Investment Risk and Return in Qualified Tuition Plans

By Alan R. Sumutka, Margaret O’Reilly-Allen, Maury R. Randall, and James Morgart

In Brief

In-depth Analysis of One State’s 529 Plan

Section 529 qualified tuition program plans have enthralled those that follow Congress’ attempts to make paying for education easier for taxpayers with enough income to be ineligible for financial aid but not enough wealth to just write a check. Rather than describe the tax legislation and show how to set up and administer a section 529 account, the following article provides by example a means of analyzing the overall investment program offered by a particular state’s 529 plan, New Jersey’s NJBEST. The detailed analysis of NJBEST that follows indicates that it might be an attractive plan for certain investor profiles.

The New Jersey Better Education Savings Trust (NJBEST) is New Jersey’s only IRC section 529 qualified tuition program. Managed by a state government division, the plan is available only through the state, and generally is open only to N.J. residents. NJBEST has received little publicity from traditional sources, such as brokerages, mutual funds, or financial planners, because they do not receive sales-related fees for it.

Despite a conservative investment strategy (a large-cap, hybrid, age-sensitive plan is the only investment option), NJBEST has generated impressive equity returns and average bond returns, at a low risk. It allows greater flexibility in asset allocation than many states’ plans, charges low fees, and holds a stock portfolio described by its manager as a “core U.S. equity holding.” Another appealing feature of the plan is that it has a “moral obligation” clause, which appears to protect contributions from loss.

The plan has been criticized because contributions are not deductible in New Jersey, and they have a relatively low maximum. Nonetheless, the potential for a minimal first-year scholarship at an in-state institution is attractive to students ineligible for financial aid. Such a scholarship and the promise to ignore $25,000 of assets in NJBEST for N.J. need-based financial aid purposes may provide less benefits than expected to students eligible for aid. With a potential plan restructuring in the near future, prospective NJBEST investors may need to act quickly, while current owners may have to reassess their options.

The authors have developed an analytical framework that is useful in deciding whether to participate in a 529 plan. The detailed analysis of NJBEST that follows indicates that it might be an attractive plan for certain investor profiles.

Why Consider a Plan

Like most states’ 529 plans, NJBEST offers the contributor the opportunity to invest significant amounts of cash in growth and income investments in a tax-sheltered environment, but with no federal tax deduction. Accumulations can be withdrawn tax-free if used to pay for the beneficiary’s qualified higher education expenses. While the plan allows broad-based qualified education distributions, the earnings on other nonqualifying distributions can be subject to income and penalty taxes. Although contributions are treated as completed gifts and excluded from the contributor’s estate, the contributor has the benefit of retaining control over the account.

In New Jersey, contributions to the plan are nondeductible, which appears to be a disadvantage when compared to other states. New York, for example, allows a $5,000 ($10,000 married, filing jointly) deduction annually. Because most N.J. residents get no tax deduction for contributions to any state-sponsored plan, this shortcoming is not signifcant, except for the N.J. resident who works in New York, files a N.Y. nonresident return, and is entitled to the N.Y. deduction. Delaware offers no education tax benefits to N.J. nonresidents, and Pennsylvania offers only a prepaid tuition plan.

Some states provide an incentive to invest in their own plans by limiting the earnings exclusion to in-state plans, similar to the tax treatment of state bond interest. N.J. Statute title 54A:6-25 excludes the earnings from any state’s qualified tuition program.

Who Is Eligible to Participate?

Unlike most states, New Jersey restricts participation to in-state residents. A contributor who is at least 18 years old can open an account for a beneficiary provided either is a N.J. resident at the time. There can be only one contributor and one beneficiary, although the contributor can name a spouse as a successor contributor in the event of death and can change the beneficiary or roll over the account under certain circumstances. If the contributor or beneficiary moves out of state, the contributor may continue to invest, but should explore whether the new state offers better resident benefits.

How Much Can Be Contributed?

Minimum contributions. An account can be opened for as little as $25, but to maintain an account, at least $1,200 must be invested during the first four years: either $25 per month for four years, $300 annually for four years, or $1,200 at inception. Further contributions above the $1,200 threshold are necessary to earn certain N.J. scholarships (discussed below). Such minimums are comparable to other state plans.

