This is a continuation of Part 1: Extension of Retirement or Standalone Portfolio?
If you’ve chosen a standalone portfolio for your 529 plan, every provider will offer you age-based portfolio that automatically adjusts based on the age if your child. In general, it starts out with mostly stocks and over time becomes mostly bonds and cash. This preset plan is called the glide path.
My biggest gripe about the glide path of most age-based default portfolios is their short holding periods for stocks. Nearly every one starts with a ton of stocks, and then quickly shifts to a ton of bonds. You’re basically hoping for big stock returns over a short window of time, which is more gambling than investing. Allow me to explain…
Here is the glide path for Moderate Age-Based Option of the Vanguard 529 plan, Nevada (click to enlarge):
You start at 75% stocks, and then at 6 years old you are down to 50% stocks, and then at age 11 you are down to 25% stocks. So 25% of your portfolio only holds stocks for at most for 6 years. (Imagine if you contributed money at age 5.) Another 25% is only held at most for 11 years.
If you contributed equal amounts of money every year to this Nevada 529 moderate age-based plan, your average hold time for half your portfolio (2/3rds of the stock portion) is around 4-5 years in stocks. If you did a lump-sum in the beginning, the average hold time for half your portfolio would be 8.5 years.
Here is the glide path for Moderate Age-Based Option of the UESP 529 plan (Utah):
You start at 80% stocks, and then at 7 years old you are down to 60% stocks, and then after another 3 years (age 10) you are down to 40% stocks. At age 13, you are at 20% stocks. That means 20% of your portfolio only holds stocks for at most 7 years. Another 20% only holds stocks at most for 10 years. Another 20% holds stocks at most for 13 years.
If you contributed equal amounts of money every year to this Utah 529 moderate age-based plan, your average hold time for 60% your portfolio (75% of all your stock holdings) is around 5 years in stocks. If you did a 100% lump-sum in the beginning, your average hold time for 40% of your portfolio would be 8.5 years.
Hold time vs. Investment returns
Note that within 5-year and 10-year periods, there are lots of white and red squares which indicate periods of zero or negative inflation-adjusted returns. The longest drawdown was 10 years. Wouldn’t you like to have ridden that out with a longer holding time?
Side note: Some people have criticized the sharp step-downs in the glide path. Vanguard addressed this concern in their 529 whitepaper [pdf]. They ran back-tested simulations and found little difference between a smoothed and stepped glide path (click to enlarge).
They concluded asset allocation was more important, which I agree with, but I wasn’t satisfied with the amount of evidence supporting their short stock holding periods. Sure, on average things look good, but in any given 5-year period things could be quite bad.
My alternative plan is more slow-and-steady, just like my overall retirement portfolio. I will start out with a balanced allocation at roughly 60% stocks and 40% bonds, as opposed to 75%, 80% or 100% stocks. I will then stay that way as long as I can so the stock portion will have a long holding period. Probably 6 years out from college, I will convert 10% from stocks to bonds/cash. So 60/40 > 50/50 > 40/60 > 30/70, and so on until I am at 100% cash at age 18.
I will also front-load my contributions so that they are within the first few years. I know not everyone can do that. This means I will hold all of my stocks for a minimum period of 10 years, with the average holding time closer to 15 years. Look again at the green/red chart above with a 15-year holding period.
I haven’t quite decided on the exact fund mix, but I have settled on using the Utah 529 plan, as it allows full customization and scheduling of your own glide path with a pretty solid menu of low-cost and passive investment options. Last part of this series will have the full implementation.