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By Karen Wallace and Leo Acheson, CFA | 10-20-2016 04:00 PM

Notable 529 Plan Upgrades and Downgrades

Morningstar's Leo Acheson discusses what's behind our decisions to boost some state plans and to lower our rating on others.

Karen Wallace: Hi, I'm Karen Wallace for Morningstar.com. Morningstar analysts regularly review and rate 529 college savings plans. Joining me to discuss the latest research on this topic is Leo Acheson. He is a senior analyst in Morningstar's manager research group focusing on multiasset strategies.

Leo, thanks so much for being here.

Leo Acheson: Of course.

Wallace: So, I think one big question a lot of people have is, why wouldn't I just buy my own state plan? When would it make sense to instead look at another state's plan that might be highly rated?

Acheson: So, there are actually plenty of cases where you should consider another state's plan and shouldn't just blindly buy your own state's plan. In fact, a little bit over half of the U.S. population lives in a state where you don't receive additional tax benefits from buying your state's plan, either because the state you live in has tax parity, it has no state tax income, or they don't offer an additional benefit for buying your state's plan. So, investors in those states have a good reason to shop around.

However, if you live in a state with a state tax benefit for buying your state's plan, usually it makes sense to stay in state, but still not always. And it depends on the amount of the tax benefit you get. As a general rule of thumb, we would say that if your tax benefit is equal to 5% of what you're contributing in that year, then it would make sense to stay in state. If not, then you might want to shop around.

Wallace: Morningstar analysts rate 529 plans based on five key pillars and assign a Medalist rating to the [plan] based on that evaluation. Can you discuss what factors you look at, and what makes a best-of-breed plan compared to a lower-rated plan?

Acheson: The main things that we're looking for--five main things. We're looking for strong underlying investments within the plan. We're looking for a solid asset allocation approach that was used to design the glide path that's followed by the age-based portfolios, because those tend to be the most popular options within 529 plans. Of course, we are looking for options with low fees relative to similar peers. We also prefer plans that have strong oversight from both a state perspective and also on the investment management side. And then finally, we'll evaluate the plan's past performance to see how they have done.

Wallace: So, let's get into some of the notable ratings changes. In last update the Virginia529 inVEST plan was upgraded. Let's talk a little bit about why you and the team think that plan's better than it was before.

Acheson: Yes, we upgraded that plan from Silver to Gold this year. It was already a very strong plan. It uses very solid underlying investment options and actually, it's open architecture so they can pick best-of-breed managers from a lot of different shops. And also, the asset allocation approach used by the age-based options is very thoughtful. They use a progressive glide path, which means that over time the equity roll-down is very smooth and that process reduces the risk of shifting out of equities at an inopportune time. Then finally, the fees were already low, but this year they cut expenses even more, actually, to a meaningful extent, and now the plan deserves a Gold rating.

Wallace: And there is another group of plans that received upgrades and that was the direct-sold Fidelity-run plans. Can you talk a little bit about what's improved there?

Acheson: Yes. We rate four direct-sold Fidelity plans, and this year we upgraded them from Neutral to Bronze. And there are two driving factors for the upgrade. One, they cut their fees on their index-based options, and now those strategies rank among the cheapest across the entire 529 industry. And then Fidelity also uses an actively managed age-based track. And within this track they introduced tactical allocation a couple of years ago and since they didn't have a public track record within this space, we were a little bit hesitant about how they were going to perform within that space. However, as it turns out, after evaluating and keeping a close eye on it, we have realized that they operate within pretty strict guardrails and it won't lead to a chance where it will take performance meaningfully off-track. So, overall, we are comfortable with it, and the plans are really solid. They have strong underlying investments and overall, we think that a Bronze rating is fair.

Wallace: And one notable downgrade, two plans run by T. Rowe Price, Alaska and Maryland, now rated Silver, not Gold. What led to your decision to downgrade this plan?

Acheson: So, T. Rowe's plans in Alaska and Maryland are both really strong plans. We still assign them a Silver rating. So, we think that they are among the best options in the 529 space. However, there are a few reasons that we decided to downgrade them this year. First of all, over the past couple of years while the underlying quality of the managers remains very strong overall, you have seen a little bit of deterioration in that. A few of the strategies have been downgraded to Neutral by Morningstar analysts over the past couple of years. So, the underlying lineup is strong, but not quite as strong as it used to be.

In addition, T. Rowe Price selects its underlying managers based on their mandates and won't really consider swapping out strategies if they see manager turnover, and we believe that that's not exactly a best practice. And finally, given the size of the T. Rowe Price plans and the amount of assets they manage in the space, fees are average but we think they could be a little bit lower.

Wallace: There was also one plan that was downgraded all the way to Negative, and that's the Hartford SMART529 of West Virginia. Can you discuss why that plan just doesn't make the grade in your opinion?

Acheson: Yes, we downgraded that plan from Neutral to Negative this year. And one of the biggest concerns about the plan is just the really high fees that it has. It's one of the most expensive plans within the 529 industry when you're looking at the age-based options. So, that will continue to be a hurdle for the plan, especially given that the industry continues to cut costs in general. Additionally, you see that the underlying fund mix is--there are some solid strategies, but then there are some that are so-so or have relatively short or new track records. And actually, some of those underlying funds have struggled lately, and it's led to lagging performance for the plan. The plan actually offers generous tax deductions for in-state residents but it markets primarily to out-of-state investors and so now it earns a Negative rating.

Wallace: OK, great. Now, the full report, which contains all of the upgrades and downgrades, is now available on Morningstar.com. 

Leo, thank you so much for being here to discuss this research.

Acheson: Of course. Thanks for having me.

Wallace: For Morningstar.com, I'm Karen Wallace. Thanks for watching.

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