HOUSE HEALTH, EDUCATION AND SOCIAL SERVICES STANDING COMMITTEE January 27, 2000 3:12 p.m. MEMBERS PRESENT Representative Fred Dyson, Chairman Representative Jim Whitaker Representative Joe Green Representative Carl Morgan Representative Allen Kemplen Representative John Coghill MEMBERS ABSENT Representative Tom Brice COMMITTEE CALENDAR HOUSE BILL NO. 268 "An Act relating to the Alaska Higher Education Savings Trust; and providing for an effective date." - HEARD AND HELD HOUSE BILL NO. 260 "An Act relating to coverage of children and pregnant women under the medical assistance program; and providing for an effective date." - BILL HEARING POSTPONED PREVIOUS ACTION BILL: HB 268 SHORT TITLE: COLLEGE TUITION SAVINGS PLAN Jrn-Date Jrn-Page Action 1/10/00 1889 (H) PREFILE RELEASED 12/30/99 1/10/00 1889 (H) READ THE FIRST TIME - REFERRALS 1/10/00 1889 (H) HES, FIN 1/10/00 1889 (H) REFERRED TO HES 1/27/00 (H) HES AT 3:00 PM CAPITOL 106 WITNESS REGISTER REPRESENTATIVE LISA MURKOWSKI Alaska State Legislature Capitol Building, Room 406 Juneau, Alaska 99801 POSITION STATEMENT: Testified as sponsor of CSHB 268. BOB MANLEY, Estate Planning and Tax Attorney Hughes, Thorsness, Powell, Huddleston and Bauman 550 West Seventh Avenue Anchorage, Alaska 99501 POSITION STATEMENT: Testified in support of CSHB 268. CHRIS LYNCH, Program Director for the Western Region of the U.S. Tuition Financing Inc. TIAA-CREF [Teachers Insurance and Annuity Association-College Retirement Equities Fund] 730 Third Avenue New York, New York 10017 POSITION STATEMENT: Testified on CSHB 268. JIM LYNCH, Interim Vice-President for Finance University of Alaska P.O. Box 755120 Fairbanks, Alaska 99775 POSITION STATEMENT: Testified in support of CSHB 268. DANA OWEN, Special Assistant to the Commissioner Department of Revenue P.O. Box 110400 Juneau, Alaska 99811 POSITION STATEMENT: Expressed some legal concerns on CSHB 268. ACTION NARRATIVE TAPE 00-5, SIDE A Number 0001 CHAIRMAN FRED DYSON called the House Health, Education and Social Services Standing Committee meeting to order at 3:12 p.m. Members present at the call to order were Representatives Dyson, Whitaker, Kemplen and Coghill. Representatives Green and Morgan arrived as the meeting was in progress. HB 268 - COLLEGE TUITION SAVINGS PLAN CHAIRMAN DYSON announced the first order of business as House Bill No. 268, "An Act relating to the Alaska Higher Education Savings Trust; and providing for an effective date." REPRESENTATIVE COGHILL made a motion to adopt the proposed committee substitute (CS) for HB 258, version 1-LS1235\H, Ford, 1/24/00, as a work draft. There being no objection, proposed CSHB 268 was before the committee. REPRESENTATIVE LISA MURKOWSKI, Alaska State Legislature, sponsor, came forward to present CSHB 268. She indicated this is a very exciting concept, and there doesn't appear to be any opposition. Everyone she has talked to about this has been very enthusiastic about the prospects for opportunities to invest for higher education savings accounts. She referred the committee to articles in their packets which discuss what has happened on the national level with regard to qualified state tuition programs. In 1998 there was federal legislation [in the Internal Revenue Service (IRS) Code] adopting section 529 programs which allow states to institute qualified state tuition programs that have certain tax deferred benefits and allow greater contributions into an education savings trust. REPRESENTATIVE MURKOWSKI said presently the options are limited in terms of saving for higher education. There is an IRA [Individual Retirement Account] that one can put in $500 per year and the University of Alaska has the Advanced College Tuition (ACT) program. This legislation allows greater flexibility and options to individuals as they set up these trust accounts. She referred to an article in the packet which shows what the 50 states are doing in terms of education savings plans. Alaska's ACT program is rated the lowest possible simply because it is not structured to take into account the smorgasbord of options. This legislation would allow Alaska to offer very positive, flexible plans for investors for their children's educational future. Number 0470 BOB MANLEY, Estate Planning and Tax Attorney, Hughes, Thorsness, Powell, Huddleston and Bauman, testified via off-net from Seattle. He told the committee he has been practicing in this area for 25 years. He is part of an informal group of tax and estate planning attorneys that do pro-bono work by assisting with technical review of legislative issues in their area. He is not representing anyone regarding this bill. His interest comes from seeing many of his estate planning clients sending money outside Alaska for other state's programs, and he likes the idea of keeping the money inside Alaska. MR. MANLEY believes that CSHB 268 is good for