The 5 Best (and Worst) 529 College-Savings Plans

WITH TUITION ON the rise and student-loan lenders exiting the market en masse, paying for college seems harder than passing an applied physics exam. But there is one glimmer of hope in this challenging environment: a marked improvement in 529 college-savings plans.

According to an annual study of the best and worst 529 plans by investment research firm Morningstar, a growing number of plans are lowering fees and offering a larger assortment of well-diversified portfolios.

529 plans, which are also known as qualified tuition plans, are designed to encourage parents to save for future college costs. (Withdrawals, as long as they're used for qualified higher education expenses, are federally tax-free.) However, in the past, some have been criticized for being too expensive and logging poor returns. Now, as more consumers sign onto these plans, the educational institutions, state governments and agencies that run these funds have worked toward shutting down expensive funds and offering better investment options, says Marta Norton, Morningstar mutual fund analyst and author of the study.

Morningstar's report should come as welcome news for parents who are facing the prospect of an unfriendly lending environment and already-expensive tuition that's creeping higher. Average tuition costs, plus fees, rose roughly 6% for both private and public colleges and universities during the 2007-08 academic year, according to the College Board. And they are only expected to go higher.

In order to select the five best and worst plans, Morningstar focused on a handful of criteria, including portfolio diversification, fund quality, fees and a flexibility that allows investors to make adjustments to their exposure based on their risk tolerance and time horizons. Morningstar says it favors funds that don't rely too heavily on one area of the market to boost returns. "You want to see a well-rounded portfolio," says Norton. Fees are also a key factor; because so many plans use similarly constructed index funds, the lowest-price ones will likely earn the best returns.

(For more information about the different kinds of 529 plans and how to pick one, read our tutorial here).

Among the top five was Illinois Bright Start College Savings Program, which Norton calls a "Cinderella story" for the dramatic turnaround it managed to accomplish over the past few years. The plan now offers a choice between well-constructed all-index funds from Vanguard and an actively managed age-based option with funds from Oppenheimer. It also substantially lowered fees. "It measures up on many different fronts," says Norton.

Another standout: Virginia Education Savings Trust. This was a plan that "wasn't too impressive a few years ago, but they made some changes and upped the ante there," says Norton. Of particular note, she says, are the range of investment options investors can choose from, including a REIT index, an inflation-protected securities fund and an international fund.

Not all plans were Cinderella stories, though. The Ohio Putnam CollegeAdvantage (which is broker-sold) is a repeat offender this year. It appeared on Morningstar's worst-of list in 2004 because of stewardship concerns, Norton says, and problems still remain. "We see a ton of turnover on the analyst and manager level. So it's hard to be confident about who's running the show back there," she says.

The New York 529 College Savings Program boasts reasonable fees and offers solid underlying index funds, but somewhat surprisingly, it ended up on the five-worst list. Its primary offense: a lack of diversification, particularly in international markets. By not offering exposure to foreign markets — which have generally been outperforming U.S. markets over the past several years — the plan is selling investors short, Norton says.

Here's a breakdown of the winners and losers in Morningstar's survey of 529 college-savings plans: