Finding the best college savings plans for your children isn’t always easy. Families saving for their children’s university educations can reap substantial benefits from 529 college savings plans, as these enable parents to squirrel away and invest spare cash to pay for college tuition via tax-free withdrawals. Nevertheless, selecting the right plan can be problematic for those with lower levels of financial literacy, owing to complicated plan disclosure documents and hefty advisor fees. Indeed, new Wharton research shows that hundreds of billions of dollars of parents’ hard-earned money is parked in suboptimal 529 plans, meaning that millions of families are missing out on higher returns.

What the Research Says About the Difficulties of Saving for College

The paper titled “Household Investment in 529 College Savings Plans and Information Processing Frictions” by Wharton professors Olivia S. Mitchell and Christina Zhu, and PhD student James Li, underlines the magnitude of the problem. In 2020, households had 14.9 million 529 accounts open, with a total of $425 billion in assets under management. Of those assets, the authors estimate that about $281 billion and 8.9 million accounts were in suboptimal plans, representing 66% of assets under management and 60% of accounts in 2020.

“Our study brings awareness to the idea that there could be a lot of suboptimal investment. And that has major implications for the next generation,” said Zhu — not just in terms of the immediate hit to educational attainment and all the benefits a college degree bestows, but also a longer-term negative impact on individuals’ financial well-being.

“Kids who have [financial literacy] education grow up to be young adults who save more and plan for retirement, and they also do a better job allocating their investments.”— Olivia S. Mitchell

Why Are Families Struggling to Find the Best College Savings Plans? 

So why would households continue to plough funds into savings plans that fail to deliver superior investment returns, in ways that could be detrimental to their long-term financial health?

One explanation that has been floated is that families may prefer to invest in 529 plans based in their home state, in the belief that they have an information advantage about the investment prowess of their state plan’s trustees. In fact, while the research does demonstrate a preference for home-state plans, it shows no higher risk-adjusted returns when people invest in local plans versus those in other states. The results suggest that information advantages are unlikely to explain why people park their college savings in suboptimal plans.

Instead, the paper says the root of the problem is the high cost of acquiring and processing the information necessary to make effective financial decisions, given the need to understand how tax breaks and management fees affect the ultimate pay-off from a wide menu of potential 529 options.

As such, the authors report that financial literacy is one key factor that determines 529 plan investment returns. This is borne out by state-level data from 2010 to 2020 taken from plan disclosure documents, as well as the College Savings Plan Network, Morningstar, the National Financial Capability Survey, the Census Bureau, and the National Bureau of Economic Research. The research documents that households living in states with higher levels of financial literacy invest less in suboptimal plans. Moreover, the expensive plans are often sold by advisors charging higher fees. This suggests that less financially savvy families are seeking more costly financial advice, given the complexity of 529 plans.

The average 529 plan participation agreement runs over than 60 pages, and it is full of financial and accounting-related information. Unlike with retirement plans and mutual funds, 529 plans are not required to provide a standard and simple summary. “Plan disclosure complexity leads to a tendency to invest in suboptimal ways,” said Zhu. “Therefore, increasing the transparency and reducing complexity of disclosure would be an important step in resolving the information processing frictions,” she added, noting that other financial products are more tightly regulated than 529s.

“Our study brings awareness to the idea that there could be a lot of suboptimal investment. And that has major implications for the next generation.”— Christina Zhu

What Can Help Parents Invest in the Best College Savings Plans?

Beyond improving disclosure policies, the authors say that raising levels of financial literacy through education could enhance decision-making for household savers when it comes to finding the best college savings plans. In particular, Mitchell said that an online calculator could help, where people could work out what their optimal plan would be, based on their state of residence, local tax laws, holding periods, and investment management fees.

“This would be equivalent to finding a higher rate of return on one’s gift, for the next generation,” said Mitchell, adding that mandating financial literacy education in high schools may also be beneficial. “Kids who have that education grow up to be young adults who save more and plan for retirement, and they also do a better job allocating their investments.”

The wider point is that such policies are beneficial not just for establishing the best college savings plans for families, but also for boosting financial well-being over peoples’ lifetimes. Moreover, financial literacy has become an even more important topic because the move to defined contribution pension plans has given individual savers more say over where to invest their money.

“The new financial environment means people have to be very attentive to fees, as these seemingly small percentages can really eat away the intended benefits,” said Zhu.