College Savings in 529 Plans May Be Worth Less Than HopedCollege Savings in 529 Plans May Be Worth Less Than Hoped

(The writer is a Reuters contributor. The opinions expressedare her own.)

By Gail Marks Jarvis

CHICAGO, Sept 20 (Reuters) - Parents who are counting onsavings in 529 plans to pay for college this year or next couldbe in for an unpleasant surprise.

Right when they need the money most to cover costs fortuition and dormitory rooms, they could find their 529 stash hasdwindled.

The reason: Bonds.

Most 529 money for students about to go to college is placedin bonds by fund managers. The idea is to avoid the volatilityof the stock market and keep money safe in bonds so families canrely on their savings at the crucial moment when the collegebills must be paid. But, while bonds are safer than stocks,there are times when bonds can present losses. And that timecould arrive soon if the Federal Reserve raises interest ratesas expected this year and next.

As expectations for a stronger economy and rising U.S.interest rates arose during the last quarter of 2016, theaverage mutual fund that invested in a variety of bond typeslost 2.89 percent, according to Lipper.

Because most 529 plans hold small portions of stock and cashin addition to bonds, these accounts did not lose that much. Butwith bond funds dominating "age-based" 529 portfolios forstudents at age 18 or 19, the average lost 0.57 percent in thelast quarter of 2016, and many lost about two percent, accordingto Morningstar.

The 529 plans are offered by states and have become apopular way to save for college because parents can put away alittle at time for children routinely as they grow up, and moneyused for college isn't taxed. Of these, parents tend to preferthe so-called ‘age-based approach’ to investing, in which fundmanagers invest heavily in stocks to grow money when thechildren are young. As students approach their college years andcan't afford a loss in the stock market, managers pull away fromstocks and invest heavily in bonds and some cash.

A 0.57 percent loss, or even a two percent loss in collegesavings, would be nothing to keep a parent awake at night iftheir child was young. But when parents are sending a child tocollege every penny is precious.

According to research by Sallie Mae the average family hadsaved only $16,380 for college in 2016, which wasn't enough tocover even a single year. Last year parents said their averagecost of college was $23,757, and many colleges now run more than$30,000.

SEARCH FOR SAFETY

As 529s for 18 and 19 year old students lost value, someadvisers told parents to move money into the safety of stablevalue funds, money market funds or CDs, depending on what theirstate 529s offer. Advisers acknowledge that it is impossible toguess what interest rates will do at any point, but when moneyneeds to be spent that is not the time to risk a bad cycle ineither stocks or bonds.

"If a 529 goes down and you owe tuition on September 1,that’s when you have to pay," said Minneapolis financial adviserGary Greenberg. "You can’t wait. So the question is: Is it worthtaking a risk or is enough, enough?"

People vary on the risks they are willing to take, saidGreenberg. "But too often people stay in these funds withouteven thinking about it."

Here is why rising interest rates turn bonds into losers:Whenever interest rates are rising, investors are able to buynew bonds that pay higher interest than the old bonds theypurchased before rates surged. So the old bonds that are sittingin 529 plans decline in value.

Think of it this way: If you had a choice between an oldbond paying you two percent interest or a new bond paying threeor four percent interest, which would you want? Clearly, peoplewant to earn as much interest as possible, so funds holding ontoold, low-yielding bonds suffer losses.

With time, a bond fund manager will be able to buy bondsthat pay higher interest rates and the fund should recover, butstudents going to college do not have the luxury of time. Theyneed money instantly, and while some families lost only abouttwo percent during the last quarter of 2016 in 529s, the futurecould be more harsh if the economy continues to strengthen andthe Fed pushes rates higher.

To check your 529 bond risks look at what is called"duration." It estimates how sensitive a fund will be ifinterest rates change.

According to Morningstar, the duration of the average 529fund for 19-year-olds is 4.32 percent, but many have durationsclose to six percent, which would make their losses greater.

What does that mean for 529 investors? Fidelity Investmentsnotes that if rates were to rise one percent a bond or a bondfund with a five-year duration would lose approximately fivepercent of its value.(Editing by Lauren Young and Diane Craft)