Saving for College. Talking Points

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1 ? Saving for College Christine Benz s Talking Points November 2017 Talking Points Saving for college differs from saving for retirement in a few ways. College matriculation years aren't negotiable, time horizons are usually shorter, and inflation is a more-significant foe. A college portfolio's asset allocation should begin downshifting into cash and bonds when the child is in grade school, and the portfolio should be dominated by bonds by the time the child is in high school. Contents 1 Talking Points 3 How to Allocate Assets for College Savings 6 Morningstar Names Best 529 College Savings Plans for Three 529 Plans Suffer Downgrades in Morningstar Analyst Ratings for 529 College Savings Plans The inflation rate for college costs has been running in the neighborhood of 5% over the past decade. Investors with extremely conservative asset-allocation plans are going to have difficulty matching the rate of college inflation. Age-based options within plans vary widely in their glide paths. That makes it important to conduct due diligence on a prospective plan's asset-allocation framework and see how it compares with other options within that same general age band. Families who aren't using an age-based 529 option can still use 529 glide paths to help get their own plans' asset mixes in the right ballpark. The 529 industry made meaningful improvements over the last year, with many plans reducing expenses and improving the asset-allocation approach used within the age-based portfolios by smoothing out the transition from stocks to bonds as the beneficiary ages.

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3 Page 3 of 14 How to Allocate Assets for College Savings Families must contend with competing challenges: steep glide paths and high inflation. By Christine Benz Published October 23, 2017 Finding the right asset allocation or mix of investments for college can be a tricky business. If you're a minimalist, it may be tempting to buy a good-quality balanced fund and call it a day. Especially if you're just starting out and the assets in the college savings plan are still small, it may seem like overkill to manage a college portfolio with lots of moving parts. There are certainly worse ways to go about saving for college (life insurance, anyone?). But before you invest your college savings in anything, it's worth considering how investing for college is different from saving for that other long-term goal, retirement. Those differences, in turn, argue for taking a more hands-on approach to asset allocation than a balanced fund would allow. Nor do target-retirement vehicles fit as one-stop options for college savers. Truncated Time Horizon In contrast to retirement, your child's college matriculation year isn't a negotiable date. A person who encounters a bear market shortly before retirement may have some wiggle room to keep working or rely on other sources of income to avoid tapping his nest egg at a low ebb. But try telling your 18-year-old that he'll have to wait until age 21 to start school so that his college fund will have time to recover. In addition, your time horizon for saving for college is much shorter than is the case for retirement, as is the time horizon for spending those assets. One might save for retirement for 40 years or more and be retired for another 30 or 35 years. But you have less than half that amount of time to amass the funds needed for college, and if all goes well, you'll spend down those assets quickly in four years or so, or perhaps a few more if you're also footing the bill for graduate school. Both of those facts call for a much steeper glide path the gradual shift from more volatile investments such as stocks to more conservative investments such as bonds in the years leading up to and during college than the typical glide path before and during retirement. A college portfolio's asset allocation should begin downshifting into cash and bonds when the child is in grade school, and the portfolio should be dominated by bonds by the time the child is in high school. That's because an equity-heavy college fund that encounters a bear market in the years leading up to college could incur losses that it couldn't recoup during the student's time horizon. Even parents who worry that they're grievously behind on college savings should resist the urge to swing for the fences by maintaining a too-high equity allocation too long. (That's likely a great temptation for college savers right now, as equity markets have been performing terrifically while bond performance has been underwhelming.)

4 Page 4 of 14 Inflation a Bigger Foe Yet college savers must strike a tricky balance because the risks of being too conservative also loom large. Inflation is a major foe for college savers, and a portfolio heavy in bonds and cash could have trouble keeping up with rising tuition costs. The inflation rate for college costs has been trending down very recently, but it has been running in the neighborhood of 5% over the past decade. Given that current yields have historically been a good predictor of future bond returns and the Barclays Aggregate Bond Index, which serves as a broad bond market benchmark, is currently yielding 2.5% investors with extremely conservative asset-allocation plans are going to have difficulty matching the rate of college inflation. Morningstar head of retirement research David Blanchett says prepaid 529 plans, which allow you to lock in today's tuition levels by paying in advance, may be a better option for families who would otherwise maintain a very conservative asset-allocation mix in their 529 college savings plans. "If someone is relatively certain their child is going to attend an in-state school, and there is a prepaid state savings plan and the individual would otherwise invest conservatively in a 529 college savings plan, it may make the prepaid plan more attractive," he says. Blanchett notes, however, that the trade-off doesn't factor in the tax benefits that can accrue to investors in 529 college savings plans. Alternatively, investors might use a 529 college savings plan but make sure that plan includes at least some inflation protection albeit not a direct hedge against college costs such as Treasury Inflation-Protected Securities. Finding a Baseline Given the specific considerations that should go into a college savings allocation plan, it's probably no wonder that the age-based options within 529 college savings plans have historically held the lion's share of assets. Age-based options aim to provide age-appropriate asset mixes that gradually become more conservative over time, and in so doing they take the onus off of parents and other family members to arrive at an optimal asset mix and to provide ongoing oversight of a portfolio of individual holdings. But the age-based plans also vary widely in their glide paths, and plans are increasingly offering multiple options for a given age band: conservative, moderate, and aggressive. That makes it important to conduct due diligence on a prospective plan's asset-allocation framework and see how it compares with other options within that same general age band. If it's an outlier, make sure you understand and agree with the rationale that its managers use for diverging from the peer group. After you select a plan from your (or any other) state from Morningstar's 529 Plan Center you can see how that state's age-based glide path compares with the 529 averages for that same age band. For

