[Senate Hearing 108-716]
[From the U.S. Government Publishing Office]
S. Hrg. 108-716
OVERSIGHT HEARING ON SECTION 529 COLLEGE SAVINGS PLANS: HIGH FEES,
INADEQUATE DISCLOSURE, DISPARATE STATE TAX TREATMENT, AND QUESTIONABLE
BROKER SALES PRACTICES
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HEARING
before the
FINANCIAL MANAGEMENT, THE BUDGET, AND INTERNATIONAL SECURITY
SUBCOMMITTEE
of the
COMMITTEE ON
GOVERNMENTAL AFFAIRS
UNITED STATES SENATE
ONE HUNDRED EIGHTH CONGRESS
SECOND SESSION
__________
SEPTEMBER 30, 2004
__________
Printed for the use of the Committee on Governmental Affairs
U.S. GOVERNMENT PRINTING OFFICE
97-046 WASHINGTON : 2004
____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov Phone: toll free (866) 512-1800; (202) 512�091800
Fax: (202) 512�092250 Mail: Stop SSOP, Washington, DC 20402�090001
COMMITTEE ON GOVERNMENTAL AFFAIRS
SUSAN M. COLLINS, Maine, Chairman
TED STEVENS, Alaska JOSEPH I. LIEBERMAN, Connecticut
GEORGE V. VOINOVICH, Ohio CARL LEVIN, Michigan
NORM COLEMAN, Minnesota DANIEL K. AKAKA, Hawaii
ARLEN SPECTER, Pennsylvania RICHARD J. DURBIN, Illinois
ROBERT F. BENNETT, Utah THOMAS R. CARPER, Delaware
PETER G. FITZGERALD, Illinois MARK DAYTON, Minnesota
JOHN E. SUNUNU, New Hampshire FRANK LAUTENBERG, New Jersey
RICHARD C. SHELBY, Alabama MARK PRYOR, Arkansas
Michael D. Bopp, Staff Director and Chief Counsel
Joyce A. Rechtschaffen, Minority Staff Director and Counsel
Amy B. Newhouse, Chief Clerk
------
FINANCIAL MANAGEMENT, THE BUDGET, AND INTERNATIONAL SECURITY
SUBCOMMITTEE
PETER G. FITZGERALD, Illinois, Chairman
TED STEVENS, Alaska DANIEL K. AKAKA, Hawaii
GEORGE V. VOINOVICH, Ohio CARL LEVIN, Michigan
ARLEN SPECTER, Pennsylvania THOMAS R. CARPER, Delaware
ROBERT F. BENNETT, Utah MARK DAYTON, Minnesota
JOHN E. SUNUNU, New Hampshire FRANK LAUTENBERG, New Jersey
RICHARD C. SHELBY, Alabama MARK PRYOR, Arkansas
Michael J. Russell, Staff Director
Richard J. Kessler, Minority Staff Director
Nanci E. Langley, Minority Deputy Staff Director
Tara E. Baird, Chief Clerk
C O N T E N T S
------
Opening statements:
Page
Senator Fitzgerald........................................... 1
Senator Lautenberg........................................... 5
Senator Pryor................................................ 18
Prepared statement:
Senator Akaka................................................ 49
WITNESSES
Thursday, September 30, 2004
Steven T. Miller, Commissioner, Tax Exempt and Government
Entities Division, Internal Revenue Service.................... 7
Mary L. Schapiro, Vice Chairman and President, Regulatory Policy
and Oversight, NASD............................................ 9
Ernesto A. Lanza, Senior Associate General Counsel, Municipal
Securities Rulemaking Board.................................... 11
Hon. Michael A. Ablowich, Treasurer, State of New Hampshire, on
behalf of the National Association of State Treasurers......... 23
Jacqueline T. Williams, Executive Director, College Advantage
Savings Plan, Ohio Tuition Trust Authority, on behalf of the
College Savings Plan Network................................... 25
Martin M. Noven, Deputy Chief of Staff, on behalf of Judy Baar
Topinka, State Treasurer, State of Illinois.................... 27
Richard O. Davis, Deputy Executive Director for Finance and
Administration, Utah Higher Education Assistance Authority..... 29
Daniel McNeela, CFA, Senior Analyst, Morningstar, Inc............ 30
Mercer E. Bullard, President and Founder, Fund Democracy, Inc.... 32
Alphabetical List of Witnesses
Ablowich, Hon. Michael A.:
Testimony.................................................... 23
Prepared statement........................................... 90
Bullard, Mercer E.:
Testimony.................................................... 32
Prepared statement........................................... 123
Davis, Richard O.:
Testimony.................................................... 29
Prepared statement........................................... 112
Lanza, Ernesto A.:
Testimony.................................................... 11
Prepared statement........................................... 65
McNeela, Daniel:
Testimony.................................................... 30
Prepared statement........................................... 114
Miller, Steven T.:
Testimony.................................................... 7
Prepared statement........................................... 51
Noven, Martin M.:
Testimony.................................................... 27
Prepared statement........................................... 107
Schapiro, Mary L.:
Testimony.................................................... 9
Prepared statement........................................... 56
Williams, Jacqueline T.:
Testimony.................................................... 25
Prepared statement........................................... 103
APPENDIX
The chart entitled ``Value of a $10,000 investment after 10
years''........................................................ 164
The chart entitled ``Value of a $10,000 investment after 18
years''........................................................ 165
The chart entitled ``Growth in Section 529 Plans 1996-2004''..... 166
The ``529 Plan Information'' chart from the Morningstar website.. 167
Barbara Hafer, Treasurer, Commonwealth of Pennsylvania, prepared
statement with an attachment................................... 170
Tim Berry, Indiana State Treasurer and NAST President, National
Association of State Treasurers................................ 180
Questions and Responses to Senator Lautenberg from Mr. Miller,
Mr. Lanza, Ms. Schapiro, Mr. McNeela, and Mr. Bullard.......... 186
OVERSIGHT HEARING ON SECTION 529 COLLEGE SAVINGS PLANS: HIGH FEES,
INADEQUATE DISCLOSURE, DISPARATE STATE TAX TREATMENT, AND QUESTIONABLE
BROKER SALES PRACTICES
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THURSDAY, SEPTEMBER 30, 2004
U.S. Senate,
Subcommittee on Financial Management,
the Budget, and International Security,
of the Committee on Governmental Affairs,
Washington, DC.
The Subcommittee met, pursuant to notice, at 10:30 a.m., in
room SD-342, Dirksen Senate Office Building, Hon. Peter G.
Fitzgerald, Chairman of the Subcommittee, presiding.
Present: Senators Fitzgerald, Lautenberg, Carper, and
Pryor.
OPENING STATEMENT OF SENATOR FITZGERALD
Senator Fitzgerald. This hearing will come to order. I
would like to begin by welcoming all of our witnesses who are
present today, and by thanking them for taking time out of
their schedules to be here.
Today, we are conducting an oversight hearing on Section
529 College Savings Plans, State-sponsored investments that are
designed to encourage families to save money for their
children's college education. Section 529 refers to the
Internal Revenue Code section that authorizes and confers
special tax treatment on these entities, and it shouldn't be
confused with IRS Section 527, which confers special tax
treatment on those political groups that are now so
controversial in the current Presidential campaign.
Section 529 College Savings Plans are instrumentalities of
the various State Governments. The States usually organize the
plans as trusts which, in turn, typically invest the plan
assets in mutual funds managed by third party asset managers.
Today's hearing will build on two previous hearings in
which this Subcommittee examined mutual fund management and
governance, mutual fund fees, and the adequacy of fee
disclosures.
Because they typically invest their assets in mutual funds,
all of the same problems that are prevalent with mutual funds--
high fees, inadequate disclosure, and questionable brokerage
sales practices--are also prevalent with Section 529 College
Savings Plans. But as problematic as ordinary mutual funds may
be, many Section 529 plans are even more problematic. That is
because the State Governments which run Section 529 plans are
exempt from most of the Federal securities laws, including the
Investment Company Act of 1940. Indeed, the Securities and
Exchange Commission does not have jurisdiction over the State
Governments which run the college savings plans.
Section 529 plans are also more problematic than ordinary
mutual funds, at least in my judgment, because they carry an
extra layer of fees. With an ordinary mutual fund investment,
the consumer may pay a fee to a broker who steers him or her
into a mutual fund and then pay ongoing management fees to the
fund manager. With a Section 529 plan, the consumer may not
only have to pay a brokerage fee and ongoing fees to the fund
manager, but in addition will almost certainly have to pay one-
time and ongoing fees to the State Government that sets up the
plan.
In other words, with Section 529 plans, the State
Governments interpose themselves as additional middlemen and
take additional fees from investors. State fees associated with
Section 529 plans can include enrollment fees, application
fees, account maintenance fees, program management fees,
administrative fees, and asset-based fees.
As our earlier hearings pointed out, fees charged to mutual
fund investors when they are stated as a percentage of the
assets sound de minimis and trivial, but small differences in
fees add up to very large differences in investment returns
over time. Just as investors are free to experience the miracle
of compounding returns, so, too, they are free to experience
the tyranny of compounding costs.
We had a chart in an earlier hearing that showed one
percentage point of fees over 40 years of investing will cut
someone's retirement nest egg by 45 percent, and that math has
all been worked out and it actually is true. You have to
recognize that those fees compound over time, and each year
there is money that is not in your account that you are no
longer earning a return on.
Given the additional fees that college savings plans charge
over and above ordinary mutual funds, it is probably safe to
say that no one would invest in Section 529 plans if they
weren't tax advantaged. In fact, the tax advantages are
probably the only reason to invest in Section 529 plans.
It is, then, a fair question whether the additional fees
which States charge to Section 529 plan investors carry any
benefit. I am going to be asking questions about that today.
Clearly, Congress could devise a means of authorizing Section
529 plans that would eliminate the dead weight fees that the
State Governments charge. State bureaucrats might not like it,
but the millions of American families which have Section 529
accounts would be a lot better off. There are now about 6.8
million Section 529 accounts holding about $54 billion in total
assets as of the middle of this year.
Few things in life are more important to parents than the
education of their children, and few things in life are more
expensive than a college education. Over the last 10 years, the
cost of attending college has increased a whopping 40 percent.
According to the College Board, the average cost of a 4-year
post-secondary education is currently $42,544 for State
universities and $107,416 for private colleges and
universities. The price tag for higher education is expected to
continue rising, likely outstripping any gains in average
household earnings.
The hearing we are holding today will address a number of
the vexing issues and concerns which analysts and commentators
have raised regarding Section 529 plans. We hope to make saving
for college easier for average American families.
Even before the hearing begins, though, I have several
suggestions for how we might do that. First, Section 529 plans
have a complex cost structure which makes it difficult for
investors to compare and select plans in an informed manner. At
a minimum, Congress ought to simplify and improve fee
disclosures so that families can more easily compare Section
529 plans on an apples-to-apples basis.
Second, in some cases, high fees and commissions are
charged not only by the broker and the State, but also some
mutual funds, in fact, charge a higher fee to Section 529 plan
participants than they do to regular mutual fund investors in
the same fund. Some analysts have questioned whether these high
fees offset the tax advantages of investing in a Section 529
college savings account, and as we have heard before, small
differences in fees can result in enormous differences in
returns over time.
This chart was actually prepared from a hypothetical
example that the Securities and Exchange Commission included in
a memorandum prepared by SEC staff who are studying Section 529
plans for Chairman Donaldson and delivered to House Banking
Committee Chairman Oxley.\1\ This shows that actually under
certain circumstances, you may be better off investing in a
fully taxable but low-cost, low-fee ordinary mutual fund than
you would be investing in a tax-advantaged college savings plan
that charges very high fees.
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\1\ The chart entitled ``Value of a $10,000 investment after 10
years,'' appears in the Appendix on page 164.
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Theoretically, you may be brought into a Section 529 plan
by a broker, and thus pay a 5\1/2\ percent sales load for Class
A shares, and then have to pay 2 percentage points in aggregate
annual fees. Assuming an 8 percent annual return, then after 10
years, you would be worse off than if you had gone into a fully
taxable fund that only charged 50 basis points or \1/2\ of 1
percentage point in annual fees and had no load. Even if you
paid a 10 percent capital gains tax at the end when you took
the money out, you would have $1,625 more on an original
$10,000 investment. Again, that example came from the
Securities and Exchange Commission.
Another chart, if you could put chart 2 up,\2\ this is a
comparison of a low-cost Section 529 plan with a high-cost
Section 529 plan. The Rhode Island J.P. Morgan Higher Education
Plan is a very high-cost plan. It has a 4.75 percent sales
load, 135 basis points, or 1.35 percentage point annual expense
ratio, and a $25 annual fee. If you invest $10,000 in that
Rhode Island fund for 18 years, you will have $7,700 less than
if you invest in the Utah Educational Savings Plan Trust. Utah
has a Vanguard fund underlying it. Vanguard only charges 10
basis points for their management fee. The State of Utah,
however, as you can see, interposes an additional 17 basis
points in fees, bringing the total expense ratio up to 27.5
basis points, but that is still way better than being in the
Rhode Island fund, in which you pay a $25 annual fee. After 18
years, you will have $7,700 more in the Utah fund. You will
have $37,000 as opposed to $29,000 for your kid's education.
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\2\ The chart entitled ``Value of a $10,000 investment after 18
years,'' appears in the Appendix on page 165.
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So the bottom line is that in a high-cost college savings
plan, the brokers and fund managers, together with a new actor,
the State Governments which set up the plans, in effect can
swallow up the tax benefits, leaving the uninformed consumer
worse off than if he or she had invested in a fully taxable but
low-cost mutual fund.
Now, according to Morningstar, the five worst plans are
offered by the States of Wisconsin, Arizona, Wyoming, and Ohio.
That is only four States--oh, Arizona has two of the five
worst. OK. [Laughter.]
The five best are offered by Utah, which we just saw,
Nevada, Virginia, Michigan, and Alaska. Now, some of those may
have changed, I understand, since some of these reports have
come out. Possibly some of the worst States have improved their
plans, and they can certainly set that record straight.
Quite simply, in my judgment, Congress should act to make
sure that investors and not State bureaucrats, brokers, or fund
managers capture the tax benefits from Section 529 plans. Right
now, there are too many middlemen, including State bureaucrats,
that are feeding at the Section 529 college savings trough.
Third, several areas of disclosure warrant increased
scrutiny of Section 529 plans. These disclosure issues include
the level of disclosure required, the type of information
disclosed, and the manner in which the information is
presented. Under the Investment Company Act, ordinary mutual
funds have to provide annual and semi-annual disclosure
discussing the fund's performance, listing its holdings, and
providing the fund's financial statements. Unfortunately,
Federal securities laws do not require Section 529 plans to
make even these limited disclosures. Congress should, in my
judgment, at a minimum, at least provide the minimal
disclosures that are now provided by regular mutual funds.
Fourth, while Federal tax advantages are standard for all
Section 529 College Savings Plans, State tax treatment varies
from State to State, sometimes holding residents captive to a
given State's home State plan. Congress, in my judgment, should
encourage States to compete amongst themselves and discourage
protectionist measures which lock State residents into
substandard State funds. Congress could easily make these
improvements.
The growth in the college savings plan industry has no
doubt resulted in growing pains. While Section 529 plans were
created under the Federal tax code for use under State law, no
comprehensive regulatory regime was created to oversee this new
financial product. Although lacking in enforcement powers, the
industry's trade group, the College Savings Plan Network,
issued voluntary disclosure principles in May 2004 to help
enhance uniformity of fee disclosure across the industry. This
morning, we will hear from the College Savings Plan Network
about their progress in this effort.
In addition, several agencies are also examining Section
529 plans. They are subject to anti-fraud rules and broker
dealer sales practices. Earlier this year, Securities and
Exchange Commission Chairman William Donaldson announced the
creation of the Chairman's Task Force on College Savings Plans
to study the fee disclosure issue in the sale of Section 529
plans. The SEC is expected to report its findings before the
end of this year.
Additionally, the NASD, whom we will also hear from this
morning, has been investigating alleged misconduct by
securities firms in the sales of Section 529 plans. Mary
Schapiro is here, chomping at the bit, waiting to go.
Our other witnesses will address statutory and regulatory
guidelines for Section 529 plans and those who sell them,
discuss investor and consumer concerns regarding these State
plans, and make recommendations for change. We will also hear
from two witnesses, one from my home State of Illinois and the
other from the State of Utah, who will discuss their State's
Section 529 plans.
