529 Plans: Age-Based Options Don’t Make Sense

January 4, 2010 by TFB

A new-born niece came into my extended family recently. I got the task for looking into setting up a college education fund for her.

I know about 529 plans. Every state has at least one plan. Some states have several plans. I quickly identified Ohio CollegeAdvantage 529 plan as the best plan for my niece. Her parents live in a state that does not give a tax deduction for 529 plan contributions. They can use a plan offered by any other state. The Ohio CollegeAdvantage 529 plan has low cost Vanguard index funds.

Like many other 529 plans, the Ohio CollegeAdvantage 529 plan offers age-based investment options. There are actually four age-based options, three of which offer exclusively Vanguard funds. Within the Vanguard age-based options, there are conservative, moderate, and aggressive tracks. Here’s how the middle-of-the-road Vanguard Moderate Age-Based Option will invest:

At a first glance, age-based options seem to offer convenient, expert-constructed balanced portfolios. They are modeled after the target date funds for retirement. As the child gets closer toward college age, the assets are automatically shifted into less risky investments. However, when I think about them a little more, they don’t make sense to me.

Take the transition at age 6 for example. Switching from 75% stocks 25% bonds to 50% stocks 50% bonds means selling 25% of the portfolio from stocks to bonds. With regard to that 25% of the portfolio being sold from stocks to bonds, assuming annual contributions at the beginning of each year, the longest time the contributions stayed in stocks is six years. The shortest time is just one year (contributed at age 5). Investing in stocks for just one year before selling for bonds is too much a gamble.

Even six years isn’t that long. Suppose the stock market doesn’t do well in the first six years but it does well in the next five years. You eagerly invest 75% in stocks for six years, but you are forced to sell down to 50% in stocks when the child reaches age 6, only to see the stock market taking off afterwards. You get the double whammy. You are much better off keeping 62.5% in stocks until age 11. Then it doesn’t matter if stocks do better in the first six years or the second five years.

This transition pattern is not unique to the Ohio CollegeAdvantage 529 plan. Age-based options in other 529 plans work pretty much the same way. There are some age brackets. When the child reaches a milestone, you sell stocks for bonds and you sell bonds for cash. In effect, some of your investments in stocks stay in stocks for only a few years before you sell.

Besides the transition problem, I think even the Moderate option is too risky.

When we invest for retirement, the age-in-bonds rule of thumb says to invest for retirement at age 65, a 25-year-old should have 75% in stocks and 25% in bonds. That’s a 40-year time frame until retirement, plus another another 20 years for drawing down. Here we have a child needing college money in 15-20 years investing 75% in stocks. That’s equivalent to a 55-year-old investing 75% in stocks for retirement. And they call it moderate?

After the child enrolls in college (age 19+), the entire college fund is about to be spent in four years. The average dollar in the fund has only two years to go. However the “moderate” age-based option is still 75% in intermediate term bond funds. That’s not moderate. That’s gambling on interest rates.

Investing for college is much harder than investing for retirement. The timeframe is much shorter. The drawdown is much faster. The investment strategy has to be much more conservative than investing for retirement because there is simply not much time to make up for losses. I will not use the age-based options at all.

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Comments

12 Comments on 529 Plans: Age-Based Options Don’t Make Sense

  1. DS on January 4, 2010 | permalink
     

    What do you think is a prudent allocation b/w stocks, bonds and cash in a 529 fo a newborn child, and how would you reallocate over time?

  2. Mike Piper on January 4, 2010 | permalink
     

    I was recently looking into Illinois’s 529 plan (which also uses Vanguard funds) and came to the same conclusion.

    It seems that the plans are based upon a simple miscalculation of holding period.

  3. Austin Frakt on January 4, 2010 | permalink
     

    I agree 100%. When I came to these conclusions myself I dropped out of the VG age-based options and constructed my own 529 AA that made more sense to me. I only wish I had thought this through years ago when I begin those investments (i.e. before the crash).

    It is good to be reminded that not all things VG are good. They do some dumb things like every other company. Investor beware!

  4. Wai Yip Tung on January 4, 2010 | permalink
     

    Thank you for calling out this problem. I picked age based option because that’s what I choose for my 401k. I though this would be a no-brainer. Now I have to rethink.

