The False Security of Prepaying Tuition Participants in Early Payment
Plans Learn Their College Bills Aren't Always Covered; States Scramble
to Shore Up Funds

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By JANE J. KIM

Patti Lambert wanted to pay the college tuition for her eight
grandchildren. So for the past 16 years, the real-estate agent signed
onto the state of Alabama's prepaid tuition program. She invested
more than $100,000—a daunting amount but a good deal because the
prepaid plan promises to cover tuition no matter how much it increases.
[prepaid0219] Owen Stayner for The Wall Street Journal

Patti Lambert, left, invested more than $100,000 in prepaid tuition
plans for her grandchildren.

Or so she thought. Facing a severe funding shortfall, Alabama is trying
to renege on its promise to foot the whole bill. Instead, the state
wants to pay the average tuition rate, potentially forcing schools and
families to make up any difference.

"There's nothing more shocking than having something that you thought
was so protected just pulled out from under you," said Ms. Lambert of
Decatur, Ala. She may not get that money back if the plan runs out of
funds in 2015, as one study predicted. But even if she recovers her
principal and 1% interest, she could be out thousands of dollars if
tuitions continue to rise. Alabama's Treasury officials declined to
comment, citing pending litigation against the state's prepaid plan.

"Everything about the way the plan was promoted implied that it was
backed by the state," Ms. Lambert said.

Across the nation, college prepaid plans are operating in the red,
putting their promises to investors like Ms. Lambert in jeopardy. For
now, the states still are paying tuition as they agreed. But the fine
print in some state contracts gives them some wiggle room to pay out
less than the promised amounts.

"There's an aura of guarantee around many of these programs," said Tim
Ranzetta of Student Lending Analytics. "But when you dig into it, it's
often a lot less than you'd expect."

Prepaid plans—a type of 529 plan where qualified educational
distributions are tax free—allow families to make an up-front payment in
exchange for future tuition contracts or credits. They can prepay either
the full tuition bill or a portion of it, in one lump sum or over time.

In general, the tuition guarantee applies to state schools in the state
where it is offered, though you can use the money to pay for out-of-state
or private schools, though the amount is likely to fall short of the
full cost of tuition. If a beneficiary elects not to attend a college
covered by the plan, the investor can get his principal back, usually
with interest. If he receives more than his contributions, the excess
is subject to tax and penalties unless, within 60 days, he rolls it over
to another 529 plan.

Investors had flocked to prepaid plans in recent years as they witnessed
skyrocketing tuition and huge market losses on their monthly statements
for more-popular 529 college savings plans, which often invest in
mutual funds.  [PREPAID]

But market losses also hammered prepaid plans—just less visibly than
conventional 529 savings plans. Prepaid plans hold roughly $15 billion
in assets, and their investments are still recovering from recent
stock-market declines. At the same time, schools are jacking up tuition
to cover state budget shortfalls. That is forcing states to raise prices
and impose fees—a move that makes it more expensive for new families
to join and threatens to damp future cash flows into the plans, making
them less solvent.

Some states now are asking for a bailout. In Alabama, lawmakers are
considering legislation that, among other things, would inject at least
$236 million into the prepaid program. In South Carolina—whose plan
is estimated to run out of money by 2017—the General Assembly is
considering funding options to keep it going, such as making a lump-sum
payment of $69 million this year. Included in Tennessee's proposed
state budget is a request for a $15 million infusion into the prepaid
plan, while West Virginia recently received $8 million from the state's
unclaimed-property fund to shore up its program.  More Weekend Investor

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For the prepaid plans, it's déjà vu. After the dot-com bubble burst
earlier this decade, a number of states—including West Virginia,
Ohio, Kentucky, and Texas—barred new participants when poor market
returns, paired with sharp tuition increases, bled reserves faster than
expected. That allowed them to keep their tuition promises to existing
participants.

But with state funding for higher education waning, more state
legislatures are giving universities the authority to increase their own
tuition above what is set each year by lawmakers. "The result of tuition
deregulation is sometimes a spike in tuition rates" which often results
in higher prices for families, said Joe Hurley of Savingforcollege.com.

After Florida passed a law in 2007 that allowed the state's research
universities to charge a "differential" tuition on top of state's base
tuition, prices more than quadrupled for one of its plans aimed at
covering that difference. Washington expects prices for its prepaid
plan to increase by at least 14% this fall—in step with tuition
increases. Michigan raised contract prices 15% for the current enrollment
period.

Faced with the prospect of hefty tuition increases, Nevada, which is
waiting for a state-legislature committee to approve a $5 million loan
to bolster its prepaid plan, raised rates about 10% this year, up from 6%
and 7% increases in prior years. So families buying a four-year university
plan now have to pay $20,250 for a newborn if they are making a lump-sum
payment, up from $18,350 last year.

But as more states raise prices, some parents and advisers are backing
off the plans. Fred Amrein, a Wynnewood, Pa., adviser, used to be a
fan of Pennsylvania's Guaranteed Savings Plan. But after the state
raised fees last fall, he stopped using it as an option for some of
his clients. "Those changes were pretty expensive," he said. The state
tacked on some up-front premiums up to 8% and also changed its annual
account-maintenance fee to 0.49% of assets from a flat $25 fee.

Investors need to read the fine print. Five state plans are backed by
the full faith and credit of the state. Other states, including Illinois
and Maryland, are required by law to consider helping out the funds if
there is a potential shortfall. States including Alabama, Michigan,
Nevada, Pennsylvania, and Tennessee are backed by the funds' assets,
meaning investors can lose money if the funds run dry and states don't
rescue them.

If that is the case, Ms. Lambert, at 64 years old, frets that she
doesn't have enough working years ahead of her to make up any tuition
shortfall for her grandchildren. "I bought tuition so my grandchildren
would not be crippled with a bunch of student loans," she said. "That
was my nana legacy."

Write to Jane J. Kim at jane.kim@wsj.com