5 Options for Risk-Averse College Savers

For risk-averse investors, trying to keep pace with college costs while also choosing a safe investment vehicle for college savings can be tricky.

"It's a hard place to be, because if you want safety and yield, it's pretty difficult to find that right now," says Kevin McKinley, a registered investment advisor, owner of Wisconsin-based McKinley Money LLC, and author of "Make Your Kid a Millionaire: 11 Easy Ways Anyone Can Secure a Child's Financial Future." "That's definitely true when you're trying to save for college."

It's understandable that investors are apprehensive about market turbulence, McKinley says. Compared with saving for retirement, the timeline for saving for college is much shorter, leaving less time to weather the swings of the stock market.

[Learn three important facts about stocks within college savings plans.]

But being too timid with savings can have its own pitfalls, especially because college costs have soared above inflation in recent years, says Patrick Runyen, a certified public accountant, personal financial specialist and a certified financial planner with Wayne, Pennsylvania-based Independence Advisors LLC.

Maintaining a diversified portfolio is key to hedging risk, he says.

"When we're thinking about an individual who tends to be more risk averse, we're going to look at how diversified they are," he says, "and what approach within a diversified portfolio makes the most sense to make sure they're not taking a substantial amount of risk, but still in a position to not succumb to inflation."

The following are options for conservative investors both within 529 plans -- which offer federal and sometimes state tax benefits -- and outside of them.

1. Bond funds and FDIC-insured 529 plans: Many states have added bank products such as FDIC-insured savings accounts or CDs to their 529 investment options in recent years.

They won't yield high returns, but investors won't lose the principal and the funds can be withdrawn free of federal taxes and most state taxes for qualified education expenses, just like other 529 investments.

"Within a 529 plan, you're not going to get a hot deal, but at least it's tax free," says Marc Hebert, president of Bedford, New Hampshire-based The Harbor Group Inc. and a certified financial planner.

[Ask four questions before opening a 529 plan.]

Investors can also buy 529 funds made up of bonds, but they should keep in mind that if interest rates go up, the value of the bonds goes down.

"Just because you have a bond fund within your 529 plan doesn't mean you can't lose money," he says.

Hebert advises doing research to find a plan with a good bond manager that can control some of the downward volatility.

2. Age-based 529 plans: Age-based 529 plans start with a more aggressive mix -- more stocks, fewer bonds -- when the child is young, then shift to a more conservative mix as the child nears college.

"You don't want to get to a point where you crash land the 529," Hebert says. "So if you're in 100 percent equities the night of the high school senior prom, you could be in big trouble if the market has a major correction."

Experts say that parents of young children can stand more risk and volatility. Even if the markets bounce around, they'll likely earn a strong rate of return over time.

[Know when to shift age-based college savings.]

But because a plan manager is making decisions about how aggressive to be, investors should be careful to make sure they agree with the amount of risk the plan takes on.

"You really need to take a look at what they're investing in and what their allocation is to see if it fits your profile for risk," Hebert says.

3. Prepaid 529 plans: Prepaid 529 plans allow investors to pay money now for future college expenses. The plans remove stock market risk and instead tie the value of the money to tuition increases. Four states -- Florida, Mississippi, Massachusetts and Washington -- have a full-faith guarantee on their prepaid plans, meaning the state has a legal obligation to fund the program if it doesn't keep up with rising college costs.

Drawbacks to the plans include having to be a resident of the state offering the plan to participate and, depending on the plan, limitations on where they can be used.

4. Series I savings bonds: Series I savings bonds have an inflation adjustment component: The interest rate rises and falls according to the Consumer Price Index.

If certain income requirements are met, parents can pull the proceeds out tax free to pay for qualified higher education expenses. Although interest rates may stay in the 1 or 2 percent range, they'll never go below zero, McKinley says.

"They're very safe, the rates are very competitive and they're very liquid," he says. However, if you make a withdrawal within the first five years, you will have to give up three months' worth of interest as a penalty -- and they are only redeemable after a year.

5. Life insurance: Another option some families consider is tapping their life insurance policies. While the policies are intended to pay out upon a policyholder's death, some people choose to take out money or to borrow against their policies during their lifetime. Those funds can then be used to pay for college.

Earnings in a life insurance policy grow tax deferred, and in most cases insurance companies guarantee a minimum return. However, there may be high fees that can eat into returns, and borrowing against the policy can decrease the value of the death benefit.

"Parents could wind up with something that is a very low-return, high-fee investment," McKinley says.

Trying to save for college? Get tips and more in the U.S. News College Savings 101 center.

Deborah Ziff is a Chicago area-based freelance education reporter for U.S. News, covering college savings and 529 plans. You can follow her on Twitter.