The Chronicle: 1/19/2001: Who Benefits From States' College-Savings Plans?

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Who Benefits From States' College-Savings Plans?

By ANDREW P. ROTH

Today almost every state sponsors a program that confers tax benefits to help students and their parents save for college. The growing popularity and importance of such programs should not go unnoticed by higher-education leaders. In fact, the trend demands that we ask, once again, classic questions of any program that provides some form of student aid. Who pays? Who benefits? Who should pay?

Since 1997, in research for a book on the topic, I have studied virtually all the college-savings plans, in 48 states. I have reviewed legislation, state-sponsored studies, program brochures, disclosure statements, letters from governors and state treasurers, Web sites, and other sources to understand how states develop and promote their plans.

That research demonstrates that the growth of college-savings plans is generating fundamental shifts in financial-aid policy: away from access and equity for lower-income students and toward middle-class affordability, away from need-based assistance and toward tax-based assistance, and away from government support and toward greater parental responsibility for tuition.

Higher-education officials and policy analysts must become more aware of those shifts and how they ultimately will affect who receives financial support to attend college.

The federal government exempts the purchaser of a college-savings plan from gift taxes associated with creating the account, and defers taxes on earnings until the account is redeemed -- when earnings are taxed at the student beneficiary's presumably lower income-tax rate. State policies vary: Some simply follow the federal model, others deduct all contributions from taxable income, others deduct a certain dollar amount, and still others provide no tax advantage. Some states exempt all earnings from taxation; others defer taxation until redemption.

Proposals to use the tax code in student-assistance programs date to the original debates over the Higher Education Act of 1965 and its revision in 1972. Because facilitating access and equity were still considered more important than college affordability for middle-income students, neither federal nor state governments seriously considered the concept until the 1980's. At that time, the combination of rapidly increasing tuition and fees and decreasing state and federal student aid -- notably, the shift from grants to loans -- created an "affordability crisis."

Michigan's Education Trust was the first college-savings program. Begun in 1987 under the sponsorship of the governor at the time, James J. Blanchard, it attempted to give state residents a way to escape future tuition increases by allowing them to prepay for their children's college education at current rates. Several other states -- Alabama, Florida, Ohio, Wyoming -- quickly developed their own programs, but then growth stalled until the Internal Revenue Service resolved the tax status of the savings plans in the mid-1990's.

The recent explosion of new plans has provided additional resources for many families hoping to afford college, but we should not ignore the drawbacks. Various states' plans differ not only in the tax incentives offered, but in the basic form that they take: They can be college-savings bonds, prepaid-tuition plans, or college-savings trusts. A state's choice to provide one of the three types can have significant policy implications.

College-savings bonds are zero-coupon, general-obligation bonds of the issuing state that are exempted from all state taxes when the proceeds are used to pay higher-education expenses. From the purchaser's point of view, they are risk-free because they are guaranteed by the state; from the state's perspective, they constitute a known risk -- the amount of bonds, or debt, outstanding. Only three or four states offer bonds.

More than 20 states offer prepaid-tuition plans, including Tennessee, Texas, Virginia, and Washington. Such plans come in several types, but all are variations on the concept of a financial future. The purchaser buys X amount of tuition at today's price for future delivery, regardless of the price at the time of delivery.

Because the rate of return on prepaid-tuition plans is a function of the increase in the price of tuition, they are not particularly aggressive vehicles for saving. When guaranteed by the state, however, they do provide the investor with a high degree of security. The principal is protected, and the tuition -- however high at the time of redemption -- is prepaid. For the state, however, prepaid plans entail the risk that its investment earnings will not match the rate of increase in tuition -- leading to either default or the need to draw from other state resources to fulfill plan obligations.

College-savings trusts, the third and newest form of the plans, are essentially state-sponsored mutual funds whose earnings are accorded favorable tax status when used to pay certain higher-education expenses. Some are managed by the state treasurer's office, others are run by the state student-assistance agency, and many are subcontracted to third-party fund managers, such as Fidelity Investments, the College Savings Bank, or TIAA-CREF.

