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Red ink flows in state-run prepaid tuition programs

In three years the Prepaid Alabama College Tuition Program (PACT) will run dry. The State Treasurer reports PACT which pays $100 million in tuition a year, has $347 million in investments remaining. To fulfill its obligations to all 40,000 participants over the next 20 years, PACT needs an additional $843.9 million. The state Supreme Court recently struck down a potential solution put forth by the legislature: cap payouts to 2010 tuition levels and have beneficiaries make up the difference. The remedy didn’t pass scrutiny due to a 2010 law that promises PACT be 100 percent funded.

PACT worked for about 20 years until hit with the combination of unrelenting tuition inflation and a bear market which halved the plan’s investments.

Unfortunately, Alabama isn’t the only state with a prepaid program in the red. The Wall Street Journal reports South Carolina’s plan expects to run out of funds in 2017. Tennessee’s budget seeks an infusion of $15 million into its program. And West Virginia recently transferred funds from an unclaimed-property program to shore up its struggling prepaid plan.

In remarkably bad shape is IllinoisCrain’s Chicago Business finds that Illinois’ 12-year old $1.1 billion prepaid plan has the largest shortfall in the entire nation. Worse still, plan managers are making up for losses by embracing a huge amount of risk. In 2011, 47 percent of Illinois’ prepaid tuition plan was shifted into alternatives and investment expectations set at 8.75 percent. An expectation that far outstrips any other prepaid plan by a long-shot. (Florida has the country’s largest prepaid tuition plan and operates with an expected return of 4.3 percent on plan investments).

This year the agency that runs the prepaid program, the Illinois Student Assistance Commission ,has dropped that return assumption to 7.5 percent.  According to its actuarial report College Illinois! has enough money to pay out tuition for a few more years.

Prepaid plans are a type of 529 plan (the other is the college savings program) that allow parents to purchase contracts (or credits) for their children’s education.  The prepaid tuition plan locks-in tuition for the current year for eligible in-state colleges. Contributions are invested and benefits paid from those funds. To remain well-funded asset performance must track or exceed tuition increases. Given the rapid increase in college tuition which on average has increased 5.6 percent per year over the rate of inflation in just the past decade, it’s easy to see why so many plans have gone bust.

PACT participants who may not recoup their initial investments are understandably upset, “everything about the way the plan was promoted implied it was backed by the state.”

But, just how good is the state’s guarantee?

That is often in the fine-print. The WSJ finds three levels of guarantee in operation. 1) Full Faith and Credit – the state promises to pay for shortfalls if the fund goes dry. (Washington, Texas, Ohio, Mississippi and Florida)  2) Legislative appropriation – the legislature must consider an appropriation to cover shortfalls. (Illinois, Maryland, Virginia, South Carolina and West Virginia)  and 3) Fund Assets – the plan is solely backed by the assets in the plan. (Alabama, Michigan, Nevada, Pennsylvania, and Tennessee.)

Alabama’s PACT participants found they had little recourse in 2009.  Since the state doesn’t guarantee payment of tuition,they were technically out of luck. However, after a series of demonstrations and hearings in 2010 the Alabama legislature granted a $548 million bailout, tiding the plan over for the next three years. And then what? The state legislature filed a bill last week to tweak the previous solution to the court’s liking. It is again proposing to cap tuition payouts at 2010 levels.

Strangely, in spite of the risk present in pre-paid tuition plans they continue to provide a “flight to safety” for some investors. Last year growth in pre-paid plans outstripped growth in 529 college savings plans. The lure of higher returns attracts some who are banking on the ability of governments to keep their promise to pay it out regardless of market performance or the fine-print.