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Saving for College: Stick With the Program

Most parents encourage their kids not to drop out of school. I’m here to give another type of encouragement—to you. Don’t drop out of your long-term investment program, especially if you’re saving for a child’s (or grandchild’s) college education!

Millions of people, battered by the 2008 financial crisis and worn down by the slow economic recovery since, have given up on the stock market. According to a survey recently published by Prudential Financial, 58% of Americans say they’ve “lost faith” in the market, and 44% say they’ll never again put more money into stocks.

The frustration is certainly understandable. However, I believe these folks are making a serious mistake. If you’re hoping to build a kitty for the really big-ticket expenses in life (such as retirement or a child’s college education), you won’t get very far by stashing cash in the bank.

At today’s one-year CD rate of 0.45% (the national average), it would take 155 years to earn $1 of interest on a $1 deposit. And by then, inflation—to say nothing of taxes—would likely have eroded more than 90% of the value of your great-great-grandchild’s bank account.

A Better Path to Growth

There’s a better path. You don’t have to sink every last dime of your college fund into stocks. In fact, you shouldn’t, if the student you mean to help is only a few years from entering the ivied halls.

But you shouldn’t totally exclude equities, either. Bear in mind, a large part of the stock market’s disappointing performance over the past decade or so traces back to two events that, in all probability, won’t be repeated on the same scale in your lifetime or mine: the Internet bubble and the housing bubble.

Yes, the market will take its lumps now and again. That’s to be expected. And admittedly, today’s share prices don’t equate to the fire-sale bargains we saw in March 2009. Nevertheless, the odds suggest that—five to 10 years from today—a basket of stocks will have grown your wealth a good deal faster than most bonds or bank accounts.

Assuming a starting level of 1,200 for the Standard & Poor’s 500, my baseline scenario, which anticipates historically average earnings growth sandwiched around two fairly severe recessions in the next 10 years, calls for the index to generate a 7.6% compound annual return over that span. (I also assume a market P/E no higher than the average for the past 130 years.) Allowing for only one recession and a P/E ratio equal to that of the post-World War II era, we come up with an annualized return of 9.4%. (Of course, in either scenario, a higher going-in price for the S&P would mean a lower return, and a lower price would mean a higher return.)

Both of these projections, as I’m sure you’ve noticed, fall considerably short of the 18.5% a year return shareholders pocketed from 1982 through 1999. But would you really feel happier earning less than 3% on a 10-year Treasury IOU?

Sliding Allocation Plan

In the kind of world we’re living in, where stocks are risky but offer just about the only prospect of a reasonable return, it makes sense to have a sliding asset-allocation plan for long-term goals like college. For a newborn or toddler, I recommend concentrating most (or even all) of a college-savings portfolio in equities. As time goes by, you should gradually trim the stock exposure until it drops to zero, or near zero, once the student enters college.

How about some specific numbers? Everyone’s sense of what the future might hold for the economy and markets is different, so I don’t want to imply there’s one “correct” scientific formula to suit every situation. But here’s the allocation plan I’ve worked out to guide the college-savings accounts I’ve set up for my grandchildren:

Age Stocks Medium-Term Bonds Short-Term Bonds
Newborn to 8 100% 0%  0%
9–12 80 20 0
13–15 60 40 0
16–18 30 30 40
College (yr 1) 0 40 60
College (yrs 2–3) 0 20 80
College (yr 4) 0 0 100

As you can see, I’m an outright bull on stocks through age eight. Given the baseline scenario I described earlier, it seems very unlikely to me that stocks will underperform bonds or interest-bearing cash over the next eight years.

Starting with age nine, I begin to hedge my bets—gently at first, but then with increasing conviction. By the time the student enters freshman year in college, the only significant market risk I’m willing to shoulder is in bonds, not stocks. At that stage, not losing money becomes more important than making it.

Three Horses in the Race

Once you’ve noodled out an allocation plan you feel comfortable with, your next step is to choose an investment vehicle. For college savings, there are three main options:

+ Uniform Transfers to Minors Accounts. Most brokerage firms and mutual fund families offer these. You can donate up to $13,000 a year to each child on your list, without eating into your lifetime gift-tax exclusion; and your spouse can do the same.

However, UTMAs carry a few drawbacks. The child gets full control of the money at age 21 (18 in some states). If Aidan or Sophia decides to run off on a toot, you’re powerless to cut the purse strings.

In addition, UTMAs can generate taxable income. Above $950 a year, the child must pay tax at his or her own rate; above $1,900, it’s at the parent’s rate.

All in all, I consider UTMAs to be a decent tool if you want to make an unrestricted gift that the recipient can use for college—or anything else.

+ Coverdell Education Savings Accounts. Again, most brokers and funds make these available. Earnings accumulate tax-free, and there’s no tax on withdrawals if they’re used for qualified education expenses. It’s even OK to tap a Coverdell account for elementary or secondary tuition.

Sounds great, but the most you can stash away is $2,000 a year. Also, Uncle Sam clamps income limits on Coverdell donors: $110,000 for singles, $220,000 for joint filers.

+ 529 plans. These state-sponsored programs are my clear favorite. Like a Coverdell, the account grows without incurring any taxes, and withdrawals for college purposes are tax-free. No income limits. If you wish, you can even bunch up to five years’ worth of contributions ($65,000) in one year, without exceeding your annual gift-tax exclusion.

The downside? 529s only allow you to invest in mutual funds (or bank accounts), not individual stocks, and most plans offer a very narrow range of funds. Some plans impose hefty fees. Others refuse out-of-state residents. And all 529s let you swap your funds only once a calendar year.

And the Winner Is…

Still, I think 529s are the winning choice for most college savers. I’ve personally enrolled my six grandchildren in the New York plan—even though I’m a New Hampshire resident. The New York plan (www.nysaves.org) has a low $25 minimum to start, and no set-up or maintenance fees. Operating costs are capped at an ultra-low 25 cents a year per $100 invested. Vanguard, known for its Scrooge McDuck habits, manages the funds.

New York offers three age-based tracks that automatically shift the mix of funds as the beneficiary ages. In addition, you can select among 13 individual funds yourself. (I prefer the latter option.) Among the more interesting items on the menu are funds specializing in small caps, midcaps, international stocks and inflation-adjusted bonds.

If real estate appeals to you, the Nebraska 529 plan (www.nest529.com) features 14 funds, including Vanguard REIT Index. Nebraska also carries the world’s largest bond fund, Pimco Total Return.

Nevada, true to its gambling ethos, gives you access to junk bonds via Vanguard High-Yield Bond Fund. (Nevada’s plan simply links to Vanguard’s master 529 plan; for details, visit www.vanguard.com.) However, Vanguard requires a $3,000 minimum to set up an account, and there’s a $20 annual fee if your balance falls below that threshold.

In the end, having a cornucopia of funds to choose from probably isn’t crucial to a successful college-savings program. What you need are: (1) a sensible method of asset allocation and (2) the discipline to keep shoveling money into your account(s) during down markets.

Remember, market pullbacks, like the one we’ve just experienced, ramp up your return on new money (versus what you could have expected when the market was higher). Investors who understand that simple principle will not only put their kids (and grandkids) through college, but will have all the rest of the goodies a person can ask for as well.