Top Investment Risk Factors for College Savers

Morningstar mutual fund analyst Greg Brown discusses potential pitfalls, including overly conservative allocations, states' 529 tinkering, and a compressed drawdown window.

Top Investment Risk Factors for College Savers Rachel Haig: In a time of rising tuitions, stretched state budgets, and volatile markets, it's hard to blame college savers for being a little bit on edge. Here with me to talk about the top risks facing college savers is Morningstar mutual fund analyst Greg Brown. Thanks for joining me, Greg. Greg Brown: Thanks for having me. Rachel Haig: So, you've done a lot of Morningstar's 529 researches. What would you say are some of the top risks facing college savers right now? Greg Brown: Well, I think one of the biggest risk, and it may not seem like a risk at first, is that college savers, you know, maybe have a temptation to get too conservative in a time when after coming out of the 2008 bear market and some problems we had in 2009. And then most recently with some of the setbacks we've had few months ago, I think there's a temptation for college investors to be a little more conservative with their savings. I think that's a particular problem for people that have young children that they are saving for college for, because you really have quite a bit of time to make up for any kind of market corrections. And there's a lot of—one trend we noticed in the college savings market is a lot more CD options, a lot more money markets, a lot more ultra-safe. And that's responding to the market environment, and people demanding those, but I think people just have to be a little "cautious" because really the college tuition rate is going up quite quickly and those really can't keep up with college inflation. Rachel Haig: So, you are saying people have in a big way overcompensated for the losses they may have seen in 2008, 2009? Greg Brown: Yeah. And I certainly feel the pain and there is a lot of uncertainty in the market right now. I just think there's a natural tendency to be —there is a potential to be overly conservative at a time when it may not be the best time to do that. Rachel Haig: Have you seen the state plans leaning in a more conservative way too or is this more on an individual level? Greg Brown: We have seen some of the age-based options become more conservative as a result of the 2008 market crash particularly, Ohio's age-based options. Now, their top plan and I'm not trying to knock them, but I think they were contemplating being conservative. In 2008, they didn't actually ratchet back the equity exposure in their age-based options until after the market crashed. So, now they're a little bit more conservative in the 14 to 18 age bands and they are incorporating new research, basically, the event that happened in 2008. But I just, I question the timing. Rachel Haig: Do you think that part of that is that they are trying to cover themselves for investors in case something like that happens again? Greg Brown: I think so, yes. I think so. I think there is an element of political risks that are involved in these 529s for state treasurers. They are run by states. And so state treasurers have to worry about their constituents, and when there is big correction like that a lot of people get really nervous. I mean this is sort of sacred money—this is for their kids to go to college. So when you see big losses like that it's really painful. And it can be a real problem for the states. And I'd argue that there is a potential for them to become overly conservative for that reason, too. Rachel Haig: What other risks are you seeing right now in the college saving space? Greg Brown: Well, one risk that we're seeing that is picking up a little bit more is for the states to tinker with the underlying investment option. So 529s are made up mostly of mutual funds and the underlying roster of those mutual funds is subject to quite a bit of change, because states use consultants most of the time. The consultants need to always recommend new choices and the states need to—they quite often update those plans. A good example is Oppenheimer's plans. They had some trouble, some pretty serious trouble with their fixed income investments in 2008. And, as a result, the states added a lot of index-oriented options. There was some continuous tinkering going on. So, a risk certainly and I think, it's become more apparent is just, what you get today may not be what you are going to get, two or three years down the road. So it's really important—especially for investors that choose age- based options. It's not just to set and forget it. You have to—at the very least, you have to look at it once a year to make sure that the investments that an investor looked at initially are still there to begin with. One way to mitigate that a little bit is to focus on index-oriented plans. Those tend to be a little more stable, because one S&P 500 fund is the same as another one. So there is really no reason for them to constantly tinker with these plans. Rachel Haig: Right. And then, of course, another challenge that college savers have to deal with, that retirement savers don't have to deal with, is the more compressed drawdown period. They only have four years usually to use the money, or at least, when they'd want to use the money. What are the added challenges that that pose? Greg Brown: That's really a good point. The drawdown period is certainly more compressed, and so, the easiest way to look at that is, you just simply have less time to recover from a market setback. So, if another 2008 happens right before your child is in college, it can be pretty detrimental if you have 40%, 50% or 60% in equities. That can spell some pretty bad damages for the 529 portfolio. So, it is important. It's a very debated subject of how much equity to have as that child gets to be 16, 18, and then in college. I'm not going to state any of that stuff here. It's not quite the right forum, but it's important that an investor is comfortable with it. Just make sure they look at it. The end points are really important, both as the child gets into college and also, to a lesser extent, when a child is first born. If there is 40% in bonds, is that really what the investor wants or would they want something like a 90%, 100% in equity. So, yes, it's certainly a lot different than target date funds, so there is a lot less time to make up for losses. So it's completely reasonable if it's in someone's risk tolerance to reach college savings and then put most of that money 90% or even 100% in something safe like fixed incomes or even a money market. Some investors may decide to do that, especially if they are close to their goals. So it's certainly a different paradigm, 529 college savings investments. And to be honest, I don't know if all of the 529s out there have taken that into full account. I think a lot of target dates have been shoehorned into 529s without kind of looking at those compressed periods. So we'll probably see some changes in the age-based options going forward. Rachel Haig: Well, those are all certainly good things to think about. Thanks for talking with us today. Greg Brown: Sure. No problem. Rachel Haig: For Morningstar.com, I am Rachel Haig.