5 Page 5 of 14 example, the Silver-rated Maryland College Investment Plan, managed by T. Rowe Price Group TROW, has a heavier equity weighting than its peers across age bands. Even families who aren't using an age-based 529 option can still use 529 glide paths to help get their own plans' asset mixes in the right ballpark. In the table below are the median equity, bond, and cash weightings for each of Morningstar's medium-equity (that is, moderate) age-based 529 categories. You can see that the plans start out with the majority of their assets in equities, then gradually become more conservative over time. K Exhibit 1 Median 529 Portfolio Weightings for Moderate Allocation Source: Morningstar.

6 Page 6 of 14 Morningstar Names Best 529 College Savings Plans for 2017 Thirty-four plans are Morningstar Medalists, and two receive Negative ratings. By Leo Acheson, CFA Published October 24, 2017 Each year, we assign Morningstar Analyst Ratings to college savings plans based on five key pillars Process, People, Parent, Price, and Performance. When evaluating 529 plans, we may also take into consideration the unique benefits that plans offer to college savers, including local tax breaks, grants, and scholarships, which can influence a plan's Analyst Rating but usually do not drive the overall outcome. In 2017, Morningstar identified 34 plans that it believes to be best-in-class options, assigning these programs Analyst Ratings of Gold, Silver, and Bronze. These plans for the most part follow industry best practices, offering some combination of the following attractive features: a strong set of underlying investments, a solid manager selection process, a well-researched asset-allocation approach, an appropriate set of investment options to meet investor needs, low fees, and strong oversight from the state and program manager. These features improve the odds that the plan will continue to represent a strong option for investors. Gold-rated plans have all or a vast majority of these attributes. Silver- and Bronze-rated plans embody most of these qualities but often have some room for improvement. Meanwhile, 26 plans earned Neutral ratings. These plans remain unexceptional, because either weaker aspects offset stronger ones or an element of uncertainty, such as an investment team change, clouds their prospects. Some Neutral-rated programs may hold appeal for in-state residents because of meaningful added benefits, such as local tax breaks, so investors should research their state's particular benefits. Just two plans received Negative ratings in These plans generally lack compelling traits and have at least one major flaw that makes them worth avoiding. Nationwide, there are college savings plans, and these 62 ratings represent more than 95% of assets invested in 529 plans. A complete list of ratings is included at the end of this issue of Talking Points. Ratings Changes This year, Morningstar upgraded six plans and downgraded three, compared with six upgrades and six downgrades in We also dropped coverage of Illinois advisor-sold Bright Start College Saving plan, which will merge into Illinois other advisor-sold plan, Bright Directions College Savings Program, in November 2017.

