As Wall Street staggered through a prolonged slump, and mutual funds, 401Ks, and blue-chip investments tumbled along with it, parents who stashed money outside the stock market, in prepaid-tuition programs for college, have seen their savings quietly grow.
The beauty of those comparatively low-risk plans, which allow families to start paying for their children’s years on campus ahead of time, became clearer as investment options with more zing took a beating.
But lately, the nation’s economic woes are catching up with prepaid-tuition plans, too.
Faced with the two-pronged pickle of rising tuition and investment woes of their own, a number of the 20 states with prepaid-tuition programs have approved or are considering raising the prices they charge families to enroll. State officials say they have no choice, if they are to fulfill their obligations to parents who already committed thousands of dollars toward a college education and expect to have tuition costs covered.
“We’d been in an environment where tuition was fairly predictable. Now, we’re in a free market,” said Jacqueline Williams, the executive director of the Ohio Tuition Trust Authority, which raised prices it charges prepaying families by 43 percent in 2002. “The volatility of the stock market has been a factor. The increases in college costs have clearly been a factor.”
The other main investment option for families, known as college-savings plans, have taken a far greater hit, many market watchers say. Already a fixture in at least 48 states, college-savings options typically allow families to invest in stock- driven accounts, which until recently grew as the market did. Both types of plans are commonly known as “529s,” named for the section of the federal tax code that spells out the tax breaks they provide.
For families, prepaid- tuition plans are more insulated from the stock market’s swings. Many of those initiatives, which first began taking shape in states in the late 1980s, even offer guaranteed yearly growth on investments. But guaranteeing benefits while simultaneously avoiding deficits has put Ohio and other states in a squeeze.
Facing steep tuition increases, officials in Washington state raised prices in their prepaid program by 24 percent in 2002, the biggest jump in the initiative’s history. Worried about a deficit and high costs, Tennessee leaders are considering a temporary halt on allowing new people to enroll.
The concept behind prepaid tuition is simple, and it taps into a central source of anxiety for millions of American families. The programs allow parents, grandparents, and other relatives to pay portions of a child’s college tuition years ahead of time, putting that money into a program managed by the state. The family locks in tuition costs at today’s rates, rather than paying higher prices they would surely face years down the road.
The state typically raises money for those families by investing the money in the stock market or in other ways, and allowing it to grow. Then, when the students are ready to enroll in college, parents are able to use that money to pay tuition.
Unbalanced Equation
But over the past two years, several factors have unbalanced the prepaid equation. When the stock market withered in 2001 and 2002, state investment funds shriveled, too. At that same time, college prices nationwide were climbing fast, rising 11.6 percent at four-year public universities over the past two years, according to the New York City- based College Board. States were faced with the choice of not being able to pay parents what they were owed, running a deficit, or asking families to contribute more on the front end.
Most states allow families to enroll in prepaid programs on a “contract” basis, in which the buyer agrees to make regular contributions, with the promise of having a predetermined chunk of future tuition paid.
Other states, like Ohio, have families prepay tuition by purchasing however many “units,” or small portions of a college cost, they want to. In Ohio, 100 units cover one year’s tuition. When tuition at the state’s 13 public, four-year universities rose by an average of 14.5 percent last year, program officials raised rates to keep up, from $56 per unit in October 2001 to $80 this fall.
Yet despite those setbacks, demand for both kinds of 529s has only climbed, many observers say. From June 2000 to March 2002, the number of investors in college-savings plans rose from 560,000 to 1.78 million, and prepaid-tuition accounts rose from 1 million to 1.35 million people enrolled.
In some states, it seems nothing can slow the growth in prepaid programs. When state officials in Tennessee began talking publicly about their prepaid program’s financial struggles earlier this year, and raised the possibility of suspending it, rather than scaring families off, those discussions served to spark a new rush of applicants, said Janice Cunningham, the executive director of the Baccalaureate Education System Trust, the state’s name for its prepaid-tuition program.
“We got all kinds of people calling in. It was an unintended marketing tool,” said Ms. Cunningham, who says Tennessee’s program has 7,800 accounts. “People realized they were getting a good deal and wanted to sign up.”
That logic applies to parents like Tammi Spayde, 39, who hasn’t been discouraged by Ohio’s higher rates. Paying more now was still better than waiting for soaring tuition rates to sock her family later, the Westerville, Ohio, resident said.
