American families contributed more than $3 billion to state college savings plans this year, even as federal legislators, regulators and financial analysts blasted these plans for exorbitant fees, poor performance and unnecessary complexity.

Many experts agree that the patchwork of plans offered by all 50 states and the District of Columbia

urgently needs reforming. Yet Congress will pass no legislative fix this year -- even though both the Senate and the House held oversight hearings in recent months detailing the system's many shortcomings. Moreover, two federal task forces revealed when they will complete their investigations into the popular 529 plans, which are named for a section of the federal income tax code.

College savers can choose from a variety of investments, most of them similar to mutual funds and run by established mutual fund families. All the plans offer sizable federal tax savings on earnings, and half of them offer some kind of state tax savings.

Independent critics of the programs have said that families struggling to pay escalating college costs would be best served if the federal

Securities and Exchange Commission

regulated them as the agency does mutual funds. Although the plans have gained popularity because of their federal tax breaks, the SEC has only limited jurisdiction over them because they are administered by the states.

The apparent lack of enthusiasm on the part of federal legislators and regulators to oversee the rapidly growing college savings program leaves the competing state programs just where they want to be: fully in charge. A network of college savings plan administrators vows that it is up to the task of self-regulation by the start of next year.

Critics disagree. "The ideal solution is to give the SEC authority," said Mercer Bullard, assistant professor of law at the University of Mississippi School of Law and president of Fund Democracy, a nonprofit shareholders' rights organization.

And that's what Bullard said in testimony before a Senate subcommittee on Sept. 28. "The SEC could do it if it was being very aggressive," he added, in an interview following the hearing. "The state treasurers are a powerful lobby. They now have a fiefdom to protect. And it's a growing fiefdom."

Despite the negative publicity the plans generated this spring amid the mutual fund scandals, families invested an additional $3.2 billion in college savings plans between the first quarter and second quarter of this year.

That brought the total to $54.4 billion, a 53% increase from a year ago, according to the College Savings Plans Network, the nonprofit affiliate to the National Association of State Treasurers, which promotes college savings programs and is lobbying for self-regulation. One private research firm estimates that 529 plans will mushroom to $100 billion by 2006 and $300 billion by 2010.

Meanwhile, here is an update on the actions -- or lack of actions -- relating to 529 plan reforms.

Congressional Hearings

An oversight hearing of the Senate Subcommittee on Financial Management, the Budget and International Security, led by Sen. Peter G. Fitzgerald (R.,Ill.), a mutual fund industry critic, last week took aim at 529 abuses.

Fitzgerald said that the fees on 529s are so steep, most people would not invest in them without the federal tax breaks. Just as investors can enjoy the "miracle of compounding interest," Fitzgerald said, the many fees piled onto 529 plans -- enrollment fees, applications fees, account maintenance fees, and so on -- are forcing investors "to experience the tyranny of compounding costs."

The senator said that Congress should act to ensure that investors, rather than brokers or fund managers, reap the 529 tax benefits. "Right now, too many middlemen, including state bureaucrats, are feeding at the trough."

While Fitzgerald is clearly eager for reform, Congress is awaiting reports from two regulatory agencies, the SEC and the National Association of Securities Dealers, or NASD, a national nonprofit organization that regulates the nation's stockbrokers. About three-fourths of college savings plan investments are sold by paid brokers and advisers.

Fitzgerald himself is retiring at the end of this year, after his own political party declined to back him for a second term.

Several witnesses at the hearing suggested that Congress act to ensure that the full tax benefits do not fall away in coming years. Currently, earnings from 529s can be withdrawn and used tax-free for qualified educational expenses. But unless the law is modified, the earnings will be allowed to grow tax-deferred only, rather than tax-free, after 2011, because of budgetary restraints.

SEC Review

Unlike mutual funds, college savings funds are not directly regulated by the SEC but by the Municipal Securities Rulemaking Board (MSRB), which is better known for regulating municipal bonds.

