The New York Times
By: Ron Lieber
April 1, 2011
The predicament of state workers has drawn a great deal of attention recently, and rightly so. The health of their pension plans and their right to organize are fundamental issues.
But the state budget crises that have led to these reckonings have also put state university students and their families in troublesome situations.
In California, this has meant enormous increases in tuition. In Georgia, the beloved Hope scholarship that covered many educational costs for academically qualified students will be less generous come autumn. And in November, Tennessee stopped letting new participants into a plan that allowed parents to lock in tuition prices for their children.
It is in Illinois, however, where the discussion over what a state owes its families has become most intense in recent weeks, as scores of families in one of its 529 college savings plans realize that they may not get the returns that they thought the state had promised them.
Like Tennessee, the College Illinois prepaid tuition program allows parents to pay early to lock in prices for later. But many of those families were not aware until they read a recent article in Crain's Chicago Business that their ability to lock in tomorrow's prices today was not, in fact, 100 percent guaranteed. If the Illinois plan became unable to pay its obligations to families in or near college, the state legislature would not necessarily ride to the rescue to pay every child's tuition.
About a dozen such state plans, known as prepaid 529 plans, are still open to new entrants. If you're enrolled in one, today's the day to go back and read the entire rulebook. But anyone saving for college (or retirement, for that matter) ought to take the following lesson away from the tale of confusion in Illinois: Even if your state tells you something is safe, you should check the fine print.
Here's how 529 plans are supposed to work. There are two basic types. The first is a savings plan, in which you invest in a handful of mutual funds and other investments. As long as you use the money for higher education expenses, you don't have to pay taxes on capital gains.
The second type, the prepaid savings, generally allows parents who are state residents to pay money today to lock in prices at a state university later. Families usually pay some sort of a premium over the current tuition price to make up for the expected tuition inflation in between. (There is also usually a refund available for people whose children do not attend a state college after all.)
What many parents fail to realize, however, is that states differ in how (or if) they guarantee the return on these upfront payments.
Florida, Massachusetts, Mississippi and Washington do guarantee that the state will step in to make good on the promises to keep up with tuition inflation if the fund can no longer meet its obligations because its own investments have underperformed, according to Savingforcollege.com, a Web site about 529 plans. Illinois, Kentucky, Maryland, Michigan, Nevada, Pennsylvania, South Carolina, Virginia and West Virginia do not offer an overarching guarantee.
In the online version of this article, I've linked to a Saving for College chart with more detail on all of the prepaid plans. The chart includes some plans that are closed to new entrants, important footnotes on the Virginia and West Virginia plans and information on Texas, which is its own special case.
Illinois opened a prepaid 529 plan in the late 1990s, and like most other states, it allowed early participants to lock in prices that were much too low, in retrospect. In the states' defense, few people anticipated that many state university systems would end up like the one in Illinois, which has raised tuition by an average of 10 percent annually over the last decade.
Just how far off was the Illinois plan's pricing? In 2006, parents of a newborn there could buy an eight-semester contract for tuition (though not room and board) to attend its flagship university for $41,493. Today, that would cost parents $95,521, a whopping 130 percent increase in five years.
Here's what the Illinois program promised in its various marketing materials to parents frightened by the rapidly escalating prices (all of these statements are direct quotations).
Prepaid tuition programs give you peace of mind knowing you have all or part of your student's college tuition covered.
A College Illinois savings plan is not dependent on stock market performance, so there are no worries about a plan lessening in value.
Each contract holder is entitled to receive the tuition and fee benefits as stated in the contract, regardless of fluctuations in the market.
All of that sounded pretty good in late 2008 to David Mutnick, an options broker who lives in Deerfield, Ill., given that the world seemed to be falling apart around him each day at work. So he and his wife prepaid for their daughter's tuition in full and were contemplating doing the same thing for their younger son when the Crain's article appeared.
It reminded readers that plan managers invest the money, and the state does not guarantee that it will make good on the plan's intent to cover tuition inflation if the investments underperform. If the fund is in danger of not being able to meet its obligations to families with children in or near college, however, it will ask the legislature for a bailout.
The plan does disclose this -- in capital letters -- on page 14 of its master agreement with participants, among other places. Mr. Mutnick and, he said, every one of his friends and colleagues, did not see it. "If someone had called from a financial company promising certain returns, my guard would have been up," he said. "You don't have that same reaction when your state presents you with this option as a way to help families to afford college."
And all of the state's language about peace of mind and entitlement? "It's a lie," he said.
As you might expect, John Samuels, who oversees marketing for the state commission that operates the Illinois plan, doesn't particularly like that characterization. "I don't think peace of mind and a guarantee necessarily go hand in hand," he said. "We don't know of any option to keep up with tuition inflation that provides more peace of mind than this program."
It's hard to draw much reassurance from the most recent numbers. The plan had $1.35 billion in assets and $1.69 billion in liabilities as of June 30, 2010. It believes it will make up the shortfall if tuition doesn't rise by more than 8 percent each year, the number of new plan participants increases sharply and the fund's investments return more than 8.75 percent annually.
I asked Mr. Samuels on Wednesday for the actuaries' projections on when or if the fund might be in danger of needing a bailout if returns were lower, tuition inflation was higher or fewer new families signed up in the wake of the bad publicity. He said he'd see what he could do but then did not provide the numbers, promising to do so soon. (I'll put them up on our Bucks blog once they arrive.) On Friday afternoon, the state commission that runs the plan announced that it was hiring "nationally recognized" experts to review the plan's investment strategy and actuarial assumptions.
So let's say the fund did need a bailout. Would the state legislature come through? After all, it worked that way in Alabama recently when its plan ran into problems.
I put the question to Jim Durkin, a lawyer and Republican state representative who had also put money in the fund for his daughter before he ran for public office. He, too, did not realize it was not guaranteed until the Crain's story appeared.
"I guess the response would be, 'Get in line,' " he said, noting that the state has much bigger problems with its pension obligations and its chronic inability to balance its budget. "We're talking about 55,000 contracts for 35,000 families. I don't think this is a Tier 1 priority."
Risk-averse families will probably read that comment as a clear signal to withdraw their money from the program. But Representative Durkin isn't trying to cause some kind of run on the bank. "That would be devastating," he said. "It may take time, but I want to at least restore integrity to the program, which I think it has lost."
Mr. Mutnick, the options broker, has a simple suggestion for Representative Durkin: given how confident the plan managers seem to be in its solvency, the state legislature could simply step in and provide a true guarantee on the funds. "If they are not willing to do that, then that is an admission that the program is underfunded," Mr. Mutnick said.
Representative Durkin said that he was reluctant to pursue a legislative solution, but was not foreclosing the possibility either.
If this movie hasn't come to your state yet, you can be reasonably sure that it will soon enough. People like me preach the virtues of diversification so often that it is in danger of becoming mere background noise. But this is yet another case study in why it's so important.
Are you inclined to cross your fingers and keep money in a plan like the one in Illinois? Well, it's best to have a 529 savings account, too, to pay for costs that a prepaid account doesn't cover, plus some just-in-case money in the event a state doesn't make good on a prepaid plan and you only get, say, your original investment back if it fails.
The same advice goes for any pension plan, particularly one for government employees. You want alternative sources of retirement money, in case of some kind of unforeseen circumstance.
And if you're a taxpayer without children and plenty of money in the bank? Don't count on being immune from all of this. Failures in any of the above may lead your elected representatives to reach into your pockets to make up the shortfall.