Alaska and for the university. These plans are often called section 529 plans because the IRS Code section 529 authorized states to adopt these kinds of programs. Forbes magazine called section 529 the sleeper tax break of the 1997 Tax Act. He explained the plan is not state specific. For example, people can invest money for their children's higher education in the Arizona program and the children can use it in Massachusetts or wherever. It is a flexible financial vehicle for saving for college. Every state is in competition so it is important to offer one of the best programs. MR. MANLEY said this program will be good for Alaska because it will allow savings in anticipation of college expenses. From an income tax view, it is like an IRA. There is tax-deferred accumulation, the money goes into the account, and there are no income taxes paid on the money earned or the capital gains until the money is withdrawn. When the money is withdrawn, it is usually withdrawn for a student's higher educational expenses, and it is taxed at the student's income tax rate, which is usually much lower than the parent's tax rate. Under the new tax bill pending in Congress and under the last tax bill President Clinton vetoed, the withdrawals would have been income tax free if they are used for higher education. There is a good chance that type of provision will be enacted in future federal law. MR. MANLEY indicated this program is good from an estate tax and gift tax point of view. Under federal law, contributions to these kinds of plans qualify as completed gifts. That means people can use their $10,000 per year annual exclusion from gift tax, and they can forward average five year's worth of exemption. So people can give $50,000 to an account for a single student and elect to use the next five year's $10,000 exemption from gift tax. Husband and wife could each do that. MR. MANLEY added there is tremendous flexibility in this program which provides a tax break that is available to the rich and not- so-rich alike, unlike the Roth IRA and many other tax advantages. In addition, up to $100,000, or possibly more, per beneficiary can be put in the account. This is controlled by the cost of higher education which is the highest cost of all higher education expenses for a normal program. Montana has calculated the maximum up to $172,000. The university can decide what to set the maximum at to qualify. The best thing is the participant control where the parent can change beneficiaries within the family or can even pull the money out. This is a big distinction from the normal gifts to children, like a uniform transfer to minors act account, where the money goes in and when the child reaches 21, the money will be the child's no matter what. Here the parent can pull that money out at any time, but if it is not used for higher educational purposes, then there is a penalty. That penalty can be as low as 10 percent of the earnings, and the penalty goes to the University of Alaska. MR. MANLEY said this program is good for Alaskans because the assets put away for the child's college are protected from creditors. This program is good for the university because the university will be able to earn fees regarding administration and management of the program and receive penalties as mentioned before. Non-Alaskans will benefit also because they can invest in the Alaska program because there will be more money under management. Non-Alaskans will have the opportunity for a spendthrift trust creditor protection. Under current bankruptcy law, other states can't probably protect non-residents. For example, an Alaska investing in Maine's program probably won't be protected from creditors and bankruptcy. However, Alaska has a unique spendthrift trust law. That is why Alaska's trust law has been so successful and why it has developed new business in Alaska, and why Delaware, Nevada and Rhode Island have copied this trust legislation. Those are the only states which have legislation to allow spendthrift trust protection for these kinds of plans. Alaska will have a competitive advantage over most of the other states. Alaska should be able to attract back the money going out-of-state to section 529 plans in other states. In addition to being able to change beneficiaries and terminate the program with a penalty, these accounts can be rolled over. In addition to new investors, Alaska may be able to get rollovers from other states. MR. MANLEY expressed support for this legislation. Number 1011 REPRESENTATIVE WHITAKER asked if the benefit of the $10,000 gift exclusion accrues to the tax recipient or the giver. MR. MANLEY answered if he gives $10,000 to someone, and it is not categorized as a completed gift, then that feeds into unified credit against the state gift tax. Instead of being able to give over his entire lifetime $675,000, that would be