Academic

Should Investors in Prepaid College Tuition Plans Be Bailed Out?

By Roger Dennis

My good colleague Dan Filler seems obsessed by the cratering of the Alabama Prepaid College Tuition (PACT) Plan.  At first, I thought this fixation was driven by his continued Alabama nostalgia coupled with post modern views of finance.  On further review, his obsession opens a fascinating window on two complex (and now unfortunately related) subjects---the current economic crisis and the financing of undergraduate college education.   As Dan?s first post on the subject properly noted the Alabama Plan fully and prominently disclosed that it was not backed by credit of the State of Alabama nor any other entity.  Moreover, by surfing Alabama?s website I quickly discovered the plan had invested its assets more than 70% in equities and had done no hedging.   Needless to say, the plan?s value over the past six months has been whacked by more than 30%. 

The simple answer to the plan?s funding crisis seems to be:  ?listen you widows, widowers, orphans and grandparents: tough luck.  No bailout for you.  There was full disclosure.  You knew the plan was not credit enhanced.  You knew the plan was very exposed to the risks of investing in equities.  Those risks were priced into the plan.  It would be a great moral hazard to now protect you from your folly.  Moreover, you had many other options for investing for future tuition costs including multiple forms of tax advantaged instruments including several different kinds of educational IRAs, full faith and credit backed municipal bonds, and 529 qualified mutual funds.  Plus your student is eligible for Pell grants and many layers of tax credits.  Suck it up.? 

The easy ?it was disclosed? answer does not, however, completely account for the peculiarities of the situation.  The reasonable objective investor in a prepaid college plan appears to be particularly risk averse.  We could also posit that she is not typically investing in the equity markets.   She does not appreciate the volatility of such markets.  To get at the real risks of the deal maybe there should have been a prominent statement ?We are investing in stock. If the stock market goes down significantly, there won?t be money to pay your kid?s tuition.  You are at risk of losing significant portions of your investment.? Another way of approaching the problem is broker/dealer suitability law.  Investment advisors owe their clients a duty of recommending suitable investments, considering the risks the investor can tolerate.  Would it be suitable advice to our risk averse investor to expose her so deeply to equities?  Maybe not.  The advice might be viewed as particularly inappropriate because other strategies - such as municipal bonds - can provide similar tax advantaged returns at lower risk.   

The hidden issue here is how to get our widows, widowers, orphans and grandparents reliable information about the welter of financing options and tax benefits available for higher education expenses.   The system has grown by accreation over decades.  You need a Ph.D to fund a B.A.  Complexity isn?t our friend.

Full post as published by The Faculty Lounge on March 12, 2009 (boomark / email).