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Why is There Risk When Using a Prepaid College Plan?

Oct 7, 2012

Saving for college and retirement are the two most expensive endeavors any family has to deal with. Both have ever rising costs and trying to save for something that you do not specifically know the total cost of, just makes it even harder to do. When saving for either one most people choose mutual funds that invest in the stock market.

These days most people do not have much faith using mutual funds as an investment vehicle, they want something with less risk and a more of a guarantee. That's why prepaid college plans are becoming more popular. But are prepaid college plans any less risky than their mutual fund counterparts?

Prepaid college plans are a type of 529 plan according to section 529 of the Internal Revenue Code. In addition to deferring federal tax, these plans may have considerable state tax advantages, allow for matching grant and scholarship opportunities, and offer protection from creditors and exemption from financial aid calculations for investors. Prepaid college plans allow you to purchase tuition credits at a rate that is fixed today to be used in the future. That “fixed” rate is usually higher than the current tuition rate, but would be much lower than the expected tuition by the time the child enters university. As many as 20 states once provided a prepaid tuition plan – currently 12 states do.

Tuition-based 529 plans have an advantage over 529 savings plans, where growth is generally based upon market performance of the underlying investments, typically consisting of mutual funds. While the aim of savings plans is for the underlying investments to keep up with rising tuition costs, prepaid plans have already fixed the cost of tuition, presumably at a bargain price.

But prepaid tuition plan funds might still be risky for a number of reasons. The first is that the funds might close to new contributions, even from existing investors. These closures have resulted from the gap between sputtering market performance and rising college costs, the latter exacerbated by declining or frozen state support for higher education. According to the College Board, Standard & Poor’s 500 stock index has dropped three percent since 2000, while tuition and fees at public four-year schools have increased at an inflation-adjusted 72 percent.

Ohio closed its prepaid plan to new enrollments in 2003 in anticipation of potential shortfalls caused by declining investment returns and soaring tuition after the state had lifted a lid on fees. Some funds took greater financial risks to bridge the funding gap, but those actions resulted in widening the gap. For example, the Illinois plan made bets on private equity and hedge funds, leaving it 30 percent underfunded. As a result, the state in 2011 temporarily closed the fund to new investments.

The second risk is that the plans are not necessarily guaranteed. This fact may surprise many consumers, considering that the plans are state-run and often advertise themselves as “guaranteed.” However only five states truly guarantee their plans. Massachusetts, Florida, Mississippi and Washington guarantee their plans through the full faith and credit of the state. The Texas plan is also state-guaranteed, through the state universities and colleges.

Plans run by the states of Pennsylvania, Nevada, and Michigan are only backed by assets in the trust. Plans in Maryland, Virginia and Illinois require varying degrees of legislative action for the state to pay back investors in the event of a funding crisis, meaning that it may take consumer action if legislators are reluctant to bail out the state’s tuition plan fund.

Finally, legislatures have and continue to “adjust” all plans, raising the cost of buying credits from time to time. They are constrained mainly by the fact that sales of plans would fall if credit costs rose too much. Despite the funding uncertainties, the best hedge against this third sort of risk is to prepay for more of your child’s tuition sooner.

Got further questions? Catch me on twitter and DM me @529SavingsPlans or e-mail me at 529CollegePlans at Gmail.comWant to be heard? Leave a reader comment below.

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