April 2, 2018
Odds are that if you’re saving for college, you’re using a 529 savings plan, U.S. savings bond(s), or a plain-old ordinary savings account. But one of the best deals in college savings is also one of the least-used. You could be missing out on increased returns and reduced risk by omitting it from your investment portfolio.
Recent analysis has shown that incorporating some portion of prepaid 529 plans in a college savings strategy alongside a 529 savings plan could result in improved returns and reduced risk for college savers.
Reduce the investment risk of your college savings strategy
That Other 529 Option
529 savings plans are excellent savings vehicles and the default option for most college savers for good reason. Their tax benefits, flexibility, and intuitive design make them ideal for most savers. In a 529 savings plan, the investor usually selects from a menu of investment options tied to securities like stock and bond mutual funds. 529 savings plans are like 401(k)s in this way.
The other type of 529 is called a prepaid 529 plan (prepaid). They are less well-known, representing only about 10% of total 529 assets, but can be a smart option due to their protection from bear markets and lack of correlation (how one investment changes relative to another) to other asset classes, like equities (stocks) and fixed income (bonds). If 529 savings plans work like 401(k)s, prepaid plans work like pensions, where the plan or sponsor guarantees that the account owner will receive a certain return on their investment.
Most prepaid plans will peg their return against college tuition, be it in-state public schools, an index, or participating institutions. As a result, prepaid plans do not report their performance in a way that makes it easy to compare them with 529 savings plans (which are hard enough to compare to one another as it is!). To look at how the returns of a prepaid and 529 savings plan compare, we created a proxy using the annual change in tuition and fees with data from The College Board.
For example, in 2017 college tuition and fees rose approximately 1.9% at four-year private schools on average, which the S&P 500 index rose 21.6%, and the three-month treasury 1.4%. For 2017, investors would have been far better off investing in the S&P 500 index in a 529 savings plan rather than using a prepaid. The opposite was true in 2008, when markets fell 36.6%, and tuition and fees at private schools rose 0.4%. Taking the average data over time, we compared college tuition and fee changes against the annual returns of the major indices, and the result was that their was either very low or no correlation between investment markets and the change in college tuition pricing over the past 22 years.* When creating any investment plan, a low correlation tells us that we can potentially reduce our overall risk by using both options.
- S&P 500 and Annual Change in Private College Tuition and Fees: 0.419
- S&P 500 and Annual Change in Private College Tuition and Fees: 0.081
- Bloomberg Barclays U.S. Aggregate Bond Index and Annual Change in Private College Tuition and Fees: 0.004
- Bloomberg Barclays U.S. Aggregate Bond Index and Annual Change in Private College Tuition and Fees: 0.180
Source Data: The College Board, Federal Reserve Bank of St. Louis
If we use this change in tuition and fees as a proxy for prepaid plans, we can get an idea of how a prepaid plan performs relative to investment markets. What we found was that the benchmark portfolio, using a simulated age-based model for the 529 savings plan, had slightly better performance, but at greater risk. As a result, the prepaid plan offered better returns per unit of risk.
Returns are more volatile for a portfolio without a prepaid investment.
How Prepaids Fit Into A College Savings Strategy
As shown above, 529 prepaid and 529 savings plans do not have to be mutually exclusive. Consistent with the tenets of Modern Portfolio Theory (MPT), adding a prepaid plan to an existing college savings strategy results in a more efficient portfolio, since the prepaid plans can be treated as its own asset class due to its low correlation to 529 savings investment options.
To be plain, investing in a prepaid plan augments your risk-adjusted return by limiting your downside. Prepaid plans follow their own return profile, tracking tuition inflation rather than stocks or bonds. When your savings plan loses money in a bear market, your prepaid plan continues to increase in value, assuming tuition increases (there have been rare years where tuition has decreased).
The result is that for the most recent 22-year period, adding a 20% weighting of a prepaid plan that tracks the change in tuition and fees resulted in a superior risk-adjusted return to the age-based option alone, both for private and public school.
Caution: Some Prepaid Have Big Drawbacks
Despite the benefits of a guaranteed return, there are risks associated with using a prepaid 529 plans:
- Limited School Choice: Many prepaid plans either limit use of assets to schools in their network or state. Those that allow withdrawals for use outside the state often do so at a significant penalty to encourage participants to stay in-network. Check to ensure that either the network is sufficiently large to provide adequate school choice, or that the reduced return on withdrawal is palatable. Using Texas again as an example, participants would want to be sure that a Texas public institution is desired. Some families might balk at the more limited pool of institutions, but other will be happy to have a paid education.
