A College Savings Account Disaster

(MoneyWatch)  When 529 prepaid college plans arrived on the scene in the 1990s, the college savings accounts seemed like the dullest, most risk-free investments that a parent could ever make. The prepaid plans appeared perfect for conservative investors, who were too scared to save for college through the stock market.

Here's the deal that states, which rolled out these 529 prepaid college savings plans, generally offered parents and grandparents: They could lock in tuition at public universities for the current rates even if their children were still in diapers. So if a couple bought a semester's worth of tuition for their toddler, it would still cover a semester's tuition years later when the child was finishing his college applications.

But what's happening lately to these sure-thing 529 college plans is ugly. Almost all of them are now experiencing serious financial trouble. The college prepaid plans are being smacked around by a double whammy: rising tuition at state schools and sinking stock prices.

When tuition at state institutions was rising slowly and the financial markets were prospering, the states could turn a high enough profit to meet the tuition obligations. But today, according to a story in The New York Times, 16 of the 18 state 529 college prepaid plans are underwater.

The South Carolina and Alabama plans appear to be in the worst shape; the two states only have enough assets to cover 66% of their tuition obligations. Many other states have shortfalls ranging from 10% to 20%. Florida, which operates the nation's largest state prepaid college plan with 850,000 participating families, is also a ticking time bomb. The Florida Legislature is allowing its state universities to hike tuition by up to 15% annually for the next five years. It's hard to imagine how the state will meet its tuition obligations to all those families when nearly all its 592 money is invested in bonds.

And here's more bad news: While many parents assumed that these education funds were a sure thing, it turns out that only five states offer a tuition guarantee to all those nervous parents.

While all the troubled 529 plans are state programs, there is also a private prepaid college program called Independent 529 Plan, which has 275 private schools participating including Princeton, Notre Dame and Stanford. According to Thomas Kepple, who is president of Juniata College (my daughter's school) and one of the creators of the independent plan, the private schools are assuming the investment risk so families don't need to worry. "In a good investment period a college would get more than current tuition so over time the theory is that it will all even out and our parents will get a tax wise way to save for college with a guarantee," Kepple observes.

Considering the grim news regarding the state programs, what should parents do? I asked Mark Kantrowitz, who heads up FinAid.org, for his take. Here are his recommendations:

If a child will be enrolling in college within a few years, parents should probably continue investing in their prepaid 529 plans since there should be enough money in the state coffers for these teenagers. For younger children, Kantrowitz recommends investing in a regular 529 college savings plan. If you've already got cash in a prepaid 529 for little ones, he suggests that you could be better off moving the money into the more popular 529 college savings plan.

Piggy bank image by Daniel Y. Go. CC 2.0.