United States General Accounting Office

GAO Report to Congressional Requesters

August 1995 COLLEGE SAVINGS

Information on State

Tuition Prepayment

Programs

GAO/HEHS-95-131

GAO United States

General Accounting Office

Washington, D.C. 20548

Health, Education, and

Human Services Division

B-254026 

August 3, 1995

The Honorable Nancy Landon Kassebaum

Chairman, Committee on Labor and

 Human Resources

United States Senate

The Honorable James M. Jeffords

Chairman, Subcommitee on Education,

 Arts, and the Humanities

Committee on Labor and Human Resources

United States Senate

The Honorable Thad Cochran

United States Senate

In response to your request, this report presents the results of our study of state tuition

prepayment programs. These programs represent one approach that some states have adopted

to encourage families to save for their children’s college educations.

Copies of this report are also being sent to appropriate congressional committees, the Secretary

of Education, the Commissioner of the Internal Revenue Service, and other interested parties.

This report was prepared under the direction of Wayne B. Upshaw, Assistant Director, who may

be reached on (202) 512-7006 if you have any questions about it. Other major contributors are

listed in appendix IV.

Cornelia M. Blanchete

Associate Director, Education

 and Employment Issues
Executive Summary

Purpose In the 1980s, several factors combined to create the perception of a college

affordability crisis. From 1980 to 1987, the total cost of college attendance

increased by an average of almost 9 percent annually, while median family

income grew by an average of less than 6 percent. Also, student financial

aid did not keep pace with rising college costs, and the mix of aid changed

from mostly grants to loans, contributing to concerns about excessive

student debt.

In light of these trends, government officials at both the state and federal

levels developed numerous proposals to encourage families to save for

college. A handful of states adopted a tuition prepayment program,

allowing parents or others to pay in advance for tuition at participating

colleges on behalf of a designated child and guaranteeing to cover the

child’s future tuition bill at one of these colleges, no matter how much

costs rise. By allowing purchasers to “lock in” today’s prices, these

programs are intended to ease families’ concerns about whether they will

have sufficient funds in the future to pay for their children’s college

educations.

The Chairman of the Senate Committee on Labor and Human Resources;

the Chairman of the Subcommittee on Education, Arts, and the

Humanities; and Senator Thad Cochran asked GAO for information on state

tuition prepayment programs. GAO agreed to (1) describe how these

programs operate and the participation rates they have achieved,

(2) assess participants’ income levels and options for increasing the

participation of lower-income families, and (3) discuss the key issues

surrounding these programs. To address these objectives, GAO reviewed

the literature, interviewed key program officials and other people

knowledgeable about these programs, and analyzed data on program

participants and other residents of these states.

Background In 1986, Michigan became the first state to create a tuition prepayment

program—the Michigan Education Trust (MET). At least a dozen other

states have followed Michigan’s lead by authorizing such programs, but

only seven had implemented their programs by 1994: Alabama, Alaska,

Florida, Michigan, Ohio, Pennsylvania, and Wyoming. The programs

operate as follows. Purchasers pay in advance for educational benefits

that a designated beneficiary is expected to use in the future at

participating institutions, usually in-state public colleges. The program

pools all payments into one large fund and invests it with the goal of

achieving a rate of return that is higher than the rate of tuition increases

Page 2 GAO/HEHS-95-131 State Tuition Prepayment Programs
Executive Summary

anticipated at participating colleges. When the beneficiary enrolls at a

participating college, the program pays to the school whatever it charges

at that time for tuition and fees and any other prepaid expenses, such as

housing costs.

Results in Brief Although the seven programs GAO studied all operate similarly, they also

have many unique features that distinguish them from one another.

Existing programs have also achieved varying overall participation rates.

The factors that program officials emphasized as important for maximizing

participation include (1) effective advertising and marketing, (2) a positive

public perception of the program, (3) simple and flexible program

features, and (4) affordably priced benefits.

Most participants in state tuition prepayment programs come from middleand upper-income families; lower-income families are underrepresented.

When asked about the potential of two options—sliding-scale fees and a

tax credit—for increasing participation among lower-income families,

program officials said the former option would pose too great an

administrative burden, and some questioned the effectiveness of the latter

option. Although officials have tried to make program benefits affordable

for all families, substantially increasing the participation of lower-income

families will probably be difficult, given their lack of discretionary income.

Four major issues concerning these programs are (1) the potential effect

they have on students’ educational choices; (2) their appeal to mostly

middle- and upper-income families, and the possibility that such families

receive subsidies through participation; (3) their value as an investment

for purchasers; and (4) the degree of risk they pose for states. The most

significant issue facing these programs, however, is the potential

applicability of federal tax provisions. Nearly 8 years after the first state

tuition prepayment program started operating, questions remain

unresolved about the potential tax liability of purchasers, beneficiaries,

and the programs themselves. Officials are concerned because certain

federal tax consequences could make it difficult to operate these programs

successfully. Federal legislation could resolve this issue quickly and

favorably. However, certain factors would need to be considered, such as

the potential cost to the federal government in terms of lost tax revenues

and possible negative effects on private sector institutions competing for

college savings dollars.

Page 3 GAO/HEHS-95-131 State Tuition Prepayment Programs
Executive Summary

Principal Findings

States’ Experiences in

Operating Tuition

Prepayment Programs

The seven programs GAO reviewed have followed two approaches to

selling prepaid tuition benefits. In Alabama, Florida, Michigan, and

Wyoming, purchasers sign contracts to pay for a certain type and amount

of benefits. In Florida, for example, purchasers can choose among

contracts covering 2 years at a community college, 2 years at a community

college plus 2 years at a state university, or 4 years at a state university.

With these programs, purchasers also typically can choose between either

one lump-sum payment or a long-term payment plan. In Alaska, Ohio, and

Pennsylvania, tuition benefits are sold in small amounts, such as credit

hours or even smaller units, allowing purchasers to buy whatever amount

of benefits they want at any time. In addition to these two different

approaches to selling prepaid benefits, each state’s program has its own

operating rules and unique features.

Existing programs have achieved varying participation rates. For example,

Florida’s program has sold an average of about 37,000 tuition contracts per

year, equivalent to 1.57 percent of nonpoor children in the eligible age

range. In contrast, Wyoming’s program has sold about 100 contracts per

year, which is only 0.14 percent of nonpoor children in the eligible age

range.

One factor that program officials described as particularly important for

maximizing the total number of participants is an effective advertising and

marketing effort to reach potential purchasers. A second key factor is

developing and maintaining a positive public perception of the program as

a good way to save for college. For example, sales in Ohio decreased

about 60 percent last year after the Governor questioned whether the

program was a good deal for state families. A third key to maximizing

participation is having a simple, flexible program. For example, after

Florida’s program introduced more flexible rules on using benefits at

out-of-state colleges, tuition contract sales increased substantially. A

fourth factor officials identified is making program benefits affordable.

GAO’s analysis found that annual program participation rates are generally

higher in states where tuition is more affordable to average-income

families.

Page 4 GAO/HEHS-95-131 State Tuition Prepayment Programs
Executive Summary

Participants Relatively

Well Off; Lower-Income

Families Hard to Reach

Most participants in state tuition prepayment programs come from middleand upper-income families. For example, in Alabama, Florida, and Ohio,

the majority of purchasers reported family incomes of over $50,000 in

1992, while the majority of state families with children had incomes under

$30,000. In addition, Alabama state tax returns from 1992 and 1993

revealed that the median income among purchasers was about $61,200,

while Bureau of the Census data showed the 1992 median income for all

families in the state was about $27,400.

Significantly increasing participation among lower-income families will

probably be difficult. States have already tried to make their prepaid

benefits affordable; for example, some offer extended payment plans.

Also, officials said a sliding-scale fee system would be administratively

burdensome, and some questioned whether a tax credit for lower-income

purchasers would be effective, because it would not solve the cash-flow

problem these families would face in paying for program benefits. Five

states have developed plans to provide prepaid tuition scholarships to

needy students, but these efforts generally have not lived up to their

potential because of funding constraints.

Major Issues Concerning

State Tuition Prepayment

Programs

One key issue concerning these programs is the effect they might have on

beneficiaries’ educational choices. A common criticism is that

beneficiaries will choose to attend in-state public colleges, because their

prepaid benefits will fully cover tuition costs at such schools, even though

an in-state private or out-of-state college would better meet their

educational needs. GAO found evidence suggesting that most beneficiaries

may not believe their educational choices are constrained. Specifically,

(1) about 72 percent of all freshmen students in the country enroll at a

public college in their home state and (2) some program

beneficiaries—18 percent in Michigan, for example—have used the value

of their benefits to attend nonparticipating colleges.

A second issue concerning these programs is that they appeal mainly to

middle- and upper-income families. Critics are concerned that the

programs could subsidize their mostly well-off participants, while doing

little to help lower-income families. Supporters say not all programs have

to help the poor, and that increased saving by middle-income families may

free up financial aid funds for lower-income students. GAO found that these

programs can involve various subsidies to participants, such as tax

advantages and discounts on benefit prices. However, these programs can

also operate without providing these kinds of subsidies. In addition, they

Page 5 GAO/HEHS-95-131 State Tuition Prepayment Programs
Executive Summary

likely will not free up substantial financial aid funds for lower-income

students.

A third issue concerning these programs is their value as an investment

option. Critics say purchasers could earn a better return on their money

through other investments, while supporters praise the programs’

simplicity, affordability, and the guarantee to cover future costs. GAO found

that while purchasers might earn a higher return from other investments,

such as stocks, many purchasers may be too risk averse to invest in such

options; for example, over 50 percent of purchasers in Alabama indicated

that without the prepayment program, they would be depositing their

money in a passbook savings account.

A fourth issue for these programs is the degree of risk they pose for states.

Critics worry that the programs could create an unfunded liability for the

state, while supporters claim the risk of a shortfall can be minimized. GAO’s

review found that one state suspended new sales several years ago when

its program appeared headed for financial trouble, but officials say the

program is still actuarially sound. In addition, if a program faced a

shortfall, it is unclear which of several possible outcomes might occur, and

whether they would be negative is a matter of opinion.

Federal Taxation Most

Significant Issue

The most significant issue facing states in establishing and operating a

tuition prepayment program is the possible applicability of federal tax

provisions to purchasers, beneficiaries, and the programs themselves. This

issue is important because certain tax consequences could make it more

difficult—perhaps even impossible—for programs to survive. Concerns

about taxation have led some states to defer implementation of these

programs.

Officials are most concerned about two potential tax consequences. First,

officials hope these programs are exempt from federal taxes on their

investment earnings, because paying such taxes makes it more difficult to

meet future liabilities. What it takes to qualify as exempt, however, is

somewhat unclear, in part because the Internal Revenue Service (IRS) and

a federal appeals court have disagreed on the tax status of Michigan’s

program, and also because other existing programs have not received

guidance from IRS.

Second, program officials are concerned that IRS may decide purchasers or

beneficiaries are liable for federal income taxes annually on the imputed

interest earned from their investments in prepaid tuition benefits. Until

Page 6 GAO/HEHS-95-131 State Tuition Prepayment Programs
Executive Summary

now, officials have followed guidance that IRS issued for Michigan’s

program, which said that beneficiaries are liable for taxes on the increased

value of their prepaid benefits at the time of redemption. Officials believe

that changing from a deferred to an annual tax would create an

administrative burden for their programs and a disincentive for potential

purchasers.

Agency Comments GAO discussed a draft of this report with IRS officials, who agreed with the

discussion of federal tax issues. The information in this report was also

reviewed by officials from all seven state tuition prepayment programs,

who agreed with GAO’s characterization of the issues and descriptions of

their programs. Where appropriate, GAO incorporated minor wording

changes suggested by IRS officials and state program officials.

Page 7 GAO/HEHS-95-131 State Tuition Prepayment Programs
Contents

Executive Summary 2

Chapter 1 

Introduction

12

College Affordability Became Major Concern in 1980s 12

States Respond With College Savings Initiatives 14

Federal Proposals and Action on College Savings 17

Private Sector College Savings Plans 18

Objectives, Scope, and Methodology 18

Chapter 2 

Tuition Prepayment

Program Operations

and Participation

Levels

20

Similarities and Differences Between State Tuition Prepayment

Programs

20

Programs Have Achieved Varying Participation Rates 26

Several Factors Considered Important for Maximizing Number of

Participants

28

Participation Levels Linked to College Affordability 32

Chapter 3 

Income Distribution

of Participants and

Options for Increasing

Lower-Income

Participation

34

Most Participants Come From Middle- and Upper-Income

Families

34

Variable Fees, Tax Credits Considered Poor Options for

Increasing Lower-Income Participation

40

Indirect Efforts to Attract Lower-Income Purchasers 42

Direct Outreach to Lower-Income Families 44

Increasing Participation Among Lower-Income Families Will Be

Difficult

45

Chapter 4 

Major Issues

Concerning State

Tuition Prepayment

Programs

49

Potential Impact on Student Choice 49

Programs Mainly Help Middle- and Upper-Income Families 52

Investment Value for Purchasers 55

Risk to States 58

Applicability of Federal Tax Provisions 59

Chapter 5 

Concluding

Observations

63

Agency Comments 65

Page 8 GAO/HEHS-95-131 State Tuition Prepayment Programs
Contents

Appendixes Appendix I: Overview of Tuition Prepayment Program Features 66

Appendix II: Additional Problems States May Encounter in

Establishing and Operating a Tuition Prepayment Program

90

Appendix III: Federal Taxation a Major Issue Facing State Tuition

Prepayment Programs

93

Appendix IV: GAO Contacts and Staff Acknowledgments 99

Bibliography 100

Tables Table 2.1: State-by-State Comparison of Tuition Prepayment

Programs

22

Table 2.2: Participation Statistics for State Tuition Prepayment

Programs

26

Table 2.3: Participation Generally Higher in States Where Tuition

Is More Affordable

33

Table 3.1: Income Distribution of Purchasers in Alaska, Michigan,

Pennsylvania, and Wyoming

39

Table 4.1: What Happens If a Beneficiary Chooses to Attend a

Nonparticipating College?

50

Table 4.2: Most Prepaid Beneficiaries Appear Not to Need

Financial Aid—Data From Six Participating Institutions

54

Figures Figure 1.1: College Costs Increased Faster Than Income and

General Inflation in the 1980s

13

Figure 3.1: Income Levels of Families Participating in Florida’s

Program, Compared With All Families in the State

36

Figure 3.2: Income Levels of Families Participating in Alabama’s

Program, Compared With All Families in the State

37

Figure 3.3: Income Levels of Participants in Ohio’s Program,

Compared With Nonparticipants in the State

38

Figure 3.4: Cancellation Rates for Tuition Contracts Purchased

From Florida’s Prepayment Program, by Income Level

46

Figure 3.5: Income Levels of College Savings Bond Buyers in

Three States, Compared With All Households in These States

47

Figure 3.6: Income Levels of College Savings Bank Depositors,

Compared With All U.S. Households With Children Under 18

48

Figure 4.1: Most First-Time Freshmen Attend a Public College in

Their Home State

52

Figure 4.2: Tuition Increases, Compared With Returns on Stocks

Over 15-Year Periods

56

Page 9 GAO/HEHS-95-131 State Tuition Prepayment Programs
Contents

Abbreviations

CD certificate of deposit

CPI Consumer Price Index

CPS Current Population Survey

IRA individual retirement account

IRS Internal Revenue Service

MET Michigan Education Trust

Page 10 GAO/HEHS-95-131 State Tuition Prepayment Programs
Page 11 GAO/HEHS-95-131 State Tuition Prepayment Programs
Chapter 1 

Introduction

As the cost of college rose faster than family income for several

consecutive years in the 1980s, many people became concerned about the

future ability of average American families to afford a college education

for their children. In response, both state and federal government officials

sought ways to encourage and help families to save for college. One

innovative approach, tried in a handful of states, allows people to pay

roughly current prices for tuition at participating colleges in exchange for

a guarantee that a child’s future tuition bill at one of these institutions will

be covered, no matter how high costs rise. These programs are known as

tuition prepayment programs.1

 Many other states started college savings

bond programs for their citizens, and the federal government created a tax

advantage for using U.S. savings bonds to pay for college.

College Affordability

Became Major

Concern in 1980s

In the 1980s, a number of factors combined to create the perception of a

college affordability crisis—a perception that persists today. Chief among

these factors was the rapid rise in the cost of college attendance,

especially relative to income growth and general inflation (see fig. 1.1).

From 1980 to 1987, the cost of attendance at U.S. colleges rose an average

of 8.8 percent annually. This figure was substantially higher than the

growth in median family income during the same period, which increased

an average of 5.6 percent per year. Moreover, the increase in college costs

was almost twice as great as the average annual increase in the cost of all

goods and services, as measured by the Consumer Price Index (CPI), at just

4.7 percent. This pattern was a major reversal from the previous decade: In

the 1970s, college costs rose an average of 6.5 percent per year, while

median family income and the CPI went up 7.9 percent and 7.8 percent,

respectively. However, the general pattern of the 1980s has continued into

the 1990s, with college cost increases regularly surpassing general

inflation.

1

Although all the existing prepayment programs cover mandatory fees in addition to tuition, and some

also cover housing and other costs of college attendance, we refer to them simply as “tuition

prepayment programs” for the sake of brevity.

Page 12 GAO/HEHS-95-131 State Tuition Prepayment Programs
Chapter 1 

Introduction

Figure 1.1: College Costs Increased

Faster Than Income and General

Inflation in the 1980s

Average Annual Percent Change

0

1

2

3

4

5

6

7

8

9

10

Cost of Attendance

Median Family Income

All Goods and

Services (CPI)

Cost of Attendance

Median Family Income

All Goods and

Services (CPI)

6.5

7.9 7.8

8.8

5.6

4.7

1970-80 1980-87

Source: Arthur M. Hauptman with Jamie P. Merisotis, The College Tuition Spiral: An Examination

of Why Charges Are Increasing (New York: Macmillan Publishing Co., 1990), p. 4.

Using recent trends in average college cost increases, analysts often

project future prices that can sound astronomical. Last fall, for example, a

magazine devoted to planning for college projected that by the time a child

born in 1994 is ready for college, the average bill for 4 years of tuition,

fees, room and board, books, and transportation would be about $128,000

at a public school and $268,000 at a private one. Given such projections for

the cost of a 4-year degree in the future, many Americans worry that a

college education might soon be priced beyond their means.

At the same time college costs were climbing faster than family income,

the real value of student financial aid was dropping, further contributing to

the concern over college affordability. Although total federal aid increased

38 percent in nominal terms from 1980 through 1989, this represented a

Page 13 GAO/HEHS-95-131 State Tuition Prepayment Programs
Chapter 1 

Introduction

1.3-percent decline after adjusting for inflation. And while state and

institutionally awarded aid rose by 11 percent in real terms, it did not keep

pace with college costs, either. Thus, as one expert put it, “middle-income

families, who might have held out hope that financial aid would be

available to help with college expenses, awakened to diminished

prospects for such assistance at precisely the time that trends in college

prices looked especially ominous.”2

Not only did financial aid fail to keep up with college cost increases, but a

shift from grants to loans meant that students were borrowing more than

in the past, fueling concern about excessive student debt. In the 1980-81

academic year, grants composed 56 percent of all aid, loans 40 percent,

and work-related aid 4 percent. By 1988-89, however, grants had decreased

to 48 percent of all aid, loans increased to 49 percent, and work-related aid

remained about the same, at 3 percent. In 1976 only 17 percent of tuition

costs were financed with loans, but in 1987 the figure was over 50 percent.

Finally, student debt increased 60 percent between 1980 and 1987.

In light of these various factors—the rising cost of college, especially

compared with increases in family income; declining financial aid in real

terms; and increasing levels of student debt—it became apparent that

fewer families would be able to finance higher education out of current

income while their children were enrolled in college. Thus, many experts

concluded that it was increasingly important for parents to plan ahead and

save for their children’s college educations, so they would have the money

in the future, when they needed it. In the mid- to late 1980s, therefore,

state and federal government officials began looking for ways to help

families to save for college.

States Respond With

College Savings

Initiatives

Over 30 states have responded to the concern about college affordability

by adopting some type of college saving program. In 1986, Michigan

became the first state to pass a law establishing a tuition prepayment

program. Known as the Michigan Education Trust (MET), the program

(1) allowed parents and others to pay for the cost of tuition and fees at a

state college years before a child reached college age and (2) guaranteed

to cover those costs, no matter how high, when the child eventually

enrolled.3

 The idea was a response to the common worry that, given rapid

2

Janet S. Hansen, “Pay Now. Go Later. College Prepayment and Savings Plans,” The College Board

Review, No. 147 (Spring 1988), p. 10.

3

Because of this guarantee, these programs are sometimes referred to as “guaranteed tuition

programs.”

Page 14 GAO/HEHS-95-131 State Tuition Prepayment Programs
Chapter 1 

Introduction

tuition inflation, even people who save for college might not have enough

money when their children are ready to enroll.

The program attracted a great deal of attention nationwide, both in other

states and the popular press; in fact, the enactment of MET has been called

“the most widely publicized government action in the field of higher

education finance during the 1980s.”4

 Soon, programs similar to MET were

under consideration in as many as 40 states. At least 12 other states have

passed laws authorizing a tuition prepayment program, but only 7 had

implemented their programs by 1994: Alabama, Alaska, Florida, Michigan,

Ohio, Pennsylvania, and Wyoming.5

 Most states that considered the idea of

a tuition prepayment program chose instead to adopt a college savings

bond program or another type of savings plan.

