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Time to panic about prepaid tuition plans?

The New York Times reported on October 5, 2009 that 16 of the 18 state prepaid tuition plans are facing funding shortfalls because of a combination of stock market losses and increases in tuition at public colleges. Only five state plans are backed by the full faith and credit of the state. While the other states will be under political pressure to make families whole, there’s still a possibility of losses. The prepaid tuition plans are likely to react by closing to new investment and/or increasing the premiums they charge for a year’s tuition.

Is it time to start panicking about prepaid tuition plans?

These shortfalls are actuarial shortfalls. It means that the plan does not currently have enough assets to meet all projected future obligations. Most of the states have 10-15 years before they will run out of money. So this is not an immediate crisis. It is possible that the stock market will recover enough to erase the shortfall in the interim.

College-Age Children

If your child anticipates enrolling in an in-state public college within the next few years, you should probably continue to invest. Money should remain available for students matriculating in the next few years.

Children Who Will Not Enroll in an In-State Public College

If your child will not be enrolling in college, ask about the plan’s refund policies. Some plans are changing their refund policies to yield no net return on investment (or even a slightly negative return, after fees are deducted). It would be best to move the money out of the prepaid tuition plan before this happens.

Likewise, if your child will be enrolling in a private college or an out-of-state school, you may be better off moving the money to a 529 college savings plan before any change in policies.

Younger Children

There’s no point in keeping the money in a prepaid tuition plan if there’s a risk the plan may reneg on its guarantee. The main attraction of prepaid tuition plans is the ability to shift risk from the family to the state. But if the prepaid tuition plans are backed by an empty guarantee, you’re still carrying all the downside risk with none of the upside potential return.

If your child will not be enrolling in college for at least four years, you should probably roll the money into a 529 college savings plan.

(Note that if you make an unqualified distribution, you will have to pay income tax plus a 10% tax penalty on the earnings. However, you can avoid the tax and tax penalty by rolling the money into a 529 college savings plan.)

If you are thinking about investing in a prepaid tuition plan for the first time, you would probably be better off investing in a 529 college savings plan. The prepaid tuition plans are likely to increase the premiums they charge for a year’s tuition to help make up the shortfall. This will reduce your effective return on investment. On the other hand, a family that is already invested in a plan and expects to take a qualified distribution in the near future is probably ok, since the faster-than-inflation increases in public college tuition yield a better return on investment.