Nevertheless, a SEC task force was created in March after Rep. Michael G. Oxley (R., Ohio), chairman of the U.S. House of Representatives Committee on Financial Services, wrote to SEC Chairman William H. Donaldson inquiring whether fees on 529s had gotten so exorbitant that they offset the tax benefits granted by Congress.

Donaldson, in establishing the task force, agreed that some plans cost so much that they could wipe out potential tax breaks.

Although the SEC does not regulate 529s directly because the plans are created by the states, the agency does have control over the brokers and advisers who sell the investments.

While Sen. Fitzgerald stated that the task force should wrap up its findings by the end of this year, an SEC spokesman earlier declined to give a date.

NASD Review

Since last year, a NASD task force has been focusing on the actions of broker-dealers, now up to 20 unnamed firms in number. The regulatory organization is seeking to determine if brokers and advisers put their own financial interests in commissions ahead of their clients' interests, by selling them out-of-state plans, rather than in-state plans that carried state tax benefits.

Mary L. Schapiro, NASD vice chairman and president of regulatory policy and oversight, told the subcommittee that her association had recently conducted a preliminary investigation of 12 firms that sold $2.1 billion worth of 529 plan investments. The vast majority were sold as out-of-state plans, even though at least half the states offer tax benefits to investors who choose in-state plans.

Most college savings plans are sold by brokers and financial advisers who receive commissions, which can run as high as 5.75%. However, many states offer residents the option of investing directly with no commissions.

An MSRB rule could allow a broker-dealer to recommend an out-of-state plan, even if the client were to lose a tax benefit -- as long as the broker-dealer believes the plan is "suitable" -- because it offers superior management or a wider range of investment choices, Schapiro noted.

Schapiro stated that last month her association recommended to the MSRB and to the SEC that every standard SEC and NASD sales practice applicable to mutual funds for retail investors should also apply to 529 plans. "We shouldn't reinvent the wheel for 529 plans," she said.

The NASD will continue to investigate broker-dealers regarding their 529 sales, said Shapiro, but she declined to say when the investigation would be complete.

In some cases, however, the NASD conducts "examination sweeps" as it is currently undertaking with 529 cases, to alert brokers to what it considers best practices, then does not bring disciplinary action.

Industry Review

Hoping to prevent SEC regulation of college plans, the College Savings Plans Network is striving to have all state college plan providers sign off on a plan of uniform self-disclosure by year-end. It would require all 529s to use the same kind of investment offering materials as mutual funds, to explain fees, commissions and the approximate cost of a $10,000 investment in different commission classes, an apples-to-apples comparison.

Diana F. Cantor, CSPN chair and executive director of the $4.2 billion Virginia College Savings Plan, said she hopes to have the disclosure plan in place at the start of 2005. "I absolutely think it goes beyond standards that even the regulators are looking for," she said, adding that the group has shown the plan to the SEC and other regulators. "So far, we have gotten zero comment."

Meanwhile, some states, such as Virginia, Rhode Island and West Virginia, have seen the political handwriting on the wall and lowered their plan fees. Others, such as Ohio and Wisconsin, which brought Vanguard funds aboard, have added lower-cost funds to their 529 investment choices.

Two other states plans, however, got some recent negative publicity.

In July, Morningstar, the Chicago investment rating service, added the Illinois 529 plan run by


(C) - Get Report

to its list of worst college savings plans. It's not just that Citigroup is a "mediocre underachiever," said Morningstar, it's because Illinois denies state tax breaks to residents choosing other state plans, and it taxes residents who withdraw 529 money on plans in other states.

And last month, the Utah state auditor reported that the deputy executive director of the state's college savings plan, who had personally set up 49 different college savings accounts, allegedly stole $85,500 from administrative funds and attempted to steal another $203,400 while under investigation. No investor money was appropriated. The director has been fired.

Before joining, Ann Perry was the personal finance columnist for The San Diego Union-Tribune. She is the author of "The Wise Inheritor: A Guide to Managing, Investing and Enjoying Your Inheritance" (Broadway Books, 2003). She has a B.A. in English and Communications from Stanford University and a master's degree from the Columbia University School of Journalism. She can be reached at