Tuition Prepayment

Programs

Tuition prepayment programs provide a “pay now, learn later” approach to

college financing by allowing people to pay in advance for educational

benefits that a designated beneficiary will use in the future. The programs

charge roughly current prices for tuition and fees and other prepaid

benefits, such as dormitory housing—in some cases, a premium may be

charged; in others, a discount may be offered. Purchasers may pay for the

desired benefits all at once with a lump-sum payment, or with a series of

payments over time.

The revenues from purchasers’ payments are pooled into one large fund

and invested with the goal of achieving a rate of return that exceeds the

inflation rate for tuition and fees and other prepaid expenses at

participating institutions, typically in-state public colleges. Each semester

that the beneficiary enrolls in a participating college, the program pays to

the school whatever amount it currently charges for tuition and fees and

any other prepaid benefits. If the prepaid benefits are not used as

intended—for attendance at an in-state public college—a variety of refund

provisions come into play.

4

Jeffrey S. Lehman, “The Distribution of Benefits From Prepaid Tuition Programs: New Empirical

Evidence About the Effects of Program Design on Participant Demographics,” Prepaid College Tuition

Plans: Promise and Problems, ed. Michael A. Olivas (New York: College Entrance Examination Board,

1993), p. 28.

5

Some states, including Indiana and Tennessee, decided against implementation; South Dakota and

Virginia are still in the planning stage; Massachusetts implemented its program in February 1995.

Detailed descriptions of the tuition prepayment programs in Alabama, Alaska, Florida, Michigan, Ohio,

Pennsylvania, and Wyoming are provided in app. I.

Page 15 GAO/HEHS-95-131 State Tuition Prepayment Programs
Chapter 1 

Introduction

College Savings Bonds and

Other State Programs

At the state level, the most common initiative has been to establish a

college saving bond program. Many states have viewed issuing bonds as

less financially risky and easier to administer than tuition prepayment

programs. About 20 states have sold college savings bonds, though

relatively few have done so on a regular basis. However, these bonds have

commonly received a positive response, selling out very quickly.

State college savings bond programs work as follows. The state issues

general obligation, zero-coupon bonds, marketed as a way for families to

save for future education expenses and targeted at individual, as opposed

to institutional, investors.6

 These bonds, similar to U.S. savings bonds, are

sold at a discount from their face value and pay no interest until maturity.

The bonds typically are valued at $1,000 to $5,000, with maturities ranging

from 5 to 20 years. Generally, the bonds cannot be called in early, meaning

the issuer cannot redeem them prior to maturity. And because the bonds

are state debt instruments, the interest earned is exempt from state taxes

(for residents of the issuing state) and federal taxes (for all purchasers).

Although the bonds are marketed as a way to save for college, there is no

requirement that the funds be spent on college expenses, and purchasers

need not have a designated beneficiary.7

 Furthermore, states use the

proceeds from college savings bonds as they would proceeds from other

state bonds, such as to build roads and bridges.

Finally, some states have implemented other kinds of programs to help

families save for college, different from both tuition prepayment and

college savings bond programs. Kentucky’s program, for example, allows

participants to save money in a special college savings account. People

can save as much or as little as they like on behalf of a designated

beneficiary, depending on their individual savings goals, and deposits may

be as low as $25. The program guarantees a minimum 4-percent rate of

return, and the interest earned is exempt from state—though not

federal—income taxes. When withdrawn, the funds can be spent at

virtually any college in the country. However, a penalty applies if the funds

are withdrawn inside of 8 years.

6

Because the bonds are intended as a college savings vehicle, they are sometimes referred to as

baccalaureate bonds.

7

To encourage purchasers to use these bonds to pay for college, however, at least one

state—Illinois—pays a bonus on redemption if the funds are spent at an institution of higher

education.

Page 16 GAO/HEHS-95-131 State Tuition Prepayment Programs
Chapter 1 

Introduction

Federal Proposals and

Action on College

Savings

As state officials moved to enact college savings programs in the late

1980s, the federal government also responded to concerns about the rising

cost of a college education. During the 100th Congress (1987-88), the

Senate Committee on Finance held a hearing on ways to encourage saving

for college, and numerous college-savings proposals were introduced in

the Congress. These proposals, typically involving preferential tax

treatment, included a wide variety of approaches to encourage college

savings:

• Some proposals called for the establishment of a national education

savings trust, similar to a state tuition prepayment program. Individuals

would have been able to buy contracts covering a certain amount of future

college expenses at any college in the country. Participants would have

received various tax advantages, such as (1) a deduction for cash

payments to the program and (2) an income exclusion for the funds paid

out by the program to a college. In addition, the trust itself would have

been designated as a tax-exempt entity, free from federal, state, and local

taxes.

• Another proposal would have created federal tuition savings certificates

that could either be redeemed for cash or turned over to a college as

payment for tuition. Colleges that accepted the certificates and kept

tuition increases under a certain level would have received a bonus based

on all the certificates they redeemed. Taxes on the interest earned from

the certificates might have been deferred and possibly assessed at the

student’s tax rate.

• Still other proposals would have created special savings accounts for

education featuring various tax advantages, such as a tax credit for

contributions or a tax exclusion on the interest used to pay for higher

education.

The 100th Congress did pass one major college-savings proposal. With the

Technical and Miscellaneous Revenue Act of 1988 (P.L. 100-647), the

Congress created a federal income tax advantage for using series EE

savings bonds to pay for certain higher education expenses. For savings

bonds purchased in 1990 or later, taxpayers may deduct from their gross

income the interest earned on bonds used to pay for tuition and required

fees at accredited colleges and universities. However, there is a phase-out

structure for the exclusion, designed to favor lower- and middle-income

families: Taxpayers below a certain income level may qualify for a full

exclusion; those between the lower and upper income limits for a partial

exclusion, decreasing as their income rises; and those above the upper

limit do not qualify for any exclusion. For 1994, the lower and upper

Page 17 GAO/HEHS-95-131 State Tuition Prepayment Programs
Chapter 1 

Introduction

income limits were $41,200 and $56,200 for single filers, and $61,850 and

$91,850 for joint filers.8

Passage of the higher education provision for U.S. savings bonds,

however, did not quell lawmakers’ concerns about the ability of American

families to pay for college. In subsequent years, Members of Congress

continued to introduce college savings legislation. Over 20 bills addressing

tax advantages for college savings were introduced in the 101st Congress,

for example, but none was enacted. Twice during the 102nd Congress,

both houses of the Congress passed legislation that, among other things,

would have allowed penalty-free withdrawals from individual retirement

accounts (IRA) to pay for higher education expenses, but both bills were

vetoed by the President. Similar proposals were introduced in the 103rd

Congress, but did not pass.

Several more college-savings proposals have been introduced in the 104th

Congress. One approach, proposed in two of the bills, would allow

taxpayers to establish special savings accounts, similar to IRAs.

Contributions to these accounts would be made with after-tax dollars, but

distributions used to pay certain higher education expenses would be

deductible from the taxpayer’s gross income.

Private Sector College

Savings Plans

The private sector also responded to the growing interest in saving for

college. Insurance companies, investment firms, and financial planners

offer a range of services to help parents meet their college savings goals.

One notable private sector initiative is the College Savings Bank of

Princeton, New Jersey, which issues a certificate of deposit (CD) indexed

to annual increases in private college costs and guaranteed to cover

tuition, fees, and room and board in the future, no matter how high those

costs rise. Participants decide how much and how often to save. The CDs

are available in maturities from 1 to 25 years. The minimum initial deposit

is $1,000 and subsequent deposits must be at least $250.

Objectives, Scope,

and Methodology

Because of their interest in helping families to save for college expenses,

the Chairman of the Senate Committee on Labor and Human Resources;

the Chairman of the Subcommittee on Education, Arts, and the

Humanities; and Senator Thad Cochran asked us to report on state tuition

8

For more information on the rules pertaining to the savings bond income exclusion, see Education

Savings Bonds: Eligibility for Tax Exclusion, Report No. 89-570 EPW, Congressional Research Service,

Library of Congress (Oct. 16, 1989). For information on the extent to which people have claimed the

exclusion thus far, see College Savings Issues (GAO/HEHS-95-16R, Nov. 4, 1994).

Page 18 GAO/HEHS-95-131 State Tuition Prepayment Programs
Chapter 1 

Introduction

prepayment programs. In response, we agreed to (1) describe how these

programs operate and the participation rates they have achieved,

(2) assess participants’ income levels and options for increasing the

participation of lower-income families, and (3) discuss the major issues

concerning these programs.

To meet these objectives we

• reviewed available literature on these programs, state reports assessing

various college saving programs, and brochures and other documents

produced by, or pertaining to, tuition prepayment programs;

• interviewed key program officials in all seven of the states that were

operating tuition prepayment programs during the time of our study,

financial aid officials in several participating colleges, federal officials in

the Department of Education and the Internal Revenue Service (IRS), and

other experts; and

• obtained income data on program participants from state officials, which

we compared with similar data on other state residents from the Bureau of

the Census, including the decennial census and the Current Population

Survey.9

We conducted our study from June 1993 to May 1995 in accordance with

generally accepted government auditing standards.

9

Further details on our data and analytical methods are presented in ch. 3.

Page 19 GAO/HEHS-95-131 State Tuition Prepayment Programs
Chapter 2 

Tuition Prepayment Program Operations

and Participation Levels

Although existing state tuition prepayment programs operate similarly,

they all have unique features that distinguish them from one another. Until

recently, these programs have followed one of two models for how they

package and sell prepaid benefits, but Massachusetts has now introduced

a third model. Analyzing program participation rates, we found

considerable variation between states. When asked what factors are

important for achieving a high level of participation, program officials

emphasized effective advertising and marketing efforts, a positive public

perception, affordability, and the simplicity and flexibility of the program.

We also found that participation rates are generally higher in states where

tuition is more affordable to the average family.

Similarities and

Differences Between

State Tuition

Prepayment Programs

Existing state tuition prepayment programs share certain basic similarities

in terms of how they operate. A purchaser may be the beneficiary’s parent,

grandparent, other relative, or friend, and in some cases, even businesses

and charitable organizations can purchase tuition benefits on behalf of a

designated beneficiary. In most programs, either the purchaser or the

beneficiary must be a resident of the state to join the program. Also, most

states require beneficiaries to be below a certain age or grade level.

The programs charge roughly current prices for tuition and other

educational benefits at in-state public colleges; however, in some cases a

premium may be charged and in others a discount may be offered,

especially for younger children who are many years away from enrolling in

college. The prices are adjusted annually to reflect increases in college

costs. Purchasers can pay for the desired benefits either all at once with a

lump-sum payment or with a series of payments over time. To make

purchasing the benefits as easy as possible, some programs offer the

option of payroll deductions or electronic fund transfers. To join the

program, would-be purchasers also generally must pay a nonrefundable

application fee. In some states, the program enrollment period is limited;

in others, enrollment is year-round.

In a sense, the programs operate like pension plans—they invest money

now to meet an estimated future liability. The revenues from purchasers’

payments are pooled in one large fund and invested with the goal of

achieving a higher rate of return than the rate at which tuition and other

prepaid expenses increase. Indeed, beating the tuition inflation rate is

more than just a goal, it is imperative for programs to succeed. However,

in case the fund becomes actuarially unsound, most states have built in an

Page 20 GAO/HEHS-95-131 State Tuition Prepayment Programs
Chapter 2 

Tuition Prepayment Program Operations

and Participation Levels

escape clause that would allow them to end the program and issue refunds

to the participants.

Each semester that the beneficiary enrolls in a participating college, the

program pays to the school whatever amount it currently charges for

tuition and fees and any other prepaid benefits, such as housing expenses.

Beneficiaries who are not state residents when they enroll in a

participating college may be required to make up the difference between

in-state and out-of-state tuition rates. Typically, the benefits can be used

for several years after the beneficiary reaches college age.

Various refund provisions apply if the beneficiary cannot use the benefits

due to death or disability; chooses not to go to college at all; or decides to

attend a nonparticipating college, such as a private college or an

out-of-state public college. (The programs do not guarantee that the

beneficiary will be accepted for enrollment at one of the participating

colleges.) Under certain circumstances, the programs allow a new

beneficiary to be named in place of the original one; however, prepaid

benefits may not be sold or traded.

Despite the overall similarities between state tuition prepayment

programs, each state’s program is unique in its details, with different costs,

rules, and other program features. Table 2.1 presents an overview of the

seven programs we studied.

Page 21 GAO/HEHS-95-131 State Tuition Prepayment Programs
Chapter 2 

Tuition Prepayment Program Operations

and Participation Levels

Table 2.1: State-by-State Comparison of Tuition Prepayment Programs

Alabama Alaska Florida Michigan Ohio Pennsylvania Wyoming

When did the

program start?

Summer 1989 Spring 1991 Fall 1988 Fall 1988 Winter 1989 Fall 1993 Summer 1987

What does a

purchaser buy?

Contract Tuition credits Contract Contract Tuition credits Tuition credits Contract

What is the cost

of a lump-sum

payment for 4

years of tuition

and fees at a

state college?

In 1993:

$7,961 for an

8th grader,

$4,892 for an

infant

As of fall 1993:

$7,920

As of fall 1993:

$5,879 for an

11th grader,

$5,639 for a

newborn

As of fall 1990:

$15,496 for a

12th grader,

$8,380 for a

newborn

In 1994:

$15,000

As of fall 1993:

$12,057 for

state system

schools,

$21,918 for

state-related

schools

As of fall 1993:

$28,182 for a

4th grader,

$14,462 for a

newborn

What additional

types of benefits

can a purchaser

buy?

None None Housing None None None Room and

board

How many

institutions

participate in

the program?

15 4-year

institutions and

35 community

collegesa

1 4-year

institution

(3 campuses)

and 1

community

college

9 4-year

institutions and 

28 community

colleges

15 4-year

institutions and 

29 community

colleges

13 4-year

institutions and

23 community

colleges

18 4-year

institutions and

14 community

colleges

1 4-year

institution and

7 community

colleges

Is there a

residency

requirement for

either the

purchaser or the

beneficiary?

Yes No Yes Yes Yes Yes No

Can a

beneficiary

move to another

state and still

qualify for

resident rate

when using

benefits at time

of enrollment?

No Yes Yes No Varies by

school

No Varies by

school

When can

people join

program?

May 1-31 Year-round Mid-October -

mid-January

Before

contract sales

were halted in

1991,

enrollment took

place in the fall

Year-round Year-round Year-round

Does the

program offer

monthly

payment

contracts?

Yes b Yes Yes b b No

(continued)

Page 22 GAO/HEHS-95-131 State Tuition Prepayment Programs
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Tuition Prepayment Program Operations

and Participation Levels

Alabama Alaska Florida Michigan Ohio Pennsylvania Wyoming

What is the

minimum

amount of

benefits that can

be purchased?

Contract for 4

years of tuition

and fees

6 tuition credits

initially and

subsequent

purchases of 1

credit

Contract for 2

years of tuition

at a community

college

Contract for 1

year of tuition

and fees

1 credit 1 tuition unit

(1/20 of a

tuition credit)

Contract for 1

year of tuition

and fees

What is the

maximum

amount of

benefits per

beneficiary?

4 years b 4 years of

tuition and

fees; 5 years of

dormitory

space

4 years 400 credits b 4 years

Can a purchaser

or beneficiary

get a refund with

interest in case

of

—death or

disability of the

beneficiary?

Yes Yes Yes Yes Yes Yes Yes

—voluntary

withdrawal?

No No No Yes No No Yes

—a decision not

to attend

college?

No No No Yes No No Yes

Can the value of

benefits be used

toward cost of

attendance at a

nonparticipating

institution?

Yes Yes Yes Yes Yes Yes Yes

Can benefits be

transferred to

someone else?

Yes Yes Yes Yes Yes Yes Yes

How long after

anticipated

college

enrollment date

can benefits be

used?

10 years

(extensions

allowed)

15 years

(extensions

allowed)

10 years

(extensions

allowed)

9 years No stipulation

on when

benefits can

be used

15 years

(extensions

allowed)

6 years

How much is the

application fee?

$75 $40 $42 $25, plus a

$60

processing fee

$50 $65 None

Are there any

additional fees

for

—failing to make

payments on

time?

Yes b Yes - $10 Yes - $10 b b b

(continued)

Page 23 GAO/HEHS-95-131 State Tuition Prepayment Programs
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Tuition Prepayment Program Operations

and Participation Levels

Alabama Alaska Florida Michigan Ohio Pennsylvania Wyoming

—voluntary

withdrawal from

the program?

Yes Yes - $50 Yes Yes - $200 No Yes - $10 No

—involuntary

termination due

to failure to use

benefits, default,

or fraud?

Yes No Yes Yes Yes - $25 No No

—beneficiary

substitution?

Yes Yes - $20 Yes - $5 Yes - $25 Yes - $25 Yes - $10 No

—transfer of

contract

ownership?

Yes b b b b Yes - $10 No

Are benefits

taxed by the

state?

No b b Yes No No b

Is the program

backed by the

full faith and

credit of the

state?

No No Yes No Yes No No

Will the program

honor benefits if

the program is

terminated?

Yes Refund Yes, for

beneficiaries

within 5 years

of college

enrollment.

Others will

receive a

refund with

interest.

Refund Refund Yes Yes

aAlthough some states also have “junior colleges,” “technical colleges,” or “senior colleges,” we

use the term community colleges to represent all public 2-year institutions.

bNot applicable.

Two Main Types of

Prepayment Programs

Until recently, state tuition prepayment plans have followed one of two

basic models in terms of how they package and sell their education

benefits. Michigan’s tuition prepayment program served as a general

model for those adopted later in Wyoming, Florida, and Alabama. Under

these states’ programs, purchasers sign a contract to buy a predetermined

amount and type of tuition benefits. For example, Florida’s program offers

prepaid tuition contracts for 2 years at a community college, 2 years at a

community college plus 2 years at a state university, or 4 years at a state

Page 24 GAO/HEHS-95-131 State Tuition Prepayment Programs
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Tuition Prepayment Program Operations

and Participation Levels

university.10 Typically, if the purchaser fails to pay for the benefits as

agreed, program officials will cancel the contract and issue a refund.

Furthermore, in prepayment programs such as these, the price of the

benefit packages varies by the age of the beneficiary, with prices highest

for those children closest to college age and lowest for newborns/infants.11

For example, during the 1993-94 enrollment period in Florida, a lump-sum

payment for a contract guaranteeing 4 years at a state university was about

$5,900 for a child in eleventh grade and about $5,600 for a newborn.12

Ohio took a slightly different approach with its tuition prepayment

program, which became a general model for those established later in

Alaska and Pennsylvania. In these states, purchasers open a prepaid

tuition account for a designated beneficiary by making an initial minimum

purchase; thereafter, they may buy whatever amount of benefits they

desire—typically, up to a cumulative maximum of 4 years—at any time.

These programs are sometimes referred to as prepaid tuition credit

programs, because they sell tuition benefits by the credit hour, or in even

smaller units. Thus far, none of these account-based prepayment programs

has offered housing benefits. The prices of tuition benefits for these

programs do not vary by the beneficiary’s age; rather, all purchasers pay

the same price for the same type of benefit.

Massachusetts Program

Represents New

Prepayment Model

In February 1995, Massachusetts introduced a tuition prepayment plan

different from all others. The program sells “tuition certificates”

redeemable toward the cost of tuition and fees at any public or private

college in the state that agrees to participate in the program; 67

institutions have signed up so far. The certificates are guaranteed to hold

their value until redeemed by the beneficiary. For example, if a $1,200

certificate is equal to 20 percent of tuition costs at a given college at the

time of purchase, the certificate will cover that same percentage of costs

when the beneficiary enrolls at that college in the future. Actually, the

program will pay colleges an amount equal to the face value of the

certificate plus interest at the rate of 2 percent above the CPI, compounded

annually. Thus, the colleges accept the risk that their costs will rise more

than the value of the certificates. Because the certificates are based on

state bonds, they are exempt from state taxes, and program officials

10Purchasers of a 4-year state university contract in Florida can also prepay the cost of up to 5 years of

housing benefits, guaranteeing the beneficiary a space in a university dormitory.

11The programs we reviewed used either “newborn” or “infant” to describe the youngest age category.

12In Alabama’s program the difference between the highest and lowest prices is much greater,

reflecting a significant discount for younger children. In 1993, the lump-sum payment for a 4-year

contract was $7,961 for an eighth grader and $4,892 for an infant.

Page 25 GAO/HEHS-95-131 State Tuition Prepayment Programs
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and Participation Levels

expect they will also be exempt from federal taxes. The minimum

purchase is $300 per beneficiary per maturity year.

Programs Have

Achieved Varying

Participation Rates

One measure of the success of state tuition prepayment programs is their

overall participation level—the total number of contracts purchased or

tuition accounts opened. Naturally, a goal of any program like this is to get

as many families saving for college as possible. We found that the number

of participants in existing state tuition prepayment programs varies

considerably, largely due to differences in the state’s population and the

number of years the program has been in operation. To account for such

differences, we calculated the average annual participation rate for each

program. We divided the average number of new participants per year by

the number of children in the state most likely to become beneficiaries in

these programs. We defined this target group as the number of children

below the age limit for joining the program and not living in poverty.13 Our

results are shown in table 2.2.

Table 2.2: Participation Statistics for

State Tuition Prepayment Programs

State

Total

number of

participants

Number

of

enrollment

periods

Average

number of

participants

per year

Size of

target

group

Average

annual

participation

rate (percent)a

Alabama 33,379 4 8,345 660,922 1.26

Alaskab 9,053 3 3,018 145,963 2.07

Florida 256,339 7 36,620 2,330,317 1.57

Michigan 54,717 3 18,239 2,127,625 0.86

Ohio 31,989 5 6,398 2,169,162 0.29

Pennsylvania 7,713 1 7,713 1,965,049 0.39

Wyoming 693 7 99 70,414 0.14

aTypically, the first year of operation yields a much higher number of participants than the

following years. Therefore, over time these rates will likely decrease.

bFigures for Alaska represent number of contracts, not number of beneficiaries; a given

beneficiary may have several contracts.

