Choosing a Section 529 college savings plan without examining its investments is like buying a car without looking under the hood or taking a test drive.
Yet many financial advisers and investors look no further than the federal income, estate and gift tax benefits that have made 529s so popular. Although those benefits are the same from plan to plan, it is the differences between investments that ultimately determine college savings outcomes and client experiences.
The good news is that 529s have evolved significantly and now merit a second look from advisers who shied away in the past. Asset managers and states are more aligned in pursuing better outcomes for college savers, and investment choices are more robust than ever.
However, not all 529 plans are created equal. They may offer similar-sounding age-based and asset allocation portfolios, but that is typically where the similarities end.
As an investment carrying risks and rewards, a 529 should be treated with the same thoughtful analysis that advisers use when screening mutual funds.
Here are four key criteria:
Asset class diversification. Few, if any, advisers would concentrate a client's retirement portfolio in a single core bond fund, especially given low yields and rising-rate risks. College-savings assets shouldn't be positioned so narrowly, either, but they often are.
Some 529s hold only one core bond strategy, surrounded by a fairly traditional blend of stocks and cash. Others diversify into extended and alternative assets — lower-correlated investments commonplace in the taxable- fund space but not necessarily in 529 discussions.
Beware the illusion of diversification. Simply owning more underlying funds may result only in overlap of investment styles and holdings.
Bottom line: Markets are likely to remain volatile for college investors. Those 529s with a greater level of asset class diversification may help clients pursue the higher returns needed to meet rapidly rising tuition costs without unwanted risk.
Glide path design. Nearly all 529s offer age-based portfolios that automatically become more conservative as college gets closer. However, there can be major differences in how plans aim to capture growth and manage volatility at each stage along the glide path.
Understanding a 529 manager's approach to glide path design can help advisers optimize clients' risk/return objectives.
Some plans offer multiple glide paths, for example, one more aggressive and one more conservative. The key question is whether either option suits the many clients in between, those seeking more return potential early in the glide path and less risk near college.
Portfolio construction. Advisers usually outsource construction of a multiasset 529 investment portfolio, either age-based or risk-based. Managers should demonstrate a clear process for screening and selecting underlying holdings, as well as adding or replacing strategies as better options become available.
Selecting a 529 manager who picks the best ideas from a deep and diverse pool of investment candidates is paramount. There also can be meaningful value in combining both active and passive strategies from in-house and external managers.
Tactical asset allocation. Tactical 529 managers have the added flexibility to exploit opportunities and avoid obstacles as markets change.
Many plans take a “set it and forget it” approach in which assets periodically re-balance back to strategic allocations regardless of market conditions. This isn't to be confused with a tactical manager who actively monitors the potential impact of near-term volatility and adjusts portfolio positions accordingly.
Tactical management is particularly important in 529s because Internal Revenue Service rules permit account owners to change investments only once per calendar year. If markets move sharply after they have completed their annual investment exchange, clients can't respond unless their 529 manager has the ability to make tactical shifts.
The process, however, involves complex decisions about when to reallocate, which assets to shift and by how much. As always, selecting a skilled manager is essential.
Choosing 529s based on these four factors helps reinforce the conversations that advisers are already having with clients about allocating assets, diversifying portfolios and managing risk in challenging markets.
Michael Conrath is executive director and 529 program director at J.P. Morgan Asset Management, the investment manager for New York's 529 Adviser-Guided College Savings Program.