Yesterday I described the best prepaid tuition plan I know of, Washington state’s Guaranteed Education Tuition plan, which allows you to place a tax-free bet on the trajectory of tuition inflation at Washington public universities. It’s a weird investment vehicle, but you could see how it might play a speculative role in the portfolio of a sufficiently wealthy person, especially because it comes with all the tax advantages of a 529 college savings plan.
By way of comparison, today I want to describe the wrong way to invest in a prepaid tuition plan: the Virginia Prepaid529 plan.
The Virginia Prepaid529 plan differs in important ways from Washington’s GET program:
- Prepaid529 uses “semesters” as the unit of investment, rather than GET’s “units.” A “semester” is equal to the cost of one semester at a Virginia public 4-year university or 2.6084 semesters at a Virginia 2-year college.
- The price paid per semester varies depending on the age of the beneficiary. While GET allows all enrollees to buy units for the same price, set somewhat above the current payout value of a unit, Prepaid529 charges less for semesters purchased closer to the beneficiary’s enrollment. For example, a newborn beneficiary is charged $8,825 per semester, while a 9th-grade beneficiary is charged $8,145 per semester. By way of reference, mandatory tuition and fees for undergraduates enrolling at the University of Virginia in 2017 are about $8,390 per semester (this information is remarkably difficult to find).
- Accounts must be opened by the end of the enrollment period during the beneficiary’s ninth grade year (as far as I can tell — Virginians feel free to correct me if I’m wrong).
So far, the plan looks pretty similar to GET. In-state tuition and fees at the University of Virginia are somewhat more expensive than at the University of Washington, so prepaying tuition is somewhat more expensive, but not radically so. The difference comes in when it’s time to redeem your prepaid semesters:
- At Virginia public colleges and universities, you can redeem one semester investment unit for one semester of mandatory tuition and fees (2.6084 semesters at two-year and community colleges).
- At Virginia private colleges and universities, you can redeem one semester investment unit for the lesser of the payments you made plus the actual rate of return Prepaid529 earned on those payments or the highest Virginia public institution tuition and mandatory fees.
- At colleges and universities outside Virginia, you can redeem one semester for the lesser of your payments plus a “reasonable rate of return” or the average Virginia public institution tuition and mandatory fees. I can’t find any record of that average on Prepaid529’s site, but it will always be much lower than the highest tuition and fees used in the above calculation.
What is a “reasonable rate of return?” Prepaid529 helpfully defines it as “the quarterly performance of the Institutional Money Funds Index as reported in the Money Fund MonitorTM by iMoneyNet.” As far as I can tell that’s essentially 0%. Reasonable!
Do not invest in Virginia’s Prepaid529 plan…
Virginia has essentially set up a three-tiered outcome structure:
- Some number of Prepaid529 beneficiaries will attend Virginia public colleges and universities. They’ll receive the number of semesters of tuition and fees they paid for, at the price they paid for them. In exchange, Prepaid529 gets to invest their money during the intervening period. If Prepaid529’s investments outperform tuition inflation, Prepaid529 gets to keep the difference. If they underperform, they (hopefully) still pay out as promised. This is a traditional single-premium annuity or insurance contract.
- Some number of Prepaid529 beneficiaries will attend Virginia private colleges and universities. If Prepaid529’s investments underperform tuition inflation, they’ll receive a lower payout amount based on that performance. If Prepaid529’s investment outperform tuition inflation, the beneficiary doesn’t participate in that outperformance; instead they receive an amount based on the highest Virginia public university tuition and fees. In other words, you participate fully in the downside and only partially in the upside, like a twisted variable indexed annuity contract.
- Some number of Prepaid529 beneficiaries will attend out-of-state colleges and universities, and receive their money back, plus a nominal return.
The one thing I’ll give Prepaid529 is that this structure allows them to charge lower prices per semester compared to Washington’s GET. You can buy 10 semesters of in-state tuition and fees for a newborn today for $88,250, about a 5.2% premium over current tuition and fees, while 500 GET units would cost $56,500, a premium of about 8.8% over the current $51,930 payout value. That’s not nothing.
But in exchange for the relatively low Prepaid529 premium, you are buying into the three-tier payout structure I described, in which the investment returns on the payments of students attending private and out-of-state schools subsidize the guaranteed tuition of students attending in-state public schools. Meanwhile, the higher GET premium buys you a return based on Washington state public tuition inflation regardless of where you decide to enroll.
For an older student with their heart set on attending the University of Virginia, that might make sense. But for a younger beneficiary who may or may not even decide to enroll in higher education, investing using a 529 college savings plan offers all the benefits of internal tax-free compounding without the larcenous payout structure of Virginia’s prepaid plan.
…with one exception
If you or your beneficiary is a Virginia resident in the 9th grade year of your beneficiary and you think there’s even a chance the beneficiary will attend a Virginia public college or university, you might consider rolling over a 529 college savings plan into the Prepaid529 plan. Why? Because if you plan on spending your 529 assets for higher education (instead of for estate planning), those assets should be mainly in cash and bonds anyway by the time your beneficiary reaches high school, in order to preserve their value against stock market volatility. If you’re going to earn a low rate of return on 529 assets anyway, you may as well get a cheap hedge against tuition inflation.
The same logic doesn’t apply to Washington state’s GET program because the purchase price of investment units is too high compared to the near-term payout value of those units.
In other words, the best course is to invest your 529 assets in GET as early as possible, and invest them in Prepaid529 as late as possible.