Chapter 6: Education
Create a College Savings Plan
Summary
In response to spiraling college costs, many states have created prepaid
tuition and college savings plans to help families save money for their
children’s education. In Texas, the
Texas Tomorrow Fund
began operating in January 1996, allowing participants to lock in college
tuition and fee rates at today’s prices. In recent years, however, the
popularity of such programs has waned. In response, many states have created
college savings plans that permit parents to invest in mutual fund portfolios,
allowing them to earn greater returns on their investments. Texas should
establish a plan with these features to supplement the prepaid tuition
program.
Background
The 1970s saw little real growth in the cost of college education. Since
1980, however, the cost of college tuition has risen at twice the rate of the
increase in the Consumer Price Index (CPI). Because median family income has
risen only 22 percent since 1981, low- and middle-income families have been hit
hardest by the rapid rate of tuition increases. Student aid also increased over
this period, but not fast enough to keep pace with rising tuition. Moreover,
most of the increase in student aid came in the form of student
loans.[1]
In response to skyrocketing increases in college tuition and fees at both
public and private colleges and universities, many states created prepaid
tuition programs during the 1980s and 1990s. Such programs allow parents to lock
in the future cost of a college education for their children at today’s
prices.
When they were first established, the federal tax treatment of state prepaid
tuition programs was unclear. The Internal Revenue Service subsequently
declared, however, that the Michigan Educational Trust did not qualify for
favorable tax treatment because it was not an “integral part of state
government” and served a private purpose. This ruling had a chilling
effect on other states’ efforts to create similar programs. States with
existing programs tried to overcome this hurdle by incorporating structural
features designed to meet the IRS’ objections, such as operating the
program within a major state agency such as the state’s treasury.
The federal Small Business Protection Act of 1996 added
Section 529
to the Internal Revenue Code. This section outlines the criteria a state must
meet to establish and maintain a program as a “qualified state tuition
program” (QSTP) and describes their federal tax treatment. Section 529
gives states considerable latitude in determining how to structure and
administer QSTPs. As a result, programs in different states vary considerably
from one another in structure. For example, some states (including Texas) allow
the purchase of plans to benefit only current residents. Other states allow
purchasers to establish accounts for future students who reside in another
state.
After favorable tax treatment was ensured, state-sponsored prepaid tuition
programs and savings plans spread rapidly across the United States. In 1996,
only seven states had prepaid tuition programs; at this writing, there are 22.
Texas Tomorrow Fund
In response to
a proposal by the Texas Performance Review,
the 1995 Legislature enacted
House Bill 1214,
which created the Texas Prepaid Higher Education Tuition Program. The program
was placed in the Comptroller’s office, with the Comptroller serving both
as chair of the board governing the program as well as its executive director.
The program was marketed by the name of the trust fund set up to invest proceeds
from contract sales, the
Texas Tomorrow Fund
(TTF).
The TTF is a constitutionally–protected fund. In November 1997, Texas
voters approved
Proposition 13,
a constitutional amendment that put the state’s official backing behind
the program. Investments in the Texas Tomorrow Fund are guaranteed with the full
faith and credit of the state. As of mid-2000, the Texas Tomorrow Fund has sold
nearly 100,000 contracts, and about 6,000 students are already attending
colleges and universities with prepaid tuition funds.
Despite these successes, contract sales have been declining since the
fund’s first enrollment period. During the initial enrollment period, more
than 40,000 contracts were sold; in 2000, that number fell to just over 12,000.
To some degree, this decline could have been anticipated, because sales during
the first contract period captured “pent-up” demand for the program.
In addition, contract prices have risen, as Texas’ public college and
university tuition continues to rise at a rapid clip. A contract for four years
(120 semester credit hours) at a state university cost less than $10,000 in
1996. In 2000,
that same contract costs $14,759.
(The contract now covers 128 semester credit hours; adjusted to 120 semester
credit hours, the contract would cost $13,837).
While increased cost is a factor, part of the recent enrollment decline also
reflects the popularity of alternative savings vehicles such as mutual funds and
stocks. Many potential purchasers may be foregoing participation in the TTF
because they believe that they can get a higher rate of return investing on
their own, even after allowing for the favorable tax treatment the TTF
receives.
