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.