reduced by $10,000. If it is a completed gift, there is no such reduction and no potential of gift tax. The person avoiding gift tax is the person who gives the money. The recipient never ends up paying a gift tax on gifts. Number 1131 CHRIS LYNCH, Program Director for the Western Region of the U.S., Tuition Financing Inc., wholly owned subsidiary of TIAA-CREF [Teachers Insurance and Annuity Association-College Retirement Equities Fund], testified via off-net from New York. He said TIAA-CREF is honored to be selected as program manager for more state-sponsored section 529 programs than any other organization. He related the development of the section 529 savings market place over the past few years. The section 529 prepaid plans existed since the late 1980s, but the most growth of states participating has been in the past two years. Number 1217 MR. CHRIS LYNCH noted the majority of assets that are invested in section 529 programs are in the prepaid model plan such as the plans in Florida, Michigan and Texas. Those programs have existed for a number of years. The trend is toward state- sponsored savings programs recognized by the national financial press, about 20 states are either offering or in the process of implementing state savings programs. Most of those 20 states have moved in that direction over the past two years. He believes that the section 529 programs have been recognized by these states as a fundamentally better way to solve a fairly daunting problem of financing higher education. MR. CHRIS LYNCH noted there are a variety of models out there. In addition to the federal tax deferral, when the proceeds are withdrawn for qualified education use, they are then taxed at the beneficiary's rate which is almost always an advantageous situation. That is the hook of the section 529 program generally. The difference between the section 529 and traditional prepaid programs and savings programs is on the investment aspect of these programs. Funds directed into a plan such as Alaska's plan would be directed into individual accounts where the account owner and beneficiary would bear the risk of the underlying investment portfolios. The prepaid model has the risk shifted away from the account owner and the beneficiary and towards the schools or whoever is administering the program. In some ways analogies have been drawn between the savings model and prepaid model to the traditional defined benefit type of pension plan and a defined contribution type of pension plan. MR. CHRIS LYNCH mentioned the national ratings add to a more competitive environment for these programs. One of the primary reasons that savings programs do better in the scoring is the fact that the money is invested in a different way. In most situations the money is directed toward mutual funds investments where there is risk involved, but the returns can be greater. Most of the existing state savings programs offer, either exclusively or as a component of their investment structure, what could be defined as a management allocation or banded allocation approach. An account owner will purchase a savings program, contract or certificate, and the money that someone directs toward that program will be allotted toward the (indisc.) allocation model usually made up of stocks and bonds or may include a money market or guaranteed investment. Some apportion those benefits based on the age of the beneficiary. The younger the beneficiary, the heavier the weighting towards the equity investments. For a beneficiary who is two years old, maybe 60 or 70 percent of the investment would be weighted toward higher risk investments and 30 percent would be weighted toward lower risk investments. As the beneficiary grows up, the investment allocation shifts. Some state programs have people move from one investment allocation band to the next every two years, some do it every five years, but fundamentally every program that uses this approach has individuals move from the more aggressive allocations in the early years to a more conservative allocation as they approach college age. MR. CHRIS LYNCH noted the national trend is towards offering individuals some choice in addition to the traditional banded managed allocation type investments. More recently programs have started offering a guaranteed option for people who are more conservative than average or an all equity option for those willing to take more risk with their money. While people do get favorable tax treatment on this, an individual does not have investment discretion the way they would under a mutual fund. One of the criticisms of the section 529 programs is that people can't trade their accounts, which is not necessarily a bad thing. The Alaska program could offer both a banded allocation approach and either a more conservative option or more aggressive option or something in between. Staying