When i started in the financial services industry almost 20 years ago, the standard recommendation given to parents saving for their kids’ education was to load up on equity funds when children are young.
Parents had lots of time to ride out the market’s ups and downs – the reasoning went – so back up the truck. Although that strategy works in extended bull markets, there are key factors that should temper that advice in favour of a more balanced strategy
– time horizon. If beginning early, the accumulation period for education funding approaches 18 years. Although that’s a long period, it’s a much shorter time frame than the typical retirement accumulation period that most financial advisors are used to. And low returns over long periods are not unusual.
Based on monthly returns, there have been 1,522 rolling 15-year periods for U.S. stocks from 1871 through October 2012. Returns failed to reach 5% a year in 164 of those rolling periods – about 11% of the time. Fees and the timing of investor cash flows are major factors that historically have left investors roughly 2%-4% a year shy of market returns. Slicing past returns by those amounts would have seen investors fall short of 5% annually in about half of all past rolling 15-year periods.
This is entirely consistent with my research on investor returns over the past 18 years, through which I found, among other things, that investors have performed worse with equity funds than with bond or balanced funds.
– asset mix. I do not usually advocate such an aggressive asset mix as 100% stocks for education funding. Instead, I advocate a decades-old rule I first learned from Benjamin Graham’s writings.
For novice investors, Graham suggested a simple 50/50 split between stocks and bonds. For what Graham called “enterprising” investors (i.e., those willing and able to take an active role), he suggested always holding at least 25% in stocks but never more than 75% because of the market’s inherent uncertainties.
Most people can’t handle the ups and downs of an all-stock portfolio. But the risk of not earning enough (even to cover inflation) is a very real risk of going fully into bonds today. Although Graham’s 75/25 rule was no doubt inspired by the Great Depression, it’s as relevant today as it was when Graham articulated it more than 50 years ago.
– withdrawal strategy. Unlike retirement withdrawal strategies, most investors will draw down their education savings plans in three to six years. Such a compact withdrawal period requires a brisk transition from a long-term asset mix toward a conservative, cash-heavy mix to begin in the last couple of years of accumulation.
A history of disappointing equity fund returns for investors, a relatively short accumulation period and a very compact withdrawal time frame all point to a more balanced strategy for education funding. A simple strategy is to use a reasonably priced and well-managed balanced fund. As the withdrawal period approaches, the account can tilt toward cash and short-term bonds. Generous registered education savings plan grant money will more than offset bonds’ modest yields.
This should prove to be a more successful and sustainable strategy that is more tightly aligned with client goals and the associated time frames.
Dan Hallett, CFA, CFP, is director, asset management, for Oakville, Ont.-based HighView Financial Group, which designs portfolio solutions for advisors, affluent families and institutions.
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