7 Page 7 of 14 The 529 industry made meaningful improvements over the last year, with many plans reducing expenses and improving the asset-allocation approach used within the age-based portfolios by smoothing out the transition from stocks to bonds as the beneficiary ages. This article focuses on this year's upgrades. In-depth analyses of all 62 plans under coverage are located in the 529 Plan Center on Morningstar.com. On the Rise We upgraded two direct-sold plans run by program manager Union Bank & Trust. Illinois overhauled the direct-sold Bright Start College Savings Program in July 2017 when it replaced program manager Oppenheimer Funds with Union Bank & Trust. With the revamped plan, investors can choose passively managed age-based tracks or tracks that blend active and passive underlying managers. The tracks have strong underlying funds, with passive strategies from Vanguard and a number of well-regarded active funds from firms including Dodge & Cox, T. Rowe Price, and BlackRock. Fees also declined; in fact, the index age-based tracks rank among the cheapest in the industry, with fees ranging from 0.12% to 0.15%, and the state also eliminated a $10 account maintenance fee that previously weighed down the indexbased portfolios. The total package makes for one of the best plans in the industry, leading to its upgrade to Gold from Bronze. In addition, we upgraded Alabama s CollegeCounts 529 Fund to Silver from Bronze. Alabama takes an active role in overseeing the plan, and Union Bank and Trust s involvement increases our confidence that the plan will remain an exceptional choice for the long haul. Investors can choose from three agebased tracks that invest in passive underlying strategies, or they can build customized portfolios from an impressive lineup of 26 active and passive strategies. The plan is not as attractive as Illinois' direct-sold plan, however, as the age-based tracks charge higher fees than Illinois' tracks that invest in passive underlying funds. Two New Morningstar Medalists We also upgraded four advisor-sold plans. Ohio s BlackRock CollegeAdvantage 529 plan made a number of improvements during the last year. It cut fees meaningfully, with expenses for the age-based portfolios falling by 17 basis points on average. Moreover, in November 2017, the plan will restructure the age-based portfolios by moving from a stepped approach, which courts market-timing risk by making a number of large single-day asset-allocation shifts, to a progressive process that allows for a smoother transition to bonds from stocks. The plan s rating increased to Bronze from Neutral in light of these changes. Meanwhile, we raised Colorado s Scholars Choice College Savings Plan s rating to Bronze from Neutral thanks to another year of stability following a program-manager shakeup in QS Investors became the program manager here after Legg Mason acquired the firm in Many of Legg Mason s assetallocation team transitioned to QS, though a couple of departures raised concerns. Nonetheless, the regime change has ultimately not had a meaningful impact on the plan. The underlying fund lineup

8 Page 8 of 14 remains solid, and the plan s age-based options carry very low fees versus advisor-sold peers that invest primarily in active underlying funds. Off the Lows Lastly, two advisor-sold plans that we previously rated Negative were upgraded to Neutral. South Dakota s CollegeAccess 529 plan and West Virginia s The Hartford Smart529 College Savings Plan each smoothed the transition to bonds from stocks within the age-based portfolios, and they also lowered fees. Both plans previously had equity step-downs as large as 25 percentage points in the age-based portfolios, but now both tracks have average step sizes of about 10 percentage points. Meanwhile, both plans also cut fees by about 10 to 15 basis points. Morningstar Analyst Rating Inputs Since 2012, ratings for 529 plans use the same scale as the Morningstar Analyst Rating for mutual funds. Both Analyst Rating methodologies consider the same five factors to arrive at the final rating, though the 529 ratings reflect the quality of the entire plan not a single investment, as is the case for the fund rating. To arrive at an Analyst Rating for 529 plans, analysts consider: Process: Did the plan hire an experienced asset allocator to design a thoughtful, well-diversified glide path for the age-based portfolios? What suite of investment options is offered? People: What is Morningstar's assessment of the underlying money managers' talent, tenure, and resources? Parent: Is the program manager a good caretaker of college savers' capital? Is the state managing the plan professionally? Performance: Have the plan's options earned their keep with solid risk-adjusted returns over relevant time periods? How is the plan expected to perform going forward? Price: Are the investment options a good value? K

9 Page 9 of 14 Three 529 Plans Suffer Downgrades in 2017 With broad improvements across the 529 industry, plans that stand still fall behind. By Leo Acheson, CFA Published October 26, 2017 Morningstar's annual ratings for 529 plans in aggregate represent more than 95% of the industry's assets. Morningstar identified 34 plans that it believes to be best-in-class options, assigning these programs Morningstar Analyst Ratings of Gold, Silver, and Bronze. Twenty-six plans earned Neutral ratings, and two received Negative ratings. Some Neutral-rated programs may hold appeal for in-state residents because of meaningful added benefits, such as local tax breaks, so investors should research their states' particular benefits. In terms of ratings changes, Morningstar upgraded six plans and downgraded three this year. The previous article focused on the upgrades; this article details the downgrades. In-depth analyses of all 62 plans under coverage are located in the 529 Plan Center on Morningstar.com. So, what spurs a downgrade? Oftentimes it is a result of plans not keeping pace with the increasingly competitive landscape. In general, the industry continues to move toward best practices via fee cuts, beefed up asset-allocation resources and processes, and improved investment lineups. Asset-Allocation Approaches Have Improved One major trend under way is an increased emphasis on smoothing the transition from stocks to bonds within the age-based portfolios. Age-based options reduce equity exposure over time via one of two methods. A progressive approach gradually trims stocks in favor of bonds, making for a smooth transition over time. Meanwhile, a static approach makes relatively large asset-allocation shifts on individual days, which can introduce meaningful market-timing risk. We favor the smoother method employed by progressive age-based options or a static approach that uses moderate steps, as defined by 10 percentage points or less. Plans have made efforts to smooth the shift from stocks to bonds by either implementing a progressive approach or reducing the size of the equity step-downs. For instance, in November 2017, Ohio's advisorsold BlackRock CollegeAdvantage 529 Plan will transition from a static to a progressive approach. Meanwhile, most plans that use Vanguard as the investment manager reduced the size of the equity step-downs from 25 to 12.5 percentage points, and program manager Union Bank and Trust went from 20- to 10-percentage-point steps in its age-based tracks. Prior to 2016, about 25% of all age-based tracks used either a progressive approach or had step sizes of 19 percentage points or less. By the end of 2018, that number will have increased to 75%, marking a meaningful shift in the industry. As a result, plans that haven't considered smoothing the glide path followed by the age-based options are increasingly becoming outliers.

