Grad expectations: saving for your child’s education

I hope my daughter doesn’t get into Harvard. The cost would kill me. Even a four-year degree at a Canadian university — if I’m to believe the projections — will cost more than $60,000 by the time my two-year-old is ready to enroll. When I first looked at the numbers, I figured I had better forget about vacations and restaurants for the next 16 years and shunt every penny into my little girl’s education savings plan.

At least, that’s what I thought until I looked closely at the figures and talked to financial experts. What I learned will be a relief to every parent. First, you don’t need to save as much as you think. And second, if you do it right, saving that money won’t cramp your family’s lifestyle. Here’s how.

Set a realistic goal

According to the 2004 — 2005 Guide to University Costs in Canada, compiled by USC Education Savings Plans, the cost of a four-year program for a child born in 2004 will be $66,816 if you live within commuting distance of the college or university. It will be $134,987 if you have to pay for room and board on top of tuition and books. For parents with two or more children, those estimates are positively panic-inducing. But read the fine print and you’ll see they include “incidental expenses” such as local travel, entertainment and cable. Should you really be worried about saving for these items? Probably not.

For a more realistic estimate, let’s start with $4,400, about the national average annual tuition fee last year. Assuming tuition grows at the same rate as inflation, you can expect to pay around $6,500 a year when your child starts university in 2023. Over the course of a four-year program, the total tuition would be about $27,000. Include textbooks and equipment and the all-in cost is about $35,000 over four years.

You can save that by putting away just $20 a week. (I’ll explain how later.) But before we get into the calculations, let me assuage your guilt complex. As parents, we want to help our kids get the best possible start. But that doesn’t mean we have to shell out for every three ring binder they will ever need until they finish a master’s degree. You can teach your children an important lesson by putting some of the responsibility on them. “Kids learn a lot by having to work part-time through school,” says Sandra Foster, a financial educator and the head of Headspring Consulting Inc. in Toronto. “So before you think about how much you’re going to need to put away, think about what would really be in your child’s best interest.”

Patricia Lovett-Reid, senior vice-president of TD Waterhouse and the mother of four, agrees. “We sat down with each of our children and said, ‘We will fund to this amount, but we expect each of you to put in $2,000 a year,’ because I think that’s a reasonable amount they could save. We really thought there should be an incentive and a commitment on their part financially.”

Here’s how the numbers work in my case. Based on my $35,000 estimate for four years of tuition, books and supplies, minus $3,000 a year in summer job revenue that I expect my daughter to kick in ($2,000 a year in today’s dollars, adjusted for inflation), my goal is to save $23,000 by the time she turns 18. By then, my husband and I expect to have retired our mortgage, freeing up $1,000 a month for unexpected expenses, such as room and board if she chooses to attend a university out of town.

Pick a savings plan

Once you’ve decided on a realistic savings goal, you need to choose an investment plan that does three things. First, because your investment horizon is fairly short — a maximum of 18 years — your plan should protect your principal against a market downturn. Second, your plan should produce decent growth and compound your savings. Finally, unless you’re an investing expert, you probably want a low-maintenance program that won’t require you to make constant investing decisions.

Do it yourself

For most people, a self-directed Registered Education Savings Plan (RESP) fits the bill perfectly. You can set up one of these plans through your bank at no charge (although there may be a small annual maintenance fee of $50 or so) and it works like a self-directed retirement savings plan. You can make lump-sum contributions or arrange for monthly debits from a bank account and you can place those contributions in GICs, mutual funds, treasury bills, even stocks and bonds. There are no foreign content limits on your investments. And although your contributions are not tax deductible, the money in an RESP grows 100% tax-free until your child needs it to fund her education — and at that point it’s taxed at her rate, not yours. Since her income will likely be low, she will probably be able to combine her basic personal exemption (currently $8,012) and tuition tax credits to offset any taxes owing on her withdrawals.

Best of all, even if your stock picks perform dismally or bond rates are in the basement, you’re guaranteed a 20% return on the first $2,000 of what you contribute every year for every child, courtesy of the federal government’s Canada Education Savings Grant (CESG). Put in $1,000 a year and you pick up a free $200; put in $2,000 and you’ll get the maximum $400 grant. This grant money grows with the rest of your savings and compounds for even bigger returns. Factoring in the CESG and assuming average annual returns of 5%, I need to save only $16 a week, starting when my child is an infant, to hit my $23,000 goal by the time my daughter turns 18. If I want to build in a cushion, I can raise my contribution to $20 a week. Based on the same assumptions as above, that should compound into the full $35,000 cost of tuition and books by the time my daughter hits 18.