Again, I want to thank our witnesses for being here today.
Before I introduce them, I would like to turn to Senator
Lautenberg, who has graced us with his presence this morning,
and welcome him to make an opening statement.
OPENING STATEMENT OF SENATOR LAUTENBERG
Senator Lautenberg. Thanks very much, Mr. Chairman. I
assume that the audience here noted that neither of the weaker
plans was from New Jersey or from the State of Illinois, and
the Chairman wasn't sure that I was going to be here, so that
the truth is obvious.
Mr. Chairman and all of our guests here today, this is an
important hearing. The economy is in the doldrums. Real family
incomes are declining while costs for tuition continue to rise
and that makes college more and more unaffordable for many
Americans. And yet post-secondary education has never been more
important for people entering the workforce. According to the
Department of Labor, college graduates earn nearly twice as
much as workers who have only a high school diploma.
Because of these circumstances, the Section 529 College
Savings Plans are crucial. But the problems that are there need
attention, as we will see today, and those problems can and
must be fixed.
The problems that we need to address include the following:
First, because Section 529 plans are run by States, they are
only loosely regulated by the Securities and Exchange
Commission. Section 529 plans are not subject to most of the
securities laws, and as a result, we are seeing problems that
parallel the ones in recent mutual fund scandals.
Also, too many layers of investment management are
involved, as we have heard from our Chairman. As a result,
investors are paying such high fees that in some instances,
those fees actually cancel the benefits that these tax savings
plans have.
We need to look at ways that Section 529 plans are
regulated and administered to make them more investor and
beneficiary friendly. Section 529 plans are complex. Tax rules
vary from State to State. Many of the plans do not have
understandable or meaningful disclosures.
Mr. Chairman, I know firsthand how important a college
education is and I know how it can be out of reach for the
ordinary person. When I returned from Europe at the end of
World War II, the only way I could afford to go to Columbia
University--which was a dream of mine--was on the GI Bill, and
I want to improve Section 529 plans because I want to make sure
that everyone who wants to go to college and is willing to do
the work can go to college. An educated person is an
incomparable asset for our country, far more valuable than some
of our natural resources. No matter how precious the other
assets are, we have got to focus on this one. We have got to do
whatever we can to seed, grow, and harvest an educated society
and we intend to do that.
Mr. Chairman, I commend you for holding this hearing and I
want to apologize because I have another function to go to. I
would ask that the record be kept open so that any questions
for our distinguished guests can be submitted in writing.
Senator Fitzgerald. Absolutely, and thank you for being
here. I have to say, even though you are a member of the other
party, I think that we are probably better off--small investors
certainly are better off--now that you have returned to the
Senate after a brief retirement.
Senator Lautenberg. That is very kind.
Senator Fitzgerald. I am retiring now on January 2, so you
may have to pick up----
Senator Lautenberg. Think about it a couple of years and
see how you feel.
Senator Fitzgerald. You may have to pick up a couple of
these issues, and you might be able to eliminate some of these
fees after I am gone.
Senator Lautenberg. You have an advantage, Mr. Chairman,
having come from a business background. I really believe that.
Senator Fitzgerald. Yes.
Senator Lautenberg. This is not to discourage or dissent
with any opinions about our attorneys and other professionals.
We have doctors and lawyers. We almost have an Indian Chief,
and he is about to retire, unfortunately. But the fact of the
matter is that a business background, Mr. Chairman, I think is
invaluable. So we may as well gloat while we can and thank all
of you.
Senator Fitzgerald. Well, thank you. I just want to add
that since we did those hearings on the high fees before,
several mutual funds have announced they are lowering their
fees. Fidelity has lowered them down to 10 basis points on
their index funds. So even though we didn't pass legislation
yet, I think the focus on those high fees has helped. Thank you
very much, Senator Lautenberg.
I would like to now introduce our witnesses. Our first
witness is Steven T. Miller, who serves as Commissioner of the
Tax Exempt and Government Entities Division of the Internal
Revenue Service. Mr. Miller's division oversees the
administration of tax laws relating to employee plans, tax-
exempt organizations, and government entities. Before joining
his current division in June 2004, Mr. Miller served as the
Director of Exempt Organizations within the IRS.
We would also like to welcome back our second witness, Mary
L. Schapiro. She appeared first before this Subcommittee in
November 2003 on the mutual fund trading practices and abuses.
Ms. Schapiro currently serves as Vice Chairman and President of
Regulatory Policy and Oversight at NASD. Prior to assuming her
duties at NASD, Ms. Schapiro was appointed the Chairman of the
Commodity Futures Trading Commission in 1994 by President
Clinton. Before that position, she served as a Commissioner of
the Securities and Exchange Commission from 1988 to 1993, when
she was appointed Acting Chairman of the SEC. So she has been
Commissioner and Acting Chairman of the SEC and Chairman of the
Commodity Futures Trading Commission--a very impressive
background.
I would also like to welcome Ernesto A. Lanza, who is the
Senior Associate General Counsel of the Municipal Securities
Rulemaking Board, the MSRB. The MSRB is a self-regulatory
organization established by Congress to develop rules
regulating securities firms and banks involved in underwriting,
trading, and selling municipal securities. Mr. Lanza joined
MSRB in 1997 after practicing law as a public finance attorney.
I would like to thank all of you for being here. In the
interest of time, it is usually best if you can just introduce
your written statements into the record and we will make them a
part of the permanent record of the Committee. We ask, as best
as possible, if you could summarize your remarks within 5
minutes. I won't be too tough on that, but in order to keep the
hearing going, we would like to stick to that 5 minutes.
Mr. Miller, I thank you for being here and you may proceed.
TESTIMONY OF STEVEN T. MILLER,\1\ COMMISSIONER, TAX EXEMPT AND
GOVERNMENT ENTITIES DIVISION, INTERNAL REVENUE SERVICE
Mr. Miller. Thank you, Mr. Chairman, for the opportunity,
and I would ask that my written testimony be entered into the
record.
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\1\ The prepared statement of Mr. Miller appears in the Appendix on
page 51.
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Thank you for inviting us today. My division, as you
mentioned, is responsible for ensuring that Section 529
programs meet the exemption requirements under the Code. I will
divide my remarks into two parts, first, a general overview of
the tax rules, and second, how the Service interacts with
Section 529 programs.
As you mentioned, Section 529 of the Internal
Revenue Code exempts qualified tuition programs provided they
meet certain requirements. The first requirement is that the
program has to be established and maintained by a State, an
agency or instrumentality of the State, or by one or more post-
secondary institutions. Thus, the plan either needs to be a
State-run program or a program established or maintained by
private colleges or universities.
Second, the operation of the program is limited to one of
two designs. State programs may be either pre-paid or a savings
program. Those programs established by eligible private
colleges and universities may offer only the pre-paid design.
Under pre-paid design, the person purchases actually credits or
certificates for qualified education expenses. Under a savings
plan maintained by a State, a person contributes to an account
that is established for the purpose of meeting a designated
beneficiary's education expenses. The balance in the account
can go up or down depending on what the investment does over
time.
When we talk about qualified higher education expenses
defined in Section 529, we are talking about tuition, fees,
supplies and equipment required for either enrollment or
attendance at an eligible educational institution. Certain room
and board expenses are also included in that.
The third requirement is that the individual must be
designated at the time that you make the contribution to the
plan.
Other requirements include the fact that only cash can be
contributed to these plans, and that there is a separate
accounting with respect to each beneficiary in the plan. With
respect to college and university programs, those programs must
employ a trust instrument, and an interest in the program may
not be used as security for a loan.
The Code has one final requirement that I will mention. The
ability to select and change investments in a program is
limited under Section 529. Contributors and beneficiaries may
not direct the investment of earnings or contributions. That
does not mean, however, that a program violates the requirement
if selection is permitted among various broad-based investment
strategies that are designed exclusively for the program.
Turning to rules relating to contributions under Section
529, there is a limitation on the amount that can be
contributed. Those amounts are limited to amounts that are
necessary to provide for a beneficiary's qualified expenses.
There is no statutory dollar limitation, but proposed rules in
the area indicate that 5 years' worth of expenses can be funded
through one of these accounts.
Contributions are not deductible for Federal income tax
purposes, and as you mentioned, whether a State deduction is
available quickly depends on the State law.
Let me move to tax rules on distributions quickly.
Distributions are not taxed if they are used to pay qualified
expenses. The earnings component might be subject to income tax
if it is not used for those expenses and will be subject to a
10 percent additional tax, as well, in many instances.
There are also special estate and gift tax rules that we
briefly discuss in the written testimony.
That is a quick outline of some of the tax rules. Let me
talk very quickly about how the IRS administers the section.
State programs are not required to come to us for a ruling
that they are a Section 529 plan. In contrast, private colleges
and university plans must come in to the IRS to be approved as
a Section 529 plan. Coming in, they will request a private
letter ruling. I think it is important to note that Section 529
doesn't require plans to follow a prototype, so that all plans
that come in are different and there are discussions with our
staff concerning whether they meet the requirements before we
can confirm status.
In terms of reporting, a program generally has no
requirement to file a tax or information return regarding its
operations with the IRS. This is consistent with our treatment
of other State Governmental entities. If there is unrelated
business income tax due, then we do require a Form 990-T. In
terms of reporting to the participants, a program is required
to provide an annual account statement showing the total
account balance, the contributions to the account, earnings,
and any distributions. A plan is also required to issue a Form
1099-Q for each designated beneficiary who has actually
received a distribution, and also where there is a transfer
between plans, a 1099-Q will occur, as well.
I see my time has run out and so has my testimony, Mr.
Chairman, so I am willing to take any questions. Thank you.
Senator Fitzgerald. Thank you, Mr. Miller. Ms. Schapiro.
TESTIMONY OF MARY L. SCHAPIRO,\1\ VICE CHAIRMAN AND PRESIDENT,
REGULATORY POLICY AND OVERSIGHT, NATIONAL ASSOCIATION OF
SECURITIES DEALERS
Ms. Schapiro. Thank you very much, Mr. Chairman. It is a
pleasure to be back before this Committee. We are very grateful
to have this opportunity to talk about Section 529 College
Savings Plans. We also have a longer statement that we would
like to submit, with your permission, for the record.
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\1\ The prepared statement of Ms. Schapiro appears in the Appendix
on page 56.
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NASD is the world's largest private sector regulator of
financial services. We regulate every broker dealer in the
United States, about 5,200 of them, that do business with the
public. Last year, we brought more than 1,400 enforcement
actions and barred or suspended more than 850 individuals from
the securities industry, and I am sorry to say these are both
record numbers.
Our interest in scrutinizing Section 529 sales stems in
part from their having become hugely popular. Every State
offers at least one Section 529 plan and there are now about 80
available. Our investor protection duty compels us to examine
sales practices of all investment products and most
particularly those that generate a high level of investor
enthusiasm.
This morning, I would like to briefly cover three topics.
First is our investigative efforts regarding Section 529 plans.
The second is the need for standardized disclosure among plans.
And finally, our efforts to help educate investors about them.
By way of background, Mr. Chairman, NASD does not regulate
the State issuers of Section 529 plans nor do we directly
regulate mutual funds that are offered as investment choices in
Section 529 plans. As you pointed out, Congress has authorized
the MSRB to regulate sales of Section 529 plans. We enforce the
MSRB's rules.
In 2003, we began hearing allegations of inappropriate
recommendations of brokers selling Section 529 plans. We
undertook a review of six firms, chosen based on the number of
customer complaints and the sales volumes of particular plans.
We wanted to learn about the suitability of the recommendations
investors were getting and about the procedures firms had for
ensuring the efficacy of those recommendations. Since last
year, we have expanded our review to include 12 additional
firms in order to have a more comprehensive and representative
sample of the firms we regulate.
We were surprised to discover that in some cases, more than
95 percent of the dollar value of Section 529's sold came from
sales to customers who are not residents of the States in whose
plans they invested. Selling an investor an out-of-state plan
is not necessarily a problem. It may be that the underlying
investment companies offered by the in-state plan could provide
inferior portfolio management or a relatively limited array of
investment choices. As you point out, the fees associated with
the in-state plan could be very high. And, of course, some
States don't provide a tax deduction or other benefit.
Consequently, another State's plan might be a perfectly
suitable recommendation.
But since half the States offer State tax deductions for
residents investing in their plans, and some are quite
significant, the fact that out-of-state sales exceeded 95
percent in some cases led us to wonder if broker dealers were
doing suitability analyses before making recommendations and
whether they were giving their customers all the information
they needed before deciding which plan to buy, in-state or out-
of-state.
Our sales practice investigations have also included
reviews of advertising and marketing materials. In a number of
cases, we have required firms to significantly revise
advertising to be more balanced, to disclose risks as well as
potential rewards, and to disclose more prominently the fees
and tax implications of Section 529 investing. And finally, we
are reviewing suitability, breakpoint, and supervisory issues,
as well.
Most importantly, however, retail investors have been ill
served by the lack of uniform disclosure among Section 529
plans. Such disclosure would allow easy comparison in making
investment choices. The lack of transparency concerning fees
and expenses, disparate State tax policies and rates, share
classes, and other features of Section 529 plans have led to
significant investor confusion. We strongly support a uniform
disclosure regime for Section 529 plans.
With this lack of uniformity in mind, NASD has increased
its effort to educate investors about Section 529's. We have
two tools on our website to help investors in this area. Our
booklet, ``Smart Saving for College,'' details all of the
features of Section 529 College Savings Plans as well as other
college savings vehicles, including Coverdell Education Savings
Accounts, prepaid tuition plans, custodial accounts, and even
U.S. Savings Bonds.
We also offer an online Section 529 expense analyzer which
can calculate for investors how fees and expenses affect their
returns. The analyzer explains the many different Section 529
plan fees and provide guidance on where to find them in the
Section 529 disclosure documents. It also provides prompts that
help investors to make the best possible comparison between
plans.
We recently issued an investor alert, advising investors to
be aware of certain facts, including that contribution limits
and State tax treatment vary from State to State, that
investment options vary broadly, from high-risk stock funds in
some plans to more conservative short-term bond funds in
others, and that there are wide disparities among fees and
expenses from plan to plan.
More positively, I would note, as you did, that several
States have been working to make their Section 529 plans
clearer and more attractive to investors by lowering enrollment
and management fees and expanding investment options.
In closing, Mr. Chairman, NASD is committed to protecting
investors by ensuring that they have all the information they
need to make informed investment choices and that the brokers
they work with adhere to just and equitable principles of
dealing. We will, as appropriate, continue to broaden both our
educational and regulatory and investigative efforts with
regard to Section 529 College Savings Plans.
Thank you again, and I am happy to answer any questions
that you might have.
Senator Fitzgerald. Thank you, Ms. Schapiro. Mr. Lanza.
TESTIMONY OF ERNESTO A. LANZA,\1\ SENIOR ASSOCIATE GENERAL
COUNSEL, MUNICIPAL SECURITIES RULEMAKING BOARD
Mr. Lanza. Yes. Thank you, Mr. Chairman, Members of the
Subcommittee. My name is Ernesto Lanza, Senior Associate
General Counsel of the Municipal Securities Rulemaking Board. I
appreciate this opportunity to testify today. I ask that our
written statement be admitted into the record. Thank you.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Lanza appears in the Appendix on
page 65.
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The MSRB is a self-regulatory organization established by
Congress to write rules covering the municipal securities
activities of brokers. Because shares in Section 529 plans are
municipal securities, our rules apply to brokers in this
market.
Congress sought to protect investors in municipal
securities through MSRB regulation of broker activities while
exempting State and local governments from Federal securities
laws. MSRB rules, therefore, must recognize that unregulated
State and local governments may act in their best judgment in
widely divergent ways. Further, we are prohibited by statute
from using broker regulation to indirectly require issuers to
produce disclosure materials for customers. In contrast,
Congress provided for interlocking mutual fund regulation
covering all parties so that mutual fund broker rules fit hand-
in-glove with issuer rules.
Within this statutory landscape, the MSRB has adopted a
comprehensive set of broker rules in the Section 529 plan
market. Our primary customer protection measures which
establish standards of fair practice and professionalism
require that brokers deal fairly with all persons and not
engage in any deceptive, dishonest, or unfair practice.