Because a TTF contract is tied to actual tuition costs, its value rises only
as tuition and fees rise. If tuition inflation slows, the return on a TTF
investment will decline. Holders of TTF prepaid tuition contracts have an
investment that is backed by the state, something not true of any investment in
the stock market. Nevertheless, that guarantee is less attractive when potential
purchasers can earn greater returns through alternative investments.
College Savings Plans
Federal law allows states to sponsor savings programs that allow purchasers
to save for college in tax-deferred investment accounts. These accounts are
managed by a private investment manager and can be invested in a combination of
portfolios including both equity and fixed-income investments. As with a 401(k)
plan, this combination can vary based on the age of the child, with a greater
proportion of the account invested in equities at a young age, shifting to
fixed-income investments as the beneficiary nears college.
Many states are choosing to create college savings plans, allowing
participants to invest in portfolios managed by respected investment firms such
as Vanguard, Fidelity Investments, and Merrill Lynch. (Section 529 does not
permit individuals to direct their own investment accounts.) Thirty-four states
now offer college savings plans; Texas does
not.[2]
New Hampshire’s UNIQUE College Investing Plansm
is managed by Fidelity Investments. Contributions are invested in one of the
UNIQUE Plan portfolios, which in turn are invested in Fidelity mutual funds.
Fidelity automatically adjusts the balance of stock, bond, and money market
mutual funds in the portfolio according to the beneficiary’s age. When the
beneficiary is 10 or more years away from entering college, the portfolio is
heavily invested in equity mutual funds to increase the account’s capital.
As the beneficiary nears college age, the portfolio gradually shifts to bond and
money market mutual funds to preserve capital that will be needed for college
expenses.
Colorado’s program,
CollegeInvest,
operates both a prepaid tuition plan and a college savings plan. The savings
plan, Scholars Choicesm, allows participants to select one of
three investment options. Under Option 1, contributions are invested based on
the age of the child, as with New Hampshire’s program. Option 2 is a
“balanced option” with 50 percent invested in equity mutual funds
and 50 percent in fixed income funds. Option 3 is based on the number of years
remaining until enrollment, rather than the beneficiary’s age; this
involves more aggressive investments early in the plan and may be more
appropriate for older children or adults planning to further their educations.
Option 1 and 3 contributions are invested in a series of portfolios that shift
from equity mutual funds to bond and money market funds as the student
approaches college enrollment. Salomon Smith Barney manages the investments for
all three options.
Reviews of the TTF in investment periodicals, such as Kiplinger’s
Personal Finance magazine, have criticized Texas’ program because it
lacks some of the flexibility and potential for higher returns offered by other
state-sponsored programs. Investors in TTF cannot earn more than the actual cost
of tuition; some other programs offer the potential to earn money above
future tuition costs.
Kiplinger’s also notes that, because contract prices are based
on weighted average tuition and fee rates (which vary considerably among Texas
colleges and universities), the parents of a child who select a less-expensive
college or university can come out ahead by canceling the tuition contract, even
after paying the 10 percent penalty assessed on prematurely withdrawn earnings.
Kiplinger’s cites a recent analysis of college savings programs
that noted that nearly all participants in the Texas plan earned less than the
rate of tuition and fee inflation over the last two years, because the program
prices contracts at a premium over current rates to cover administrative
expenses. The magazine recommends that parents select a college savings plan
offered by other states instead.[3]
When the TTF was created, uncertainty concerning the program’s IRS
status caused its sponsors to be cautious about its features. In addition to its
investment structure, the program is limited to Texas beneficiaries who are
under 18 years old. Today, 19 states have no residency requirement. No such
limitations are required by Section 529, which had yet to be enacted when HB
1214 was passed in 1995. The time has come to revisit TTF’s structure and
provide more options than are available under existing state law.
