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College savings plans: Is prepaid tuition still a good idea?

College savings plans are struggling in many states because of rising tuition costs and declining returns. About half of prepaid college savings plans have stopped accepting new money.

By Jessica Toonkel and Jilian MincerReuters / January 14, 2012

Connecticut State Treasurer Denise Nappier, Larry the Stag, and Liam McGee, chairman and CEO of The Hartford, celebrate the 2010 launch of CHET Advisor, a new 529 college savings plan for Connecticut residents. Special prepaid college savings plans are being squeezed by low investment returns and big tuition increases.

Business Wire/File

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Jim and Celeste Durkin thought when they began investing six years ago in Illinois state's prepaid college savings plan that they were locking in a bargain price if their daughter Caroline, who is now 10, eventually attended the University of Illinois.

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That might not be the case. The plan took some risky bets on private equity and hedge funds and is now 30 percent underfunded and temporarily closed to new investments.

"It was highly recommended by investment professionals and people we knew, and with all of the uncertainty in the markets we thought it was a safe investment," Durkin said.

An Illinois state representative, Durkin is determined to do something about it: He expects to introduce legislation this month to make the plans more transparent.

The Illinois plan is in worse shape than most prepaid plans, but it isn't unusual in facing problems. Prepaid plans, popular college savings vehicles offered at one time in about 20 U.S. states, are increasingly running on empty.

About half of them have stopped taking new money, according to Savingforcollege.com, and many of the rest are struggling. It means that the majority of Americans, including those in places such as Illinois and Tennessee, don't have access to a state plan, and the minority who do need to be very wary.

Declining market returns and rising tuition costs have been creating an unsustainable funding gap for the college savings plans ever since the dotcom bust in 2000-2001. The financial crisis and its aftermath only made it worse.

Since the end of 2000, the S&P 500 stock index dropped 3 percent while tuition and fees at a public four-year school when adjusted for inflation climbed on average 72 percent in the last decade, according to the College Board, and financially strapped states have in many cases reduced or frozen funding for education.

It all means that at a time when families are particularly rattled by the volatility and low returns of financial markets and want the security of a prepaid plan, the college savings vehicles have become more expensive and higher risk than consumers realize.

Many states have significantly raised the amount consumers need to contribute to keep up with potential tuition hikes, and most don't guarantee the money will be available in the plans they oversee when the time comes to send junior to college.

Worst-case scenario - parents think they have paid for future college costs and then are suddenly told the money isn't all there, or even that the plan has collapsed because of investment losses (though that hasn't happened yet), and they have to make up the difference.

"People need to read the fine print and understand what kind of guarantee their plan really offers," said Andrea Feirstein, a consultant to college savings plans.

A HISTORY OF DIFFICULTIES

Almost all U.S. prepaid plans are a type of so-called 529 college savings plan, which allow American parents to save for college costs without paying federal tax on investment returns if the assets are used for higher education expenses. Prepaid plans are professionally managed and allow families to lock in future tuition payments for universities in a particular state.

For example, a family could set a tuition rate for colleges within the state's boundaries at $40,000 for four years when a child is five years old and spend the next 12 years contributing that. If the four-year course costs $60,000 when the child gets to college, the family still only pays $40,000, and will save $20,000.

But while there may have been great bargains like that in the past, they are becoming rare.

Ohio, for example, closed its prepaid plan to new investments at the end of 2003 because actuaries anticipated potential shortfalls as investment returns slipped and tuition at public universities soared after the state lifted a lid on fees.

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