When a broker recommends that a customer invest in a
specific Section 529 plan, the broker needs to first conclude
that this investment is suitable for the customer. The broker
can't steer customers toward a particular share class just to
increase his commissions, and the broker can't steer customers
away from available break-point discounts. Brokerage firms
can't conduct sales contests or use incentives that may cause
individual brokers to act unfairly toward customers. These
marketing rules will soon be strengthened by a pending proposal
banning most forms of non-cash sales incentives.
Unlike in the mutual fund market, the MSRB is legally
prohibited from setting broker fees. However, our fair
commission rule should effectively keep Section 529 broker
charges at a level consistent with if not lower than broker
charges for the comparable investment in the mutual fund
market.
Full and timely disclosure is central to investor
protection and to the health of the Section 529 plan market. We
require brokers to disclose to their customers at the point of
sale the material facts about that investment. Also, a broker
that markets an out-of-state Section 529 plan must let the
customer know that he or she may lose out on a State tax break
by not investing in-state. Then, by no later than settlement,
the broker must deliver the Section 529 plan's program
disclosure document to the customer.
On Section 529 plan advertisements, we provided extensive
guidance on a number of specific items of disclosure and we are
moving towards comprehensive standards that will greatly
improve the quality and comparability of performance data in
advertisements.
Because of the political environment in which State and
local governments operate, the MSRB also has unique conflict of
interest rules. These rules, G-37, dealing with political
contributions, and G-38, on outside consultants, apply equally
to the Section 529 plan market.
The MSRB strongly encourages vigorous enforcement of these
rules by the SEC, NASD, and the bank regulators. These are the
agencies that enforce our rules. It is worth noting, however,
that our broker rules do not apply when State personnel market
their own Section 529 plans directly to investors.
Now, turning to the other topics for this hearing, the MSRB
has long been an advocate for the best possible disclosure
practices in the Section 529 plan market. The needs of
investors dictate that disclosure be based on six basic
characteristics: Comprehensiveness, understandability,
comparability, universality, accessibility, and timeliness.
The MSRB applauds the College Savings Plan Network's first
steps at addressing the need for such disclosure through its
draft voluntary disclosure principles. Meaningful success in
this area will require the ongoing commitments of the issuer
community.
In cases where Section 529 program costs exceed those of
comparable mutual fund investments, this can often be
attributed to the extra layering involved in plan structures,
either from fund of funds structures with expenses incurred at
two levels, or from costs incurred for State agency public
policy initiatives for in-state or lower-income residents, such
as subsidized fees, matching grants, or scholarships. In our
view, these activities are within the purview of the States. We
strongly believe, however, that all material program expenses
must be fully disclosed to investors.
Finally, on variation of State tax treatment, we have been
at the forefront of ensuring that brokers inform their
customers of the possible loss of State tax benefit for out-of-
state investments. The MSRB believes that any State tax benefit
is one of many appropriately weighted factors that can
influence a customer's investment decision but should not
necessarily always be the controlling factor.
The MSRB takes no position on States providing or
withholding State tax benefits based on their own public policy
determinations. We believe that comprehensive and easily
accessible centralized disclosure of State tax treatment would
enhance the market and provide investors with the tools needed
to make meaningful investment choices.
Thank you for inviting me to testify this morning. I will
be happy to take questions.
Senator Fitzgerald. Thank you. I thank all of you very
much. I appreciate your being here.
We have been joined by Senator Pryor from Arkansas. Senator
Pryor is welcome to make an opening statement if he wishes to,
or ask questions.
Senator Pryor. I really don't have an opening statement. I
was just down on the floor a few moments ago doing the
intelligence issue, which I know most of the Committee Members
are very interested in that because that has come to our
Committee, so I don't have any opening statement, but you go
ahead and ask questions.
Senator Fitzgerald. Well, thank you.
I wanted to start with Ms. Schapiro and ask you about the
NASD's investigations. You began your investigations of the
sales of Section 529 College Savings Plans because you heard of
numerous customer complaints, as I understand it. What types of
complaints were you getting, and is it the complaints that were
to such an extent that it caused you to begin the
investigation?
Ms. Schapiro. Thank you, Mr. Chairman. We received several
customer complaints. They related largely to investor confusion
about State tax deductibility issues, quite honestly, but also
about some of the fees that are associated with investing in
Section 529 plans.
What really spurred our interest in this area, though, as I
said, is the tremendous growth in assets invested in Section
529 plans and whether when a product becomes very popular very
quickly, broker dealers have in place adequate supervisory and
compliance procedures to ensure that the product is being sold
appropriately.
Senator Fitzgerald. Now, did you get people complaining
that after they were in the plan for a while, they realized
that they weren't getting a tax benefit because maybe they had
invested in an out-of-state plan?
Ms. Schapiro. Yes, that kind of question, and a number of
the complaints were not received by us directly but were
reported on in the press as well as received at some of the
brokerage firms where investors had sent complaints.
Senator Fitzgerald. So then you follow up on them. Now,
during NASD's investigation of 20 securities firms, it was
discovered that 18 firms had made sales of out-of-state Section
529 plans which accounted for 84 percent or more of total sales
and the other two firms had percentages of 69 percent and 37
percent. These figures are pretty astounding.
What criteria are you using to evaluate any possible
violations of MSRB rules? Mr. Lanza has testified that the MSRB
rules require the brokers to explain the possible loss of tax
benefits by going out of State. Is that what you are looking
for, to see if the brokers explained to consumers that they
might lose tax benefits?
Ms. Schapiro. Yes. We want to ensure that they fully
explain to investors--first of all, that they did the
suitability analysis, that they determined that the Section 529
plan, if they recommended a particular one, was, in fact,
suitable for investors, including the underlying investments of
that Section 529 plan, a stock fund versus a bond fund, for
example. And then secondarily, whether they explained the
presence of a State tax benefit that might exist for the
investor who chose to buy their home State's plan if, in fact,
there was one. About half the States don't give any State tax
deduction for the contributions, but about half do.
So we also focused our second round of inquiries on firms
that were selling particularly to residents of States where
there was an in-state tax benefit to see if they were doing a
better job of disclosing that information.
Senator Fitzgerald. Have you had any settlements yet with
brokerage firms?
Ms. Schapiro. No. We are still in the information gathering
part of this investigation. We are looking at their sales
literature to understand whether they are accurately and
adequately disclosing risks. We look at the training materials
to see whether firms are adequately training brokers to make
all the explanations and disclosures that they need to make. We
are looking at the offering memoranda, the dealer agreements
between the plans and the dealers, as well as customer
complaints, and then the transaction data, which allowed us to
come up with the chart that is in the written testimony that
demonstrates the very high percentage of out-of-state sales.\1\
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\1\ The chart entitled ``Growth in Section 529 Plans 1996-2004,''
appears in the Appendix on page 166.
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Senator Fitzgerald. Would you have any recommendations at
this point based on what you found so far?
Ms. Schapiro. Well, I would say that we strongly recommend
that there be uniform disclosure of fees, expenses and tax
issues with respect to Section 529 plans. It strikes us as
incongruous that there is very detailed, specific and formatted
disclosure for mutual funds, but investors who are basically
investing in mutual funds but do so through the Section 529
program are not getting anywhere near that kind of uniformity
of disclosure. Without uniform disclosure, you don't have
comparability and you put investors----
Senator Fitzgerald. It is not just that there is not
uniform disclosure, there really doesn't have to be any
disclosure. There is no mandate that they disclose the fee,
really, is there?
Ms. Schapiro. We cannot require, nor can the MSRB require
the issuers, the States, to disclose particular information.
Senator Fitzgerald. Congress could, though.
Ms. Schapiro. Yes, that is right.
Senator Fitzgerald. Congress has said that the States are
exempt from our securities regulations except for maybe in a
couple areas, but they are certainly exempt from the Investment
Company Act, which imposes certain requirements such as having
a semi-annual statement that mutual funds have to give. I
thought those disclosures were inadequate, and I wanted to beef
them up. But, in fact, in the case of Section 529 College
Savings Plans, the States don't even have to give those minimal
disclosures that mutual funds give.
Mr. Miller, you mentioned in your testimony, you went
through the IRS requirements and you said there is no
requirement that the fees be disclosed. Is that correct?
Mr. Miller. There is a requirement to give an annual
account statement that shows contributions, earnings, and any
distributions, but I am unaware of anything that would indicate
that.
Senator Fitzgerald. And Congress dictated that law, right?
I mean, we drafted that law and you are just enforcing that.
Mr. Miller. I believe so. We have rules out in terms of----
I think we probably could go beyond that, Mr. Chairman.
Senator Fitzgerald. Well, could the IRS go beyond the rules
that are out there and require a disclosure of the fees?
Mr. Miller. The disclosure on the fees--I think the answer
probably is yes. The problem, Mr. Chairman, is it would be too
late in the plan by that point because the account balance
information is once you are in the plan. There is no
requirement under the code for disclosure prior to entry into
the plan. So the timing would sort of miss, I believe.
Senator Fitzgerald. OK, but could you draft a rule pursuant
to Section 529 that required, say, from now on, that every plan
participant would receive an annual or at least semi-annual
statement that included the fee, not just an account statement
that tells you how much money you have at the end of the year,
but showed you the fee? Could the IRS----
Mr. Miller. I would have to check on that, but I believe
the answer is that we could.
Senator Fitzgerald. I would encourage you to look at that.
We don't have to wait around for Congress to get to revising
the statute. If you have that authority, take that up with
people because we are dealing with a vehicle that was supposed
to encourage people to save for college, and there are tax
advantages here, but it looks like high fees are gobbling up a
lot of the tax benefits. The SEC isn't a player here. There is
no one to regulate these programs except possibly the IRS. I
know it is not your usual area, but you are the only ones who
potentially have any authority. So I would encourage you to
take that up with the Commissioner.
Mr. Lanza, would you have any recommendations you would
want to add here? I know that the MSRB has proposed an
extensive set of draft amendments to its advertising rules that
would improve the quality and comparability of performance
data. If adopted, these rules would only apply to broker
dealers. Since the rules would not apply to the States which
also sell the plans directly, how can we ensure consistent
dissemination of information?
Mr. Lanza. Right. I should start off by saying that we, in
fact, are a broker dealer organization and therefore our
mission is to regulate broker dealers, and so we typically have
not opined as to what it is that issuers should or should not
be required to do. We clearly have stated that disclosure is
fundamental to----
Senator Fitzgerald. Could you require the broker dealers to
disclose what the State plans----
Mr. Lanza. Well, we do require at the time of trade that
broker dealers provide disclosure to the customer of all
material information about the program so that if there is a
material fee, expense or cost, that is covered by our
disclosure obligation. But again, it only applies to broker-
sold plans. It would not apply to non-broker-sold plans.
Senator Fitzgerald. Right. So if somebody buys it directly
from the State, there is nothing you can do about it.
Mr. Lanza. That is correct.
Senator Fitzgerald. So they are likely to get more
information if they go through a broker. However, they are also
likely to pay a load.
Mr. Lanza. There is a trade-off, but certainly the States
are making an effort, it seems, to try to create uniform
disclosure and we are hopeful that effort will work.
Senator Fitzgerald. Would any of you have any
recommendations for Congress on what we might be able--I mean,
there is nothing any of you can really do about this because
you don't have any powers over the State Governments that are
administering these plans. Does it make sense to you that we
have this additional layer of fees interposed by State
Governments? Why couldn't Congress just design Section 529
plans that would allow you to go directly to Fidelity or
Vanguard or any one of the mutual fund companies and open a
Section 529 plan and not pay a fee to a State Government? Do
any of you want to venture forth on that?
Ms. Schapiro. I probably shouldn't, but I will. That is
something that clearly should be considered and an option that
the Congress ought to consider very carefully. There is a
tremendous amount of confusion because of the different way the
plans are administered and the different, particularly tax
issues associated with the contributions at the State level.
But I also think that if we could have very clear, very concise
disclosure for investors about fees and expenses on one page,
so that they could not only see what happens with their in-
state plan, but compare across plans within their State and
across all the States and then make an informed investment
decision, that would be a tremendous step forward. The
comparability from our perspective, whether it is mutual funds
you are talking about, variable annuity sales, or Section 529
plan sales, it is absolutely critical for investors to be
informed of choices.
Senator Fitzgerald. Do any of you see any reason why
college savings plans need to be run by State Governments? Is
there something I am missing here? All I see is an additional
layer of fees. Do any of you see any benefit to having the
State Governments be involved? I suppose the one benefit is the
tax benefit. If they are not running them, they are probably
not going to give you a State tax benefit, right?
Mr. Lanza. I would let the States speak for themselves, but
it is a policy question between the Federal and State
Government as to where things should lie. Some States provide
certain benefits that they believe are beneficial to their
residents and others may not. Again, it is a policy decision,
at least from the MSRB's view, between the States and the
Federal Government.
Senator Fitzgerald. Well, the Federal Government could
simply make them all tax-exempt, Federal and State tax-exempt,
and that would be the end of it, and you could go and just buy
them directly online and not pay an additional layer of fees.
Am I missing something here? Can you think of a benefit that
having an additional middleman, in addition to the brokers and
in addition to the fund managers, having the State Governments
get in there and get their paws on a fee? Can you articulate a
benefit we get by setting it up this way?
Mr. Miller. The only thing I would mention, Mr. Chairman,
is that the history of these plans is that they grew out of the
States, and so in the 1980's and 1990's, that is how these
things were created out of State plans, and when the Congress
acted in 1996, that is what was in front of it at that time----
Senator Fitzgerald. Were there any State plans prior to
1996, or was it in 1996 the State Treasurers Association came
to Washington----
Mr. Miller. No. There were, in fact, plans in the 1980's
and 1990's that States had set up and their tax treatment was a
point of discussion and contention, to some extent. That was
clarified in 1996. So that gives some background as to why we
are where we are today.
Senator Fitzgerald. So it was just clarified in 1996. It
arguably may have been--they may have been tax advantaged
before 1996?
Mr. Miller. There would be a court case that indicated that
that was the case. We lose a court case against Michigan's
Education Trust.
Senator Fitzgerald. Oh, I see. OK. So in 1996, we made the
internal build-up in the accounts tax advantaged by Federal
statute, and then in 2001----
Mr. Miller. Distribution side.
Senator Fitzgerald [continuing]. We made distributions from
the plan, and then the funds have really grown since that time,
is that correct? Making the distributions tax-exempt when used
for educational purposes, that has caused additional quick
growth.
Mr. Miller. We are not tracking that at the Service.
Inferentially, that would seem right, but I would look to other
people to answer that question.
Ms. Schapiro. I would agree with Mr. Lanza. It is really a
question of where the authority ought to lie, with the Federal
Government or the State Governments. I will say that it would
provide a tremendous simplification for the brokerage industry
to have some uniformity here with respect to the tax treatment
across all the States and would help with sales practice
issues, quite honestly.
Senator Fitzgerald. It is really tough for the brokers,
too. They may make a mistake, because you have to know the tax
laws in all 50 States, then, in order to be able to fully
educate your customers, right?
Ms. Schapiro. MSRB rules don't require them to specifically
analyze the different tax treatments of every State. They do
have to give general disclosures--such as ``there may be an in-
state tax benefit versus going out of State.'' But nonetheless,
good brokers really do want to be able to explain what the
impact on the value of an investment is of a tax benefit at the
State level as well as the impact of expenses----
Senator Fitzgerald. So the broker's only obligation is to
say to the customer, if you go out of State, you might lose a
tax benefit. I don't know, but you will have to look this up.
He doesn't have to tell you, I am recommending this plan and--
--
Mr. Lanza. That is a baseline obligation. If you are
marketing an out-of-state plan, the duty is to let the
customers know that they may be missing out on an in-state
benefit.
Senator Fitzgerald. That is a pretty minimal requirement. I
would think a lot of brokers are going to want to know a lot
more than that. Say if you are a broker in my State of Illinois
and somebody is going to go out of State, you are going to want
to know what happens to your Illinois customers as far as their
taxes are concerned. So maybe from the standpoint of your
rules, they don't have a duty of going further, but I would
think a lot of diligent brokers out there would be forced to
study the tax laws very carefully here. That seems to me it
imposes an additional enormous obligation on them.
Ms. Schapiro. I think that is absolutely right. Brokers
really do want to be able to give that information to their
customers. In addition, brokerage firms are working very hard
to increase the number of States plans that they sell so that
they can have within their menu of investment options one that
is an in-state plan for as many of their customers as they can.