Maximum contributions. If an NJBEST account is opened, the total contributions to all section 529 plans in the name of the beneficiary (anywhere in the country) cannot exceed $185,000, or the reasonable cost of education expenses (in current dollars) that the beneficiary is likely to incur, whichever is less. Of course, earnings on the investment should increase the account balances. A $10,000 annual contribution over 18 years would grow to about $309,000, given an estimated 6% annual return.

Most state plans allow contributions over $200,000 (North Dakota and North Carolina allow $269,000; West Virginia and Rhode Island, $266,000), which can provide greater deferral opportunities. If necessary, the NJBEST balance can be rolled over to a higher-limit state. The following issues affect how much money should be invested in a single plan:

Annual contributions. Up to $11,000 can be contributed annually without federal gift tax consequences (New Jersey has no gift tax). Under IRC section 529(c)(2)(B), taxpayers can elect to make one $55,000 contribution and average the gift over five years (Form 509). A married couple could therefore shelter up to $110,000 in NJBEST in one year.

Fees and penalties. A $5 annual fee is charged when an account is opened. In subsequent years, the $5 fee is deducted from the account.
A $75 out-of-pocket fee is charged when any amount is rolled over to another qualified tuition program.

NJBEST charges an annual 0.5% management fee, which is deducted pro rata monthly from investment earnings, not the account balance. By limiting fees to earnings, fees can be zero if plan earnings are insufficient to cover the fees. Only Utah (Vanguard managed) offers an age-sensitive plan with lower fees (0.31–35%).

If funds are withdrawn for any reason other than to pay for qualified higher education expenses, the earnings are subject to federal and N.J. income taxes and a 10% federal tax penalty.

How Is It Managed?

Aside from their tax advantages, section 529 plans are first and foremost investments, whose performance is linked to the investment manager. While most states outsource plan management to well-known companies (e.g., TIAA-CREF, Fidelity, T. Rowe Price, Vanguard, Salomon Smith Barney, and Merrill Lynch), New Jersey chose the New Jersey Higher Education Student Assistance Authority (HESAA) to administer NJBEST, and it selected the N.J. Department of Treasury,Division of Investment, as the investment manager.

According to HESAA (www.hesaa.org), “the division was created in 1950 to centralize all the functions related to the state’s diverse funds under experienced and competent management. As of December 31, 2001, the division managed 181 investment funds with a total market value of approximately $79 billion.… According to a 2001 survey of worldwide pension funds, the division manages the twelfth largest pension fund in the world ranked by total assets.” The average pension fund return for the five years ending June 30, 2001, was 11.8% (1997: 22.1%; 1998: 22.7%; 1999: 16.1%; 2000: 11.9%; 2001: -10.4%), and for 10 years was 11.9%.

As can be seen in Exhibit 1, NJBEST consists of six trusts. In August 1988, New Jersey opened the first trust, the N.J. Better Educational Savings Trust (the core trust). The state pooled all contributions, regardless of the beneficiary’s age, and invested a maximum of 40% in equities and the remainder in fixed income instruments. Though maligned during the 1990s bull market, this conservative strategy has proven prudent over time.

On July 1, 2000, the state opened five “age-sensitive” trusts (A through E) which pooled contributions by the beneficiary’s age and expected college entrance date. Contributors to the core trust could remain or transfer assets to the new trusts. The various trusts, with their constant asset rebalancing, allocate more assets to equities in early years and allocate more assets to fixed income when liquidity is needed in later years. For example, 60–80% of assets are invested in equities for beneficiaries under age four in 2002, whereas up to 20% of assets are invested in equities for beneficiaries over age 16.

The division has the discretion to both select investments and allocate assets. In many other plans, managers control only investment selection, not asset allocation. In this form of passive investing (e.g., TIAA-CREF, Fidelity, T. Rowe Price), plans maintain a single, “fixed” target allocation (e.g., 80% stock for a one-year-old), regardless of market conditions. As losses mount, however, the time to recoup them diminishes as equity holdings are reduced systematically.

