6 529 Plans Suffer Downgrades in 2016
2 former Gold-rated plans slip, the list of Negative-rated plans grows.
Earlier this week, we released our annual ratings for 63 529 plans, which in aggregate represent more than 97% of the industry’s assets. Morningstar identified 33 plans that it believes to be best-in-class options, assigning these programs Morningstar Analyst Ratings of Gold, Silver, and Bronze. Twenty-seven plans earned Neutral ratings, and just three received Negative ratings. Some Neutral-rated programs may hold appeal for in-state residents because of meaningful added benefits, such as local tax breaks, so investors should research their states' particular benefits.
In terms of ratings changes, Morningstar upgraded six plans and downgraded six this year. The article published earlier this week focused on the upgrades; this article details the downgrades. In-depth analyses of all 63 plans under coverage are located on Morningstar.com.
So, what spurs a downgrade? Oftentimes it is a result of plans not keeping pace with the increasingly competitive landscape. In general, the industry continues to move toward best practices via fee cuts, beefed up asset-allocation resources and processes, and improved investment lineups. Plans that sit still can fall behind in this rapidly evolving setting.
T. Rowe Price’s Plans Lose Their Gold Ratings
Alaska’s T. Rowe Price College Savings Plan and Maryland College Investment Plan, both direct-sold and managed by T. Rowe Price, saw their ratings decease to Silver from Gold. The plans still represent topnotch options; a Silver rating signifies a strong vote of confidence, with only 13 of 63 plans under coverage earnings similar or higher marks. However, the plans have room for improvement.
T. Rowe Price manages the plans in a nearly identical fashion. Both plans’ age-based options follow the same glide path designed by T. Rowe Price’s proven target-date team, each invests exclusively in T. Rowe Price underlying funds, and the plans offer a similar lineup of stand-alone options. The main difference is that Maryland’s plan uses a short-term bond fund shortly before and during college, which leads to lower duration as compared with Alaska’s plan.
The quality of the plans’ underlying T. Rowe Price funds remains strong, though it is not quite as impressive as it was a couple of years ago. Morningstar analysts rate 12 underlying strategies across both plans; nine receive medals in Alaska’s plan, and eight receive medals in Maryland’s plan, meaning the analysts expect those strategies to outperform their respective peers and indexes over the long term. However, during the past two years, each plan had four Silver-rated funds downgraded to either Bronze or Neutral ratings. Manager turnover spurred the majority of the downgrades. T. Rowe Price selected the plan’s underlying funds based on their mandates and won’t swap out strategies unless their approaches or styles change. In contrast, Morningstar considers it a best practice for program managers to continually assess the stand-alone merit of each underlying strategy within the lineup.
Additionally, although T. Rowe Price manages more than $7 billion in 529 assets, fees for these plans look average compared with direct-sold programs that use primarily active managers. T. Rowe Price could lower expenses by more than 10 basis points for the age-based portfolios by moving to cheaper, institutional share classes of the underlying funds; the plan’s assets invested in the underlying funds easily qualify for the $1 million minimum investment necessary to gain access to that share class. For example, within the Maryland plan, Portfolio 2021 alone has $37 million invested in T. Rowe Price Blue Chip Growth.
Three Plans Fall to Neutral From Bronze
iShares 529 Plan
Arkansas’ advisor-sold iShares 529 plan’s rating fell to Neutral from Bronze because of subpar oversight. This plan's stand-alone options and age-based portfolios invest in iShares exchange-traded funds exclusively, but iShares Core offerings are notably absent from the mix. The iShares Core offerings are much cheaper than the plan’s current options. For example, the plan includes iShares Russell 1000 and iShares Emerging Markets with expense ratio of 0.15% and 0.67%, respectively. However, iShares Core S&P 500, which costs 0.04%, and iShares Core Emerging Markets, which costs 0.14%, provide similar exposure for much lower fees.
On the surface, the existing options may not seem too expensive, but the plan's 0.35% program-management fee more than doubles the cost of many of the existing options. The inclusion of iShares Core options would help rein in the plan’s already hefty costs and indicate that those in charge have college-savers' best interests in mind.
