The funding dilemma: retirement or college?

• Author: DeCandido, Frank J.

At a recent meeting, a client wanted to talk about paying for his child's college costs for the upcoming spring semester. When asked if he had any retirement savings, he answered that he had a small amount in a whole-life insurance policy. He also noted that he had very little in personal savings. Did he have any other investments? No.

This client is not unique. The dilemma between funding college and retirement can be a difficult one. A parent's first reaction is to provide for his or her child, so the child does not start out life burdened with debt, a very noble cause. In a perfect world, it would be wonderful to have sufficient savings to fund retirement fully and put money away for college. Often, however, a parent cannot afford to do both.

If parents can save for only one of these goals, they should fund their retirement before paying for college, because there are very few ways to fund retirement, but many ways to pay for college. Put simply, money can be borrowed for college, but not for retirement.

Retirement Funding

Experts estimate that an individual will need to replace approximately 65% to 75% of pre-retirement income to maintain his or her current standard of living. Lower-income earners may need up to 90%. One-third of current retirees receive more than 90% of their income from Social Security; see Munnell and Soto, "How Much Pre-Retirement Income Does Social Security Replace?" Center for Retirement Research at Boston College Issue in Brief (No. 36, November 2005), available at www.bc.edu/centers/crr/issues/ib_3d.pdf.

Thus, the first question is, how much confidence does the client have that Social Security will be there on retirement? And, will it provide sufficient funds to maintain his or her current standard of living? With more and more companies no longer providing pension plans, the burden of funding retirement is squarely on the retiree's shoulders.

The main source of retirement funding will come from the retiree, either through a company-based Sec. 401(k) or 403(b) plan, the retiree's own business (in the form of a savings incentive match plan for employees, a simplified employee pension or other qualified retirement plan) or through funding a regular or Roth IRA. Other funding sources are investments, including real estate, stocks, bonds, life insurance, deferred annuities and mutual funds.

Sources: In addition, an individual's residence may be used to fund retirement. For example, New York real estate has increased tremendously in value over the last few years. A homeowner could sell his or her house and bank the proceeds for retirement. The problem with this strategy is timing; it will not work if retirement coincides with a down market in real estate. Also, the retiree needs to move somewhere else affordable. A New York retiree generally would have to move far away (or into a place smaller than the one previously owned) to gain any real benefit from selling.

For the owner of a successful business, the needed retirement funds may be obtained by selling the business. Others may be counting on an inheritance or hoping to win the lottery.

All in all, there are only a limited number of ways to fund retirement. Of course, the longer a person lives, the more he or she will need. The best asset in all of these opportunities is time. With the right planning and funding, the proper amount of retirement savings can be achieved.

However, all of these options require retirement to be funded in some manner; there are no borrowing options. In funding college costs, many options are available to ensure that children are provided for.

Determining College Costs

The first step is to determine how much will be needed for college--the cost of attendance (COA). A parent should pick three colleges, with low, medium and high tuitions. Using the child's age and a 7.8% college inflation rate (the amount of the average annual increase for public colleges and universities for the 2004-2005 school year), tuition costs can be reasonably determined; see "College Investing: Planning for your Child's Future" (American Century Investments, 2005). The COA includes not only tuition, but also fees, room and board, books and supplies, personal computers, child care, transportation and personal expenses.

Next to be determined is the expected family contribution (EFC). The EFC is the amount a family is expected to contribute to the child's college education for one year. Typically, the lower the EFC, the more financial aid the child will receive. Factors such as family size, number of family members in college, family savings and current earnings...