Investment style. NJBEST holds a large-cap hybrid portfolio. As described on the HESAA website, “All common stocks for the NJBEST program are maintained in one managed equity account, with each fund owning a portion of that account based on its target equity ratio. … The trust will invest primarily in a broad range of equity securities in order to achieve its objective of long-term growth of capital,” and “investments may include common stocks, preferred stocks and convertible securities. While the trust will primarily invest in companies domiciled in the United States, it may invest in foreign securities which are included in the S&P 500 Index. … The trust invests in a combination of growth and value stocks and seeks to provide a diversified portfolio [and] seeks stocks with dominant positions in major product lines, sustained earnings growth and strong financial conditions.” The NJBEST portfolio manager says that the trust is permitted to invest in an approved list of approximately 1,200 common stocks, composed of the S&P 500 and 700 other mostly large-cap stocks traded on U.S. stock exchanges.

With regard to fixed income investments: “Each NJBEST fund has its own unique portfolio of fixed income securities with maturities tied to the number of years remaining until the beneficiaries … reach college age. Each fund also maintains a balance in money market securities to meet any account withdrawals.” The trust is permitted to invest in U.S. government, U.S. government agency, and corporate bonds, and can invest up to 25% in money market securities. As defined on the HESAA website, money market investments mature in two years or less.

Investments as of December 31, 2001. As shown in Exhibit 1, the equity allocation in the age-sensitive trusts is at the lower end of the range (i.e., 9.4% in 0–20% range, 25.5% in 20–40% range, 36.3% in 30–50% range, 46.7% in 40–60% range, 62% in 60–80% range) and is at 37.9%, close to the maximum 40%, in the core trust. Of the $47 million invested in NJBEST overall, only 39.8% was invested in stocks.

As described by the portfolio manager, NJBest stock holdings should be viewed as a core U.S. equity fund. There are no investments in preferred stock, convertible preferred stock, warrants, options, or international stocks. According to the HESAA website, approximately 27% of the equity portfolio was in the following 11 companies: Microsoft (4.26%), General Electric (3.44%), AOL Time Warner (3.10%), Pfizer (2.99%), Citigroup (2.98%), Verizon (2.54%), Merck & Co. (2.21%), Wal-Mart (2.16%), Exxon Mobil (1.90%), and Boeing (1.87%). The average market capitalization of stocks held in the portfolio was $84.0 billion, with an average dividend yield of 1.26%, an average price-to-earnings ratio of 27.20, and an average price-to-book-value ratio of 4.17.

While the portfolio manager suggested that NJBEST might purchase corporate bonds in 2002, the December 2001 year-end portfolio contained only U.S. government and U.S. government agency securities, which carry no perceived default risk. Approximately 50% of NJBEST assets are invested in bonds and 10% in short-term money market instruments. The long-term fixed income portfolio indicates further conservatism, with a weighted-average bond maturity of 6.01 years (generally, longer maturities are more sensitive to interest rates than shorter maturities) and a weighted-average duration of 4.20 years (if interest rates increase by 1%, the portfolio is expected to lose 4.20% in value, and vice versa for decreases). Within each age-sensitive trust, however, the bond maturity and duration decrease as the beneficiary nears college age, reducing its interest rate risk.

Investment safeguards. Although investment performance is not guaranteed by the state, NJBEST provides a moral, but not legally binding obligation clause that it will return at minimum the amounts contributed to the fund. No other education fund makes this offer, and some are skeptical as to whether this obligation will be honored should the neccessity arise. Nevertheless, the state might comply, because they are promoting this benefit and to do otherwise would invite adverse publicity, embarrassment, and a political maelstrom from NJBEST’s 23,000 current account holders.

What Is Its Past Performance?

Although quarterly performance for all age-based plans is available from some websites (e.g., www.savingforcollege.com), evaluating the investment performance of age-based plans is challenging. Most plans are dissimilar and hold different investments with varying risks, so raw performance data are not comparable to most published indices. Comparing plans against each other ignores differences in investment style and risk. The following section evaluates the performance of NJBEST.

Overall performance. Exhibit 2 assesses the overall performance of the NJBEST equity and fixed income portfolios. Only the NJBEST columns and other bold data represent actual returns. Data in the index columns below the NJBEST v. Benchmark row represent the extent to which NJBEST performed against the index, not the actual return of the index. Equity performance was evaluated from April 9, 1999, and fixed income performance from March 12, 1999, the date of the first purchases in each asset class, through March 31, 2002. The NJBEST returns ignore the 0.50% management fee. The current year and since-inception returns were calculated by compounding the quarterly returns using the methodology found in Morningstar reports, which explains why the sum of the quarterly returns does not equal the current-year returns. Because New Jersey computes its returns daily, a difference exists between the Exhibit 2 results and those reported in N.J. communications.

