While many 529 college savings plan investors know all too well that their investments can decline in value, 529 prepaid tuition plan holders may not be aware that their plans may be in trouble, too.
First, a refresher course: Most prepaid plans allow families to purchase tuition credits or a percentage of tuition credits at a price slightly above today's face value, then cash them in when the child attends college. Conversely, investors in 529 savings plans put money in a portfolio of stock or bond funds that they hope will grow over time, then withdraw the proceeds to pay for college expenses.
The main difference: States generally assume risk for the prepaid plans, while families bear all risk with the savings plans.
Created as insurance against tuition inflation, prepaid plans are not so infallible it turns out. With Alabama's Prepaid Affordable College Tuition plan threatening to fold, other states closing or limiting enrollment, and still others significantly raising the price of tuition credits, the prepaid tuition plan could be headed the way of the dinosaur.
"History shows that these plans have been able to climb out of their holes, but there is some risk that you may not get your full promised benefits or even your full contributions back if the plans run out of money," says Joe Hurley, founder of Savingforcollege.com, a Bankrate company. "No one has lost money or benefits to date, but there's always a risk."
Risk, says Hurley, is exactly what prepaid plan holders don't know their taking.
Some guaranteed, others not
Thirteen states offer prepaid tuition plans that are open for new enrollment, either currently or seasonally, according to the College Savings Plans Network. Another two, Kentucky and West Virginia, have been closed to new enrollment for several years. The Colorado and New Mexico plans have been permanently shut down to any enrollment and will close when the last beneficiary finishes school.
In addition to these state programs, the Independent 529 Plan is national in scope, allowing parents to prepay tuition for its 274 member colleges, which are private schools.
The problem, says Hurley, is that most families who enroll in prepaid plans believe the programs are guaranteed to pay off regardless of what fiscally happens between the time of enrollment and the child's collegiate freshman year.
Of the 18 prepaid plans, 16 are underfunded, meaning they don't have enough money to pay future tuition obligations, according to The New York Times. And only a handful of plans are fully guaranteed by the state.
"There is significant risk in those states where the plan is not fully backed by the state," says Hurley.
But the rules can change, even for those plans that are guaranteed by the state. The Texas Tomorrow Fund, for example, has been closed to new enrollment since 2003. Backed by the full faith and credit of the state of Texas, it recently announced a change in policy about how it would reimburse parents who might cancel contracts because their children receive scholarship funds or matriculate to a school outside of the system. Rather than pay them an amount based on current tuition and fees at public universities, as originally promised, parents will get back exactly what they paid into the fund, minus annual administrative fees.
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The Texas Tuition Promise Fund, which opened in September 2008, replaces the Texas Tomorrow Fund. Kevin Deiters, director of educational opportunities and investment for the Comptroller of Public Accounts in Texas, the body that oversees the state's new prepaid tuition plan, says the new plan doesn't assume much risk if its investments tank. Texas, he says, is currently the only state that places risk on the universities themselves. Should the state's new prepaid plan lose money, all Texas in-state schools are still required to accept the credits anyway.
But those who cancel the contract can lose out. "With our system, the only way someone is subject to investment risk is if the student(s) goes to a private institution or they go out of state," says Deiters. "In that case, we give them a return based on how well our portfolio has done in the stock market, and if tuition inflation exceeds that, (families) absorb that risk."
Promises vary from one state plan to another. While such states as Virginia provide a legal guarantee that they'll match in-state tuition increases, others publish financial reports on the state of prepaid investments but leave risk ultimately in the hands of plan holders.