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Prepaid College Savings Plans Might Not Cover All Costs

The New York Times
By Sean D. Hamill
October 5, 2009

In the last two decades, more than a million families around the country have invested in state funds that pledged to cover the cost of attending their state's public colleges and universities, regardless of how much tuition increased.

But in the last year, the stock market slump and rising college costs have combined to drive all but two of the nation's 18 such funds, known as prepaid college savings plans, into the red, jeopardizing those pledges.

Even with stock market gains since March, the losses have forced some programs, like Pennsylvania's and Washington's, to impose new and higher fees that could amount to thousands of dollars a year in additional costs to parents.

Others, like South Carolina's, have developed doomsday scenarios, capping how much a family would get if the program shut down completely. West Virginia had to pump $8 million into its prepaid program to help restore its financial health because its fund lost 25 percent of its value in the last year. And Alabama closed its program to new enrollees because the fund lost almost half of its assets -- more than $300 million -- in the stock market in the last year, and the state might have to put its own money in to keep it solvent.

"I think ultimately more and more of these plans are going to close down to new investments," said Mark Kantrowitz, the founder and publisher of FinAid.org, a financial aid Web site.

"Every time there's a significant market downturn, there's two main ways states make up for the losses: close to new participants to cut off the losses," Mr. Kantrowitz said, "or raise fees. And raising fees makes it less attractive to new participants."

The funds were first proposed 23 years ago in Michigan as a fail-safe investment tool. They were quickly adopted by other states after 1996, when Congress allowed them to be tax-deferred under Section 529 of the Internal Revenue Code. In 2001, Congress expanded that to make all qualified educational disbursements tax-free. As a result, the 529 prepaid funds -- not to be confused with 529 college savings plans that do not promise a specific return -- grew into financial powerhouses, even though 7 of the 18 funds have closed to new investments over the years.

All 18 state prepaid plans differ slightly, but most sell contracts or tuition credits that establish how much someone will pay in now to receive a certain return in the future based on projected in-state public university tuition.

If, in the end, students decide not to go to a state school, they can use the money at other schools, though the amount is likely to fall short of the full cost of tuition.

Between them, the 18 state funds serve nearly 1.6 million families and hold $23.8 billion in assets, ranging from Tennessee's small $80 million fund serving 9,700 families to Florida's massive $8.7 billion fund that serves about 850,000 families.

"The reason they're popular is simply because the states bear the risk, not the individual," said Jackie Williams, who was executive director of the Ohio Tuition Trust Authority for 10 years, until June.

The trust oversees Ohio's $590 million prepaid fund, which was closed to new enrollees in 2003 after the state began allowing public universities to raise their tuition as high as they wanted. That resulted in double-digit increases, which, combined with a tough stock market, threw the fund out of balance.

Not every state fully guarantees its prepaid funds. Only five states offer a "full faith and credit" of the state guarantee, and seven are required by law to consider helping the funds out if need be. The other five states -- Alabama, Colorado, Nevada, Pennsylvania and Tennessee -- and Texas's new prepaid fund have no guarantee, though officials say they doubt that the states would ever let the funds become insolvent and would step in if need be.

All of the funds but Florida's and Colorado's now have an actuarial deficit, meaning they do not have enough money to pay all of their future college tuition obligations. Most are only about 80 percent to 90 percent funded. But many are worse off, like the Illinois fund, which is about 75 percent funded, and South Carolina and Alabama's funds, which are both about 66 percent funded.

Carol M. Perdue was troubled by a letter she got from Alabama's treasurer this summer that said the state's prepaid program had lost about 50 percent of its assets in the stock market. She is suing to force the state to put money into the fund to make up for the losses.

"At first I was kind of scared," said Ms. Perdue, 40, an insurance agent in Phenix City who has about $30,000 in the program for her two daughters. "And then I felt almost cheated, like I was sold a bill of goods that wasn't there."

Even Florida's program could be in for tough times. The state has stayed out of trouble because it has 90 percent of its assets in fixed income investments, unlike other funds with 50 percent to 70 percent of their assets in the stock market, and it has enjoyed very low tuition increases.

But the Florida Legislature for the first time has allowed public universities to raise tuition by up to 15 percent a year for the next five years, which is much greater than the 6.5 percent average the fund has counted on in the last two decades.

"You can't keep up with 15 percent tuition inflation with fixed income," said Andrew A. Davis, executive director of the Illinois Student Assistance Commission, which oversees that state's prepaid fund. "They'll have to change something."

Despite all this bad news, investors continue to see the funds as an attractive option, particularly in a tough economy, for one simple reason.

"Even with all the problems, no one has ever lost money in the process," said Joseph F. Hurley, founder of Savingforcollege.com, which specializes in dissecting the different 108 college savings and prepaid plans.

Ganesh Seshadri has invested $200,000 in Pennsylvania's fund, which has lost about 25 percent of its value. He is philosophical about the fund's losses, which have not affected his investment, though he has stopped investing in it because of the increased fees and costs imposed recently.

"If I get back the return they promised, it will be a good investment, because all of my other investments tanked," said Mr. Seshadri, 55, a hospital computer analyst in Murrysville, Pa. He has children at Northwestern University and Carnegie Mellon, and one in high school.

Many states, aware of the allure of prepaid funds, are now keeping an eye on Texas, which opened a fund in the last year after closing another one in 2003 to new enrollments. The new fund shifts the burden of the guarantee from the state to the public university system. If the fund runs short, the universities agree to cover the difference between what is available and how much tuition is in the future.

"It's an interesting idea, but the money has to come from somewhere," Mr. Kantrowitz said. "Saying you'll pay anyway is sweeping it under the rug. But it will be interesting to see if it works."

Texans apparently think it will. Since last September, amid the financial meltdown, about 13,000 families invested a total of $95 million in the fund.

(c) 2009 The New York Times

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