That creates a lot of administrative burden on the firms.
Senator Fitzgerald. Thank you all for your testimony. I
appreciate it.
Senator Pryor, do you have any questions you would like to
ask?
OPENING STATEMENT OF SENATOR PRYOR
Senator Pryor. Let me just say, Mr. Chairman, I think you
have done a great job of quizzing the panel and defining some
very important issues here. I think I share your concerns about
the confusing nature and some of the details of this policy
that we have on the books today.
I would say this, and I think everybody pretty much in the
room and probably in the Congress would agree that I think as a
matter of national policy, it is a good thing for us to get
more people to go to college. I think that we should find ways
here in the Congress, whether it is through our tax code or
whatever, but we need to find ways--if it is creative, so be
it--but find ways to incentivize people to go to college.
I think, really, if you look at the Section 529's, that is
probably the original intent of this, is to allow investors,
allow people to look at their options and have this as a viable
option for them to really give them a tax incentive, an
advantage, if you will, in sending their children to college.
So that concept is totally acceptable to me. In fact, I think
it is something that we need to keep on the books.
But at the same time, some of the ways this program is
implemented, whether it was intentional or unintentional, I
don't know and we can't speak for all of that, but I do think
it is time for us to revisit this. Mr. Chairman, I appreciate
your leadership on this because I think you have really laid
out the issues and helped us define the issues so that we can
proceed on this and hopefully have some positive restructuring
of the Section 529 program.
So let me just make a couple observations, but really ask a
few questions, and that is in looking at the Section 529
savings plans, I think it is confusing. As I understand it,
there are at least, or about, six possible fees that could
apply, and depending on what you are doing and what your
circumstances are, you may get one or a combination of those
fees. My impression is that there is just not a very good
system in place to disclose all of this to the investor. Is
that fair? Ms. Schapiro, I don't want to pick on you, but is
that a fair statement?
Ms. Schapiro. That is a fair statement.
Senator Pryor. I guess my first question is, why don't we
just adopt--I know you all can't do it, but why doesn't
Congress just adopt a uniform fee, just a flat or very easy to
understand formula, just a uniform fee that would apply to
this? Do you all see any problem with just a uniform fee in
some way? Does that create a problem?
Mr. Lanza. It would be a different approach than currently
exists elsewhere in the marketplace, but I see no legal
problem.
Senator Pryor. All right. Well, let us talk about that.
What currently exists in the marketplace today?
Mr. Lanza. Typically, for example, the MSRB--and again, our
jurisdiction is limited to broker dealers--we are statutorily
prohibited from setting fees. The Congress's determination at
the time that we were created, and I believe it also applies in
general to the NASD, was that market forces should be left to
operate. So we certainly don't have any kind of mandate to
create any kind of fixed fees.
Senator Pryor. OK. I see these as a little bit different,
like the Chairman said, because the State has a role in this,
but anyway, that is good.
Ms. Schapiro. There actually is, under NASD rules with
respect to mutual funds, an 8.5 percent cap on sales charges in
funds where there are no 12b-1 fees or services assessed.
Otherwise, it is a 6.25 percent cap. But generally, fee caps
and limits and the dictation of fees has not been done by the
government or by the Congress but rather set in the
marketplace. Critical to the marketplace functioning with
respect to the competition among fees is disclosure that
investors can understand so that they can make informed choices
about whether they want to pay particular fees or not----
Senator Pryor. Right.
Ms. Schapiro [continuing]. And so that they can understand
what the impact of multiple levels of fees are on their
investment's return over time.
Senator Pryor. Right. As I understand, the SEC has mandated
the so-called ``plain English'' rule so that investors, when
they read materials, etc., most investors, at least, can
understand it or at least come closer to understanding it than
if it is just filled with legalese. I think the National
Association of State Treasurers and the College Savings Plan
Network have come up with what may be considered their version
of this. It is kind of voluntary disclosure principles,
guidelines, etc.
These are voluntary disclosure principle guidelines. Do you
know how many are complying with these voluntary disclosures?
Do we have a sense of what everybody is doing out there?
Mr. Lanza. I don't have a figure. I understand that some
States have begun to implement it. Others are, I believe,
waiting for the SEC Chairman's task force report. But again, I
am not the person to speak to that.
Senator Pryor. I guess what is puzzling to me about this
is, and maybe it is because of my Attorney General background
where we did a lot of consumer protection work, but it is just
puzzling to me where the States would not want their consumers
to have full knowledge and a clear understanding of what they
are getting themselves into. I am puzzled by that. I know that
you can't speak for them or speak to that.
Let me ask you just one last question. Is it your opinion
that the States and the investment community are doing enough
to allow parents and students to make intelligent investment
decisions, or do you think that we need to review and revise
what we have on the books today?
Mr. Lanza. Clearly, we believe disclosure can be improved.
I mentioned the six characteristics that we think disclosure
needs to bring in, which is that it be understandable,
comprehensive, comparable, universal, accessible, and timely.
All the information that anyone needs needs to be available in
a timely manner and in a simple manner and in a way that they
can compare one State versus the other.
Again, we are hopeful that the CSPN disclosure principles
will get them there. It is not an easy process. It will take a
lot of work and real vigilance.
I will mention that MSRB also regulates broker dealers in
the municipal bond area, which has clearly had a longer
history, and over time, disclosure practices have improved in
that market, as well, even though there is no mandatory set of
requirements for disclosure. So certainly it is possible. I
just can't predict where it will go.
Ms. Schapiro. I think improving disclosure is key, too. We
have developed a one-page disclosure document that would lay
out for investors what fees they pay to buy and own a Section
529 plan and then, out of those fees and expenses that they
pay, what is paid to the brokerage firm and to the broker for
selling that plan. I don't know if it is perfect, but it is
that kind of point-of-sale, simple, one-page disclosure that
allows for comparability across different plans that I think
would be the greatest service we could provide investors in
this area.
Mr. Miller. That is not really a tax issue for our side of
it.
Senator Pryor. Thank you very much, Mr. Chairman.
Senator Fitzgerald. Senator Carper from Delaware has joined
us. You are free to ask any questions or we can bring up the
second panel.
Senator Carper. Let me just ask a question of each of the
witnesses, if I could. Thank you for being here. I apologize
for not being here to hear your testimony, but I would just ask
that you briefly give me a take-away or two, what you would
have us take away from this hearing.
Steve Miller, you are about the third Steve Miller we have
had testify in this Congress.
Mr. Miller. There are a lot of us.
Senator Carper. I always ask the same thing, like what have
you been doing since your recording career sort of leveled
off---- [Laughter.]
But you still look young. You look great.
Mr. Miller. Thank you. [Laughter.]
What we testified on, Senator, were the basic requirements
for exemption for a qualified tuition program under Section
529. There is nothing explicit in that that really deals with
the disclosure area to prospective customers, and I think that
is a take-away.
Senator Carper. All right, thanks. Ms. Schapiro.
Ms. Schapiro. I sound a bit like a broken record, but I
would say that the key take-away from our perspective would be
the need for uniform disclosure concerning fees, expenses, tax
treatment, and all the other unique features of Section 529
plans that go well beyond the underlying mutual fund
investment, things like the rollover options and designation of
beneficiaries and so forth.
Senator Carper. Thank you. Mr. Lanza.
Mr. Lanza. I spoke to the broker dealer obligations to
customers and I think, as Ms. Schapiro said, we believe
disclosure really is the key in this marketplace because it is
complex and there are lots of features and the best thing for
investors as well as the broker dealers who market to investors
is to be able to understand the marketplace and understand all
the key features. So we urge the issuer community to really
work on quality, comparable, timely, and comprehensive
disclosure.
Senator Carper. I don't know if any of you have children of
your own, but some of you may, but if you are giving advice to
people who have children, about to have children, someday have
children, what they might want to keep in mind as they prepare
for their children's education as it relates to the Section
529's. What would you have them keep in mind?
Ms. Schapiro. I do have children. I have two daughters,
both of whom have Section 529 plans. I also serve on the board
of a college, and so I see from that perspective what
tremendous burdens are placed on families who are trying to pay
for a particular private school education, but even today,
public school education. My advice would be to start saving day
one. The day the child is born, open a Section 529 plan. Look
for one with the lowest possible fees and expenses, with a good
reputation on the part of the mutual fund complex that
underlies the Section 529 plan, and make regular contributions
to it, watching the investment very carefully, of course, so
that if there are issues that arise over time, you can make the
appropriate changes.
Senator Carper. Good. Thank you. What college?
Ms. Schapiro. Franklin and Marshall in Lancaster,
Pennsylvania.
Senator Carper. We know where that is in Delaware.
Ms. Schapiro. That is right. [Laughter.]
Senator Carper. Gentlemen.
Mr. Miller. I think that the most likely take-away on that
is that you really do need to do your homework because the
plans are very different, and that is really what we would
suggest, as well.
Senator Carper. All right.
Mr. Lanza. I don't think anyone in their right mind would
want to take financial advice from me, but we have college
savings plans as well for our children. We think they are very
helpful. We were very careful in our selection, making sure
they met with our----
Senator Carper. What did you consider when you were making
those selections?
Mr. Lanza. Well, it is a matter of personal choice. I tend
to go for the low-cost indexed type of funds. Others have other
views towards the mutual fund industry in general. Some like
more actively managed. In my case, it is more of an index fund,
so I went in that direction.
Senator Carper. All right.
Mr. Lanza. But it is a matter of what your personal
investing style is.
Senator Carper. How old are your children?
Mr. Lanza. One is 11. The other one is six.
Senator Carper. Ms. Schapiro.
Ms. Schapiro. Eight and ten.
Senator Carper. Eight and ten, all right. Mr. Miller.
Mr. Miller. Five years old.
Senator Carper. Five years old, OK. Fourteen and sixteen,
and we have a plan for each of our boys, too. Thank you very
much.
Senator Fitzgerald. Thank you to this panel of witnesses. I
did want to tell Senator Pryor there definitely are huge
variations in fees. I am going to have my staff try and get you
something that has been worked up by Morningstar. We are going
to hear from a Morningstar witness. You might want to take a
look at the fees they charge in Arkansas, too. I won't state
those publicly, but you might want to take that up with your
Treasurer back home.
All of you, you have been great. We appreciate your time.
Thank you so much for coming here.
Now, I would like to welcome our witnesses for panel two.
Our first witness on this panel is the Hon. Michael A.
Ablowich, who is the Treasurer for the State of New Hampshire.
Treasurer Ablowich began his 2-year term in January 2003 and is
responsible for cash management and investment of more than
$300 million daily, banking relationships, debt management, and
trust fund management. Treasurer Ablowich also is statutorily
appointed to a number of State committees, including the New
Hampshire Municipal Bond Bank and the New Hampshire College
Tuition Savings Plan Advisory Commission.
Our second witness is Jacqueline T. Williams, who serves as
the Executive Director of the Ohio Tuition Trust Authority. The
Ohio General Assembly created the Tuition Trust Authority in
1989 to promote savings for higher education. Prior to her
current role, Ms. Williams held leadership roles as Chief
Administrative Officer for the Ohio Bureau of Workers'
Compensation and the Director of Consumer Services for the Ohio
Consumers Council.
Our third witness is from my home State of Illinois. Martin
M. Noven serves as Deputy Chief of Staff to Illinois State
Treasurer Judy Baar Topinka. Mr. Noven joined the Treasurer's
Office in 1993 and his responsibilities include supervision of
all legal, legislative, and policy matters, including program
creation and new initiatives. Mr. Noven is responsible for the
implementation and supervision of Bright Start, the college
savings program established by Treasurer Topinka.
Our next witness is Richard O. Davis. Mr. Davis is the
Deputy Executive Director for Finance and Administration for
the Utah Higher Education Assistance Authority. The Authority
is a subsidiary organization of the Utah State Board of Regents
that oversees the operation of the State's student loan
secondary market activities, guarantor operations, and the Utah
Educational Savings Plan trust.
Our fifth witness is Dan McNeela, who is a senior analyst
at Morningstar, an independent investment research firm. Mr.
McNeela has researched mutual funds for Morningstar since
October of 2000 and is the firm's lead editorial analyst
covering Section 529 College Savings Plans.
Our final witness is Mercer Bullard, whom we welcome back
before this Subcommittee. Mr. Bullard also testified at our
mutual fund hearings in November 2003. Mr. Bullard is the
founder of Fund Democracy, a nonprofit membership organization
that serves as an advocate and information source for mutual
fund shareholders and their advisors. Mr. Bullard also is an
assistant professor of law at the University of Mississippi,
where he teaches in the areas of securities and banking
regulation, corporate finance, and contracts. I know one of my
staff members was keeping abreast of the conference you held on
mutual fund ownership down in Mississippi, and you have been a
great advocate for investors. We thank you for being here.
To the best of your ability, please try to summarize your
remarks within 5 minutes. We will take your full written
statements for the record, and we will make them part of the
record. Thank you all for being here.
I would like to begin with Treasurer Ablowich from New
Hampshire. I went to Dartmouth College in Hanover, New
Hampshire, so I have some connection to your State. Welcome.
TESTIMONY OF HON. MICHAEL A. ABLOWICH,\1\ TREASURER, STATE OF
NEW HAMPSHIRE, ON BEHALF OF THE NATIONAL ASSOCIATION OF STATE
TREASURERS
Mr. Ablowich. Thank you very much, Mr. Chairman and Members
of the Subcommittee. My name is Michael Ablowich. I am the
Treasurer of the State of New Hampshire and trustee of both the
UNIQUE College Investing Plan and the Fidelity Advisor Section
529 Plan, both of which are sponsored by our State. I would
like to have my written testimony entered into the record of
this Subcommittee, please, Mr. Chairman.
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\1\ The prepared statement of Mr. Ablowich appears in the Appendix
on page 90.
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Senator Fitzgerald. Without objection.
Mr. Ablowich. I am also a member of New Hampshire's College
Tuition Savings Plan Advisory Commission and a member of the
College Savings Plan Network, which is an affiliate of the
National Association of State Treasurers. CSPN coordinates
State college savings efforts by harnessing the collective
resources of States to improve industry practices and develop
self-regulating policies.
It is my sincere pleasure to be here today to speak with
you about Section 529 College Savings Plans, the State of New
Hampshire's perspective, and philosophy regarding these plans
and how States are making them successful.
The States have been working with Congress for over a
decade to increase access to college by helping families
overcome one of the greatest barriers to college, the ever-
increasing cost of higher education for their children.
New Hampshire's story is really no different in this case.
We began our Section 529 plans in 1998 and since then,
residents in New Hampshire and other States have responded to
these plans with excitement and enthusiasm. More than $3.3
billion has been invested in more than 330,000 accounts in our
two programs combined. That high level of response is even more
amazing when you consider that we started these plans a couple
years before one of the most challenging financial markets in
history.
Investors clearly understand the need for higher education
and the principle of saving early and regularly in a tax
advantaged account. Of course, while periodic investing
strategies do not guarantee a profit or protect against loss in
a declining market, investing in a Federal income tax-free
vehicle like a Section 529 plan may be one of the simplest and
best ways for families to start saving for college.
Our Section 529 plan is built on the foundation of putting
investors and beneficiaries first. We make every program
decision with the interests of our investors in the forefront,
and while we maintain an outstanding relationship with our
private sector partner, our first priority is always to our
investors, the plan participants. That is why New Hampshire
currently has two Section 529 plans to choose from, each
offering investors a different method of deciding on which
investment options are best for them.
The UNIQUE College Investing Plan is sold directly to
investors and the Fidelity Advisor Section 529 Plan is marketed
to investors through intermediaries, like financial planners or
brokers. Both plans give investors a wide range of college
savings options to satisfy their college savings goals. Our
retail UNIQUE plan is designed with smaller investors in mind,
but these investors, they can get started with as little as $50
and $50 monthly contributions, or for a one-time contribution
of $1,000. It is our goal to offer solid investment choices to
attract a wide range of investors with varying risk tolerances
and investment philosophies.
Everyone talks about the amount of money saved in Section
529 plans, and it is substantial, but I believe the more
important statistic is the number of accounts. I really don't
care whether people are saving $50 or $50,000 as long as they
save. I am also not concerned whether they save in one of our
two Section 529 plans or in another plan or, frankly, in their
name in a traditional bank savings account or some other
method. The important thing is that parents are making plans
for one of the most important investments in their lives, their
children's education.
