Parents looking to save money for their child's college education might want greater stability than investing in the stock market but need more growth than what savings accounts offer. One option that could be more palatable: age-based 529 education savings plans.
These plans, designed for families to save for education, are comprised of a variety of investments at varying risk levels—including mutual funds, bond funds, and savings accounts. As the child ages, the fund automatically reduces investments in higher risk, stock market-based investments, commonly referred to as equity investments. The changes happen in age bands, depending on the age of the child for whom the funds are being saved. For instance, industry experts say, you'd expect a less risky set of investments in a 16- to 18-year-old bracket than in the 10- to 12-year-old band.
According to Morningstar's 2011 "529 College Savings Plans Research Paper and Industry Survey," between August and September 2011, parents and grandparents chose age-based plans with investments beyond savings accounts—such as money invested in the stock market—for younger children while they increased safer investments for 14-year-olds.
There are four main steps parents and grandparents should take when choosing age-based 529 plans:
1. Consider personal risk tolerance: Risk tolerance is the degree to which a person accepts risk within their investments. For instance, if someone has $5,000 invested in a mutual fund, would they want to sell their funds if the value dropped 20 percent to $4,000? Another person may get rid of the mutual fund if it dropped 10 percent to $4,500.
Sometimes risk tolerance is based on a need, such as not being able to wait for the possibility of investments increasing in value because a child starts college next year. Other times, it's based on an emotional reaction. If a parent is uncomfortable with investments that could rise or fall in the stock market, financial experts say, no matter how much an investment is predicted to grow in the next five years, he or she might prefer to opt for something less aggressive.
Since age-based 529 plans are sold in conservative, moderate, and aggressive options that contain a variety of investments, it's important for potential 529 investors to rate their overall risk tolerances. Since an individual's risk tolerance is both an emotional and financial decision, Vanguard offers questionnaires to determine risk tolerance levels.
One question asked: "From September 2008 through November 2008, stocks lost over 31%. If I owned a stock investment that lost about 31% in 3 months, I would… (If you owned stocks during this period, select the answer that corresponds to your actual behavior.)" Other questions ask about income stability and amount of time until the funds are needed.
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2. Balance security and growth: Ultimately, the goal of saving for college is to pay for it. The best way to do that, experts say, is to choose a diverse group of investments so part of your funds are always secure, while the rest can grow in funds that have great records of growth.
"Don't choose too conservative or too aggressive," says John Heywood, principal for Vanguard's retail investor group. "On the conservative end, you could choose a conservative age-based track or an all-savings-account option with an extremely low interest rate. The savings account option could make sense for someone close to attending college, but not if your child is 3 years old."