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Prepaid College Tuition Plans: Know This Before You Invest

Prepaid college tuition plans are no longer the surefire solution to runaway tuition costs they once seemed.

The mostly state-sponsored plans were designed as a way to save for college by locking in at least a portion of future tuition at today's prices.

The premise remains sound: Pay now to minimize the shock of rising costs. After all, tuition has increased an average 7% annually since 1990 and shows no sign of slowing.

But the battered finances of state governments have raised questions about whether some plans will live up to their promises.

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Numerous states have shut down their plans or changed them as their deficits widened. Facing shortfalls, some have bumped up the prices by charging substantial premiums above the cost of current tuition. And several of the 11 open plans do not offer guarantees.

"It's a model that doesn't always work," says Joseph Hurley, a CPA and the founder of Savingforcollege.com.

College financing experts advise parents and students to carefully review the specifics of their state's plan and determine if it makes sense for them.

A closer look at some important points to consider about prepaid plans:

Basics

A prepaid tuition plan allows families to buy future tuition units or credits at current prices. If you purchase shares worth one semester's tuition when your child is young, the shares should always be worth one semester's tuition regardless of how much rates increase. The credits can sometimes also be applied to room and board.

Most prepaid plans have residency requirements. Purchased credits can be applied toward a college in another state, but there's no assurance the full cost will be covered. If a student decides to attend a private or out-of-state college, the plans typically pay the average of in-state public college tuition, according to Mark Kantrowitz, founder of the financial aid site FinAid.org.

States invest families' money in the stock market and use their investment returns to pay for the tuition.

But some programs have run into trouble after investments lost money in the market downturn in 2008-09 and tuition rose faster than expected.

Alabama had to make compromises in its program this spring in order to keep it operating, and now pays less than full tuition. Prepaid plans in Kentucky, Illinois and South Carolina are less than 80% funded for future payouts, raising the risk of future changes.

Available plans

There are 21 prepaid plans offered in 19 states. But 10 states have closed plans to new participants.

Among the 11 open plans, only Massachusetts, Mississippi and Washington guarantee theirs with the "full faith and credit of the state," according to the College Savings Plans Network. That means they will borrow if necessary to make up the difference if the plans run short of money.

Alaska, Florida, Maryland and Virginia also back their plans with differing guarantees. Open plans in Michigan, Nevada, Illinois, Pennsylvania and Texas are backed only by the funds' assets.

Just two prepaid plans are open to residents of any state: Massachusetts' U.Plan program and the Private College 529 Plan, sponsored by the Tuition Plan Consortium representing more than 270 private colleges and universities nationwide.

Pros

Advocates of prepaid tuition plans call them "peace of mind programs" and say they still offer that comfort.

"They're still very appealing in this environment with unknown amounts of tuition increases as well as investment volatility ahead of you," says Joan Marshall, executive director of College Savings Plans of Maryland. "A couple of states clearly have had problems, but it's unfair to lump them all in together."

Prepaid plans as a whole are 93% funded, up from 91% a year ago and that's more than adequate to assure future payouts, according to the College Savings Plans Network.

As to any fears of not getting your money back, Marshall says no one who has used a prepaid plan has received a lower amount than was paid in.

They're still very appealing in this environment with unknown amounts of tuition increases as well as investment volatility ahead of youJoan MarshallCEO, VantagePoint Venture Partners

Kathy and Joe Halliday of Bel Air, Md., paid off their daughter's tuition through Maryland's prepaid plan by the time she was in middle school. That meant they didn't agonize when the stock market crumbled. The plan covered Leah's two years in community college and now will take care of her tuition at Johns Hopkins University.

"It was a great relief," Kathy says. "It was the best financial investment we ever made."

Mat Forrest and his wife Jillian of West Palm Beach, Fla., recently purchased a Florida prepaid college plan for their daughter Addison, who turns 2 in August. He acknowledges that the interest rate is small and they might well do better investing the money in a stock plan. But he likes the simplicity of being locked into a fixed monthly payment of $287.71 and knowing that should take care of Addison's college tuition.

"Any time you can lock in the cost 18 years before you need to pay it, that's probably a good thing," he says. "And I don't need to stress out over the markets."

Cons

Some experts who once recommended the plans for new investors no longer do. They cite the increased risk that states won't make good on their original commitments and the chance that parents will have to pay more to make up for shortfalls in state funds.

"Peace of mind may be a fiction," says Kantrowitz. "If you're investing now for the first time, the money may disappear by the time your child is ready for college."

While losing your money is unlikely, there's a real chance of seeing your investment stay flat or even decline in value if the state makes changes that dilute the plan.

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