- Lack Of Options: Unlike other retail asset management products like mutual funds or ETFs, there are not a lot of 529 plans. There are ninety-one 529 savings plans and only 19 prepaid plans. Many prepaid plans also have residency requirements, usually that the beneficiary or account owner be a state resident. And of those 19 prepaids, only 11 are open to new investors, and of those only two have no state residency requirements of any kind, the U.Plan from Massachusetts, and the Private College 529 Plan (the Private College 529 Plan is a unique 529 plan that is comprised of about 300 participating universities). Unless your state has a plan that aligns with your goals – and there are some good ones – there may not actually even be a prepaid plan that’s right for you. As a result, one of the biggest drawbacks to prepaid plans is the simple lack of selection and availability.
- The Guarantee Is Only As Good As Its Backer: The analogy of prepaids being like pension plans extends to their risks as well as their benefits. Like a pension, a prepaid that is underfunded by its administrator may not be able to meet its commitments, so there is a risk of default. Make sure your prepaid plan is backed by the full faith and credit of its state sponsor and/or that the schools in that state or program are required to honor account holders. For example, in Texas the public colleges are required to honor units redeemed from its Texas Tuition Promise Fund, even if the plan itself is underfunded, eliminating default risk for participants.
- Unique Restrictions: Some plans have their own special restrictions. The Michigan Education Trust, for example, makes contributions irrevocable. Other plans require that the plan be used within a certain time period, or that the beneficiary be at or below a certain age at the time of enrollment.
- Fees: Most prepaid plans have no ongoing fees, but they can have enrollment fees up to $100, depending on the plan. If you’re investing smaller dollar amounts, this can be a significant portion of your investment, so review fees carefully. Some plans offer a reduced enrollment fee for applications completed online.
- Administrative Burden: Odds are that if you have a 529 savings account already, you probably have other savings or investment accounts too, making a prepaid 529 account just one more separately held account that can be an annoyance to manage.
Are Prepaid Plans Right For You?
Prepaid plans have a narrow focus that does not make them appropriate for many college savers. The greater return potential and flexibility of a 529 savings plans will usually make them a better option for the average investor. However, for those investors who have a shorter time horizon, larger starting funds, who are more sophisticated, or who fit the risk profile of a prepaid plan, they can add value by providing superior risk-adjusted performance.
Assumptions and additional data from this first pass at analyzing prepaid 529 plan data relative to broader market movements follow. Historical data from the The College Board and Federal Reserve Bank of St. Louis.
Optimal weightings between savings and prepaid plans is still being researched, but that there is a low correlation and higher Sharpe Ratio (a measure of risk-adjusted return) for portfolios incorporating a percentage of prepaid plan exposure shows that there is value in using both options.
Of course, these results may vary by time period and the particular investment option selected. Note also that this is a single example portfolio for a 22-year period. As such, it is not an indicator of future performance, and is a highly simplified illustration. More complex iterations over multiple time periods are ongoing.
Prepaid Analysis Appendix Stats
This scenario analysis used the following assumptions:
- The most recent 22-year period from 1995 – 2017 (assuming the investor starts saving at birth and continues to hold their 529 portfolio through the senior year of college). Future behavior and performance may not reflect historical returns.
- A combination of the S&P 500, Barclays U.S. Aggregate Bond Index, and the 3-month T-Bill to represent equity, fixed-income, and money market asset class returns. Small-cap, international, and certain other asset classes used by many 529 plans will be added in future iterations.
- The model “glidepath” of the Vanguard 529 Plan Moderate Age-Based Option was used to shift the weightings between asset classes of the model portfolio over time. A glidepath is how a portfolio changes over time, starting aggressive by holding more equity, and becoming more conservative over time. This model mimics Vanguard’s glidepath only and does not represent Vanguard in any way. For example, in year one, there is a 90/10 equity/fixed income weighting, and 30/70 equity/fixed income weighting in year 13, etc. The last four years all use the 19+ weightings.
- Fees were excluded for purposes of this analysis and may have a significant impact on the results depending on the combination of plans used and state of residency.
Tax implications were excluded, as all plans are using tax-preferred 529 plans (savings or prepaid). However, in-state incentives such as matching grants, tax deductions, or other incentives would modify individual results.
* Multiple time periods going back as far as data is available all yield low and sometimes negative correlations between market indices and changes in tuition and fee pricing. The 22-year period was used for simplicity as part of the proof of concept analysis, and for sake of consistency.