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

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

  1. DS says

    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 says

    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 says

    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 says

    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 says

    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. Harry Sit says

    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 says

    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 says

    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. Harry Sit says

    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 says

    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. Zak says

    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.

  12. Jason Reaves says

    Your main point – that the age-based funds are too risky given only a 20 year horizon – may be correct. However, I disagree with some of your reasoning. You suggest that poor stock market performance during the first six years would be mitigated by keeping assets in stocks longer. (You say, “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.”) Sounds like the gambler’s fallacy to me. The fact is that stocks could just as easly stagnate or even continue to slide over the ensuing 5 years. The longer you keep assets in stocks, the greater the risk (and expected rate of return). To decrease risk, shift assets from stocks to bonds and/or cash sooner; don’t double down on stocks in hopes of a market turnaround.

  13. Harry Sit says

    Steve – It’s not too late, especially if you get a state tax deduction from contributing to a 529 plan. Just make sure you select a safer investment option. For example the Ohio CollegeAdvantage 529 plan I mentioned in this post offers FDIC insured CDs.

  14. B says

    What are your thoughts on Utah’s 529? I read an article that compared Utah’s to Ohio’s. She has a good chart comparing the investment timelines of both.

  15. Harry Sit says

    B – Utah’s 529 plan is also a good one. In terms of age-based investment options though, some in the Utah plan are even more aggressive than the ones in the Ohio plan.

  16. AK says

    I ive in OH and will be investing in the College Advantage Plan. I have three children under the age of 5. I was thinking the age-based plan was too risky. My intuition tells me to go with the Vanguard Conservative Growth Fund (Balanced Options – mix of stocks and bonds) and when the market gets a little better switch to Vanguard Moderate Growth Fund still Balanced Option. I noticed the Vanguard Wellington Option looked good as well but has a higher fee. Is the balanced approach better and is conservative to conservative?

  17. Zak says

    @AK

    When the market gets better?The DOW is above 11,000 this week, so I don’t know what your definition of “getting better” is. Right now we are probably either at a peak before another swing down or finally starting the long (and probably quite volatile) track back up the mountain, but I don’t think many people could predict which.

    What I am saying here is to stick to your fundamental risk tolerance. If you have a low tolerance for risk, stick with the conservative growth fund. My guess is that with kids under the age of 5, the “typical investor” in your situation would sway more towards moderate growth, but at the same time you shouldn’t necessarily follow the typical investor. If market volatility keeps you up at night, just go for the conservative option.

    One last point on the Wellington option. First, don’t jump over dollars for dimes. One of the main concepts that are pushed on personal finance sights is that higher fee funds are bad. That’s a total pile of BS. Funds report performance net of fees… they are required to by law. So, all other variable being equal, if one fund has a higher 10 year performance record (with higher fees) than another fund (with lower fees), why would you even consider the second fund?

    Anyways, second point on the Wellington fund. That is a straight up growth fund, with only 30-40% of its assets invested in fixed income securities. It also has 1, 3, and 5 year betas that are higher than 1, which means that in almost every time period (except for the 10 year time frame) it has had HIGHER volatility than the S&P 500. So basically, it has produced pretty great returns, but at a trade off for slightly higher volatility than the S&P. So, not really the best fit from a risk standpoint if you are hesitant to even go for a moderate growth fund. The moderate growth fund is more conservative than Wellington.

  18. Harry Sit says

    AK – I decided to start off with 45% in stocks, 55% in bonds at age zero. That’s close to the moderate option you mentioned, but it’s for a child at birth. Every year thereafter I will reduce the % in stocks by 3 percentage points: 30% in stocks at age 5, 15% in stocks at age 10, 0% in stocks at age 15. When the child is 15 I will switch to CDs.

  19. cd says

    hi guys –

    i have 529 nevada through usaa/ age based , my kids are now 14 yo , with the volatility of the market, im scared there wont be money left there in 4 years? should i change it to preservation of capital? please please feedbacks!

  20. Harry Sit says

    @cd – Yes I think at age 14, the age-based allocation in USAA’s Nevada 529 plan is too risky. It invests 47% in stocks when the money is needed in 4-7 years. The Preservation of Capital looks better if you must stay in that plan. Otherwise you may want to consider a plan that offers CDs or fixed income options, for example Ohio (FDIC-insured CDs) or Michigan (TIAA-CREF Principal Plus Interest).

  21. Mike says

    If you don’t like the typical age based allocation of 529 plans but want the simplicity of the shifting allocation and low expenses, folks may be interested in a recent change to Utah’s 529 plan. In addition to lowering the asset fee from 0.22% to 0.20% (which is in addition to fund fees – but those funds are institutional Vanguard funds like total stock market at .02% ER.. so overall it is still cheap) they now offer the ability to create your own age based plan and it will automatically adjust at the age brackets. Take a look at possible options and the fee calculator : http://www.uesp.org/Investment-Info/Customized-Age-Based-Fee-Calculator.aspx

  22. Vicki says

    I am looking for a 529 for both of my children. One is 8 and the other is 6. Please tell me what to choose. I am looking at Utah’s plan as it seems it has a good longer term return as well as short term so far and it has low costs. I live in CA so there is no tax incentive to invest within CA. I was just about to enroll in an age based plan here but pulled up your page before I signed on the dotted line. Help!! I just want this over with. I thought I had looked at all options and was satisfied with my decision until I read your article.

  23. Will says

    Hey guys, I set up an account with collegeadvantage exactly 1 year ago when my daughter was about to turn 1. I’ve been doing automatic contributions of $100 to the VAAB age based aggressive option. She’s about to turn 2 and decided to do a little more research….I don’t have a very strong background in investing. I was thinking of doing:

    20% VAAB (Vanguard Aggressive Age Based)
    40% OMSS (Oppenheimer Main Street small and mid cap option
    40% some other 100% stock risky investment

    I’d like to be pretty risky for her first few years.
    Maybe I should abandon the VAAB altogether? I need help! lol I want risky but the stocks that I buy that are risky – I want to stay in my account for over a decade.

  24. Will says

    Excellent article and recommendations TFB :) And thanks for the quick reply! One last question…When my daughter turns 3 and I adjust…should I simply change my future monthly contributions to reflect the new risk change from then until she turns 5 or pick up my entire portfolio and reallocate all I have invested so far and drop it all down on the new risk allocations?

  25. Harry Sit says

    Will – If you decide to follow the allocations as I outlined, that means both new money and existing money will go to the new allocation when the child’s age hits the next age group.

  26. DanaS says

    I am having trouble with balancing the risk that the investment will not grow quickly enough to keep up with the rate at which college tuition is increasing versus the risks of a volatile investment in stocks. The short time horizons seems to call for a more conservative investment strategy, but the rate of tuition increase seems to call for a more aggressive strategy.

    I have done some reading on Pennsylvania’s guaranteed savings, but I have concerns that this plan is not backed up by the state if the plan does not have enough assets to meet its obligations.

    Thoughts?

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