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Should You Be Worried About Prepaid 529 Plans?

If a client's plan is facing a shortfall, consider following these steps.

Esther Pak, assistant site editor, 06/28/2011

Question: A client has money invested in a state prepaid 529 plan, but we know some states have struggled to meet their obligations. Is the client's money at risk?

Answer: During times of economic uncertainty, anything that comes with an element of "guarantee" seems attractive to investors--particularly for parents who want to help fund their children's college tuition. To this end, prepaid 529 plans proposed a compelling offer amid quickly rising college costs and a volatile investment climate: Insure against tuition inflation by purchasing future college credits in advance at a set price (usually slightly above today's tuition prices) and receive a tax break to boot.

With tuition rates increasing about twice the general rate of inflation--or about 8% on average--a plan that promises to keep pace with tuition inflation sounds promising. But this guarantee might not be as airtight as it seems. Once touted as a worry-free way to fund a child's college education, prepaid 529 plans are beginning to look less infallible, as some states' plans have struggled to keep up with tuition hikes and recover from losses incurred during the 2008-09 market downturn.

Prepaid Plan Basics
Prepaid 529 plans are distinct from conventional 529 savings plans, where parents invest in a combination of stocks, bonds, and cash and leave it to grow over time. By putting money in a prepaid plan, investors gain the assurance that their outlay will at least keep up with inflation in college tuition regardless of how the market behaves.

Prepaid 529 plans also have similar tax benefits as conventional 529 plans. Qualified distributions are exempt from federal income taxes and might also be exempt from state and local taxes; many states also offer tax breaks on contributions. And there's usually some type of a refund available if the child doesn't end up attending college in-state.

With that said, prepaid plans come with their fair share of stipulations. For one, not all states offer prepaid 529 plans, and investors usually need to be a resident of a given state to invest in its prepaid plan. Additionally, you might not be able to open an account if your child is older and nearing college age, and you'll only be able to contribute to your plan at certain times a year. (The specific guidelines vary from state to state.)

Funds in most prepaid plans will only cover tuition and mandatory fees, not room and board, though some plans allow you to purchase a room and board option or use excess tuition credits for other qualified expenses.

But by far, the biggest caveat is that prepaid-plan program managers assume a specific increase in college costs and manage the program to meet those expenses, wagering that their investment results will outpace tuition inflation. However, history tells us that neither college costs nor the market is predictable. If the former spikes and the latter plummets, prepaid plans could be quickly faced with unmet obligations, forcing them to make changes that could be at odds with savers' goals. That has been the case recently: As the bear market did a number on many prepaid plans' investment portfolios, some have been forced to close accounts, increase the risk level in their investment portfolios, or raise the price of tuition credits. For additional shortcomings of prepaid plans, click here.

State of the State
Illinois' prepaid program, for example, faced a deficit of more than $250 million at the end of March, according to the Chicago Tribune. To help shrink the shortfall, the plan's managers have steered nearly roughly 40% of the portfolio toward hedge funds, real estate, and private equity investments. The goal of those investments is to improve the portfolio's return potential, but they could also increase risk. Moreover, declining plan participation and an increased number of families canceling their contracts have the potential to put further pressure on the plan, if the money going out to pay tuitions outweighs the dollars coming into the plan. Illinois, like most states offering prepaid plans, is not on the hook to shore up the plan if it can't meet its obligations.

Meanwhile, Alabama's Prepaid Affordable College Tuition plan closed to new enrollment in 2009, but its troubles are far from over. Owing to the economic downturn and rising college tuitions, its shortfall is so severe that in the plan's current contract holdings will not receive the full amount of tuition paid toward their PACT program by the year 2014, according to a plan official.

This table provides an overview of the status of prepaid plans throughout the United States, including details on whether the plan is accepting new contracts as well as any guarantees in place to cover shortfalls.

What You Should Do?
If a client has already bought a prepaid 529 plan, scout around on the plan's website and seek out information from third-party sources for details on the plan's financial health and management. Also check to see whether the projected rate of return is realistic--Illinois, for example, was recently assuming an arguably unrealistic return rate of 8.75% for its plan--as well as the assumed rate of tuition increases. (For comparison's sake, college-cost inflation has been running around 8%.) In addition, look for details about whether the plan has made any changes to its investment mix that could ratchet up risk.

Also ask what guardrails have been put in place to stabilize the fund if the plan starts to lose money while your client is invested in it. Just a handful of states' plans are backed by the full faith and credit of that state, meaning the state would step in to shore up a plan facing a shortfall. Other states require their legislatures to consider shoring up the plan, while some states provide no safeguards at all.  If states face shortfalls, they will most likely try options to preserve some benefits to participants, such as capping payouts at less than full tuition or phasing out payments over several years (in this scenario, participants within a couple of years of college would get most of tuition paid out, while people further from college would receive less). If more moderate solutions are not possible, the next step would be to refund participants' principal with a small amount of interest.

If you determine a plan is on shaky footing, check to see what it would take to get out of the contract. For example, Illinois' College Illinois prepaid program promises a full refund (minus applicable fees and service charges) if you cancel the plan during the first three years of a contract. If you cancel after three years, you will receive a refund equal to payments made plus 2% interest compounded annually. 

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