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By Josh Peters, CFA and Jeremy Glaser | 05-28-2014 10:00 AM

How Dividends Can Help Toward Your College-Savings Goals

With opportunities for reinvestment and compounding income, dividends can increase the value of a college-savings portfolio faster than the broader index.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Josh Peters. He's the editor of Morningstar DividendInvestor and also our director of equity-income strategy. A new addition to his family got him thinking about the future of investment returns, and we're here to get his thoughts on that.

Josh, thanks for joining me.

Josh Peters: Good to be here, Jeremy.

Glaser: Josh, first off, congratulations on your fourth child.

Peters: Yes, thank you. It was back on April 30, a new little baby girl named Abigail Grace, very healthy at 6 1/2 pounds. She's been a really good sleeper compared with the experiences I remember with our older three kids when they were newborns. So, it's been a wonderful addition. But with that, I'm pretty sure we're done. Four should probably be enough.

Glaser: But that did get you thinking a little bit about potentially college costs. You calculated that could cost $1 million to send the four kids through four years of college. How do you think about actually how much money you really need to save to get to that $1 million figure.

Peters: Well, $1 million is an incredibly daunting figure, and that may be too conservative actually or too low. I took just a $30,000 a year, all-in cost per year, which is what some of the public universities here in Illinois are charging. Multiply that by four kids by four years, throw in a 5% inflation rate, which frankly sounds too low, and I did come up with about $1.15 million. But how do investment returns shrink that liability for me out there in the future, and I just did a little more back-of-the-envelope math and figured that, if the market could return 10% a year between now and the time Abby, the youngest, is at her final year of college, then the present value of that liability falls to about $200,000 a year. It's still a tremendous amount of money, but much more manageable to contemplate.

If the markets only returned 5% a year, over these next 20-some years that I'm looking at for planning purposes, then the present value of all these tuition bills and everything else is closer to $500,000. So, there's a huge swing there in the effective cost--meaning how much we're all going to have to save here at my house--depending on how the markets do over this extended period of time.

Glaser: But given that it's such a huge gap, how do you think about if market returns are going to be more in that 10% range or more in the 5% or less range, how do you make that kind of call?

Peters: I'm not terribly optimistic when it comes to the longer-run outlook, which I think it's good to perhaps be conservative, even a little bit skeptical when you're thinking about how fast the economy will grow and how that will translate into investment returns. But we're starting from a period where valuations are, I think, in the fair to perhaps full range. I think valuations are being supported in part by very low interest rates. In turn, the low interest rates means that it's very difficult to try to get adequate returns from long-term bonds, let alone cash or short-term bonds. 

But if interest rates go up in the future, then stock valuations may suffer somewhat, especially for some of the areas that I otherwise like in the market, like utilities and REITs, where these are good businesses for a lot of income investors to own. But, by and large, they're pretty expensive in the low-interest-rate environment. Although I'd like to think that the market can go on to do 10% a year, which you kind of think 9% to 10% is a generic long-run average for stocks, that seems to me like an optimistic appraisal. I'd really like it do that well. Perhaps a lower figure is a better planning assumption, in which case we need to save more.

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