Sources: Tuition prepayment program officials and U.S. Bureau of the Census.

13For states that do not have an official age limit, we subtracted the number of years beneficiaries must

wait to use their benefits from 18, the age at which students typically enroll in college. The age limits

we used were, for Alabama, 14; Alaska, 16; Florida, 17; Michigan, 18; Ohio, 16; Pennsylvania, 14; and

Wyoming, 10. (In states with prepaid credit programs, however, credits can still be purchased for

beneficiaries past the age limits we used.) We excluded poor children because their families are

unlikely to join these programs (see ch. 3).

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Tuition Prepayment Program Operations

and Participation Levels

While none of the seven programs has achieved an average annual

participation rate that seems very high, quite a bit of variation exists

between states. For example, during its first 7 enrollment periods,

Florida’s program sold an average of about 37,000 tuition contracts per

year, equivalent to 1.57 percent of nonpoor children in the eligible age

range. In contrast, Wyoming’s program has sold an average of fewer than

100 contracts per year, which is 0.14 percent of its target group.

Nonetheless, if sustained over several years, even seemingly small average

annual participation rates can eventually result in a large number of

program participants, as is the case in Florida.

Extent of Participation

Also Varies

The average annual participation rate is an imperfect indicator of program

participation, because it does not reflect the varying extent to which

people are participating. It counts each participant equally, whether he or

she has paid for 4 years of tuition benefits or just a few tuition credits; it

even includes individuals who joined these programs but later withdrew.

Therefore, to give a more complete picture of program participation, we

also obtained data on the amount and type of tuition benefits purchased

for beneficiaries in each program, and available information on program

cancellation rates.

• Alabama features only one benefit plan—a contract covering 4 years of

tuition and fees at any public college or university in the state. Officials

report a 6-percent cancellation rate.

• In Alaska, as of June 1993, roughly 54 percent of participants had

purchased 1 year’s worth of tuition credits or less, about 30 percent had

bought 1 to 2 years’ worth, about 11 percent had bought 2 to 4 years’

worth, and about 5 percent had bought more than 4 years’ worth.

• In Florida, about 74 percent of participants have purchased a contract

covering 4 years at a state university, about 21 percent have bought

contracts for 2 years at community college plus 2 years at a state

university, and about 5 percent have bought contracts for 2 years at a

community college. Of those who have chosen a 4-year state university

contract, about 39 percent have also purchased a dormitory contract

covering 1 to 5 years of housing costs. Of the roughly 220,000 tuition and

dormitory contracts purchased in the first 5 enrollment periods, about

15 percent had been cancelled by September 1993.

• In Michigan, about 96 percent of participants bought the full benefits

contract, less than 1 percent bought a limited benefits contract, and about

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and Participation Levels

4 percent bought a community college contract.14 Very few MET contracts

have been cancelled.

• In Ohio, as of January 1995, 72 percent of participants had paid for 1 year’s

worth of tuition credits or less, 13 percent had bought 1 to 2 years’ worth,

6 percent had bought 2 to 4 years’ worth, and 9 percent had bought 4

years’ worth.

• In Pennsylvania, as of November 1994, about two-thirds of participants

had purchased tuition benefits (credits or units) for state related

universities, almost one-third had bought benefits for universities in the

state system of higher education, and only about 2 percent had bought

benefits for community colleges. The average amount of money spent by

each participant was $2,700.

• In Wyoming, 91 percent of participants have purchased contracts covering

4 years at the University of Wyoming, 4 percent have contracts for 1 to 3

years at the University, 4 percent have contracts for 2 years at a

community college plus 2 years at the University, and 1 percent have

2-year community college contracts. Of all contracts purchased, 94 percent

cover room and board in addition to tuition and fees. To date, only three

contracts have been canceled.

Several Factors

Considered Important

for Maximizing

Number of

Participants

Clearly, program participation rates are not solely dependent on the size of

a state’s population and the number of years its program has been

operating. When asked what factors were important for maximizing the

number of participants, program directors emphasized advertising and

marketing, the public’s perception of the program, program simplicity and

flexibility, and affordability.

Developing Effective

Advertising and Marketing

Strategies

Several officials mentioned the significance of effective advertising

campaigns or other marketing strategies; in fact, some ranked advertising

or marketing as the single most important factor for maximizing program

participation. Programs have adopted a wide range of advertising and

marketing strategies to reach out to potential participants. Following are

some examples of these efforts.

• Michigan’s program mailed packets of information to elementary and

secondary schools, advertised on place mats used at a major fast-food

14The full benefits contract covers tuition and fees at any Michigan public university or community

college. The limited benefits contract covers tuition and fees only at Michigan public colleges whose

tuition costs do not exceed 105 percent of the weighted average tuition cost of Michigan’s 4-year

institutions. The community college contract covers tuition and fees at any of Michigan’s community

colleges.

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and Participation Levels

chain, and distributed flyers in the largest grocery store chain in the state.

Michigan also produced a short, informational videotape about the

program that could be borrowed free from video rental stores and public

libraries throughout the state.

• Florida’s program, which has an annual advertising budget of $500,000,

pays for numerous television and radio commercials—in both English and

Spanish—during the 3-month enrollment period. Similar to strategies used

in Michigan, the program mails packets of brochures to every elementary

and secondary school in the state, and it also distributed a videotape to

video rental stores throughout the state. “Florida has averaged over 40,000

prepaid contracts each year,” wrote the program’s Director, “because it

has approached consumers rather than expecting them to seek out the

program.”15

• Alabama’s program has never paid for commercial advertising, relying

instead on public service announcements; when done correctly, the

Director said, this method can be quite effective for reaching potential

purchasers.

• Alaska’s program Director also said paid advertising may not be necessary

to reach potential customers. Alaska’s primary marketing strategy is to

enclose information about the prepayment program in the annual mailing

that goes to all state citizens concerning their Permanent Fund dividend.16

• Pennsylvania’s program also uses the mailing services of another state

agency: a brochure on the tuition prepayment program is included in every

license renewal notice sent out by the Bureau of Motor Vehicles—over

20,000 per day. Like Michigan and Florida, Pennsylvania also produced a

videotape on its program, which officials distributed to about 5,000

schools in the state.

• Ohio’s program has done some advertising on television and radio, but

found newspaper ads to be the most effective form of paid advertising.

The program also does extensive marketing in schools, and officials work

at trade shows and youth fairs to promote the program and to give away

items like refrigerator magnets and jar openers with the program’s logo

printed on them. Ohio also does grassroots outreach, such as having

program participants volunteer to speak at meetings of various community

and civic groups.

15William Montjoy, “State Prepaid Tuition Plans: Designing a Successful Program,” Prepaid College

Tuition Plans: Promise and Problems, ed. Michael A. Olivas (New York: College Entrance Examination

Board, 1993), p. 47.

16The Permanent Fund is made up of revenues from oil companies doing business in the state. Every

year, a portion of the fund’s earnings is distributed, as a dividend, to all state residents. Everyone

receives the same amount, regardless of income, age, or other factors.

Page 29 GAO/HEHS-95-131 State Tuition Prepayment Programs
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and Participation Levels

Officials had differing opinions about the challenge involved in getting

people to join a tuition prepayment program. One said it is difficult to get

people to save money for anything, let alone their children’s college

educations, which could be many years away. In contrast, however, one

official said that prepaid tuition benefits are naturally appealing, and that

once people are aware of the program, it practically sells itself.

Achieving and Maintaining

Positive Public Perception

Another factor considered important for achieving a high participation

rate is developing a positive public perception of the program. Several

officials described the need to build and maintain the public’s confidence

in the program as a safe, reliable way to provide for children’s college

educations.

One way to develop a positive image, some officials said, is through the

involvement of a well-known, high-profile supporter, someone who can

attract the public’s attention and stir up interest in the program. In some

states this role has been played by the state treasurer. Another key is

getting positive coverage by the news media; for example, several officials

mentioned the importance of favorable newspaper stories and editorials

about the program.

The fact that these programs are affiliated with the state government or

the state university, a few officials said, may also help some participants to

have confidence in the program. That is, people could be more trusting

and feel more comfortable dealing with public officials than with private

investment advisors. However, being a state-sponsored program can cut

both ways, one official said, because some people strongly distrust

government and would not voluntarily give their money to the state for

any purpose. Furthermore, although these programs are connected with

the state, some officials stressed the importance of trying to remain

nonpartisan in a political environment. “If the public’s impression is that

the program has become politicized,” wrote Florida’s Director,

“confidence will be lost and sales will plummet.”17

The connection between public perception and sales levels is clear to

Ohio’s program Director. She said public confidence in the state’s program

was shaken somewhat last year when state newspapers widely reported

that the Governor had questioned whether the program was a good deal

for participants. As the Governor’s office, the legislature, and program

17Montjoy, “State Prepaid Tuition Plans,” p. 48.

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and Participation Levels

officials decided what to do about the program, the number of new

participants dropped to less than 2,000 in 1994, after averaging over 5,300

in the preceding 3 years. The issues in question have been resolved,

according to the Director—the program is now a better deal than ever, she

said, with lower prices and backed by the full faith and credit of the

state—but now officials must rebuild a positive public perception of the

program to increase sales to their previous level.

Creating a Simple, Flexible

Program

Two additional factors that officials described as important for achieving a

high participation level were program simplicity and flexibility. In terms of

simplicity, one official explained that typical participants in these

programs do not have experience with complex, sophisticated investment

vehicles; they are looking for a program that is easy to understand. Some

officials described coupon books as a simple way for purchasers to make

payments. Here is how Florida’s program Director addressed this general

issue: “In marketing a prepaid program, every effort should be made to

keep it simple. One of the primary elements of success is providing a plan

that the public can easily understand and use. Facilitating applications,

without imposing numerous rules and guidelines, is critical to contract

sales volume.”18

In addition to being simple, some officials said, tuition prepayment

programs must also be flexible. They need to offer purchasers and

beneficiaries a range of choices, such as different types of benefit plans

and payment options. These programs should also not prohibit early

withdrawals, according to one official; purchasers should be able to get

back at least their principal if needed. Flexible features are often

emphasized in program literature. For example, Pennsylvania’s program

brochure describes how purchasers can buy credits at any time, in any

amount desired, and that students can use their benefits toward the cost of

any accredited college in the country. Florida’s brochure mentions the

ability to convert from one benefit plan to another, and that students can

use their benefits while attending college part time over more than 4 years.

The notion that program flexibility is associated with participation levels

is supported by anecdotal evidence from Florida. In the spring of 1993 the

program changed its rules to allow beneficiaries to use the full value of

their benefits toward attendance at out-of-state colleges; prior to then,

they could receive the principal but no interest. While the number of

18Montjoy, “State Prepaid Tuition Plans,” p. 47.

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Tuition Prepayment Program Operations

and Participation Levels

tuition contracts sold the previous 3 years averaged about 30,000, during

the 1993-94 enrollment period, sales jumped to about 44,000.

Making Program

Affordable

A few officials stressed program affordability as another key to achieving a

high level of participation. Alabama and Michigan tried to make their

programs more affordable by offering substantial discounts on contracts

for younger children. Ohio and Pennsylvania sell tuition benefits in small

units, rather than multiyear contracts that might seem prohibitively

expensive, given the relatively high cost of tuition in those states. In

addition to making the prepaid benefits affordable, another official

mentioned the importance of keeping program fees at a reasonable level,

so as not to impose a financial burden on participants. Initial fees for the

programs we reviewed ranged from none in Wyoming to $75 in Alabama.

Affordability, of course, is also a function of people’s incomes. In deciding

whether to participate in these programs, one official explained, potential

purchasers ask themselves if the payments will fit into their monthly

budgets. When people find it difficult to make ends meet or are worried

about their job security, they are less likely to make a significant financial

commitment to these programs, and those who are already participating

may decide to cancel their contracts or stop purchasing credits. For

example, a couple of officials reported that the recession in the early 1990s

hurt program sales.

Participation Levels

Linked to College

Affordability

In general, program participation is higher in states where tuition is more

affordable. To measure affordability for each state, we first obtained

Department of Education data on the average cost of 1 year of tuition and

fees at 4-year public colleges during each year the program has been in

operation. Second, we used data from the Census Bureau’s Current

Population Survey (CPS) for the same years to determine the annual

median family income for all families with children under age 18. Finally,

we divided the tuition cost by the median income, and averaged the

percentages over the years the program has been operating. We then

compared each program’s affordability measure with its average annual

participation rate, described above. As table 2.3 shows, with the exception

of Wyoming (which has had the most affordable tuition rates and the

lowest participation rate), as tuition accounts for a smaller percentage of

median family income, participation generally rises. This analysis suggests

that tuition prepayment programs will be more successful in states where

tuition is relatively more affordable to the average family.

Page 32 GAO/HEHS-95-131 State Tuition Prepayment Programs
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Tuition Prepayment Program Operations

and Participation Levels

Table 2.3: Participation Generally

Higher in States Where Tuition Is More

Affordable

Numbers in percent

State

Percentage of family income

needed to cover tuition and

feesa

Average annual participation

rate

Wyoming 3.19 0.14

Alaska 3.84 2.07

Florida 4.37 1.57

Alabama 5.28 1.26

Michigan 6.27 0.86

Ohio 7.30 0.29

Pennsylvania 9.57 0.39

aAverage percentage of median family income needed to cover the cost of 1 year’s tuition and

fees for a state resident at 4-year public colleges and universities during the years the program

has been selling prepaid benefits.

Page 33 GAO/HEHS-95-131 State Tuition Prepayment Programs
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Options for Increasing Lower-Income

Participation

By comparing the income distribution of program participants to that of

other families living in tuition prepayment states, we found that

participants come disproportionately from middle- and upper-income

families. However, officials saw drawbacks to the use of sliding-scale fees

and tax credits, and were not optimistic about the chances of significantly

increasing lower-income participation in their programs. Most of these

states have explored ways to give prepaid tuition scholarships to needy

students, although these efforts generally have not been very successful.

Despite efforts to make prepaid benefits affordable to all families, a

significant increase in lower-income participation is unlikely, given that

such families lack discretionary income; unable to save substantially for

college, such families will have to rely more on various financial aid

programs.

Most Participants

Come From Middleand Upper-Income

Families

Participants in tuition prepayment programs mainly come from middleand upper-income families. For example, in each of the three states with

the best available income data on participants—Florida, Alabama, and

Ohio—most families with children under 18 had annual incomes of under

$30,000 in 1992, while most purchasers reported incomes of $50,000 and

above. For the other four states, which did not have direct measures of

participant income, our analysis generally indicated that a

disproportionate percentage of program participants live in zip codes with

relatively high median incomes.

Income Analysis and

Results for Florida,

Alabama, and Ohio

Officials in Florida, Alabama, and Ohio were able to provide us with

self-reported income data on program participants. For both Florida and

Alabama, the program application contains an optional question for

purchasers to indicate their family income level in one of several

categories, such as less than $20,000, $20,000-$29,999, $30,000-$39,999,

$40,000-$49,999, and $50,000 or more. Both states provided us with these

data for several enrollment years. We compared the income distribution of

program participants in these two states with that of all state families with

children under 18, using CPS data.

For Florida, we limited our analysis to include only purchasers who were

parents of beneficiaries under age 18 at the time of enrollment. This

provided the best possible comparison with the families represented by

the CPS data. The response rate to the optional income question among this

group of purchasers was about 63 percent. However, after comparing the

payment plans and contract types chosen by respondents and

Page 34 GAO/HEHS-95-131 State Tuition Prepayment Programs
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Participation

nonrespondents, we have no reason to believe their income distributions

differ substantively.

For Alabama, our analysis of program application data included all

purchasers with beneficiaries under 18, regardless of their relationship to

the beneficiary. Although program officials did not provide specific

numbers, they said the vast majority of purchasers are parents of the

designated beneficiaries. The response rate to the optional income

question was about 72 percent. Alabama also provided us with state

income tax data on over 25,000 program purchasers, representing

93 percent of all active purchasers as of fall 1994.19 We compared

purchasers’ total income from their 1992 or 1993 state tax return

(whichever was the most recent available) with the same CPS data used in

the preceding analysis.

Ohio’s tuition prepayment program does not routinely collect income data

on its participants. The income data we present come from a 1992 market

study conducted for the program by a private consulting firm.20 The study

used telephone interviews of 200 purchasers and 400 nonparticipants in

the state with children or grandchildren aged 14 and under. We adjusted

the percentages reported in the study to reflect only respondents who

answered the income question, which included about 85 percent of each

group.

In Florida, most program participants come from middle- and

upper-income families. Over one-half of the 1992-93 purchasers in our

analysis reported incomes of $50,000 or more, compared with about

one-quarter of all Florida families. In addition, only 5 percent of the

participating parents had incomes of less than $20,000, compared with

36 percent of all families in the state. (See fig. 3.1.) The data for other

years we examined yielded very similar results.

19The tax data provided by the Alabama Department of Revenue did not include individuals’ names,

social security numbers, or any other personal identifiers. Active purchasers includes all those who are

either paid in full or continuing to make payments on their contracts.

20OTTA Market Survey Report, Clark Jones Inc. (Columbus, Ohio: Aug. 1992).

Page 35 GAO/HEHS-95-131 State Tuition Prepayment Programs
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Participation

Figure 3.1: Income Levels of Families

Participating in Florida’s Program,

Compared With All Families in the

State

Percentage of Families

0

5

10

15

20

25

30

35

40

45

50

55

60

Less Than

$20,000

$20,000-$29,999 $30,000-$39,999 $40,000-$49,999 $50,000 or More

1992 Family Income

5

36

11

16 16 15

18

9

51

25

Program Participants (N=13,849)

State Families With Children Under 18

Note: Percentages may not add to 100 because of rounding. Sampling errors for CPS estimates

do not exceed plus or minus 3 percentage points.

Sources: Florida program officials and Bureau of the Census’ 1993 Current Population Survey.

The results for Alabama were very similar to Florida’s. About 60 percent of

all 1992 purchasers in our analysis reported incomes of $50,000 or more,

compared with about 20 percent of all families in the state. At the lower

end of the scale, only 2 percent of the purchasers reported incomes of less

than $20,000, compared with about 35 percent of all Alabama families.

(See fig. 3.2.) In other years, the results were comparable. The Alabama

tax return data produced results similar to the program application data.

For example, only 8 percent of purchasers had 1992 or 1993 incomes of

less than $20,000 and 66 percent had incomes of $50,000 and above.

Furthermore, the median income for purchasers was about $61,000,

compared with about $27,400 for all families in the state.

Page 36 GAO/HEHS-95-131 State Tuition Prepayment Programs
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Figure 3.2: Income Levels of Families

Participating in Alabama’s Program,

Compared With All Families in the

State

Percentage of Families

0

5

10

15

20

25

30

35

40

45

50

55

60

Less Than

$20,000

$20,000-$29,999 $30,000-$39,999 $40,000-$49,999 $50,000 or More

1992 Family Income

2

35

7

20

14 15

18

9

59

21

Program Participants (N=6,458)

State Families With Children Under 18

Note: Sampling errors for CPS estimates do not exceed plus or minus 6 percentage points.

Sources: Alabama program officials and Bureau of the Census’ 1993 Current Population Survey.

The income distributions of participants and other families in Ohio are

similar to those in Alabama and Florida. About 60 percent of purchasers

reported incomes of $51,000 or above in 1992, compared with less than

20 percent of nonparticipating families. In addition, only 2 percent of the

purchasers had incomes of less than $21,000, compared with about

30 percent of nonparticipants. (See fig. 3.3.)

Page 37 GAO/HEHS-95-131 State Tuition Prepayment Programs
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Figure 3.3: Income Levels of Participants in Ohio’s Program, Compared With Nonparticipants in the State

Percentage of Families

0

5

10

15

20

25

Under

$10,000

$10,000-

$20,999

$21,000-

$30,999

$31,000-

$40,999

$41,000-

$50,999

$51,000-

$60,999

$61,000-

$70,000

Over

$70,000

1992 Family Income

0

11

2

18

11

24

12

19

14

11

23

6

19

3

19

8

Program Participants

Nonparticipants in State

Note: Percentages based on responses by approximately 170 participants and 328

nonparticipants with a child or grandchild aged 14 or under.

Source: Ohio Tuition Trust Authority Market Survey.

Income Analysis and

Results for Remaining

States

The four remaining states—Alaska, Michigan, Pennsylvania, and

Wyoming—do not collect income data on their purchasers, but they did

have a record of each purchaser’s zip code, which we used as a rough

proxy for income. First, we used 1990 Decennial Census data to determine

the median household income and the total number of residents under age

18 for every zip code in each state. Next, we assigned the median

household income of each zip code to each child living in that zip code.

Then we divided the number of children in each state into quartiles on the

basis of their assigned income. Finally, we determined the percentage of

program purchasers living in each of the income quartiles. If there were no

relationship between income and program participation, we would expect

Page 38 GAO/HEHS-95-131 State Tuition Prepayment Programs
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to find about 25 percent of purchasers living in each quartile. Our findings

are shown in table 3.1.

Table 3.1: Income Distribution of Purchasers in Alaska, Michigan, Pennsylvania, and Wyoming

Alaska (N=7,290)a Michigan (N=47,935) Pennsylvania (N=5,611) Wyoming (N=450)

Income

quartile

Income

range

Percentage of

purchasers in

quartile

Income

range

Percentage of

purchasers in

quartile

Income

range

Percentage of

purchasers in

quartile

Income

range

Percentage of

purchasers in

quartile

Lowest

$33,801

and under 20

$24,364

and

under 7

$22,802

and

under 13

$22,955

and

under 29

Second

lowest

$33,802 -

$42,868 26

$24,365 -

$30,658 16

$22,803 -

$28,333 22

$22,956 -

$26,250 27

Second

highest

$42,869 -

$47,472 27

$30,659 -

$38,382 23

$28,334 -

$35,230 27

$26,251 -

$33,427 25

Highest

More than

$47,472 28

More

than

$38,282 54

More

than

$35,230 38

More

than

$33,427 19

Totalb 100 100 100 100

aFigures represent number of contracts, not number of beneficiaries; a given beneficiary may

have several contracts.

bTotals may not add to 100 because of rounding.