In its approximately three years of existence, the NJBEST equity portfolio has gained 6.89% while the S&P 500 index and Russell 3000 index lost 11.64% and 7.26%, respectively. Thus, the equity portfolio outperformed the S&P 500 by almost 19% and the Russell 3000 by just over 14%. The portfolio handily outperformed the indices in 1999, underperformed them in 2000, outperformed them in 2001, and closely approximated them in the first quarter of 2002.

The fixed income portfolio has generated a 16.23% gain since inception. However, because there is no common index of only U.S. government and agency obligations with a 6.01 weighted-average duration, its performance was difficult to assess. On the surface, other common indices appear to have outperformed NJBEST. For example, the Lehman Brothers U.S. Aggregate index earned 20.95%, but it includes corporate bonds. The remaining Lehman Brothers indices presented in Exhibit 2 include only government obligations but are still questionable benchmarks. The U.S. Government index earned 19.81%, but includes bonds with maturities from one to 30 years, with an average maturity of 8.42 years. The U.S. Government 5–10 Year Mutual Fund Portfolio index measures all government bond funds with these maturities and earned 19.99%, but it had an average maturity of 7.60%. Similarly, the U.S. Government 1–5 Year Mutual Fund Portfolio index earned only 2.62% but had an average maturity of only 2.62 years.

The most useful benchmark was located in the April 6, 2002, issue of Morningstar Mutual Funds, in an overview and summary of 34 Intermediate Government bond funds at December 31, 2001 (p. 161). This surrogate group of funds had approximately 98% of its assets invested in bonds (100% for NJBEST), an average effective maturity of 6.3 years (6.01 years for NJBEST), an average effective duration of 4.5 years (4.20 years for NJBEST), and an average weighted coupon of 6.23% (5.35% for NJBEST). NJBEST gained 17.81% through December 31, 2001, versus 17.29% for the surrogate. However, because the surrogate data is net of investment expenses (not NJBEST) and the first quarter 1999 surrogate was prorated (actual data was unavailable from March 12, 1999, through March 30, 1999), the NJBEST, fixed income portfolio effectively performed similar to the surrogate.

Individual trust performance. Despite the impressive performance of the overall NJBEST portfolio, individual investors should look more carefully at individual trust performance, displayed in Exhibit 3 (first section, second section).

All of the returns shown in Exhibit 3 (first section, second section) are net of management fees, unlike Exhibit 2. Only the NJBEST columns and other bolded data represent actual returns. Data in the index columns below the NJBEST v. Benchmark row represent NJBEST’s performance against the index, not the actual return of the index. As can be seen, since inception, gains were earned in the core trust (17.74%) and trusts A (5.24%), B (1.91%), and D (0.38%); losses were incurred in trust C (–0.40%) and the heavily stock-weighted trust E (–6.45%).

To provide a benchmark, the HESAA website compares the individual trust results to the S&P 500 index and reports that each trust significantly outperformed the S&P 500 by anywhere from almost 30% to almost 13%. This comparison is misleading, however, because each trust is a mixture of stocks and bonds.

Accordingly, Exhibit 3 (first section, second section) also compares each trust to a Lehman Brothers U.S. government bond index, which most closely approximates the average maturity of bonds held in the trusts. The individual trusts significantly underperformed the bond indices. This conclusion, again, is misleading because the trusts also contained stocks.

Once again, because a valid index was not available as a benchmark, a surrogate benchmark was constructed from hybrid domestic funds in Morningstar’s Principia database as of December 31, 2001. The resulting 915 funds were narrowed by eliminating any funds with holdings in foreign companies or in preferred stock, warrants, and options. The few remaining mutual funds were grouped by asset allocations similar to the individual trusts. As can be seen in Exhibit 3 (first section, second section), no mutual funds had a stock allocation of 0–20% and only one fund had an allocation of 20–40%, which trust B underperformed by 13.75%. Five funds had a stock allocation of 30–50%, whose average performance mirrored Trust C. Trust D outperformed the average of the five funds with a 40–60% allocation by 5.01%, and Trust E underperformed the average of 10 funds with a 60–80% allocation by 7.99%.

