Parents who are counting on savings in 529 plans to pay for
college this year or next could be in for an unpleasant surprise.
Right when they need the money most to cover costs for
tuition and dormitory rooms, they could find their 529 stash has dwindled.
The reason: Bonds.
Most 529 money for students about to go to college is placed
in bonds by fund managers. The idea is to avoid the volatility of the stock
market and keep money safe in bonds so families can rely on their savings at
the crucial moment when the college bills must be paid. But, while bonds are
safer than stocks, there are times when bonds can present losses. And that time
could arrive soon if the Federal Reserve raises interest rates as expected this
year and next.
As expectations for a stronger economy and rising U.S.
interest rates arose during the last quarter of 2016, the average mutual fund
that invested in a variety of bond types lost 2.89 percent, according to
Lipper.
Because most 529 plans hold small portions of stock and cash
in addition to bonds, these accounts did not lose that much. But with bond
funds dominating “age-based” 529 portfolios for students at age 18 or 19, the
average lost 0.57 percent in the last quarter of 2016, and many lost about two
percent, according to Morningstar.
The 529 plans are offered by states and have become a
popular way to save for college because parents can put away a little at time
for children routinely as they grow up, and money used for college isn’t taxed.
Of these, parents tend to prefer the so-called ‘age-based approach’ to
investing, in which fund managers invest heavily in stocks to grow money when
the children are young. As students approach their college years and can’t
afford a loss in the stock market, managers pull away from stocks and invest
heavily in bonds and some cash.
A 0.57 percent loss, or even a two percent loss in college
savings, would be nothing to keep a parent awake at night if their child was
young. But when parents are sending a child to college every penny is precious.
According to research by Sallie Mae the average family had
saved only $16,380 for college in 2016, which wasn’t enough to cover even a
single year. Last year parents said their average cost of college was $23,757,
and many colleges now run more than $30,000.
SEARCH FOR SAFETY
As 529s for 18 and 19 year old students lost value, some
advisers told parents to move money into the safety of stable value funds,
money market funds or CDs, depending on what their state 529s offer. Advisers
acknowledge that it is impossible to guess what interest rates will do at any
point, but when money needs to be spent that is not the time to risk a bad cycle
in either stocks or bonds.
“If a 529 goes down and you owe tuition on September 1,
that’s when you have to pay,” said Minneapolis financial adviser Gary
Greenberg. “You can’t wait. So the question is: Is it worth taking a risk or is
enough, enough?”
People vary on the risks they are willing to take, said
Greenberg. “But too often people stay in these funds without even thinking
about it.”
Here is why rising interest rates turn bonds into losers:
Whenever interest rates are rising, investors are able to buy new bonds that
pay higher interest than the old bonds they purchased before rates surged. So
the old bonds that are sitting in 529 plans decline in value.
Think of it this way: If you had a choice between an old
bond paying you two percent interest or a new bond paying three or four percent
interest, which would you want? Clearly, people want to earn as much interest
as possible, so funds holding onto old, low-yielding bonds suffer losses.
With time, a bond fund manager will be able to buy bonds
that pay higher interest rates and the fund should recover, but students going
to college do not have the luxury of time. They need money instantly, and while
some families lost only about two percent during the last quarter of 2016 in
529s, the future could be more harsh if the economy continues to strengthen and
the Fed pushes rates higher.
To check your 529 bond risks look at what is called
“duration.” It estimates how sensitive a fund will be if interest rates change.
According to Morningstar, the duration of the average 529
fund for 19-year-olds is 4.32 percent, but many have durations close to six
percent, which would make their losses greater.
What does that mean for 529 investors? Fidelity Investments
notes that if rates were to rise one percent a bond or a bond fund with a
five-year duration would lose approximately five percent of its value.