In Alaska’s program, purchasers were almost evenly distributed among the

four income groups, with a slightly lower percentage living in the

lowest-income quartile. About 28 percent of purchasers lived in the zip

codes that made up the highest-income quartile, with median incomes over

$47,472, and about 20 percent lived in the zip codes composing the

lowest-income quartile, with median incomes of $33,801 or less.

In Michigan, the distribution of purchasers was more skewed toward the

higher-income quartiles than in the other three states. Over half of the

purchasers were from the zip codes included in the highest-income

quartile, with median incomes of $38,282 and above. In contrast,

purchasers residing in the zip codes composing the lowest-income

quartile, with median incomes of less than $24,364, represented only about

7 percent of all purchasers.21

21Following a similar methodology, another researcher previously found similar results for Michigan

participants, showing 50 percent of the beneficiaries residing in the richest quintile of state zip codes,

compared with only 4 percent living in the poorest quintile. See Jeffrey S. Lehman, “Social

Responsibility, Actuarial Assumptions, and Wealth Redistribution: Lessons About Public Policy From a

Prepaid Tuition Program,” Michigan Law Review, Vol. 88 (Apr. 1990), pp. 1035-1141 (see especially

app. 1, pp. 1134-1141).

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In Pennsylvania, people from the higher-income zip codes accounted for a

somewhat disproportionate share of program participants. About

38 percent of purchasers were living in the zip codes that constituted the

highest-income quartile, with median incomes over $35,230. In contrast,

about 13 percent of purchasers were living in the zip codes composing the

lowest-income quartile, with median incomes of $22,802 or less.

In Wyoming, the distribution of purchasers was reversed from what we

found in the other three states. Although purchasers were almost evenly

distributed among the four income groups, slightly more lived in the

lower-income quartiles than in the higher-income quartiles. About

19 percent of the purchasers lived in the zip codes composing the

highest-income quartile, with median incomes of $33,427 and above, while

about 29 percent lived in the zip codes that made up the lowest-income

quartile, with median incomes of $22,955 or less. We are not sure what

factors might account for this finding.

Variable Fees, Tax

Credits Considered

Poor Options for

Increasing

Lower-Income

Participation

Program directors believed that using sliding-scale fees and offering tax

credits would have drawbacks as options for increasing participation

among lower-income families; specifically, they expressed concerns about

administrative feasibility and effectiveness. Although other options could

be developed, we asked officials for their opinions on these two options

because they were mentioned in the literature.

Sliding-Scale Fees Officials did not respond favorably to the idea of implementing a

sliding-scale fee system, in which upper-income purchasers would pay

more for tuition benefits and lower-income purchasers would pay less.

Their primary objection was that such a system would pose substantial

administrative problems. It would require them to verify purchasers’

incomes, which would be very labor-intensive and especially difficult with

limited staff resources. Officials might also have to set up an appeals

process, one director said, which would make the programs seem too

bureaucratic. Another official said programs might need to obtain special

legal authority to verify purchasers’ incomes by checking state tax

records, because of confidentiality concerns. Finally, a few officials also

said a sliding-scale fee system would make it more difficult to make sound

actuarial assumptions, because of less certainty about expected revenues.

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Besides voicing concerns about administrative feasibility, some officials

offered additional reasons why they thought a sliding-scale fee structure

might not succeed. For example, two program directors said the concept

of charging different prices on the basis of income would be unappealing

to many program participants. Applying an income test, one said, would

make tuition prepayment seem more like a “social program” and less like

an individual savings program. People with above-average incomes would

feel penalized, as though they were being required to subsidize others,

when all they wanted to do was to help their own children. The program is

more appealing, the other director said, when all participants are treated

the same.

Another program director had concerns about the fairness of a

sliding-scale fee structure. Would it be fair, he asked, to charge variable

prices for people who prepay the cost of tuition, based on their incomes,

while people who wait to pay for tuition when their children enter college

would all face the same rate, regardless of their income? The same official

also pointed out that family income can change over time, sometimes

dramatically, which could result in some families having prepurchased

tuition at a rate that does not reflect their income level when their child is

ready for college.

Tax Credits Compared with their reactions to the idea of sliding-scale fees, officials

were somewhat more favorable toward the concept of offering a state or

federal tax credit to lower-income purchasers. A few directors thought the

idea might succeed in increasing the participation rate among

lower-income families. In addition, one official pointed out that because

his state does not have an income tax, the tax credit would have to be

offered by the federal government; presumably, he said, this would mean

fewer administrative headaches for state program officials.22

Some officials, however, doubted whether a tax credit would appreciably

increase the participation of lower-income families. The problem with a

tax credit, two officials said, is that it would not benefit lower-income

families until they filed their tax returns; in other words, such families

would still find it financially difficult to join the program and make

payments in the initial months. Two officials also thought the idea might

not succeed because potential purchasers might not fully understand how

a tax credit works. Another official said that although the concept has

22Three of the states with tuition prepayment programs—Alaska, Florida, and Wyoming—do not have a

state income tax.

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some appeal, it might meet with political opposition. For example, the

higher education community might object out of a concern that legislators

would make up for the forgone tax revenues by reducing state

expenditures on higher education.

Indirect Efforts to

Attract Lower-Income

Purchasers

Rather than taking any special steps specifically intended to increase

lower-income participation, such as targeted advertising, program officials

have mainly tried to attract lower-income families by making prepaid

benefits affordable to all state residents.23 Some officials said that their

programs had been designed from the beginning to make it possible for

lower-income families to participate, through features such as low-priced

benefits and long-term payment plans. Emphasizing these features in

brochures and advertisements is the primary way some state tuition

prepayment programs try to appeal to lower-income families. Following

are some examples of these features in the programs we studied.

• In Pennsylvania, program designers broke down tuition benefits into

“units,” equivalent to one-twentieth of a credit hour, specifically so that

lower-income families could more easily afford the program. During the

program’s first year of operation, the average cost of one tuition unit for

community colleges was only about $3.00. Pennsylvania’s state Treasurer

stated that the program offers “even the most financially strapped families

a mechanism to provide for their children’s higher education.”24

• Wyoming and Michigan both worked with financial institutions to create

special loan programs enabling people to borrow the money needed to

purchase a contract, even though they might not have had the kind of

collateral that would be required for many traditional loans. With these

“secured” loans, the prepaid contract itself served as collateral, to be held

by the program until the loan was repaid. Also, in its third year of sales,

Michigan added monthly payment plan options that allowed contract

purchasers to spread out their payments over periods of up to 10 years.25

23Interestingly, however, two officials mentioned a goal of increasing minority participation. To the

extent that minorities have lower incomes than whites, efforts to increase minority participation could

also increase lower-income participation.

24Catherine Baker Knoll (remarks prepared for the Third Annual Conference of the College Savings

Plans Network, New Orleans, July 8-9, 1994).

25One study, however, found that the availability of these long-term payment plans did not significantly

change the income distribution of participants in Michigan’s program. The author conjectures that the

monthly payments were simply too high for most lower-income families; the lowest monthly payment

for a contract covering four years of tuition was $112. See Jeffrey S. Lehman, “The Distribution of

Benefits From Prepaid Tuition Programs: New Empirical Evidence About the Effects of Program

Design on Participant Demographics,” Prepaid College Tuition Plans: Promise and Problems, ed.

Michael A. Olivas (New York: College Entrance Examination Board, 1993), p. 28.

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• Florida and Alabama both offer long-term payment options, allowing

purchasers to finance a prepaid tuition contract with monthly payments

from the time of purchase until the child reaches college age. In addition,

Florida offers a 2-year community college contract, which is much less

expensive than the 4-year state university contract.26 In Florida’s 1993-94

enrollment period, the parent of a newborn could purchase a community

college contract for just $11 per month using the long-term payment plan.

• In Alaska, citizens can have the state automatically direct up to half of

their annual Permanent Fund dividend toward the advance purchase of

tuition credits. Parents can even arrange for a portion of their dependent

children’s dividends to go to the tuition prepayment program. In recent

years, the dividend has been about $900 per person. The Director believed

this unique source of income, and the ease with which it can be used to

purchase tuition credits, might give Alaska’s program a greater proportion

of lower-income families than other states’ programs.

Officials have mixed views on the potential impact these kinds of program

features might have on lower-income participation levels. On one hand,

some officials are not very optimistic about the likelihood of substantially

increasing the proportion of lower-income families participating in state

tuition prepayment programs. These programs are intended primarily to

help middle-income families, they said, and most lower-income families

simply lack the discretionary income to save for their children’s college

educations. One director even expressed concern that it would be wrong

to encourage lower-income families to sign up for a program that might

require too great a financial sacrifice.

On the other hand, some officials believe that although it may not be

possible for many lower-income families to prepay the cost of 4 full years

of tuition at a state university, certain features—especially selling benefits

in small units—can help make it possible for some lower-income families

to participate in the programs to a lesser degree. From this perspective,

even paying for one semester of tuition in advance would be a good thing

for these families to do, because it could help get their children thinking

ahead about college, looking forward to it as part of their future.

26Depending on the child’s age and the payment plan chosen, a community college contract is only

about one-third to one-quarter of the cost of a university contract. Furthermore, the community

college contract has been much more popular among lower- than upper-income participants. During

the program’s first 5 years, about 13 percent of purchasers with incomes under $20,000 signed up for a

community college contract, compared with less than 2 percent of those with incomes over $50,000.

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Direct Outreach to

Lower-Income

Families

Recognizing that many lower-income families will have difficulty

purchasing tuition benefits for their children, but believing that ownership

of such benefits will have a positive impact on these children’s educational

experiences, some states have tried other ways to get prepaid tuition

benefits into the hands of needy children—for example, by awarding

prepaid tuition scholarships. However, some of these initiatives, described

in the following paragraphs, have not yet lived up to their potential.

• Florida established a program to give prepaid tuition scholarships to

low-income and at-risk students who might not otherwise be able to afford

a college education. The program was initially funded by a $1.2 million

state appropriation and an equal amount in matching funds raised from

private contributions. Thus far, the program has succeeded in awarding

scholarships to about 1,000 children throughout the state.

• Michigan also established a prepaid scholarship program, which received

a state appropriation of $100,000 in 1991. After officials raised an equal

amount in matching funds, they were able to award scholarships to 10

students who had qualified for state-based financial aid but did not receive

any because the funds had been depleted. The state appropriated another

$50,000 for the scholarship program in 1993, but the money was contingent

on 3:1 matching funds, which officials were unable to raise.

• Alaska also created a program to provide prepaid tuition scholarships for

needy students, paid for out of excess funds generated by the tuition

prepayment program. Unfortunately, however, the prepayment program

has not been able to achieve a surplus.

• Alabama established a prepaid scholarship program similar to Florida’s,

but officials have not had the resources to get it up and running. In

addition, the Office of the State Treasurer worked out an agreement with a

bank whereby a small percentage of the profits from a certain credit card

would go toward prepaid scholarships for foster children. But until now,

other cards have offered lower initial interest rates and, in marketing the

card, it has been difficult to target consumers with an affinity for the

groups who stand to benefit from the profits. Thus, with relatively few

people using the card, very little money has been accumulated toward

prepaid scholarships.

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Increasing

Participation Among

Lower-Income

Families Will Be

Difficult

Notwithstanding some of the efforts to make program participation

affordable to families from all income levels, it may be unrealistic to

expect significantly higher participation rates among lower-income

families. Tuition prepayment programs—and other college savings

programs as well—are primarily intended to help middle-income families;

those who have the ability to save, who will probably be expected to pay

for a significant portion of future college costs, and whose children will

likely not qualify for need-based grant aid. However, the federal and state

governments operate various financial aid programs to assist

lower-income families in financing a college education.

In addition, lower-income participants appear to have more trouble than

others in meeting the financial commitment inherent in some tuition

prepayment programs, especially those that sell contracts with fixed

payment schedules. Our analysis of Florida’s program found that the lower

the purchaser’s income, the less likely he or she is to fulfill the terms of the

contract (see fig. 3.4). Of all the people who signed up to purchase tuition

contracts in the first five enrollment periods (through January 1993), about

28 percent of those with incomes under $20,000 had cancelled out of the

program by September 1993. In contrast, for purchasers with incomes over

$50,000, the cumulative cancellation rate was only about 10 percent.

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Figure 3.4: Cancellation Rates for

Tuition Contracts Purchased From

Florida’s Prepayment Program, by

Income Level

Percent

0

5

10

15

20

25

30

Less

Than

$20,000

$20,000-

$29,999

$30,000-

$39,999

$40,000-

$49,999

$50,000

or More

Self-Reported Family Income at Time of Purchase

28

21

17

15

10

Source: Florida program officials.

Nonetheless, when it comes to attracting families with modest incomes,

tuition prepayment programs may do at least as well as, if not better than,

many other college savings options in both the public and private sectors.

For example, limited data on the income levels of participants in three

states’ college savings bond programs show that lower-income families are

significantly underrepresented, and upper-income families

overrepresented (see fig. 3.5). In Texas, for example, only about 2 percent

of 1991 bond purchasers had household incomes less than $25,000,

compared with about 39 percent of state households with children under

age 18; in contrast, about 41 percent of purchasers had incomes over

$65,000, compared with 15 percent of state households with children. We

found similar results for both Connecticut and New Hampshire.27

27These are the only three states for which we found income data on college savings bond buyers.

However, we cannot be sure whether the data are representative of all bond buyers in these states: the

numbers of respondents in Connecticut and Texas were not reported; New Hampshire’s data were

based on only 90 respondents out of 1,856 buyers.

Page 46 GAO/HEHS-95-131 State Tuition Prepayment Programs
Chapter 3 

Income Distribution of Participants and

Options for Increasing Lower-Income

Participation

Figure 3.5: Income Levels of College Savings Bond Buyers in Three States, Compared With All Households in These States

Percentage of Households

0

5

10

15

20

25

30

35

40

45

50

55

60

$29,000

or Less

$29,001-

$38,500

$38,501-

$71,900

$71,901

or More

Under

$25,000

$25,000-

$44,999

$45,000-

$65,000

Over

$65,000

Under

$25,000

$25,000-

$39,999

$40,000-

$84,999

$85,000

or More

Household Income

5

25

8

15

51

47

36

14

2

39

32

30

26

16

41

15

3

22

9

24

43 44 44

10

Connecticut - 1988 Texas - 1991 New Hampshire - 1991

College Savings Bond Buyers

State Households With Children Under 18

Note: Percentages may not add to 100 because of rounding. Sampling errors for CPS estimates

do not exceed plus or minus 8 percentage points.

Sources: Connecticut Treasurer’s Office, Texas Veterans Land Board, New Hampshire Family

College Savings Plan, and Bureau of the Census’ 1989 and 1992 Current Population Surveys.

As for another type of state initiative—Kentucky’s program, in which

parents establish special college savings accounts—a 1991 survey of

participants found that the median gross family income was $50,000. In

contrast, according to data from the Census Bureau, the median gross

family income for all Kentucky households with children under age 18 was

$28,020.

And as for options in the private sector, the College Savings Bank, which

sells CDs indexed to increases in college costs, also draws its depositors

Page 47 GAO/HEHS-95-131 State Tuition Prepayment Programs
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Income Distribution of Participants and

Options for Increasing Lower-Income

Participation

disproportionately from middle- and upper-income groups (see fig. 3.6). A

survey of its clients found that in 1991 only about 3 percent had pre-tax

household incomes under $25,000, while about 78 percent had incomes of

$50,000 or more, including about 28 percent with incomes of $100,000 or

more.28 In contrast, about 33 percent of all American households with

children under age 18 had total incomes of under $25,000, about

30 percent had incomes of $50,000 or more, and only about 4 percent had

incomes of $100,000 or more.

Figure 3.6: Income Levels of College

Savings Bank Depositors, Compared

With All U.S. Households With

Children Under 18

Percentage of Households

0

5

10

15

20

25

30

35

40

Under

$15,000

$15,000-

$24,999

$25,000-

$49,999

$50,000-

$74,999

$75,000-

$99,999

$100,000 or

More

1991 Household Income

1

19

2

14

18

36

30

19 20

7

28

4

College Savings Bank Depositors

Households With Children Under 18

Note: Percentages may not add to 100 because of rounding. Sampling errors for CPS estimates

do not exceed plus or minus 1 percentage point.

Sources: College Savings Bank and Bureau of the Census’ 1992 Current Population Survey.

28These percentages are based on responses by approximately 980 of the 5,750 households

participating in the savings program at the time, and we cannot be sure whether these respondents are

representative of all participants.

Page 48 GAO/HEHS-95-131 State Tuition Prepayment Programs
Chapter 4 

Major Issues Concerning State Tuition

Prepayment Programs

From the beginning, state tuition prepayment programs have received

mixed reviews, with critics and supporters voicing a wide range of

arguments for and against these programs. Some of the most commonly

discussed issues have been whether the programs have a negative impact

on students’ choices regarding college attendance, provide an unnecessary

benefit to middle- and upper-income families, are a good investment for

purchasers, and pose too much risk for states. An overriding issue,

however, has been the potential applicability of federal tax provisions.

This is the most significant problem or barrier that state officials told us

they encounter in trying to establish and operate a tuition prepayment

program.29 Nearly 8 years after the first such program started operating,

state officials are still uncertain about the federal tax liability of the

participants as well as the programs themselves. Applying certain tax

provisions, state officials say, will make it considerably more

difficult—perhaps even impossible—for these programs to succeed.

Potential Impact on

Student Choice

One issue concerning state tuition prepayment programs is that they might

limit or bias students’ educational choices. Some critics have argued that

by purchasing tuition benefits in advance, parents lock their children into

attending a limited set of public colleges. Also, some have argued that

because these programs guarantee to fully cover future costs only at

in-state public colleges, beneficiaries will feel pressured to enroll in one of

these schools, even though they may have sound personal or educational

reasons to enroll at an in-state private or out-of-state college.

The notion that beneficiaries in these programs can only attend in-state

public colleges is not supported. Our review of the rules governing

existing state tuition prepayment programs found that, in general, benefits

are portable to nonparticipating institutions; that is, beneficiaries may

apply the value of their prepaid benefits toward the cost of attending

in-state private and out-of-state colleges (see table 4.1).

29Additional problems that program officials mentioned in interviews are summarized in app. II.

Page 49 GAO/HEHS-95-131 State Tuition Prepayment Programs
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Table 4.1: What Happens If a

Beneficiary Chooses to Attend a

Nonparticipating College? Alabama Program pays to student’s chosen school

the average current in-state rate for tuition

and fees or the amount the school

charges, whichever is less.

Alaska Student receives refund in amount of

in-state tuition rate or cash value of

account, whichever is less. Refund check

is made out jointly to student and chosen

school.

Florida For in-state private colleges, program pays

value of in-state public tuition to student’s

chosen school. For out-of-state colleges,

program pays to student’s chosen school

the in-state tuition rate or the purchase

price plus 5 percent interest, compounded

annually, whichever is less.a

Michigan Students can either direct payment to

chosen school or request a refund. For

in-state private schools, program pays the

weighted average tuition of in-state 4-year

public colleges; for out-of-state schools,

program pays the nonweighted average

tuition of in-state 4-year public colleges.

For students who request a refund,

program pays designated recipient the

lowest tuition charged by a 4-year

Michigan public college.b

Ohio Program pays to beneficiary the weighted

average tuition of in-state public schools.

Pennsylvania Program pays to chosen school the lesser

of (1) the school’s tuition rate, (2) the

actual tuition for the number and type of

credits purchased, or (3) the value of the

student’s account.

Wyoming Student must cancel contract, but receives

refund of purchase price plus 4 percent

interest, compounded annually.

aRule in effect since 1993; previously, benefits were not portable out of state. Also applies only to

baccalaureate-granting schools, not out-of-state community colleges.

bRule for the full-benefits contract, which was purchased by about 96 percent of program

participants.

It may be true that some beneficiaries will decide to enroll at an in-state

public college simply because their tuition costs at such schools will be

fully covered by their prepaid benefits. However, students might make

similar decisions if they were to accumulate the same amount of money

Page 50 GAO/HEHS-95-131 State Tuition Prepayment Programs
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Major Issues Concerning State Tuition

Prepayment Programs

for college through any other means, such as a state college savings bond,

a CD, or a stock mutual fund. Budget constraints commonly play a role in

students’ decisions about which college to attend.

Although we did not try to determine whether beneficiaries who have

begun using their benefits felt constrained in choosing a college to attend,

we did learn that in four states, many program beneficiaries have applied

the value of their prepaid tuition benefits toward the cost of attending

nonparticipating colleges.30

• In Alabama, of the approximately 600 beneficiaries who used their benefits

in the fall of 1994, at least 14 percent were attending an in-state private or

out-of-state school.

• In Florida, of the 12,093 beneficiaries who used their prepaid tuition

contracts in 1994, about 2 percent attended an in-state private college and

about 3 percent attended an out-of-state college.

• In Michigan, of the 4,063 beneficiaries who were enrolled in college in the

fall of 1994, about 18 percent were attending an in-state private or

out-of-state school and had arranged for the program to send the dollar

value of their contracts directly to their chosen school.31

• In Ohio, of the beneficiaries who began using their benefits by the fall of

1994, about 10 percent had enrolled at private in-state schools and about

11 percent used their benefits at an out-of-state school.

