Kids… Kids are a blessing in your financial planning for long-term independence.
Said no FIRE enthusiast ever.
I think we can all agree that (most of the time) kids are a blessing, but they sit firmly on the “loss” side of the “profit and loss” ledger. And college fees! Man! You need to prepare for those – am I right?
Perhaps like me you’ve created a little spreadsheet to calculate how much you should be saving in your kids’ 529 accounts assuming a certain rate of return. But that is literally only an hour of fun. At most.
C’mon Team Actuary! We can extract lots more fun from research into 529 investing. There are a ton of questions that need answering and data that needs mangling, and in all honesty I need a break from thinking about retirement issues. So let’s get into this.
Fungibility of Investments
Fungibility of investments sounds like a nasty case of something like athlete’s foot – right? We might need to take our investments out and give them a good airing and perhaps sit them down and have a firm discussion around personal hygiene. But no!
What I mean is that I believe that your investments shouldn’t necessarily sit in different “pots” with different goals. You should instead view your investments as one totality meeting a number of different obligations, and you should optimize one single investment strategy.
But you know what screws it all up? Taxes. If it weren’t for taxes then I think we would all have one big pot of money and one investment strategy. We’re not going to get into that here, and there is plenty of information out there about the tax implications of investing, see here for example.
As you know a 529 account provides tax advantages and in return the money has restricted uses. So essentially the money is ring-fenced for the paying college fees and that is what I’m going to assume here.
I’ve been modeling the minimum annual contribution I need to make to my 529 accounts, and I’m defining my measure of success as having sufficient funds at the start of the college to pay for 4 years. I know you don’t need the full amount on day one, but let’s make things a bit simpler for the modeling.
I’m going to pull two levers:
- The period of the investment, and
- The investment strategy.
I’m going to keep the investment strategy simple with just static allocations to equities and bonds and keep that constant throughout the period of the investment.
Let’s Quickly Talk About Utility
My success measure above might not necessarily be what you judge to be the right success measure. For example you might not be that bothered if you fall short of saving the complete college cost and are happy to take any shortfall from taxable savings or a student loan. Conversely you might not be too worried about any surplus and have plans for mopping up excess funds. There was a debate around these issues recently on the White Coat Investor forums.
We’re starting to get into “utility functions” here. These define how happy or sad you are under certain outcomes. I’ve shown three potential utility functions above.
Under ‘A’ a dollar of shortfall or surplus impacts you the same. Under ‘B’, if you are below target this can have a big impact on your utility, and being over-target only has a marginal impact on increasing your utility. Utility ‘C’ says that you get no increase in happiness from a surplus and you see it as wasted funds.
I don’t explicitly use Utility functions in my analysis as such, but there is an implicit utility of ‘B’ I would say. And this probably best represents how I see things with college savings.
Get To The Numbers!
I’m going to take historical investment returns of equities and bonds from 1802 to 2015 and consider periods of investment from 1 year to 18 years. You can make all sorts of arguments that the equity markets from the turn of the 19th Century only had a few railroad companies in, but I have this data lying around, and if you don’t like it then start your own goddam blog.
Note also that my returns are net of inflation, or real returns. It’s worth noting that college costs have generally increased faster than CPI, but I do not take that into account here.
Instead of dollars I am going to work in units of annual college cost. So 1 unit is one year’s worth of college cost. If your child has their eye on a college costing $50k a year, then 1 unit is $50k, and saving 0.1 per year, is equivalent to saving $5k per year in this example. My success measure was saving four years of college costs and so this is equivalent to saving 4 units. Get it?
Impact on Terminal Value
Before we look at the minimum contribution rate required to save up 4 units let’s look at what factors might impact on the terminal value. The terminal value is the value at the end of the period of investment.
The above chart shows the terminal value for a 10 year period of investment and an annual contribution 0.15. You can see it falls quite a bit short of our target of 4. (Remember 4 units is equivalent to four years’ of college costs). In addition you can see there is quite a bit of variability over the different periods.
So what has the biggest impact on the terminal value?
With a set investment horizon I think there is an understandable fear of a market crash the same year that you need to access the funds. You really don’t want to experience another 2008 directly before you have to write the check to the college. But is this fear justifiable, or is it an example of psychological bias?
I looked at the terminal value after 10 years along with the last year’s return.
The blue line is as before and shows the terminal value of the account after ten years. I have overlaid in red the last year’s investment return. It’s like actuarial spaghetti thrown at the wall! I guess if you squint a bit you might see a pattern, but I don’t think there is a strong connection.
Instead of the last year’s return let’s look at the last ten years’ of annualized return.
That’s a nice correlation! This is telling us that the return over the whole period plays a big part in determining the value of the account at the end of the period. You don’t necessarily need to fear a poor return in the final year, it’s a whole decade of crappy returns that will kill you.
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Gimme The Big Picture!
That’s enough noodling, we need to look at the bigger picture.
I’m now going to find the minimum contribution rate (MCR) to meet a terminal value of 4. We’re going to look over all time periods from 1 to 18 years.
The above chart shows the MCR for a 90% equity strategy. Here’s a few observations:
- The MCR gets lower the longer the period of investment. No surprise! It’s a cliché in personal finance, but I’ll say it. Start saving early! Compound interest is your friend!
- The start year makes a difference, and so market returns matter. Those lighter areas in the blue are big market downturns. This could impact your MCR by 10-20%, which is a lot.
We can break things into broad regions.
In broad terms you can see that for a period of investment north of 13 years then a contribution of 0.1 per year is sufficient in all but the worst sequences. But if your investment period is only 5 years (bad parents!) then a contribution of 0.5-0.6 is required.
What is not smacking you in the face is the speed of the exponential growth over the time periods. It’s really difficult to appreciate the power of this effect (without a logarithmic scale). But let’s quickly put on our 3-D glasses.
Key takeaway – if you don’t give yourself a long enough runway you have to rely on contributions and not investment returns.
Let’s now look at how things change when you flex the investment strategy. First with 60% equities and then 30% equities.
It’s difficult to compare easily (and I’ll work on that in a later post) but you can see that as we reduce the equity allocation two things happen. The colors bleed out more, a higher MCR is required, and the colors get less “spiky”. What this means is that as you have a more balanced portfolio you see less volatility year to year. Part of the reason is sequence of returns. More on this in a later post.
Did you think I was going to wrap this up in one post? Nope, there is too much fun to be had here. So I’m going to leave things on a cliff-hanger for this week and come back to this analysis soon with some firm recommendations. Hopefully I’ve whetted your appetite for some more investigation and you’ll return for another installment.
What did you think? Do you think this kind of analysis will help you plan for investing for college education? Did you disagree with my target of fully funding all four years on day one? Do you not care if you build up a surplus? Comment below on any further aspects of this you would like to see.