competitive would encourage adding options besides just a single managed allocation type option. MR. CHRIS LYNCH said the distribution flexibility of the program is very important. Individuals who are participating in the Alaska program need to have the ability to have that money go towards room and board as well as tuition fees. Failure to have a program that allows for room and board expenses would be counted against the program. MR. CHRIS LYNCH repeated that one of the important aspects of these programs is the fact that a beneficiary in Alaska can attend an institution anywhere in the country. That is often the number one reason people will participate in a program of this type. The fact that CSHB 268 has beneficiary flexibility worked into the bill is favorable to a successful program. Another popular feature of these programs from the purchaser's perspective is it gives people the ability to name contingent account owners, making things run more smoothly should the original account owner pass away. From a corporate perspective, TIAA-CREF also believes the protection from creditors will also make this program popular in Alaska as well as other states. The maximum amounts people can contribute are important as well as the minimums that are established within the contract. Most people are probably going to start out at low levels. Establishing low barriers of entry to this program is the surest way to expand the reaches of the program across the socio- economic spectrum. Currently there are programs that allow people to participate for as low as $25, or if it is through payroll deduction, it is as low as $15. That doesn't make for large accounts immediately, but it does get people to participate in the programs. MR. CHRIS LYNCH told the committee that keeping program expenses on the low side is clearly favorable. The break point for this in their experience is keeping it under 100 basis points in terms of expenses. [One basis point is equal to one-hundredth of a point.] This will be seen as a program that is offering good value provided they are flexible in terms of the investments out there and flexible in the other things he mentioned. There are programs that operate significantly under 100 basis points, but 100 points seems to be the line drawn in the sand for these programs. Number 1851 JIM LYNCH, Interim Vice-President for Finance, University of Alaska, came forward to testify. He told the committee he is a member of the College Savings Plans Network (CSPN) and one of the original drafters of the Advanced College Tuition (ACT) program. The ACT program is an arcane program which is only about eight years old. At the time the program was implemented, it was probably a cutting edge program. The problem was it was designed under a different tax code, and section 529 really turned the tables upside down on the Alaska program. He relayed information from the [CSPN] national conference in July. At that time there were 17 prepaid states, 15 savings states and one state offering both programs. The other states that were at the meeting indicated they would have programs by 2001. Clearly there is a shift to savings programs which function much like defined contribution pension plans and away from the prepaid programs which function similar to defined benefit pension plans. Number 1923 MR. JIM LYNCH shared some history behind the programs. Michigan started their plan in 1987, filed for an IRS ruling, and the IRS came back and said the Michigan program was a taxable entity, and investment earnings would be taxed. People could take a deduction for the payments that they make out to the participants ten or fifteen years later. Florida filed their tax return and filed suit, they lost in circuit court, went back on appeal, and this was about the time the Alaska program entered the market. By that time Florida, Ohio and Alabama had programs. Kentucky had the one savings program out there which was a taxable program. There was no way to even create an argument that a savings program was exempt. Michigan then won their appeal, and the IRS chose not to take it to the Supreme Court. Instead the IRS took on another of the state programs in another circuit to see if they couldn't get some wins under their belt. At that point, the IRS issued notices that they were going to give adverse rulings to the other state programs including Alaska. That notice initiated a movement to get section 529 passed, and it was passed in August 1996. MR. JIM LYNCH noted at that point there was an explosion of savings programs because there is essentially little or no risk for the state offering the program. Most of the prepaid programs have a risk, whether there is a guarantee or not, that there won't be enough money in the account when the student shows up to go to school. Even if there is no legal risk, there is a moral risk. That