My bride and I received a phone call the other night announcing we were Grandparents for the first time, albeit three weeks early. Kelly and Joe, the proud parents, crouched the arrival of Talia Karen Winters, 7 lb 4 oz, by commenting that it seems a future wedding, in addition to her college education, will require additional savings. As a father of three daughters, I can sympathize with my son-in-law’s new dilemma.
Kelly and Joe have already set aside $3,600 for this purpose, and they were waiting for their child to arrive in order to invest the proceeds. As the grandfather, I have decided to voice my opinion as to a potential avenue for this capital. My suggestion as to how to invest this is quite simple.
Take $2,000 and establish a Coverdell Educational IRA. In the US, it is a tax-deferred account, with Talia as the beneficiary, which can be funded by annual contributions of $2,000. Upon reaching the age of 18, Talia can withdraw funds for college expenses. If Talia decides not to attend college, at age 30, she can roll the account over to a relative, such as her own daughter or son. Utilize the $1,600 balance to fund a DRIP with the goal of growing it into another year’s $2,000 contribution.
In Canada, I would consider opening a Registered Educational Saving Plan, or RESP. A RESP can be used to fund post-secondary education expenses. The Canadian government matches the account funding with annual assistance of up to $400 for the first $2000 contributed to the RESP. The assistance accumulates as Canadian Educational Savings Grants (CESG) and is payable for future college expenses by the beneficiary. As the maximum annual RESP contribution is $4,000, I would consider funding it all at once.
These accounts are funded with post-tax contributions and contributions are not tax deductible. However account income and capital gains are not taxed, and proceeds are generally withdrawn tax-free for qualified expenses. Usually, these accounts can be funded by any relative, such as grandparents, or uncles and aunts.
There are long-term advantages of tax exempt investing for a specific future purpose. Not only does capital grow faster without the burden of taxes, but separate accounts for specific future needs helps maintain focus. As always, review long-term gifting plans with the appropriate accounting counsel, or conduct a detailed review of your own, prior to establishing these tax-advantaged accounts.
As to investing the proceeds, I would choose investments in the following: an international floating rate bond fund such as BlackRock Global Floating Rate Income (BGT $18) or Aberdeen Asia-Pacific Income Fund (FAX $6), and two large cap equities, 3M (MMM $73) and Johnson and Johnson (JNJ $59).
As the US economy is still under the thumb of rising interest rates, fixed income investments should be kept flexible and shorter duration. Although I don’t usually like mutual fund fees, these closed end bond funds focus on non-US denominated, variable interest rate investments. Currently, BlackRock Global Floating Rate (BGT) trades at a discount of 6% to their net asset value (NAV) and offers a current yield of 7.5%. Aberdeen Asia-Pacific Income Fund (FAX) trades at a discount of 4% to their NAV and offers a current yield of 6.8%. BGT purchases bank notes made to major international companies while FAX invests mainly in government issued debt. Distributable income and NAV of both funds will be directly affected by the value of the US dollar to these foreign currencies. Generally, these funds should perform better in a falling dollar rather than a rising dollar environment.
Historically, 3M management has been top notch, expanding through strong internal growth and innovation, coupled with timely acquisitions. The company is expected to earn $5.06 in 2007, up from $4.40 this year. Going forward, earnings should grow by around 12% annually, down from the average of 16% over the past five years. 3M has $1.06 billion in cash with relatively little debt. The stock price is off a high of $90 in mid 2004 and over $80 in early 2005. It seems to have found support at $70 in late 2005 and again in early 2006. The current dividend yield is a respectable 2.5%, with the potential for high-single digit growth.
Johnson and Johnson is a well-managed health care giant that will continue to dominate its chosen markets. The current turmoil over failed acquisitions and the generally unstable state of the US healthcare business has created a nervous investor base. JNJ is expected to earn $4.03 in 2007, up from $3.68 this year. Going forward, earnings should grow by a minimum 10% annually, down from the average of 15% over the past five years. The company has $15 billion in cash with relatively little debt. The stock price is off a high of $70 in early 2005 and has been falling ever since. The current dividend yield is also a respectable 2.2%. At its current stock price, JNJ is a better valuation than in the past, with the added potential earnings growth from future acquisitions. In addition, the stock may be forming a long-term bottom and consolidation trend going back to $40 in March of 2001, and $50 from June 03 to May 04.
If the educational accounts are restricted to investing in mutual funds, I would look at a short-term, variable rate, international bond fund; a large cap index fund; and a mid-cap index fund.
Kelly and Joe - congratulation and good luck with those future expenses. Don’t forget, Talia wants a sister some day.
George C. Fisher is a 30-year veteran in DSP/DRIP investing. He is author of All About DRIPs and DSPs (McGraw Hill, 2001) and The StreetSmart Guide to Overlooked Stocks (McGraw Hill, 2002). Mr Fisher is an avid dividend reinvestment advocate and utilizes the strategy with all dividend paying stocks, both at the broker and direct with the companies using their DRIP programs.