State-operated college savings plans are relatively new, making it hard to
assess their popularity compared to prepaid tuition programs. Nonetheless, some
evidence suggests that they will prove popular to savers. Massachusetts operates
both a prepaid tuition program and a college savings plan. The state’s
college savings plan, known as the
U.Fund,
gathered $130 million in 18,000 separate accounts during its first 13 months of
existence. By comparison, the
U.Plan,
the state’s prepaid tuition program, has collected just $95 million in its
five-year existence.[4]
Using private firms to manage investment accounts for college savings plans
creates opportunities for joint marketing efforts. For example, Salomon Smith
Barney’s (SSB’s) brokers and Citibank customer service
representatives are promoting Colorado’s program. SSB markets the program
to existing and potential clients nationwide and will likely work with the State
of Colorado to develop a television campaign. The state and SSB also share some
of the costs related to print media
advertisements.[5]
If marketed successfully, state college savings plans have been popular
beyond their sponsoring state. For example, the
Montana Family Education Savings Program
has 1,752 accounts, 637 of which are out-of-state accounts. The program has
$11.1 million in deposits, with $3.5 million from Montana
families.[6]
Texas and other states only have begun to answer the widespread need for
college savings vehicles. A recent survey by the
College Savings Plan Network,
an organization of state plans, found that 73 percent of parents are saving for
their children’s education. Just 4 percent are using qualified state
tuition programs, even though 54 percent of the survey’s respondents are
aware of these programs.[7]
Recommendation
The Texas Education Code should be amended to
create a college savings plan to provide purchasers with greater flexibility and
potentially higher returns than are available through the Texas Tomorrow
Fund.
The plan would be administered by the Texas Tomorrow Fund, with investments
managed by a private firm to be selected through a competitive bid. As with
savings programs in other states, investments would be held in accounts that
allocate a greater proportion of the investment to equity funds for younger
beneficiaries, shifting to relatively safer, fixed-income investments as
beneficiaries near college enrollment.
Section 529 of the Internal Revenue Code does not specify a limit on the
amount of funds that can be invested for a beneficiary, but does require that
the state set a limit. The purpose is to prevent purchasers from investing funds
far in excess of those that are required to finance a college education. A limit
should be established that takes into account any funds invested in the prepaid
tuition program. For example, Colorado limits investments in its prepaid tuition
and college savings programs to a combined total of $150,000.
The college savings plan should accept beneficiaries from any state, rather
than restricting participation to Texas residents. In addition, the plan should
have no age limit for beneficiaries. This change would allow adults to use the
plan to save for their own education, an important feature since lifelong
learning will be critical to the state’s future economic success.
The constitutional provisions that guarantee the payment of prepaid tuition
contract benefits should not apply to the college savings component of the
program. While funds should be safeguarded because they could not be diverted by
the Legislature for other uses, the plan would not offer a guaranteed rate of
return. Purchasers could select from either the prepaid tuition program, with
its guaranteed benefits and potentially lower rate of return, or the college
savings component, with potentially higher returns but no guarantee.
Participants could contribute to both plans, but total contributions should be
capped.
Fiscal Impact
The Education Code requires TTF to be self-supporting. The program’s
operating costs are paid for from the sale of contracts, administrative fees and
investment income.[8] Although the state will
incur some additional costs by creating a college savings component, these
expenses would be paid from the fund. No additional state appropriations would
be required.
[1 ] College Board, Trends
in College Pricing 1999, New York, 1999, p. 3.
[2 ] College Savings Plan
Network, “State of the States: State College Savings Plans
Overview,” April 11, 2000
(http://www.collegesavings.org/state-table.htm). (Internet
document.)
[3] Kristin Davis,
“College Bound,” Kiplinger’s Personal Finance (August
2000), p. 110-117.
[4] Chris Pope,
“U.Fund at head of class; College savings participation high,”
Worcester Telegram & Gazette (March 9, 2000).
[5 ] “SSB Plugs New
College Savings Plans on Web Site,” Financial NetNews (June 5,
2000), p. 1.
[6 ] “Montana Family
Education Savings Program Exceeds Expectations By Threefold During First Two
Years of Operation,” PR Newswire, March 24, 2000. (Press
release.)
[7] “College Saving Made
Easy,” Journal of Accountancy (November 1999), p. 27.
[8 ] V.T.C.A., Education Code
§54.640(a).
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