Another surrogate benchmark was created to evaluate the division’s performance (using its discretion over asset allocation and investment selection) against other state plans, considering asset holdings. The returns of each individual trust were compared to those of an “equivalent individual trust” drawn from other age-sensitive state plans in existence from July 1, 2000, through March 31, 2002, whose quarterly results were reported on www.savingforcollege.com. For example, if another state “trust” had a 20% stock allocation, it was included for comparison against trust A (0–20% stock allocation); if the state trust had a stock allocation of 20–40%, it was included for comparison against trust B (20-40% stock allocation), and so on. The quarterly results of each resulting comparative trust (e.g., the 25 state trusts to be compared against trust A) were averaged and compounded to create an equivalent individual trust.

Despite its conservative investing style and greater discretion, each NJBEST trust outperformed the comparable equivalent individual trusts, often managed by well-known managers with lesser asset allocation discretion but more diversified investments in foreign stocks and corporate bonds, as follows: A by 1.70%, B by 4.60%, C by 7.67%, D by 11.81%, and E by 9.57%. While this may not have been impressive during a bull market, it may be considered as comforting in the current investment climate.

How Are Funds Withdrawn?

In order to withdraw funds to pay for qualified higher education expenses, a form obtained from NJBEST must be submitted with documentation of the education expense (a bill or receipt) and will be processed by NJBEST within two weeks to 60 days. Unpaid bills are paid jointly to the educational institution and beneficiary; paid bills are reimbursed to the contributor.

A beneficiary can be changed at any time with no fee by submitting a form to NJBEST. The change is a nontaxable event if the new beneficiary is a member of the family of the former beneficiary (i.e., the former beneficiary’s son or daughter or descendant of either, stepson, stepdaughter, brother, sister, stepbrother, stepsister, father or mother or ancestor of either, stepmother, stepfather, niece, nephew, aunt, uncle, son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, sister-in-law, any spouse of the aforementioned, the former beneficiary’s spouse, or a first cousin). Beneficiary changes to a younger generation may be subject to federal gift tax.

Once a year, a contributor can roll over an account for the same beneficiary to another qualified state tuition plan without income tax consequences.

If the funds are not needed or used. If the beneficiary receives a scholarship, funds can remain in the account for future use, the beneficiary can be changed, or funds can be withdrawn up to the amount of the scholarship, subject to federal and N.J. income tax on the earnings but without the 10% federal penalty.

If the beneficiary does not pursue higher education, the contributor can change the beneficiary or withdraw the account balance, subjecting the earnings to federal and state income taxes and a 10% federal penalty.

In the event of the death or disability of the beneficiary, the beneficiary can be changed or the account can be closed and the balance paid to the contributor, subject to federal and N.J. income taxes on earnings, but not the 10% federal tax penalty.

In the event of the death of the contributor, a surviving spouse becomes the account owner if previously named as such by the contributor. If there is no named successor, and the beneficiary is under age 18, a trustee or guardian must be appointed (if not designated in the decedent’s will), and no further contributions, beneficiary changes, or withdrawals for other than education expenses are permitted. If the beneficiary is over 18, she becomes the account owner.

Are There Other Benefits or Limitations?

NJBEST scholarship. Contributors of at least $25 per month over four to 12 years are eligible for a scholarship in the beneficiary’s name, which can amount to a substantial return depending on the amount of contributions and the time they remain in the account. The one-time scholarship is available only to an undergraduate who attends a N.J. college, university, or proprietary school, and only for the student’s freshman year. As shown in Exhibit 4, scholarships range from $500 to $1,500 and are linked to the amount and period over which contributions are made. No other state offers this benefit.

For a beneficiary ineligible for financial aid, the scholarship is helpful, but worth less than advertised in present value terms. It could be of little value to a student who qualifies for N.J. need-based financial aid, which takes the form of grants (not loans) and is available only to a full-time student at a N.J. institution (to estimate N.J. need-based aid, visit the 2002–2003 tuition aid grant estimator at www.hesaa.org/students/index.asp). Because a scholarship is counted as a financial resource, which results in a dollar-for-dollar reduction for aid, the result is merely the conversion of a need-based “grant” into a “NJBEST scholarship” at no additional cost to the state and no added benefit to the student.

