Vigilant Investor

After writing yesterday’s critique of lobbying by the corporate retirement plan industry to create more work for its members - at the expense of small businesses — I thought I’d touch on a similar example of messy government causing undue complexity, and wasteful allocations of our nation’s vast, but limited and declining resources.

Today’s example? 529 college savings plans. Regardless if you are a candidate for such a plan, I encourage you to read today’s dispatch through to its conclusion, because it illustrates perfectly a deeper, nationwide problem that is just one of the many reasons why we remain long term bearish on the U.S. economy.

On the surface ‘529 plans’ are a great idea (although it should always be kept in mind that had the government stayed out of the way in the first place, 529’s wouldn’t be necessary). Essentially, a 529 plan allows family members to contribute large amounts of money to the education of future students in a tax advantaged investment account. From a federal tax perspective, contributions are not deductible like an IRA or a 401k. However, so long as the money inside the account is used for purposes of broadly defined higher education, the money - gains and all - may be accessed tax-free to pay the related bills.

Sounds like a great, straight forward idea, right? Well, not so fast.

Congress left it up to the states to decide if they would provide any state income tax advantages for their taxpayers. Some states have allowed for deductible contributions, and most allow for tax free withdrawals on gains providing the use is for higher education. However, those state level tax benefits only apply if you are a citizen of that state AND if you use that state’s 529. While the 529 law allows for citizens to use the programs of states in which account owners don’t live, doing so means giving up state-level tax advantages.

As it turns out, Congress decided to also give the states the ability to determine how their 529 programs would be run on an investment level. While I’m not entirely certain what the constraints Congress placed on the state governments, I can tell you that the result is that 529s provide one of the dumbest investment environments I’ve yet seen. What has happened is that each state usually provides two tracks of 529s. One is entirely state run, where the investor gives the money to the state treasury to invest for the future. The more popular track gives the account owner the ability to pick the investments on their own, or with the help of an investment professional.

However, in this second track the state makes a special arrangement to usually allow only one or two investment product companies (think along the lines of mutual fund companies) to be THE 529 providers for the state. Ordinarily, one option is for investors to do it themselves, while the other is geared for investment-professional-assisted situations.

Consider the much freer world of IRAs, where a citizen can choose to invest with virtually anyone who offers investment services, from banks to major Wall Street brokerages, to insurance agents, to discount brokers, to mutual fund families, to local investment firms, etc. Instead, 529 users get only one or two choices with their state programs. The consequence is a near-monopoly on state 529’s granted by the legislatures of each state.

Consequently, many state residents find that their native 529 program offers investment alternatives from a company they would never choose were they offered the freedom of an open market. Pennsylvania, for example, only offers residents tax advantages with the “TAP 529“, a package sponsored by Lincoln Financial, a marketing subsidiary of insurer, Lincoln National. Through Lincoln, investors are offered a handful of mutual fund options and prefabricated allocations from Delaware Investments, plus a few others that are ’socially responsible’ from the folks at Calvert.

Most investors who encounter those names as they investigate their 529 in PA say, “Who are these guys?” Well, it should come as no surprise that Lincoln Financial, known mostly for its insurance business and its presence in small market 401ks, is located in Philadelphia along with its subsidiary, Delaware Investments. (Calvert is located in Washington D.C.)

Of course, investors can use any state’s 529 for their college savings, but these citizens wanting to have a little freedom of choice regarding investments are held hostage to losing tax advantages afforded only to those choosing the politically approved Lincoln product. By all measures, limiting investment choices to politically selected entities is in defiance of conventional fiduciary prudence - the standard professionals in the investment industry tend to hold themselves to. Fiduciaries are required to only do what is in the best interest of their clients. Limiting options and flexibility hardly fits that bill. You’ll note that no 529s offer any type of alternative investment styles or management styles. Investors looking for commodities, or gold, or specific sectors, or long-short type management: they are out of luck.

Now, while this situation is not ideal for investors, it is even worse for investment professionals. Among the considerations are the pros and cons of lesser investments in a native state’s restricted plan vs. those available in more flexible states, weighed against the tax-advantages being offered by the native product’s state. Because the funds in the 529s are not the same as the retail funds available through other retail channels (as one might access via an IRA), new systems for tracking and measuring each managed account is required since existing systems are not valid. Then there is the question of is it better to use alternative investment and management styles instead of being confined by the limits of all 529s.

As well, 529s - because they are state regulated - are considered to be municipal securities, even though they are 100% otherwise “general securities”. This info means nothing to the average investor, but to the investment professional it translates into an additional NASD exam to obtain a license for ‘municipal securities’, as required by the SEC. This, when there is functionally no material difference between a 529 investment fund and a conventional variable annuity sub account or a mutual fund.

Of course, I’m only touching on the surface of the 529 and college savings plan market, a subject vast enough to require many books. Should you use a education IRA? How do various savings programs effect eligibility for financial aid? Needless to say, all this complexity has created yet another financial industry profession: the college savings / 529 expert. Various designations are now available for financial professionals to get the expertise they need, as well as to earn a few letters for their business card to differentiate themselves from the herd of competitors.

But what’s lost in all the glory of fancy designations is the question of, is any of this productive for the U.S. economy? Or, is an investment professional really providing any value to his clients by being forced to learn a whole new load of absolutely unnecessary and complex information? Does the family saving for college benefit by paying for another advisor to navigate the complexity, and then having to track yet another set of accounts for each potential student, each with its own account minimum fees? The answer is absolutely a resounding NO!

Nonetheless, the 529 college savings area of law is just the tip of the iceberg related to unnecessary, time consuming complexity in the financial services industry. There is the income tax complexity related to different investment types and investment income types. There are estate related taxes. There are business related taxes. There are corporate retirement plan regulations and tax codes. Moreover, why do we need to have so many types of IRAs and IRA laws? Or trust variations? For that matter, what about all the complex life insurance rules? A husband and wife with three children can easily have eight or ten of fifteen accounts, and five or six different advisors, and thousands of dollars of unnecessary fees thanks to the stupid complexity. Why must each individual bear the burden and costs associated by maintaining so many unique accounts just to comply with an asinine tax and regulatory code?

The answer is simple: Because so many careers now depend on it, and because bureaucracy begets always more bureaucracy.

You see, this legislation nurtures growth in the industry that feeds off existing legislation — an industry that pushes for more and more complexity. However, this is hardly a contribution to the economy - to production and growth. Rather, it is a parasitic relationship, where industry professionals - insurance agents, stock brokers, CFP financial planners, CPAs, Attorneys and actuaries all unwittingly (or not, in some cases) leech off the productivity of others, and lobby for more fresh blood each and every day. It is really no different than unions and their members fighting to force their employers to agree to salaries and benefits that would never be tolerated in a free market, the cost of which is, of course, paid by all consumers who end up with the resulting higher prices. Yet financial, tax and legal professionals would bristle at any comparison.

All this sullies the basic objective on which the industry should be focusing - the objective of most American citizens: to live the American dream by accumulating wealth and retiring comfortably without having to pay countless trolls to cross the many bridges of daily living. Instead, the entire related service industry claims to be helping consumers, but it is in partnership with a meddling Congress; together they plant minefields in the way of all Americans, for which they charge heavy fees to serve as guides. The brotherhood of financial professionals lives on!

Again, I remind the readers - when you wonder why our jobs go abroad, and why the U.S. is now a nation of debtors rather than producers, don’t blame foreigners. It’s time to look in the mirror and weigh these issues along side the dozens of other structural economic problems we write about each day that are faced by the U.S. economy as a whole.

Vigilant investors are doing so. Are you?

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