Prepaid Bailouts Present Dilemma

It's been a politically popular move for lawmakers to bail out prepaid college tuition plans that are now going broke, but doing so raises some potentially troubling questions of equity. Indeed, these bailouts could have the net impact of forgiving investment losses for middle- and upper-income families at the expense of low-income people, higher education researchers say.

April 1, 2010

It's been a politically popular move for lawmakers to bail out prepaid college tuition plans that are now going broke, but doing so raises some potentially troubling questions of equity. Indeed, these bailouts could have the net impact of forgiving investment losses for middle- and upper-income families at the expense of low-income people, higher education researchers say.

It’s easy to understand why parents flocked to prepaid tuition plans, and it’s not surprising many of them are now crying foul. Parents say they reasonably assumed that paying into plans “guaranteed” their children would receive a college education, and they’re none too happy to hear state officials now say that investment losses and skyrocketing tuition increases have put the plans on a path toward insolvency.

The political and legal pressure to honor the plans has led a number of states to dig into greatly depleted coffers to bail out the programs. In so doing, states have made the calculation that those who were savvy enough to invest in prepaid plans -- typically middle- and upper-income parents -- have earned the right to be saved by money drawn from the state’s overall tax base, according to scholars who've studied the growth of prepaid programs.

“That means the people who can’t afford to go to college are going to be fundamentally underwriting the ability of the wealthy [to attend college],” said Michael Olivas, director of the Institute for Higher Education Law and Governance at the University of Houston. “It’s very regressive, extremely regressive, and in our society it seems to me it ought to be the wealthy who subsidize the poor going to college, not the reverse.”

The median household income of parents using state-sponsored prepaid plans is $100,000, according to a spring 2003 survey conducted by the Investment Company Institute, a national association of U.S. investment companies.

While prepaid programs are not without critics, they are not a societal ill because they encourage families to make responsible preparations for their children’s education, Olivas said. The problem, however, is that states greatly underestimated the rates of future tuition increases and didn’t have plans in place to deal with the consequences of a recession, he said. That was a poor model destined to implode, and now states have created the expectation that they'll bail out participants -- even if some of the contracts aren't explicitly backed by the "full faith and credit" of the state.

"That’s like me going to TIAA-CREF and saying 'Look, I did poorly last year, you’ve got to make it up for me,' " Olivas said.

Plans May Actually Deter Low-Income Families

Prepaid plans are among two college savings vehicles known as 529 programs, which are named for the federal tax code that gives special benefits to participants. The prepaid plans typically allow parents to pay a certain monthly fee over a period of years while locking in a specific tuition rate. Other 529 plans are savings arrangements that create a tax incentive for setting aside money for higher education-related expenses.

“It targets people who have money to save; it targets people in higher tax brackets, and it targets people who have kids they are quite certain are going to go to college,” said Katie Baird, associate professor of politics, philosophy and economics at the University of Washington at Tacoma.

Most who enter into prepaid plans are college-educated and married or living with partners, the Investment Company Institute reported.

There are a number of factors that make prepaid programs appealing to higher-income families, and may actually make them unattractive to low-income students, research suggests. Since money placed in prepaid plans counts as a student resource, saving for college in these plans would actually reduce the amount of need-based aid for which a low-income student was eligible, according to a 2004 report from the Congressional Research Service.

Prepaid programs not only deter low-income students from participation, but they may even be inappropriate for all but the wealthiest families, the Congressional Research Service reported. Penalties for pulling money out of the plans are substantial, and middle-income families are more likely than high-income earners to need immediate access to the money in the event of a reversal of fortune such as unemployment or high medical bills.

“For some middle-income families, saving for college through a vehicle not dedicated to a single purpose might be a more prudent choice,” according to the report, “Saving For College Through Qualified Tuition.

A 2008 update of the report further noted that a tax break in the plan "confers greater benefits on families with relatively high incomes."

Characteristics of Households Saving for College

  Saving with Prepaid Plans Saving Without Prepaid Plans
Age 42 42
Household Income $100,000 $75,000
Married or Living with Partner 95% 91%
College or Postgraduate Degree 71% 54%
Employed 90% 84%

Source: Investment Company Institute

Prepaid programs not only cater to higher income individuals; they also make those individuals less concerned about tuition hikes, Baird said. With a locked-in tuition rate, they no longer have a vested interest in keeping tuition low.

“I think the state definitely has an interest in trying to channel more and more people into higher education, and the primary way they can do it is to make sure it’s affordable to those who otherwise cannot afford it and to make sure the kids have the skills they need to [do college-level work]. Prepaid tuition has nothing to do with those objectives in my mind,” Baird said.

