When Should You Start Saving for College?

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Last month, Morningstar released its annual ratings of the best 529 college savings plans for 2020. But choosing a good plan isn't enough. Time is an important part of the equation. Joining me today to discuss when you should start saving for college is Madeline Hume. Madeline is an analyst in Morningstar's Manager Research group on the multi-asset team.

Thanks for being here today, Madeline.

Madeline Hume: Thank you so much for having me, Susan.

Dziubinski: Let's start off by talking a little bit about the ratings. Morningstar made some methodology changes to the ratings this year. Can you talk a little bit about those?

Hume: Absolutely. One of the changes that we made was to make our ratings simpler. We now rate four underlying pillars instead of five that roll up to our overall ratings of Gold, Silver, Bronze, Neutral, and Negative. Our Performance Pillar is now getting absorbed into other assessments. Another was to provide greater transparency into what's really driving our ratings, with our written analysis expressing our pillar ratings across the five-point scale, ranging from High to Low.

Our Price Pillar puts even greater emphasis on the absolute value of a plan's fees and now conveys our assessment of a plan's fees irrespective of its distribution channel or the strategy of the underlying investment options. As a result, this new methodology favors direct-sold plans over advisor-sold plans.

Given how much the investments that 529 plans hold have improved over recent years, our new People Pillar emphasizes the team behind a plan's investment options, which raises the bar for a plan's investment resources. We also don't include any tax benefits in our analysis anymore, given how highly individualized the benefits that individuals receive from contributing to a 529 plan can be.

Dziubinski: Given those changes to our methodology, which plans came out with our highest rating of Gold? Did they share any particular traits?

Hume: Yes. Two plans were reaffirmed at Gold this year. Bright Start Direct out of Illinois and Utah's my529 plan. Joining them this year was a new entrant, which was Michigan's Education Savings Program. These plans are all unique, but what they have in common is low costs, strong stewardship, and exceptional asset allocation. Any investor that finds themselves in these plans can have confidence that they've made an excellent choice.

Dziubinski: And let's look at the flip side. What are some plans that didn't fare quite as well under our new approach?

Hume: Our enhanced methodology does set a higher standard for Neutral ratings, and six plans failed to reach that bar for the first time this year, receiving downgrades to Negative and joining two other plans that were previously given that designation. Five of these downgrades were for those more expensive advisor-sold plans that I mentioned. And all eight of these plans currently charge fees that investors are better off avoiding even if they live in a state that provides some tax benefits for investing in that plan. Some may also have significant design flaws, like large allocation steps.

Dziubinski: If someone is looking to open a 529 college savings account, how can they use these ratings to help inform that decision?

Hume: Our Medalist-rated plans carry our strongest recommendations from Gold at the highest level down to Bronze. For investors that live in a state with no state-specific income tax benefits or if you have a home state that earns one of these designations, you need look no further than this short list. However, many states offer state-specific incentives and may make up for a so-so plan, which we would give a Neutral rating under our methodology. Again, we don't take those tax benefits into account anymore, given how highly specific each tax situation for a college saver is. So, in those cases, investors should weigh the potential cost savings of a yearly tax benefit against the higher expense ratios and lower-quality investments that these plans provide, ideally in consultation with a financial advisor.

Dziubinski: Now, many of these age-based plans work under the assumption that these assets are invested for 18 years. But given how hard choosing a plan can be and saving for college can be, when have you found that families actually start saving for college?

Hume: Right. We conducted a study last year that shows that the average 529 account is open when a child is 7 years old and that only gives him 11 years to save for college. That makes an already compressed investing time horizon that much more fraught, and a lot of these plans are designed with 18-year time horizons in mind, so investors aren't getting the full utility out of these plans that they offer.

Dziubinski: Then what's the opportunity cost to an investor by starting so late?

Hume: Based on that study, to put it into context, for a $50,000 total savings balance, even one additional year that investors delay can cost some potential gains of up to $5,900 depending on when that account is open.

Dziubinski: Now, that's significant. What if you are one of those late-start college savers? Do you have any suggestions for those people and what they might be able to do to play a little catch-up?

Hume: Right. It's tough. College savers who start investing in 529 plans later do miss out on those equity-heavy portfolios with the most growth potential. While stocks are certainly more volatile than bonds, they do have greater return potential over the long run, and each year that investors wait lowers the growth potential of their savings as age-based portfolios gradually de-risk. College savers may be tempted to make up for lost time by making large contributions or taking on additional risk in their portfolios, but it is hard to make up for years of missed compounding, which underscores the virtue of saving for college as soon as possible. However, college savers do have some benefits that other investment savers like retirement savers don't have, which include student loans and other kind of less traditional investment options. It's prudent to consider the entire menu of options that are available to college savers beyond just the 529 account.

Dziubinski: Madeleine, thank you so much for your time today. We really appreciate it.

Hume: Thank you so much, Susan.

Dziubinski: I'm Susan Dziubinski for Morningstar. Thank you for tuning in.