What We're Buying for College Funding

When you read a Morningstar mutual fund analyst weighing in on the best way to save for a child's education, it's a good bet that he or she is speaking from experience. That's because six in our cadre of more than 25 analysts have had children within the past six months, another analyst is expecting a child in June, and several more have children under the age of 3. So we thought it made sense, given that we recently wrote about how to pick a 529 plan and how to choose among various college-funding vehicles, to tell you what some of our analysts have done to invest for their own children.

Investing toward a child's education is every bit as complex and difficult as other types of investing, such as investing toward retirement. First, when a baby's born, the investment time horizon is long term but not as long as it is for a young worker who's just starting to invest toward retirement. Plus, the dollar goal is a moving target based on where college tuition and other education expenses will go; it's difficult to know just how much to invest. There's also an array of savings vehicles to choose from, including Coverdell accounts, 529 plans, UGMA accounts, and so forth. And yet, unlike with 401(k) plans, for instance, you pretty much have to make all the investment decisions yourself.

So maybe it's of some comfort that even people who think about such matters all day find investing toward an education to be difficult. Moreover, within our group there have been quite different solutions to the puzzle. I've polled the new parents around the department, and here are some of the things we came up with.

A Focused Fund in a Coverdell
The decision about which college-fund vehicle to use for our daughter, Megan Joy Trubey, wasn't particularly tough for my wife, Liz, and me: We quickly picked the Coverdell account over its closest competitor, the 529 plan. Illinois' 529 plan is poor, the state makes it tricky to invest in other states' plans, and we didn't have a massive amount of money to invest immediately (which is when a 529 comes in very handy).

Many college-savings plans feature broad diversification and marketlike exposure, and while we considered that option for Megan, we ultimately chose to invest in a high conviction fund. Either philosophy can work well, of course, but we simply decided to take a shot at beating the market with a fund that places a very great emphasis on preserving value. That latter factor held a lot of weight for us philosophically. Coverdells can hold only $2,000 per year, so we really didn't want the account to lose value. I should note that Megan's investments could become more marketlike over time.

The fund we chose for Megan is  Ariel Appreciation (CAAPX). It is and has been an  Analyst Pick for some time. (Fund Analyst Picks are free to Premium Members of Morningstar.com; for a free trial membership, click here.) Plus, an admitted perk of my job is that I get to talk with the managers of the funds I cover, including John Rogers at Ariel. He and his team have struck me as incredibly disciplined, very smart, and thoroughly committed to their craft. The fund's strategy hasn't done particularly well on a relative basis the last several years, but the fund's worst year was a 10% loss in 2002--when many funds lost 20% or more. Ultimately, it's a fund that we think will do well for Megan without taking on inordinate risk. We have already made full contributions for both 2005 and 2006, helped toward that goal by gifts from generous relatives.

Broader Funds in Coverdells
Like the Trubeys, analyst Kerry O'Boyle and his wife, Shannon, decided that the Coverdell option was superior to 529 plans for the first dollars invested for their two boys, Mason and Clark. It’s worth mentioning that Kerry, who heads up our analysis of 529 plans, has not written off those state-sponsored options; in fact, he outlined the best and worst 529 plans in the new issue of Morningstar FundInvestor. But Coverdells offer greater flexibility than do 529s in terms of spending options--you can use them for high school expenses, for instance--and investment options. And to date, investing in a 529 plan when you live in Illinois poses problems. First, the investment options within the Illinois plan are lackluster. Second, if you invest in an out-of-state plan, withdrawals are subject to Illinois state taxes.

Whereas the Trubey household went with what you might call a rifle approach (one concentrated fund), the O'Boyles have taken a shotgun approach. Mason's college-savings money is in  T. Rowe Price Retirement 2020 (TRRBX) and Clark's will go into  T. Rowe Price Retirement 2025 (TRRHX) soon. The O'Boyles prize the simplicity of a one-stop, age-based plan that provides automatic rebalancing and adjusts its asset allocation as the time horizon gets shorter. Kerry picked the T. Rowe Price funds because the components of the fund-of-funds are high-quality, actively managed vehicles. He also likes that T. Rowe's target funds are more stock-heavy than are competing funds from Fidelity and Vanguard. These target-maturity vehicles are surely an elegant solution: The O'Boyles will likely never need to pick another fund; they just need to keep sending checks.

The O'Boyles currently fund the accounts with lump sums. They might look into the possibility of dollar-cost averaging, to make the process fully automated and even more hassle-free, but haven't done so to date.

Analyst Andy Gogerty and his wife, Colleen, have also opted for a T. Rowe Price fund in a Coverdell account for their daughter, Kailan, and they have chosen an auto-invest strategy. Each month a specific amount will come out of their checking account and go into the Coverdell. There are some key advantages to doing so. On the practical side, it's passive: The money gets invested automatically unless you stop it. So, you can't forget to send a check, and when the market's behaving poorly, it remains disciplined. Plus, over time, you will buy more shares when the market has gone down and fewer shares when the market has gone up; you can think of that as a sort of automatic opportunistic plan. Andy notes that a key reason they liked T. Rowe Price is that there was no minimum to open the account, and it has a low minimum for monthly contributions (it's $50 per month).

The Gogertys selected the  T. Rowe Price Personal Strategy Growth (TRSGX) for Kailan. Like the firm's target-maturity funds, it's managed by a collection of T. Rowe Price managers, but here it's an investment committee managing in concert, not a fund-of-funds. And its asset allocation doesn't change over time; it will consistently remain a largely stock-based fund. The Gogertys did like the fairly small bond slice, however, because it tamps down volatility and increases diversification marginally.

The Gogertys will probably consider a 529 plan in the future. It's especially important to realize that parents can invest in both a 529 plan and a Coverdell account. Indeed, all of the families profiled here would consider a 529 plan in the future, especially given that it can be a great deal for grandparents looking to gift assets.

Going the 529 Route
Unlike the other analysts I polled, analyst Laura Pavlenko Lutton and her husband, Josh, did choose 529 plans for their two boys. They saw it as the best long-term plan for them, and a key reason is that they can make monthly contributions and also add windfalls and gifts from family without worrying about going over the $2,000 contribution limit of Coverdell accounts.

The Luttons lived in Massachusetts in 2002, the year Ted was born. Remarkably, given the prominence of money management in that state, there was no tax incentive to choose the Massachusetts 529 plan. So they chose the New York plan, which now offers a number of Vanguard offerings. By the time Cal arrived in 2004, the Luttons had moved to Illinois, but they enrolled Cal in the Utah plan because that state's program had very low costs for its own Vanguard offerings. Laura reports that at some point they'll probably transfer Ted's assets to the Utah plan as well.

As far as investment elections go, it's pretty straightforward for Cal and Ted. The Utah plan is age-based, so Cal is in the 0-3 bracket, with 95% in an S&P 500-like index fund and 5% in a total bond index. The New York plan is also age-based, but with conservative, moderate, and aggressive asset allocations with each age group. Within the 0-5 year bracket, the Luttons have chosen the Moderate allocation, which is 65% equities and 35% bonds. A big part of that equity stake is in  Vanguard Total Stock Market Index (VTSMX).

Laura notes that it will be interesting to see how these plans do over time. Cal's allocation is more aggressive, but he's missing the smaller-cap exposure. Meanwhile, Ted has a stout bond exposure that could hold his portfolio back a bit--and it could also provide stability in an equity bear market.