Finally, on the basis of college attendance patterns, it seems very likely

that most beneficiaries would choose to attend an in-state public college

even if they were not participating in a state tuition prepayment program.

In the fall of 1992, for example, about 72 percent of all first-time college

freshmen in the United States were enrolled in a public 2- or 4-year college

in their home state (see fig. 4.1). Furthermore, in most of the seven states

with tuition prepayment programs, the percentage of first-time freshmen

enrolled at in-state public colleges was close to the national average.

30In the remaining three states, substantial numbers of beneficiaries have not yet enrolled in college.

31These figures include all three types of MET prepaid contracts.

Page 51 GAO/HEHS-95-131 State Tuition Prepayment Programs
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Figure 4.1: Most First-Time Freshmen

Attend a Public College in Their Home

State

Percent

0

10

20

30

40

50

60

70

80

90

100

Nationwide

Alabama

Alaska

Florida

Michigan

Ohio

Pennsylvania

Wyoming

72

85

58

72 75

71

60

72

Source: U.S. Department of Education, National Center for Education Statistics, Integrated

Postsecondary Education Data System, 1992 Fall Enrollment Survey.

Programs Mainly Help

Middle- and

Upper-Income

Families

Another issue surrounding these programs is that they appeal to mostly

middle- and upper-income families. Some critics point out that these

programs do little to help lower-income families finance a college

education, and should not “take away from the primary goal we have of

public policy, which is basically to equalize opportunity.”32 In addition,

some have raised equity concerns because of the subsidies that these

programs may provide to participants. Supporters argue, however, that not

every government program must redistribute wealth from the rich to the

poor, and that increased saving by middle-income families will reduce

their need for financial aid, thus making more of these resources available

to lower-income students.

Our work showed that state tuition prepayment programs can provide

various subsidies to participants. First, the discount prices offered by the

programs in Michigan and Alabama represent a subsidy to participants on

32Arthur Hauptman, comments made at the Invitational Conference on College Prepayment and

Savings Plans, in Denver, July 7-8, 1987; see conference proceedings (New York: College Entrance

Examination Board), p. 67.

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Major Issues Concerning State Tuition

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top of what they would receive through state subsidization of higher

education. A second subsidy can come in the form of state expenditures

for program operations. For example, (1) Alabama’s program received

$500,000 in start-up costs, which it was not required to repay;33 (2) Ohio’s

program received a $1 million appropriation in 1994 for operating

expenses; and (3) Alaska’s program does not collect enough in participant

fees to fully cover its administrative costs, so these expenses—currently

about $200,000 per year—are paid mostly out of unrestricted university

funds.

Potential tax advantages represent a third type of subsidy to participants.

Currently, purchasers are not required to pay federal income taxes

annually on the increased value of their investment in the program;

instead, beneficiaries are liable for federal taxes on the increased value of

their benefits at the time of redemption.34 Some states have also granted

tax advantages to program participants. For example, in Alabama, Ohio,

and Pennsylvania, beneficiaries are not required to pay state income taxes

on the increased value of their benefits at the time of redemption. And in

Michigan, purchasers are allowed to deduct the amount of their payments

for state income tax purposes.

Some programs, however, operate without some of the subsidies

mentioned. Most programs have priced their benefits close to the current

cost of tuition, some slightly higher. In Ohio, for example, prepaid tuition

credits are now priced about 8 percent above current tuition prices, and

previously were priced about 35 percent above current prices. The

programs in Ohio, Florida, and Michigan repaid the initial state

appropriations (ranging from $300,000 to about $1 million) they were given

as start-up funds. And in Alabama, staff salaries and other operating costs

are now covered with application and other administrative fees paid by

participants.

Furthermore, not all government subsidies are equitable in the sense that

lower-income families benefit to the same extent as middle- or

upper-income families. Sometimes, however, subsidies to certain income

groups are, in a sense, balanced by different subsidies to other income

groups. For example, while the mortgage interest deduction helps

primarily middle- and upper-income families, there are also various

33However, the board that oversees the program may decide to repay this money in the future,

according to the program’s Director.

34We discuss the perceived importance of these tax breaks for participants and the programs

themselves later in this chapter.

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Major Issues Concerning State Tuition

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housing subsidies for the poor. Similarly, while subsidies involved in state

tuition prepayment programs primarily benefit families who are relatively

well off, state and federal governments also subsidize higher education for

lower-income families through various financial aid programs.

Regarding whether these programs will free up substantial financial aid

dollars for lower-income students, our review of federal financial aid rules

and data from six major universities indicated that this probably will not

occur. First, the vast majority of current beneficiaries do not appear to

need financial aid. Most of them do not apply for aid, and those who do

typically do not qualify. For example, of the 789 beneficiaries enrolled at

Florida State University in 1993-94, 86 percent did not apply for aid, and of

those who did, 72 percent were determined not to need assistance because

(1) they and their parents had enough money—not even counting the value

of their prepaid benefits—to cover all college costs, or (2) the combination

of their family resources and merit aid, such as scholarships, exceeded

anticipated costs (see table 4.2).

Table 4.2: Most Prepaid Beneficiaries

Appear Not to Need Financial

Aid—Data From Six Participating

Institutions

Institution

Number of

prepaid students

enrolled

Percent who did

not apply for

financial aid

Of those who

did apply,

percent

ineligible

Eastern Michigan Universitya 163 85 46

Michigan State Universityb 925 78 60

Florida State Universityb 789 86 72

University of Floridab 1,864 40 77

University of Central Floridab 692 74 35

Ohio State Universitya 103 49 53

aData for 1994-95 academic year.

bData for 1993-94 academic year.

Source: Estimates provided by financial aid offices at these six institutions.

Second, although federal financial aid rules have the effect of reducing the

amount of aid that prepaid beneficiaries can receive, this will not translate

into savings that can be passed along to other, potentially more needy

students. Once the value of their prepaid benefits is taken into account,

beneficiaries typically are eligible for a smaller guaranteed student loan

than they would have been otherwise; for some, the aid reduction may

mean not qualifying for a loan at all. But the money that goes unborrowed

by prepaid students does not then become available to other students,

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Major Issues Concerning State Tuition

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because, unlike grants, there is no fixed amount of money allocated each

year for guaranteed student loans. Rather, lenders will provide loans to as

many students as qualify.

Investment Value for

Purchasers

A third issue concerning these programs is their value as an investment

option. One common criticism is that purchasers could lose some or all of

the interest on their principal if (1) the beneficiary does not to go to

college at all or attends a nonparticipating college; (2) the purchaser

withdraws from the program; or (3) the program is terminated. Some

critics have also argued that even if beneficiaries do use their benefits as

intended, purchasers can simply earn a higher return from other

investments, such as stocks. Supporters, on the other hand, argue that

these programs (1) have resources and expertise that enable them to

invest more effectively than the average family can on its own; (2) provide

an easy and affordable way to save for college; (3) offer a unique

psychological benefit—peace of mind—because of the guarantee to cover

future costs; and (4) may have tax advantages over other investment

options.

To determine whether purchasers could potentially earn a better return on

their money from other investment vehicles than from tuition prepayment

programs, we compared the effective annual rate of return on large

company common stocks with the effective annual rate of inflation for

tuition and fees at public universities over more than a dozen 15-year

periods, up to 1993.35 Over most of these periods, the stocks provided a

higher rate of return than the rate of tuition inflation for public universities

(see fig. 4.2).

35The effective rate of return, also sometimes referred to as the annualized rate of return, is greater

than the simple arithmetic average of individual interest rates, because it includes compounding

during the investment period.

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Major Issues Concerning State Tuition

Prepayment Programs

Figure 4.2: Tuition Increases, Compared With Returns on Stocks Over 15-Year Periods

Percent

0

2

4

6

8

10

12

14

16

18

20

1965-80 1966-81 1967-82 1968-83 1969-84 1970-85 1971-86 1972-87 1973-88 1974-89 1975-90 1976-91 1977-92 1978-93

Periods

7.1 6.7 7.3 7.1

8.0

7.0

8.5

7.7 8.2 8.7 8.1

10.5

7.9

10.8

7.7

9.9

8.0

12.2

8.5

16.6

8.4

13.9

8.7

14.3

8.8

15.5

9.1

15.7

Increase in Tuition for Public Universities

Returns on Large Company Stocks

Sources: SBBI 1994 Yearbook (Chicago: Ibbotson Associates) and U.S. Department of

Education.

However, while parents could earn a higher return from other investment

vehicles, it is not at all certain that they would. With alternate investment

options, parents take the risk that they may not end up with enough

money when their children are ready to enroll in college. Even stocks have

not always kept pace with tuition increases at public universities. For

example, as shown in figure 4.2, during the 15-year periods ending in 1980

to 1983, tuition inflation exceeded the effective rate of return on large

company common stocks. Thus, parents beginning to save for their

children’s college educations in 1965-68 would have done better by joining

tuition prepayment programs, had they existed, than by investing solely in

stocks.

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Major Issues Concerning State Tuition

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To beat the tuition inflation rate over the long run, investors would need to

(1) put the right amount of money in the right investment vehicles at the

right time and (2) not use the money for other purposes before their

children reach college age. Would the participants in state tuition

prepayment programs make the correct investment choices? On the basis

of evidence from one state, it seems likely that many would not. When

asked on Alabama’s program application how they would save for college

costs without the tuition prepayment program, about 52 percent of

purchasers in 1991-94 checked “savings account,” about 17 percent

checked “savings bonds,” about 15 percent checked “life insurance,” and

only about 6 percent checked “stocks.”36 With passbook savings accounts

currently offering interest rates of less than 3 percent, it appears that a

large percentage of Alabama’s participants would be putting their money

in investments that would be expected to provide a lower return than the

anticipated rate of tuition inflation, about 7 percent to 8 percent per year.

Purchasers apparently see the risk of losing some of the interest they

accumulate in tuition prepayment programs as outweighed by other

benefits of program participation. Limited evidence to support this

position comes from a 1992 report by the Florida Auditor General’s office,

which asked a sample of purchasers to describe what they saw as the

advantages and disadvantages of the state’s tuition prepayment program.

As for the disadvantages, 35 percent of participants referred to losing

interest on the money paid into the program if the beneficiary did not use

the prepaid benefits at all, and 11 percent mentioned that beneficiaries

could not use their benefits at an out-of-state college.37 Many more

participants, however, identified various advantages of the program: About

67 percent mentioned the guarantee to cover future educational costs with

payments based on today’s prices; 42 percent mentioned that paying now

instead of later gave them peace of mind; and 33 percent referred to the

availability of easy, affordable payment options.38

Finally, regarding the tax advantages that these programs may have over

other investment choices, certain advantages could be eliminated in the

36The remaining 11 percent checked “other.” Source: Data provided by Alabama program officials.

37At the time of the survey, beneficiaries who wanted to attend an out-of-state college would have

received the principal from their contracts, but no interest.

38Office of the Auditor General, State of Florida, Performance Audit of the Florida Prepaid

Postsecondary Education Expense Program, Report No. 11825 (Mar. 25, 1992). Responses cited are for

participants whose designated beneficiaries had not yet enrolled in college. Response totals exceed

100 percent because respondents were allowed to cite more than one advantage and disadvantage.

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future. We discuss this possibility in greater detail in the final section of

this chapter.

Risk to States A fourth major issue surrounding state tuition prepayment programs is the

degree of risk they pose for states. A key criticism is that they may not

earn sufficient investment returns, thus leaving the state with a large,

unfunded liability. A program shortfall, or even the threat of one, could

lead to many undesirable outcomes, such as a taxpayer bailout, reduced

spending on higher education, or lower-than-anticipated tuition increases

at state colleges. In contrast, supporters claim that the risk of a shortfall

can be minimized, so long as the programs properly price their benefits;

make sensible actuarial assumptions; and develop a diversified, though

aggressive, investment portfolio. Some also argue that safeguards can be

adopted to protect against excessive losses, such as an “escape clause”

that allows the state to suspend or terminate the program quickly if it is

determined to be actuarially unsound.

We found two instances in which tuition prepayment programs were

suspended because they appeared headed for financial trouble. First,

Duquesne University, a private institution in Pittsburgh, Pennsylvania,

implemented its own tuition prepayment program in 1985 but suspended it

just 3 years later, because investment returns were running lower than

expected and the school wanted to raise tuition faster than originally

anticipated. Second, Michigan’s tuition prepayment program stopped

selling new contracts after 3 years, at least in part because of state

officials’ concerns about its ability to meet its future obligations.39 The

Director explained that MET’s investment returns had dropped somewhat,

making it harder to keep up with state tuition inflation—especially

because the program was also required to pay federal taxes on its

earnings. However, the program Director also pointed out that the

program is still actuarially sound.

The experiences of Duquesne and MET may help other program officials

avoid similar problems. For example, both programs offered deep

discounts on contracts for younger children. According to one analysis of

Duquesne’s program, in 1986 the cost of a 4-year contract for a child

planning to begin college in the year 2000 was $9,182, while the cost of

39Some MET supporters have argued that the suspension was also politically motivated.

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tuition for the 1986-87 academic year alone was $6,270.40 Such low prices

mean that investment returns must not only keep pace with but

substantially exceed the rate of tuition inflation. Most of the state

programs, though, have not offered such deep discounts and some have

even charged prices slightly higher than the current cost of tuition at

participating colleges.41

Finally, if a state tuition prepayment program were facing financial

trouble, it is unclear which, if any, of the predicted outcomes would occur.

In addition, whether these outcomes would be negative is a matter of

opinion; what one observer sees as unacceptable might be acceptable to

another. For example, some people might oppose a state bailout on equity

grounds, as a subsidy to relatively well-off families. In contrast, the

Michigan Treasurer who helped develop MET once said, “So we go through

that horrible scenario of the state government bailing out a system so

10,000 kids can go to college. But what better way to spend the taxpayers’

dollars than on educating kids? The worst is that we’re spending more

money on education than we might have been planning instead of

spending it on dredging some lake that some legislator sits on.”42 Similarly,

requiring state colleges to keep down their tuition prices could be seen as

impeding the colleges from carrying out their educational mission or as

helping to keep college affordable and accessible to families of modest

means.

Applicability of

Federal Tax

Provisions

The most serious issue facing state tuition prepayment programs,

according to program officials, is the potential applicability of federal tax

provisions. Which provisions apply now, or may apply in the future, is

unclear. Program officials are particularly troubled by the possibility that

IRS will require (1) programs to pay taxes on their investment earnings and

(2) participants to pay taxes annually on program benefits.43

40Presentation by John Finnerty at the Invitational Conference on College Prepayment and Savings

Plans, in Denver, July 7-8, 1987; see conference proceedings (New York: College Entrance

Examination Board), pp. 25-31.

41Programs’ efforts to avoid the tax liability that contributed to MET’s problems are described later in

this chapter.

42Robert Bowman, comments made at the Invitational Conference on College Prepayment and Savings

Plans in Denver, July 7-8, 1987; see conference proceedings (New York: College Entrance Examination

Board), pp. 18-19.

43This section presents a brief overview of federal tax issues; a more complete discussion is presented

in app. III.

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Michigan’s History of Tax

Problems

Much of the concern over federal taxation stems from the experience of

Michigan’s pioneering program. Before MET sold any contracts, it requested

a ruling from IRS on the applicability of federal tax provisions. IRS ruled in

March 1988 that (1) purchasers may be liable for the federal gift tax,

(2) beneficiaries would be liable for federal income taxes on the increased

value of their benefits at the time of redemption, and (3) MET itself would

have to pay federal taxes on its investment earnings. Although some

observers saw the ruling as unfavorable—especially the requirement that

MET pay taxes on its investment earnings—the program began selling

prepaid tuition contracts in the fall of 1988.

In 1991, however, when lower investment returns made it more difficult to

stay ahead of tuition inflation, MET suspended sales and requested a full

refund of the $15.8 million it had paid in taxes for its first 3 years of

operation. When IRS denied the refund request, MET and the state of

Michigan sued the United States, arguing that the program’s investment

earnings were exempt from federal taxes because the program is an

integral part of the state. MET lost in U.S. district court in July 1992, but

won its appeal in the Sixth Circuit Court of Appeals in November 1994.

Although IRS disagreed with the Circuit Court’s decision, the Solicitor

General recently decided not to appeal the case to the U.S. Supreme Court.

Some States Defer Action

Because of Tax Concerns

After the IRS ruled on MET, several states that had been interested in

starting tuition prepayment programs backed away from the idea. Indiana

decided not to implement such a program after receiving its own ruling

from IRS in September 1988, which indicated that the proposed program

would be subject to federal taxes on its investment earnings. One state

official said, “We didn’t feel that we could keep up with tuition costs that

are rising about 9 percent a year. We would have to earn a return of

around 13 percent before taxes to get 9 percent after taxes.”44 Also, 1994

legislation authorizing a tuition prepayment program in Virginia stipulated

that it cannot begin selling contracts until IRS rules that the program’s

investment earnings are exempt from federal taxation.

Efforts to Avoid Tax on

Program Earnings

In light of Michigan’s experience, states that implemented programs have

tried to structure them more clearly as an integral part of the state. For

example, in some states the program is within and under the direct control

of the state Treasury Department, and in others the program is

44Cited in Jacqueline Mitchell, “Michigan Flunks Its Tuition Trust Fund,” Wall Street Journal (Mar. 26,

1992), p. C16.

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administered by the state’s higher education system. Thus far, IRS has

emphasized that backing these programs with the full faith and credit of

the state may help protect their investment earnings from federal taxation,

because it demonstrates the state’s financial stake in the program.

However, some officials told us that their states have not taken this step

because it is prohibited by their state constitutions. Florida’s program is

the only one to operate with the full faith and credit of the state from its

inception. By statute, in the event of a shortfall, the legislature must

provide the program with the funds it needs to meet its obligations. Also,

in 1994, Ohio citizens approved a constitutional amendment that enabled

the state to back the tuition prepayment program with its full faith and

credit.

Annual Tax Liability for

Participants Also a

Concern

Although IRS rulings apply only to the parties who request them, program

officials in other states have generally interpreted IRS’s ruling on the tax

consequences for MET purchasers and beneficiaries as applicable to their

programs, too. And, in general, these provisions are not considered a

hindrance to successful program operation. But program officials are

concerned that IRS may change its opinion on the tax liability of program

participants. Specifically, IRS has indicated that regulations on contingent

debt recently proposed by the Department of the Treasury could be

interpreted as applying to tuition prepayment programs. This

interpretation could result in either purchasers or beneficiaries being

liable for federal income taxes annually on the imputed interest on their

investment in these programs.

Program officials believe that such a tax would hurt program operations.

First, they argue that purchasers would not understand or be receptive to

paying taxes on income they had not personally received (sometimes

referred to as “phantom income”), and as a result, program sales would

decrease significantly. Second, they claim that notifying participants of

this tax liability every year would be an administrative burden. Some

program officials recently expressed these views in letters to IRS and in

testimony before IRS and Treasury officials on the proposed regulations.

Some Programs Awaiting

IRS Rulings

Like Michigan, some of the other states with tuition prepayment programs

also requested IRS rulings to clarify their federal tax consequences. But

none of the states has received a ruling; Florida and Ohio have been

waiting 5 years. IRS officials told us that rulings on other programs would

likely be delayed while the MET case was in litigation. However, even

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though litigation concerning MET has now ended, rulings on other

programs may not be immediately forthcoming, and tax questions could

remain unanswered even longer. For example, IRS may wait until Treasury

issues the final regulations on contingent debt, expected late this summer,

because they could determine how IRS rules on the federal taxes applicable

to program participants. In addition, IRS could audit an existing program

that it believes is liable for federal taxes on its investment earnings. If

ordered to pay these taxes, the program might then challenge IRS in court,

further postponing the issuance of rulings while the case is in litigation.

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Concluding Observations

In response to rapidly rising costs of higher education, several states have

implemented tuition prepayment programs. These programs are intended

to ease families’ concerns that they will not have enough money in the

future to cover the costs of their children’s college educations. Each of the

seven programs we reviewed is uniquely designed and structured,

although they all operate in a generally similar manner.

Judging by their overall participation rates, the programs have had varying

degrees of success. However, the programs are fairly new and are still

learning how best to package and market their benefits and reach

potential purchasers. Most participants in these programs are from middleor upper-income families—families that can afford to save and will be

expected to pay for a significant proportion of their children’s future

college expenses. These programs are probably not a viable option for

most lower-income families.

In deciding whether to establish a tuition prepayment program, and in

later operating such a program, states face a variety of issues and potential

problems. For example, there have been long-running debates over what

effect these programs might have on beneficiaries’ educational choices

and the degree of risk they pose to states. Some of the issues represent

matters of opinion and differing philosophies and therefore cannot be

resolved through empirical analysis.

Regarding the issue of federal taxation, nearly 8 years after Michigan first

raised questions about the applicability of various federal tax provisions to

these programs and their participants, the issues are still unresolved. This

constitutes a significant problem for these programs, because certain tax

consequences can have a negative impact on program operations. Officials

in some states are concerned about which tax provisions apply to their

existing programs, and officials in other states have deferred

implementation of such programs pending more clarification of the tax

issues. Furthermore, if state officials have to wait for IRS and the courts,

several more years could pass before some resolution is reached—and

there is no guarantee the resolution will be favorable.

