While many 529 college savings plan investors know all too well that their investments can decline in value, 529 prepaid tuition plan holders may not be aware that their plans may be in trouble, too.

First, a refresher course: Most prepaid plans allow families to purchase tuition credits or a percentage of tuition credits at a price slightly above today’s face value, then cash them in when the child attends college. Conversely, investors in 529 savings plans put money in a portfolio of stock or bond funds that they hope will grow over time, then withdraw the proceeds to pay for college expenses.

The main difference: States generally assume risk for the prepaid plans, while families bear all risk with the savings plans.

Created as insurance against tuition inflation, prepaid plans are not so infallible it turns out. With Alabama’s Prepaid Affordable College Tuition plan threatening to fold, other states closing or limiting enrollment, and still others significantly raising the price of tuition credits, the prepaid tuition plan could be headed the way of the dinosaur.

“History shows that these plans have been able to climb out of their holes, but there is some risk that you may not get your full promised benefits or even your full contributions back if the plans run out of money,” says Joe Hurley, founder of Savingforcollege.com, a Bankrate company. “No one has lost money or benefits to date, but there’s always a risk.”

Risk, says Hurley, is exactly what prepaid plan holders don’t know their taking.

Some guaranteed, others not

Thirteen states offer prepaid tuition plans that are open for new enrollment, either currently or seasonally, according to the College Savings Plans Network. Another two, Kentucky and West Virginia, have been closed to new enrollment for several years. The Colorado and New Mexico plans have been permanently shut down to any enrollment and will close when the last beneficiary finishes school.

In addition to these state programs, the Independent 529 Plan is national in scope, allowing parents to prepay tuition for its 274 member colleges, which are private schools.

The problem, says Hurley, is that most families who enroll in prepaid plans believe the programs are guaranteed to pay off regardless of what fiscally happens between the time of enrollment and the child’s collegiate freshman year.

Of the 18 prepaid plans, 16 are underfunded, meaning they don’t have enough money to pay future tuition obligations, according to The New York Times. And only a handful of plans are fully guaranteed by the state.

“There is significant risk in those states where the plan is not fully backed by the state,” says Hurley.

Broken promises

But the rules can change, even for those plans that are guaranteed by the state. The Texas Tomorrow Fund, for example, has been closed to new enrollment since 2003. Backed by the full faith and credit of the state of Texas, it recently announced a change in policy about how it would reimburse parents who might cancel contracts because their children receive scholarship funds or matriculate to a school outside of the system. Rather than pay them an amount based on current tuition and fees at public universities, as originally promised, parents will get back exactly what they paid into the fund, minus annual administrative fees.

The Texas Tuition Promise Fund, which opened in September 2008, replaces the Texas Tomorrow Fund. Kevin Deiters, director of educational opportunities and investment for the Comptroller of Public Accounts in Texas, the body that oversees the state’s new prepaid tuition plan, says the new plan doesn’t assume much risk if its investments tank. Texas, he says, is currently the only state that places risk on the universities themselves. Should the state’s new prepaid plan lose money, all Texas in-state schools are still required to accept the credits anyway.

But those who cancel the contract can lose out. “With our system, the only way someone is subject to investment risk is if the student(s) goes to a private institution or they go out of state,” says Deiters. “In that case, we give them a return based on how well our portfolio has done in the stock market, and if tuition inflation exceeds that, (families) absorb that risk.”

Promises vary from one state plan to another. While such states as Virginia provide a legal guarantee that they’ll match in-state tuition increases, others publish financial reports on the state of prepaid investments but leave risk ultimately in the hands of plan holders.

Do due diligence

Families enrolled in plans that aren’t guaranteed shouldn’t automatically assume their money is in jeopardy, says Karen Duddlesten, Nevada’s senior deputy treasurer. Nevada’s prepaid program isn’t backed by the state; however, the plan remains in good standing thanks to a 100 percent increase in enrollment this past year as well as a healthy level of savings the program accumulated in fiscally brighter times.

Duddlesten says parents should ask what happens to the plan in the case of monetary emergency.

“You need to ask how long the program’s been around, what their anticipated rate of return is, what kind of tuition increases they’re expecting, how the board manages investments and how much they’ve built into the formula to stabilize funds in case bad times happen,” she says.

Examining how a prepaid plan will operate 15 years or 20 years down the road also means looking at the ratio of cash going out versus available funds, she says. While some programs are barely squeaking by with ratios of 50 percent or less — paying out $2 for every $1 in cash on hand — stronger programs like that of Nevada are still operating at 100 percent, even without a state-backed guarantee.

Besides the influx of new enrollees, the health of Nevada’s program can be measured by the amount of funds in cash reserves — anywhere from 20 percent to 30 percent, depending on the year.

“Parents should be looking for at least a 15 percent reserve in any plan they enroll in,” Duddlesten says. “They need to know that the board operating the plan is making reasonable and attainable assumptions for the future.”

Demand transparency

Andrew Davis, executive director of the Illinois Student Assistance Commission which operates that state’s 11-year-old prepaid plan, says that when it comes to investing — whether in a 529 program or otherwise — investors should always demand transparency.

“Families should ask to see a plan’s financial statements,” he says. “Each month we publish an updated report on the investments we have on our Web site so people can gauge the financial strength of the program. There are also actuarial reports by an outside party to provide families with objective data.”

The Illinois plans’ most recent actuarial report, performed by PricewaterhouseCoopers, shows the fund down by $273.2 million, but Davis says it should be able to pay full benefits through 2021. He adds that this figure is based on conservative fiscal assumptions, including a 9 percent increase in tuition each year, despite the fact that tuition at Illinois public institutions only increased 5.3 percent last year, according to the College Board. It also assumes zero returns on investments for the next nine years and no new enrollees.

“It’s a worst-case scenario kind of estimate,” Davis says. “Even if absolutely everything in our plan fails, we can still cover benefits until 2021.”

Davis also adds that examining a program’s fiscal assumptions is crucial in evaluating how well-funded the program is. While Illinois is only about 75 percent funded based on a 9 percent tuition inflation estimate, it’s actually performing comparable to Florida’s prepaid plan, which is currently 100 percent funded but only assumes a 6.5 percent annual tuition inflation rate. This past fall, all of Florida’s public four-year institutions increased tuition by 15 percent.

Diversify investments

Even after doing due diligence, families that enroll in a plan that isn’t backed by the state or state institutions are still at risk of losing their tuition credits if the market takes a sudden plunge. One way to mitigate that risk is to diversify your investments, says Duddlesten, by putting some money in 529 savings plans that can help pay for other college expenses such as dorm fees and books. In these savings plans, parents can control their risk exposure by choosing from among conservative and aggressive funds.

Pulling funds out of a prepaid plan altogether can be expensive. According to the Securities and Exchange Commission, unless the beneficiary receives a lucrative scholarship, withdrawing funds from a prepaid plan for anything other than tuition, death or disability will cost you 10 percent of all plan earnings, plus you’ll have to repay any federal or state income tax deductions you’ve taken for the plan over the years. An alternative: Funds can be rolled over into a 529 college savings plan without penalty.

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