In New Hampshire, we have worked to develop college savings
awareness to ensure that every resident, regardless of income,
understands and has easy access to the Section 529 plan and
other college financing options. We have also made this
decision simpler for our residents by allowing them to receive
favorable State tax interest and dividends tax treatment
regardless of the plan they participate in.
The States have a legitimate vested interest in making
college more affordable and accessible to their citizens. In
New Hampshire, the Treasurer's Office is responsible for our
Section 529 plans, as is the case in most States. We have been
entrusted with looking after the hard-earned dollars of
families who are saving for their children and grandchildren's
education.
Our Advisory Commission meets regularly to review plan
operations, the performance of securities markets, and
performance in each of the portfolios and investment options
available to our investors. We have worked hard to ensure that
our Section 529 plans, whether bought directly or through
financial advisors, offer competitive fees that are fully
disclosed to all investors.
We also spend much time reviewing the performance of each
portfolio to ensure that investors are earning competitive
returns net of fees compared to the appropriate benchmarks.
This allows me and our commission to exercise full and
effective control over the program as well as oversee our
private sector program manager. Every significant decision made
regarding the plan, whether investment-related or
administrative, is analyzed and approved by the commission. The
roles of the Treasurer and the Advisory Commission and the
terms of the contract with Fidelity Investments, our plan
administrator, have been approved consistent with the process
used for all State contracts.
After listening to the customer concerns regarding
disclosure and transparency, the National Association of State
Treasurers and the College Savings Plan Network have undertaken
an effort to create voluntary disclosure principles. These
principles were adopted in draft form with input from our
private sector partners this May at the Network's annual
meeting. The National Association of State Treasurers has also
adopted the principles at its annual conference earlier this
year.
The goal of the principles is to provide a framework for
disclosure so that investors can easily understand his or her
own State's plans compared to other Section 529 plans on an
apples-to-apples basis.
Senator Fitzgerald. You have got to wind it up.
Mr. Ablowich. Can I have 2 more minutes, Mr. Chairman?
Senator Fitzgerald. We will give you time in the question
and answer segment. We have got to give everyone an
opportunity. We want to stay to that 5 minutes, so please watch
these lights. We will come back to you.
Mr. Ablowich. Thank you, Mr. Chairman.
Senator Fitzgerald. Thank you very much, Treasurer. Ms.
Williams.
TESTIMONY OF JACQUELINE T. WILLIAMS,\1\ EXECUTIVE DIRECTOR,
COLLEGE ADVANTAGE SAVINGS PLAN, OHIO TUITION TRUST AUTHORITY,
ON BEHALF OF THE COLLEGE SAVINGS PLAN NETWORK
Ms. Williams. Thank you, Mr. Chairman and Subcommittee
Members. I am Jackie Williams, Executive Director of the Ohio
Tuition Trust Authority and I appreciate the opportunity to
share one State's perspective on Section 529 plans and
hopefully clear up some misperceptions and highlight the
enormous value these plans provide to America's families.
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\1\ The prepared statement of Ms. Williams appears in the Appendix
on page 103.
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Our agency is an independent State agency governed by an
11-member board comprised of business, education, and elected
leaders in our State. In 1989, Ohio was one of the first States
in the country to offer a Section 529 qualified tuition
program. The General Assembly created the plan to make higher
education more affordable and accessible for all Ohio citizens.
Since inception, our State provided tax-exempt earnings to
encourage early savers. Only 11 States have fewer college
graduates than Ohio, and a recent report by our governor
indicates that our economic future depends on increasing
participation in higher education.
The Tuition Trust first offered a unit-based prepaid plan
designed to keep pace with tuition inflation at Ohio's public
universities. The plan enjoyed wide acceptance and market
success. Long before I became an employee of the plan, I
financed the education of my two sons through the guaranteed
program.
In 1994, the Ohio General Assembly and Ohio voters approved
a constitutional amendment putting the State's full faith and
credit backing behind the plan if it could not meet future
obligations.
In 1996, Ohio's plan fell under guidelines established by
Congress establishing qualified State tuition programs and
adding Section 529 to the Internal Revenue Code. These changes
have encouraged more States to offer college savings plans and
expanded their ability to offer new investment choices and tax
incentives. Legislation to take advantage of the Federal
changes was approved unanimously by the Ohio General Assembly
in 1999, and this also created new investment options and added
a $2,000 annual State tax deduction on contributions.
Launched in the Fall of 2000, College Advantage included
the original prepaid plan and the new actively managed
investments. We were one of the first States to offer both a
director-sold and an advisor-sold program. We found that many
savers wanted investment advice from financial professionals
and were willing to pay to receive it and that there were also
do-it-yourself investors who wanted to make their own
investment decisions and wanted a broad range of low-cost
options. With product enhancements and improved distribution,
we have over 266,000 beneficiaries in Ohio alone.
The Federal Tax Act of 2001 permitted a tax exemption on
earnings on funds when they were used for qualified higher
education expenses. When that law took effect in June 2001,
there were a million-and-a-half U.S. children with Section 529
accounts valued at $9.5 billion. Three years later, Section 529
plans have become the preferred college savings vehicle, with
6.8 million accounts valued at over $54 billion. Unfortunately,
unless extended by Congress, the Federal law will expire after
December 2010.
For 15 years, our organization has worked very hard to
educate people to determine what kinds of products and features
to offer, how best to inform and educate, and how to distribute
products to a broad cross-section of the public. Each
investment manager is selected through a rigorous competitive
process subject to State procurement laws.
We currently work with two investment firms, Putnam
Investments, which provides actively managed investment
products, and the Vanguard Group, which provides passively
managed index funds. Recently, we selected an Ohio bank to
develop a Section 529 banking product. Our goal is to make
investment vehicles available to savers at every level of
income, education, and investment experience.
We encourage families to save through flexible contribution
methods, such as electronic funds transfer, payroll deduction,
and online investing. Participants pay no application or
service fees. Ohio residents pay no annual account fees. And
account fees are waived for non-residents who are participating
in systematic investing. A College Advantage account can be
opened for as little as $15.
And while expense ratios vary by investment, our direct-
sold plan offers some of the industry's lowest fees and our
advisor-sold fees are about average for advisor-sold actively
managed funds. Obviously, enhancing disclosure of fees and
performance is a very high priority of ours and we fully
support CSPN's direction on this.
Earlier this year, we took a leadership position and
disclosed all of our fees on a single page in our opening
statement. I would just like to say that there are a number of
organizations that rate Section 529 programs, and I think in
many cases they have done a disservice to the people who read
their reviews and have not shed light on these plans. Frankly,
much of their information has a very long shelf life, and these
plans are dynamic ones which can change the day after these
articles are written. For example, the Rhode Island J.P. Morgan
fund no longer exists. So clearly, it is in the best interests
of States, as well, to make sure that our information is out
there and that the organizations reporting on them are using
accurate, timely information. Thank you very much.
Senator Fitzgerald. Thank you, Ms. Williams. Mr. Noven,
welcome.
TESTIMONY OF MARTIN M. NOVEN,\1\ DEPUTY CHIEF OF STAFF, ON
BEHALF OF JUDY BAAR TOPINKA, STATE TREASURER, STATE OF ILLINOIS
Mr. Noven. Thank you. Good morning, Chairman Fitzgerald and
Members of the Subcommittee. I would like to enter my written
comments into the record, as well.
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\1\ The prepared statement of Mr. Noven appears in the Appendix on
page 107.
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Senator Fitzgerald. Without objection.
Mr. Noven. Thank you. We appreciate the opportunity to
present this testimony. I personally appreciate your inviting
me to testify on behalf of Treasurer Topinka. She feels very
strongly about a number of the issues that you are discussing
and appreciates the opportunity to share her views on the
matter.
When these State Section 529 programs were set up, they
were set up so that there would be someone looking out for the
interests of consumers. They were set up by States so they
would have a product to offer their investors in-state and
their consumers in-state that would be protected by someone who
was looking out for their interests so they could feel
comfortable that they weren't paying high fees, that they
weren't getting false information.
In that spirit, Treasurer Topinka created the Bright Start
College Savings Program. It wasn't an easy program to start.
Legislatively, we had a difficult time getting authority. We
were actually forced by the banking industry to include some
unique provisions in our law that made it more difficult to
have a successful program. For example, all contributions and
applications have to go through Illinois banks to participate
in the Illinois plan, and banks even have the option, although
very few actually--it is a negligible amount have actually
taken advantage of it--to have some deposits on hand as part of
the investments that are in the participants' portfolio.
So we worked very hard to get a plan together. We were glad
that despite the fact that we had a hard time getting people to
respond to the RFP and some of the responses that we did get
had inflated fees because of our unique requirements, we were
able to negotiate a contract with Smith Barney that gave us one
of the lowest-cost programs in the Nation. It gave a tremendous
amount of control to the Treasurer to protect consumers. And
also, with their affiliation with Citibank, they were able to
comply with our enabling legislation.
We are extremely pleased with the success of the Bright
Start program. We have more than 100,000 accounts that have
been opened. Our performance places us among the top in the
Nation. We have done all of this without engaging in the
problems that you have mentioned: The high fees and
commissions, the questionable sales practices, the inadequate
disclosure. We feel very strongly that all of these are
important things that we need to consider. We applaud the
efforts of the Federal regulatory agencies that are looking at
some of these issues. We think it is important.
When the largest programs in the Nation, the ones that are
growing the fastest and being sold most aggressively and have
the most consumer assets, are the ones that are least consumer-
friendly and are the ones that charge consumers the highest
fees so they have the least amount of assets to grow, like you
mentioned on the charts that you have, we have got a real
problem here and we are glad that it is being looked at.
We have been fighting that battle in Illinois, as well,
where two dollars is being invested out of State in these high-
priced broker-sold plans for every dollar that is being
invested in-state. The performance of these plans has not been
better than Bright Start. The broker fees are higher in these
plans. These citizens are paying higher fees and not getting
the tax benefits in Illinois. That has caused some concern in
Illinois, and instead of the brokerage community dealing with
this conflict by changing their selling practices, they have
come after us with a fleet of lobbyists in Springfield, trying
to force us to extend those benefits to encourage Illinoisans
to go to plans that are not in their best interests as a
consumer. Those are the concerns we have.
We have tried to extend our State tax benefits to any other
State plan that will agree to adequate disclosure and the
industry killed the bill. We tried to extend it to any plans
that had reasonable sales charges. The industry killed that
bill. We offered--it was a legislative proposal, it didn't get
to the bill form--if other States would treat Illinois
residents as well as they treated their own and not charge
extra fees and commissions to help pad their State treasury,
extend the tax benefits to them, and the industry rejected that
proposal.
So we have been working very hard on this issue. On a
state-by-state level, we fear that States are competing with
each other for assets as opposed to looking out for consumers,
as was the original intention of this bill. We very much
welcome the chance to address these issues.
Senator Fitzgerald. Thank you very much, Mr. Noven. Mr.
Davis.
TESTIMONY OF RICHARD O. DAVIS,\1\ DEPUTY EXECUTIVE DIRECTOR FOR
FINANCE AND ADMINISTRATION, UTAH HIGHER EDUCATION ASSISTANCE
AUTHORITY
Mr. Davis. Thank you, Mr. Chairman. Mr. Chairman, Members
of the Subcommittee, my name is Richard Davis, Deputy Executive
Director for Finance and Administration for the Utah Higher
Education Assistance Authority, which is a subsidiary board of
the Utah State Board of Regents. We manage the Utah Section 529
plan as part of our role to provide financial and informational
assistance to Utah residents.
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\1\ The prepared statement of Mr. Davis appears in the Appendix on
page 112.
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The Utah plan was set up in 1996 as a State agency and is
governed by a 17-member Board of Directors comprised of members
from both private and the public sector. In response to the
burden of increasing costs of education, the Board of Directors
was charged with creating a safe, simple, and low-cost college
savings program. The Board made a conscientious decision to
create a plan that charges the lowest fees possible. To
maintain these lower costs, the Board has chosen to offer its
plan, manage it internally, and market it directly to
investors. For example, a Utah account with a balance of
$10,000 will pay, on average, between $50 and $60 of fees per
year, depending on the investment options.
A Utah savings account may be established with no
enrollment fees and an initial deposit as low as $25 per
family. Once this account has been created, there are no
deposit requirements and the account holder may choose a
payment schedule that meets their specific needs.
We have ten investment options utilizing nine Vanguard
mutual funds and the Utah Public Treasurer's Investment Fund,
which mirrors the attributes of a money market account. We have
four static investment options where the allocation of funds
remains the same throughout the entire time the account is open
and five different age-based options, all of which provide
portfolios that change the allocation of funds to become more
conservative as the beneficiary approaches college enrollment.
Residents of Utah also benefit from a State tax deduction
of up to $1,470 currently, or $2,940 on a joint return.
As a confirmation of the value of this decision to offer a
low-cost college savings plan, Utah has been consistently rated
by various investment research organizations and financial
magazines and other third parties as among the top five Section
529 plans in the Nation. Although we only market within the
State of Utah, 80 percent of our participants are non-Utah
residents, out of State.
We recently began a new pilot program which provides
matching funds for low-income families in Utah. We provide a
matching incentive of up to $300 per year for 4 years for
families with incomes up to 200 percent of the Federal poverty
level.
As a member of the College Savings Plan Network, Utah
supports the effort to create a voluntary disclosure system
among the various plans. We are currently working towards
developing and refining our own offering materials to meet the
objectives of the disclosure principles and plan to provide
materials that will help consumers make more informed and
objective comparisons of fees and expenses.
Mr. Chairman, Section 529 plans in general and Utah in
particular have proven to be very successful among families as
they plan for their children's education. Congress set out to
create a simple and easy-to-understand process to assist
participants save money for college. We believe this goal is
being accomplished every day through the continued growth in
these plans.
Thank you, Mr. Chairman and Members of the Subcommittee. I
appreciate the opportunity to speak here and would be pleased
to address any questions.
Senator Fitzgerald. Mr. Davis, thank you very much. Mr.
McNeela.
TESTIMONY OF DANIEL McNEELA,\1\ CFA, SENIOR ANALYST,
MORNINGSTAR, INC
Mr. McNeela. Thank you. I ask for my written testimony to
be entered into the record.
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\1\ The prepared statement of Mr. McNeela appears in the Appendix
on page 114.
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Senator Fitzgerald. Without objection.
Mr. McNeela. Thank you for the opportunity to appear before
this distinguished Subcommittee. My name is Dan McNeela. I am a
senior analyst with Morningstar, Inc. My testimony focuses on
the shortcomings of Section 529 plans and the steps that can be
taken to ensure that the generous Federal tax breaks are not
squandered.
Some of our greatest concerns relate to the host of costs
investors pay to participate in a Section 529 plan. Investors
face enrollment fees, account maintenance fees, administrative
fees, management fees, and in many cases, broker fees. Some of
those costs are dollar-based while others vary depending on the
amount of assets an investor has in the plan. Most Section
529's exacerbate this problem by burying this important cost
information in the back of a 100-page-long program disclosure
document. At its worst, the complexity of the cost structure
and the reluctance to make this information easily accessible
and understandable amount to deceit on the part of Section 529
providers.
When all the costs are added together, too many Section 529
plans appear to be prohibitively expensive. One reason these
plans cost so much is that several groups have lined up to
collect fees. With States, fund companies, brokers, third-party
administrators all putting their fingers in the pie, it is no
wonder that investors can end up with a knuckle sandwich.
With several plans having investment options whose costs
approach or exceed 2 percent of assets, investors' ability to
capture needed investment gains is significantly impaired.
States offering Section 529 plans need to provide more
disclosure on how fees are used and how investment managers are
chosen. Only by opening up these decisions to public scrutiny
can citizens feel comfortable that the plans are being operated
for their benefit.
The final area in need of improved disclosure is
performance evaluation. To grasp how well a plan is performing,
investors need to see the performance of relevant benchmarks
alongside the plan's returns. If this is done properly, plans
saddled with poorly performing funds and high cost structures
will have few places to hide. As a supplement to those numbers,
plans should provide investors with a written commentary
explaining why the investment options did better or worse than
their benchmarks.
This distinguished Subcommittee must decide what, if
anything, must be done on a Federal level to assure that
Section 529 plans reach their full potential. Toward that end,
I submit the following recommendations.