is also true with the ACT program. In 1997 the ACT program was changed essentially to make it look more like a savings program. It functions much like a mutual fund at this point, but it earns only around 4.5 percent interest, and that is why it rates so poorly nationally. MR. JIM LYNCH indicated the university had been trying to work on a plan to initiate a savings program when Representative Murkowski and Senator Kelly developed the concept of the Alaska Higher Education Savings Trust. At that point they got together to try to figure out how to make the Alaska savings trust work with ACT program. There are some long term commitments, probably 30 years out, under the ACT program for students to come to school. The market is small in Alaska so there really can't be two programs functioning very well competing with each other, particularly one that is not going to do very well. They will wind up with a lot of liabilities with one program and all the money somewhere else. The ACT program needs to be fixed to make it competitive and compatible with the savings trust program. Then people would have multiple options to choose from, and that is the intent of CSHB 268. Number 2062 CHAIRMAN DYSON asked Mr. Lynch if the university approves of CSHB 268. MR. JIM LYNCH stated that the university is very supportive of CSHB 268. They have a program, whether anybody likes the program or not, they are stuck with it, and they want it to be a success. It does give the university access to a lot of future students, and that is where the university will benefit. They haven't developed a business plan to know what fees the university will receive. He would like it to break even, and if they have some monies to support the program, that would be wonderful. This program provides financial access to education for the citizens of Alaska. Currently there is only merit-based and need-based aid available. For the students who are neither scholars nor qualify for need-based aid, there is very little support for their education. They wind up in loan programs which have to be paid back. Number 2126 REPRESENTATIVE GREEN asked about the fund being protected from creditors. MR. MANLEY explained that as long as the money stays inside the trust or plan, it is protected from creditors similarly to the protection of an IRA. Upon withdrawal of the money, there may be a right for an injured person to get to it. It is like other protected assets like IRAs, 401Ks, limited interest in insurance and homestead protection. REPRESENTATIVE GREEN asked whether this plan would be compatible with what the President has put forth. Number 2212 MR. MANLEY said he believes the state program would be compatible with anything that comes along and there is not a good reason to defer action on this. MR. JIM LYNCH stated that the IRS has been the biggest obstruction to making these programs successful for the last ten years. It isn't without reason; if this works for college savings, maybe there would be a lot of other good reasons why tax exempt or tax deferred vehicles could be created. All of the benefits for the state programs have come because of congressional action and the White House pretty much stays away from providing any benefits at all. It has been difficult to get anything through the Clinton Administration at this point for state programs. REPRESENTATIVE COGHILL asked if there was any law that prevents this type of trust being done on a private level. TAPE 00-5, SIDE B Number 2305 MR. JIM LYNCH answered that only states can offer or sponsor the programs, and that is what makes the programs attractive to firms such as Smith Barney and Merrill Lynch and TIAA-CREF. They are unique and only states can do it. REPRESENTATIVE COGHILL agrees with the idea of the trust, but he objects to the state being the warehouse of so much money. He would like to see it more in private industry. He isn't against the university having the benefit. MR. JIM LYNCH said the university will not be managing the trust. It will be out-sourced. There will be a contract with firms like Merrill Lynch, Smith Barney or TIAA-CREF who will do the work. The firms are the registered brokers. Number 2263 CHAIRMAN DYSON asked Mr. Chris Lynch how a firm like TIAA-CREF gets paid for providing these services. MR. CHRIS LYNCH indicated that TIAA-CREF is a non-profit organization. He explained the way they get their investment back from a given program is through the program expense structure. Their programs typically run from about 65 basis points to about 80 basis points. They recoup their investment through the expense charges built in to the program. There are programs where the payback is done via commissions or some kind of annual fee. It is not uncommon to see with other companies that they get it entirely through the expense ratios. Number 2214 CHAIRMAN DYSON asked for