Description: Selecting the right 529 fund investments is done through a combination of not paying fees-upon-fees and adjusting your investment choices to be appropriate for what’s going on in the markets and when the money is needed.
After knowing if there is a tax benefit, you want to know how good the investment options are. Each state will have a variety of options but I’ll tell you what they are in general.
1. Age-based Portfolios: The premise here is that the older your child is, the less risk should be taken because a significant decline in the value would mean you may have lost money right when you need to use it. Early on, the portfolio can take on more risk because the time horizon is far enough in the future. Sounds good but this option is terrible and is a guaranteed way to put yourself in a hole. Here’s why:
- First, the portfolio is being managed by a portfolio manager who doesn’t know you and is choosing to allocate your money into various mutual funds. This is called a fund-of-funds or better stated, fees-on-fees. You’re paying a manager his/her fees to invest in mutual funds managed by someone else who also charges fees.
- Second, the way the manager “reduces risk” is by allocating more money to bonds over time. The common misconception is that bonds are safer than stocks but that’s not true. Bond prices fluctuate based on how much someone is willing to pay in order to receive a dividend (which is like getting a paycheck).
Let me give you an example: Economics will tell you that if you can get a 6% dividend while interest rates are 1%, then your true return is 5%. If interest rates are 3% and the dividend is 6%, then your true return is 3%. Let me ask you, which of these would you pay more for? You of course would pay more to get 5% returns because it’s worth more. Well if you’re willing to pay more, that’s going to raise the price because a bunch of other people (known as The Market) are thinking the same as you. So the price of bonds goes up when interest rates are low. But what happens when interest rates are expected to increase? Well then the price of bonds are going to go down.
So if your child is 2 years away from going to college and interest rates were 0-0.25% (as they are today), you know the only place for interest rates to go is up and prices to go down. If you know the prices are going to go down, why would you invest in it? Just because it’s historically “safer”? Well who cares what it is historically, you care about not losing money today! In this scenario, being 2 years away from college with interest rates at all time lows, these are terrible investment options.
2. Risk-based Portfolios: The premise with these portfolios is that you can determine how much risk to take and change that risk tolerance when you want. Risk in this case is determined by the percent invested in stocks vs. bonds. The more that goes into stocks, the riskier. But as we discussed in the previous example, we know this is not true in the short-term depending on a number of factors. So while the “Aggressive” risk means being all in stocks with no bonds, that would actually be safer in a time when interest rates are so low as they are today. The good thing about this strategy is that you can set which risk level to take but the bad news is that this is still paying a fund-of-fund their fees-on-fees.
3. Individual Fund Options: Not all state plans offer this option but those that do, recognize the importance of letting you choose which funds to invest in. This option is the best for a host of reasons. You can determine exactly what to invest in and not have to pay someone else their fees to do so. This will save you thousands of dollars in fees. If you have a professional money manager, they can select the fund options for you and if they are paid as a percent of assets, then you know they are aligned with your interests because if the value goes up, they make more money and if the value goes down, they make less.
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