as soon as they can.”