On one hand, federal legislation could significantly speed up resolution of

these issues and ensure that resolution is favorable. For example, the

Internal Revenue Code of 1986 could be amended to exempt these

programs’ investment earnings from federal taxation and to exclude

purchasers and beneficiaries from having to pay federal taxes annually on

the imputed interest on their investments in these programs. In fact,

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Concluding Observations

legislation addressing some of the tax issues concerning these programs

and their participants has been introduced in the current Congress and in

the past.45

On the other hand, the problem of federal taxation could be resolved in

other ways. For example, IRS could issue a favorable letter ruling for one

or more programs, which might send a clearer message to other states

about what it takes to establish a program that IRS considers an integral

part of the state, and whose investment earnings are exempt from federal

taxation. IRS could even take a different position on these issues than it did

concerning MET. Treasury officials could heed the comments of

prepayment officials on the proposed contingent debt regulations and

either explicitly exempt these programs from the regulations, or indicate

to IRS that it should not interpret them as applying to tuition prepayment

programs.

In addition, before pursuing a legislative resolution, several other factors

would need to be considered. For example, what impact, if any, would

exempting these programs’ investment earnings and beneficiaries from

annual federal taxation have on private sector financial institutions and

intermediaries? The head of the College Savings Bank (see ch. 1) has

argued that without creating similar tax advantages for private sector

college savings options, such legislation would “distort investor choices”

and “crowd out virtually all private sector competition in the

marketplace.”46

Enacting the kind of tax provisions favored by program proponents could

also have an uncertain impact on federal revenues. For example, if the

money purchasers spend on prepaid tuition benefits would have otherwise

been put in taxable investment vehicles, the federal government would

lose potential tax revenues. On the other hand, exempting the programs’

investment earnings might not be considered a loss to the federal treasury,

because the programs are not paying taxes now on their interest income.

Nonetheless, these kinds of potential costs would have to be weighed

against the perceived benefits of legislation aimed at resolving the tax

problems currently facing state tuition prepayment programs.

45See, for example, H.R. 1328, 104th Cong., and H.R. 2404, 100th Cong.

46Peter A. Roberts, “Market-Based Solutions: Federal and State Legislative Alternatives to Increase the

Rate at Which Families Save for College” (prepared statement presented at the Third Annual

Conference of the College Savings Plans Network in New Orleans, July 9, 1994).

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Agency Comments We discussed a draft of this report with IRS officials, who agreed with the

discussion of federal tax issues concerning these programs. Officials from

all seven state tuition prepayment programs also reviewed the information

in this report, and they agreed with our characterization of the issues and

descriptions of their programs. Where appropriate, we incorporated minor

wording changes suggested by IRS officials and state program officials.

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Appendix I 

Overview of Tuition Prepayment Program

Features

The tuition prepayment programs in each of the seven states have in

common the guarantee that parents can “lock in” future college tuition at

today’s program prices. However, each state’s program is unique in terms

of the benefits offered and the rules governing eligibility, benefit

redemption, refunds, and so forth. This appendix presents detailed

descriptions of the programs in Alabama, Alaska, Florida, Michigan, Ohio,

Pennsylvania, and Wyoming.

Alabama Alabama enacted the Wallace-Folsom Prepaid College Tuition Trust Fund

Act in 1989, establishing the Prepaid Affordable College Tuition program.

Since 1990, the program has sold contracts guaranteed to cover up to 4

years of undergraduate tuition and required fees at any public college or

university in the state, including 2-year and 4-year schools. There are 50

eligible institutions in the state. The Alabama State Treasurer’s Office

administers the program, under the guidance of a 10-member board of

trustees. Contract payments are received and invested in the

Wallace-Folsom Prepaid College Tuition Trust Fund.

Educational Benefits The tuition benefit covers up to 135 semester hours, or the equivalent at

schools on another academic term basis. The fee benefit covers mandatory

fees for 8 registrations on a semester system, or 12 registrations on the

quarter system, or the equivalent number for schools on a different

academic term basis.

Enrollment Process To qualify, beneficiaries must be in the eighth grade or less. They must

also be either a resident of Alabama or the child of a noncustodial parent

who is a resident. Children of military personnel whose “home of record”

is Alabama are also eligible. The program allows only one purchaser per

contract. However, people other than the purchaser may make payments.

Enrollment takes place from May 1 through May 31 each year. The

program charges a $75 nonrefundable application processing fee.

Purchasers can make a single payment for 4 years of tuition, or choose one

of two monthly payment plans. Under the 5-year payment plan, purchasers

make 60 equal monthly payments. This plan is only available for

beneficiaries in the sixth grade or less. The extended payment plan calls

for equal monthly payments from contract initiation until the beneficiary

reaches college age. For both monthly payment plans, the program

provides coupons, which the purchasers send in with their checks.

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Payments can also be arranged through automatic deductions from bank

accounts or through direct deposit from the purchaser’s employer.

Monthly payments begin September 1 of each year; single payments are

due July 1. Purchasers may change their payment schedule during the

enrollment period in which the contract is initiated for a $15 fee. The

window of opportunity begins the month in which the contract is

purchased and ends the 15th day of the month when their first payment is

due. The charge for late payments is $15.

Purchasers who choose one of the monthly payment plans are permitted

to pay off the contract balance at any time. Purchasers can also pay more

than the required monthly payment amount at any time, which will reduce

the total number of payments, but not the monthly payment amount. The

contract must be fully paid off, including any outstanding fees, before the

beneficiary can use the benefits.

Price Structure Contract prices vary by the age of the beneficiary and the length of time

over which the contract will be paid off. In 1993, the single payment for an

eighth grade student was $7,961; for an infant the price was $4,892. Under

the 5-year payment plan, the monthly payment for a sixth grader was $156;

for an infant it was $105. The extended payment plan cost $203 for an

eighth grader and $50 for an infant. The prices reflect the weighted

average cost of tuition and fees at state schools. Tuition and fees for

1992-93 ranged from $945 at Wallace Community College to $2,269 at the

University of Alabama, Huntsville.

Redeeming Prepaid

Benefits

Beneficiaries have 10 years from the projected date of enrollment to use

all benefits. Extensions may be granted for military service. Beneficiaries

must still meet in-state residency requirements for the Alabama school

they attend, regardless of the purchaser’s residency at the time of

enrollment. If beneficiaries are ineligible for in-state tuition, they must pay

for any remaining costs.

Program Flexibility The program makes several allowances for benefits to be refunded,

transferred, or used at nonparticipating institutions. For example, benefits

can be used at any private or out-of-state institution. The program sends to

the institution an amount based on the average cost of tuition and fees at

Alabama’s public 4-year colleges and universities, or the cost of tuition and

fees at the beneficiary’s school, whichever is less. The program charges

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$25 for each term that the beneficiary uses the benefits at a

nonparticipating school.

Beneficiaries may also transfer among any of the Alabama public colleges

and universities. For instance, a student may transfer to a 4-year

institution after completing a community college. Also, a student may

transfer from one 4-year university to another.

If the beneficiary gets a scholarship, the program will pay the school as if

it had not been received, and then the purchaser can request a refund from

the institution for overpayment.

If a beneficiary starts college and then stops, the program will refund the

remaining benefits, minus a $150 cancellation fee. The program will pay

the refund to the beneficiary over a period of time. However, once a

beneficiary starts college, he or she may not transfer the benefits to

someone else. If the beneficiary decides not to go to college, he or she may

receive a refund of the unused benefits.

Benefits may be transferred, instead of refunded, only if the beneficiary

has died, received a scholarship, or never enrolled in school. Benefits can

only be transferred to a younger member of the beneficiary’s immediate

family, or another child, if approved by the board, for a $55 fee.

Also, purchasers can cancel their contracts for a refund before the

beneficiary reaches college age. However, the program will deduct

cancellation and administrative fees, which includes the account

maintenance fees. The cancellation fee is 50 percent of the amount paid

into the fund or $150, whichever is less. However, no cancellation fee is

charged if the child dies or becomes disabled. The purchaser will receive a

refund of the current value of the contract.

Ownership of the contract can be transferred by naming a new purchaser,

subject to written authorization of the original purchaser. The transfer fee

is $20, but this is waived if the contract has to be transferred because of

the death of the purchaser.

Additional Features As an added feature for participating in the program, purchasers who

qualify can receive a lower interest rate on one particular credit card. The

“Alabama’s Future Card” is a Visa card offered through Colonial Bank, in a

joint venture with the state. Purchasers can receive a 15.5 percent annual

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percentage rate, while regular card holders pay 16.9 percent. In addition, a

percentage of all sales is donated to the state of Alabama to benefit four

programs for children, including the Prepaid Affordable College Tuition

program.

Alaska Alaska established the Advance College Tuition program in April 1991, and

the program began selling tuition credits that fall. The tuition credits may

be used at the University of Alaska, the only state university in Alaska,

which includes three regional campuses and a community college. The

University of Alaska Board of Regents administers the program.

Educational Benefits Participants purchase tuition credits toward undergraduate or graduate

education at the University of Alaska. For an undergraduate degree, each

tuition credit is redeemable for one undergraduate semester credit hour.

For graduate education, two tuition credits are worth one graduate

semester credit hour. It generally takes at least 120 credit hours to

complete a bachelor’s degree. The number of credits for a graduate degree

varies according to the course of study undertaken.

Enrollment Process Purchasers may be any person, institution, or business, and only one

purchaser may be named on each agreement. Purchasers must designate a

primary beneficiary, and also may name up to three alternate beneficiaries

in the event that the benefits are not used by the primary beneficiary.

Purchasers may name anyone they choose as beneficiaries, regardless of

their relationship to one another. Purchasers may even name themselves

as the beneficiary.

Neither purchasers nor beneficiaries are required to be residents when

applying to the program. However, to qualify for resident tuition status at

redemption, beneficiaries must have been a resident of Alaska, or the child

or legal ward of a resident or of an alumnus of the university, when the

agreement was established, at the time of redemption, or any time in

between.

To begin the program, purchasers must buy a minimum of six tuition

credits. Purchasers also pay a nonrefundable $50 contract initiation fee.

Thereafter, purchasers may buy a minimum of one credit per purchase.

Although new prices go into effect each January, enrollment takes place

year-round.

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Purchasers can make payments at any time using checks or money orders.

In addition, they can also designate up to 50 percent of their annual

Permanent Fund dividend to purchase tuition credits. Purchasers who are

the legal guardian of a beneficiary may also use the beneficiary’s dividend

to purchase tuition credits for that child. Purchasers receive regular

account statements to apprise them of the account’s progress.

Price Structure The program charges purchasers roughly the current cost of tuition at the

time they make each payment. Prices are adjusted each year to reflect

tuition increases. For instance, the cost of one tuition credit in 1993-94 was

$66; in 1994-95, a tuition credit was $71. The cost of one tuition credit for

the 1995-96 academic year will be $78, making the single payment cost of 4

years of undergraduate education $9,360.

Redeeming Prepaid

Benefits

In order to use the tuition credits, beneficiaries must notify the program at

least 3 months prior to the time they plan to start college. They must let

the program know the number of credits they plan to use, and indicate

how many will be used for tuition. They must also specify the institution

they plan to attend. The program will then issue the student a tuition

waiver to be used at registration. Beneficiaries may begin using credits 2

years after joining the program. In addition, beneficiaries have up to 15

years after their anticipated college enrollment date to begin using the

credits.

Program Flexibility The program allows purchasers and beneficiaries to receive refunds in

various amounts based on the reason for the refund. In addition, alternate

beneficiaries may use credits under certain circumstances.

Refund amounts are calculated in three ways—the cash value of the

credits, the tuition value, and the purchase price. The cash value is the

value of a tuition credit based on earnings and market value of the fund

investments, the outstanding tuition credits, and other actuarial

adjustments. Tuition value means the value of a tuition credit based on a

weighted average of the University of Alaska resident undergraduate

tuition rates. The purchase price means the amount paid by the purchaser

for tuition credits, not including any investment earnings or outstanding

fees.

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Primary beneficiaries qualify for a refund of the cash value if they become

disabled. If the beneficiary dies, the estate of the primary beneficiary will

receive a cash-value refund, unless an alternate beneficiary was named.

Primary beneficiaries qualify for a refund of the tuition value, not to

exceed the cash value, if they (1) attend a nonparticipating institution,

(2) fail to gain admittance into the University of Alaska, (3) have unused

credits after completing college, or (4) have more than enough credits to

graduate. In the latter two cases, the refund only includes unused benefits.

If a beneficiary gets a full tuition scholarship, the plan will reimburse the

student at that year’s fixed cost, for each semester he or she has the

scholarship. The value of the benefits can then be used to pay for other

costs of attendance, such as books, transportation, and room and board. If

a beneficiary gets a full scholarship covering all costs of attendance, he or

she may either save the credits for graduate school or get a refund. If the

beneficiary chooses a refund, he or she will receive either the amount that

would have been spent for tuition or the value of a tuition credit, which is

based on the weighted average of the University of Alaska resident

undergraduate tuition rates, whichever is less.

If the primary beneficiary quits college or decides not to go to college, the

program will refund the purchase price for any unredeemed credits. Such

refunds are paid out in four annual installments to discourage requesting

refunds for short-term cash needs.

In most cases, if an alternate beneficiary is named, tuition credits are

transferred to the alternate, rather than refunded to the primary

beneficiary or his or her estate. For instance, if the primary beneficiary

dies, does not go to college, or fails to gain admittance into the University

of Alaska, the credits are transferred to an alternate beneficiary. In

addition, if the primary beneficiary does not use any credits during any

6-year period after the anticipated college enrollment date, the program

notifies the primary beneficiary that his or her credits will be transferred

to the alternate beneficiary. In other circumstances, if a primary

beneficiary has additional credits after finishing college or decides not to

finish college, the unused credits will be transferred to the alternate

beneficiary. Such a transfer leads to a 6-year extension of the time frame

for using benefits.

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Features

Additional Features The program has two additional features to encourage higher education

attainment—graduation incentive awards and prepaid tuition scholarships.

The program funds both of these features by allocating a portion of any

excess amount of the prepaid tuition fund over the actuarial requirements

to a special account for them each year.47

Beneficiaries may receive graduation incentive awards to encourage them

to continue and complete their college education. Beneficiaries can earn

one graduation incentive credit for each tuition credit redeemed or

refunded for payment of tuition at the University of Alaska or any eligible

institution. After a beneficiary earns a degree or equivalent certificate, he

or she can either redeem the graduation credits toward graduate

education or get refunds for a variety of other uses.

Prepaid tuition scholarships offer an incentive for younger Alaskans to

achieve higher academic standards of performance in middle and high

school and to complete their secondary education. Scholarships may be

given to students in grades 6 through 12 who attend school in Alaska, and

they can only be used for attendance at the University of Alaska.

Florida Florida enacted the Florida Prepaid Postsecondary Education Expense

Program in June 1987; the program began selling contracts for

undergraduate prepaid tuition in the fall of 1988. The benefits are

guaranteed to cover future education costs at Florida’s 9 state universities

and 28 community colleges. The program is backed by the full faith and

credit of the state, meaning the state is required to appropriate to the trust

fund an amount necessary to meet the program’s obligations if the money

in the trust fund is insufficient. The program is administered by the Florida

Prepaid Postsecondary Education Expense Board, a state agency affiliated

with the State Board of Administration.

Educational Benefits The program offers three prepaid tuition plans, plus a prepayment plan for

dormitory space. Participants can prepay the cost of undergraduate tuition

and mandatory fees for 2 years at the community college level, 4 years at

the university level, or 2 years at community college plus 2 years at a

university. Purchasers of the 4-year university plan only can also prepay

the cost of dormitory space for up to 5 years. The dormitory contract

covers the cost of a double-occupancy, air-conditioned room.

47According to program officials, these features are not yet offered because the fund does not have any

excess proceeds.

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Features

Enrollment Process When the contract is purchased, the beneficiary must be a state resident or

the child of a noncustodial parent residing in Florida. Children of military

personnel for whom Florida is their “home of record” are also eligible to

participate. Beneficiaries must also be below the twelfth grade.

Purchasers need not be a relative of the beneficiary; even corporations,

businesses, and civic and fraternal organizations can purchase a contract.

Two people may jointly purchase a contract, but no provisions can be

made for separate or split payments.

Beneficiaries can only have one tuition and dormitory plan. Prepaid

dormitory contracts are restricted to beneficiaries in the eighth grade or

lower. In addition, housing benefits are for fall and spring semesters only;

they may not be used during summer sessions.

For each benefit plan, the program offers three payment plan options:

(1) the single-payment plan, in which the contract is paid for with one

lump-sum payment; (2) the 5-year installment plan, in which purchasers

make 55 monthly payments; and (3) the monthly payment plan, in which

payments are made from the time of purchase until the beneficiary’s

projected enrollment year. The 5-year installment plan is only available to

purchasers if the beneficiary is in the eighth grade or lower. Monthly

payments can be made by check or automatic transfer. In addition, state

employees and employees from some other organizations can arrange to

pay through payroll deductions.

The enrollment period is from mid-October through mid-January.

Purchasers must pay a nonrefundable $42 application fee per child.

Applications may be submitted to the program office or to any branch of

First Union National Bank, the approved agent for distributing information

on the program.

Price Structure The costs of prepaid tuition and dormitory contracts vary by the benefit

plan selected and the age of the beneficiary. Following are some examples

that show the range of costs in 1993-94.

• Under the 4-year university plan, the lump-sum payment was $5,879 for an

eleventh grader and $5,639 for a newborn; the monthly payments were

$328 and $47, respectively. Under the 5-year installment plan, payments

were $125 for an eighth grader and $121 for a newborn.

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• Under the 2-year community college plan, the lump-sum payment was

$2,065 for an eleventh grader and $1,328 for a newborn; the monthly

payments were $115 and $11, respectively. The 5-year installment plan

payments were $41 for an eighth grader and $29 for a newborn.

• Under the community college/university plan, the lump-sum payment was

$4,983 for an eleventh grader and $4,127 for a newborn; the monthly

payments were $278 and $35, respectively. The 5-year installment plan

payments were $103 for an eighth grader and $89 for a newborn.

• For a 1-year dormitory contract, the lump-sum payment was $2,002 for an

eighth grader and $1,589 for a newborn; the monthly payments were $43

and $14, respectively; and the 5-year installment plan payments were $43

and $35, respectively.

• For a 4-year dormitory contract, the lump-sum payment was $7,755 for an

eighth grader and $6,156 for a newborn; the monthly payments were $166

and $51, respectively; and the 5-year installment plan payments were $166

and $132, respectively.

The tuition prices quoted reflect an average 6.5-percent surcharge over the

1993 tuition rates to ensure that the payments would meet future tuition

costs. The cost of prepaid dormitory contracts is based on a weighted

average of dormitory rates throughout the state university system.

Redeeming Prepaid

Benefits

The beneficiary can begin using benefits up to 3 years in advance of the

expected date of enrollment specified on the contract as long as the

contract is paid in full. Benefits can be used for up to 10 years after the

anticipated date of enrollment. Also, the time frame can be expanded an

additional 10 years upon request, for an additional fee. Any time spent on

active duty in the U.S. armed services will be added to the time frames for

using tuition and housing benefits. Also, students can attend part time,

spreading out their tuition credit hours over more than 4 years. In

addition, beneficiaries always qualify for resident status tuition, even if

they move out of Florida after the contract is purchased.

Program Flexibility Purchasers are allowed to change their benefit plan while still making

payments, in some cases even after the beneficiary starts college. For

example, if a student with a prepaid contract for the 4-year university plan

decides to enroll in a community college instead, the benefits will be used

to pay the lower tuition rate, and the purchaser will be given a refund of

the difference, which can be used to pay for other educational expenses.

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Also, if a student with a prepaid contract for the community college plan

transfers to a state university after 1 year, the student’s remaining benefits

will be applied toward tuition at the university. The conversion

calculations are based upon the tuition rates at the time of enrollment. Any

unmet costs will be the responsibility of the student.

If the beneficiary gets a scholarship, the purchaser will get a refund with

interest for each semester covered by the scholarship.

Contracts may be used at any in-state private or out-of-state, not-for-profit

institution that confers baccalaureate degrees. If a beneficiary attends a

private in-state institution, the program will pay the school the amount

equal to the cost of public tuition at the time of enrollment. If a beneficiary

attends an out-of-state institution, the program will pay the school an

amount equaling the value of Florida public tuition at time of enrollment

or the original purchase price plus 5 percent interest compounded

annually, whichever is less.

Purchasers may elect to terminate a contract at any time. If the purchaser

terminates a contract because a beneficiary dies or becomes disabled prior

to enrolling in college, the purchaser will get a refund equal to the amount

paid into the plan plus 5 percent compounded interest or the current

in-state tuition rate, whichever is less.

When contracts are terminated for other reasons, refunds are typically for

the amount paid into the plan minus administrative fees; no interest is

refunded. For instance, if a beneficiary leaves school (whether voluntarily

or not) before completing all the semester hours paid for in the contract,

the purchaser will receive a refund of the remaining benefits, minus an

administrative fee of $50 or 50 percent of all money paid, whichever is

less. However, this refund will not include payments for the remainder of

any semester in which the student was enrolled. Also, if a contract for the

4-year university plan is terminated after a student completes an Associate

of Arts degree, but the student decides not to pursue further education,

the $50 cancellation fee will not be assessed.

If a contract held 2 years or less is terminated because of default or

purchaser’s decision to voluntarily cancel the contract, the refund will

equal the total of all money paid into the plan minus an administrative fee

of the lesser of $50 or 50 percent of all money paid, and any outstanding

late fees. For contracts held more than 2 years before termination by

election or default, no administrative fee is subtracted from the refund.

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The purchaser can change the beneficiary named on a contract so long as

(1) the new beneficiary is a sibling, half-sibling, or step-sibling of the

original beneficiary; (2) the new beneficiary meets the requirements of a

designated beneficiary at the time of the substitution; and (3) the

substitution is made before the original beneficiary enrolls in college. The

purchaser must pay a $5 fee for substituting beneficiaries. Additionally, if

the new beneficiary is expected to enroll in college more than 3 years

before the original beneficiary, the purchaser also must pay a sum to

ensure the actuarial soundness of the program.

