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How Should Baby Bonds Be Invested?

These tools hold enormous promise, but there are some implementation challenges.

The road to implementing a baby bonds program doesn't come without obstacles. But the positive impact they'll have is worth putting in the required work.

In a recent column, I summarized new Morningstar analysis on baby bonds. Our conclusion was that a program in which the government contributed to children’s accounts based on their families’ incomes could help dramatically reduce the racial wealth gap and help to level the playing field for children as they turn 18 and became independent.

Protections and Guidance The biggest policy challenge is the need to balance implementing guardrails with enough flexibility so that children can use their baby bonds at age 18 to invest wisely. Most baby bond proponents focus on using the money for higher education and housing, but it would also be helpful to have off-ramps for investing in securities.

The current proposed legislation would stand up a new regulatory body to define acceptable uses that “provide long-term gains to wages and wealth,” but there is no defined way to invest the funds. Indeed, the path of least resistance for an 18-year-old who wishes to set aside money for retirement would simply be to leave some money in their baby bond account and withdraw it at age 59.5.

However, given that long an investment time horizon, it would make sense to take risks with the possibility of much greater returns by investing in a mix of bonds and stocks that gradually shifted to more bonds, as is common for most retirement savings.

At a minimum, we think that it should be easier to roll money into a Roth IRA, but that creates another challenge: ensuring there are sufficient protections for young adults with larger baby bond balances.

Furthermore, we believe that baby bond legislation should establish fiduciary protections for baby bond recipients to ensure they receive high-quality advice on investing their accounts after turning 18. Policymakers need to do a lot more thinking about adding protections to ensure that participants invest in low-cost, high-quality options.

We believe the prohibited transactions embedded in the Employee Retirement Incomes Security Act, the prudential standard under ERISA, and the SEC investment advisor fiduciary duties of care and loyalty are appropriate frameworks to use when developing these protections.

Aligning Baby Bonds with 529s Baby bonds also need to be better aligned with existing savings vehicles for children, particularly 529 plans. State treasurers run these tax-privileged college savings plans, and they will continue to market them even if baby bonds become law.

While 529 plans are of less benefit to lower-income families (who in turn have the highest balances), our analysis reveals that the median baby bond accountholder will have $13,700 by age 18. Many of these accountholders will be from middle-income families, or at least families that have often been middle-income, who might be interested in investing in other vehicles alongside using baby bonds to pay for college.

Policymakers, particularly at the state level, should consider aligning their 529 investment options and marketing with baby bonds. That could encourage families use both a baby bond account and a 529 for college savings. As baby bonds are, by design, invested without risk, families could potentially take more investment risk in a 529, secure in the knowledge they would have a baby bond to fall back on when it came time to pay for college.

Weighing Return Versus Risk Speaking of risk, policymakers need to determine whether they want this program to principally focus on equity or whether they are willing to allow baby bond holders to bear risk to potentially get larger returns, thus potentially further reducing the racial wealth gap.

There will be pressure on policymakers to do so during bull markets, as families investing in public markets see their wealth (and resources for their children) rocket ahead of families that primarily rely on baby bonds. There may be disappointment during bear markets if lower-income families see their wealth in these government-sponsored accounts melt away.

The timing issues riskier strategies create, in which different children born a few years apart have very different account balances upon turning 18, may make the program seem less fair. This would be particularly true for siblings in the same family.

However, policymakers need to develop a clear rationale for why these accounts should be invested in riskless, lower-return assets, or establish clear guidelines around introducing risk into these accounts.

Baby bonds have enormous promise. Challenges for implementing them are no reason to give up. But it is important to be clear-eyed about the messy parts of implementing such a program and ensuring they balance competing needs and mesh with existing policy.

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About the Author

Aron Szapiro

Head of Government Affairs
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Aron Szapiro is head of retirement studies and public policy for Morningstar. Szapiro is responsible for developing research reports on policy matters, coordinating official responses to regulatory proposals, and providing investor-focused comments on policy issues to clients and the press. He also chairs Morningstar’s Public Policy Council. Szapiro also heads the Morningstar Center for Retirement Studies. His research has been covered in The New York Times, The Wall Street Journal, The Washington Post, The Journal of Retirement, and on National Public Radio.

Before assuming his current role in June 2021, he served as Morningstar’s head of policy research and as policy and finance expert at HelloWallet, a former subsidiary of Morningstar. Previously, he was a senior analyst at the U.S. Government Accountability Office (GAO), specializing in retirement security issues and pension plan policy. He also worked at the New Jersey General Assembly Majority Office.

Szapiro holds a bachelor’s degree in history from Grinnell College and a master’s in public policy from Johns Hopkins University.

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