5 Conservative Ways to Save for College

As high school students around the country prepare for their first exams of the year, some of their parents are preparing for their own test: saving enough money to fund a higher education.

Saving for college remains a Catch-22 for many families. Although most parents want to help their children – 63% of parents are saving for college expenses, according to a September 2009 Fidelity survey – they also have to juggle saving for retirement and everyday expenses. During the past year, many parents who contributed to a 529 college savings plan (an investment vehicle where earnings grow tax free) saw those savings take a hit. Many 529 plans were heavily invested in stocks, though their beneficiaries were just a few years away from attending college, says Greg Brown, a Morningstar mutual fund analyst.

Between the first quarter of 2008 and the first quarter of 2009, total assets in 529 college savings plans fell by 25% to $85.9 billion, according to the Financial Research Corporation. After six consecutive quarters of market declines, an uptick during the second quarter brought total assets to $98.6 billion – still well below the two-year peak of $111.9 billion reached during the fourth quarter of 2007.

The sudden loss of college savings has parents thinking about more conservative approaches to saving for college, says Sheryl Garrett, a fee-only certified financial planner. Although there are many options, including bonds and stable value funds, parents whose children are still many years from college should consider that by taking a more conservative approach, they risk not saving enough money to keep up with college inflation. Including tuition, room, board and fees at public and private colleges, college inflation has averaged 5.9% during the past five years, according to the College Board.

On Sept. 17, Rep. Emanuel Cleaver, II (D., Mo.) introduced the Deposit Restricted Qualified Tuition Programs Act of 2009 that would create 529 bank accounts that offer tax treatment similar to 529 plans but guaranteed by the federal government. “These are parents and grandparents trying to do the right thing and save for their children’s education, but some have seen the value of their investments drop in value by 50%,”Cleaver said in an email. “In this continued economic downturn they are understandably hesitant to invest more of their hard-earned money into the stock market.”

Here are five conservative options that can help you save for college.

Given the recent losses among 529 plans, it’s understandable that parents would consider reshuffling their plan’s asset allocation by moving from equities to a more conservative asset class. Most 529 plans offer a menu of conservative investment options, says John Middleton, an investment advisor at Brighton Financial Planning, an independent fee-only financial planning firm in Clinton, N.J. (The firm doesn’t sell 529 plan-related products.)

When choosing investment vehicles, parents should consider the number of years their child has until he or she begins college and their risk tolerance. With high school students, parents should begin minimizing their exposure to stocks while increasing their exposure to more conservative investments, says Middleton. (One example is short-term bonds.) When children are two years away from attending college, parents should tilt toward a fixed-income portfolio that includes corporate and government bonds and global bonds, which are a bit more aggressive and tend to have a higher return than other conservative options, he says.

Investors who plan to stash their children’s college funds in CDs or money-market accounts can find comparable vehicles within 529 plans that offer tax-free growth on earnings. Also, some 529 plans include stable value funds, which are often comprised largely of government-backed securities with insurance that can prevent losses.

“This kind of approach has its own set of risks, primarily the rate of return on a CD or stable value fund won’t match the rate of inflation,” says Middleton. “You’re avoiding market volatility but still have inflation risk in your portfolio.”

Typically, investors who choose an age-based portfolio within a 529 plan know that their investments will automatically become more conservative as their child nears college. However, during the recent market downturn, many age-based portfolios were hit in part because they were still too exposed to equities.

According to Morningstar’s April 2009 “Best and Worst 529 College-Savings Plans” study, “some plans didn’t move out of equities fast enough and were courting far too much risk given that they were geared toward students getting close to matriculation.” The study point to Utah’s “S&P and Bonds” age-based option that – as of April 2009 – had stashed 65% of assets in equities for a college-enrolled beneficiary. Separately, Oregon’s OppenheimerFunds 529 plan “1-3 Years to College” portfolio had 40% in equities until March 30.

“Many investors don’t really understand what the underlying allocation of their investment is in the older age bands,” says Doug Chittenden, a vice president at TIAA-CREF, a financial services company. For high school students, those with more than 20% exposure to equities fare well when the stock market is up, but over the past year, investors in such plans have seen negative returns, he says.

Parents typically can review how an age-based portfolio will break down their investments and their exposure to risk, and they can usually make limited changes without incurring penalties. (In 2009, investors can make two changes. Unless the Treasury extends this, investors will only be able to make one change in 2010.) “The age-based options are a low-maintenance approach but not a no-maintenance approach,” says Brown. “You still have to do some looking under the hood to see how it transitions from stocks to bonds.” Brown recommends checking your 529 plan at least once a year.

Expenses come out of the plan’s return, regardless of whether it’s positive or negative. Finding a 529 plan with lower expenses is more important during a volatile market because it’s one thing investors can control, Garrett says.

One of Morningstar’s top-rated 529 plans, the Ohio CollegeAdvantage 529 Savings Plan, has expenses that range between 0.23% and 0.91%. With the Indiana CollegeChoice 529 Direct Savings Plan, fees range from 0.35% to 0.53%. Investors should be wary of fees higher than 1%, Brown says. Those paying more than that should make sure they’re getting a well-respected manager and a very high-quality fund, he says.

Online money-market accounts often keep up with inflation and savers can withdraw money from them typically within 24 hours, making them appealing savings vehicles for college expenses.

Before choosing an online money-market account, investors should make sure it’s insured by the Federal Deposit Insurance Corporation (FDIC) and keep in mind that, unlike 529 plans, these accounts don’t offer tax-deferred savings for college purposes.

“This is the best place I know where you can get all flexibility, the ease of adding to it automatically with each paycheck and should inflation pick up the yield will go up as well,” Garrett says.

I Bonds are U.S. government bonds that carry low risk and protect savers against inflation, a feature that may prove extremely helpful in the next couple of years, Garrett says.

Their earnings rate is determined by a fixed rate and an inflation rate. Both rates are announced each May and November; the fixed rate remains the same for the life of the bond. The inflation rate is based on changes in the Consumer Price Index for Urban Consumers (CPI-U). The CPI-U is combined with the fixed rate to determine the earnings rate of the bond every six months. Although they’re not worth stashing college savings in now – I Bonds issued since May 1 have just a 0.10% return – parents should keep an eye on them because their earnings rate is likely to rise once inflation starts to kick in, Garrett says.