The program can terminate a contract if the program finds that the

purchaser made fraudulent statements relating to the beneficiary’s

residency. If this happens, the purchaser gets a refund of all remaining

money paid into the fund after charging a termination fee. The program

will charge either 100 percent of money paid into the plan or $250,

whichever is less.

Additional Features Florida’s program offers a life insurance plan, underwritten by North

American Life Assurance Company, that ensures purchasers that contract

payments will be completed in the event of their death. A prepaid contract

purchaser must be under age 65 to qualify for the life insurance policy. To

acquire coverage, contract purchasers fill in a special section on the basic

program application. The cost of the annual insurance premium depends

on the contract payment plan, the benefits purchased, and the age of the

purchaser. During the 1993-94 enrollment period, the annual premiums

ranged from $10 for a person under 35 purchasing a community college

contract under the 5-year installment plan to $225 for a person aged 50 to

65 purchasing a university contract plus 4 years of housing under the

monthly payment plan. The insurance and annual premium payments

continue until the purchaser either makes the final contract payment or

turns 75, regardless of whether all contract payments have been made,

whichever comes first. If a purchaser is ever more than 30 days late with

an insurance premium, the insurance will end. Also, the purchaser can

cancel the insurance at any time.

Michigan Michigan enacted the Michigan Education Trust program in 1986. The

program, which first sold contracts in the fall of 1988, provides for the

prepayment of undergraduate tuition and fees at any of Michigan’s 15

public universities and 29 community colleges. Although contract sales

were halted after the 1990 enrollment period, the program still invests the

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money it received and honors contracts it sold. The program is

administered by the state Treasury Department.

Educational Benefits Participants could choose from three benefit plans—full benefits, limited

benefits, and community college. The full benefits plan guaranteed to

cover in-state tuition and fees at any 4-year public college or in-district

tuition and fees at any 2-year public college. The limited benefits plan

guaranteed to cover tuition and fees only at any public colleges whose

tuition costs did not exceed 105 percent of the weighted average tuition

cost of Michigan’s 4-year institutions. Finally, the community college plan

covered in-district tuition and fees at any of Michigan’s 29 community

colleges. Under the full and limited benefits plans, individuals could

purchase contracts for 1, 2, 3, or 4 years; under the community college

benefit plan, individuals could purchase contracts for 1 or 2 years.

Enrollment Process Michigan’s program had a limited enrollment period during the fall. At the

time of enrollment, purchasers had to pay $85 in nonrefundable

application and processing fees and specify the beneficiary and a refund

recipient, in case the benefits were not used by the beneficiary. At the time

of purchase, the beneficiary had to be a Michigan resident, and the

purchaser had to be a U.S. resident. Purchasers did not have to be related

to the beneficiary.

The program allowed businesses, as well as individuals, to purchase

contracts. Only one person could be named as the contract purchaser.

However, a beneficiary could be named on more than one contract. For

example, a parent and grandparent could each buy a 2-year full benefits

plan contract for the same child.

In its first 2 years of operation, purchasers had to make lump sum

purchases for all contracts. In 1990, however, purchasers could use one of

three monthly payment options to purchase contracts. Monthly payments

could be spread over 4, 7, or 10 years from the purchase date, depending

on how soon the beneficiary was expected to enroll in college. Purchasers

could not use the monthly payment option if beneficiaries were past a

certain age or grade in school. In addition, purchasers could only use

monthly payment options when purchasing full benefits or community

college plans. Payments could be made through payroll deductions, direct

debit, electronic funds transfer, or with personal checks.

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During all 3 years that contracts were sold, purchasers could also finance

a lump-sum purchase through secured loans available from Michigan

savings and loan institutions. If borrowers defaulted on these loans, the

program would pay off the lending institution from the value of the

contract. The terms of the loans varied by institution.48 The fee for

processing defaults on secured loans was $50.

Price Structure The cost of contracts depended on a number of factors, including the

beneficiary’s age or grade in school, and the benefit plan and payment

option chosen. In 1990, under the full benefits plan, 4 years of tuition cost

$15,496 for an eleventh or twelfth grade student, which represented the

current cost of tuition and fees for the highest-priced public university in

the state. Contract prices decreased along with the beneficiary’s age. For

instance, the same plan cost $9,296 for a child in kindergarten. Prices also

varied by the chosen payment option. For example, if a purchaser chose a

monthly payment plan to pay for 4 years of tuition and fees for a second

grader, payments would be $130 a month for 10 years, $164 a month for 7

years, or $252 a month for 4 years.

Redeeming Prepaid

Benefits

Beneficiaries must notify the program when they are ready to start college.

The program will then pay the tuition each year as the student enrolls. If

beneficiaries do not meet residency requirements for a Michigan school at

the time of enrollment, they are responsible for paying the additional

charges of the nonresident tuition rate. Students can use their tuition

benefits up to 9 years after they are scheduled to begin college.

Program Flexibility Beneficiaries may voluntarily terminate their contracts and get a refund

for a variety of reasons. They may also transfer contracts under certain

circumstances. Furthermore, the program makes allowances for

purchasers who stop making payments or who default on loans to use

benefits they have paid for.

Refund amounts vary depending on the reason for terminating the

contract, but they will never be less than the contract amount paid to the

program. In most cases refunds are not available until the beneficiary

reaches college age. Under the full benefits plan, refund rules are as

follows:

48We spoke with officials at three of the institutions that made these loans. We found that, in general,

purchasers had up to 15 years to repay the loans, depending on the age of the child. The loan rates

ranged from about 8.75 percent to 12.5 percent.

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• If the beneficiary receives a full scholarship, the average tuition cost of

Michigan’s 4-year public institutions will be paid to the refund designee in

four annual installments.

• If the beneficiary decides to attend a private institution in Michigan, the

weighted average tuition cost of Michigan’s 4-year public institutions will

be paid to the beneficiary’s chosen school, or the lowest tuition at

Michigan 4-year public institutions will be paid to the refund designee.

• If the beneficiary decides to attend an out-of-state college, the average

tuition cost of Michigan’s 4-year public institutions will be paid to the

beneficiary’s chosen school in four annual installments.

• If the beneficiary does not plan to attend any higher education institution,

the program will pay to the refund designee the lowest tuition of

Michigan’s 4-year public institutions, in four annual installments.

• If the beneficiary dies or becomes disabled, the program will pay the

refund designee a lump sum equal to the lowest tuition of Michigan’s

4-year public institutions.

• If a refund request for any other reason is approved, the program will pay

the refund designee the lowest tuition of Michigan’s 4-year public

institutions, in four annual installments.

In all these cases, except when the beneficiary attends an in-state private

college or in cases of death or disability, refunds will be reduced by a $200

termination fee.

Refunds may not be available in certain circumstances. The most

significant restriction is that beneficiaries may not terminate their

contracts for a refund after they have completed more than half the credit

hours necessary to receive a 4-year baccalaureate degree, even if they have

not used the contract benefits to pay for college. However, this restriction

does not apply to graduates of Michigan community colleges who

terminate their contracts before enrolling in a 4-year state institution.

Beneficiaries may also lose their right to a refund if they state fraudulent

information in their contracts or do not use their benefits within the 9-year

time period after the expected date of college enrollment.

Beneficiaries who are 18 years or older may transfer their contracts to

another beneficiary in their immediate family or the purchaser’s

immediate family. Contracts transferred to an older person, or one in a

higher grade than the original beneficiary, will require an additional

payment to the program. Contracts may also be transferred if the

beneficiary dies or becomes disabled, or if the beneficiary receives a full

tuition scholarship. However, benefits cannot be transferred after more

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than half the benefits have been used toward a 4-year degree. The fee for

transferring the contract to a new beneficiary is $25.

If purchasers using a monthly payment option stop making payments, they

are not terminated from the program. Instead, they receive the educational

benefits they paid for. If they want to purchase additional educational

benefits in the future, they can do so at the new cost. Similarly, if a

purchaser defaults on a secured loan, he or she still can get any

educational benefits remaining after the program pays the savings

institution the outstanding loan amount.

Ohio In 1989, Ohio created the Ohio Tuition Trust Authority, a state agency

specifically established to operate the Prepaid Tuition Program. The

program began selling tuition credits at the end of that year for

undergraduate education at Ohio’s 13 public universities and 23

community colleges. The program is backed by the full faith and credit of

the state.

Educational Benefits Participants purchase tuition credits. Each credit is worth 1 percent of the

weighted average cost of full-time tuition and fees for 1 year at Ohio’s

public universities. Therefore, at a 4-year institution, 100 credits would

cover a student’s tuition and fees for 1 year, and 400 credits would cover 4

years’ worth. At a community college, 100 tuition credits would cover 2

years’ worth of tuition. Students can attend full or part time.

Enrollment Process Purchasers may enroll throughout the year. They must purchase at least

one tuition credit and pay a nonrefundable $50 enrollment fee. There are

no residency, relationship, or age requirements for purchasers, although

those under age 18 must have the signature of a legal guardian.

Beneficiaries must be residents when their account is established and

must have a social security number. The program allows only one

purchaser per account, but other individuals may contribute. Purchasers

may start multiple accounts for multiple beneficiaries. Likewise,

beneficiaries may be named on more than one account.

When an account is opened, the purchaser must specify (1) whether the

purchaser or the beneficiary will receive the refund if credits are not used,

(2) whether the purchaser’s consent is required to terminate the contract,

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and (3) whether the purchaser’s consent is required to transfer some or all

credits to a new beneficiary.

The program allows purchasers to make payments by check at any time,

using coupons provided by the program. Purchasers can also make

payments through payroll deduction or automatic transfers from checking

or savings accounts. However, the program requires monthly minimum

payments of $25 per contract for transactions made through payroll

deduction or automatic transfers.

The program also has offered various purchase plans that allow

participants to meet different savings goals. For example, the “Helping

Hand Package” encourages people to save $50 per month over many years;

the “Semester Package” encourages people to save $180 per month over 1

year to prepay one semester of tuition. However, none of these packages

requires people to adhere to the payment schedule—all payments are

optional. Purchasers receive semiannual account statements to give them

an update of their status.

Price Structure The program sets prices each August for the following year based on the

annual weighted average of tuition and fees at Ohio’s 4-year public

institutions. In addition, the prices reflect a premium to ensure that the

payments meet future tuition and administrative costs. In 1994-95, the

weighted average tuition was $3,455, but the program charged $3,750, or

$37.50 per credit, based on this adjustment. Thus, the lump-sum cost of 4

years of tuition was $15,000.

Redeeming Prepaid

Benefits

Beneficiaries may redeem tuition credits 2 years after purchase. If

beneficiaries are not state residents when they start college, they may have

to pay the difference between the resident and nonresident tuition rates if

they return to Ohio to attend college.

Program Flexibility Beneficiaries who attend a state institution with tuition lower than the

weighted average may need fewer than 100 credits per year for tuition and

can spread their credits to cover more than 4 years of school. Beneficiaries

who attend a state institution with tuition higher than the weighted

average may need more than 100 credits per year for tuition.

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The program allows credits to be used at nonparticipating institutions. For

instance, if a beneficiary goes to a private or out-of-state school, the

program will pay the school the weighted average tuition of the Ohio

public colleges and universities at the time. The beneficiary would be

expected to pay any remaining costs.

Unused benefits can be refunded or transferred. Only beneficiaries may

request a refund or transfer of credits when they reach college age. Credits

cannot be refunded until the beneficiary is 18 years old and the credits are

mature (on account for 2 years or more). Further, funds cannot be

withdrawn before the beneficiary reaches college age, except in cases of

death or permanent disability. Following are some of the conditions in

which refunds apply, and their amounts.

• If a beneficiary receives a merit-based scholarship, the program will either

(1) pay to the beneficiary, through the academic institution, an amount

equal to the value of his or her credits; or (2) refund 99 percent of the

current weighted average tuition after the student graduates.

• If a beneficiary dies or becomes disabled, the program will pay the refund

recipient the greater of the current weighted average tuition or the

purchase price.

• If a beneficiary graduates before all the tuition credits are redeemed, the

credits can be used for graduate or professional studies, or they can be

refunded at 99 percent of weighted average tuition.

• If a beneficiary requests a refund—either because he or she does not want

to go to college or has started but wants to stop—the program delays any

refund for 1 year to allow the beneficiary to reevaluate the decision. Then,

if the beneficiary decides not to attend or finish college, the program will

pay the refund recipient a maximum of 100 credits per year until all credits

are paid, minus a $25 termination fee per year. The value of the credits

refunded is equal to 99 percent of the current weighted average tuition. If

the beneficiary decides to start or return to college, the program will stop

the refunds, and the remaining credits can be used.

In any of these cases in which a refund might apply, a beneficiary may

choose to transfer any unused credits to a new beneficiary. The new

beneficiary must be an Ohio resident and an immediate family member.

The program charges $25 for transferring credits to a new beneficiary.

After a beneficiary reaches college age, if there are no more payments into

an account or credits redeemed for 10 years, the program may terminate

the contract and keep the funds. The program also may terminate a

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contract if it finds that fraudulent information has been reported about the

purchaser or beneficiary.

The state also reserves the right to terminate the program, cancelling

contracts and providing refunds.

Pennsylvania Since the fall of 1993, the Pennsylvania Tuition Account Program has

offered tuition credits for use at Pennsylvania’s public colleges and

universities. Pennsylvania has 14 community colleges; 14 universities that

compose the state system of higher education; and 4 state-related

universities, which include Pennsylvania State, Temple, Pittsburgh, and

Lincoln. The state’s Treasury Department administers the program, which

was enacted in April 1992.

Educational Benefits Participants in the Pennsylvania Tuition Account Program purchase

tuition credits that can be redeemed toward tuition and mandatory fees of

undergraduate study at public colleges and universities in the state. At

4-year institutions, each tuition credit equals one twenty-fourth of an

academic year of tuition for full-time students. Thus, if attending as a

full-time student, beneficiaries would need 96 credits to cover 4 years of

study. At community colleges, each tuition credit equals 1 credit hour.

Community colleges require 15 credit hours per semester; therefore, a

full-time student would need to have 60 credits for the 2 years of study

required for an associate degree.

Participants can also purchase even smaller amounts, known as tuition

units, for use at 4-year and 2-year institutions. Each tuition unit equals

one-twentieth of a tuition credit.

In addition, purchasers have the option of purchasing credits or units for a

specific institution, or for one of the three standard tuition

categories—community colleges, state system of higher education, or

state-related institutions. The standard tuition category is the approximate

average tuition for 1 year’s tuition at all the schools within a given tuition

category. Purchasers who are unsure of the specific school the beneficiary

will attend, but certain of the type of school they will attend, might choose

this option. Purchasers receive an annual account statement showing the

total number of tuition credits purchased.

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Enrollment Process Either the purchaser or the designated beneficiary must be a state resident

when the purchaser applies to the program. Purchasers must be at least 18

years old, and they may designate themselves as beneficiary. They may

also designate the beneficiary as “unnamed” if the credits will be used as

part of a scholarship program approved by the program. In addition, any

legal entity can also be a purchaser, enabling clubs and other

organizations to establish accounts for either specified or unspecified

beneficiaries. While joint ownership of an agreement is not allowed,

beneficiaries can be named on multiple agreements. Also, someone other

than the purchaser may contribute toward the account.

When applying, purchasers must designate the beneficiary’s anticipated

date of college enrollment. They must also purchase at least one tuition

unit. Purchasers pay a $65 nonrefundable application fee when applying to

the program. Program enrollment takes place throughout the year, but

new prices go into effect each year on September 1.

Purchasers may choose one of several payment methods, including

personal check, direct transfer from their bank account, and payroll

deduction. The program will change the payment method at any time for a

$1 fee, upon written request of the purchaser. Purchasers may make either

one lump-sum payment or send in payments whenever they want using

coupons provided by the program.

Benefits may be purchased at either the resident or nonresident rate,

depending on the beneficiary’s residency at the time of application or the

residency status anticipated at the time the beneficiary enrolls in college.

Pricing Structure The price of benefits varies by institution, tuition category, campus

location, residency, and course of study. For example, at Pennsylvania

State University, tuition credits for the main campus and two other

campuses are the same, but for all other branches prices are slightly

different. Similarly, at the University of Pittsburgh main campus, tuition

credits for studying engineering or nursing cost more than credits for

studying arts and science or social work. Community colleges also have a

tuition credit price for students who are state residents but live outside of

the district of the community college that they will attend.

Prices are based on current tuition prices, plus a premium based largely on

tuition trends at specific schools over a 20-year period. The premium for

credits at schools where tuition has increased dramatically in recent years

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is likely to be higher than for schools where tuition increases have been

more moderate. The premium is intended to guarantee that the credits will

be of sufficient value when they are needed. Premiums are set by an

actuarial firm.

Following are some specific prices that were in effect from September 1,

1994, to August 31, 1995:

• For community colleges, the lowest price of a tuition credit was $50 for an

in-district resident at Westmoreland Area Community College; the highest

price was $215 for an out-of-state student at Bucks County Community

College. The standard tuition price was $64 for residents, $121 for

out-of-district students, and $175 for out-of-state students. This translates

to $960, $1,815, and $2,625 per semester, respectively.

• Tuition credit prices at all universities in the state system of higher

education were the same—$129 for residents and $328 for nonresidents;

this translates to $1,548 and $3,936 per semester, respectively.

• At state-related universities, the tuition credit price ranged from $126 for

state residents at Lincoln University to $670 for nonresidents in the

pharmacy program at Pittsburgh. The standard tuition price per credit was

$233 for residents and $480 for nonresidents, translating to $2,796 and

$5,760, respectively, per semester.

In all cases, a tuition unit is one-twentieth the cost of a tuition credit.

Redeeming Prepaid

Benefits

Tuition credits (and units) must be 4 years old before they can be used.

Beneficiaries must begin using their benefits within 5 years of their

projected enrollment date specified on the application. The program will

extend the start date an additional 5 years, although in such cases, the

program may require an assessment fee to ensure that the tuition account

will meet the tuition costs at the time of use. Time spent on active duty in

the U.S. armed services does not count toward the 5-year period for

beginning to use tuition credits. All credits must be redeemed within 10

years after the beneficiary first enrolls in college. Time spent on active

duty will be added to this 10-year period.

To use the credits, the purchaser or the beneficiary must write to the

program to request a certified statement of accumulated tuition credits.

The letter must include the name of the institution to be attended, the

amount of any scholarship awards, the number of the account as it

appears on the agreement, and the institution’s tuition rate.

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Next, the program will convert credits if changes occur in the selection of

a specific institution or the category of institutions. The conversion is an

adjustment between what has been purchased and what the credits will

actually be used for. For instance, the program will convert credits if a

beneficiary changes from one institution to another. Also, if payments

were made for a standard tuition category, the program will convert the

credits once the student selects a specific school. The conversion also

takes place for changes in residency. In these cases, the student may end

up with more than enough credits or not enough credits, depending on

what was originally purchased and how the credits were later used.

Beneficiaries who do not have enough credits will be expected to pay any

remaining costs. Beneficiaries with excess credits can apply them toward

a master’s degree or some other postbaccalaureate program. Also, if the

student decides to attend college on a part-time rather than full-time basis,

the cost may be greater per credit hour. In this case, the program will also

convert the value of the account to the part-time equivalent.

After the conversion is made, the program will send the certificate to the

purchaser or beneficiary. The purchaser or beneficiary must then forward

the certificate to the institution. The institution will return the certificate

to the program with a letter certifying that the student has been accepted

for that academic year.

The value of prepaid benefits does not affect eligibility for state-based

financial aid. If the beneficiary gets a scholarship at either a participating

or nonparticipating institution, a refund will be given for the benefits

covered by the award in the amount of either the tuition for the number

and type of the tuition credits purchased or the value of the account,

whichever is less. However, such refunds for a given academic award will

not exceed the amount of the scholarship for that year.

Program Flexibility Tuition credits may be applied toward the cost of tuition at

nonparticipating institutions, which include private in-state or any

out-of-state schools meeting certain accreditation standards. However,

tuition credits are not guaranteed to cover the student’s tuition at a

nonparticipating institution. Tuition credits may be redeemed for a

nonparticipating institution once the beneficiary or purchaser submits to

the program an invoice for tuition at the institution. The program will then

pay the institution the lesser of (1) the amount of the invoice, (2) the

actual tuition for the number and type of credits purchased, or (3) the full

value of the account, which is all money paid for credits or units plus a pro

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rata share of fund earnings. Any remaining costs must be paid by the

student.

If the beneficiary decides not to go to college, the purchaser can exercise

one of two options—designate a substitute beneficiary or request a refund.

If a substitute beneficiary is chosen, the substitute must be a family

member of the purchaser or the original beneficiary, and must meet

residency requirements if the purchaser is not a state resident. If the

purchaser requests a refund, the program pays the purchaser either

90 percent of the tuition for the number and type of the tuition credits

purchased or 90 percent of the value of the account, whichever is less.

If the purchaser chooses to withdraw from the program for any other

reason, the purchaser receives the lesser of (1) 90 percent of the tuition for

the number and type of the tuition credits purchased, (2) 90 percent of the

value of the account, or (3) all money paid toward tuition credits or units.

If the beneficiary dies or becomes disabled, or if the beneficiary fails to

gain admittance into college, the program pays the purchaser the value of

the account. If the beneficiary fails to redeem all credits within the

appropriate time frames, the program will terminate the agreement. In this

case, the program will pay the purchaser either 90 percent of the tuition

for the number and type of the tuition credits purchased or 90 percent of

the value of the account, whichever is less.

Purchasers may transfer agreement ownership to a new purchaser, as long

as the new purchaser is a family member of the current owner and meets

residency requirements if the beneficiary is not a state resident. In

addition, transfers must be made without consideration; that is, benefits

cannot be sold or traded.