For several reasons, college-savings trusts are the fastest growing of the three types of programs; as of last spring, 35 states had adopted them. In recent years, investors have liked savings trusts because such plans provide market rates of return that have often exceeded tuition increases. Meanwhile, college-savings trusts present state officials with the irresistible opportunity to offer their citizens a public benefit at virtually no cost. The state doesn't guarantee a program's principal or earnings, and the earnings are not tied to increases in tuition. In addition, a purchaser pays the administrative costs as a percentage of earnings or as a fixed fee.

As a result, the surge in college-savings trusts -- in contrast to the previous growth in prepaid-tuition plans -- signals a return to the view that paying for college is a private responsibility. As long as prepaid-tuition plans complement existing need-based aid programs, such plans stake out an increased public responsibility -- the state guarantees both a rate of return and the security of principal. College-savings trusts do neither; they simply provide a state's residents with access to savings instruments with tax advantages at no risk to the state. An even greater cause for concern than that retreat from public responsibility, moreover, is that such plans benefit middle-class families rather than provide aid to those with the greatest need.

In fact, the plans essentially create a Catch-22. Most colleges include plan assets in their needs analyses to determine whether students deserve additional aid. That practice defeats the plans' basic purpose, by penalizing students and families for their thrift. But, on the other hand, institutions that exclude plan assets from their needs analyses make eligible for student aid those who by definition are more affluent than others because they have more money to invest.

Thus, if a state offers college-savings trusts in addition to other forms of student assistance, they are beyond criticism. Who would oppose encouraging people to save to meet their obligations?

But if a state substitutes such plans for other forms of aid, it can put lower-income students and their families at a great disadvantage. College-savings trusts, because they presuppose possession of investable assets, by definition exclude those without assets to invest. The trend for more states to offer such programs signals a retreat from the principle of providing access to college regardless of a student's, or his or her family's, ability to pay.

Indeed, my research suggests that meeting the challenge of middle-class affordability has surpassed access and equity as the primary public-policy goal of many state financial-aid programs. In state after state, in all types of documents -- whether statements of legislative intent or public-relations brochures -- I found calls for increased attention to the affordability challenge confronting the middle class. For instance, John Sharp, the chairman of the Texas Prepaid Higher Education Board, stated in a letter included in the 1997 Texas Tomorrow Fund application booklet: "With tuition and fees rising every year, it's still the source of sleepless nights for many families, especially those who earn too much for their children to qualify for need-based scholarships, but who aren't so well off that the cost of college tuition represents mere pocket change." In my literature review, similar comments about middle-class affordability appeared at least four times as frequently as comments about access and equity.

Need-based student-aid programs and the existence of public colleges and universities themselves speak to a significant state commitment to affordable higher education. But, increasingly, states are saying that their resources are limited and that their role is simply to assist. The size of that role, however, depends on each state and its residents' abilities to invest in the plan or plans that it offers. Although investors receiving the tax advantages of Iowa's high-return college-savings plan might find them an important public benefit, those without assets to invest certainly don't. On the other hand, Washington's prepaid plan, with its guaranteed returns and low purchase requirements, may be very attractive to those with limited investable assets.

Recent developments indicate that some policymakers understand that states should offer several different plans to assist citizens at all income levels. Virginia, Ohio, and Pennsylvania -- states with prepaid plans -- have recently added college-savings trusts to their program mix. Those states' experiences bear watching, for the combination of a prepaid plan, with its minimal purchase requirements and wide appeal, and a college-savings trust, which affords lucrative returns to college savers, might provide the best of both worlds. In any case, a state should not simply reallocate need-based financial aid to meet obligations for prepaid-tuition plans or offer only college-savings trusts that primarily benefit middle-income students.

The greatest financial boom in U.S. history has obscured the public-policy issues surrounding the rise of college-savings plans that confer tax advantages. Because the plans have not yet affected state treasuries, policymakers have been able to avoid the question of whether to offer college-savings plans in addition to or instead of existing need-based student-aid programs. However, recent rumblings in the financial markets suggest that we can no longer count on a robust economy to shield us from difficult choices.

Andrew P. Roth is vice president of enrollment and information services at Mercyhurst College. He is the author of Saving for College and the Tax Code: A New Spin on the "Who Pays for Higher Education" Debate, to be published this month by Garland Publishing.

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