College remains the highest savings priority of parents of college-bound children. Over 75% of parents in this group, when surveyed by The College Investor (TCI), indicated that they’re currently saving for college. TCI found that over 80% of parents are concerned about the impact of inflation on their college savings and the volatility of the stock market.
The amount that parents need to save increases as tuition rises. TCI found that parents intend to save an average of 69% of their child’s college costs, but most will fall short of this goal. Parents are actually on track to save only 27% of college costs. This may be partially due to their reliance on inaccurate data about tuition, but, for the most part, it’s due to the fact that it’s easy to underestimate the astonishing rate of growth of tuition.
Inflation and the U.S. Economy
The rate of CPI inflation appears to have peaked at 9.1% in June, but the rate was still elevated at 7.1% in November of 2022. Inflation is heading down, but it’s still too high for a healthy economy. As long as the labor market is growing rather than contracting, the Federal Reserve Board will continue to raise interest rates. The Fed has increased interest rates by raising its own discount rate to member banks by 2.75% since March of 2022. The Fed is expected to continue to raise rates at the same pace until inflation is below 5%.
Inflation is caused by an imbalance between supply and demand. In 2022, inflation was aggravated by supply chain problems, the impact of the war in Ukraine on energy prices, the remaining effects of the pandemic, and other factors. Higher interest rates raise the borrowing costs that affect credit cards, auto loans, business loans, mortgages, and other rates. The Fed hopes that increasing the cost of borrowed money will slow spending, or demand, and thereby bring inflation down. Sometimes this works. However, high inflation has been accompanied this time by a tight labor market, which heats up the economy that the Fed is trying to cool down by forcing businesses to raise wages.
The raising of interest rates by the Fed is a blunt instrument that doesn’t target the root causes of inflation. In fact, historical data show a weak correlation between interest rates and inflation. Yet, increasingly, interest rate and money supply manipulation are the only tools available to the Fed to fight inflation.
Parent’s Concern Over Stock Markets
Most 529 Plan providers market the ability to invest in stocks as the core of their appeal. But in the current stock market this message is problematic. Parents tend to panic when they see the value of their account move downward due to a decline in their stocks.
Stock valuations depend on the calculation of the Net Present Value (NPV) of the future revenue stream of a stock. The discount rate used in NPV calculations needs to take the anticipated rates of inflation and interest into account. This means that the NPV discount rate will rise in line with them.
Hence, stock valuations decline in an inflationary economy, encouraging investors to sell and forcing stock prices down. Stock market turmoil is likely to persist at least as long as the Fed continues to tinker with interest rates, probably at least through 2023. Interest rate moves by the Fed and the stock market’s reaction to them are notoriously hard to predict.
Inflation and Tuition
In 2020 and 2021, tuition rose at a slower rate than inflation for the first time in a generation. Between 1978 and 2020, the CPI increased by 326%, but college tuition rose 1,426%. During the pandemic, the typical college faced a fiscal crisis caused by declining enrollment, high COVID-related expenses, and the cost of deploying distance education technology. During this period, average tuition rose only 2.1% at private colleges and 1.6% at public colleges despite a rise of 5.3% in the CPI.
The resulting pressure on college “profitability” led to another reversal in direction. In its Opinion section on March 1, 2022, the Wall Street Journal ran an article titled “How Inflation Affects Universities: Rising Tuition Is a Concern for Students”. The article addressed the fact that, at many colleges, tuition had resumed its rapid rate of growth.
Currently, the key question in the college savings account environment is: “How can families save effectively for rising college tuition prices if inflation is undermining the value of the investments in their college savings accounts? “
Inflation’s Impact on College Savings Accounts
Let’s consider the implications of inflation on 529 Plans, which, along with Education Savings Accounts, are the most popular, tax-advantaged methods of saving for college. 529 Plans may be at least partially invested in equities. Despite recent declines in the stock market, most advisors recommend that 529 investors stay the course, remain invested in stocks, and contribute more investable funds every month. According to the TCI survey, 83% of parents are taking this advice and plan to maintain or increase the amount that they contribute to their 529 Plan. They recognize that pulling out their investment now will only lock in losses, causing them to miss out on the next bull market.
Stock market volatility has less of an impact on families who choose an age-based or enrollment-date asset allocation methodology for their 529 Plan. These pre-planned investment strategies periodically adjust the mix of investments, reducing the percentage invested in stocks as the child approaches college age. When enrollment is near, the allocation for stocks usually declines to 10% of the total amount in the account. This reduces the exposure of a 529 Plan to a major market decline when it’s too late to recover from it. Almost 70% of current 529 Plans use one of these investment options.