When your client wants an age-based 529 plan with more equity exposure

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Vince Sullivan

By Vince Sullivan

April 30, 2018

Age-based portfolios exist to make 529 plans easy to manage from an investment standpoint. With an age-based approach, risk is automatically reduced at specific age / years-until-enrollment intervals, from equities to fixed income securities to money market type portfolios. This is the same strategy many of your clients use for retirement savings. But, as you may have experienced, some clients aren’t satisfied with the amount of equity exposure in age-based portfolios. 

How much is too much equity exposure? 

Prudent portfolio management theory states that the farther away an obligation is, whether it be college, retirement, or some other obligation, the more that time and investment risk is to your advantage – allowing you to be more aggressive with your investment selection. The inverse of this premise is that the shorter the investment horizon, the more the investment markets should be viewed with caution and risk aversion. 

One other investment theory holds that equities are viewed as more aggressive than fixed income investments, and their corresponding returns generally are divergent from each other – when one asset class is in favor, the other class is out of favor, with corresponding positive and negative returns and performance. The problem with this simplified description is that there have been numerous instances when these investment premises have been unreliable – such as right now, in the Spring of 2018, when many investment professionals are saying that the US stock markets are long overdue for a correction and that people should be in cash instead if invested in the markets. When will this inevitable and long-overdue correction come? What will cause it? How much will the markets correct, which areas of the market will correct, and how fast will they rebound?

These are all nearly-impossible questions to answer accurately for two reasons. First, because no one really knows, and second, because the investment markets are inexact and irrational. There have also been times when the risk of fixed income investments has exceeded the perceived riskiness of equity investments, based on fundamental and technical analysis, as well as other times when the equity and fixed income markets have converged, moving in the same direction as the other asset class, for certain short-term periods and reasons.

One conclusion can be drawn from the above conversation: the markets are irrational. MANY risks abound for today’s investor, and the argument for diversification is as strong today as it has ever been. A prudent investment conversation to have with clients is that the sooner they need to access their money to fulfill a prior obligation (like college), the less risk that should be taken with that sum of money.

Just imagine if the day, week or month immediately preceding when your client needs to withdraw their funds, the markets correct and wipe out any account gains – or perhaps even worse – put the account into the negative return category. I’d prefer to see this perspective as realistic and practical rather than pessimistic! 

What to suggest to clients who want more equity exposure

Yet many of us have had clients looking for more equity exposure than what’s offered in their age-based 529 plan portfolio. It’s important that you, as their advisor, to remind them of the risks associate with their request. You can also offer the following alternative suggestions:

  • Alternative 1: Discuss the additional risk and recommend that the client continues with 100% of their 529 account invested in the age-based portfolio for their child. 
  • Alternative 2: Split the 529 plan funds among available investment choices, such as 80/20: 80% age-based & 20% specific-objective or risk-level (aggressive, moderate, conservative) portfolio. There are a number of ways of splitting up the portfolio using this methodology – a couple other ways could be 50/50: 50% aged-based & 50% specific objective or 50/30/20: 50% aged-based, 30% specific objective, and 20% moderate risk portfolio. 
  • Alternative 3: When completing the online application, change the age of the child, so the child’s stated age is younger than their actual age. This way, your client can still invest in the glide path, and get additional equity exposure over time. Will this work? Sure. Is it advisable? I suppose situationally, it’s fine, but I’d advise against this alternative for most clients.

You’ll also want to consider how long the student may be in school. Age-based portfolios are meant to reduce risk to near-zero by the time the beneficiary is about to enroll in school. However, the current national average for a student to be enrolled in a four-year institution is not four years…. not even five years…. but actually, SIX years. This is not some short-term data anomaly – this has been the case now for several years. Unfortunately.   

But whether the number is four, five, or even six years, the same consideration applies – there are several more years for which the money in the 529 account will remain. Remember, amounts withdrawn in any calendar year must be for qualifying 529 expenses incurred during that same year. That means some of the account value will be distributed in year one, some additional money distributed in year two, and so on until graduation occurs.   

For the portion of the account which will not be distributed for four or more years into the future, could, or should, that money remain invested in some type of equity or fixed income investment? Perhaps. The answer depends on several considerations, including the client’s risk tolerance. For a particular client who is looking for that additional equity exposure, going with alternative #2 (splitting the funds among different investment portfolios) might just be the perfect solution. Does it carry risk? Yes. Can an argument be made against it? Yes. However, this strategy offers a number of different options to meet each client’s individual needs. You can choose to split among almost any investment portfolio combination available, as long as it adds up to 100% on the exchange form or online screen. 

Be an advisor to your clients. That means be knowledgeable, be creative and think outside the box! Remember that by taking this splitting approach, the account will more ongoing attention and portfolio monitoring, since only the chosen percentage of the portfolio will have that automatic risk reduction over time, with the remainder staying invested according to the selected investment objective. 

Other considerations

There are also scenarios where the client wants additional equity exposure given certain life events. For example, the fortunate “problem” of having money leftover in a 529 plan after graduation, due to scholarships or other unforeseen situations. In this case, the client can change the beneficiary to a sibling or other qualifying family member so that the attained earnings remain tax-deferred (a non- taxable transfer event) do nothing with the account (non-taxable), change the account beneficiary to someone outside the family (taxable) or effect a partial or complete non-qualified distribution (taxable). Ideally, the account earnings will continue to grow tax-deferred and be used in the future in a tax efficient manner, however, an account owner has the right to do whatever he/she chooses with those unused funds.

Might the owner decide to leave the 529 account intact and hopefully have it grow, tax-deferred, for many more years based on its equity-based investments? Could the account be used to fund another obligation? Possibly adding it to your client’s rainy-day slush fund or future ‘fun’ education degree, or be an extra sum of money to help your client cover an unexpected emergency or life event? Be the advisor, be creative, and know the rules! 

To help your clients determine the appropriate asset allocation for their college savings portfolio, check out each plan’s investment options details

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