Complex college investment products no sure thing
NEW YORK -- When Robert Allen, 50, opened college savings accounts for his children, he wanted an investment with a guarantee.
"The hope was with the earnings and what we put in it, we would have just about enough by the time the kids were ready to go," said Allen, a Waltham, Mass., lawyer, with three sons: a college junior, high school senior and eighth grader.
Allen started saving for college eight years ago, when most assets in 529 savings plans were flowing into investment options that mirror mutual funds, according to Morningstar Inc., a Chicago-based research firm. He chose a plan that provided a principal guarantee, an alternative that was then offered mainly by insurers. Sponsors of 529 college savings plans are adding federally insured options including index-linked products to attract savers wary of losing money in the stock market.
Unlike mutual funds, these structured products are opaque and it's difficult for investors to determine how much they're paying in built-in charges and whether they're sacrificing too much in returns.
"They try to give you what sounds like the best of both worlds -- you can't lose your principal and you participate in the market upside," said Glenn Frank, a director of investment tax strategy with Lexington Wealth Management, of structured CDs in some 529 plans. "Typically they stack the deck against the investor. They limit the upside and you have to keep the money in there for some long period of time or pay a penalty."
Frank, based in Lexington, Mass., said he has compared options in 529 plans when advising his clients, including Allen, the Waltham lawyer, who want to protect their original investment.
The 529 plans are set up by states and generally offer tax-free gains on earnings if used to pay for eligible college expenses. Assets totaled about $119 billion as of September, up from $200 million in 1998, according to Morningstar. The number of states offering federally insured investments has more than doubled to 14 since May 2009, said Andrea Feirstein, managing director of AKF Consulting Group, a New York-based firm advising state administrators of 529s.
Investors who rely solely on guaranteed investments -- whether structured products or federally insured certificates and savings accounts -- may find their account balances trail the increase in college costs or earn nothing at all.
"The investment will likely not keep pace with the cost of tuition, which continues to rise at roughly twice the rate of inflation," said Stephen Jobe, director of 529 programs for New York-based BlackRock Inc., with about $4 billion in plan assets. "At that rate, a family will never get ahead."
Tuition and fees at public four-year colleges and universities increased at an average rate of 5.6 percent a year beyond the rate of general inflation in the past decade, according to the College Board, a New York-based nonprofit. The average tuition and fees at private, four-year nonprofit colleges this year is $27,293, up 4.5 percent from last year, while the average cost at public, four-year universities for in-state students is $7,605, an increase of 7.9 percent.
Allen said he opened three accounts through Michigan's plan after comparing fees and investment choices because his home state of Massachusetts doesn't offer a tax deduction or credit, as do 35 other states, according to Morningstar. He said he invested about $150,000 in each and picked an option that provided a return of principal plus an interest rate set annually, which can't be lower than 1 percent and currently yields 2.5 percent.
Michigan's plan is managed by TIAA-CREF and the guaranteed option is backed by the New York-based company's life insurance unit, said Doug Chittenden, head of the firm's 529 business. TIAA-CREF has $7 billion in 529 plan assets in multiple states.
Not all products with guarantees are created equal, Chittenden said. Savers should look at rates of return, tax benefits in their states, and liquidity as some certificates of deposit may have penalties for early withdrawal, he said.
"There are many people who could be saving for college who are scared off by mutual funds," said Indiana State Treasurer Richard Mourdock. More than three-quarters of assets in 529s are in securities that mirror mutual funds, according to Morningstar. The average 529 investment option lost almost 24 percent in 2008 when the Standard and Poor's 500 Index declined about 38 percent.
Indiana last month approved the addition to its plan of three certificates of deposit provided by the College Savings Bank in Princeton, N.J., and insured by the Federal Deposit Insurance Corp., said Jodi Golden, executive director of the state's 529 program. It's the first time a state has added the bank's products since Arizona in 1998 and Montana in 1997.
One of the CDs has a traditional, fixed interest rate and the other two are structured products that use derivatives to link returns to an index's performance. Derivatives are contracts whose value is derived from stocks, bonds, loans, currencies and commodities, or linked to specific events such as changes in interest rates.
The bank's "CollegeSure CD" is tied to college inflation as measured by an index of the College Board. Investors receive the rate of college inflation minus 3 percent or 4 percent currently with at least a zero-percent guaranteed return, said Gil Johnson, president and chief executive officer of College Savings Bank.
Another, called the "InvestorSure CD," is linked to the performance of the S&P 500 Index and has attracted about $15 million since its creation in 2008, Johnson said. The CD earns a variable rate of return determined by 85 percent of the S&P's average gains per quarter. If the calculation over the five-year maturity produces a negative return, the CD pays zero percent interest.
While bank yields may be muted when evaluated against a strong equity market, the CD will protect principal when held to maturity regardless of market conditions, said Johnson. "I believe principal protection is priority one when saving for a child's future," he said.
The structured products are hard for an investor to evaluate and compare, said Frank of Lexington Wealth Management. "You'd have to do some math and play out some different scenarios in different markets," to figure out what you could make, he said. "It's just overly complicated."
The CDs linked to indexes require investors to do more reading to understand the risks and potential returns, though they may offer greater upside on earnings than a traditional CD, said Feirstein of AKF Consulting Group.
Indiana plans to make the College Savings Bank CDs available to savers by the first quarter next year and consumers may be able to purchase them in local banks across the state as well as through a website and financial advisers, Golden said.