By Jim McConville
It sounded like a marvelous deal when prepaid state tuition plans first rolled out: Pay for your child's college tuition now at a particular school at a fraction of what the actual cost will be years later when she attends.
The programs allow families to buy "units" of education credits at a price set by the state. The states then invest the money with the expectation that their investment gains will more than offset tuition costs.
But faced with spiraling tuition increases averaging between 8 to 15 percent a year, coupled with less-than-expected investment returns, eight states -- Alabama, Colorado, Kentucky, Michigan, Ohio, South Carolina, Tennessee, Texas and West Virginia -- of the 20 states that offer plans have closed them to new investors.
"The buzz saw that prepaid plans ran into is that you've got tuition inflation increasing at a rate that is greater than your investment return," says Andrea Feirstein, founder of New York-based AKF Consulting Group, which offers advice on 529 plans. "Three plans -- Illinois, Tennessee and Alabama -- closed in the past 18 months."
In the last two years, however, some state plans have started to turn themselves around. Pennsylvania, now fully funded, replenished its money pool and is again open for business. In 2011, investments in traditional state prepaid tuition college plans increased 6.8 percent over 2010, compared with private 529 plans, which increased an estimated 4.4 percent, according to Boston-based Financial Research Corp.
"State prepaid tuition plans that are open are growing quite well," says Paul Curley, director of College Savings Research for Boston-based Financial Research Corp. "As the economy comes out of its slump, we expect financial backing of prepaid plans to improve as well."
Many financial advisors have questioned the value of prepaid college plans, often thinking that other vehicles would be more flexible and earn higher returns. Section 529 college savings plans, which allow parents or grandparents to contribute post-tax dollars to an account and choose from a selection of investments, are more popular with advisors than the prepaids.
A major downside to a state prepaid plan, say some advisors, is that clients may be locking their children into one particular state's college system a decade or so before their children are to attend.
"Most people didn't want to take that bet," says Valerie L. Adelman, a financial advisor at New York-based Financial Asset Management Corp. "Regardless of the amount of the investment, they just didn't want to be locked into a particular school."
"You're pretty much confined to that state," says Jeffrey A. Looker, a financial advisor at Toms River N.J.-based Sea Coast Wealth Care LLC. "And you never know where a child is going to want to go college -- usually, it's as far away from home as possible."
Scott Kahan, president of Financial Asset Management Corp., says that if parents and their future college-bound child are really locked into one particular state school, then investing in a prepaid tuition plan is a legitimate option. "If there are no if, ands or buts that they're going to that school, then that's something definitely worth considering if it makes sense," he says.
Anyone considering investing in a state prepaid tuition plan should do his homework before signing up, says Kahan. "You have to look at what state it is and what is the financial pool that they are pulling from," he explains. "If it is a bigger state, they may be pulling more money in; but if it's a smaller state, they may not be -- you have to be concerned about that."
He adds families should get as much information as possible from the state and the school to determine how much money is in the prepaid tuition fund and "to find out how it has worked, and whether it's worked to what the original expectations were."
Another advisor in Fairfield, N.J. says a state prepaid plan is "generally a tough sell," especially when you've got a client who is worried whether their child will get into that particular college or state university. "They may worry about what happens to the state fund. Most clients right now aren't sure about their own state's finances, never mind someone else's. They'd rather see it invested in an account somewhere."