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How to Allocate College Savings

Families must deal with tough challenges: steep glide paths and high inflation.

Christine Benz, 01/09/2014

If you take a minimalist approach to college-savings planning, it may be tempting to buy a good-quality balanced fund and call it a day. But before you invest your college savings in anything, it’s worth considering how investing for college is different than saving for that other long-term goal: retirement. Those differences, in turn, argue for taking a more hands-on approach to asset allocation than a balanced fund would allow.

1 Know the Time Horizon
In contrast with retirement, a child’s college-matriculation year isn’t a negotiable date. A person who encounters a bear market shortly before retirement may have some wiggle room to keep working or rely on other sources of income to avoid tapping his or her nest egg at a low ebb. By contrast, try telling an 18-year-old to wait until age 21 to start school.In addition, the time horizon for saving for college is much shorter than is the case for retirement, as is the time horizon for spending those assets. One might save for retirement for 40 years or more and be retired for another 30 or 35 years. By contrast, savers have less than half that amount of time to amass the funds needed for college, and if all goes well, they’ll spend down those assets quickly—in four years or so.

2 Be Smart With Asset Allocation
Both of those facts call for a much steeper “glide path”—the gradual shift to more conservative investments—in the years leading up to and during college than the typical glide path for retirement. A college portfolio’s asset allocation should begin downshifting into cash and bonds when the child is in grade school and the portfolio should be dominated by bonds by high school. That’s because an equity-heavy college fund that encounters a bear market in the years leading up to college could incur losses that it couldn’t recoup during the student’s time horizon. Even parents who worry that they’re grievously behind on college savings should resist the urge to swing for the fences by maintaining a too-high equity allocation too long.

3 Monitor the Impact of Inflation
The risks of being too conservative also loom large. Inflation is a major foe for college savers, and a portfolio heavy in bonds and cash could have trouble keeping up with rising tuition costs. College costs have been increasing at a rate more than 3 percentage points greater than the general inflation rate during the past few decades, notes Morningstar head of retirement research David Blanchett. If college costs continue to outstrip general inflation by that margin, college savers will be contending with a 5.5% inflation rate. Extremely conservative asset-allocation plans are going to have difficulty matching the rate of college inflation.

4 Is Prepaying an Option?
Blanchett says that prepaid 529 plans, which allow you to lock in today’s tuition levels by paying in advance, may be a better option for families who would otherwise maintain a very conservative asset-allocation mix. “If someone is relatively certain their child is going to attend an in-state school, and there is a prepaid state savings plan and the individual would otherwise invest conservatively in a 529 college-savings plan, it may make the prepaid plan more attractive,” he says. Blanchett notes, however, that the trade-off doesn’t factor in the tax benefits that can accrue to investors in 529 college-savings plans. Alternatively, investors might use a 529 college-savings plan but make sure that plan includes at least some inflation protection—albeit not a direct hedge against college costs—such as Treasury Inflation-Protected Securities.

5 Compared and Contrast
Finding the right asset allocation for college is difficult, so it’s probably no wonder that 529 plan age-based options have historically held the lion’s share of assets. But the age-based plans also vary widely in their glide paths, and plans are increasingly offering multiple options for a given age band. That makes it important to conduct due diligence on a plan’s assetallocation framework and see how it compares with other options within that same general age band. If it’s an outlier, make sure you understand and agree with the rationale that its managers use for diverging from the peer group. The overview tab of Morningstar.com’s 529 plan reports provides a look at how each state’s age-based glide path compares with the 529 averages for that same age band.

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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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