Market Volatility Message
Saving For College In A Volatile Market
November 18, 2008
Bad news in the financial markets is always stressful, but it feels especially unsettling to parents who are seeing the balances in their 529 college savings plan accounts decline. What is happening, and how should 529 investors respond? We've asked T. Rowe Price Certified Financial Planners Judith Ward and Stuart Ritter to discuss their perspectives on college savings-not only as planners but also as parents. T. Rowe Price is the Program Manager for John Hancock Freedom 529.
Most 529 savings plans are broadly diversified, and the typical enrollment-based portfolio is automatically managed to become more conservative as a child approaches college age. But these features have not spared these portfolios from feeling the impact of the current market downturn. With most major asset classes except short-term Treasuries being battered, even more conservative, bond-heavy portfolios have been hard-hit.
The temptation in extreme circumstances is to change your strategy, in the belief that doing so will secure the financing of your child's education. Ward and Ritter understand that impulse, especially Ward, who has a child in college and one rapidly approaching college age. But she also understands the risks. "While this market may be driving you emotionally to pull everything out or make dramatic changes to your strategy, it's better to stick to your plan," says Ward.
Ritter agrees, "If your time horizon has not changed since you opened the account, neither should your investment plan."
The Risks of Dropping Out
In this troubling economy, you may feel pressure to take all of your assets out of your 529 account, but pulling out of a 529 plan altogether can be a particularly damaging move. Investors in a 529 plan can get significant tax benefits that they would lose altogether. And, because of those benefits, the Internal Revenue Service has rules about taking a distribution from a 529 plan. In most cases, if you withdraw money from the account for anything except college expenses, you must pay a 10% penalty on any earnings, along with any applicable income taxes.
In many 529 plans, it's also possible to move assets to a portfolio dominated by cash or very short-term bonds. This option may seem appealing in the midst of market turmoil, but it, too, has risks for parents who still have many years until college expenses come due. Pulling out of equity markets when they are at such a low point effectively locks in your losses, while preventing you from benefiting from any future upswings in the market that can help you recover previous losses. As Ritter explains, this is especially true of the early days of a market recovery.
"In environments like this," he explains, "we typically can anticipate a few days of significant market gains, but it is almost impossible to predict when they will happen. Missing even a few of them can seriously limit your ability to recover."
History Class
Market upswings are as unpredictable as declines, and history shows that a significant amount of the long-term return available from investing in stocks comes from gains made in a relatively small number of trading days. The table below demonstrates this: over the 10-year period ended December 31, 2007, the stock market's gains would have been wiped out completely if you removed just the 10 best trading days.
T. Rowe Price research indicates that this principle also applies to recoveries from bear markets. In the rebounds from the 12 bear or near-bear markets (declines of 20% or more) since 1957, the S&P 500 Index, on average, recouped one-third of its losses in just the first 39 days after the bottom. The challenge, of course, is that investors only know in hindsight that a bottom has been reached.
Though not all recoveries have been the same, the broad pattern has been clear: investors who maintain their exposure to stocks during a market downturn tend to get better results once the market recovers.
The rules of 529 plans only allow you to change asset allocations for a particular beneficiary once per calendar year; so if you shift away from equities now, you risk missing the strongest days of the recovery before you are able to shift back.
Dealing With Near-Term Tuition Bills
The circumstances may be a bit different if your child will be attending school in the next couple of years. Even though some portfolios are designed to become more conservative as time passes, you may still have some equity exposure along with holdings in bonds. What's the right approach if the tuition bill is coming soon?
One option, says Ward, is to direct new contributions to the most conservative portfolio, so you have choices when it is time to pay tuition. Or if you only recently started saving and your account balances are small, you could shift the account to a younger child in your home, using loans or other savings to bridge the gap.
Another option is to shift money needed for imminent college bills to a more conservative portfolio within the 529 lineup-one dominated by cash or short-term bonds. Of course, most enrollment-based portfolios are designed to shift asset allocations to more conservative investments as the child nears college, but it's worth investigating to determine the specific asset allocation in your portfolio.
In subsequent years, you can repeat this step if need be. But be aware: this approach may steady the value of your account in the short term, but it virtually guarantees you will lose some growth potential of your college investment.
End Notes
The current economic and market backdrop has few historical precedents. Nevertheless, a good way to get your college funding back on track is to prepare properly for the market's recovery. It's worth remembering why your enrollment-based portfolio has stock exposure in the first place-because over the long term, stocks historically have outperformed every other asset class and given investors the best opportunity to grow their assets faster than tuition inflation.
1 Source: Ned Davis Research; analysis: T. Rowe Price.
Data shows average annual returns based on price movements only and do not include reinvested dividends or compounding. The performance shown is that of the S&P 500 Index, which tracks the stocks of 500 U.S. companies. This chart is for illustrative purposes only, and is not intended to represent the performance of any specific security. Investors cannot invest directly in an index. Past performance cannot guarantee future results.
