Planning for College Costs, Part II

In part 1 of this article, I explored how you can estimate how much college will cost and how much you need to save, going forward, to accumulate enough savings to cover the amount that you plan to contribute towards your child’s college costs.  One of the major variables in this calculation is what you assume about how you will invest the money that you save.  While you can design a portfolio yourself, it is also worth looking at funds that combine the major asset classes into portfolios at various risk levels. 

Asset allocation funds provide a pre-built mix of stock and bond exposure that can provide a simple way to save for college.  Target date funds are asset allocation funds that become more conservative (less risky) as time goes.  Target date funds are designed for retirement savings, but may be appropriate for college savings, depending on an investor’s specific situation.  There are also investment funds aimed at college savers that take a student’s age (and thus years until college costs are incurred) into account.  These are conceptually similar to target date funds.  An investor choosing one of these funds for college savings needs to careful that the associated risk levels are consistent with a realistic ability to handle the risk.  Bad outcomes happen in the market and it is naïve to ignore these.  In the wake of 2008, it was not uncommon to see articles suggesting that the asset allocations offered in 529 college savings plans were too risky.  It is crucial to make the choice of investment options from a fully informed perspective.

As a starting point in understanding the impacts of investment risk on college savings, the big market swings in recent years provide a sense of what is possible.  In a 2011 study, for example, Morningstar found that the average annual return for asset allocation funds classified as ‘Conservative’ was 2.53% per year for the five-year period through September of 2011 (see table below).  For ‘Moderate’ asset allocation funds, the average annual return was 1% per year.  The study also found that funds offered within a 529 plan slightly under-performed funds offered outside of these plans, but this difference is small.  In the example from Part I, with a family with four years to go until their child enters college, the online calculator estimated that they need to save $658 per month for the next eight years to cover all of the costs on an in-state education, assuming a 5% rate of return on investments.  If they end up with a 1% return per year, due to a bad run of market returns, they will end up about $14,000 short of what they need.

529Investment Options

Source: Morningstar

An examination of the table above shows that bond funds provided the best returns over this five year period.  It is important to understand, however, that the best estimate of expected future returns from a bond fund is the current yield for broad bond funds and current yields are well below the returns obtained from these bond funds shown in the table above.

For families considering an investment in a fund, the Morningstar classification provides useful guidance.  While there are substantial differences among funds that Morningstar classifies as ‘Conservative Allocation,’ for example, using the category returns in the table above as a stress test is useful when considering the potential risks associated with that fund.  This will not be the case for bonds funds, however, because the period in the table above was a good very one for bonds.

Let’s now look at a specific example in which you are considering investing in the Vanguard Wellington Fund (VWELX) to save for college.  Note: while I am using this fund as an example, I am in no way recommending this fund for any specific investor or investor type.  This fund currently has a five-star rating from Morningstar.  This fund is classified as ‘Moderate Allocation’ by Morningstar.  Over the last fifteen years, according to Morningstar, this fund has had an average annual return of 7.6% per year.  The average Moderate Allocation fund has had an average annual return of 5.6% over this same period.  In 2008, VWELX lost 22% while the average Moderate Allocation fund lost 28%.  In addition, we see from the table above that the average Moderate Allocation fund had an average annual return of about 1% over the five-year period through September of 2011.  If you plug 7.6% per year for assumed returns into the portfolio, this will result in lower required savings.  This should probably be considered the best case.  You should also test how your plans would have to change if your portfolio grew at only 1% per year (following the Morningstar five-year return example for Moderate Allocation funds), and if your savings portfolio lost 22% in a single year, as this fund did in 2008.  These are all possible scenarios and we want the worst cases to be survivable.

By using the online calculator introduced in Part 1 in conjunction with reasonable estimates of the range of returns that different funds have provided, as well as the actual past returns from a fund, you can get a reasonable handle on how much you need to save and the tradeoffs inherent in investing at different risk levels.

One of ways that saving for college is different from planning for retirement is that a shortfall when the money is needed is less catastrophic in the case of college.  In the worst case scenarios in which your college savings accounts lose substantial value or simply don’t grow enough to cover your needs, you may be able to pay more in out-of-pocket, obtain loans, or even get grants.  Need-based aid will increase if your assets available to pay for college are smaller.  In addition, your child might choose a less expensive college.  None of these are the hoped-for outcomes, but they are possibilities.  These contingencies are unlikely to compensate for a gross lack of savings or too risky an investment strategy, however.

Saving and investing for children’s college costs is a major challenge for most families.  Beyond purchasing your home, and saving for retirement, it is quite likely the single largest expense that you will face over your working years.  While there are many unknowns in the planning process, the calculations presented in this two-part article can provide a ballpark sense of how much you will need and how to get there.

The main points from Part 2:

  1. Most investment options for college have risk and the risk levels vary
  2. The amount of money that you will need to save is largely determined by the returns you can generate from your investments
  3. Historical performance can provide a range of returns that can be used as ‘stress tests’ for your plans
  4. It is crucial to spend time understanding the risk-return tradeoffs inherent in different investment options

Related Links:

Folio Investing The brokerage with a better way. Securities products and services offered through FOLIOfn Investments, Inc. Member FINRA/SIPC.

One thought on “Planning for College Costs, Part II

  1. Pingback: Review of Pound Foolish by Helaine Olen | Portfolio Investing Blog: Portfolioist

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