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College Savings Plans – Choosing the Right Allocation

Friday, June 4, 2010   

According to the College Board, the average annual cost of a private, four-year university was over $26,000 during the 2009-2010 school year (about $7,000/year for a public university), with tuition costs rising 5% faster than the inflation rate.  Today’s college savings plans provide more incentives and flexibility than ever before, but they don’t relieve parents and grandparents of the important responsibility of choosing the right investment mix.  Just as in saving for retirement, the success of your college savings plan hinges on your ability to develop and execute a risk-appropriate asset allocation plan.

Think of College as a Four-Year Retirement that’s 18 (or Less) Years Away

The most common mistake made by college savers is to misunderstand their risk capacity.  While age-based college savings funds are popular because of their simplicity, they often lead investors to choose an allocation that’s far too aggressive given their time horizon.  From a risk perspective, it’s helpful to think of college as a mini-retirement, but with a lower tolerance for volatility due to compressed contribution and withdrawal schedules.  Some age-based funds call for 100% equity investments until college is only 12 years away; would you invest for a four-year retirement that aggressively?  I hope not.

Smooth the Transitions

In my opinion, Vanguard’s Moderate Age-Based Option follows a risk-appropriate path for most investors, but it illustrates another suboptimal feature of age-based plans: abrupt allocation changes.  For example, the fund switches from 75% equities to 50% equities when your child turns six.  While automatic rebalancing is convenient, such a drastic change in volatility at an arbitrary milestone can add significant risk, depending on the size and timing of your contributions.  A smoother transition is more desirable from a risk perspective and makes more intuitive sense. 

Fortunately, most plans provide a means for smoothing allocation transitions while only adding a slight degree of complexity.  Instead of waiting until age six to make a change, you could modify your allocation every three years, opting for a 50/50 split of Vanguard’s Growth and Moderate Growth portfolios at age three, for instance.  Or, if you make regular contributions, you could assign your contributions to a fund that would provide a more gradual transition to the next investing phase.  Finally, it’s perfectly reasonable to construct your own college savings portfolio and allocation glide path, but most investors find this task overly time consuming.

Document Your Plan

Once you’ve developed a sensible plan, you should document it in your Investment Policy Statement and only modify it when your risk profile changes.  For example, if another child is born that will use the same plan, you can afford to be more aggressive with your overall allocation.  Alternatively, as you approach your savings goal and your need for risk diminishes, you could shift to a more conservative investment mix.  If you don’t formally document your plan, you’ll feel most tempted to shift your allocation after a market downturn, often the worst time to get conservative. 

Conclusion

If you’re thinking about setting up a college savings account for the first time, use this Morningstar chart to compare the different types of plans.  529 Savings Plans are the most popular college savings vehicle because of their flexibility, high contribution limits, and tax advantages.  529 plans are available in all 50 states, but before opening an account, you should compare plans across state lines, as fees, expenses and fund choices can differ dramatically. 

Given the unique set of challenges associated with college savings plans, there’s far too little guidance about choosing a reasonable asset allocation.  Even the most well-intentioned parents and grandparents continue to make mistakes like investing too aggressively and failing to account for abrupt allocation changes.  A little bit of time spent developing and documenting a risk-appropriate plan can go a long way in helping to ease the financial burden of higher education.

Reminder:  Need an opinion on a risk-appropriate asset allocation?  Get a free personalized portfolio recommendation today!

Posted by George | DIY Investing | Comments (0)
 

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