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Prepaid 529 woes: Bail out or sail on?
In the sea of college savings choices, prepaid tuition plans — allowing parents to lock in future college tuition at current prices at in-state public institutions — have been seen as pretty sturdy and safe.
But are they? Recent headlines about some states' plans suggest otherwise.
Alabama's Prepaid Affordable College Tuition program, or PACT, reportedly lost nearly half its value between fall 2007 and spring 2008. State officials blame the market downturn for hurting the program just when it reached its peak for making benefit payments. Although participants believed their investments were guaranteed, they learned this isn't the case. Unless legislators act to save the plan, the Alabama PACT will run out of money.
Plans in other states - such as Tennessee, South Carolina, West Virginia and Washington — are also in severe trouble financially. Plans that are expected to meet their current obligations still need to make adjustments to ensure they can survive in the long term.
There are different prepaid models, but the basic concept is that plan administrators invest the money paid in advance by participants and then pay the college or university the full tuition amount at the time, says Mary G. Morris, executive director of the Virginia College Savings Plan. The individual has locked in their costs, but the program is responsible for paying current tuition," she says.
"The prepaid 529 is a great risk transference device," says Andy Davis, executive director of the Illinois Student Assistance Commission, which operates the College Illinois 529 Prepaid Tuition Program.
Most standard state-sponsored college savings accounts differ from the prepaid plans by offering more flexibility in how much money can be saved and at what pace, and in college choice. The prepaid accounts generally offer locked-in tuition at in-state public colleges and universities.
Both have grown over recent years. The College Board, using data from the College Savings Plans Network and the National Association of State Treasurers, says there were 11 million 529 accounts in 2008, up from just half a million in 1996. In most of those years, prepaid-plan assets have been smaller than standard college savings plans, and in 2008 only 12 percent of all 529 funds were in prepaid tuition accounts. In some states, however, prepaid plans are popular, accounting for more than half of 529 assets in Alabama, Florida, Kentucky, Mississippi, Pennsylvania, Texas and Washington.
"We have an actuarial deficit," because projected earnings weren't met, says Morris. "I think every state's program, except for Florida, has that (situation), given the current market volatility."
Anyone who's running a prepaid tuition program, says Davis, is challenged by a pair of universal facts:
- Tuition has increased, and that trend appears to be continuing.
- Unprecedented and bad market returns of late.
"Your liabilities continue to grow, and your assets and allocations have in many cases been significantly negative. That's a challenge," he says.
Consumers are primarily concerned about what states will do to ensure promises are kept.
"Sadly, it does not appear that any assurances are forthcoming from even the highest levels of state government," says Lee Rosenberg, Certified Financial Planner and co-founder of ARS Financial Services in Long Island, N.Y.
"The states' inability to cover the shortfall puts the entire plan at risk," says Steve Bloch, Certified Financial Planner and managing partner in MHB Financial Group in Redondo Beach, Calif.
Rosenberg calls the uncertainty about prepaid plans "an enormous disappointment for parents who were astute enough to plan for their children's college educations by locking in the cost of future tuition and fees."
Financial advisers who believed in these plans are also experiencing a huge disappointment. "Of this we were sure: There is death, taxes, and increases in tuition," Rosenberg says. "Having a way to cap these costs by investing upfront made perfect sense."
As with any investment vehicle, "parents and students should understand fully what it is they're buying into," says Justin Draeger, vice president of planning and development at the National Association of Student Financial Aid Administrators Guaranteed rates of return, risks, and plan payouts are key terms and conditions to comprehend.
In Illinois, and perhaps elsewhere, says Davis, plan administrators are required to post a statement of investment returns on the plan's Web site each month. Therefore, that's one place to dig.
Ask specifically what kind of guarantees are in place, says Morris. "In Virginia, we have a statutory guarantee — an appropriation in the state budget could be used as an interest-free loan to the plan, if it were ever necessary.
"You have to ask questions, look at your contract and understand what you bargained for," Morris says. "Some states have a full guarantee, and some states have no guarantee."
In some plans, the risk lies with the state's public colleges and universities rather than the plan itself. Take the Massachusetts U.Plan Prepaid Tuition Program, which is structured differently from most prepaid programs and includes private universities as well. In this kind of plan, "the schools agree to accept prepaid dollars in place of full tuition," says Bloch.
In light of the current economy, other programs, such as the Texas Tuition Promise Fund, are moving to this model. That plan launched in September 2008. (In 2003, new enrollment in Texas' first prepaid plan, which now falls under the name Texas Guaranteed Tuition Plan, was suspended after rapid tuition increases put the program fund in financial trouble.)
When it's the school that "takes the haircut" if plan investments don't keep up with tuition increases, Bloch says, "the plan itself probably has a lower risk of total failure." In his view, schools are typically better prepared than the states to respond to a shortfall.
Plans help themselves
Meanwhile, prepaid plan administrators are examining their long-term investment plans and projected rates of return in conjunction with the pricing to participants, for example, to help ensure adequate funding.
"There are a lot of moving parts, and (our) job is to keep an eye on those moving parts," Morris says. "The one thing that is certain is that every state with one of these programs takes it very, very seriously and will do everything they can to honor their commitments."
Administrators also must keep in mind what Rosenberg calls the elephant in the room. "Because of the current economic climate, high unemployment, and jitters about the benefits of these college tuition programs, there has been a decrease in new deposits," which he says could mean a shortage of money to release to parents for tuition.
Getting out of a prepaid plan
Not surprisingly, people in state plans such as Alabama's PACT are questioning whether they should cancel their contracts and remove their money. Officials there respond that it's certainly an option, but suggest giving the state time to work through the situation.
Both options exist elsewhere, too. "If you decide to make a change, there really don't have to be any adverse tax consequences because you can roll over into another 529 program," Morris says, adding that most states allow it. Rolling over to a different state's program could also be an option, although there may be state tax consequences.
As for removing funds completely, depending on the circumstances, any earnings would be taxable and subject to a 10 percent penalty, similar to an IRA withdrawal, she says.
Speaking of IRAs, if the plan is really in trouble, pull the money out, pay the penalty and move it into a Roth in the child's name, says Tracy Foote, author of "The Kid's Roth IRA Handbook." Just keep in mind that large sums can only be moved a little at a time ($5,000 in 2009), and only a child with some earned income can qualify for a Roth.
Don't be too scared of media reports, Davis says. "What are important are not the headlines so much but the specifics of your situation. Be an informed consumer," but provided your program is sound, "I don't think this is one of the things (to) lose a lot of sleep over."
Posted May 29, 2009
Melissa Ezarik is a Connecticut-based writer and editor.