Families must contend with competing challenges: steep glide paths and high inflation.
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By Christine Benz | 10-21-13 | 06:00 AM | Email Article

Note: This article is part of Morningstar's November 2013 Investor Starter Kit special report. This article originally appeared Oct. 21, 2013.

Christine Benz is Morningstar's director of personal finance and author of 30-Minute Money Solutions: A Step-by-Step Guide to Managing Your Finances and the Morningstar Guide to Mutual Funds: 5-Star Strategies for Success. Follow Christine on Twitter: @christine_benz and on Facebook.

Finding the right asset allocation--or mix of investments--for college can be a tricky business. If you're a minimalist, it may be tempting to buy a good-quality balanced fund and call it a day. Especially if you're just starting out and the assets in the college-savings plan are still small, it may seem like overkill to manage a college portfolio with lots of moving parts. 

There are certainly worse ways to go about saving for college (life insurance, anyone?). But before you invest your college savings in anything, it's worth considering how investing for college is different than saving for that other long-term goal, retirement. Those differences, in turn, argue for taking a more hands-on approach to asset allocation than a balanced fund would allow. Nor do target-retirement vehicles fit as one-stop options for college savers.

Time Horizons Truncated
In contrast with retirement, your child's college-matriculation year isn't a negotiable date. A person who encounters a bear market shortly before retirement may have some wiggle room to keep working or rely on other sources of income to avoid tapping his nest egg at a low ebb. By contrast, try telling your 18-year-old that he'll have to wait until age 21 to start school so that his college fund will have time to recover.

In addition, your time horizon for saving for college is much shorter than is the case for retirement, as is the time horizon for spending those assets. One might save for retirement for 40 years or more and be retired for another 30 or 35 years. By contrast, you have less than half that amount of time to amass the funds needed for college, and if all goes well, you'll spend down those assets quickly--in four years or so, or perhaps a few more if you're also footing the bill for graduate school. 

Both of those facts call for a much steeper "glide path"--the gradual shift from more volatile investments such as stocks to more conservative investments such as bonds--in the years leading up to and during college than the typical glide path before and during retirement. (Morningstar's Adam Zoll discusses these glide-path differences here.)

A college portfolio's asset allocation should begin downshifting into cash and bonds when the child is in grade school, and the portfolio should be dominated by bonds by the time the child is in high school. That's because an equity-heavy college fund that encounters a bear market in the years leading up to college could incur losses that it couldn't recoup during the student's time horizon. Even parents who worry that they're grievously behind on college savings should resist the urge to swing for the fences by maintaining a too-high equity allocation too long. (That's likely a great temptation for college savers right now, as equity markets have been performing terrifically while bond performance has been underwhelming.) 

Inflation a Bigger Foe
Yet college savers must strike a tricky balance because the risks of being too conservative also loom large. Inflation is a major foe for college savers, and a portfolio heavy in bonds and cash could have trouble keeping up with rising tuition costs.

College costs have been increasing at a rate more than 3 percentage points greater than the general inflation rate during the past few decades, notes Morningstar head of retirement research David Blanchett. If college costs continue to outstrip general inflation by that margin, college savers will be contending with a 5.5% inflation rate.

Given that current yields have historically been a good predictor of future bond returns--and the Barclays Aggregate Bond Index, which serves as a broad bond market benchmark, is currently yielding 2.4%--investors with extremely conservative asset-allocation plans are going to have difficulty matching the rate of college inflation. 

Blanchett says that prepaid 529 plans (learn more about the different types of college-savings plans), which allow you to lock in today's tuition levels by paying in advance, may be a better option for families who would otherwise maintain a very conservative asset-allocation mix in their 529 college-savings plans. "If someone is relatively certain their child is going to attend an in-state school, and there is a prepaid state savings plan and the individual would otherwise invest conservatively in a 529 college-savings plan, it may make the prepaid plan more attractive," he says. 

Blanchett notes, however, that the trade-off doesn't factor in the tax benefits that can accrue to investors in 529 college-savings plans. Alternatively, investors might use a 529 college-savings plan but make sure that plan includes at least some inflation protection--albeit not a direct hedge against college costs--such as Treasury Inflation-Protected Securities.

Finding a Baseline
Given the specific considerations that should go into a college-savings allocation plan, it's probably no wonder that the age-based options within 529 college-savings plans have historically held the lion's share of assets. Age-based options aim to provide age-appropriate asset mixes that gradually become more conservative over time, and in so doing they take the onus off of parents and other family members to arrive at an optimal asset mix and to provide ongoing oversight of a portfolio of individual holdings. 

But the age-based plans also vary widely in their glide paths, and plans are increasingly offering multiple options for a given age band: conservative, moderate, and aggressive. That makes it important to conduct due diligence on a prospective plan's asset-allocation framework and see how it compares with other options within that same general age band. If it's an outlier, make sure you understand and agree with the rationale that its managers use for diverging from the peer group. (To further aid in the due-diligence process, Morningstar will be launching a series of 529 indexes later this year.)

The overview tab of Morningstar's 529 plan reports provides a look at how that state's age-based glide path compares with the 529 averages for that same age band. For example, the Gold-rated Maryland College Investment Plan, managed by  T. Rowe Price Group , has a heavier equity weighting than its peers across age bands. 

Even families who aren't using an age-based 529 option can still use 529 glide paths to help get their own plans' asset mixes in the right ballpark. In the table below are the median equity, bond, and cash weightings for each of Morningstar's medium-equity (that is, moderate) age-based 529 categories. You can see that the plans start out with the majority of their assets in equities, then gradually become more conservative over time.

Median 529 Portfolio Weightings for Moderate Allocation 
 
Children's Ages
U.S. Stocks
Foreign Stocks
Bonds
Cash
Just Starting Out
0-6
53%
24%
18% 3%
Elementary School
7-12
37%
16%
38% 4%
Junior High and High School
13-18
23%
9%
52% 6%
The College Years
19+
12%
5%
52% 28%

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