State college savings and prepaid tuition plans: A reappraisal and review

Journal of Law and Education, Oct 2003 by Olivas, Michael A

Notwithstanding, these programs are state entities, even as they must meet 529 federal eligibility criteria for federal tax treatment purposes. As such, policy analysis requires attention at the state level, as well as at the federal level. Three major state level issues have emerged in the decade and a half since these plans began, and especially in the half dozen years since the enactment of the Taxpayer Relief Act of 1997:33 finance and financial stability, system complexity, and the proper role of states in a federal financial aid system. (Additional issues of state taxation in the federal tax regime are treated separately in the following section, and mirror the parallel tracks of state/federal program design and implementation.)

III. FINANCE

The financial success of state prepaid and savings programs is not a slam-dunk assured matter. After all, Wyoming closed the country's first such program, and others have found it a rocky road to program solvency. When inflation is low and when the stock market is rising, even modest state programs make geniuses of their managers. After all, most investors are in it for a long haul, purchasing their children's contracts that do not come due for many years: a newborn's payout will not come due for eighteen years, allowing a variety of investment strategies to states-including a mix of stocks and bonds, invested on an age-basis that becomes more conservative in the later stage of the transaction. Bundled together with many thousands of such contracts, a state's investment portfolio has many advantages, doing business as tax-exempt entities and having access to sophisticated markets that risk-averse individual investors do not possess. In a number of instances, states provide substantial public funds to establish or operate these programs; much of their cost is subsidized. In 1994-95, for example, Ohio underwrote its prepaid program by investing $1 million to reduce the cost of its prepaid contracts and to provide a FF&C guarantee to the program.34 Virtually all the programs have been subsidized by the sponsoring state at some point in their operation, even those administered or operated by private investment companies or financial institutions. These state contributions have surely enabled the programs to become established and operational.

But it is one thing to operate a program in the 1990s, when the stock market defied gravity, and it has proven to be another in the slowed-down, self-correcting stock market of the new century. In 2002 alone, Morningstar reported that average 529 stock funds it monitored had fallen by 21.2%, a better performance than the year's S&P 500-stock index, which performed even more poorly, at a 21.8% loss for the year.35 In 529 bond funds, the average 529 programs performed better, gaining 2.5% for the year; however, age-based bond funds keyed to five-year-old children (with thirteen years left before they cash out and attend college) declined by an average of 16%.36 And this occurred in a year when college tuitions rose by almost 10%, leaving even the most successful funds losing ground. In its first year of operation, the TTF37 planned for a 9% payout in its prepaid program, and then discovered that the aggregate Texas public college tuition and fees rose by 19%.38 Such a one-year shortfall can be made up over time by improving estimates and adjusting program charges, but no portfolio can sustain long-term losses even if college costs did not increase. Sometimes, states have even discounted the costs, in order to attract program participants, as the MET39 program did in its early period.40 This mistake and the early tax problems caused the state to suspend its sales operations for a time until financial stability was restored.