The one drawback to a self-directed RESP is that you have to make investing decisions for your child, which can be stress-inducing if you’re a novice when it comes to stocks and bonds. A simple and smart choice is to put your child’s money into a good, low-cost balanced mutual fund. (See Suzane Abboud’s Best Mutual Funds 2005 for some good candidates.) A balanced fund holds both stocks and bonds and provides a way to give your child a diversified portfolio in one easy swoop. If, for whatever reason, you don’t feel comfortable with a balanced fund, you can have a financial adviser oversee an RESP on your behalf; just remember that his fees will cut into your returns.

Playing pool

Once upon a time, the only RESP option was a socalled scholarship trust, a pooled investment that parents buy into by purchasing units in the trust. The two largest of these, Canadian Scholarship Trust Plan (CST) and USC Family Education Savings Plans, have been around since the 1960s. These firms manage your funds and guarantee your principal by sticking to safe investments such as government bonds and GICs.

Canadians have more than $5 billion in scholarship trusts, but the plans are plummeting in popularity now that most financial institutions offer self-directed RESPs that are more flexible and more transparent. Last summer, scholarship trusts came under scathing criticism from the Ontario Securities Commission, which lambasted them for luring customers with questionable marketing tactics, hidden fees and downplayed risks.

You should take the trusts’ marketing hype with a huge grain of salt. Many claim to achieve above-average returns. Many also promise to top up their payouts with the forfeited earnings of people who drop out, or whose kids don’t go on to post-secondary education. In 2002 — before the Ontario Securities Commission report — CST was claiming an 11.04% return for members whose children completed post-secondary studies that year. However, when MoneySense contacted its head office to get more details, we found the savings plan that earned 11.04% was no longer sold and that the 11.04% figure doesn’t take management fees into account. Details about those fees, which can be extremely high, are buried in the fine print of CST’s eye-blurring 68-page prospectus.

A major concern about many scholarship plans is their limited flexibility. While most will allow you to adjust your monthly or yearly contribution to reflect your financial situation, they also penalize or even disqualify you for missing payments. So if you have one or two months when your cash flow unexpectedly dries up, your entire RESP could be in jeopardy. Stringent rules can also be a problem when it comes time for your child to collect. Most plans mete out payments once a year for four years. That’s not ideal if your child’s financial needs fluctuate from year to year of study, or if she goes to university for more than four years. In contrast, a self-directed RESP lets you make withdrawals anytime you see fit and the plan doesn’t have to be closed until the end of the 25th year after you opened it, which should give your child plenty of time to earn a master’s degree.

Self-directed RESPs are nearly always a better way to save for kids’ schooling than scholarship trusts, but if you’ve already signed up for a scholarship trust, you don’t have to panic and cash out. The Ontario Securities Commission was clear that the problems with these plans relates to the way they are sold, not their accounting practices.

Trust us

An informal trust used to be one of the most popular ways for parents to put aside money for post-secondary education, and some people still swear by this method. Start-up is as simple as making an appointment with your bank or financial adviser to open a savings or brokerage account in trust for your child. To make it official, you must name a beneficiary (your child, of course) and a trustee (your spouse or any adult who is not the donor).

A trust fund’s main appeal is that it can be used for anything that is related to your child, not just his or her education. You can treat it as an emergency fund — if you’re laid off, you can tap the fund to cover the cost of food, clothing and other child-rearing expenses. In contrast, if you were to withdraw money early from an RESP, you may pay a stinging 20% penalty and lose any government grant money.

There are drawbacks to a trust, however. The biggest is that you miss out on the 20% government grant, or CESG. Maintaining a trust is also more work than an RESP. Because the income that grows within the trust is not tax-sheltered, you may have to file a tax return in your child’s name to report the income. Capital gains are not likely to be a problem — they’re taxed at your child’s rate, so unless she’s earning huge sums, she probably won’t have to pay any tax. But dividends and interest may be taxed in your hands.

Most frightening of all, when your child reaches the age of majority — 18 in most provinces — the trust is hers. So if she decides to blow it on a sports car or a trip to Rome instead of law school, you have absolutely no say in the matter. (If you want to stipulate that the funds can only be used for education, you have to open a formal trust, which means hiring a lawyer and paying legal fees.)

My advice is that unless the freedom to access your money at any time is worth more to you than a guaranteed 20% return, stick with an RESP for at least the first $2,000 a year of education savings. Then, since you won’t receive any CESG money for contributions above $2,000 a year, you might start an informal trust with any educational savings left over. This half-and-half approach gives you the best of both approaches: a trust’s flexibility along with free money in your RESP.

“To me the RESP is a no-brainer,” says Heather Clarke of Investors Group in Winnipeg. “A guaranteed 20% return — you probably need to go back to school yourself if you don’t realize that’s a great deal.”