Why Direct-Sold 529s Are Better Than Advisor-Sold Plans: Morningstar

When it comes to 529 plans, cheaper is better, and that favors direct-sold rather than advisor-sold plans, according to Morningstar’s latest annual report on these plans.

Fees have fallen across both types of 529 plans, reflecting cost cuts across the investment industry, but they have fallen more for plans sold directly to investors, which charge 0.35% of assets, compared with 0.89% for advisor-sold plans, according to Morningstar.

Advisor-sold plans have higher costs because they tend to favor more expensive actively managed funds, as opposed to index funds that are favored by direct-sold plans, and because they usually include 12b-1 distribution fees paid to advisors in their expense ratios.

“When viewed through this lens, the fee burden placed on investors in advisor-sold plans looks particularly hefty,” reads the Morningstar report written by Madeline Hume and Emory Zink, analyst and associate director, respectively, of Morningstar’s Multi-Asset Manager Research.

“All else equal between two plans, the cheaper one will deliver better results for beneficiaries,” according to the report, which studied 83 plans — 54 direct-sold and 29 advisor-sold.

Advisor-sold plans are not necessarily favored by financial advisors. Direct-sold plans have become “increasingly popular with cost-conscious fee-only financial advisors,” growing at a 15% annual rate over the nine years ended Dec. 31, 2020, according to Morningstar. That compares with 10% growth for advisor-sold plans, which are primarily sold by commission-based advisors.

The Morningstar report notes that lower-fee plans have a competitive advantage because they “present lower performance hurdles, putting less pressure on portfolio managers to take more risk to make up their funds’ costs. … Low fees, however, are a dependable advantage that compounds over time and lead to better investor outcomes.”

Growing Assets

The Morningstar report found that overall assets in 529 plans have more than doubled since  2012, when Morningstar started to assign its first forward-looking ratings, to $394 billion by year-end 2020. The report highlighted three trends that are expected to continue to shape these plans in the future.

Greater Use of Progressive Glide Paths to Change Asset Allocations

529 plans generally reduce their equity allocations over time as the date approaches for the first withdrawals to be used to fund educational purposes. They can do this two ways: via a static glide path, which makes abrupt shifts from stocks to bonds at predetermined dates; or via a more progressive track that uses smaller, more frequent allocation changes, which provides a smoother transition that is less susceptible to locking in losses if a rebalance occurs in a period of market stress.

Morningstar found that in 2020, 58% of 529 plans used step-downs (from equity allocations) of 10% or less, up from 21% in 2016, while 40% used step-downs between 11% and 20%, which was little changed from five years ago. Just 3% had step-downs of 21% or more, down from 41% in 2016.

Enhanced Flexibility of Use

529 plan assets can now be used to fund a lot more than college costs. The 2017 tax overhaul allowed 529 plan assets to be used to pay for K-12 private education, and the 2019 Secure Act allowed assets to pay for apprenticeship programs and for up to $10,000 in outstanding student loan debt.

If the purposes of these plans keep evolving, “529 savings plans could morph into tax-advantaged pools of assets that beneficiaries could tap throughout their working lives,” according to Morningstar.

Enhanced Accessibility

Many states, which are the sponsor of 529 plans, are working to broaden access to plans for lower-income households. Pennsylvania, for example, seeds 529 savings accounts with an  initial deposit ranging from $50 to $100 for every baby born or adopted by families in the state, and Illinois and California are expected to launch similar programs soon, according to Morningstar.

Not only will such initiatives help serve more families, they may also appeal to investors who prioritize environmental, social and governance factors in their investment decisions, according to Morningstar.