Improvements in Age-Based Asset Allocation Strategies for College Savings and Retirement Plans

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Executive Summary

During any 17-year period, the stock market suffers at least three corrections and at least one bear market, involving stock market drops of at least 10% and 20%, respectively. Thus, the risk of a market downturn is unavoidable when one is saving for a child's college education.

Delaying the onset of a shift in age-based asset allocation by as much as 10 years can increase the return on investment by as much as a percentage point without significantly increasing risk.

However, one can minimize the impact of the risk of investment losses by using an age-based asset allocation strategy. An age-based asset allocation strategy starts with an aggressive mix of investments when the child is young and shifts to a more conservative mix of investments as college approaches.

Aggressive investments include high-risk, high-return investments like stocks. Conservative investments include low-risk, low-return investments like bonds, CDs, money market funds and cash. As the return on an investment increases, the risk of investment loss also increases.

An age-based asset allocation reduces the impact of market downturns by changing the percentage of the portfolio that is invested in high-risk investments each year from birth to college. When the child is young, the portfolio is invested more in high-risk investments, when less money has been saved and there is more time to recover from losses. When the child approaches traditional college age (e.g., age 17), the portfolio is invested in lower-risk investments to lock in the gains.

Traditional age-based asset allocation strategies for college savings may shift from high-risk, high-return asset classes to low-risk, low-return asset classes too quickly.

This paper presents a systematic way of improving the performance of age-based asset allocation strategies by delaying the onset of the shift to a more conservative mix of investments by up to 10 years. This increases the return on investment by increasing the duration of the initial investment in high-risk, high-return asset classes, but without significantly increasing the overall risk of investment loss. The age-based asset allocation is then compressed to fit the remaining investment horizon.

A similar change to the investment glide path (the change in asset allocation over time) for retirement savings may also lead to performance improvements for retirement plans without significantly increasing the overall risk of investment loss.

This approach can help maximize the amount of money available to pay for college, retirement and other major life-cycle events. It should yield about an 8% increase in total college savings and about a 23% increase in total retirement savings by age 65.