Research

Probing Question: What are prepaid college tuition plans?

money in a hatJames Collins

John Rockey started planning for his daughters' college educations soon after they were born. A prepaid savings plan that Rockey set up in 1988 will provide his second oldest daughter Rebecca, now a freshman at Penn State, with guaranteed college tuition—at 1988 rates—until the day she graduates.

"What I liked about starting the plans when they were young was that I didn't have to worry about inflation, tuition increases or what the investment was doing," he says. Even with four daughters who plan to go to college, Rockey won't ever have to borrow student loans or pay off college debt.

In the last 25 years, college tuition in both public and private institutions in the U.S. has increased at roughly twice the rate of inflation, says Donald Heller, Penn State associate professor in education policy studies. In contrast, the average family income has lagged behind inflation rates, widening the gap between tuition costs and affordability for many families.

"There aren't many forces moderating tuition increases," Heller says.

One solution for families like the Rockeys is savings plans that freeze present-day tuition costs to pay for a child's education, whether they enroll five or eighteen years from now.

These plans, also known as 529 prepaid tuition plans, are currently provided by 19 states, including Pennsylvania, as an alternative to stock market savings plans. When the plans first came out in the '80s, they were only offered for in-state schools. Since then plans have evolved allowing the investment to pay for out of state and even universities abroad, according to the national College Savings Plans Network (CSPN). Private institutions have also developed a similar system, with the Independent 529 Plan provided by over 100 schools around the country.

While earnings may fluctuate with a standard savings plan, the 529s are guaranteed to meet or exceed annual college tuition inflation, says CSPN. In other words, explains Heller, if a family buys into a plan by investing 50 percent of what it costs to go to college today, when their child is ready to go to college the family is guaranteed that 50 percent of tuition will be covered—whatever the intervening rate of inflation.

While it sounds almost too good to be true, there are potential drawbacks, cautions Heller. If a child doesn't get accepted or decides he or she wants to go to a college that is not sponsored by the plan, the family will receive back only what was initially invested, Heller notes—without interest.

Another potential drawback: Prepaid plans typically stipulate reduced eligibility for financial aid. But "families who are using these plans are primarily upper middle or upper income families who in most cases aren't going to be eligible for much financial aid anyway," Heller adds.

If 529s represent some degree of risk for investors, they are also a risk for the states that offer them. At current rates of tuition increase, Heller explains, "some states have begun to grow concerned that they aren't going to be earning enough return to meet these contractual promises." As a result, some states have already suspended further purchases into prepaid plans. Even so, Heller notes, "From the perspective of the state, the more families can contribute by the time the child goes to college, the less the state has to contribute in terms of financial aid and appropriations."

With their pluses and minuses, he concludes, 529s are not for everyone. But prepaid tuition plans, he suggests, can be another useful tool for combating the rising cost of a college education.

Donald Heller, Ph.D., is an associate professor of higher education at Penn State University and can be contacted at deh29@psu.edu. For more information on ways to save for college, visit CSPN.

Last Updated February 26, 2010