The plan does have a few solid features, starting with the age-based portfolios. BlackRock's asset-allocation team, which makes the allocation decisions and rebalances the age-based portfolios, is an accomplished group. That team also manages BlackRock's suite of LifePath target-date retirement offerings. The age-based track stands out for having a progressive glide path, which is similar to the asset-allocation rebalancing approach behind target-date retirement funds. Most 529 plans offer age-based tracks that move investors, sometimes abruptly, from one static age-based portfolio to another. A progressive glide path lowers the market risk by gradually shifting to bonds from stocks rather than making sudden, dramatic allocation shifts.
Arkansas residents may also find the plan appealing, as couples can deduct up to $10,000 per beneficiary from their taxable state income. Nonetheless, residents and nonresidents alike would benefit from a move to iShares’ cheaper underlying ETFs.
Future Scholar 529 Advisor
We downgraded South Carolina’s advisor-sold Future Scholar 529 College Savings Plan to Neutral from Bronze owing to its lackluster lineup of underlying investments. The age-based and static portfolios combine active and passive management. With the exception of a few iShares exchange-traded funds, Columbia runs the underlying active and passive strategies. The Columbia index strategies have performed as expected, but the lineup of Columbia active strategies isn't exceptional compared with top-tier plans.
Columbia sets the glide paths for the age-based options and has flexibility to deviate from the portfolio's strategic asset-allocation weightings to boost returns. Tactical management is notorious hard to execute successfully, adding uncertainty. Moreover, Columbia has struggled to distinguish itself as a top-tier asset-allocation manager in general (it even hired Jeff Knight from Putnam in 2013 to revamp that effort).
The plan has some attractive features, including below-average fees. Additionally, South Carolina residents can deduct all plan contributions from their state tax income, improving the appeal for them. But out-of-staters hold roughly half this plan’s assets and can find better options elsewhere.
Path2College 529 Plan
We downgraded Georgia’s direct-sold Path2College 529 plan to Neutral from Bronze, as the plan in general does not stand out from the competition. In fact, we assign four of the plan’s five pillars Neutral ratings, indicating that the plan does not follow industry best practices on most fronts. The only pillar with a Positive rating is Performance, which carries the smallest weighting of all the pillars in determining a plan’s Morningstar Analyst Rating, as past performance is not necessarily indicative of future results.
The plan invests in a mix of active and passive TIAA strategies, with a meaningful bias toward the latter. Costs become a meaningful differentiator for plans that stash the majority of assets in index-based funds. Even after a small fee reduction during the past year, the plan does not look compelling from a fee standpoint relative to direct-sold peers that use primarily passive underlying strategies.
The plan is a serviceable vehicle for Georgians who can contribute annually in order to maximize their state tax benefit, which recently increased to $4,000 from $2,000 for couples filing jointly. Other investors, though, can readily find plans at other states with similar investments and better prices.
A New Negative-Rated Plan
We downgraded West Virginia’s advisor-sold Hartford SMART529 to Negative from Neutral primarily because of its high fees. The plan’s Price pillar has received a Negative rating since 2014; although the age-based options’ expenses didn’t change during the past year, they actually increased slightly in 2015. Meanwhile, many competitors have slashed expenses during the past two years, making this plan increasingly unattractive. Expenses clock in at 1.26% or higher for three of the five age-based portfolios.
Other aspects of the plan fail to inspire confidence. The age-based options follow an asset-allocation roll-down path that steps down steeply and abruptly, exacerbating the track's market-timing risk. At age 16, for example, the glide path decreases its equity allocation by 25 percentage points in one day. Meanwhile, the quality of the underlying managers is mixed. Some strategies, such as Hartford Dividend and Growth and Hartford World Bond, are Morningstar Medalists, an indication of analysts' conviction in the funds' potential to outpace peers and indexes on a risk-adjusted basis over the long term. Many of the other heavily used underlying funds have produced uninspiring results. For example, Neutral-rated Hartford Capital Appreciation’s three-year return trails most large-blend peers through September 2016. The fund's manager changes raise doubts about its process. Moreover, important underlying fixed-income funds, such as Hartford Unconstrained Bond and Hartford Strategic Income, are run by experienced yet relatively short-tenured managers, introducing uncertainty. Altogether, they've made for poor relative results in the age-based portfolios, which hold the bulk of assets.
The Hartford SMART529 college-savings plan mainly makes sense only for residents of West Virginia. That’s because only they can enjoy the state's generous tax benefits, which can make up for this plan's sometimes questionable investment merits and high fees. Yet more than 80% of the plan's assets come from out of state, a consideration that further contributes to the plan's Analyst Rating of Negative.