The Well Funded Grandchild

Allow me to introduce The Well Funded Grandchild, the kid with something better than a silver cup and spoon. We are talking now about a child whose grandparents seek to go a step beyond filling a room with stuffed animals from F.A.O. Schwartz, elaborate construction toys, or dresses marketed to grandmothers that happen to be worn by granddaughters.

What would such a child have?

It depends on whom you ask. The Hard Cases will tell you that nothing is any good unless it is earned. At the other extreme you’ll find folks who want to establish a Fund for Ski Passes at Tahoe and Vail.

In fact, there are three broad areas where grandparents ( or parents) regularly wish to help a child: education, buying a first home, and some form of financial security such as a retirement fund. Let’s see what the tab is:

College Education. This is a grab bag of assumptions. The 1997 edition of the Princeton Review Guide To Paying For College estimates that attending the average private college will cost about $20,000 this year. That figure includes tuition, room and board, and fees. With costs rising at 6 percent a year, this means you’d need $80,000 on matriculation day. If you project that forward you’d need to have about $228,000 in 18 years.

An awesome sum? Yes. Fortunately, you don’t have to put aside $228,000 today to have that amount in 18 years. If your money earns 10 percent a year you can buy a college education for about 50 cents on the dollar, about $41,000. You can cut the cost by funding a public college. The cost of the average public institution is now about $7,700 a year. That means you can fund a grandchild with about $16,000.

How do you actually do it?

My choice would be a low cost, tax efficient index fund such as the Vanguard Index 500. While there would be some taxes to pay along the way, they would at first be limited by the child’s tax deduction. In the current market, for instance, dividend income would be virtually tax free. In addition, a large portion would be tax-free or taxable at the lowest rate when it was actually spent.

Caveats?

Absolutely. While college expenses may not continue to outpace inflation, there is no assurance that stocks will bring an average return of 10.7 percent a year before fund expenses. According to Ibbotson Associates the best 15 year period for large common stocks ( 1942-1956) brought an 18.24 percent annual return while the worst ( 1929-1943) brought an annual return of only 0.64 percent.

With a range like that, the thoughtful grandparent is buying a very good lottery ticket. But it’s the best you can do.

Home Down Payment. According to the National Association of Realtors, the median sales price of existing homes was $126,500. That means you would need $12,600 for a 10 percent down payment. The amount might grow by the rate of inflation. Delivered 30 years in the future, the down payment would need to be about $30,600 if we assume 3 percent inflation. All of that would have to be after-tax income, however, so the fund would actually have to have about $38,250 in it, assuming a 20 percent tax rate.

Today’s cost? $2,200.

You need less than 20 cents on the dollar to fund the down payment.

The usefulness of this fund will depend very much on where the grandchild decides to live. It will go a lot further in Houston, Little Rock, or Kansas City where home prices are below the national median ( $93,100, $85,900, and 107,600, respectively) than in Los Angeles, Honolulu, or Boston where median home sale prices are above the national median ( $175,000, $315,000, and $204,400, respectively).

Where do we invest the money? Again, in a tax efficient index fund.

Secure Retirement. To have a secure retirement, you need about 20 years of your final income put aside. According to Jobweb.org, a website on employment opportunities, the 1997 starting average starting salary for graduates in English was $23,500 while the average starting salary for computer engineers was $37,700. We’ll pick an in-between number like $30,000 and grow it at 1 percent plus an assumed rate of inflation of 3 percent.

This means a 22 year old graduate might have a final salary of about $168,500 at age 66 and would need a retirement fund of about $3,370,000. To provide that amount for a new grandchild, however, you would only need to put aside $6,250 today if your fund can earn 10 percent. You can buy a grandchild’s retirement for only one fifth of a penny on the dollar. Such is the magical power of compound growth.

How would the money be invested? Differently. Since this money won’t be accessed until after age 59 ½, it could be put in a low cost tax deferred annuity where it would be allowed to compound, tax deferred, for the entire 66 year period. Vanguard has recently lowered the mortality charges for its tax deferred annuity products so you could invest at a total cost of about 0.5 percent a year, hardly making a dent in the 10.7 percent long term return of common stocks.

Now let’s take a look at the total tab:

The Well Funded Grandchild

If you look to the future, you can do a whole lot for the price of a car.

This information is distributed for education purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Photo: Hai Nguyen

(c) Scott Burns, 2022