Prepaid college savings plans are healthier, but advisers remain wary

Jan 8, 2012 @ 12:01 am

By Liz Skinner

The nation's prepaid college savings plans are more financially stable than they were a couple of years ago, but financial advisers are still mostly passing on the programs.

Ten states now offer the ability to pay for college tuition and fees at prices set today. The plans take investment risk off the shoulders of parents unsure about funding future college costs, a feature that is increasingly attractive to those worried about rising tuition rates and market volatility, program managers said.

“When they look at volatility of investment markets, and being able to lock in a price and know a level of tuition is covered, the appeal of the prepaid plans starts to grow,” said Joan Marshall, executive director of the College Savings Plans of Maryland.

Some advisers, though, worry about the financial health of the plans down the road. Prepaid plans in eight states have been closed to new investors over the past decade as they have tried to get a handle on how to ensure their ability to meet existing commitments.

In some cases, the plans have suffered shortfalls from less-than-expected investment returns or runaway tuition costs.

Because of its 30% shortfall, which means that its funds cover only 70% of its commitments, Illinois' $1.3 billion prepaid program stopped selling new contracts in October.

“I worry about the future of the prepaid programs,” said Marina Goodman, an adviser with Wealth Advisors. “It makes me nervous that you won't get what you think you're going to get.”

Advisers also warn that the plans don't cover all college costs — and deliver the biggest economic benefits only if a student attends certain schools.

In fact, only about 11% of advisers use prepaid college savings plans for their clients, compared with 93% who use Section 529 college savings plans to help clients reach education goals, according to a Financial Research Corp. survey of 380 advisers in July. With 529 plans, participants choose from certain investment portfolios, and the funds grow tax-free as long they are used for higher education.

Adviser Dave Karp, founder of Complete College Solutions, said that 529 plans can yield better returns over the long run.

FEWER WORRIES

He said, however, that prepaid plans do have the benefit of participants' not having to worry about asset allocations and moving investments around as the child gets closer to college age.

The 10 states with open prepaid college plans are Florida, Maryland, Massachusetts, Michigan, Mississippi, Nevada, Pennsylvania, Texas, Virginia and Washington. A consortium of 272 private colleges and universities also offers a prepaid plan.

Together, the prepaid plans have about $20 billion in assets, compared with $134 billion in 529 plans.

Although the funding level of many prepaid college plans slipped following the recession, the plans still accepting new investors have returned to near — and in some cases above — 100% funding.

For instance, Pennsylvania's plan hit a low of 70% funded in March 2009 and is now 97% funded. Virginia was at 90% at the end of 2010 and is now 100.5%.

The prepaid programs vary in terms of whether participants buy tuition in years or units, what is covered under the plan and whether the investment is backed by the full faith and credit of the sponsoring state. What they have in common is that participants pay for future college years at prices set today, which isn't to be confused with an offer to pay future tuition at today's prices.

The average cost of tuition and fees at a public college for 2011-12 is $8,274, which is an inflation-adjusted increase of 4.5% over the previous year, according to The College Board. In some years, the increase has been greater, such as in 2009-10 when the average cost jumped 9.3%, The College Board said.

Not surprisingly, the price of the prepaid contracts has been on the rise, as well.

“Prepaids are a little bit of a double-edged sword,” said Mary Morris, chief executive of the Virginia College Savings Plan.

“It's a nice hedge against tuition inflation. However, it's not in today's prices, so you have to collect more upfront to be able to make that promise in the future,” Ms. Morris said.

Virginia's prepaid program increased contract prices by 8% for the 2011-12 enrollment period, after a 10% hike a year ago.

“They are pricey — that's the bottom line,” Ms. Morris said.

In the 2011-12 enrollment year, Washington state's program managers boosted the cost of contracts by 40%, according to Betty Lochner, director of Washington's Guaranteed Education Tuition plan. Facing a budget crunch, the state has reduced its support for higher education by about 30%, and lawmakers recently granted colleges and universities unlimited tuition-setting authority for the next four years.

“That was a game changer for how we have been setting the price for this program,” Ms. Lochner said.

In their pricing model, Washington plan officials assume 19% tuition increases for the next two years, much higher than the 7% increases in the model they had been using, she said.

NEW PURCHASERS

The program, though, is still attracting new purchasers.

“People are saying, "Gosh, this is really expensive,' but it's going to get even more expensive,” Ms. Lochner said.

Maryland's figures illustrate the investment challenge that the prepaid programs face if their performance assumptions are too aggressive or predictions about tuition rates too conservative.

The lump-sum price for a four-year university plan for an infant today is $40,095 in Maryland. The program prices that contract based on assumptions that it will cost about $139,750 in tuition and fees when that student attends school.

“Even though the contract price may seem high, it's certainly a bargain compared with the projected future average cost of college,” Ms. Marshall said.

In many states, investors fund both prepaid and 529 savings plans. Florida reports that 58% of those who fund prepaid plans also invest in the state's 529 plan.

“You can't save everything you need with a prepaid plan,” said Susan James, a spokeswoman for the Florida Prepaid College Board, noting that Florida's plan covers tuition and fees.

By investing in both plans, participants can pay for additional college-related expenses, such as books or room and board, with an account that offers tax benefits.

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