a rough idea of what percentage it takes to reimburse the companies for the expenses. MR. CHRIS LYNCH said they are all less than 1 percent. The expectation is that once an organization is named as the program manager for the state that they have a relationship with the state for a contract term typically between five, seven or ten years duration. They are able to decrease the amount of the expense ratio depending upon the length of the contract. Number 2080 REPRESENTATIVE GREEN referred to page 3, Section 3 and asked Mr. Jim Lynch what sort of investments would this program be limited to and if they are like some of the IRAs which are very conservative. MR. JIM LYNCH answered it will be the university's responsibility to select a program which provides the range of alternatives which could run from fairly aggressive to very conservative. It is the same as managing a pension program. The university has a fiduciary responsibility to select quality investments. The university will create a program with a provider that takes mutual funds and select a portfolio that is unique for the program. The university will not be held responsible for what the market does. They will be responsible to the extent that the law provides for any negligence. REPRESENTATIVE GREEN referred to page 4 and asked if (f) "A participant has the right to change beneficiary..." and (h) "An account is not subject to involuntarily transfer or alienation..." were conflicting statements. Number 1934 MR. MANLEY answered he doesn't believe so. He explained that alienation is simply transferring away from the owner and involuntary transfer would be a judicially enforced transfer. They are not inconsistent, and it makes the intent clearer to any judges who might review it. REPRESENTATIVE COGHILL asked at what degree is the person filing the trust active in the portfolio. MR. JIM LYNCH answered that the participant can't do anything except choose one of the options available. Section 529 has a prohibition against the participants directly or indirectly controlling the investments. There may be several offerings and the participants can select which offering; they could put money in all of the offerings, but they can't change in mid-stream. REPRESENTATIVE GREEN asked if trade schools are qualified institutions. MR. JIM LYNCH said that vocational/technical schools are qualified institutions. REPRESENTATIVE GREEN asked if he doesn't use the money for higher education and withdraws it, would he be subject to taxes that year. MR. JIM LYNCH answered that if the money was withdrawn and the beneficiary was not using it, it would be taxable to the participant in the year the money was received. Number 1804 REPRESENTATIVE GREEN asked if it is like an IRA where he can withdraw a little at a time. MR. JIM LYNCH noted theoretically he would change the beneficiary to someone else. REPRESENTATIVE COGHILL asked if it was possible to rollover from this program to an IRA. MR. JIM LYNCH said he didn't believe at this point in time there would be a rollover allowed to an IRA account. Rollovers to beneficiaries are basically limited to members of the family as defined in the code of the beneficiary. Number 1753 DANA OWEN, Special Assistant to the Commissioner, Department of Revenue, came forward to testify. The department is supportive of the concept of the bill, but he wanted to alert the committee of an objection to one feature of the bill which probably was drafted in oversight. The department is working with the sponsor of the legislation to craft some language that might fix the concern. The concern is that while they have created a shelter from litigation, the department would not like to see that shelter applied to child support. He would like to make sure that this is not inadvertently a vehicle for hiding assets for purposes of evading child support. There is not language today to fix this problem, but he would not object to the committee passing the bill out today because there is time to amend the bill later. The committee took an at-ease from 4:15 p.m. to 4:16 p.m. Number 1683 REPRESENTATIVE GREEN made a motion to move CSHB 268, version 1- LS1235\H, Ford, 1/24/00, from committee with individual recommendations and the attached fiscal note. REPRESENTATIVE COGHILL objected for purposes of discussion. He said he didn't know if he agreed with the fix and would like the opportunity to debate the issue. CHAIRMAN DYSON asked Mr. Owens how soon he expected to have the new language. Number 1658 MR. OWENS answered in the next couple of days. Number 1632 REPRESENTATIVE GREEN withdrew his motion. CHAIRMAN DYSON announced they will revisit this on Tuesday. [CSHB 268 was heard and held.] ADJOURNMENT Number 1594 There being no further business before the committee, the House Health, Education and Social Services Committee meeting was adjourned at 4:17 p.m.