Most investors know that they need to stabilize their portfolios as they approach retirement, but not many understand why. The same concept of stabilization for retirement withdrawals over 20 or more years is even more crucial for college funding where withdrawals are spread over 4 to 5 years. Retirement assets are not typically depleted after retirement whereas college funds are in most cases. It is the fear of outliving your retirement assets over more precise college funding targets.
In the 8 to 10 years before a child enters college, the uncertainty of the stock market makes the need to stabilize a child's college funds imperative. The reallocation of equities to bonds is not done all at once; rather it should be a gradual shift over time so that you avoid "timing" the stock and bond market peaks and valleys. Another reason that you need to stabilize a portfolio is that during the withdrawal period, downside of loss exceeds the upside potential of a similar size gain. This logic is supported in the example below where withdrawals of $13,000 are made from two college funds, both having the same $52,000 balance.
*These hypothetical examples are for illustrative purposes only and are not intended to represent any specific investment. The examples do not consider any costs associated with investing. Investments involve risk and you may incur a profit or loss. Seeking higher rates of return generally involves higher risks.
Interestingly, even though the annualized returns for these two college funds are almost identical, the family with the ?Aggressive? portfolio will have to pay for the last semester out of pocket, while the family with the "Conservative" portfolio ends up with a small amount of money left. How can this happen, you ask? The answer comes in the timing and the variation in the returns. In a portfolio supporting withdrawals, early negative returns have a greater negative impact than negative returns in later years. Reverse the order of returns and you can see the results in the next example:
While the annualized returns are identical to the first example, the ending balances vary significantly. Now the Aggressive investor has a semester's worth of tuition left while the Conservative investor will be under funded by a small amount. Since the returns are identical in both examples, we know that if we had simply started with $52,000 and not taken withdrawals the ending balances for the Conservative and Aggressive investor would have been the same in both examples.
Of course, if you knew when the market was going to be up or down, this would not be problem since you would be out of the market when it went down.
In 18 or so years you have to save for your child's college, you need to begin stabilizing the portfolio around age 8-10. In addition to using intermediate term bonds, we would suggest you use uncorrelated or low correlated investments. Investments typically thought of as having a low correlation to the U.S. stock market and the traditional U.S. bond market include real estate (through investments in Real Estate Investment Trusts, or REITs), foreign stocks and bonds (especially emerging market, although these are more risky and may include additional currency and country risk), Treasury Inflation Protected Securities (TIPS) and alternative investments. However, most 529 Plans do not offer these types of investments. Using a self-directed Coverdell (or Education) IRA in addition to a 529 Plan can provide access to these type of investment options.
As college approaches, additional stability can be added through supplementing with short-term bonds (a short-duration bond portfolio) and stable value investments.
You should keep in mind that when moving investments from an aggressive to a conservative posture, it does not mean the market value of the investment will not fluctuate. Bonds are not risk free. While bonds tend to be less volatile that stocks, the market value of bonds does fluctuate due to changes in current interest rates. Generally, when interest rates rise, the value of bonds - especially long-term bonds - decreases. Bonds are also subject to other risks, such as credit and inflation risks.