For parents, proactive-forward-thinking students, and perhaps even newer financial professionals who want to tackle the topic of college planning, you may have noticed that this is a subject that the the retail financial services industry seems to be very contradictory about. On the one hand they champion a tempered risk exposure, and on the other they point out that to keep up with the soaring cost of a college education (growing annually by some accounts by as much as 7%) you need to make stocks a very serious part of your college funding game plan.
So what to do? Again, we find the source of our problem in America's huge deficiency in creative thinking and problem solving–not to mention our lack of applying math appropriately. Today, we'll dive into a new plan that has worked for quite some time, and has few detractors.
Part I The Rate of Return Boogie Man
First, let's call into question if 7% is even a reasonable expectation. I've addressed this concept before based on a Monte Carlo of the S&P where we determined that we don't break into a 90% probability until we lower our expectations on rate of return all the way down to 5% (which is 50 bps above the average return realized by mutual fund investors over the past 20 years according to DALBAR). We also know that the last 10 years have returned pretty much nothing on the S&P, so if your bundle of joy just turned 10 and you rushed out a few days after she was born (promised I'd used a female on my next example) and opened a 529 plan placing the majority of that money in stocks associated with the S&P, you'd be pretty much at your basis–a long shot from 7% CAGR. The S&P 500 would need to currently be at around 2257 itself to have grown 7% per year over the past 10 years…it's currently at 1361; by year 20 it needs to be at 4400…good luck.
So if stocks won't yield enough to keep up with the increase in college costs, what do you do? Give up and tell you child there's plenty of fun jobs out there that don't require a degree? That's one idea, but we'll introduce another.
Something that makes plans like 529's even worse than their disappointing returns, is the fact that a portion (though it's a small one) of their total value gets included in traditional financial aid calculations. The good news is they are counted as parent assets, the bad news is not only do they tend to fail to keep up with cost increases, they increase your overall expected family contribution. So why not seek out a method that takes the money saved completely off the table? Would that not enhance it's overall usability return (i.e. even if we missed the mark on rate of return, if having an asset that isn't included in the calculation for financial aid eligibility, do we not then get a little boost in usability that we could quantify in rate of return considerations?). And if that asset could be used for anything (parking tickets, off campus housing, meals, spring break vacations she just has to go on or else her friends won't be friends with her anymore) would that not make it even more powerful?
Enter cash value life insurance…
We know that cash value life insurance is extremely low risk, but surprisingly good at rate of return relatively speaking. It has produced a positive return over the course of the last 10 years and doesn't care about crashing markets nearly as much as your 401k probably did. In other words, it's predictable, and when it comes to making a plan to fund a major expense several years into the future, predictability is a really really good thing.
But not only is this assets low risk, it affords a lot of other benefits the 529 cannot. It's not included in the FAFSA and as such rarely gets considered when it comes to financial aid eligibility determinations (some private universities might as about cash value life insurance held by student and/or parents, there are ways around this as well). You can also make tax free distributions from it, for any expense you have, not just qualified educational expenses like a 529. Also, if your daughter turns out not to be the college type (at least not for now) she can split and jump into the working world, and the gain on the policy isn't then taxable on gain if spent on other non-education expenditures, you also don't have to worry about possible back tax penalties if you took a state income tax deduction on your 529.
Part II will roll out in a few days. We'll address how cash value life insurance guarantees the money is there to pay for college, and how this plan pulls double duty to pay for college and your retirement, something a 529 will never be able to do.