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With school back in session in most of the country, many grandparents and parents are thinking about how to prepare for their grandchildren's or children’s future college expenses.
Now is a good time to sharpen one’s pencil for a few important lessons before heading back into the investing classroom to tackle the issue. Get your Retirement Checklist of over 30 things that you need to think about for your retirement.
AVERAGE COLLEGE TUITION COSTS IN 2017
According to recent data published by the College Board, the average annual cost of attending college in the US in 2017–2018 was $20,770 at public schools, plus an additional $15,650 if one is attending from out of state. At private schools, average college tuition costs and fees were $46,950.
It is important to note that these figures are averages, meaning actual costs will be higher at certain schools and lower at others. Additionally, these figures do not include the separate cost of books and supplies or the potential benefit of scholarships and other types of financial aid. As a result, actual education costs can vary considerably from family to family
AVERAGE COLLEGE TUITION COSTS IN 18 YEARS
To complicate matters further, college costs have historically increased every year. This increase is due to inflation. Inflation makes the amount of goods and services $1 can purchase decline over time.
One measure of inflation looks at changes in the price level of a basket of goods and services purchased by households, known as the Consumer Price Index (CPI). Tuition, fees, books, food, and rent are among the goods and services included in the CPI basket.
In the US over the past 50 years, inflation measured by this index has averaged around 4% per year. With 4% inflation over 18 years, the purchasing power of $1 would decline by about 50%. Said another way, the amount of goods that $1 will purchase today, will only purchase $0.50 worth of goods in 18 years!
However, the cost of college tuition has historically risen faster than average inflation. In fact, over the past 5 years, college tuition costs have risen 5% per year.
What does this mean? Well, if you plan on funding your grandchildren's or children's education, you might be in for a shock. Based on data from CollegeBoard.org, at a 5% inflation rate, the total cost to attend just one year at a public, in-state college including room, board, tuition, and fees will increase from $20,770 to $49,985! This is per year.
If you want to pay for 4 years of college, total costs may rise to $215,444 in just 18-years as seen in the chart below.
Going forward, we do not know what the cost of attending college will be. But again, we should expect that education costs will likely be higher in the future than they are today.
So, what can grandparents and parents do to prepare for the costs of a college education? How can they plan for and make progress toward affording those costs?
BEST WAYS TO SAVE FOR COLLEGE
To help reduce the expected costs of funding future college expenses, grandparents and parents have several options.
Invest in a 529 College Savings Plan.
A 529 plan is a college savings plan that offers tax and financial aid benefits. 529 plans may also be used to save and invest for K-12 tuition in addition to college costs. Investment earnings in a 529 plan are not subject to federal capital gains tax and generally not taxed by state governments when used for the qualified education expenses. Additionally, some states, like Virginia, allow a state tax deduction up to $4,000 per account.
There are two types of 529 plans: college savings plans and prepaid tuition plans. Almost every state has at least one 529 plan. Using a tax-deferred savings vehicle, such as a Virginia 529 plan or other state sponsored 529 plan, parents may not pay taxes on the growth of their savings, which can help lower the cost of funding future college expenses.
Invest in assets expected to grow faster than inflation.
First, you can invest in assets that are expected to grow their savings at a rate of return that outpaces inflation. By doing this, college expenses may ultimately be funded with fewer dollars saved.
Because these higher rates of return come with the risk of capital loss, this approach should make use of an adequate investment management strategy to balance the returns you need with the amount of risk you are willing to experience. While inflation has averaged about 4% annually over the past 50 years, stocks (as measured by the S&P 500 Index) have returned around 10% annually during the same period.
Therefore, the “real” (inflation-adjusted) growth rate for stocks has been around 6% per annum. The real rate of return is simply the return of your investment minus inflation during the same time frame.Looked at another way, $10,000 of purchasing power invested at a 6% real rate of return over the course of 18 years would result in over $28,000 of purchasing power later on.
We can expect the real rate of return on stocks to grow the purchasing power of an investor’s savings over time. We can also expect that the longer the horizon, the greater the expected growth.
By investing in stocks, and by starting to save many years before children are college age, parents can expect to afford more college expenses with fewer savings.
It is important to recognize, however, that investing in stocks also comes with investment risks. Like teenage students, investing can be volatile, full of surprises, and, if one is not careful, expensive. While sometimes easy to forget during periods of increased uncertainty in capital markets, volatility is a normal part of investing. Tuning out short-term noise is often difficult to do, but historically, investors who have maintained a disciplined approach over time have been rewarded for doing so.
A key part of maintaining this discipline throughout the investing process is starting with a well-defined investment goal. This allows for investment instruments to be selected that can reduce uncertainty with respect to that goal.
When saving for college, risk management assets (e.g., bonds) can help reduce the uncertainty of the level of college expenses a portfolio can support by enrollment time. These types of investments can help one tune out short‑term noise and bring more clarity to the overall investment process. As kids get closer to college age, the right balance of assets is likely to shift from high expected return growth assets to risk management assets.
Diversification is also a key part of an overall risk management strategy for education planning. Nobel laureate Merton Miller used to say, “Diversification is your buddy.”
Combined with a long-term approach, broad diversification is essential for risk management. By diversifying an investment portfolio, investors can help reduce the impact of any one company or market segment negatively impacting their wealth.
Additionally, diversification helps take the guesswork out of investing. Trying to pick the best performing investment every year is a guessing game. We believe that by holding a broadly diversified portfolio, investors are better positioned to capture returns wherever those returns occur.
Partner with your financial advisor.
Working with a trusted financial planner who has a transparent approach based on sound investment principles, consistency, and trust can help investors identify an appropriate college savings strategy.
Such an approach may limit unpleasant (and often costly) surprises and ultimately may contribute to provide you and your family more money long-term. The money you save may be reallocated toward retirement, giving to your favorite charity, or improving your lifestyle.
CONCLUSION
Higher education may come with a high and increasing price tag, so it makes sense to plan well in advance. There are many unknowns involved in college education planning, and no “one-size-fits-all” approach can solve the problem. By having a disciplined financial planning approach toward saving and investing, however, parents can remove some of the uncertainty from the process.
A trusted advisor can help grandparents and parents craft a plan to address their family’s higher education goals.
Mark Fonville, CFP®
Mark has over 18 years of experience helping individuals and families invest and plan for retirement. He is a CERTIFIED FINANCIAL PLANNER™ and President of Covenant Wealth Advisors.
Disclosure: All expressions of opinion are subject to change. This information is intended for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, products, or services.
Diversification does not eliminate the risk of market loss. Investment risks include loss of principal and fluctuating value. There is no guarantee an investing strategy will be successful.
Past performance is not a guarantee of future results. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.
Registration of an investment advisor does not imply a certain level of skill or training.