    The other expert advice I got is one should max out your 401k before contributing to 529. It wasn’t obvious to me at the first glance. But consider the relative short span of the plan (to be draw down in some 20 years), and consider the your recent post about “money is fungible”, it is making very good sense to me.

  5. Andy Chan on January 5, 2010 | permalink
     

    I live in California, which doesn’t seem to offer tax deduction for 529 contribution. Does that mean I can get the same tax benefit from investing in any state’s 529 plan (i.e. no federal or state tax on the earnings)?

    I see that you recommend the Ohio CollegeAdvantage 529 plan for your niece. Other than the low cost Vanguard index fund, are there any other reasons?

  6. TFB on January 5, 2010 | permalink
     

    Andy – Yes for the first question; no for the second. Other than difference in investment options offered, all 529 plans are alike. You can read more and compare 529 plans at savingforcollege.com.

  7. Ted Valentine on January 6, 2010 | permalink
     

    I use Ohio’s 529 because its low cost and has a low entry level and allows a low contribution amount. I also do not like the age-based options and never had for the same reasons. They don’t make sense.

    I use the Wellington fund option. When they get in High School I will start looking at moving chunks over to a money market or CD option.

    College is so expensive that it is not within reason for me to pay for all my children on my income. Therefore I will be agressive for >10 years with the hope that there will be significant appreciation of the funds above the rate of college inflation. If that fails, then sorry kid borrow more money and get good grades so you can pay it back.

  8. GrandArch on January 8, 2010 | permalink
     

    I’m not sure about TFB’s point of maintaining a 62.5% share in stocks being the solution. You’re saying that contributions prior to any period N when adjustment occurs will only have N – k years, where k is the year a contribution was made. So whether that’s at year 5 or year 10, the effect still occurs, though presumably it’s for a smaller share of the portfolio when the adjustment occurs in year 10.

    I’d theorize that it might make sense instead of immediately selling off shares to do a more dynamic change – to change the allocation of contributions instead of the underlying portfolio before this kind of break were to occur. This would allow contributions made in year N-1 to continue growing. I haven’t run the numbers on various scenarios to see if a you could achieve that kind of large change in asset allocation in only a few years, however. Nor am I familiar enough with the dollar cost averaging theory to know if it would be undermined by significantly reducing contributions to stocks. If others have any thoughts…

  9. TFB on January 8, 2010 | permalink
     

    GrandArch – Sorry if I wasn’t clear about the 62.5%. I was only referring to the contributions at age 0. At age 9, you wouldn’t put 62.5% in stocks and then sell them off at age 11. I’m with you on varying the allocation for the contributions, not the assets.

  10. Scott on January 11, 2010 | permalink
     

    What is your opinion on Lifecycle funds for retirement purposes not college?

    Some further information:
    I am 34, and my company has negotiated a nice deal with our provider for a taylored made (not open to the public – no ticker symbol) lifecycle 2040 fund with a very low 0.10% expense ratio. I was thinking of contributing to take advantage of this “deal” and wanted to know your opinion.

  11. TFB on January 11, 2010 | permalink
     

    Scott – Lifecycle funds for retirement are fine. They ratchet down more slowly.

  12. Zak on January 28, 2010 | permalink
     

    Be somewhat wary of the very lowest fee options available in plans. Often these can be indexed funds, which is just fine, but what you need to make sure of is that they expand beyond just the S&P 500 index into other indexes as well. The reason being that the S&P 500 index is not diversified; it is simply diversified across large cap stocks (which is only one asset class). The Callahan Periodic Table of Market Returns (http://www.callan.com/research/download/?file=periodic/free/360.pdf) will demonstrate that being invested in only one index (such as the S&P 500) will lead you down an unhappy road of extreme volatility.

    Also, remember not to jump over dollars for dimes. Low-fee investments don’t do a lick of good unless they actually perform (which usually entails some degree of active management). If you have ticker symbols available, a good way to compare investments is just to go to a website like Google Finance and compare some of the standard metrics (alpha, beta, etc.) There are some higher fee investments that blow less actively-managed investments out of the water based on performance. There are also some higher fee investments that are absolutely garbage if you look at their history. Same thing for low fee investments. A simple alpha/beta analysis will usually help you to look past fees (whether they are high or low) to get an actual understanding of relative performance against similar investments.

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