Tuition increases are right up there with death and taxes in terms of certainty. In 2008, annual college costs—including tuition, room and board, and fees—rose an average of 5.7 percent, to more than $14,000 for a four-year in-state public college, according to the College Board.
Even though overall inflation has been decreasing, don't expect relief in the next few years. Many states are slashing college budgets, which means that students may have to bear more of the costs. And at many private universities, where total costs already average more than $34,000 a year, scholarships might shrink because endowments lost money in last year's market disaster.
An antidote to rising costs for many families are Section 529 college savings plans, which were introduced in 1996 and revamped by Congress in 2006 to enhance their tax advantages. Named after a provision in the tax law, these plans are offered by individual states and allow investors to accumulate savings that can compound free of federal tax as long as the money is used for qualified college expenses. Many states also provide further tax incentives for in-state investors. (Go to the FinAid Web site to see whether your state is among them.) The plans generally offer a few investment options, but it varies from state to state.
Of course, 529 plans were not exempt from the steep downturn in the stock market last year. As 2008 headed to a close, the stocks in 529 portfolios typically lost 40 percent of their value, and in one plan they had dropped as much as 65 percent.
Stocks make up only one part of the entire portfolio, but it's almost always the largest. You don't have to invest in a plan containing stocks, but many people do in an attempt to keep up with college-cost inflation, which outpaces the general inflation rate. Most successful long-term investment plans should be based on the familiar structure of stocks, bonds, and cash; over a 15- or 20-year span, returns on more conservative bank certificates of deposit will almost certainly fall short.
Many 529 plans are "age based" portfolios, which are designed to take more risk by investing in stock funds when college is more than a decade away and, as high school graduation approaches, become more conservative.
They're similar to target retirement funds, which gradually shift from stocks to bonds as you get closer to retirement. But the age-based 529 plans are usually more conservative than target funds' post-retirement portfolios. That's because retirement is a longer period than college, and portfolios that are designed to last a lifetime will continue to hold stocks even after the target year. A retiree can afford to take a few risks, but the bursar will be expecting tuition from incoming students for the next four years.
When we looked at the performance of age-based portfolios for 15- to 17-year-olds, when the portfolio should have a conservative slant, we found that some funds actually made a few dollars last year, though none gained more than 2.7 percent. But more funds than not lost money, one as much as 29 percent through November 2008 (one of the tracks in Utah's Educational Savings Plan). That's because nearly three-quarters of the fund was invested in a stock index fund. But that wasn't the only example. More than half the plans lost more than 10 percent over the same period, and most still had more than one-third in equities. While this might be appropriate for someone about to retire, it's probably too aggressive for a student who'll need to draw down 25 percent of the portfolio in a year or two.
A further complication is the shorter investment horizon for college funds. Unless you've been saving for Junior's college since, well, your college days, chances are you'll start putting aside money after the child's arrival. Ten years is the usual "growth phase" of most age-based funds, and that might not be enough time for stocks to work their long-term magic, as market returns from 1998 to now painfully illustrate.
And then there are the fees. State 529 plans are generally managed by mutual-fund families, and their investments are subject to expenses and fees. Fortunately, 529 fees aren't as onerous as many funds', although some can exceed 1 percent annually.
Because many equity funds lost half their value last year, states are now considering alternative 529 plans, and prepaid tuition plans are gaining renewed interest. Currently 18 states offer prepaid plans, and Oregon is considering offering them. In general, prepaid tuition plans are guaranteed to grow at the same rate as in-state public college tuition.
Washington state's prepaid plan, for example, allows participants to sock away up to $38,000 per student and use the funds to pay for college tuition, room and board, and other qualifying expenses anywhere in the country. To qualify, either the student beneficiary or the account owner has to live in Washington at the time of enrollment in the program, though he or she can stay in the plan after a move out of state. The Illinois prepaid plan requires one year of residence before you can open an account.
The catch: The rate you lock in is usually more than the current tuition. Washington's plan, for example, currently prices one year of in-state tuition at $7,600. That's almost 12 percent more than this year's $6,800 tuition at the University of Washington. The long-term rate of college inflation is only half that.
Despite the drawbacks, a 529 plan is a good way to save, as long as it's based on a properly constructed age-based portfolio, with relatively low fees. To that end, the Money Lab searched for some of the better options available, which we list in Some of the best and worst. We screened for below-average fees and an investment strategy that was sufficiently aggressive in the early stages and appropriately conservative later on. We also looked at the performance of a portfolio's funds last year. Maintenance fees weren't something we wanted to see, but some good plans charge them, and in some cases they can be waived.
This article appeared in the May 2009 issue of Consumer Reports Money Adviser.