Parents need more awareness of what investments are in their children's college savings accounts, experts say. "Our clients are often surprised that by the time their child reaches 18, their 529 plan accounts contain nearly 100 percent cash and bonds," says Chadderdon O'Brien, a certified financial risk manager at New Jersey-based Lassus Wherley. "When they opened their accounts, they were largely invested in stocks."
Age-based 529 plans, tax-advantaged investment accounts, automatically change over time to safer investments as children grow closer to college age, he explains.
[Follow these steps to choose age-based 529 plans.]
Parents therefore need to understand bond investments—loans to a company or government—as much as stock market investments, O'Brien says. Start by learning about these common myths surrounding bonds.
Myth 1: Bond funds are always safer than stock market investments. Even though risks are reduced, bonds aren't 100 percent safe, O'Brien says. The initial investment is guaranteed when a bond matures, meaning when it reaches the end of the agreed-upon loan term.
However, in a tough economy, such as the current economic climate, risks such as a company's bankruptcy are more likely, he says. In general, bonds provide a steady return through income, similar to interest a bank would receive on a loan.
[Consider these safe investments within 529 plans.]
Myth 2: You can buy a single bond in a 529 plan account. Bonds within 529 plans travel in packs. "Rarely will you see a single bond sold as part of a 529 plan," O'Brien says. Instead, investors purchase shares in bond funds containing bonds from potentially hundreds of companies.
Investors don't own a full share in each company, he notes. Thus, investors reduce their associated risk because the investment value isn't dependent on whether one company defaults on a bond loan.
Myth 3: Bond funds are always labeled bond funds. Bonds may also come in the form of real estate investments such as mortgage-backed securities or extremely short-term bonds in money market accounts, O'Brien says.
"Most people believe money markets are equivalent to cash, but they're comprised of bonds that could mature in as little as 1 to 30 days," he says. "While extremely uncommon, during periods of extreme financial distress, some institutions may have trouble repaying the bond's principal to the money market fund," he notes.
[See the U.S. News rankings of Best Funds.]
Myth 4: Long-term bond funds always earn more. The income earned on a five-year bond fund bought today is less than the income earned on a one-year bond fund bought five years ago, says Jimmy Williams, an Oklahoma-based certified public accountant and personal financial specialist. This is because any investor in a bond fund is essentially lending money. In the current economy, the cost to borrow money from all types of lenders is historically low, he notes; therefore, the income earned is historically low as well.
The solution is to diversify bonds by both length of time and size of company or credit rating, Williams says. This way when short-term bonds bought under today's interest environment mature, parents can buy new bond funds with higher income potential, he notes.
Myth 5: You should invest mostly in stocks to pay for rising tuition. "With mostly bond-based investments, the risk is higher that the value of the 529 plan may not grow enough to pay tuition costs, which is usually the goal of a 529 plan in the first place," O'Brien says. However, some tuition inflation risk can be hedged by buying inflation-protected bonds, he says. These bonds adjust based on general cost-of-living inflation, but not necessarily on the full increase in tuition year over year.
That's why the best option for most parents is a selection of stock-based and bond-based investments that transitions to a higher percentage of bond investments as their children age, O'Brien says. Paying for rising tuition is about finding the right balance between both types of investments.