CD Rates May Be a Better Match for College Savings Than Stock Market Volatility
November 24, 2009
CDs Can Be an Ideal Vehicle for College Savings
The hit that retirement funds took during the stock market slide of 2008 and 2009 has been widely discussed, but college savings funds that were invested in stocks are likely to have suffered a significant setback through this period as well. As a result, college savers may want to look more seriously at CDs as a suitable vehicle for college savings.
Over the past decade or so, more and more parents have turned to Section 529 plans as college savings vehicles. These plans vary from state to state but generally have a range of approved investment options, including stock funds. Unfortunately, the past decade has been a particularly weak one for stocks, while tuition at the average college certainly hasn't gotten any cheaper.
CDs vs. More Aggressive Investments
This is not to say that stocks have no place in college savings programs. Both stocks and CDs have their pros and cons as college savings vehicles, and the important thing is to recognize those pros and cons and use each vehicle accordingly.
The attraction of stocks is that they provide the potential of higher growth. The more growth in the investment account, the lower the parents' savings rate needs to be to fund a child's tuition. This, however, depends on that growth coming through. Historically, stocks have provided good growth over long periods of time, but their performance over shorter periods--even 5- or 10-year periods--can be erratic. This is an increasingly acute source of risk as a child's college years approach.
CD rates in most environments cannot compete with the potential growth rate of stocks. Therefore, investing at CD rates would require a higher savings rate in order to fund a college education. The advantage, though, is that you don't risk taking a step back just as you are getting ready to draw on the money.
Using CDs to Match College Tuition Needs
Whether you use stocks and CDs within a state's 529 program or simply set aside some after-tax dollars for education, there can be a place for both investments, as long as you make the right adjustments over time.
The key issue here is the relatively compressed timeframe for savings. If you start saving for college upon a child's birth--and remember, the longer you save, the lower the amount you need to set aside every year, thanks to compounding--you'll have roughly 18 years to save for college. Divide that savings period in half. For the first half, you can invest at least some of the savings in stocks. In the early years, you not only have more time to work with, but you also have less money at risk.
As you move into the latter half of the savings period, though, transition more and more of that money to CDs. CD rates may be lower, but they won't put your savings at risk just as those first tuition payments are looming. CDs are not only conservative, but with their term structure, they also offer flexibility. You can put together a portfolio of CDs with maturity dates to match when each semester's tuition payment comes due.
As always, the higher your savings rate, the more principal you'll have invested--and the better your chance of reaching a specific savings goal. Using CDs toward the end of the savings period will help make sure that your hard work and sacrifices are not wasted by an untimely stock market setback.
Source:
Katie Kuehner-Hebert • 529 Pain Is Traditional Product Gain • Nov 03, 2009 • American Banker: http://www.americanbanker.com/issues/174_211/pain_is_traditional_product_gain-1003603-1.html?ET=americanbanker:e1178:2242572a:&st=email
