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The Danger of Prepaid Tuition Plans

Written by Nickel - 12 Comments

The Danger of Prepaid Tuition Plans

In case you missed it, prepaid tuition plans have been in the news recently as Alabama has been forced to re-consider whether or not they’ll be able to deliver on what their plan promised.

As you’re likely aware, 529 plans come in two main flavors: college savings plans and prepaid tuition plans. With the former, you contribute to the plan and make invest the money in hopes that it will grow. These plans are similar to Roth IRAs in that you don’t get a federal tax deduction (though, unlike a Roth IRA, you may get a state tax deduction) but qualified distributions on the back end are tax free.

With prepaid tuition plans, you prepay all or part of future college costs at today’s prices. Some allow you to buy “units” of tuition that correspond to a set number of credit hours or a percentage of the tuition bill while others allow you to purchase contracts covering yearly tuition bills for up to five years. Or at least that’s how they’re supposed to work…

Unfortunately, when you combine the market turmoil that we’ve witnessed in recent years with ever-declining state support of education, you have a recipe for trouble. In the case of Alabama, their prepaid tuition plan (the Prepaid Affordable College Tuition [PACT] Program) ran into trouble starting in 2008 and they won’t be able to pay full tuition for the remaining 37k plan participants.

While the state has agreed to supplement the plan to the tune of $548M in the coming years, that’s still not enough to cover their obligations if tuition keeps rising at the current rate. As a result, the program’s board reached a settlement to continue paying tuition at 2010 rates rather than ratcheting up their support as tuition increases.

This past March, however, the state Supreme Court voided that settlement saying that it violated a state law guaranteeing full funding of tuition bills. In April, the plan’s board got the legislature to pass a law removing the provision guaranteeing full funding. Crazy, huh?

Well, earlier this month the state Supreme Court agreed to reconsider its ruling and has they have since instructed a lower court to review whether or not state officials can retroactively apply the new law and reduce tuition payments. It remains to be seen how things will settle out.

The upshot is this: even guarantees aren’t guaranteed.

Published on July 23rd, 2012
Modified on July 27th, 2012 - 12 Comments
Filed under: Education, Saving & Investing

About the author: is the founder and editor-in-chief of this site. He's a thirty-something family man who has been writing about personal finance since 2005, and guess what? He's on Twitter!

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12 Responses to “The Danger of Prepaid Tuition Plans”

  1. 1
    Lance @ Money Life and More Says:

    That is absolutely horrible. I will definitely reconsider before I ever do something like this. Thanks for the warning.

  2. 2
    Squeezer @Personal Finance Success Says:

    My state also has a PACT plan. There is one consultant that oversees the whole program. The local paper has question the program’s solvency. The state legislature brought the consultant in to testify a couple of times, and the guy charges $500/hr to testify. And both times he gave the same response, that the system has exceeded more losses than projected but future estimated returns should make up for it. I hate to see what happens in a few years.

  3. 3
    Dave Says:

    I live in Alabama. This whole PACT thing was a huge scandal and it still hurts those who paid into it. It was a *binding contract* that *promised* to pay full tuition. From what I understand the state allowed the fund manager to invest “aggressively” and without much oversight, and the fund was extremely vulnerable when the housing market turned. It may in fact have been heavily invested in CDOs and the like that led to the financial crisis in the first place. One day citizens simply woke up to the news that their guaranteed college funds were wiped out because the state didn’t want to honor the promise. This devastated thousands of families across the state.

    Of course, the education bubble caused by subsidy-chasing has caused tuition to skyrocket far beyond expectations, which I’m sure put added pressure on the fund. But tuition was already growing rapidly in the 90s, and the fund manager invested aggressively knowing the risks. That is malfeasance of public funds, just my opinion.

    I can see the state ending the PACT program for now to stop the hemorrhaging, but it should honor the promises made.

  4. 4
    Jim Says:

    Alabama has “Education”?

    First I’ve heard of it.

  5. 5
    jim Says:

    How safe they are depends on how it is setup legally, what guarantees there are as well as the financial stability and politics of the state.

    Massachusetts, Mississippi and Washington guarantee their prepaid plans with the ‘full faith and credit’ of the state. Those plans ought to be safer. Michigan, Nevada, Illinois, Pennsylvania and Texas are backed only by the funds’ assets. Those plans seem less safe. Other state plans have varying guarantees more than the simple trust balance but not as strong as the ‘full faith and credit’ of the state.

  6. 6
    Roger @ The Chicago Financial Planner Says:

    These prepaid plans are a bad deal and I have always counseled clients to avoid ours in Illinois like the plague. Our plan is is potentially facing the same issues as the Alabama plan. Even before this, the Illinois plan was a bad deal in that the tuition payments were not keeping pace with the tuition inflation at our flagship school, the University of Illinois.

  7. 7
    Ornella Says:

    Hey Nick,

    I’ve never been a fan of a one approach to education funding. Personally, there’s more to college education funding than using pre-paid tuition. It requires multiple sources and to avoid putting all your eggs in one basket. Similarly to planning retirement, you must have have multiple sources of income.

  8. 8
    jim Says:

    Roger said : “These prepaid plans are a bad deal …”

    I think some of them can be a good deal. Many aren’t a good deal, but that doesn’t mean they are all bad deals. It depends on how its set up and how safe it is.

  9. 9
    Roger @ The Chicago Financial Planner Says:

    Jim good point, it is wise to look at the details of the particular state’s plan that you are considering. However, in the current economic environment even plans that offer a guarantee should be scrutinized given the tough fiscal shape many states are in. I realize that my state Illinois is the worst in the nation fiscally, but this concern still applies elsewhere. I would just hate to see a student and their parents heartbroken over the inability of a state to make good on its “guarantee.”

  10. 10
    Evan Says:

    If it doesn’t have a FULL guarantee what is the point? Why not just invest the money yourself? I don’t know anyone who participates in one in New York so I am not sure how ours works.

  11. 11
    Lisa Says:

    These plans seem like a great deal. If stock market tanks, beg for state bailout, if that fails, at least you get your money back (guaranteed principle). If stock market rises, tuition takes off, your investment pays off.

  12. 12
    KDB Says:

    If it sounds too good to be true…sad that they couldn’t provide benefits according to the terms they offered, but that sounds like it is so common these days (social security, anyone?) So even getting it in writing is no guarantee that something will be there, especially over a period of years.

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