My oldest son, a junior in high school, took the ACT exam last weekend. Where did the time go? It seems like the elementary school years last forever only to fast forward once high school arrives. This has me thinking about investments that will be responsible for covering college costs. The best investment choice may not be as obvious as you think.
Like many families, we’ve been accumulating investments in a 529 savings plan for quite some time. In fact, I was so eager to begin investing in a 529 plan as an expectant father that I did so before our son was even born! Opening an account and adding to it from cash flow was step one. Then, once our son was born and had a social security number, I replaced my name with his as the primary beneficiary. My “inner planning self” wanted to get a jump on investing many years ago and thought, why wait? Time is your best asset when thinking about those you care about and how to save for their future. This has worked out well but does require decisions on where to invest.
A popular approach to selecting investments in a 529 plan is doing so based on your son or daughter’s age. These portfolios typically begin full of diverse companies that will contract and expand in value overtime when your student is young. As your student gets older, the plan automatically liquidates the volatile company values and redirects the proceeds into “safer” fixed income investments. These portfolios operate in a similar manner to target date retirement funds. Both approaches begin full of companies only to arrive at the targeted date or age holding mostly cash. I’ve written a far bit about target date funds and I’m NOT a fan. Why? It defeats the purpose for which investing was created for. That purpose, from my perspective, is hedging the ever-rising costs of life. Be it college costs for four years (or four and half-thank you Virginia Tech) or retirement income for thirty years plus, both require sustainable investment choices.
There are two paths to take when selecting investments inside a 529 plan. Path one includes the stability of an account that doesn’t fluctuate in value as your student approaches high school. As you can see in the example below, age-based portfolios accumulate more fixed income overtime.
- Age 16 may have a portfolio of 25 percent equity and 75 percent fixed income
- Age 14 may have a portfolio of 40 percent equity and 60 percent fixed income
- Age 11 may have a portfolio of 50 percent equity and 50 percent fixed income
Path two accepts the fact that your account will fluctuate significantly, both up and down, but in doing so stands a better chance of keeping pace with rising college costs. This portfolio includes more diverse equities from the start and continues to hold them regardless of your student’s age. That portfolio may include 80 percent equity and 20 percent fixed income investments. Equities, you’ll recall are companies of all sizes, more volatile in price, and also more likely to keep pace with rising costs. Fixed income investments are viewed as “safer” and cash like due to their stability of price.
The question I ask myself is this, do you really need all four years of college costs in safer fixed income investments before your student arrives on campus? Does a 14-year-old need to have a portfolio so tilted toward fixed income while still a freshman in high school? This seems more conservative than necessary as tuition and other associated costs continue to increase and certainly outpace the returns of fixed income.
If the university required you to pay all four years of costs up front before your student moved into the freshman dorm, then yes, the above portfolios may make sense. But thankfully, colleges don’t require this, typically they bill you one semester at a time. College costs continue to increase so why should your portfolio be automatically allocated as if they don’t?
Age based investment choices inside a 529 plan seem at first glance to be the right decision. However, when you begin to plan and strategize on how to cover costs you may realize that these portfolios are unable to address a real risk. That risk is failing to keep up with rising costs to and through college. A better approach before selecting investments in a 529 plan is to clarify the purpose these dollars serve and the timing of first use. Having a discussion on what you want most and factoring in other considerations is critical. This includes how you and your significant other define risk and volatility? How does your college experience and the funding that was available impact your decision? What other financial resources may be available?
Having a written plan that factors in cash reserves, future income, other investments, and timing withdrawals from your 529 takes effort. The reward for your work is having a higher degree of confidence while remaining flexible in addressing college costs. By reviewing your education plan annually, you are able to think proactively forward regarding other financial goals.