Parents getting schooled on 529 plans as kids return to campus

American parents are receiving an unwelcome lesson on 529 plans just as they're dropping their kids off on campus.

The stock market slide that started in January hasn't been pleasant for anybody, but it’s been most disagreeable for those with kids heading off to college this fall. That’s understandable of course. Nobody who's been saving for such a marathon length of time — potentially 20 years or more — likes to see their investment stumble so close to the finish line.

That said, it’s not the pain from the equity portions of those 529 plans that’s most acute. That’s because 529 plans have glide paths that tilt from stocks toward bonds as the child, and the account, matures.

For example, the New York state aggressive age-based 529 plan option for children aged 0 to 4 holds 100% of its assets in stocks. Sixty percent of that total allocation is held in the Vanguard Total Stock Market Index Fund, which is down 14.5% year-to-date, and the remaining 40% is in the Vanguard Total International Stock Index Fund, which is down 16.25% year-to-date.

Obviously, this is not the push off the dock a parent wants when it comes to saving for their child’s education. Nevertheless, those accounts have many years to recover from that disappointing start.

The same can’t be said, however, for kids aged 17 and 18. For these budding scholars, it's crunch time because they will soon be starting their freshman year, which is why the plan evolves over the years into something more bond-heavy and, supposedly, secure.

The New York state aggressive age-based 529 option for 17- and 18-year-olds, for instance, holds 75% of its assets in Vanguard bond funds and the remaining 25% in Vanguard stock funds. At last check, 52.5% of that fixed-income allocation was in the Vanguard Total Bond Market II Index fund.

Unfortunately for parents preparing to pack their kids' belongings into the station wagon, the Vanguard Total Bond Market II Index fund is down 9.5% year-to-date.  

Ouch! Talk about learning the hard way.

“The investment guidance given to 401(k) plan participants and 529 plan participants has been flawed," said John H. Robinson, founder of Financial Planning Hawaii. 

"Most of the educational literature paints stock mutual funds as volatile and risky while bond mutual funds are depicted as stable and safe with lower but constantly positive returns," he said. "That mantra rang true for most of the last 40 years in which bond values have benefited from the long steady decline in interest rates from their peak in the early 1980s. What investors are now beginning to realize, is that bond mutual funds lose value when interest rates rise."

Robinson stresses to his clients that saving for college is very different from saving for retirement. Upon retirement, most investors can withstand some modicum of portfolio volatility because their savings are managed and invested to last for a distribution period of 25 years or more. On the other hand, there's a lot less room for volatility in saving for college because the money typically needs to be spent over just a few short years.

And while it’s a phrase often said on Wall Street prior to an inevitably disastrous conclusion, there's indeed no denying that “This time is different.”

“What makes this time different is that investors who followed the conventional planning wisdom of using age-based investment options that shift 529 plan balances from ‘risky’ stock funds into ‘safe’ bond funds as matriculation approaches are seeing significant declines in age-based portfolio balances that have little or no stock market exposure," Robinson said. "People are now beginning to realize that bond funds are not the bastion of safety they were made out to be.”

Not that college savings plan providers aren’t trying to prepare for all phases of a market cycle when designing a glide path and its subcomponents, including the current environment in which both equities and bonds face challenges.

Tina Devine-Hartline, a portfolio analyst on T. Rowe Price’s college savings plan investment team, said 529 plan providers understand that bonds may underperform at times and seek to construct portfolios that can weather the ebb and flow of a full market cycle.

“Bonds play a role throughout most of our college savings glide path life cycle versus just in or near matriculation," she said. "As our portfolios shift along the glide path, we introduce a dedicated fixed-income allocation offering exposure to multiple segments of the bond market. Each of these subcomponents is expected to behave differently across a range of economic scenarios, and the allocation is included to reduce the risks typically associated with equity markets.”

Devine-Hartline added that nearing matriculation, when there is greater need for less risk and asset preservation, T. Rowe's funds do incorporate lower-volatility bond and TIPS offerings. Furthermore, they maintain a 20% strategic allocation to equities to ensure balance throughout the expected four-year time horizon for a college education.

Robinson suggests that parents currently confronting their kids’ bursar bills first assess their risk exposure, especially to intermediate and longer-term bond funds, which vary from one 529 plan to the next.

“Look at the portfolio's year-to-date return through the end of June 2022," he said. "If the portfolio is down 8% to 10% and your child is three years or less away from matriculation, you may wish to instruct the plan administrator to liquidate the age-based option and allocate the entire account to a money market or stable-value option within the plan instead."

One final note worth taking on the subject is that this year has been an investing anomaly, with pandemic-produced economic conditions creating returns that may never reappear.

Berkeley Revenaugh, vice president and portfolio manager at Franklin Templeton Investment Solutions, points out that 2022 has thus far been an outlier in that equity and fixed-income markets declining concurrently, which is a rare occurrence.

"Since 1948, only five calendar years have seen both equities and fixed income decline, year-to-date 2022 being the fifth and the highest magnitude in terms of drawdowns in both asset classes,” Revenaugh said.

Don't know much about history? Well, there you have it!