On December 1st, Fidelity Investments made significant reductions to the management fees on the 529 college savings plans that they manage. From this AP article:

Fees on indexed plans will be cut in half, while fees on actively managed and advisor-sold plans will be cut by a third, the firm said. Fidelity manages plans sold in Arizona, California, Delaware, Massachusetts and New Hampshire.

The changes mean a family with $50,000 in an indexed portfolio might now pay $125 a year in fees, instead of $250, assuming the amount in the plan remained unchanged. […]

Fidelity, which is based in Boston, said total fees for its direct-sold indexed portfolios will now range from 0.25 percent to 0.35 percent of assets. Total fees for actively managed plans will now range from 0.59 percent to 1.04 percent of assets.

Here is a PDF of their current expense ratios for their active and passive investment options.

According to this WSJ article, they’ll also be changing up their age-based asset allocations a bit:

Fidelity also said it plans to increase the international equity exposure in both its direct- and advisor-sold plans’ age-based portfolios to 30% of the overall equity allocation from a current range of 0 to 20%, and plans to add an emerging-markets fund to its age-based portfolios.

Both changes will be phased in over the next 12 to 18 months.

The reason for this is hardly altruistic, as Fidelity is a privately-held for-profit company. They needed to do this in order to stay competitive. The only reason I have 529 fund at Fidelity is that I have had it connected to their 2% back credit card. I’m still happy with the change though, which follows their recent addition of index fund options back in August 2009.

Despite these improvements, I still plan on shifting everything eventually to my account at the Ohio CollegeAdvantage 529 Plan, which offers inflation-protected bonds (TIPS) at a very low expense which I think are a great “safe” option for saving up for college. (They also offer a variety of low-priced index options from Vanguard.) Fidelity has no such TIPS option.

Also, until December 15th (soon!), they are still running a promotion where you can get $25 for signing up, $50 for referring others, and $25 for starting up automatic deposits. (A couple could earn $150 free for their kid’s education this way.) If you need it, my CollegeAdvantage referral code is 2439350.

I have thought about signing up for a prepaid tuition plan, as I am leaning towards conservative investments for college savings. Lock-in tuition now, and don’t worry about future hikes. However, it appears that even though 18 states have pre-paid tuition plans, only seven of them actually guarantee them – Florida, Maryland, Massachusetts, Mississippi, Texas, Virginia and Washington. (The image below says six, but the article was corrected later to add Virginia.)

Currently, the plan hurting the most publicly is from Alabama, called the Prepaid Affordable College Tuition Plan (PACT). The plan’s asset value dropped from $899 million in September 2007 to $463 million at the end of January, nearly a 50% drop. Why? Because they invested over 70% of their assets in stocks, and also assumed a consistently high rate of return:

According to an actuarial report on the fund filed by the state in January 2008, the fund’s managers then as­sumed a rate of return of about 8 percent until 2013, and 8.5 percent after that. That report also found that the fund’s liabilities exceeded its assets by about $20 mil­lion.

According to fund docu­ments, 42 percent of its assets, as of March 2008, were invested in large market capi­talization domestic stocks, 9 percent in small market capi­talization domestic stocks, 21 percent in international stocks, 26 percent in domestic fixed-income securities and 2 percent in cash.

48,000 families who were invested in the plan got letters earlier this month that the plan may have trouble meeting its future obligations. To make things worse, their brochures actually once stated that it was guaranteed by the state of Alabama, until later on it was found that wasn’t possible due to state law.

I don’t know about you, but isn’t a guaranteed return the entire point of prepaid tuition plans? I commit money now in order to know that I can afford tuition for my child in the future. I give up the chance for higher returns elsewhere. Otherwise, it’s like heads they win, tails you lose. High returns, they keep the difference. Low returns, they say “oops we got no money”.

Also reported to be in trouble are the programs in Tennessee, South Carolina, West Virginia and Washington. Finally, I also found this article which stated that although guaranteed, the Texas plan had a projected shortfall of $206 million.

