Morningstar recently released its annual 529 College Savings Plan study [pdf] for 2010. You can read about the final product Top 5 plans here (using some subjective judging components), but the paper also had some stats that I felt were note-worthy for those not wanting to read all 48 pages of it.

Broker-sold plans make up 52% of all 529 plan assets, direct-sold make up the other 48%. I guess I shouldn’t be, but I was surprised that only half of assets are by parents not going through a broker or financial advisor.

The average 529 balance was $9,700, which is a bit more than one year of tuition at a in-state public university (average $7,020) and much less than half a year of tuition of an out-of-state public school ($18,548) or a private college or university ($26,273). I wonder what the median is, to negate the effect of the tiny accounts.

Parents typically open accounts for their children when they are between the ages of 7 and 10, giving most families about a decade to save before their first tuition bill comes due. With only a decade, I would be wary of putting a big chunk in stocks. Many providers have already changed their “age-based” portfolios to hold less stocks. Only after the market drop, of course…

Here is a chart showing the industry average “glide path” for age-based investment options:

Roughly estimating, I see about 60% stocks for an 8-year old with a decade left before college. Before choosing such an option in your own 529, it’s important to see what your specific age-based glide path is. Many now have multiple options for conservative, moderate, and aggressive.

The asset-weighted total average expense ratio for direct-sold plans is between 0.49-0.64% annually, depending one if the plan allows investment options outside the program manager’s. The asset-weighted total average expense ratio for advisor-sold plans is between 1.16%-1.52%.

The five cheapest direct-sold 529 plans, ranked by asset-weighted total expense ratios, are:

1. New York’s Direct 529 Program (0.25%)
2. Utah Education Savings Plan (0.28%)
3. The Vanguard 529 College Savings Plan, Nevada (0.28%)
4. CollegeAdvantage 529 Savings Plan, Ohio (0.29%)
5. College Savings Iowa 529 Plan (0.34%)

Keep in mind that this is based on actual assets held by savers, not just based on the cheapest option available in a plan. Many of these plans offer some actively-managed options for those that wish to partake.

Since we’re on the topic of college tuitions, I have recently adjusted the investment mix in my Ohio CollegeAdvantage 529 Plan. As I’ve mentioned before, I choose a very conservative mix because I think a 20-year or less horizon with a 4-year or less withdrawal period is actually a pretty short horizon. I just want to see gradual but reliable increases in my balances. In contrast, I view retirement as a 30 year horizon with another 20-30 year withdrawal period.

Previous Asset Allocation

My original asset allocation was 100% Treasury Inflation-Protected Securities (TIPS) through the Ohio 529’s Vanguard Inflation-Protected Bond Option which is essentially the Vanguard Inflation-Protected Securities Fund (VIPSX) with a slightly higher expense ratio. Back in 2009, I ran a comparison of the CollegeSure Tuition-Indexed CDs vs. Inflation-Protected Bonds, and picked TIPS. However, back then the real yield was 1.7%, and it is now 0.49%. Accordingly, the fund has a pretty good performance since then.

Updated Asset Allocation

20% Stocks (simple low-cost index option)
40% Inflation-protected bonds
40% Bank CD 10-year initial term, paying 5% APY.

Adding Stocks

The reason I chose to add stocks is that historically, adding 20% of stocks to a portfolio has actually reduced volatility while increasing returns. Here is a chart from my Choosing An Asset Allocation series of posts. As I get closer to college start date, this 20% portion will go down to zero.

Adding a 5% Bank Certificate of Deposit

Right now, a regular nominal 10-year Treasury Bond yields less than 2.50%. The real yield on a 10-Year TIPS bond is 0.95%, so the market is basically predicting inflation over the next 10 years to be about 1.50% annually.

However, the Ohio 529 plan offers a FDIC-insured certificate of deposit with a 10-year term earning 5% APY through Fifth Third Bank. (Heads up via Bogleheads.) That’s quite a big boost in yield. For every $10,000 I put in today, I’m guaranteed over $15,000 in 10 years. Early-withdrawal penalties are steep at half of accrued interest, so I had to be sure I wouldn’t need the money sooner.

As long as the real yield on the TIPS fund stays below 1%, then as long as inflation stays below 4% over the next decade the CD will win out over TIPS. If inflation somehow goes nuts, then the TIPS will keep the portfolio from falling too far behind. (Hopefully the stocks will help out as well.)

Since these are all in a 529 plans, the gains will be tax-free if used for qualified college expenses, which is good because otherwise federal and state taxes on a bank CD would be pretty high for us.

Let’s say you’ve dutifully opened up a 529 college savings plan for your child and are looking for a suitable investment options. You’re not looking for a miracle, just a conservative investment to grow your savings for a while since college is coming up fast. You read the brochure for one of the funds:

The OIM Core Plus Fixed Income strategy is rooted in the idea that individual security selection produces the best opportunity for risk-adjusted excess returns over time. Through an extensive, bottom-up research process, our portfolio management team focuses on optimal bond selection of investment grade corporate bonds, mortgage-backed securities, US Government Treasuries and taxable municipal bonds. The team employs a tightly controlled duration discipline and closely manages all portfolio risk factors. The portfolio management team’s objective is to produce predictable, consistent excess returns net of fees over the Barclay’s Capital Aggregate Bond Index.

Sounds pretty good, all the buzzwords are hit. Risk-adjusted excess returns. Predictable, consistent, yup. Beat the average! This reminds me of the Money Magazine Mad Libs game.

Fast forward a couple of years:

In the Illinois BrightStart 529 plan, the Oppenheimer Core Plus bond fund lost 38% of its value in 2008, while the fund’s benchmark actually rose 5.24%. How’s that for “excess” returns? It turns out the fund used leverage and invested in mortgage-linked securities. After a lawsuit, Oppenheimer settled for $77 million, which amounts to only half of the losses.

In the Oregon College Savings 529 Plan, the Oppenheimer Core Bond fund made up 10% to 40% of the popular automatic age-based portfolios for the 529 plans. The fund dropped roughly 35% in 2008. Oppenheimer settled for $20 million, which is about 57% of the losses. In the New Mexico 529 Plan – you guessed it – the same thing happened and they recently settled for $67 million.

This means that in 2008 Oppenheimer lost roughly $300 million of people’s college savings across just three states in a fund that was supposed to be very conservative and sold to those with children within 5 years of college. I would never invest in any Oppenheimer fund after reading this. Not only did they mislead their investors – if not outright lied – they only partially reimbursed them after being sued and faced with a huge jury penalty.

Stories like this to keep me happily investing in low-cost passively-managed bond funds which are satisfied to carefully track a set benchmark. You really never know what a manager is doing when trying to “beat the benchmark”. When it comes to bond funds, it is very very hard to do so without taking on more risk, especially when they have to overcome their own high fees.

Resources
Found via: Mish’s Economics Blog, CNN More Money Blog.
News articles: AP, Star-Tribune, Oregon 529 Press Release