Financial aid exclusion. Another benefit that could be overstated is that the first $25,000 of assets in NJBEST is ignored in the calculation of N.J. need-based financial aid for the beneficiary. For an eligible student, the benefit may be less than advertised because, generally, need is based on parent and student assets and incomes. If a parent is the contributor, NJBEST is considered a parental asset. Because N.J. financial aid calculations mandate about 20% of parental assets to be used for education, the $25,000 exclusion increases need by only $5,000, a benefit offset largely by a NJBEST scholarship (in the first year) and a probable loss in federal financial aid. Absent a federal exclusion, $25,000 of assets reduces federal aid by at least $1,400 ($25,000 x 5.6% required parental contribution) plus 50% of the earnings withdrawn (required student contribution).

Miscellaneous benefits. Generally, NJBEST accounts are exempt from creditor claims and excluded from an estate in bankruptcy. A NJBEST account cannot be used as security for a loan, either by the contributor or the beneficiary.

For Whom Is It Most Suitable?

A NJBEST account appears to be best suited for an investor who is a N.J. resident who does not work in New York and whose beneficiary is likely to attend a N.J. institution full-time in the near future. The contributor should be able to invest at least $25 monthly for at least four years and as many as 12 years and see no need to contribute over $185,000 to all section 529 plans. The contributor should be comfortable with a large-cap, low-risk, low-cost, age-sensitive, hybrid plan, which is actively, but conservatively, managed by a state division that has generated impressive returns in a bear market.

NJBEST is less appealing to a N.J. resident who works in New York, or is disinterested in a relatively small N.J. (or potentially worthless need-based) scholarship to a N.J. institution. The contributor may desire a more risky and aggressive investment not tied to the age of the beneficiary, be willing to pay more in management fees, or have little faith in a moral obligation clause.

What Is Its Future?

A dramatic change in NJBEST appears imminent, possibly before year-end 2002. In December 2001, Title 18A of the N.J. Statutes was amended to authorize the selection of an “investment manager other than the Division of Investment.” In June 2002, a NJBEST representative indicated that proposals from outside investment managers are expected “within six months,” when the state would consider whether or not to make a change.

Although the NJBEST portfolio has performed admirably, a declining stock market tends to expose and amplify the state’s financial risks. With its management fee tied to earnings and a moral obligation clause that could be tested by further declines, NJBEST is the only education savings plan willing to subsidize investment risk with the potential to drain state funds. The size of NJBEST is small in comparison to some other state plans. With a stated objective to make “a world class education accessible and affordable for all N.J. Students” and apparent underlying objectives to add to the state’s prestige and reduce outlays in its very generous need-based financial aid program, NJBEST may be falling short. By outsourcing management to a well-known company, New Jersey may increase public interest in the program and eliminate future costs and risks.

What Should Be Done If the Plan Changes?

New Jersey might offer three options under a revised plan. A new age-sensitive savings plan (open to all investors) is likely to be managed by a well-known investment company, which relieves the state of its moral obligation, investment fee limitations, and administrative costs, but at a higher cost to investors. A new prepaid higher education expense program (open to all investors) is also authorized in the statute “through which a portion of the costs associated with attendance at institutions of higher education may be paid in advance and fixed at a guaranteed level for the duration of undergraduate enrollment.” Finally, NJBEST is likely to continue in its current form, but only for current owners. The statute notes that if the division is not the selected investment manager, “the authority shall provide for the orderly transfer of accounts and shall ensure that all the rights of the contributors and designated beneficiaries participating in the program as of the effective date of [the Statute (i.e., December 11, 2001)] are protected.” The only way the state could ensure all the rights of those in the program is to continue it. When the original core trust was superseded by the current age-sensitive plan, original core trust contributors could remain in it or enter the new option, a choice likely to be extended to current NJBEST owners.

Because the statute ensures the protection of rights only to those in NJBEST as of December 11, 2001, will New Jersey force post-enactment owners out? Because it is more likely that owners as of the announcement of plan changes will be permitted to continue in NJBEST, prospective investors should consider not delaying and contributing prior to such changes. If subsequent options prove to be more attractive, they are likely to be available to preexisting owners.
This article is not an endorsement of NJBEST and should not be construed as investment advice.

©2002 CPA Journal. Legal Notices