Overview
While 529 college savings plans continue to grow in popularity due to the various tax benefits afforded to most investors, discussions around selecting investments within these plans can often slide under the radar. One of the most frequently used investment strategies involves selecting a glide path option, commonly referred to as an age-based or target enrollment portfolio, where the portfolio de-risks as the year of enrollment approaches.
There are considerable differences in glide paths among 529 college savings plan providers that have resulted in materially different returns, which is not surprising given how equity, fixed income, and cash allocations within these portfolios can vary widely. However, when looking at portfolio choices that may be more appropriate for those who have children or beneficiaries who will be enrolling in school this fall or may already be enrolled, many generated negative returns. For example, in the Age 19+ age-based portfolios, target enrollment-2024 portfolios, and target enrollment-college portfolios, 42%, 29%, and 41% of portfolios had negative returns YTD (as of 03/31/2024), respectively, and 39%, 51%, and 48% of portfolios had negative returns on a 3-year annualized basis, respectively.
Therefore, while investing 529 college savings plan funds in a glide path strategy can be the appropriate decision from a portfolio construction standpoint, it becomes less attractive when interest rates are high and the primary goal for these funds shifts from growth to capital preservation.
Planning in Today’s Interest Rate Environment
If you met with a client today who told you they were planning on buying a house this year and were trying to determine how to invest or where to hold the funds they plan on setting aside for their down payment, what would you tell them? What if they were planning on buying a home within the next two or three years – would your answer change?
It wouldn’t be surprising to hear advisors suggest that the client keep those funds in “cash” and, given the current interest rate environment, they would likely recommend the client keep the funds in a high yield savings account where they could earn roughly 4-5%.
However, what if instead of allocating $70,000 (20% down payment on a $350,000 home) towards a home purchase, the client was planning on using those funds to pay tuition and room & board bills for college? If the same advice would apply here to allocate funds to cash or a guaranteed principal option given that the preservation of existing capital is a top priority, it might be time for both investors and advisors to review the investments held within portfolios dedicated to education funding.
When it comes to saving for college, one of the more popular options yet still underutilized is investing in a 529 college savings plan. Not only do most states offer a state income tax incentive for contributions being made, but investors benefit from tax-deferred growth while the assets remain invested, and can eventually benefit from tax-free withdrawals if the funds are used to pay for qualifying expenses for which the definition has increased with the passage of new tax laws in recent years (K-12 tuition, apprenticeships, student loans, Roth rollovers – all with certain limits in place). An added benefit, especially for individuals choosing to save on their own who might not be working with an advisor is the availability of glide path options, such as age-based or target enrollment portfolios, which operate in a similar manner to how target date retirement funds do – with a gradually declining equity allocation as the beneficiary of the plan gets older/moves closer to the enrollment date when it is assumed funds from the account will start to be distributed and used to pay for qualifying expenses.
Glide path portfolios are extremely popular and can make sense to invest in when automated low-cost investment management is desired and there is enough time remaining in the investment period to benefit from potentially higher returns generated from larger equity positions held in a tax-deferred/tax-free account. However, when the time comes to actually start making distributions from these accounts, the preference for tax-deferred/tax-free growth subsides and the preference to preserve capital becomes front and center. This is further exacerbated during a high interest rate environment, especially when the opportunity exists to earn a rate of return within a guaranteed principal/money market account on a tax-deferred/tax-free basis that matches or possibly exceeds that of the education inflation rate over the past several years – tuition and fees increased 2.5% at public four-year colleges for in-state students and 4% at private nonprofit four-year colleges in 2023-2024 according to the Trends in College Pricing and Student Aid 2023 report from the College Board.
When it comes to investing in 529 college savings plans for those who will be enrolled in the fall of 2024 or those already enrolled, there are three likely options for choosing where to invest. The guaranteed principal/money market account option, which is usually offered as either a bank deposit account or stable value account option, a target enrollment portfolio such as target enrollment-2024 portfolio or target enrollment-college portfolio, or a slightly different version of a target enrollment portfolio referred to as an age-based portfolio (Age 19+ for example).
While having funds allocated to any one of these portfolio types may seem appropriate given a client’s tolerance and capacity for risk, we find that a large percentage of the non-guaranteed principal/money market account portfolios actually had negative returns when looked at both from a YTD perspective (01/02/2024 – 03/31/2024) and over a 3-year annualized return perspective. This is primarily driven by equity, fixed income, and cash allocations within these portfolios, which can vary widely on a state by state plan basis, and the fact that high interest rates negatively impacted fixed income investments over the past three years.
We find that in the Age 19+ age-based portfolio, target enrollment 2024, and target enrollment enrolled portfolios, 42%, 29%, and 41% of portfolios had negative returns YTD, respectively, and 39%, 51%, and 48% of portfolios had negative returns on a 3-year annualized basis, respectively.
Bottom Line
Investing in glide path portfolios can be a smart choice for investors, but when it comes to portfolio construction and asset allocation during the distribution phase of college planning when the need for capital preservation is high, selecting money market portfolios that provide principal protection plus interest at rates similar to what can be earned in taxable high yield savings accounts may be more appropriate and are even more attractive in an environment where the rate of return that can be earned equals or exceeds the rate of college inflation and can be generated in a tax-deferred/tax-free account such as a 529 college savings plan.
Dr. Ross Riskin serves as Chief Learning Officer at the Investments & Wealth Institute, which is currently offering a CE approved college and student loan planning essentials course for financial advisors. To learn more about this course and the rest of the Investments & Wealth Institute’s offerings, please visit https://investmentsandwealth.org/.
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