The February issue of the Edward Jones Perspective declared, “How Long Will This Expansion Last?” as did the Schwab Market Snapshot in January. This question has been posed on-and-off for years but in December 2018 seemed to peak. There were dozens of articles and commentary from USA Today, Time, Bank of America Merrill Lynch, and seemingly everyone weighed in on the impressive gains that have been made since the end of the 2008 recession in 2009. Nobody seemed to know when a correction would occur, and strong economic indicators such as low unemployment and the low volatility of the VIX – typically used as a gauge of market fear – in 2017 made predictions more difficult. Investor worry is sometimes irrational, but the markets aren’t always rational, and the first week of February’s correction wasn’t much of a surprise for many, as a result.
The problem now is whether the correction was a one-time deal, or if we should expect a prolonged market downturn. Lacking a crystal ball, investors can only prepare for the worst and hope for the best. The last time college savers experienced a market downturn was in 2008, with the crash resulting in the first decrease in total assets in the 529 marketplace since their creation by the Small Business Job Protection Act of 1996 (assets were not tracked prior to 2002). According to the CSPN (College Savings Plans Networks), the average account size of 529 plans fell from $14,932 in 2007 to $10,690 in 2008, a decline of over 28%. By contrast, the S&P 500 fell 36.55% while the Barclay’s U.S. Aggregate Bond Index rose 5.24% during the same period. 529 plan assets didn’t recover to their 2007 levels until 2010, keeping in mind that some of that asset recovery was contributions as well as appreciation.
There are a few things you can do in response to the recent down market:
- Review Your Investment Vehicle
- Get Cheap
- Reassess Your Investment Selection
- Consider A Prepaid 529 Plan
- Look to FDIC-Insured Options
Review Your Investment Vehicle
Where you put your money is just as important as in what you invest. There are several options for education savings that are tax-deferred or tax-free, which will significantly improve your potential returns. So if you’re currently using a taxable investment vehicle to save, consider instead a tax-preferred option, such as a 529 plan, Coverdell ESA, or US Savings Bonds. The difference in return potential becomes increasingly pronounced in higher tax brackets.
- 529 plans are an excellent choice for many, many reasons, including their tax benefits, flexibility, control, simplicity, and lack of income cap. There are two varieties: Savings and prepaid. Savings plans invest in the market, and returns fluctuate in-kind. Prepaid plans follow a predetermined return path that varies by sponsor. There is extensive guidance available on selecting the right 529 plan on Forbes, and from sources such as CSPN, Morningstar and Savingforcollege.com.
- Coverdell ESAs operate much like a Roth IRA, so the fees will vary depending on who provides the account, and in which underlying asset you invest. The downside is that if you earn over $110,000/$220,000 (filing individually/married filing jointly), you cannot contribute to a Coverdell ESA. The upside is that there is a wider range of investment options when using Coverdells versus 529 plans, making them attractive for savvy investors in lower income brackets.
- US savings bonds are another alternative, but also have an earnings cap. If you earn over $93,150 individually, or $147,250 married filing jointly, you cannot claim the interest exclusion for education expenses in the year you redeem your savings bond. The relative earnings potential on US savings bonds is also lower, though they could be a good option for investors feeling skittish in down markets. If you are a highly-risk averse investor, consider discussing this option with an investment professional.
Get Cheap
There are many ways to evaluate investments: Historical returns, market risk, beta, sector allocations, selection breadth, glidepaths; trying to select the right investment can become overwhelming. Morningstar has found, however, that there is no better leading indicator of long-term returns than cost. Less-expensive vehicles have a lower hurdle to provide their investors with better results. For example, if Manager A charges 0.50% and Manager B charges 1.00%, then Manager B has to achieve an additional 0.50% in market returns just to keep up with Manager A. This holds as true for college savings as it does mutual funds, hedge funds, and other managed products.
When it comes to 529 savings plans, you want to avoid enrollment and maintenance fees entirely, as they will eat into your returns. Most plans will waive these fees if you have an automatic investment plan in place, or are a state resident. Then, look carefully at the total asset-based expense ratio. You can compare fees using the plan comparison tool on Savingforcollege.com.
Source: Center for Retirement Research at Boston College
If you’re using Coverdell ESAs, you’ll need to look closely at your selection of underlying investment vehicle. Stocks and bonds held in the account may incur only transaction fees, but mutual fund fees will vary widely.
US savings bonds have no ongoing expenses, but again, their upside potential is limited due to the low-risk of the bonds.
Reassess Your Investment Selection
If you’re worried about a prolonged market downturn, and depending on in what you’ve been saving, it might be time to reallocate to more conservative investment options. 529 plans lost less than the market in the downturn of 2008 because somewhere between 80% and 90% of assets are invested in age-based and target-risk portfolios, which automatically incorporate a portion of fixed income and cash-equivalent options.
If you’re using a 529 savings plan, you can make up to two changes per year in your investment selection. Coverdells have no such investment restriction, and you can invest in anything available on the Coverdell host’s system. So check your asset allocation and make sure your risk exposure matches your risk tolerance. You can find a great article on the basics of asset allocation in the article, “Investing Basics: What Is Asset Allocation?”
Consider A Prepaid Plan
Prepaid plans accounted for a little less than 8% of overall 529 assets at the end of 3Q17, according to Strategic Insight, but they can be a desirable option during down markets because the plans are not usually correlated with investment markets. Prepaids are typically pegged against tuition inflation or a flat rate. Prepaid plans operate much like pension plans, where the risk is shifted from the investor to the plan administrator. This is generally the state or an agency of the state, though there is one consortium of colleges and universities that offers the Private College 529 Plan, guaranteeing future tuition in today’s dollars. Just like adding another asset allocation category to a mutual fund, adding a prepaid plan in addition to a savings plan reduces the overall risk of your savings strategy.
There are still risks, of course. Depending on who is administering the plan and in what they invest, prepaids can become underfunded, just like a pension. Prepaid plans can and have closed when they have come under financial stress, stopping new contributions or – in extreme cases – liquidating the plan. So consider carefully before investing.
Look to FDIC-Insured Options
Generally, cash-equivalents such as money markets and ultrashort bond funds are going to provide sufficient protection from bear markets for conservative investors. But for those investors worried about a potential run on the banks, an admittedly extreme scenario, there are 24 college savings plans that offer options with FDIC-insurance, typically CDs or savings accounts.
But be forewarned: There is a lot of fine print when it comes to those protections. Savings accounts typically offer FDIC-insurance on a pass-through basis, meaning you would need to go back to the bank that manages the underlying product to make an FDIC claim, rather than the plan provider. Because nobody has done this before, it’s unclear how this would work or how long it would take.
If FDIC-insured products are something you might be interested in, make sure to do your homework first. Savingforcollege.com conducted a study on the FDIC-insured product marketplace in 2017 for those looking for more information.
Already Used Your 529 Reallocation? Rollover!
529 savings plan participants are allowed up to two investment reallocations per year. But if you’ve already made two investment changes this calendar year, you can still get around the restriction by making a rollover from one plan to another. When making a rollover, you select investment options for what would be considered new contributions to the receiving account. So if you’ve made those changes already, you could open another account for a sibling and transfer the assets. Then, in the following calendar year, transfer the assets back to the original owner.
This information does not constitute tax advice and is provided for informational purposes only. Please consult your tax advisor, financial advisor, local taxing authority, and/or plan provider or sponsor for more information.
