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Should I Invest in a Prepaid College Plan?

What if you could lock in your child’s college tuition at today’s prices? Prepaid college tuition plans are now offered in ten states and for those who are worried about the rising price of a college education along with the uncertainty of investment markets, buying tomorrow’s education at today’s prices seems like an easy decision.

But financial planners are largely unconvinced. Although this chart [3] shows that the college tuition inflation rate has long been much higher than the general inflation rate, the decision, according to the 89% of financial planners who don’t use these prepaid plans, isn’t as easy as the numbers may indicate.

What are Prepaid College Plans?

Most parents are now familiar with 529 plans. These are named after section 529 of the IRS code that provide tax incentives to those who begin saving for their child’s education long before they reach college age. There are two main types of 529 plans. The first is a college savings plan that allows money to be deposited in to an investment account that grows until the child reaches college age.

The second type is a prepaid college plan guaranteed to grow at the rate of college tuition inflation. If one full year of a state college education was purchased today, it would always be worth one year of a state college education, even if that is 15 years from the year of purchase. (read more here [4])

Most plans require that either the account owner or the beneficiary be a state resident when the account is opened which makes the prepaid tuition option open to a relative few amount of people but for those who are eligible, why isn’t the financial planning community not so enthusiastic about the idea?

Like a Pension

Anybody who has been in the full time workforce for the past 20 or more years may have had a pension as their main retirement vehicle. Although pension benefits are locked in, pension plans have been replaced with 401(k)s or other retirement vehicles like this for many employees.

Companies found it increasingly difficult to guarantee a payout to their employees in an increasingly challenging investment market that offers no guarantees. The same thing has taken place in these prepaid tuition plans. Eight of these plans have been closed to new investors for more than a decade because of a shortfall in funds.

An unfortunate combination of less than expected investment performance along with college tuition inflation rates higher than forecasted have resulted in funds like the Illinois fund seeing a 30% shortfall. This means that the fund can only meet 70% of its obligations.

Is It A Good Idea?

Many of these prepaid plans are almost fully funded after a tough couple of years but they’ve learned valuable lessons that make these plans out of reach for many households. The Washington plan is assuming an annual rate of college tuition inflation of 19% for the next two years [5]—much higher than the 7% increases they assumed in their previous models.

In Maryland, it costs a lump sum $40,095 to enroll an infant in the prepaid plan with the assumption that it will cost $139,750 for four years of college when that child reaches college age.

Although these prepaid plans are in a much better financial position than in the past, the sometimes large upfront costs are prohibitive for many.

Bottom Line

Remember that nothing is guaranteed. Nobody knows what will happen with the world’s economy over the next 20 years so purchasing these plans solely on the basis of the guarantee may not be a wise choice. The better choice may be to supplement a prepaid plan by paying in to a 529 account for added protection. Like every investment decision you make, never put all of your money in to one product.