Wyoming Under the Advanced Payment of Higher Education Costs Program,

contracts are sold for undergraduate education at the University of

Wyoming or any community college in the state. The program was

established in 1987, and contracts first went on sale that summer. The

program is administered under the auspices of the University of Wyoming

Board of Trustees.

Educational Benefits The program allows people to prepay the costs of tuition and fees only, or

tuition, fees, and room and board. Purchasers can buy contracts for 2

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years at a community college, and 1 to 4 years at the University. The

program offers contracts for both residents and nonresidents.

Enrollment Process Contract purchasers need not be state residents, and they can purchase

multiple contracts. Enrollment takes place throughout the year. However,

each year the program establishes new prices that are only in effect from

August 1 through August 15. The program adds 10 percent annual interest

to purchases after that date. No application fee is charged.

Price Structure Costs vary dramatically depending on which benefit package is chosen,

when the beneficiary will enroll, and the beneficiary’s residency. For

example, as of August 1993, the least expensive benefit plan was $3,763 for

tuition and fees for 2 years of community college beginning in 2013. For a

resident enrolling in 2002 for 4 years at the University, a contract covering

tuition, fees, and room and board was priced at $43,766. For a nonresident,

that same contract would have cost $122,847.

Purchasers may make lump-sum payments with cash; money orders; or

personal, cashier’s, or registered checks. They may also finance their

purchase through a secured loan offered by various Wyoming banks,

savings and loans institutions, and credit unions.49 If the purchaser fails to

make payments, the University reimburses the unpaid amount to the

lending institution. At that point, the contract will be terminated and the

program will refund the purchaser any funds that remain after settling the

default.

Redeeming Prepaid

Benefits

Beneficiaries have 6 years from the anticipated college enrollment date to

use the benefits. The beneficiary’s residency status at the time of

admission is determined by the school, regardless of the status when

applying to the program. Beneficiaries who have contracts for in-state

tuition but are deemed nonresidents by their school must pay for the

additional costs. Likewise, beneficiaries who qualify for in-state tuition but

have nonresident contracts can use the additional funds for other

educational expenses.

49We spoke with a loan officer at one of the lending institutions and found out that purchasers have 10

years to pay back the loan at a fixed rate, including a 5-year balloon payment. As of January 1995, that

rate was 8 percent. If the purchaser has good credit at the end of the first 5 years, the loan balance can

be refinanced for the remaining term at the existing loan rate.

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Program Flexibility Purchasers can cancel their contract and receive a refund if the

beneficiary dies, attends a nonparticipating institution, is not admitted to

college after properly applying, decides not to attend college, or elects not

to use the benefits and a substitute beneficiary is not named.

The amount of the refund depends on whether benefits have been used

yet. If the purchaser cancels the contract before any benefits have been

used, the program will refund the advance payment plus 4 percent interest

compounded annually. If the purchaser cancels the contract after some

benefits have been used, the program will refund the advance payment

plus 4 percent interest compounded annually, minus any benefits used.

A substitute beneficiary may be named at any time to take advantage of

any unused benefits.

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Appendix II 

Additional Problems States May Encounter

in Establishing and Operating a Tuition

Prepayment Program

In addition to unresolved federal tax questions (discussed in ch. 4),

officials identified a variety of other problems or barriers that states may

face in setting up and running a tuition prepayment program. Three of the

problems they emphasized most included (1) developing actuarial

assumptions that accurately reflect trends in college costs and investment

returns, (2) encountering opposition from various public and private

interests, and (3) working out the administrative details involved in daily

program operation. Knowledge of these problems, and how they have

been dealt with, may be instructive to state officials who are interested in

starting such a program in the future.

Making Accurate

Actuarial

Assumptions

One problem that some officials identified has to do with the accuracy of

key actuarial assumptions: problems can arise for these programs when

tuition rates increase faster than expected or investments earn a lower

return than expected. Two officials described how the years preceding the

start of their programs turned out not to be a good predictor of tuition and

interest rates in the years after the programs began. The economic

landscape changed, one official explained; state revenues decreased,

which led to pressures to increase tuition rates faster than anticipated, and

at the same time interest rates declined. Rising tuition rates seemed

particularly vexing to two officials we interviewed. How can state

universities justify an 11-percent tuition increase, one asked rhetorically,

in a year when the general inflation rate is 3 percent?

Two officials who described being somewhat disappointed with the rate of

return they have received on their investments said they may begin to

invest more aggressively in equities. Unexpectedly large tuition increases,

however, have not proven an easy problem for officials to deal with. One

director described raising the prices for program benefits, but said that the

program may now be too expensive for many people to afford. Another

official said it would be easier to operate the program if the state had some

central control over colleges’ tuition rates.

Encountering

Opposition From

Various Sources

Another barrier some officials described is opposition from a variety of

sources, particularly when the program is initially under consideration, but

also during its operation. For example, state politicians can raise concerns

about the potential for the program to create an unfunded liability for the

state; public higher education officials may worry that the program will

lead to a cap on tuition prices or a reduction in their funding, making it

harder for colleges to cover their expenses; private college representatives

Page 90 GAO/HEHS-95-131 State Tuition Prepayment Programs
Appendix II 

Additional Problems States May Encounter

in Establishing and Operating a Tuition

Prepayment Program

may raise the issue of student choice and the possibility of declining

enrollments at their institutions; and members of the banking and

investment industry may argue that a state program allowing families to

prepay the cost of college will take away business from the private sector.

The ability of program proponents to overcome this type of opposition is

obviously important to their ultimate success. Following are some

examples of the strategies program officials have used.

• To deal with the potential opposition from public colleges, one official

described having several meetings with college representatives early in the

developmental stage to explain how the program would work and correct

any misperceptions they might have had about the program’s implications.

College officials were also invited to participate in drafting the authorizing

legislation. Giving top officials from the state’s higher education system a

seat on the board overseeing the prepayment program can also help ease

their fears, some officials reported.

• To deal with opposition from banks, insurance companies, and other

private sector firms, one program director has described the importance of

emphasizing the noncompetitive aspects of tuition prepayment programs.

“For example, advertising should stress the guarantee of payment of future

tuition, rather than any perceived rate of return on the premiums paid.”50

Another step programs can take is to give the private sector some of the

business, by contracting out for services such as sales, marketing, and

records administration.

Resolving

Administrative Details

An additional challenge for some states has been working out the

administrative details of implementing and operating the programs.

Numerous decisions must be made, such as what part of the operation, if

any, should be contracted out versus handled in-house. Officials must

develop the program rules; consult with attorneys, actuaries, and

investment advisors; and hire staff with the skills needed to operate the

program. Records administration posed a particularly difficult challenge

for two programs: officials described having to develop customized

computer systems to keep track of purchasers’ accounts because there

were no adequate systems commercially available.

In resolving these kinds of problems, officials in different states have made

different decisions. For example, officials in Ohio decided to run the

50William Montjoy, “State Prepaid Tuition Plans: Designing a Successful Program,” Prepaid College

Tuition Plans: Promise and Problems, ed. Michael A. Olivas (New York: College Entrance Examination

Board, 1993), p. 47.

Page 91 GAO/HEHS-95-131 State Tuition Prepayment Programs
Appendix II 

Additional Problems States May Encounter

in Establishing and Operating a Tuition

Prepayment Program

tuition prepayment program entirely in-house with about 17 full-time staff

members. In contrast, Florida has only eight full-time staff and contracts

out for almost all its services. Officials in two states mentioned that in

setting up and running their programs, they have benefitted from the

expertise of staff in the state treasury department. Finally, a few officials

mentioned the value of talking with their colleagues in other states where

these programs were already in place and learning from their experiences.

Page 92 GAO/HEHS-95-131 State Tuition Prepayment Programs
Appendix III 

Federal Taxation a Major Issue Facing State

Tuition Prepayment Programs

The most serious issue facing state tuition prepayment programs is the

potential applicability of federal tax provisions. Two potential taxes are

particularly troubling to program officials: (1) a tax on program

investment earnings, because that would make it more difficult for

programs to meet their future liabilities, and (2) an annual tax on

participants, because that would be unappealing to purchasers and an

administrative burden, according to program officials. Uncertainty about

federal taxes began with Michigan’s pioneering program and persists to

this day. Moreover, because of the negative impact such taxes can have on

these programs, some states have decided to delay program

implementation and others have backed away from the concept

altogether. Favorable resolution of these issues would help existing

programs to succeed and stimulate renewed interest in these programs

among other states.

Michigan’s History of Tax

Problems

Federal taxation has been an important issue since Michigan established

the first state tuition prepayment program, the Michigan Education Trust

(MET). The statute creating MET required that before the program could sell

any contracts, it had to obtain a ruling from IRS that purchasers would not

be subject to federal income taxes on the benefits they purchased or on

the program’s investment earnings. MET requested a private letter ruling51

in February 1987. IRS ruled in March 1988 that (1) purchasers may be liable

for the federal gift tax, (2) beneficiaries would be required to pay federal

income taxes on the increased value of their benefits at the time of

redemption, and (3) MET itself would have to pay federal taxes on its

investment earnings.

On the third point, MET had argued in its ruling request that its investment

earnings were exempt from federal taxation primarily because it was an

“integral part of the state” and traditionally the federal government does

not tax the direct income of states.52 In its ruling, however, IRS concluded

that MET was not an integral part of the state, essentially because (1) it was

created as a corporation to operate independently from the state, under an

appointed board of directors whose decisions could not be overridden by

51As explained in an IRS publication, “A ‘letter ruling’ is a written statement issued to a taxpayer” by

the national office of IRS “that interprets and applies the tax laws to the taxpayer’s specific set of

facts.” See Revenue Procedure 95-1, Department of the Treasury, IRS, Publication 1375 (Rev. 1-95),

p. 7.

52Alternatively, MET argued, its investment earnings could be excluded from gross income under

section 115 of the Internal Revenue Code, which provides that gross income does not include income

derived from the exercise of any essential government function and accruing to a state or any political

subdivision thereof.

Page 93 GAO/HEHS-95-131 State Tuition Prepayment Programs
Appendix III 

Federal Taxation a Major Issue Facing State

Tuition Prepayment Programs

the state, and (2) its funds did not come from the state or one of its

political subdivisions, were not available to state creditors, and could not

be used by the state for any purpose.53

Although some observers saw the ruling as unfavorable—because of the

requirement that MET pay taxes on its investment earnings—the ruling

satisfied Michigan’s statutory requirements, and the program began selling

prepaid tuition contracts in the fall of 1988. In compliance with the letter

ruling, MET paid $15.8 million in corporate taxes for its first 3 years of

operation. In 1991, however, lower investment returns made it more

difficult to stay ahead of tuition inflation while also paying the required

federal taxes. Therefore, MET suspended new contract sales and requested

a full tax refund. When IRS denied the refund request, MET and the state of

Michigan sued the United States, arguing that the program’s investment

earnings were exempt from federal taxes because it was an integral part of

the state or, if not on that basis, then for other reasons.54

MET lost the case in U.S. district court in July 1992 but won its appeal in the

Sixth Circuit Court of Appeals in November 1994. The Circuit Court

concluded that MET is an integral part, as well as a political subdivision, of

the state and therefore tax exempt; IRS was ordered to refund all corporate

taxes MET had paid over the years (now totaling more than $60 million),

with interest. IRS, concerned that the decision was too broadly reasoned

and could have significant administrative implications for its operations,

requested a rehearing of the case in the Circuit Court, but was denied.

Subsequently, the Solicitor General decided not to appeal the Circuit

Court’s decision to the U.S. Supreme Court.

Tax on Investment

Earnings a Major Concern

for Prepayment Programs

IRS’s ruling on MET, along with the subsequent district court decision,

heightened the concerns of officials in other states about whether and how

tuition prepayment programs would be taxed. For these programs to

survive and proliferate, one official said, it is critical that their investment

earnings not be subject to federal taxation. In response to this concern,

53The ruling also concluded that even if MET were a political subdivision of the state, it still would not

have qualified for an exemption under section 115 because its income mainly served the private

interests of particular individuals, rather than the public interest of the community in general. Priv. Ltr.

Rul. 88-25-027 (Mar. 29, 1988).

54Michigan and MET also argued that the program’s investment earnings were exempt from federal

taxation under (1) section 115 of the Internal Revenue Code, as discussed earlier; (2) sections

501(c)(3) and (c)(4) of the Code, pertaining to tax exempt organizations; (3) the doctrine of

intergovernmental tax immunity; (4) the tenth amendment of the U.S. Constitution, which reserves to

the states powers not prohibited to them nor delegated to the federal government; and (5) the

Guarantee Clause of the Constitution, which guarantees to every state a republican form of

government.

Page 94 GAO/HEHS-95-131 State Tuition Prepayment Programs
Appendix III 

Federal Taxation a Major Issue Facing State

Tuition Prepayment Programs

some states have delayed plans to implement tuition prepayment

programs; others decided against implementation, choosing instead to

issue college savings bonds as an alternative way to help families save for

college; and some states implemented their programs, although trying in

various ways to avoid some of the problems Michigan encountered.

Some States Defer Action

Because of Concerns About

Taxation

IRS’s decision to tax MET’s investment earnings was troubling news to

states interested in tuition prepayment programs. Paying such taxes makes

it more difficult to meet future liabilities without setting benefit prices

prohibitively high. After the MET ruling, several states that had been

interested in starting tuition prepayment programs backed away from the

idea, discouraged by the prospect of getting a similar ruling. Among these

states, according to various written accounts, were Maine, Missouri,

Oklahoma, Tennessee, and West Virginia. In Virginia, 1994 legislation

authorizing a tuition prepayment program stipulated that the program

cannot begin selling contracts until IRS rules that the program’s investment

earnings are exempt from federal taxation.

Indiana also indefinitely postponed implementation of a tuition

prepayment program, after receiving its own letter ruling from IRS in

September 1988. Although it was much less publicized, the ruling was

similar to Michigan’s, concluding that Indiana’s proposed program would

be subject to federal taxes on its investment earnings. Given the corporate

tax rate the program would have faced, earning investment returns

sufficient to cover future liabilities would have been difficult, according to

one Indiana official. “We didn’t feel that we could keep up with tuition

costs that are rising about 9 percent a year. We would have to earn a

return of around 13 percent before taxes to get 9 percent after taxes.”55

Officials Focus on Making

Programs Integral Part of State

In light of Michigan’s experience, other states that have started tuition

prepayment programs have tried to structure them more clearly as an

integral part of the state. Alabama and Pennsylvania, for example, tried to

make a stronger link between the program and the state by placing the

program within and under the direct control of the treasury department.

Alaska and Wyoming established their programs within the state’s higher

education system. Alaska’s program Director reasoned that since the

University of Alaska, which offers the program, is exempt from federal

taxes as an instrumentality of the state, this exemption should apply to the

tuition prepayment program.

55Cited in Jacqueline Mitchell, “Michigan Flunks Its Tuition Trust Fund,” Wall Street Journal (Mar. 26,

1992), p. C16.

Page 95 GAO/HEHS-95-131 State Tuition Prepayment Programs
Appendix III 

Federal Taxation a Major Issue Facing State

Tuition Prepayment Programs

Another step states can take to help protect their programs’ investment

earnings from federal taxation is to back the program with the full faith

and credit of the state. Thus far, IRS has emphasized this as a significant

factor toward gaining recognition as an integral part of the state, because

it clearly demonstrates the state’s financial stake in the program. However,

Florida’s program is the only one to operate with the full faith and credit

of the state from its inception. By statute, in the event of a shortfall the

legislature must appropriate to the program sufficient funds to enable it to

meet its obligations to qualified beneficiaries.

Some states have not backed their tuition prepayment programs with the

full faith and credit of the state, officials told us, because their state

constitutions prohibit them from extending such a financial guarantee.

That did not stop Ohio, however. In 1994, to better position the program as

an integral part of the state, the legislature put on the ballot a measure that

proposed amending the state constitution to back the tuition prepayment

program with the state’s full faith and credit. In the November election,

state citizens approved the measure overwhelmingly.

Ohio officials also saw other advantages in this strategy. First, it allowed

them to reduce the price of their benefits. Prior to approval of the ballot

measure, Ohio had charged a premium on its tuition credits, so that in case

IRS ruled that the program owed taxes on its investment earnings, it could

pay the taxes without endangering the fund’s actuarial soundness. The

premium added significantly to benefit prices, which made them less

appealing to purchasers and was also a factor in prompting the governor

to question the program’s value to purchasers, as described briefly in

chapter 2. Second, Ohio officials believe that having the program backed

by the state’s full faith and credit will appeal to purchasers, making its

guarantee seem more reliable.

Possible Shift From

Deferred to Annual Tax on

Participants Also a Major

Concern

Although a private letter ruling pertains only to the taxpayer who requests

it, program officials in other states have generally interpreted IRS’s ruling

on the tax consequences for MET purchasers and beneficiaries as

applicable to their programs, too. Thus, program materials alert

purchasers to the potential gift-tax liability, and each year program

officials notify all beneficiaries using their benefits of the increased value

of those benefits for federal income tax purposes. Although some program

officials would ultimately prefer that both of these taxes be eliminated,

they are generally not considered a hindrance to successful program

operation. For example, although purchasers have to file gift tax forms,

Page 96 GAO/HEHS-95-131 State Tuition Prepayment Programs
Appendix III 

Federal Taxation a Major Issue Facing State

Tuition Prepayment Programs

few will ever have to pay this tax, because a unified estate and gift tax

credit of $192,800 can be used to shield them from gift tax liability. In

addition, requiring students to pay taxes when they use their prepaid

benefits does not create a disincentive for people to join these programs,

two directors explained, because the potential tax burden on beneficiaries

is likely to be small, given that students typically have very modest

incomes and, therefore, are subject to low marginal tax rates.

Recently, however, program officials have become very concerned that IRS

may change its opinion on the federal tax liability of program participants.

IRS has indicated that regulations proposed by Treasury on contingent debt

could be interpreted as applying to the transaction involved in state tuition

prepayment programs; that is, the prepayment agreement would be

considered a debt instrument. This interpretation could result in the owner

of the benefits—either the purchaser or the beneficiary, depending on

specific program details—being liable for federal income taxes annually

on the imputed interest on his or her investment in the program. Thus, if a

participant spent $1,000 on prepaid tuition benefits and the applicable

interest rate was 5 percent that year, the participant could owe federal

income taxes on $50.

Taxing participants this way would have a serious negative impact on

program operations, according to several officials. First, they believe

purchasers would not understand or be receptive to paying taxes on

income they had not personally received, sometimes referred to as

“phantom income.” This tax requirement would make these programs

seem more complex and much less attractive to potential purchasers,

officials claim, which could decrease program sales significantly. Second,

they claim that having to notify participants of their potential tax liability

every year would impose an administrative burden on program operations.

Some program officials recently expressed these views in letters to IRS and

in testimony before IRS and Treasury officials on the proposed regulations.

Some Programs Awaiting

IRS Rulings

In addition to MET, other state tuition prepayment programs have also

sought IRS guidance on federal tax issues, but definitive answers to their

questions have been delayed by the MET case and other factors. Like MET,

four other programs we studied—those in Alaska, Florida, Ohio, and

Pennsylvania—also took the precaution of requesting a private letter

Page 97 GAO/HEHS-95-131 State Tuition Prepayment Programs
Appendix III 

Federal Taxation a Major Issue Facing State

Tuition Prepayment Programs

ruling from IRS to get clarification of the relevant federal tax issues.56 But

none of these four programs has received a ruling; Florida and Ohio have

been waiting 5 years.

IRS officials told us they did not expect to issue rulings on any other tuition

prepayment programs as long as the MET case was in litigation. But even

though the Solicitor General recently decided not to appeal the MET case to

the Supreme Court, rulings on other programs may not be immediately

forthcoming for a variety of reasons. For example, IRS may wait until

Treasury issues the final regulations on contingent debt, expected late this

summer, because, as described earlier, they could have implications for

how IRS would rule on the federal taxes applicable to program

participants. In addition, IRS could decide to audit a state tuition

prepayment program that it believes is liable for federal taxes on its

investment earnings. If ordered to pay these taxes, the program might then

challenge IRS in court, arguing—like MET did—that its investment earnings

are tax exempt because the program is an integral part of the state.57 While

litigation was ongoing, other ruling requests could remain unanswered.

In general, IRS officials explained, state tuition prepayment programs raise

issues of national significance with potentially far-reaching implications.

For example, if states can implement prepayment programs for higher

education expenses, perhaps they will try to start similar programs for the

advance payment of other goods and services. These considerations

require IRS to be very careful and circumspect in its analysis and ruling,

officials said, which takes time.

56Officials in Wyoming did not request rulings because they felt confident their program was designed

in a way that would make its investment earnings tax exempt. On the advice of legal counsel, Alabama

officials did not request an IRS ruling for similar reasons; however, the Director said they may decide

to do so in the future.

57IRS’s goal would be to have its position supported in a different Circuit Court of Appeals than the one

where the MET case was decided, because once there is conflict between circuits, the chances are

greater that the Supreme Court will become involved.

Page 98 GAO/HEHS-95-131 State Tuition Prepayment Programs
Appendix IV 

GAO Contacts and Staff Acknowledgments

GAO Contacts Wayne B. Upshaw, Assistant Director, (202) 512-7006

Timothy W. Silva, Evaluator-in-Charge, (202) 512-7041

Acknowledgments In addition to the individuals listed above, the following staff members

contributed significantly to this report: Tamara A. Lumpkin was

responsible for the analysis of income data and helped write the report,

Bob DeRoy and Paula J. Bonin did the computer programming, Regg

Hatcher helped analyze program participation levels, and Julian Klazkin

assisted with legal matters.

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