Could Warren Buffett Fund Your Kid's College?

As I found myself watching the Berkshire Hathaway annual meeting on Yahoo! Finance today with my son by my side, I was struck with an idea that I'm sure others have had (and utilized quite well), but had never considered myself: would Berkshire Hathaway stock be a better college savings plan then a traditional 529 Plan.

If you have children, or are expecting one in the near future, you undoubtedly are familiar with 529 plans and their ability to help fund your child's college education in a manner that's tax efficient (although in my state, some of those tax efficiencies have been slowly taken away). The short story is you can invest money in your state's 529 plan and it can grow tax free (meaning there's no dividend or capital gains taxes) and it can be pulled out tax free if it's used on education (including some reasonable expenses for housing, books and the like).

However, many investors find themselves frustrated by the lack of options in their state's 529 plan, while others are frustrated by the seemingly lower returns offered by the "aggressive" plans. (Obviously many that are investing in 529 plans for their children's education treat it similarly to their own 401(k) or IRAs where they will move more to bonds and other less volatile investment vehicles as the time gets near).

So, I was left wondering, what if you invested in something different, that generated a higher rate of return, left you to pay any dividend or capital gains tax, but ultimately gave you as much, if not more income for college. That's where Berkshire Hathaway comes in.

Chairman and CEO Warren Buffett is a world-renown investor and who's holding company Berkshire Hathaway has returned a compounded average rate of return of approximately 20% over the last 50 years. A truly remarkable accomplishment. The company is also well known for its lack of a dividend. (Berkshire did pay a $.10 dividend one time in 1966, which Buffett later joked must have been declared when he was in the bathroom) So I wanted to see what would happen if Berkshire Hathaway (BRK-A, BRK-B) was the investment vehicle used for college education instead of a 529 plan.

For my testing, I assumed college education would continue to inflate at a rate of about 7%/year (similar to what it's done for the past 20). I also assumed that someone was going to make a one-time investment in their children's college education, at birth, to grow to 18, then be deployed over 4 years time. Here's what I found:

In this chart, I assumed BRK would compound at 10% a year (well below the historical rate of return, which Buffett has openly acknowledged he is not capable of reproducing), while the 529 plan would move at a 7% clip (which also equals the rate of education inflation). At the end of 4 years of college, the 529 plan would have done exactly what it was required to do, pay for a 4 year education, with nothing left over. However, BRK would have also provided an additional $200,000 in stock value, after paying for the same education (and the capital gains tax required to sell it). Not too bad, considering the additional flexibility that the BRK stock would provide in the case that your child didn't need to use the money for education.

Obviously, one of the advantages that BRK provides is Buffett's superior capital allocation skills that allow for compounding returns to the shareholder without the need for issuing dividends. This is a unique skill. That coupled with the low rate of capital gains tax, makes this an attractive alternative.

I ran many simulations, many of which with I won't bother you. However, I did look at what would happen if that capital gains rate was increased to 40%. The results for an identical simulation appear below:

In this simulation, the BRK plan survives the 4 year college experience with approximate $20,000 stock left over. Obviously it has done its job, with some (albeit significantly less) left over for secondary education, a down payment on a home, whatever you (or your child) choose to spend it on.

In the end, I'm not sure what the best plan for each individual family is, as it pertains to funding a college education. However, I have found, as I hope you have, that there are definitely some creative ways to pay for college (or other big expenses still to come in life) without simply falling in line with the crowd. 

What I like most about this type of a plan is the flexibility it provides. Imagine, in either one of the scenarios above, you would have been able to spend the same amount of money, not pay tax for 18 years and fully fund a college education. However, with the Berkshire plan, you would additionally have had money left over (in case one, over 2x as much as you started with) and had complete flexibility in how you would've wanted to spend that money in the case that you child didn't go to college (maybe the next Bill Gates or something).

Perhaps something to think about for the future.

Blessings

The #1 Pick Could Sign a $250 Million Dollar Contract: A case study on compounding interest

Tomorrow the National Football League will hold its 81st NFL Draft. The top 253 college players from across the country will be selected (sorry New England fans) over 3 days. However, the bulk of the media attention will be focused on the first round, Thursday night.

The very elite college players will be drafted to their newest, respective teams and be shipped off to cities around the country to begin their NFL journey. It is likely that we will see many of these players playing in Pro Bowls, winning Super Bowls, and earning lucrative contracts in the next 4-5 years. Malik Jackson, now of the Jacksonville Jaguars, just did two of the three back in February and March.

With all the excitement in the air, I felt like this was a perfect opportunity for a short case study on the time-value of money (not to mention how large sums of money can compound into enormous sums of money).

Tomorrow, it is likely either QB Jared Goff or QB Carson Went will be selected first by the now-Los Angeles Rams. Whichever quarterback is selected tomorrow will immediately be slotted into a guaranteed contract worth a total of $27.8 million dollars for 4 years (not bad, but certainly not as good as Sam Bradford has it the last time the Rams had the number 1 pick). Included in that is a signing bonus of $18.4 million dollars, which are dollars paid for just signing the contract.

Now, assume that the player selected simply said to himself (and wife), "we are never going to spend any more money than whatever our annual salary allows us (not as hard to do with salaries in the 7 figures), but we are going to do all of our lifetime investing at 22 and be done," what would his numbers look like.

Once the player pays his federal and state taxes (lucky him, California has the highest state taxes in the country) let's assume after everything he has 50% of his original signing bonus left over. He would have a little over $9 million dollars left. He chooses to put the money in a low-cost S&P 500 index fund (i.e. VFIAX-O, better known as the index fund Warren Buffett bet $1 million dollars to outperform hedge funds over a 10 year period and is winning) and simply reinvests all his dividends from 22 to his ultimate retirement age of 65.

Now, historically, the S&P 500 returns between right around 9-11% over long periods of time (30+ years). However, we will assume that because of the drag of dividend taxes (undoubtedly at 20% for someone in this player's income tax bracket) this fund returns 8% annually over the next 43 years. When you run these numbers, it would not be crazy if this player would find approximately $250 million dollars sitting in his account at age 65. Not to mention, it would be likely that these investments would be producing approximated $5 million dollars of dividend income each year (and growing). All of this in the year 2059, because of a one-time investment in the summer of 2016. Quite remarkable.

As a side note, if you are the last player drafted this year, pick #253 which is owned by the reigning Super Bowl Champion Denver Broncos, and chose to do the same thing (albeit a little more challenging with a "slightly" reduced salary to the #1 overall pick, you would still have nearly $800,000 from your one-time decision with a growing dividend income starting at $16,000 a year.