From the August 2010 issue of Investment Advisor • Subscribe!

August 1, 2010

The ETF Advisor: ETFs Enroll in 529 Plans

After saving for retirement, saving for college is probably the most daunting financial challenge families face. So the creation of tax exempt 529 accounts in 1996 for assets used to fund educational purposes was a warmly welcomed development by parents and grandparents.

Of the $577 billion Americans currently have saved for college expenses, about $135 billion is held in 529 savings plans, according to estimates by the research firm Financial Research Corp., which projects 529 account assets will grow to $247 billion by 2014. While still tiny compared to $3.6 trillion held in 401(k) accounts, it is a large enough pool of assets that sponsors of exchange traded funds are beginning to look for ways to get more involved.

The vast majority of the assets in 529 plans (see contact information for all plans on page 75; and details on the plans at InvestmentAdvisor.com) are invested in mutual funds. That is slowly starting to change. In August 2008, iShares teamed up with Boston-based Upromise Investments--which manages 20 different 529 plans in 11 states--to create the iShares 529 Plan, the first ETF-only plan, for Arkansas, and since then Iowa, Indiana, and Missouri have followed suit.

In Arkansas, iShares offers a lineup of funds similar to many retirement offerings. The plan has target date funds for year of enrollment beginning in 2012 and every three years after that until 2027. Like target date retirement funds, they gradually adopt a more conservative asset allocation as the target date approaches. As of late June 2010, the 2012 College Portfolio had 23.4% of its assets in equities (both domestic and foreign), and the rest in fixed income. By contrast, the 2027 College Portfolio had 78% of its holdings in equities.

Two months after the Arkansas plan went live, Indiana hired Upromise as the program manager for both its direct-sold and an advisor-sold 529 plans. The CollegeChoice Advisor 529 Savings Plan offers seven target date funds, some of which include a real estate component, that are composed of iShares ETFs, as well as seven iShares ETFs and five mutual funds.

Of course, the success of ETF-based 529 plans will largely hinge on their ability to deliver the benefits investors have come to expect from ETFs. The most important of these are the fees charged. The good news is that the ETFs available in 529 plans are in just about every instance cheaper to own than their mutual fund counterparts.

The Pros and Cons of ETFs

While their low fees make them attractive, the other benefits of ETFs--tax efficiency, exchange trading, and innovative asset classes--are notably absent in a 529 environment. Since the money withdrawn for qualified tuition purposes, as defined by the IRS, is exempt from income taxes, the tax advantages ETFs offer over mutual funds is of negligible value. As for exchange trading, IRS regulations only permitted two shifts in asset allocations in 2009, and that was twice the number permitted in 2008. Lastly, the access to new and exotic asset classes that have drawn so many investors to ETFs is undercut by the fact that 529 plans tend to offer relatively few investment options.

While there is no reason for residents of those states not to use the ETF options available, there is no clear-cut reason, other than cost, that makes them preferable to a traditional mutual fund. Until that changes, ETFs may struggle to gain share in the 529 plan world.


S&P Senior Finacial Writer Vaughan Scully can be reached at Vaughan_Scully@standardandpoors.com. Send him your ideas for ETF story topics.

Reprints Discuss this story
This is where the comments go.