Finance

Catch-22 For College Savings

"Tomorrow's tuition at today's prices." that's the slogan many states use to sell pre-paid tuition plans to parents and grandparents. The plans aim to make college affordable for the next generation of students while promoting in-state public schools.
by | March 2003

"Tomorrow's tuition at today's prices." that's the slogan many states use to sell pre-paid tuition plans to parents and grandparents. The plans aim to make college affordable for the next generation of students while promoting in-state public schools. But now the combination of skyrocketing tuition rates and a swooning stock market are forcing states to raise their prices and rethink their promises.

Nearly every one of the 18 states offering pre-paid plans for tuition at their state universities has had a price hike--many averaging close to 25 percent. There's a simple math to this: Without raising prices now, the state funds where pre-paid money is invested would run dry later. "If tuition is inflating, then prices go up," says Diana Cantor, who heads Virginia's fund and leads an association of all the state programs. "There's no magic to that."

Some state plans are taking controversial steps to stem the tide. Ohio has built a substantial "premium" into its pricing to guard against future tuition hikes. Today, it costs $8,000 to pre-pay one year's worth of a future education in Ohio, versus just $5,000 to attend Ohio State University this year. In other words, the offer is more like tomorrow's tuition at tomorrow's prices.

Colorado is looking at more drastic measures. The state, which has already cut off its pre-paid fund to new investors, is now telling existing account holders that the plan won't have enough money to cover all their tuition expenses down the line--unless the legislature makes some changes this year. Critics see this as reneging on a promise. However, plan administrator Debra DeMuth counters that the only other option is to charge big premiums as Ohio did, something that Colorado doesn't want to do. "Is it reneging? I think it's more a matter of treating everyone in the plan equitably," DeMuth says. "I'd rather do this now than be on the back end and have to tell the last 20 percent of my customers I have no money left."

Even as investors continue to buy in to the plans, their popularity is being surpassed by a newer type of state program, known as a 529. All 50 states now have this form of college savings plan, which functions very differently from the pre-paid model. Pre-paid plans operate more like a defined-benefit pension fund: The state invests the money and carries the risk of paying the benefit (tuition as of the day of enrollment). College savings plans are more like a 401(k): A parent or grandparent chooses how to invest the money, with no guarantee that the final amount will meet tuition obligations.

Despite the risk and the stock market's recent slide, these savings plans are booming. Nationwide, $15 billion is invested in 529s, compared with $8 billion in pre-paid plans. Part of their popularity comes from the 2001 federal tax cut, which made their earnings and distribution free of federal income taxes. Most states also add an income tax deduction from state taxes for deposits. In addition, private money-management firms that run the state plans are marketing them aggressively.

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