When it comes to investment returns, asset allocation is everything. According to the famous Gary Brinson study in the late 1980s, it wasn't the individual security that was most important in producing returns, it was whether you were invested in the right asset class; put another way, being in equities was more important than picking the individual stocks during the Great Bull market. (Or so the theory goes, but, note: Brinson's theory has been under attack over the last few years.)
Apply that theory to 529 college savings plans, and picking the right 529 plan becomes more complicated than just worrying about the underlying manager's reputation and the tax breaks. Although state 529 plans may look the same on the surface, in reality their asset allocations — although similarly described — could be very different. One state's aggressive plan — say, 60 percent equities and 40 percent fixed income — may look more like another plan's conservative strategy.
This One Is Too Hot
The appeal of age-adjusted 529 plans is that you don't have to do much. The fund company continually tweaks the allocation, so that as a child nears college, it grows more conservative. (For young children, the portfolios typically start by emphasizing equities, then, over the years, the mix is gradually shifted to fixed income.) While there is a do-it-yourself approach where the parents or their advisor can use individual mutual funds to set the asset allocation, most clients prefer to use the standardized portfolio designed by the mutual fund company. In fact, most retail investors and brokers alike have been selecting the standardized portfolios, according to Financial Research Corporation. T. Rowe Price reports that 70 percent of the assets in its broker-sold plans go into the standardized funds. “Many of the 529 accounts are fairly small,” says Jerome Clark, portfolio manager of the T. Rowe Price plan. “Brokers don't want to spend a lot of time adjusting allocations on an ongoing basis.”
While the off-the-rack funds may be convenient, advisors should shop carefully. The problem is that each fund manager follows a different approach, and asset allocations are all over the map. Some choices are aggressive, while others take less risk than many clients would like. One of the more aggressive choices is the North Carolina plan run by Seligman Advisors. In this plan, a 15-year old would have 69 percent of assets in equities. Of the equities, 45 percent of the money is in small and mid-cap stocks, while 30 percent is in international — which includes a sizable stake in emerging markets. “It seems rather extreme to have such a heavy weighting in small and mid-caps,” says Kerry O'Boyle, a fund analyst with Morningstar. “You usually would not want to have more than 20 percent of your assets in smaller stocks because they are volatile.”
On the other hand, O'Boyle says that the Kansas plan run by Charles Schwab may be too conservative. After age 15, the portfolio moves 60 percent of assets to cash and 40 percent in bonds. “At that age, there should certainly be an equity exposure of 20 percent, and maybe as much as 40 percent,” he says.
Some portfolios seem to follow O'Boyle's line of thinking. Legg Mason's Colorado portfolio has 20 percent of assets in equities for students who are 16 to 18. Students who are 19 or older still have 10 percent in equities. “We keep some equity throughout the college years because you always want some capacity for growth,” says Steven Bleiberg, head of global asset allocation for Legg Mason.
While T. Rowe Price has roughly the same allocations as Legg Mason for older students, the two fund companies disagree on how to handle the young cohort. At T. Rowe Price, the student has 100 percent in equities from birth until he is 5 years old. T. Rowe Price's Clark argues that it makes sense to start out aggressively, because a kindergartner still has 16 years until the end of college when the last of the money must be spent. During such a long period, equities have almost always outdone bonds. But Legg Mason starts a newborn with 20 percent in bonds. “You always want to guard against any extreme outcome,” says Bleiberg. “If the market drops when you are three years old, you may not be able to dig yourself out of the hole by the time college bills are due.”
One Size May Not Fit All
Even if a fund company's thinking is based on sound math, a standardized approach may not be suitable for every client. The standard portfolios assume that students will attend college at 18 and graduate four years later. If a teenager has decided to attend medical school, then the time horizon for the portfolio could be longer than the fund model has anticipated and the client may want to hold more equities. Someone saving for several children could also have a long time horizon. “An account can be used for more than one child, so it could happen that grandparents keep money in a 529 for 30 years,” says Bruce Harrington, vice president of product development for MFS Investment Management, which runs 529 portfolios for Oregon.
High-net-worth clients may also prefer a more aggressive approach. If a saver can afford market setbacks, he may want to put a heavier weighting in equities.
Whatever the client's needs, the advisor can build a customized portfolio using the age-weighted funds. Say a conservative client does not want to own the aggressive Seligman portfolio designed for newborns. Instead, the cautious investor could buy and hold the bond-heavy portfolio that is designed for 16-year olds.
Many 529 plans offer so-called static portfolios or individual funds. Calvert, which operates 529 portfolios for the District of Columbia, offers seven conventional funds along with age-based funds. Under the program, a client can put all the money in an S&P 500 index fund or build a balanced fund that is half in bonds and half in stocks. A Calvert client can also mix and match conventional mutual funds with age-based funds. So a conservative client could put half the assets in an age-based fund and half in a bond fund. The resulting portfolio would start out cautious and become progressively less risky as the child aged. By taking advantage of such options, advisors can build portfolios that fit clients of all tastes.
Picking the Right Allocations
Many off-the-rack 529 college saving funds gradually shift to more conservative portfolios. But fund managers offer a variety of different approaches.
|Fund Company||Portfolio Allocation||Age 3||Age 6||Age 9||Age 12||Age 15||Age 19|
|T. Rowe Price||Stocks||99%||84%||68%||49%||34%||20%|