First, bring uniformity to standards for disclosure and
transparency by appointing the SEC to set the regulatory
environment. With the SEC in charge, all plans will be required
to comply with the same set of rules. That measure will
increase investor confidence, make comparisons between plans
easier, and allow for alignment with rules and protections
already being enforced as they relate to mutual funds.
Second, ensure that the Section 529 marketplace is
competitive by granting the Federal tax break only to plans
that promote fair competition through the adoption of the
following standards. First would be State tax laws on
contributions and withdrawals should be applied uniformly to
all Section 529 plans with no special status afforded to a
State's own plan. Twenty-six States offer a deduction or tax
credit on contributions, but typically that benefit is not
bestowed on those who find an out-of-state plan more
compelling. Four States grant tax-free withdrawals for citizens
who opt for the home State plan, but require beneficiaries to
pay State tax on qualified withdrawals from out-of-state plans,
and Illinois and Mississippi residents who choose an out-of-
state plan give up both benefits.
Also, we think it is important to require uniform access to
Section 529 plans. Some States have seen fit to create two
distinct plans, one geared to in-state residents while the
other is for out-of-state residents. This two-tiered system can
impact the range and quality of the underlying investment
options.
Third, we would require uniform fee schedules regardless of
residency. In addition to restricting access, some States have
created a special low-cost share class that is available only
to its residents. Out-of-state investors can't buy the lower-
cost shares and usually must pay a sales load and higher
ongoing expenses to access the plan. Certain plans also waive
annual maintenance fees only for in-state residents.
States protect themselves from competing plans and favor
their residents over out-of-state investors because they have
little motivation to act otherwise. Only the Federal Government
is in position to set appropriate ground rules that will
promote fair competition and ensure freedom of choice for
investors. By ensuring a competitive marketplace, the Federal
Government will guarantee that tax benefits has bestowed upon
Section 529 plans are not squandered.
I thank you for your time and I will take any questions.
Senator Fitzgerald. That was excellent. Thank you very
much. Mr. Bullard.
TESTIMONY OF MERCER E. BULLARD,\1\ PRESIDENT AND FOUNDER, FUND
DEMOCRACY, INC
Mr. Bullard. Thank you, Chairman Fitzgerald and members of
the Subcommittee, again for inviting me to appear today. It is
an honor and a privilege to speak on this very important issue
and I would like my written testimony to be added to the
record.
---------------------------------------------------------------------------
\1\ The prepared statement of Mr. Bullard appears in the Appendix
on page 123.
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Senator Fitzgerald. Without objection.
Mr. Bullard. Today, I am going to deal with the four issues
that were listed in the title of this hearing: High fees, fee
disclosure, questionable sales practices, and disparate State
tax benefits.
High fees and fee disclosure are actually closely related.
Seventy years of Federal securities regulation have taught us
that effective fee disclosure can promote price competition and
mitigate high fees.
There is no coincidence that since the adoption of the
mutual fund expense ratio and fee table, for example, mutual
fund assets have increased substantially as investors have been
drawn to the product's transparency and accessibility. Mutual
fund fee disclosure rules have led investors to migrate to
lower-cost funds, and these rules, these mandatory rules, have
thereby created wealth by reducing costs. Effective fee
disclosure rules have provided Americans with more money to
finance their children's education and their retirement.
Effective fee disclosure did not come about voluntarily. It
came about only as a result of SEC rulemaking. Low-cost
providers have a strong incentive to provide fee transparency,
but high-cost providers have an equally strong incentive to
obscure their fees. Effective fee disclosure should be
standardized, transparent, understandable, and comprehensive,
but most of all, it must be mandatory. Only when the high fees
charged by high-cost providers are required to be disclosed
will the markets be able to operate efficiently to bring down
fees.
Sponsors of Section 529 plans have flatly rejected this
model for fee disclosure. Fees for many Section 529 plans are
extremely obscure. Section 529 plan sponsors argue that fee
disclosure should be voluntary and left to the markets. The
disclosure principles, for example, proposed by the College
Savings Plan Network strongly emphasize that ``the guidelines
are not intended to suggest that alternative disclosure
practices may not be acceptable or a comprehensive list of
disclosure matters that must be addressed in connection with
Section 529 plans in order to fulfill their responsibility of
State issuers to their account owners.''
As long as obscure fee disclosure is an acceptable
alternative to transparent fee disclosure Section 529 plan fee
disclosure will not promote price competition and thereby
reduce fees. Section 529 plan sponsors that charge high fees
have a strong disincentive to provide standardized disclosure
that will only put them at a disadvantage to their low-cost
competitive. It is essential that Section 529 plan fee
disclosure be mandatory.
Congress should also consider addressing high fees by
limiting certain fees. Mutual fund sales charges are already
subject to NASD rules that limit the amount of sales charges
that can be imposed. Section 529 plans should be subject to the
same limits.
Limiting sales charges would also reduce high fees while
addressing another issue, the issue of questionable sales
practices. By bringing sales charges in Section 529 plans into
line with mutual fund sales charges, the extra incentive to
push inappropriate Section 529 plans over mutual funds would be
removed. But this step is not enough. Brokers will still have
economic incentives to sell inferior Section 529 plans that pay
higher sales compensation, as indicated by Mary Schapiro's
testimony earlier this morning. Brokers may receive higher
compensation for selling one Section 529 plan than another
plan, even though the services provided to the broker's client
are the same. The situation exists because we allow investment
products to pay brokers to push the product, the functional
equivalent of a bribe.
What is even more troubling is that such differential
compensation is not required to be disclosed to the investors.
Investors should be made aware of the dollar amount of brokers'
incentives to recommend one product over another, whether or
not it is in the best interests of the client. In addition,
Congress should begin to unravel the regulatory structure that
effectively requires that sales compensation depend on which
product the broker sells rather than the quality of the
services the broker provides.
The last issue, disparate State tax treatment, arises from
States granting State tax benefits with respect to
contributions to in-state plans while denying these benefits
for contributions to out-of-state plans. This is not
surprising, as Congress has essentially authorized the States
to engage in the business of developing and selling financial
products and it should be expected that they, like any other
enterprise, will seek to gain advantages over their
competitors, such as by limiting State tax benefits to their
own investment products. This practice distorts market
incentives, however, as it may cause an investor to choose an
inferior State Section 529 plan that offers a State tax break
over a superior out-of-state plan that does not. Congress
should consider requiring that States afford equal tax
treatment on all Section 529 plans.
This disparate State tax treatment issue is really a part
of a broader problem with Section 529 plans. Governments are
good at funding public projects, and providing tax breaks for
their citizens' education fits squarely within that role.
Developing, managing, and marketing financial services products
is not something that we should expect governments to do as
well as markets. Congress should expect issues like a disparate
State tax treatment issue to arise and become increasingly
problematic.
By asking State Governments to invest in the infrastructure
needed to support Section 529 plans, Congress created a vested
governmental interest in their continued growth, regardless of
whether the markets continue to believe that Section 529 plans
provide an efficient way to save for education. This was
illustrated during a recent House subcommittee meeting in June
where a State Representative noted that lifetime savings
accounts would threaten the viability of Section 529 plans.
Congress needs to be especially vigilant in protecting against
the distortions in the financial services marketplace that
governmental sponsorship of private enterprise invariably
creates.
Thank you again for the opportunity to appear here today. I
would be happy to take questions.
Senator Fitzgerald. Thank you.
We are going to have some good basis for questions between
this side of the panel and that side of the panel based on all
that testimony.
I want to start out asking Mr. McNeela and Mr. Bullard, you
both basically seem to go in the same direction I went in my
opening statement where I was questioning what benefit we get
by allowing the States to run these plans and just charge an
extra fee. Is there any benefit that you can see to having the
States run these plans? Why can't people go to a mutual fund
provider and open a Section 529 plan and cut out this
additional layer of fees?
Mr. Bullard. That is precisely what Congress decided to do
with 403(b)s, 401(k), IRAs, Roth IRAs, and Coverdell accounts.
The entire list of accounts that have been created for tax-
deferred purposes have done that and done it very well. There
is absolutely no reason why States should be in the business of
creating and developing and marketing these products, thereby
essentially putting them in competition with industry.
Senator Fitzgerald. And do all the States charge an
additional fee for their services? Mr. McNeela, would you know?
Are there any States that don't charge an additional fee?
Mr. McNeela. I am not aware of any States that don't charge
fees. I know Utah does have a money market option that they
provide at no cost to investors, but outside of that, I am not
aware of any other State that doesn't charge fees.
Senator Fitzgerald. If I could refer to this chart that I
put up earlier \1\ and I showed how much better somebody would
do if they were in the Utah plan as opposed to the Rhode Island
plan, which Ms. Williams pointed out no longer exists, and that
is a good thing, but Utah, as I understand it, you are ranked
as one of the best year in and year out by Morningstar. Mr.
McNeela will confirm that Utah has one of the best plans. They
use Vanguard as your underlying fund provider.
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\1\ The chart entitled ``Value of a $10,000 investment after 18
years,'' appears in the Appendix on page 165.
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My understanding, your total expense ratio is 27.5 basis
points. Only 10 basis points of that is Vanguard, am I correct,
and another 17 basis points is charged by the State of Utah? Is
that correct, Mr. Davis?
Mr. Davis. Mr. Chairman, the Vanguard fees can range,
depending on the option selected, up to 42 basis points. That
is the highest.
Senator Fitzgerald. So you are not just allowing people to
invest in index funds? Vanguard's index funds are very low. You
have some that have expense ratios as high as 43 basis points
at Vanguard?
Mr. Davis. Yes, sir.
Senator Fitzgerald. Are they not index funds?
Mr. Davis. They are index funds, but not just----
Senator Fitzgerald. International index?
Mr. Davis. Yes.
Senator Fitzgerald. OK. But is it true that you impose an
additional cost on--the State of Utah charges an additional fee
on top of whatever Vanguard charges, right?
Mr. Davis. That is correct.
Senator Fitzgerald. And how much is that?
Mr. Davis. That is $5 per $1,000 of account, up to $25 max.
Mr. McNeela. But I believe there is also an administrative
fee that is added on, and largely those expenses are to pay for
customer service calls, administration of the plan in terms of
servicing and sending out the account statements, unless I am
missing something, because the Vanguard would just be providing
the investment management expertise of the index funds and
administering the accounts would be the responsibility of Utah
and there would be costs associated with that.
Mr. Davis. That comes out of the $25.
Mr. Bullard. Chairman, just to add to the issue of the
extra layer of fees, that layer of fees will exist no matter
what economic or regulatory structure is used because the way
these work is just like 403(b)s, 401(k)s, and all those other
types of investments. All the investments are pooled by some
kind of intermediary who keeps track of the accounts. What
actually goes into the mutual fund is one large account. So
there will inevitably be those costs. And in 401(k)s, employers
typically pick them up----
Senator Fitzgerald. Wait a second----
Mr. Bullard [continuing]. IRAs, you pay an account fee.
Senator Fitzgerald. OK----
Mr. Bullard. So there is a parallel in all of the privately
offered similar----
Senator Fitzgerald. Well, 401(k)s, yes, but I know some of
them have expense ratios, total expense ratios as low as 10
basis points, for example. But what would prevent someone from
going to--if Congress authorized individuals to open Section
529 plans directly at mutual fund complexes, what would prevent
somebody from going into, say, a Vanguard and getting an index
fund-based account that had a total expense ratio of 17 or 18
basis points?
Mr. Bullard. And that is exactly what would happen, but
there will be people who live in a market channel where they
are going to use an intermediary for whatever investment they
make and----
Senator Fitzgerald. They might----
Mr. Bullard [continuing]. They will get high-cost Section
529 plans----
Senator Fitzgerald. There will be some who go, but now,
with the current set-up, you have consumers paying brokerage
commissions, loads. You have them paying management fees to the
fund complexes. And then you have them paying a fee to the
State Governments. I am just trying to figure out what benefit
the State Governments bring for their additional fees. Now I
will let the Treasurer defend this.
Ms. Williams. Mr. Chairman.
Senator Fitzgerald. Yes.
Ms. Williams. Can I just make one statement? First of all,
if an individual were to go to a mutual fund company and
attempt to open a mutual fund, there is no mutual fund that I
am aware of that you could get into for a $15 minimum. Mutual
fund companies typically have very high minimums in order to
come into many of those funds, and I think the States look at
it from the perspective that we are trying to make these
programs available to residents of every income level and that
is why we establish very low points of entry for people who
come into these plans. So I think that many people who are now
able to have very small Section 529 accounts would never be
able to go into a mutual fund because they simply do not have
the initial investment amount that would allow them the
opportunity to get into the fund.
One thing I would like to correct that Mr. McNeela
mentioned, you do not have to be an Ohio resident to
participate in our low-cost options, and I would be happy to
provide him with a copy of our offering statement.
Senator Fitzgerald. Mr. Noven.
Mr. Noven. I do think there is an importance in having
someone that is overseeing what is being done in this area for
people who are saving for college that is actually looking out
for the consumer. In the State of Illinois, we have been able
to add value in a number of ways. One, we have been able to get
institutional share classes for investors that they wouldn't
get on the street. For 99 basis points in Illinois, that is an
all-in fee. There is no account maintenance fees or set-up fees
or annual fees, or any other types of additional----
Senator Fitzgerald. Of that 99 basis points, how much is
paid to Smith Barney and how much does the State of Illinois
retain?
Mr. Noven. Smith Barney provides us 5 basis points to
administer the program. We have a unique statute that the
Treasurer drafted intentionally that any monies that we bring
in with the 5 basis points that is above what is needed to
actually pay for the expenses of administering the Bright Start
program, anything extra, in excess of that, is refunded as a
dividend to participants or will reduce the fee of the program.
So it is not a money-maker for the State of Illinois.
Senator Fitzgerald. So is your net fee lower than the 99
basis points?
Mr. Noven. It will be in the future unless we issue
dividends. One way or the other, now that we have had a
successful program----
Senator Fitzgerald. OK, but of that 99 basis points, how
much--is Smith Barney keeping all but 5 basis points of that?
Mr. Noven. Well, out of the 94 basis points that are
remaining, all the internal fund management fees are paid out
of that. A broker commission is paid out of that, so it is not
charged to consumers if a financial advisor sells the product
and----
Senator Fitzgerald. It is not possible for a consumer to
pay a load----
Mr. Noven. No.
Senator Fitzgerald [continuing]. Going in----
Mr. Noven. No. Smith Barney pays the load out of their fee
because we didn't want consumers that use financial advisors to
be treated less well than----
Senator Fitzgerald. Are all the Smith Barney funds that you
allow Bright Start participants, are they all index funds?
Mr. Noven. No, they are actively managed funds. We actually
have some non-Smith Barney funds. We have a lot of control to
switch funds and make sure that consumers have funds that are
performing and are doing well. We recently put in--actually,
now it is probably a year and a half ago--we substituted an MFS
fund that on the street would cost a consumer 180 basis points
just in the fund management fees, not talking about a sales
load or any other added fees, if they bought it on the street.
They can get that as part of the 99 basis points through our
program. So we have been able to negotiate some benefits for--
--
Senator Fitzgerald. Why would you allow--I mean, 88 percent
of mutual funds, actively managed mutual funds, underperform
the market, and they underperform the market almost by the
exact amount of their fees. The markets returned, on average, a
little bit under 12 percent over the last 20 years, and the
average mutual funds returned about 2 percentage points, which
is exactly their fees. I mean, why would you even encourage
residents to go into an actively managed fund if they are just
going to pay higher fees?
Mr. Noven. There certainly is the age-old debate as to
whether you are wiser to invest in an actively managed product
or an indexed product. I think everyone would agree, if you are
not looking out for your investments, if you are not an
informed consumer, if you don't have a State entity looking out
for you and making sure those funds are performing with enough
extra benefit to justify the fees, then you would be better off
to invest in index funds. We are not a passive investor as the
State Treasurer of Illinois----
Senator Fitzgerald. If I invested in a Bright Start index
fund, will I pay less than the 99 basis points?
Mr. Noven. Well, we don't have an index fund that is
currently offered, although we are looking at----
Senator Fitzgerald. There are no index funds that are
offered?
Mr. Noven. In Bright Start? No, there aren't. We are
looking to expand our offerings. I don't want to go down that
road, but the Treasurer is----
Senator Fitzgerald. Fidelity's index funds charge 10 basis
points now. They have lowered their fees to 10 basis points.