Recently, I have been exploring the “safe” options inside various 529 plans. This would be a good choice for those who want to feel like they are making continuous gradual progress and avoid the swings of the stock market, similar to what is offered in pre-paid tuition plans in certain states like Florida. The problems with those plans are that they are usually limited to residents only, and your kid often has to go to one of the in-state schools to get the guaranteed tuition benefit. One unique pre-paid type of plan is the Independent 529 plan, but it is also restricted to certain schools (mostly private liberal arts colleges).

Next, there are plans with guaranteed-return funds backed by insurance companies, or certificates of deposit from banks. However, these types of investments are still subject to inflation risk. If a period of high inflation occurs, your returns could be squashed. Even with current deflation concerns, given current government policy I think high inflation in the future is still a potential concern.

So what’s left?

CollegeSure Tuition-Indexed CDs

Offered by the College Savings Bank, these are FDIC-insured certificates of deposit which offer an interest rate linked to college tuition levels. The CollegeSure CD earns an annual percentage yield (APY) over the life of the investment that is 3.00% less than the college inflation rate. (For a while, this margin was only 1.5%.) These are only available through either the Montana or Arizona 529 plans, but you can use the proceeds towards a school in any state.

The CDs are available in maturities ranging from 1 to 22 years, so you are basically pre-paying tuition at a fixed premium. Here’s an illustration from their site:

Changes in costs are tracked by the Independent College 500 Index (IC500), which is derived from the average tuition plus housing costs of 500 private colleges. Over the last 10 years, the college inflation rate has been 5.4% annualized, Over the last 20 years, it was 5.7% annualized. Of course, this is just an average and it both excludes public universities and ignores the average aid packages given out, but it seems to be a reasonable index.

Treasury Inflation-Protected Bonds

Treasury Inflation-Protected Securities (TIPS) are bonds that promise you a total return that adjusts with the CPI index for inflation. Very generally, it works like this: if the stated real yield is 2% and inflation ends up at 4%, your return would be 6%. TIPS are issued and backed by full faith of the U.S. government. Right now, they are only available in 529 plans in the form of mutual funds like the Vanguard Inflation Indexed Bond Fund. Some plans offer them as part of their age-based investment mixes, but a few offer them as standalone investment options. The Ohio 529 plan ($25 bonus) looks to offer the cheapest option, with an annual expense ratio of 0.32%.

The actual real yield you get varies, but here is some historical market data for a maturity of 10-years, which is close to the average mutual of the Vanguard fund:

To make a rough estimate, I’d say you average about 2% real before fees. After about 0.3% in fees, you’d end up with 1.7% + inflation.

Inflation is tracked here by the CPI-U (Consumer Price Index for All Urban Consumers), a number tracking the price of a wide basket of goods and services. From January 1999 to January 2009, the annualized inflation rate was about 2.5%. Over the last 20 years, it has been about 3.0%.

It does not focus on college tuition, or even include it explicitly as far as I know. However, there should be some correlation to college tuition.

So which is better?

Would you rather have:

If we use the average numbers from the last 10 years, the CollegeSure CD would have earned roughly 2.4% annually and the TIPS fund would have earned roughly 4.2% annually. This would seem to tilt in favor of TIPS, but there are two problems:

• Unlike with the CollegeSure CD, you can’t match the maturity of the TIPS fund with your goals. It’s more or less fixed at 10 years forever. For example, if you only have 2 years left until college, you might want to start moving money out because you can still lose principal in the short-term due to interest rate fluctations.
• If the rate of college tuition rises significantly higher than overall inflation by greater than 4.7% a year, then the TIPS fund would fall short.

One could always split money between the two as well, but for not I’m just investing in the TIPS. College inflation may continue to outpace overall inflation (or it may not), but I doubt it will do so by more than 4.7% a year for an extended period. Also, I believe that investment options in 529s will only improve with time. One day, I expect to be able to buy individual TIPS to more closely match maturities with our time horizon.

This is not to say I’ll necessarily be 100% TIPS – I’ll most likely throw a bit of stocks in there – but I think it’ll be a big component of our plan.