Friday, May 13, 2011

Are 529 College Savings Plans Too Risky?

Millions of parents have been favoring 529 accounts as a means of saving for their children's college expenses. It's easy to see why:

  • Contributions to in-state 529 college savings accounts are often tax deductible from your state taxes
  • The money is invested in any number of stock and bond funds, allowing it to grow much faster than traditional savings accounts
  • The money can be withdrawn from the fund, tax free provided it is used for approved college expenses

For those who live in states with high income tax (like New York!), 529 plans sponsored by their home state (a.k.a. in-state plans) are helpful to the parent in the short term while helping to provide for a solid educational opportunity in the future.

In fact, 529 plans are one of the few options for college savings that even offers the potential to keep pace with the absurd increase year over year of college tuition.

But there's no free lunch, and there's no investment without risk. Here are some of the risks with a 529 college savings plan.

The Risk of Complacency

While the Ron Popeil "set it and forget it" style of investing works well if you're stashing your savings for retirement in a broad based index fund (like VTI) and you're 30 years away from retirement, it can be disastrous as you near the time of needing those savings if you're not in the right kind of fund. The same is true of 529 plans.

Set your newborn's 529 portfolio up to be aggressive and things will likely look pretty good by the time he's in high school. But leave it that way until he's heading off to college and you're setting yourself (and him) up for a big fall.

An aggressively allocated 529 portfolio in 2008 would have lost close to half its value. Not what you want to see happen just before you need that money for college.

It's important to keep an eye on the portfolio at least once a year, and begin edging out of aggressive funds as your child moves up in grade level and ever closer to the day of college enrollment.

The Danger of Age-Based Funds

Age-based funds are meant to be a simple way to invest for the future while automatically re-adjusting from aggressive to conservative as the target date nears. In fact, these kinds of funds are called target date funds in 401ks and IRAs.

The idea is that you sign up for one of these funds based on the age of your child. You simply keep the fund, adding to it year after year, until it's college time. By then, the fund would be holding mostly conservative investments meant to preserve principal rather than achieve growth.

The crash of 2008 highlighted a previously unknown problem with age-based funds. Namely, the managers of many near-date funds were too heavily invested in stocks. By the time the beneficiary is a junior or senior in high school, a significant portion of the fund's holdings should be in cash or cash equivalents. Many of these age-based funds were not.

Managers seeking to increase performance and thereby increase the inflow of new money invested in their fund, were juicing up their returns with more aggressive investments than they should have held.

The result was that many people's college savings were wiped out just when they needed the money most.

If you use one of these age-based funds, it's best to keep an eye on the underlying holdings and make sure you're comfortable with the level of risk - don't just assume the fund manager is looking out for you and your child.

High Fees

Not too big a problem when compared with the alternative of not saving at all, or saving but not investing, but some 529 plans have higher than normal fees. Even within a given plan, some funds may carry excessive fees. Saving but not investing leaves you with less over time due to simple inflation, but excessive fees can cut much of the gains of a 529 account too.

In general, index funds carry less fees than actively managed funds. Of course, you'll have to weigh those fees against the performance and risk of an individual fund to determine whether you're comfortable investing in that fund.

I personally think that 529 plans are still a good idea, but they're not a magic bullet to the college cost problem. You still need to understand where the money is going and what could happen to it.


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