“Certainly, [a unit] doesn’t buy you as much,” said Ms. Spayde, who has two young children, and has about $4,000 saved in the state’s plan so far. “But it’s the opportunity to start early, and do it in a fairly simple manner. It’s kind of a balancing act.”
The continued faith in 529s was not surprising, many financial advisers said.
“If history is any guide, you have to believe that over a 10-year period, the market is going to go up,” said Bev E. Crouch, a financial planner in Warrenton, Va. He advises families to invest in prepaid- tuition plans, particularly if they are middle- or upper-income. “If a family can save $40,000 or $50,000, that goes a long way to pay for college. They’re looking to get ahead of the curve.”
Chris Hunter, the program manager at the National Association of State Treasurers, an organization of state financial officials in Lexington, Ky., noted that states had made both prepaid-tuition and college-savings plans more flexible over time, to give families more freedom to invest conservatively or aggressively. Almost all prepaid-tuition programs require either the account owner or beneficiary to be a state resident.
And all prepaid programs also allow savings to be spent at out-of- state and private colleges, though the benefits in some cases are not as great as they would be if the student went to an in-state public institution. The overwhelming majority of state college-savings plans are open to nonresidents, as well.
“We think they’re both ways to save for college,” Mr. Hunter said. “The decision comes down to what kind of an investor are you? What kind of risk do you want for your child’s college education?”
Tax Breaks
Prepaid-tuition and college-savings plans both offer families breaks on their federal income taxes. By law, states are required to manage the programs, and most run them through treasurers’ offices or independent financial advisers they hire.
Financial advantages vary from state to state, but all 529 plans protect the monetary growth they provide to families from federal taxes. In some programs, breaks on state and local taxes are offered, too. And unlike some tax benefits, 529s do not prevent higher-income individuals from gaining those benefits.
When a prepaid or college-savings plan pays out money for tuition, that distribution is free of federal taxes, too, with certain conditions. That particular tax break is set to expire at the end of 2010, though many observers say Congress, knowing the programs’ popularity, is likely to extend the benefit.
But many investment advisers raise caution about the drawbacks of 529s, most notably the way they can limit a student’s ability to get financial aid. Under federal law, the money given out through prepaid tuition reduces eligibility for aid on a dollar-for-dollar basis. If a student originally qualified for $15,000 in financial aid, but was using a prepaid-tuition program to cover $10,000 in costs, he or she would be considered as having $10,000 less in need for aid.
Similarly, college- savings plans are treated as assets in determining financial aid, meaning the amount a family is expected to contribute on their own will go up.
Because of those consequences, it does not make sense for families that may qualify for a large amount of financial aid to enroll in a prepaid or college-savings plan, some financial advisers say.
“We advise people against 529s with incomes below $100,000,” said Raymond Loewe, the founder of College Money, a financial-planning firm in New Jersey. The programs, he says, “are designed more for upper-income and wealthy than people with lower incomes.”
And others note that if a family decides to withdraw the money before a student goes to college, or not use the money for higher education at all, tax penalties are slapped back on those prepaid accounts.
Some critics say families would be better off earning money through mutual funds, or other investments, rather than putting money in a college plan that may never pan out.
“You’re buying a 2015-model Chevrolet, and you don’t even know what it looks like,” said Rick Darvis, the owner of College Funding, a Plentywood, Mont., company that trains financial professionals.
Even so, Mr. Darvis didn’t expect that sort of criticism to sap the mass appeal of 529s.
“It’s parents, it’s grandparents, and it’s their kids,” he said. “They want to help them out. What else are they going to spend money on?”
This year, Karen Naughton, of Olympia, Wash., and her husband are paying more for the security of enrolling in their state’s prepaid program. In-state tuition at the most expensive state universities in Washington rose by 16 percent this year, to $4,520 a year, and partly as a result, state officials raised unit prices for prepaid tuition from $42 to $52 next year.
That still seems like a bargain to Ms. Naughton, the mother of two children, who already used the program to help pay the college costs for her son, now 20, and is saving for her 16-year- old daughter. Tuition on campuses will rise, as surely as freshmen will cram for exams and beg parents for more spending money.
“We’re getting a bargain in the deal,” Ms. Naughton said. “That money will come back in spades. Regardless as to what happens at the current moment, [prices] are only going up, and people are aware of that.”