Mr. Noven. We have had a fortunate run, Senator, but we are
lucky to have outperformed the index, our benchmarks and
outperformed what an index fund would have done. Of course, you
never know how it is going to look over time, but so far, we
have been successful and we are committed to trying to give the
best investment product we can to consumers.
Senator Fitzgerald. Mr. Ablowich.
Mr. Ablowich. I guess, Mr. Chairman, one of the comments I
would make is with regards to active management. While I think
that your chart is an accurate mathematical calculation of the
value of fees net of expenses and a return, I think one of the
other things that we would emphasize in our plan is that we use
100 percent actively managed funds. We also use, which a lot of
plans do, so-called age-based portfolios, so that when you
first start out investing for your child--and I have a 10\1/2\-
year-old son that I participate in our plan for. When I opened
the account for him when he was younger, it is much more--it is
more heavily weighted in equities and over time it shifts more
towards fixed income and cash.
So in your example, let us assume you have a constant 8
percent compounded annual return. But what we think customers
are concerned about is not necessarily seeing a straight line
up at 8 percent, but as the markets go up and down, capture the
up side, but also, when your child is ready to go to college,
make sure those dollars are there. You may not be willing to
accept the volatility when your child is a junior in high
school or a senior in high school when you are waiting to pay
tuition perhaps in 1\1/2\ or 2 years from now.
Senator Fitzgerald. Your New Hampshire Fidelity Advisor,
the sheet that I have, suggests that it has a maximum expense
ratio of 130 basis points. Is that right?
Mr. Ablowich. That would be for the advisor-sold product,
that is right, Mr. Chairman. Again, two products, one advisor-
sold, broker-sold plan. There are some people who like working
with a broker. The broker will give them that personal advice
with regards to the unique plan, or assuming a Fidelity
advisor----
Senator Fitzgerald. That includes Fidelity's fee and
whatever you take?
Mr. Ablowich. Correct.
Senator Fitzgerald. How much do you retain of that 130
basis points?
Mr. Ablowich. In the 130 basis points you are looking at
there, I am assuming that includes not only the underlying fee
on all the mutual funds, but also 30 basis points that is split
between the State and Fidelity investments, and there is
probably in that number, as well, a trail for the broker that
sold the advisor-sold product. Which is standard mutual fund
pricing.
Senator Fitzgerald Our Federal mutual fund, the Thrift
Savings Plan, would any of you care to guess what we pay in
expense ratios----
Mr. Bullard. I was in it, and it ranges between about 5 and
8 basis points.
Senator Fitzgerald. Yes. It is going to be like 5 basis
points for our total expense ratio. It is all index funds. We
are lower than any of the private sector index funds out there
but you get much lower expenses by going into low-cost index
funds. I am just having trouble understanding, other than the
tax advantages of having a Section 529 plan, it seems to me if
the fees are so high in so many of these, so much higher than
just index funds that anybody can go to, why would anybody be
in the Section 529 plans but for the tax advantages?
Mr. Ablowich. I think one of the issues to consider, Mr.
Chairman, is the issue of the active management and an age-
based portfolio, that you can't have that security over time.
You may be willing to take more risk at the beginning, but for
some investors, they are not willing to sit down every year and
constantly review their portfolio to make sure they have the
right amount of risk given the investment horizon that they are
looking for.
So part of that cost, we believe, also goes to help an
active management so that over time, you become more
conservative, and again, limit that risk at the end of the
period when they are ready to pay for tuition.
Mr. Bullard. Those lifestyle funds are also available in
the private marketplace. There is nothing unique about Section
529 plans that provides you can only get them there. In fact,
if Section 529 plans were run like IRAs, you would have exactly
the same funds being offered privately.
Mr. McNeela. Right. And Utah, primarily using index funds,
has age-based options, as well, that get more conservative as
the child moves up to college age. So the bulk of that asset
allocation decision can be handled easily in the framework of
an index fund. The only potential for active management to
surpass that is if they made a market call saying that the
stock market was highly valued and pulled below to a low level
of stocks relative to bonds to kind of mitigate some
volatility. But it is questionable about how much benefit there
is to that effort.
Mr. Bullard. If I could just put a face on Mr. Noven's
point about protecting the residents of Illinois from high-
priced products, Mississippi has a $20,000 deduction for
contributions to its plan, but this year, I plan on investing
in the Utah plan because I would give back all of that tax
deduction in a matter of years because Mississippi's products
are more expensive. I wonder how Mr. Noven explains to his
constituents why those who choose lower-cost investments--and
that would be easy to do at 99 basis points--why they are
deprived of the Illinois State tax benefit if they go outside
to get a better product than what Illinois is providing, not to
mention the fact that Mary Schapiro's testimony shows that your
argument is simply failing. We have got 95 percent of these
brokers, whether or not the State tax benefit is available
somewhere else, going somewhere else.
So the plan isn't working. It deprives people of choice.
And it ends up--and it has ended up for me costing me more
money because I won't be able to use the Mississippi State tax
benefit.
Senator Fitzgerald. If I can defend Mr. Noven, that may not
be his responsibility. That is probably our State legislature
that enacted the tax laws that penalize you if you go out of
State, is that correct?
Mr. Noven. What we did in Illinois is we sought to get the
tax benefits to our residents when 35 States offered tax
benefits to their own residents and it was primarily a state-
by-state program. We sought to give those same benefits to our
residents that other States got in their home States.
What we have recently tried to do is promote legislation
that would give the tax deduction to plans that were low-cost
plans. We don't think that the State should, as a government,
provide a tax incentive for people to make bad financial
decisions by going to the fastest-growing, highest-cost
programs in the Nation.
The industry hired lobbyists to kill the bill that would
have extended these benefits to other low-cost programs because
they don't want the other low-cost programs to get traction. It
is truly a consumer issue.
We agree with you. I agree with what these folks are
saying, other than 99 basis points being high because that is
an all-in fee. That is not one of five different fees that is
being charged. And if you look relative to other programs, it
is one of the lowest cost in the Nation.
Senator Fitzgerald. Do you agree with Mr. Bullard's comment
earlier that Congress should act to limit the States' abilities
to offer the tax benefits only to their own benefits?
Ms. Williams. Mr. Chairman, can I just say that, coming
from a State where we do offer a tax deduction, we feel that it
is the State's exclusive prerogative to decide whether they are
going to offer a tax deduction and to whom to offer it.
Frankly, very few States would be willing to extend a tax
benefit to plans over which they exercise no fiduciary
oversight.
The other thing is that States lose tax revenues by
providing deductions.
Senator Fitzgerald. We require you to give tax benefits for
401(k)s, don't we?
Ms. Williams. Well, that, I don't know. I can't address the
401(k). I do know that with a Section 529 plan, in Ohio, you
can only get the State tax deduction on contributions if you
participate in our plan. However, on withdrawal of the funds,
the withdrawals are State tax-free and the State allows that
consideration for any plan.
So I think the key is for States to provide effective
product offerings so that they can be competitive, but I think
that States are going to----
Senator Fitzgerald. But they are enacting protectionist
legislation protecting----
Ms. Williams. Well, we certainly aren't----
Senator Fitzgerald [continuing]. Their own State's program
from competition.
Ms. Williams. We certainly aren't, and I think that if
these programs, particularly in a time of difficult State
budgets, if our State were required to extend State tax
benefits to any plan operating in the country, what would end
up happening is that the State would withdraw the tax deduction
for all plans, which I really think is what some in the
industry want. If they can't provide a competitive product and
be competitive without the State tax benefit, then perhaps they
shouldn't offer a plan. But I think that the State has the
prerogative to offer a State tax deduction only for their own
plan if they want.
Senator Fitzgerald. Mr. Bullard.
Mr. Bullard. So what you are telling Ohio residents is, we
will give you a State benefit. We really want you to be able to
afford college. But we will only give you the State tax benefit
if you buy my product.
Ms. Williams. That is exactly what we are telling Ohio
residents, but we have told any Ohio resident that there are a
wide variety of options available and we ask that they be very
well educated. It is in our benefit as a State in the final
analysis if every single child in our State has a Section 529
plan, whether it is ours or another State's, because that means
that there are resources available for that child to attend
college, and hopefully they will stay in our State and
contribute to the economy in our State. So we try to be
competitive by offering a very wide variety of product
offerings, and by the way, we do happen to have a tax
deduction.
Senator Fitzgerald. Mr. Noven, when you mentioned you would
like the money to be invested in-state, with Illinois, you
appointed Smith Barney as your agent as trustee and they are
not based in Illinois. They are part of Citibank and they are
based in New York. So the money isn't invested in Illinois, is
it?
Mr. Noven. Yes, but I don't believe I made that statement.
If I did, I didn't mean to state that. Also, to the previous
question, if Congress----
Senator Fitzgerald. There is no real benefit when a lot of
the States say, we want to keep this invested in-state. The
money is really not invested in-state unless you are in New
York or Massachusetts or maybe California or Philadelphia,
where Vanguard is. In most States, it is not an issue. The
money is not going to be invested in-state even if the plan is
sponsored by a State.
Mr. Noven. We are not talking about those assets actually
being invested physically in-state. There are two things about
having assets in Bright Start that are important to Illinois
consumers. One, we believe it is a tested program. We are
looking out for consumers and they are not being charged
excessive commissions and fees. They are getting adequate
disclosure. The Treasurer is not seeking to get any assets of
any individuals in the State if they would do better in their
home State because of tax benefits. We are running a consumer-
friendly program that we feel good about, so we feel good about
having our consumers in it.
Also, there are economies of scale when it comes to college
savings programs. We have 100,000 Illinois families that are
invested in Bright Start and if Bright Start is raided by out-
of-state programs that are entering into this broker bidding
war to get brokers to ``sell mine, sell mine,'' then Illinois
residents are hurt, and 100,000 Illinois families will be hurt
because our program will not be able to be viable unless we
compete by paying brokers high fees, and we don't want to enter
into that bidding war. We want to have a nice even playing
field. We would welcome Congress taking control of some of
these issues.
Senator Fitzgerald. How do consumers in Illinois benefit
from having to go through the State of Illinois to invest in a
college savings plan? And I would ask you that and also Ms.
Williams. I mean, why do we need to have the State Governments
involved in college savings programs at all?
Mr. Noven. If Illinois----
Senator Fitzgerald. Shouldn't you just be able to go online
on Vanguard and open your own college savings account and just
pay Vanguard's fee and not a fee to the States?
Mr. Noven. If Illinois consumers went directly to buy all
the funds that are part of Bright Start currently, they would
pay higher fees overall than if we hadn't put this program
together, we wouldn't have negotiated institutional share
classes that were lower using the economies of scale. We are
bringing a billion dollars to a vendor. We are able to use, in
the same way that we do with our Illinois Funds Investment
Program in Illinois that I am sure you are familiar with----
Senator Fitzgerald. States haven't negotiated low fees.
Some of them have negotiated awful fees.
Mr. Noven. Right.
Senator Fitzgerald. The Rhode Island J.P. Morgan Higher
Education Fund, 4.75 percent sales load, 135 basis points
annual expense ratio, annual fees. You get clobbered in some of
them.
Mr. Noven. We agree, and those are the programs that we are
unwilling to provide our tax benefits to and give consumers an
incentive to join, because those are the types of programs that
are not a good deal for Illinois consumers.
Senator Fitzgerald. But will you provide your tax benefit--
--
Mr. Noven. To Utah? Absolutely. We tried to. We tried
multiple pieces of legislation that would have given the tax
benefit to people who invest in Utah. It is a wonderful
program. It has got good fees. People should----
Senator Fitzgerald. The legislature defeated it?
Mr. Noven. Yes. Well, the brokerage industry defeated it
because they want to sell that plan over there that is on your
chart and they don't want to----
Senator Fitzgerald. Has anybody seen patterns of the
brokerage industry coming in trying to--Mr. Bullard, would
you----
Mr. Bullard. I mean, that is exactly what I would expect
them to do. But, in fact, whether or not you provide your in-
state tax benefit to those out-of-state plans, the brokers are
going to sell the out-of-state product and so that theory is
not succeeding. All you are really accomplishing is the people
in Illinois who want to buy a better plan, that is, the Utah
plan, are unable to do that and get the same State tax benefit
that those who invest in your high-cost plan, your 99 basis
point plan, get.
Mr. Noven. Some day, I would like to sit down with you and
talk about fees and show you what our fees are so we can all
talk from the same----
Mr. Bullard. The best thing that a State----
Mr. Noven [continuing]. But I would like to say, as a
fiduciary, as State Treasurer, we feel an obligation not to
provide a financial incentive to make it easier for brokers to
put people in a plan that is not in their best interest and I
think the Treasury has an obligation to do that as a policy
maker.
Mr. Ablowich. Mr. Chairman, one thought I had for you is
that when we are talking about broker-sold programs in the
Section 529 area, the pricing is really not that much different
than broker pricing for any other mutual fund product. I know
that your Subcommittee has worked, discussed this issue of the
mutual fund industry and fees and governance and oversight and
transparency. The National Association of State Treasurers and
CSPN has a long history of supporting thoughtful efforts in
this area.
To the extent that those efforts are successful and costs
come down and transparencies improve, all of those benefits are
ultimately passed on, as well, to Section 529 investors, as
well. I think that is important to mention, because this
pricing that you are talking about exists today not just in
Section 529, but in retirement plans and so on.
The other thing I would offer is that we heard from the
NASD that they are investigating and gathering information
about questionable broker practices. At this point, we don't
have any specific instances of where brokers are making
unsuitable, or not taking into account the suitability of
investors. But to the extent that there are those documented
cases, I welcome--and I know all of my colleagues do--getting
that information so that we can work with our plan
administrators.
And then also when I go back to Concord, I can walk
upstairs to see our State Securities Regulator and ask him or
her, is this something that we should be--what are you doing in
this area? Here is something you should be aware of, as well,
because those State Securities Regulators are typically on the
front line of working with those individual investors. So that
is another important point I wanted to bring up for your
information.
Ms. Williams. Mr. Chairman, can I just say that I think one
of the things that the States do, long before the savings plans
were offered, we worked to offer a prepaid plan. We have a
full-service organization. We have marketing representatives
who live in various regions of our State who work with very
small organizations. Increasingly over the years, we have
decreased the average age of enrollment in our plan to 5 years
of age. We work with over 2,000 employers in our State to offer
payroll deduction because we believe that small investors
should have access to these investments, as well.
Unfortunately, with the high minimum entry in most of these
mutual funds, the average consumer would never have the
opportunity to participate in these mutual funds were it not
for the fact that we allow them to get in with as little as
$15. That has been the fact since we first started our savings
program and we are going to continue to require that people be
able to get in with as little as $15 and can save as little as
$15 a month if they want to do it in a systematic way. They
could not do that if they were enrolling directly with a mutual
fund company.
Senator Fitzgerald. What about the disclosures, or the lack
of disclosures, in the Section 529 area? We have had repeated
testimony that the State Governments as trustees of these plans
are exempt from the Investment Company Act of 1940 and don't
even have to make the minimal disclosures that ordinary mutual
funds have to make. How do the Treasurers feel about that, Mr.
Noven.
Mr. Noven. Go ahead, Mr. Ablowich.
Mr. Ablowich. I think that the disclosure principles we put
together are certainly a very important first step. They are
not going to be perfect. That is why we have asked the NASD--
well, we haven't asked the NASD--the Securities and Exchange
Commission and the MSRB to comment on what was prepared to get
their feedback. Even before we received their feedback, around
30 States have already started adopting these principles and
incorporating them into their disclosure documents.
Senator Fitzgerald. Do these principles require a dollars
and cents disclosure, or are all the expenses stated in
percentage terms?
Mr. Ablowich. They are used in dollars and cents
disclosure, Mr. Chairman.
Senator Fitzgerald. They are? OK. That is good. Mr.
Bullard.
Mr. Bullard. They provide for dollar disclosure of dollar
fees. They do not require a dollar disclosure of individualized
costs and expenses that you are paying. They include an example
that is similar to the mutual fund example on a hypothetical
investment, but not individualized cost disclosure.
Senator Fitzgerald. Mr. Noven, did you have something to--
--
Mr. Noven. I was going to say, we support the work that the
College Savings Plan Network is doing on these disclosure
requirements but we think they need to be mandatory. We think
they need to go further. The Treasurer feels especially strong
about disclosing the fact that there may be tax benefits that a
resident may be giving up, so that people know that. We have
that notification in our glossy brochure, not on page 85 of a
program disclosure statement. We feel very strongly about
disclosure. We think it is a great first step. We should go
even further.