November 18, 2008
Bad news in the financial markets is always stressful, but it feels especially unsettling to parents who are seeing the balances in their 529 college savings plan accounts decline. What is happening, and how should 529 investors respond? We've asked T. Rowe Price Certified Financial Planners Judith Ward and Stuart Ritter to discuss their perspectives on college savings-not only as planners but also as parents. T. Rowe Price is the Program Manager for John Hancock Freedom 529.
Most 529 savings plans are broadly diversified, and the typical enrollment-based portfolio is automatically managed to become more conservative as a child approaches college age. But these features have not spared these portfolios from feeling the impact of the current market downturn. With most major asset classes except short-term Treasuries being battered, even more conservative, bond-heavy portfolios have been hard-hit.
The temptation in extreme circumstances is to change your strategy, in the belief that doing so will secure the financing of your child's education. Ward and Ritter understand that impulse, especially Ward, who has a child in college and one rapidly approaching college age. But she also understands the risks. "While this market may be driving you emotionally to pull everything out or make dramatic changes to your strategy, it's better to stick to your plan," says Ward.
Ritter agrees, "If your time horizon has not changed since you opened the account, neither should your investment plan."
The Risks of Dropping Out
In this troubling economy, you may feel pressure to take all of your assets out of your 529 account, but pulling out of a 529 plan altogether can be a particularly damaging move. Investors in a 529 plan can get significant tax benefits that they would lose altogether. And, because of those benefits, the Internal Revenue Service has rules about taking a distribution from a 529 plan. In most cases, if you withdraw money from the account for anything except college expenses, you must pay a 10% penalty on any earnings, along with any applicable income taxes.
In many 529 plans, it's also possible to move assets to a portfolio dominated by cash or very short-term bonds. This option may seem appealing in the midst of market turmoil, but it, too, has risks for parents who still have many years until college expenses come due. Pulling out of equity markets when they are at such a low point effectively locks in your losses, while preventing you from benefiting from any future upswings in the market that can help you recover previous losses. As Ritter explains, this is especially true of the early days of a market recovery.
"In environments like this," he explains, "we typically can anticipate a few days of significant market gains, but it is almost impossible to predict when they will happen. Missing even a few of them can seriously limit your ability to recover."
History Class
Market upswings are as unpredictable as declines, and history shows that a significant amount of the long-term return available from investing in stocks comes from gains made in a relatively small number of trading days. The table below demonstrates this: over the 10-year period ended December 31, 2007, the stock market's gains would have been wiped out completely if you removed just the 10 best trading days.
T. Rowe Price research indicates that this principle also applies to recoveries from bear markets. In the rebounds from the 12 bear or near-bear markets (declines of 20% or more) since 1957, the S&P 500 Index, on average, recouped one-third of its losses in just the first 39 days after the bottom. The challenge, of course, is that investors only know in hindsight that a bottom has been reached.
Though not all recoveries have been the same, the broad pattern has been clear: investors who maintain their exposure to stocks during a market downturn tend to get better results once the market recovers.
| The Price of Being Out of the Stock Market (12/31/97 to 12/31/07)1 | |
| If you missed this number of the best days... | ...your return would have been |
| 0 | 4.22% |
| 10 | -0.48 |
| 20 | -4.07 |
| 30 | -7.15 |
| 40 | -9.74 |
The rules of 529 plans only allow you to change asset allocations for a particular beneficiary once per calendar year; so if you shift away from equities now, you risk missing the strongest days of the recovery before you are able to shift back.
Dealing With Near-Term Tuition Bills
The circumstances may be a bit different if your child will be attending school in the next couple of years. Even though some portfolios are designed to become more conservative as time passes, you may still have some equity exposure along with holdings in bonds. What's the right approach if the tuition bill is coming soon?
One option, says Ward, is to direct new contributions to the most conservative portfolio, so you have choices when it is time to pay tuition. Or if you only recently started saving and your account balances are small, you could shift the account to a younger child in your home, using loans or other savings to bridge the gap.
Another option is to shift money needed for imminent college bills to a more conservative portfolio within the 529 lineup-one dominated by cash or short-term bonds. Of course, most enrollment-based portfolios are designed to shift asset allocations to more conservative investments as the child nears college, but it's worth investigating to determine the specific asset allocation in your portfolio.
In subsequent years, you can repeat this step if need be. But be aware: this approach may steady the value of your account in the short term, but it virtually guarantees you will lose some growth potential of your college investment.
End Notes
The current economic and market backdrop has few historical precedents. Nevertheless, a good way to get your college funding back on track is to prepare properly for the market's recovery. It's worth remembering why your enrollment-based portfolio has stock exposure in the first place-because over the long term, stocks historically have outperformed every other asset class and given investors the best opportunity to grow their assets faster than tuition inflation.
1 Source: Ned Davis Research; analysis: T. Rowe Price.
Data shows average annual returns based on price movements only and do not include reinvested dividends or compounding. The performance shown is that of the S&P 500 Index, which tracks the stocks of 500 U.S. companies. This chart is for illustrative purposes only, and is not intended to represent the performance of any specific security. Investors cannot invest directly in an index. Past performance cannot guarantee future results.
Version v2007.11.16