Yet, supporters of the programs are fierce in their advocacy. In Alabama, where lawmakers are wrestling with how to address shortfalls in the state’s prepaid program, parents have made an organized push for a state rescue. Save Alabama PACT argues that lawmakers have an obligation to deliver on the agreement, citing the state’s repeated assurances that the Prepaid Affordable College Tuition (PACT) program constituted a “guarantee.”

Richard Huckaby, who co-founded the grassroots coalition, said he put money into the prepaid program with the understanding that it would secure his children’s educational future regardless of the whims of the stock market or fluctuations in tuition rates.

“We bought it as a guarantee,” he said. “We believed that no matter how ignorant we might be with our money, if we bought into this program we had guaranteed our child an education. That’s what we believed, and that’s what many parents believed.”

As for parents who didn't get into the prepaid plans, Huckaby says he's sorry they missed out. For years, Huckaby has been paying $70 for one child and $80 for another into PACT. He's unconvinced others couldn't have done the same.

"You're telling me there's anybody in any general population that couldn't pay 70 to 100 a month? That's just a lifestyle decision," he said. "Quit smoking cigarettes, quit going out to eat, quit drinking."

'Full Faith and Credit'

PACT officials initially argued that the fine print of their agreements offered no guarantee, but that position has provoked threats of lawsuits from aggrieved parents. While there are legal arguments to be made about Alabama's obligations, the state is not among those whose programs are backed by the “full faith and credit” of the state. Of the 16 state-sponsored 529 plans with a prepaid option, just five carry the "full faith and credit" seal, according to

Regardless of the language of the agreements, Alabama lawmakers have proposed legislation that would cover prepaid participants. A Senate bill would infuse $236 million into the program, and a House bill would put just as much money in while also capping tuition increases for PACT participants at 2.5 percent in most years. Save Alabama PACT and the Alabama Education Association, a powerful teachers' union, both say the caps are necessary to deliver on the program’s promise, but universities have opposed the caps and argued that the tuition limits would force them to hike tuition even more on non-PACT students.

Bailing out PACT participants, while allowing tuition hikes on all but that protected class of students, would present a serious equity problem in a state that already does little to support low-income students, according to Steve Suitts, vice president of the Southern Education Foundation. In 2005-6, Alabama provided assistance to fewer than 4 percent of students with demonstrated financial need, the foundation reported.

“If that bill passes, it essentially will mean that Alabama will have spent $230 million in rescuing primarily middle-class students and their families and still leaving low-income students without any resources except for those available through the Pell Grant,” Suitts said. “While everybody understands why the state has to uphold its obligations, the bigger more long-range problem is Alabama has not made promises to its low-income students. They are out in the cold and that reality is the broader scope and the tragedy of the situation.”

PACT officials said they don’t track income levels of participants, and some reject the notion that prepaid programs are the province of the well-heeled.

“Of the 45,000 contracts, many were marketed heavily to state and education employees, most of whom have average income or below, and all have sacrificed greatly to pay into the program,” said Paul Hubbert, executive secretary of the Alabama Education Association, a union affiliated with the National Education Association.

As for whether a tuition cap simply shifts the cost burden to non-PACT participants, Hubbert said universities routinely differentiate tuition for some students and not others. By way of example, Hubbert noted that universities often waive out-of-state tuition for students living within 50 miles of the Alabama border, and subsidies are also offered to the children of faculty members.

“Universities make the decision to shift tuition burdens every day, we ask that they continue that practice by participating in this solution to help the state meet its obligation to PACT contract holders,” Hubbert wrote in an e-mail.

Like a number of states, Alabama has stopped taking enrollments in its prepaid program. Other states no longer accepting participants include Colorado, Kentucky, Ohio, South Carolina and West Virginia, according to

Texas has suspended enrollment in its Guaranteed Tuition Plan, but another program called the Texas Tuition Promise Fund has been introduced. A key distinction with the Promise Fund is that the universities – not the state – are responsible if tuition rates exceed investment returns from the fund.

As for those who invested in the now-defunct Guaranteed Tuition Plan, the state permitted them to pull out all the money they had invested and then some. The Texas plan was backed by the full faith and credit of the state, and parents came running to extract their money when a projected deficit of $2.1 billion was forecast by 2030. Not only did those participants get back everything they had put into the plans, despite investment losses, but the state also covered any tuition increases that exceeded the principal participants had paid into the fund.

The state comptroller’s office had suggested participants only be refunded the principal of their investments, but parents exerted enough political pressure to secure additional funds to cover tuition increases. Once the money was refunded, participants weren’t obligated to use it for educational purposes.

“I wish I had had the opportunity to get into it,” said Allen Spelce, spokesman for the comptroller. “It’s a great deal.”

“The people that were in this plan were very smart people,” he added. “They knew what they were getting, and they had the economic means to do it.”


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