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529 E-ditorials

02-6: If it sounds too good to be true...
Joe Hurley
Monday, July 29th 2002 probably won't be for long.

How many of us have put our money into a 529 savings account only to watch its value decline along with the stock market? (Most of us.) And how do we feel when we see the announcements of double-digit tuition increases coming this fall at many public colleges and universities. (Not good.)

Now suppose you had the opportunity to avoid both the stock market and the impact of spiraling tuition by purchasing a contract from your state's 529 plan that promises to pay future tuition for your child? In effect, you are guaranteed an investment return equivalent to the rise of tuition, not the performance of the markets.

Even if your child never uses the tuition benefits, the program may promise to return your money along with a healthy chunk of interest. More than one program guarantees a 4% minimum return on your investment. Is your taxable money market account paying you that much?

Almost too good to be true, wouldn't you say?

The deals I'm referring to are found in the prepaid tuition plans and their cousins, the "guaranteed savings" plans. We are not talking about the 529 savings programs that can go up or down based on their underlying investments, and that are not guaranteed to keep up with tuition. The prepaid and guaranteed savings plans are available in nearly two-dozen states. In many of these programs, but not all, you or your beneficiary must be a resident of the state in order to enroll.

You may want to jump in now. But be sure to take a close look first.

There is no magic that allows a prepaid or guaranteed savings program to defy the stock market and the general level of interest rates in offering its benefits to willing participants. The program trust that holds your payments must earn a sufficient return on its investments to cover its liability for future tuition payments. When tuition goes way up, and the market goes down, there is a problem brewing in the guts of the plan, and something has to give.

Here is what we've been seeing recently:

Living off the good old days

The older prepaid and guaranteed savings programs are using the "reserves" they built up during the bull market of the 1990s to soak up today's losses. Of course, this only works for those 529 plans that operated through most of the 1990s. And it only works until the reserves run out.

Increases in the price of a tuition contract

The most obvious way to replenish shrinking reserves is to impose higher pricing on new program enrollees. Several prepaid tuition plans already charge a "premium" over current tuition prices, and the premiums will likely increase in the near future. A premium means you are immediately in the hole with your investment. For example, in the Guaranteed Savings option of Ohio's CollegeAdvantage program, participants now pay a premium of as much as 30% over current tuition levels to buy protection from future tuition increases. (In some prepaid plans you can still find discounted pricing for very young beneficiaries.)

"No entry" signs

Colorado has announced it will stop taking new contributions into its Prepaid Tuition Fund as of August 1, 2002 and will go back to the drawing board to restructure the program. In Tennessee, it was reported a couple of months ago that the state treasurer had decided to suspend the BEST Prepaid program so that it could have time to regain its financial footing. (But we are pleased to see that the program remains up and running thanks to a new law that caps increases in Tennessee public tuition). We are aware of another state that is considering locking the gate on its tuition protection program, and wouldn't be surprised to find some others thinking of doing the same. Even the rock-solid CollegeSure® CDs available through the Arizona and Montana 529 plans are becoming more restrictive. The minimum maturity of this tuition-indexed bank product has increased from one year to three years.

We're not suggesting that any of the programs mentioned above have a big problem. But what happens if the financial condition of a tuition-guarantee 529 plan DOES deteriorate to the point where it can no longer meet its obligations? Unlike company pension plans, in which your retirement benefits are guaranteed by the Pension Benefit Guarantee Corporation (PBGC), there is no centralized back-up for 529 plans.

In the best case, the benefits promised to you are fully protected, either by insurance (CollegeSure® CDs are FDIC-insured) or by the full faith and credit backing of the sponsoring state (provided in the Florida, Mississippi, Ohio, Texas, and Washington prepaid plans).

In the worst case, the promised benefits may not be there. It may be possible for a prepaid tuition or guaranteed savings program to unilaterally decide to trim its benefits, increase its annual fees, or perhaps even liquidate the program and ration its remaining assets to participants. Of course, we would all like to believe that a state with a sinking 529 plan will step in and bail it out, but there may not be any real guarantee of that happening.

If you are contemplating a 529 plan that sounds too good to be true, there may be an opportunity to jump in now and take advantage of current pricing. After all, the purpose of these 529 plans is to provide families a way to deal with future college costs in precisely the type of economic environment we are seeing right now. And certainly over the longer term most of us expect the stock market to regain its strength, which will help families in prepaid and savings programs alike.

But be sure to read the enrollment materials closely, and feel free to inquire about the current financial condition of the program. Lastly, find out what the "guarantee" really means.

» 05-4: The 529 marshals have arrived - 08/30/05
» Our 5.29th-year anniversary - 06/29/05
» 05-2: 529s and the new Bankruptcy Act - 04/28/05
» 05-1: Reform or Deform? - 02/27/05
» 04-6: Perspectives on the 529 debate - 12/28/04
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