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Find the Right Stock/Bond Mix for College Savings

Here are some tips for hands-on and hands-off investors looking to save for a college education.

Christine Benz, 03/25/2011

"I can't understand this. We've tried to do everything right from the day she was born."

So lamented a friend, right after telling me that the college fund of her daughter, a senior in high school, had dropped by nearly 50% in 2008. My friend and her husband were facing a tough choice: They could either tell their daughter to look at cheaper schools or they could try to finance tuition at a more costly college by dipping into their retirement savings or asking their daughter to take out loans.

Ultimately, their daughter opted to go to a public university that cost thousands less than some of the private schools she was originally eyeing. That wasn't a calamity--in fact, she was happy with her decision, and the school she chose is highly rated. However, this family's predicament was a common one. The reason? As their child approached college, they hadn't steered enough of their 529 portfolio toward cash and bonds, thereby exposing their college kitty to the stock-market's dramatic downturn. (Some 529 college-savings plans also featured poorly performing investments that were supposed to be conservative but in reality were anything but, including bond funds that were loaded with risky derivative securities.)

When it comes to selecting specific investments for a college portfolio, asset allocation is every bit as crucial--if not more so--than it is for retirement savers. Retirement dates can be a little squishy: Although they may not do so happily, retirees can delay retirement or work part-time longer than they had originally planned if their retirement portfolios come up short. Most young people, on the other hand, want to go to college right after high school, making the target date for a college fund much more specific than is the case for a retirement portfolio. Moreover, because retirement may be 25 or 30 years long, retiree portfolios have time to make up lost ground if they lose money early in retirement. But because it takes most students only four to five years to get through college, a college fund's drop in value during the high school or early college years can be catastrophic.

Here are some key tips for determining an appropriate asset-allocation mix for your child's 529 college-savings account.

Look to Age-Based Options, But Conduct Due Diligence First
Because arriving at an appropriate asset allocation can be complicated for any age or goal, it's not surprising that a healthy share of the assets flowing into 529 plans is now directed toward the age-based options. Much like target-date mutual funds, age-based options contain a mix of stocks, bonds, and cash and grow progressively more conservative as your child nears college age.

If hands-off simplicity is your goal, such programs can seem like a godsend. But it's important to conduct due diligence on an age-based plan before entrusting your hard-earned college-savings dollars to it. Morningstar's new 529 plan reports make it easy to see if a given age-based 529 plan is more aggressive, more conservative, or right in line with other 529 options in that same age band. For example, prospective investors in the age-based options within Alaska's top-rated T. Rowe Price College Savings Plan can see that the asset-allocation trajectory (or glide path, in industry lingo) for investors in its age-based option is more equity-heavy than the 529 industry average at every point on the glide path. It culminates in a 20% equity stake even for 19-year-olds, versus 11% for the industry norm. T. Rowe argues that a more equity-heavy posture is necessary if college savers are to keep up with rising cost of college, says Morningstar analyst Katie Rushkewicz in her report, but would-be investors in this particular program should be comfortable with the volatility that a higher equity weighting entails.

And if your 529 plan's age-based options are dramatically out of whack with the industry averages, that's a red flag to look to another 529 plan, create your own age-appropriate portfolio using individual funds, or supplement the age-based plan with individual stock, bond, or cash holdings. Alternatively, an increasing number of plans offer age-based options that are geared toward investors with varying risk tolerances. For example, New York's 529 Program comprises age-based tracks for moderate, conservative, and aggressive investors.

Start With a Blueprint When Building Your Own
If you would like to select your own investments within the 529 framework, it's fairly simple to create a portfolio with an appropriate target allocation using broadly diversified holdings that are found in most 529 plans. The following asset-allocation parameters, based on industry averages for age-based target-date funds, provide a good starting point for most do-it-yourself college savers.

Note that these are just baselines, and you should customize your own 529 asset allocation based on your own situation. You'll notice that the allocations for children who are in their teens and in college are very conservative--predominantly bonds and cash. That means that your college fund won't grow much once your child is in that age range, but nor will it suffer a big drop. If you're just beginning to build a college fund for a child who's within five or six years of college, it's wise to stick with safe investments and know that you'll have to make up any shortfalls in your college portfolio by saving more, obtaining financial aid, or taking out loans. By all means, avoid building a more stock-heavy portfolio in an effort to make up for lost time; the risks of doing so are simply too great.

On the flip side, if you're one of the (rare) individuals who has socked away enough to cover four years of expenses at the school of your child's choice, there's no need to lose it by holding stocks in your child's college fund. Conservatism should be your watchword.

Schedule Regular Checkups
Making your college fund more conservative as your child gets closer to college age is an essential part of the process, and it's particularly important once a child is nearing or in high school. For that reason, I'd recommend doing a full checkup on your college-savings program every year. At that time, you can determine whether you need to adjust your asset allocation because your child is getting closer to needing the money.

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Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.
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