Senator Fitzgerald. I would like to let Mr. McNeela have a
chance to talk for a second.
Mr. McNeela. Just from my perspective, it is hard for
investors to have confidence that they are getting all the
information they need when the disclosure requirements are
voluntary and the fund company or the plans can choose to
follow some of the requirements that are recommended but ignore
others at their discretion. It makes very little sense to me to
allow that situation to exist.
Senator Fitzgerald. You have prepared a chart that is
available on the Morningstar website,\1\ apparently, that
discloses the fees for Section 529 plans, and you have the
program manager's fees on the left and then the expense ratio
on the right. Are the program manager fees the fees paid to the
State Governments? Do they include the expense ratio charged by
the underlying fund manager?
---------------------------------------------------------------------------
\1\ The ``529 Plan Information'' chart from the Morningstar website
appears in the Appendix on page 167.
---------------------------------------------------------------------------
Mr. McNeela. The program manager fees typically do not
include underlying fund fees, but they can include broker
compensation in the form of 12b-1 fees.
Senator Fitzgerald. OK. Where it says the Alaska John
Hancock Fund charges a maximum program manager fee of 165 basis
points, is that in addition to the maximum expense ratio of 130
basis points?
Mr. McNeela. Yes, it is.
Senator Fitzgerald. It is? So we are up to, like, 3
percentage points in total fees on that fund?
Mr. McNeela. It is not always appropriate to add maximums
and maximums together because sometimes they will give you a
discount on one or the other, but yes, that sounds possible
that total expenses could be well in excess of 2 percent if a B
or C Class share was sold which had large 12b-1 fees,
administrative fees, and underlying fund fees, as well.
Senator Fitzgerald. Now, on the Illinois Bright Start plan,
they list a program administration fee at 99 basis points, but
then they say an additional 65 basis points is paid in
expenses?
Mr. Noven. That is incorrect. That is an error in the
chart.
Mr. McNeela. And that was my qualification--I am sorry, if
I could just talk to that for one minute--where Illinois has a
flat fee of 99 basis points regardless of----
Senator Fitzgerald. And that includes the expense ratio----
Mr. McNeela. But they also make an effort to break out the
costs for underlying fund fees and administrative fees and
those vary depending on the investment options, but the total
always comes out to 99 basis points.
Senator Fitzgerald. So even if you invest in a lower-cost
fund, you will still pay 99 basis points?
Mr. Noven. You are paying 99 basis points to invest in a
fund that is usually 180 basis points on the street, but you
are also paying 99 basis points to invest in a fund that may be
65 basis points on the street because there are the extra
administrative fees that are charged by the vendor to comply
with the IRS regulations.
Senator Fitzgerald. But it is always 99 basis points and no
other charges?
Mr. Noven. Right, and we thought that was the best way to
disclose fees to consumers, to not have a $30 account
maintenance fee that is paid every year. If you have a small
balance, that is a huge percentage. So all those other little
expenses that consumers may not be aware of that they are going
to get socked with going forward----
Senator Fitzgerald. Now, you disclose the 99 basis points.
Do you disclose it in dollars and cents? Do you explain the
impact of the fees paid by consumers over time? Do you show
them how much their savings erode over 18 years of investing by
paying those fees?
Mr. Noven. We certainly incorporate that into the
discussion, and we are very interested in----
Senator Fitzgerald. And if I am in Bright Start, do I get
an annual account statement?
Mr. Noven. And monthly statements and regular reporting.
Senator Fitzgerald. And monthly statements?
Mr. Noven. Yes. And we will be glad to give you copies of
what we do. We are very proud of the way we do it and how we
disclose information. We would be glad to share it with you.
Senator Fitzgerald. That would be very expensive to send
monthly statements.
Mr. Noven. We have a vendor that is required to do that.
Senator Fitzgerald. Solomon Smith Barney is required to do
that, but that adds to their whole--they probably charge you
more.
Mr. Noven. Well, we believe we negotiated a good contract.
Senator Fitzgerald. All right. Ms. Williams.
Ms. Williams. I would just say that I think that a lot of
States have made a lot of progress in this matter. In fact, we
do have one page in our document that shows what all the
program fees and expenses are.
I appreciate Morningstar and other organizations who are
looking at these matters, but I guess my concern is how
frequently is the data updated to reflect changes in State
programs? I know that in June, Mr. McNeela and I had a
conversation regarding where they get their information in
order to be able to display it and how often it is updated. So
I think it is a good thing and I think that will put pressure
on States to make sure their information is accurate. I just
want to make sure that the information is reflected accurately
and is up to date.
It is in the best interest of the State to make sure that
they adhere to these disclosure guidelines and, in fact, that
they go beyond the voluntary disclosure guidelines, because
clearly, as it becomes easier to compare plans, their plans are
going to suffer by comparison if they have made it very
difficult for people to be able to find the information they
need to make a valid comparison.
So my only request would be that information is timely and
up to date and accurate, because many times, articles have been
written, comparisons have been made, and information is simply
not accurate, and that has accrued to the detriment not only of
the State programs, but also consumers who are trying to make
valid comparisons and who often find themselves paralyzed into
doing nothing regarding savings. All the while, college
expenses continue to escalate.
Senator Fitzgerald. You don't want to ever offer a bad plan
because it will stay with you forever, hang out there on the
Internet and people will see it, even if you have withdrawn a
bad plan.
Ms. Williams. That is right.
Senator Fitzgerald. So maybe the lesson is never to offer a
bad plan. But listen, all of you have been terrific. I posed
some tough questions--Mr. Davis, do you have something to add
here?
Mr. Davis. One comment, Mr. Chairman. As I sat here between
crossfire on my left and right, I thought about your question,
what do States add, and I think it is important for you to know
that there are a fair number of middle- and low-income people
in our State who have not been served and are not currently
served by the free market of the Smith Barneys and the
Fidelities of our Nation who are now saving. We are working on
that and we are seeing a tremendous support of that. The fact
that we have put together a fairly decent program cost-wise
which has drawn a fair number of out-of-state investors, we are
seeing much more progress in the State, which the intent of the
Board was to accomplish. And so that is where our success comes
from.
Senator Fitzgerald. Do all of your States competitively bid
out your asset management?
Ms. Williams. We certainly do, yes.
Mr. Noven. Yes.
Mr. Ablowich. Yes. For the record, yes.
Mr. Davis. We manage internally.
Senator Fitzgerald. You manage--well, you have Vanguard,
though. How did you select Vanguard?
Mr. Davis. The State Treasurer has dealt with them, among
others----
Senator Fitzgerald. Is there a bidding process or a request
for proposal or how did they do that?
Mr. Davis. We piggybacked on the State Treasurer's contract
initially and have stayed there.
Senator Fitzgerald. OK. In Illinois, I understand you are
about to rebid?
Mr. Noven. We are bidding an advisor-sold plan. We are
concerned that consumers that work through financial advisors
are not being offered a low-cost, low-commission, quality
program that would suit their needs. We are concerned that most
of the brokerage commissions that are being paid--everyone has
risen up to the 5.75 percent, all trying to jockey for
position----
Senator Fitzgerald. What percentage of your participants
pay a brokerage commission?
Mr. Noven. Well, none of our participants pay a brokerage
commission----
Senator Fitzgerald. They can't.
Mr. Noven. They cannot. Smith Barney absorbs that.
Senator Fitzgerald. OK.
Mr. Noven. But a lot of folks that go to brokers that do
not want to sell the Smith Barney product, they do want to have
a product to sell consumers in Illinois, their consumers that
work with them, and if we could find a consumer-friendly
advisor-sold plan, we think we would be providing a real
service to Illinois consumers. So we are looking at that, as
well.
Senator Fitzgerald. So most people are still going to their
brokers to figure out where to get one of these, and they don't
realize that their broker is going to get paid a fee out of
their savings in order to steer them into a plan.
Mr. Noven. A very large fee, right.
Senator Fitzgerald. Yes, but now, will that change as the
SEC is now going to require a statement at a point of sale?
Mr. Bullard. As currently proposed, it wouldn't include any
reference to the State tax advantages. But it is simply
unrealistic to think that a broker is going to give up any
compensation at all in order to recommend an Illinois product.
I mean, it is just not going to happen and it is not realistic
to think that has any kind of deterrent effect.
Mr. Noven. We actually have a lot of selling agreements
with a lot of folks and there are--while I share his skepticism
about brokers, there are a lot of brokers who are doing the
right thing, using a low-cost college savings program as a way
to build trust with the client and make money off of other
products. We actually think that is the right way to go. We are
not going to be competing with the most expensive plans in the
Nation because they will follow the money, but there are a core
group of brokers that we believe will do the right thing----
Senator Fitzgerald. Vanguard is the second largest mutual
fund in the country. It has done that largely by having the
lowest cost. When John Bogle was the Chairman, the company
never advertised. It is much younger than Fidelity, which goes
back to the 1940's. Bogle founded Vanguard in the 1970's, and
it grew to the second largest just on word of mouth, because of
having the lowest fees.
So if your fund is really a good deal and it is going to
get high rankings from Morningstar, consumers will figure that
out, won't they? Even without brokers and without paying loads,
you will have money migrate to your fund.
Mr. Noven. If consumers would figure it out on their own--I
think brokers talk them out of that when they go into their
office frequently. If consumers would figure it out on their
own, the largest programs in the Nation right now would not be
the ones that charge consumers the most money. We don't think
the system is working, which is why we are excited about----
Senator Fitzgerald. What is the largest right now in the
country?
Mr. Noven. I think Virginia is the largest one. I think
they have got something like 7----
Senator Fitzgerald. But that is a pretty good plan, at
least according to Morningstar, isn't it?
Mr. McNeela. It is a broker-sold plan, but it is a quality
plan with terrific investment choices and flexibility.
Senator Fitzgerald. Who is the underlying manager?
Mr. McNeela. The American Funds.
Senator Fitzgerald. OK. And Nevada also has a top plan,
doesn't it?
Mr. McNeela. Right. Nevada primarily uses Vanguard, at
least for one of their plans.
Mr. Bullard. Mr. Noven's point really just tells us that
most people buy through intermediaries, so logically, the plans
that use intermediaries are going to be the largest.
Senator Fitzgerald. OK.
Ms. Williams. Mr. Chairman, about half of our State
residents have purchased directly from our agency and the other
half have used financial intermediaries.
Senator Fitzgerald. Maybe we should just cap what kind of a
load or commission can be paid to the brokers.
Mr. Bullard. Well, the first step would be to apply
expressly to brokers of Section 529 plans the NASD limits----
Senator Fitzgerald. Which are?
Mr. Bullard [continuing]. Which MSRB cannot legally do.
Senator Fitzgerald. Right. So there is no limit now.
Mr. Bullard. Well, the MSRB can impose a fair and
reasonableness standard, but they can't expressly state that we
always consider that to be the NASD limit. So there are going
to be cases where----
Senator Fitzgerald. If a fee is paid, if a load is paid to
a broker, say a 6 percent load, is that disclosed to a Section
529 purchaser?
Mr. Bullard. Not in dollars, but, of course, that is also
true for mutual funds and the SEC proposal will, one way or
another, address that in both contexts.
Senator Fitzgerald. And require a dollar----
Mr. Bullard. Both for Section 529 plans and for mutual
funds.
Senator Fitzgerald. OK. But right now, there is technically
no limit on the load?
Mr. Bullard. Technically, no limit other than the MSRB's
fair and reasonable standard.
Senator Fitzgerald. Unbelievable.
Mr. Noven. We tried that in Illinois. We tried to provide a
tax benefit to any State that would agree to charge a load that
was under a certain cap. It was a 4 percent cap, and we thought
that was a reasonable amount of compensation for a financial
intermediary. That is what brought all the brokers out of the
woodwork and that is why there is a fleet of lobbyists working
on the issue in Illinois. You should see how full our
conference room was after we tried that in Springfield. It is a
hard issue to tackle.
Senator Fitzgerald. OK. All right. Well, thank you all. You
have been great----
Mr. Bullard. Chairman, if I could just take a second----
Senator Fitzgerald. Yes.
Mr. Bullard. I don't know if I will be back here by the end
of the year, but I wanted to thank you for your leadership on
financial services issues, especially over the last 12 months
or so, and hope that you will continue the battle--either
rejoin the Illinois Senate race or continue the battle outside
of your tenure here in the Senate.
Senator Fitzgerald. I am hoping somebody takes up the issue
after I am gone, and my last day is January 2, but I certainly
appreciate the help you supplied, Mr. Bullard. You were a great
witness a year ago at this time, and I do think our hearings on
high fees led to some of the fund complexes lowering their
fees, as we have seen. That will, over time, result in a lot
more money for savers.
I want to thank all the witnesses today. I would like to
mention that Senator Akaka, the Subcommittee's Ranking
Democratic Member, wanted to be here but was unable to attend.
He will submit a statement for the record.
[The prepared statement of Senator Akaka follows:]
PREPARED STATEMENT OF SENATOR AKAKA
Thank you, Senator Fitzgerald for your continued leadership in
helping Americans understand more fully the opportunities and risks
available to them as investors. As a father and grandfather, I know the
considerable burden facing young people and their families when it
comes to financing college educations. As a former educator, I believe
that investing in an education is one of the most important investment
an individual can make.
In response to rapidly escalating college tuition costs, Congress
amended the Tax Code in 1996 to create tax-advantaged programs to help
families save for college. These programs are called 529 plans after
the section in the Tax Code. One of the programs is a college savings
plan. These plans offer investors the opportunity to contribute to a
trust fund and accrue tax-free interest if funds are withdrawn solely
to pay for education expenses of a selected beneficiary. Qualified 529
college savings plans are sponsored by states which may directly
administer their plans or select companies to manage the funds.
These state-sponsored savings plans offer families and individuals
the ability to save for education expenses at any accredited public or
private educational institution, including colleges, universities, law
or medical schools, and most community colleges. Earnings accumulate on
a tax-deferred basis and distributions used for qualifying education
costs are tax-free. Non-qualifying distributions are subject to a ten
percent federal tax penalty and possible state tax liabilities. As with
other investment vehicles, investors pay assorted fees to cover account
costs, and the plans provide no guarantee of a specific rate of return.
Recently, the true costs of 529 college savings plans have
generated substantial attention. Many individuals have questioned the
basis of plan fees and whether these fees diminish the tax benefits of
the plans. Moreover, because the plans are not governed by federal
investment or securities laws, there is inconsistent oversight and lack
of transparency associated with these plans which has further elevated
public concern. This situation is similar to the problems the
Subcommittee examined in the mutual fund industry.
I firmly believe that transparency and accountability must be a
priority of the investment industry. Brokers and investment employees
should disclose the costs and terms of the products they sell and
provide a potential investor with the information needed to make
informed decisions. An accurate assessment and picture of investment
costs and returns should remain paramount.
Because 529 college saving plans are state-sponsored and not
regulated under federal securities laws, the Security Exchange
Commission (SEC) cannot require the same registration and reporting
requirements that exist for mutual funds. However, six months ago SEC
Chairman William Donaldson formed the Chairman's Task Force on College
Savings Plan to examine the structure and sale of the plans, and I look
forward to this review.
There are questions to be asked: Should federal securities laws
govern some aspects of 529 plans because investors now face
inconsistent disclosure policies that may result in unforeseen fees?
How do states select plan managers, and how are fees and costs to
investors allocated?
Moreover, as long as investors in a college savings plan may opt to
purchase a plan offered by a state where he or she does not reside,
consumers must be able to compare different state plans in order to
make informed investment decisions. Due to the complex nature of these
plans and the lack of meaningful disclosures, I believe there should be
strong financial literacy and investor education programs. Such
programs are necessary so that investors may choose the plan that best
meets their financial situation and savings goals. Furthermore,
promoting transparency will undoubtedly enhance the financial benefits
of these plans and the educational opportunities they put within reach
of plan recipients.
I look forward to working with Senator Fitzgerald and our
colleagues to help investors better understand 529 college savings
plans. I also wish to thank today's witnesses for sharing with us their
concerns and recommendations.
Senator Fitzgerald. The record will remain open for 1 week,
until next Thursday, October 7.
With that, this hearing is adjourned. Thank you all very
much.
[Whereupon, at 1:05 p.m., the Subcommittee was adjourned.]
A P P E N D I X
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