SAVINGS INCENTIVES AND INVESTMENT MANAGEMENT FEES: A STUDY OF THE 529 COLLEGE SAVINGS PLAN MARKET

Abstract

The government's province of encouraging educational attainment has been a priority for countless administrations in the United States at the federal and state levels. In the early 2000s. the Internal Revenue Code 529 was amended by the Economic Growth and Tax Relief Reconciliation Act to create an investment vehicle that would further encourage parental saving for college. Given exponentially rising college education costs, the appeal of these investment vehicles has been expanding such that now almost every state has multiple 529 plan options.(1) The increasing interest in these plans as investment options has spawned a corresponding interest in the fees associated with these plans and thus the analysis of the 529 plan market has become a salient issue for a considerable portion of the population. The 529 plans, especially those with deductibility of contributions from state income, are potentially of great benefit to consumers. Dynarski (2004b) finds that the advantages of 529 plans rise sharply with income. However, Dynarski (2004a) demonstrates that college savings plans can actually harm certain families on the margin of receiving financial aid when the joint treatment of college savings by the income tax code and financial aid system create tax rates that exceed 100% of college savings. Moreover, if most of the tax deductibility benefit is captured by the fund companies, prior to the convergence in the means and variances in plan fees, people in some states are no better off than they would have been by investing in housing equity or a nontax-advantaged account. The fees charged on the 529 plan accounts have been well above those charged by the underlying mutual funds that comprise the 529 plans (see Figure 1). While it is plausible that the average costs of 529 plans should be different from that of the mutual funds, it is not immediately obvious why there exists such variability of 529 fees across the states. For example. in 2006 Utah ran a 529 plan whose annual fees represented 0.39% of assets while North Carolina's plan fees were 1.32% of assets annually (Hurley 2006). Annual 529 plan fees range from 0.25% to 3.45% of assets charged annually (Hurley 2006). While the costs do differ depending on whether the 529 plan is broker sold or allows direct enrollment, even direct enroll plans exhibit considerable variation in fees across states.(2) [FIGURE 1 OMITTED] Variation in the fees of the underlying mutual funds is well documented (e.g., Dellva and Olson 1998; Khorana, Set-vacs, and Tufano 2007), so some of this variation appears to be consistent with mature equity markets. However, the changes in the tax rules of 2001. which provided additional investor benefits, should be serving to increase 529 plan competition and market efficiency.(3) Moreover, as information about the programs and their costs disseminates through the media, word of mouth, financial planners, and tax professionals, prices should further converge. Yet, from the data it is clear that competitive pressures have yet to eliminate large price differentials. _ In light of the fact that numerous investment management companies manage 529 plans for multiple states, the considerable heterogeneity with respect to 529 plan fees across states is particularly striking. Within the raw data, one can identify a number of instances in which a single investment management company sets significantly higher fees for one state over another. For example, in 2006, TIAA-CREF managed direct-sold 529 plans in both Michigan and Idaho. The average fee for the direct-sold 529 plan in Michigan was 60 basis points (bps), while the average fee for the direct-sold 529 plan in Idaho was 32 bps higher at 92 bps. Correspondingly, the fixed population average state tax rate on wage income in Michigan was 3.87%, while the fixed population average state tax rate on wage income in Idaho was 7.39%. There are several other 'unique elements that influence 529 plan fees and could account for the differences in fees across . …