10 Page 10 of 14 Fees Still Falling Plans have also shown improvement by cutting fees year over year. The asset-weighted fee for the industry fell from 0.79% at the end of 2014 to 0.70% as of year-end Since age-based portfolios carry the majority of 529 plan assets, we emphasize these options' fees when setting Price Pillar ratings for 529 plans. We divide 529 age-based options into groups based on their distribution channel and underlying investment methods. After separating age-based options by direct- or advisor-sold plans, we categorize tracks into one of three groups: actively managed, passively managed, or a blend of the two. (A blend is defined as having between 20% and 80% in active management.) We then determine the average total expense ratio for each age-based track and compare it with similar peers. The table below shows the averages as well as the 25th and 75th percentile fees within each group as of September Very few advisor-sold age-based tracks that invest exclusively in passive underlying funds exist, so we excluded the average and quartile breakpoints for that group. Exhibit 2 Average Age-Based Track Total Expense Ratios by Distribution Type Source: Morningstar. Standing Still Is Falling Behind With the landscape becoming increasingly competitive, plans that stick with the status quo often become relatively less appealing choices. That's been the case with New Jersey's advisor-sold Franklin Templeton 529 College Savings Plan, which we downgraded to Negative from Neutral this year. The plan's age-based tracks have dramatic 25-percentage-point declines in equity exposure as the beneficiary approaches college, and the team doesn't intend to smooth out that transition, citing a lack of investor demand for change. Meanwhile, fee reductions haven't kept pace with the broad industry; the plan's Growth age-based track, which is the most popular age-based option, charges an average fee of 1.19%. Generally speaking, subpar oversight at the state and program manager level decreases our confidence in the plan's long-term prospects. Meanwhile, we downgraded Colorado's CollegeInvest Direct Portfolio College Savings Plan to Neutral from Bronze as it no longer has compelling fees. The plan invests in passively managed strategies from Vanguard, making fees an important point of differentiation. The age-based options charge an average fee of 0.36%, which is more than double the price of similar peers that invest in passive strategies. That said, the plan remains a solid choice for Colorado residents, who can deduct every dollar in contributions to the plan from their state taxable income.

11 Page 11 of 14 Lastly, we downgraded New York's direct-sold 529 College Savings Program to Bronze from Silver, as politics have influenced the plan's investment process. A state law limits the amount of assets that can be invested in securities such as international equities, high-yield bonds, and emerging-markets debt. Vanguard recommended increasing the exposure to international equities and international bonds within the age-based portfolios, but the plan could not because of the state limitation. New York's governor has vetoed attempts to amend the law. Aside from this shortcoming, the plan remains a good option, with very low fees and solid underlying investments from Vanguard. K

12 Page 12 of 14 Exhibit Morningstar Analyst Ratings for 529 College Savings Plans Source: Morningstar.

13 Page 13 of 14 Exhibit Morningstar Analyst Ratings for 529 College Savings Plans (Continued) Source: Morningstar.

14 Page 14 of 14 About Morningstar Morningstar, Inc. is a leading provider of independent investment research in North America, Europe, Australia, and Asia. The company offers an extensive line of products and services for individual investors, financial advisors, asset managers, and retirement plan providers and sponsors West Washington Street Chicago, IL USA 2017 Morningstar. All Rights Reserved. Christine Benz's Talking Points is produced and offered by Morningstar, Inc., which is not registered with the U.S. Securities and Exchange Commission as a Nationally Recognized Statistical Rating Organization ( NRSRO ). Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. The information, data, analyses and opinions presented herein do not constitute investment advice; are provided solely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. The opinions expressed are as of the date written and are subject to change without notice. Except as otherwise required by law, Morningstar shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information contained herein is the proprietary property of Morningstar and may not be reproduced, in whole or in part, or used in any manner, without the prior written consent of Morningstar. To order reprints, call To license the research, call