Spooked by the stock market, more parents saving for their kids' colleges are putting their faith in something that could prove to be equally tenuous: the ability of state governments to manage money.

New figures show that growth in prepaid-tuition plans last year again outpaced traditionally more popular 529 plans. Advisers say that is because prepaid plans, with $20.4 billion in assets, are considered a "flight to safety" after several years of market volatility. In contrast, college-savings plans offer payments more closely tied to the rise and fall of the market.

"These parents are trading market risk for the risk that these plans can actually live up to their promises," says Joe Hurley, founder of Savingforcollege.com, which tracks 529 plans.

 

Risks Rise for College Prepaid Plans

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Spooked by the stock market, more parents saving for their kids' colleges are putting their faith in something that could prove to be equally tenuous: the ability of state governments to manage money. AnnaMaria Andriotis has details on Lunch Break.

Both options are offered by states. Prepaid plans allow parents to make payments today for future tuition credits that they can use when their kids enroll in college. Experts say the programs whose assets have jumped roughly 28% over the past two years through 2011, according to the Financial Research Corp. are often marketed as offering peace of mind to parents who don't want to be active investors. Those who use 529 college savings plans, on the other hand, must pick from a range of investments and consider adjustments as the market changes.

But that sleep-soundly promise for prepaid plans isn't always ironclad a growing concern given the financial condition of some state plans. Of the 18 states with these plans, just five offer an unconditional guarantee. And more than half of those states have plans that are underfunded, according to the latest data available from the College Savings Plans Network, a nonprofit association that advocates for 529 plans.

Illinois' prepaid option, for example, is only 70% funded as of June 2011, with a shortfall of $559 million. South Carolina is roughly 80% funded, with a shortfall of about $35 million. The states' latest actuarial reports suggest the plans' assets could be depleted by as soon as 2021 and 2019, respectively.

John Samuels, a spokesman for the Illinois prepaid plan, says the state is working to determine its next steps. In South Carolina, state treasurer Curtis Loftis says that if the state decides to stop the program, state law requires it to return investors' contributions plus 4% interest. States point out that prepaid-tuition plans have yet to miss any payments so far, in part because they have years to make up any short-term market losses.

Some states guarantee payments in the prepaid contract. Other states reserve the right to modify them. Parents sued Alabama's prepaid tuition plan board in 2010 after learning the plan was underfunded, and they could receive smaller payouts under a settlement. Daria Story, the state's assistant treasurer, says the plan could pay out more in the future if its financial health improves.

One of those parents, Carol Perdue of Phenix City, Ala., has filed an appeal to the state's Supreme Court to reverse the settlement. She says the proposed payouts which are pegged to 2010 state public-tuition costs won't be enough for her nine- and 14-year-old daughters when they head off to college. "It is disheartening to know that you invest in your children's education and come to find out that your investment isn't what they sold it as," she says.