text:
John J. Lee
Principal Fiscal Analyst
for Higher Education
Michael A. Bohnhoff
Intern for Higher Education
Joint Legislative Budget Committee
State of Arizona
November, 1987
goini pegislatibe pubget & ornrniifee
D4TE: February 26, 1988
' ID: Senator Jack Taylor
ative John Wettaw
FRCM: Principal Fiscal Apalyst
SUBJm: ( 23HWENSIVE INKRvRTICN CN PREPAID ? UITION W S FCYi HIGHER
EDlKXTION BY CTHER STATES
Enclosed please find a copy of A Review of Prepaid Tuition Plans for Higher
Education. As of November of 1987, thirty- six state legislatures and Congress
were exploring some kind of prepaid tuition and savings plans for higher educa-tion,
and seven states already enacted such plans into law.
The Joint Legislative Budget Cmittee Staff felt that comprehensive information
should be available to our legislators as to what other states and Congress are
doing in this area of prepaid tuition and savings plans for the future genera-tions.
Hopefully, you and other legislators will find this report informative. The
information has been updated on the pages of 106 and 107.
JJL: lh
xc: Senator Jacque Steiner, Chairman of Senate Education Cornnittee
Representative Jim Green, Chairman of House Education Cornnittee
Ted Ferris, JLEC Staff Director
Mike Braun, Senate Staff Director
Louann Bierlein, Senate Education Analyst
Kim Baker, Senate Minority Financial Analyst
Rick Collins, House Chief of Staff , House Minority Staff Director
d'PetLe yGDounnn ztaonlne z, House Education Research Analyst
A prepaid tuition plan for higher education is a recent development to help
parents prepay for their children's future education. As costs of higher educa-tion
have increased at much faster rate than the general price level in the past
several years, parents, policy- makers and law- makers have very serious concerns
that higher education in the United States is being priced. out of the grasp of
most Plmericans and endangering the most precious Pmerican Dream - educational
opportunity. Rising education costs and cuts in federal student aid have made
pay- as- you- go college almost impossible for rnost students. In response to this
dilemna, thirty- six state legislatures and Congress have been exploring prepaid
tuition and savings plans in an effort to ensure that students are provided with
educational opportunities beyond the secondary education.
Congress and state legislatures around the country are aware that higher educa-tion
is facing its long- term crisis due to many factors including the following:
( 1) Tuition has risen faster than inflation for the seventh consecutive
year since 1980.
( 2) Students have accumulated massive debt: About half of all students in
the United States now graduate in debt.
( 3) In constant dollars, federal aid to students has been cut signifi-cant
To challenge the higher education cost crisis, Congress has proposed various
federal savings plans for higher education:
( 1) The Senate has introduced six bills to establish federal~ trust and
individual education accounts.
( 2) The House of Representatives has introduced three bills for federal
trust and individual education accounts.
Seven states have enacted some form of prepaid tuition or savings plans into
law. In December of 1986, Michigan became the first state to create a tuition
guarantee program known as the Michigan Education Trust ( LET). These plans are
shown in a chronological order:
( 1) Michigan Trust
( 2) Wyoming Trust
( 3) Tennessee Trust
( 4) Indiana Trust
( 5 ) hine Trust
( 6) Florida Trust
( 7 ) North Carolina's Education Savings Bonds
In addition, Illinois and Massachusetts are in the final planning stages of
enactment process for similar plans. They are known as:
( 1) Illinois Education Accounts ( vetoed) and Illinois Education Bonds
( 2) hssachusetts Education Bonds and Massachusetts Certificates
The state prepaid tuition plans have four different types:
( 1) The prepaid tuition contract plans allow parents to pay a specific and
predetermined amount to a state trust fund early in their child's life
in exchange for the trust's guarantee to later pay for that child's
tuition at a state university. Contract price is based upon projec-tions
of tuition inflation and return on investment.
( 2) The education savings accounts plan, in contrast to the prepaid tuition
contract plan, would not require the active involvement of the state.
As an incentive for parents to save, funds deposited in special educa-tion
accounts at private financial institutions would be deductible for
state income tax purposes.
( 3) The tuition savings bonds plan allows the state to sell general obliga-tion
bonds as education savings bonds. Interest earnings are deferred
until redemption. The bonds may pay a bonus rate of interest of up to
one percent if used to pay for educational costs.
( 4) The prepaid tuition certificate plan guarantees to pay for the benef i-ciary's
future tuition by a state trust which offers the certificates
in small denminations in exchange for a specified amount. Certificate
price is based upon current tuition prices.
The federal plans have certain features that are similar to some states' plans.
The payments toward the plans may be deductible from the federal taxable income,
and interest earnings would not be subject to federal income taxes.
The prepaid tuition and savings plans are an alternative approach to lessen
parent's as well as future students' burden on educational costs. These plans
merit serious and careful consideration by the State of Arizona. Thus, it is
reccmnended that a study comnission consisting of state legislators, Governor,
university officials, and interested private citizens with experience in educa-tion
and finance be created to engage in an in- depth feasibility study of the
various plans. If any of the Congressional proposals is enacted into law, such
a federal plan can become an alternative to a state plan.
John J. Lee
Principal Fiscal Analyst
for Higher Education
Michael A. Bohnhoff
Intern for Higher Education
Joint Legislative Budget Committee
State of Arizona
November, 1987
This report was prepared by John J. Lee, . Principal Fiscal Analyst, and
Michael Bohnhoff, Higher Education Intern, of the Joint Legislative Budget
Cunnittee Staff. ' Michael Bohnhoff spent numerous hours contacting various state
and federal officials to collect and verify pertinent information.
We acknowledge our appreciation to those officials and officers at National
Conference of State Legislatures, Education Ccmnission of the States, and many
other state agencies and educational associations. 9e particularly thank Sharon
Hart and Aims Wiriness of the Education Ccmnission of the States, Lynne
Schaefer of the Michigan Education Trust, Ross Hodel of the Illinois Board of
Higher Education, Michael Noetzel of the iLhssachusetts Board of Regents of
Higher Education, and Bruce Hooper of the University of Wyoming for their utmost
cooperation and timely transmittal of information.
Without the support and guidance of Theodore A. Ferris, Staff Director of the
Joint Legislative Budget Cornnittee, this report would not exist. His foresight
and advice are most appreciated.
Finally, this report is a product of : vlichael Bohnhoff's diligent effort and pro-fessional
achievement during the months of August, September, and October of
A . Michigan's MET Plan .............................. 8
B . Wyoming's APHEC Program ........................ 16 C . Tennessee's BEST Plan ........................... 22
. D . Indiana's BEST Plan ............................. 24 E . Maine's SEED Plan ............................... 29
F . Florida's Prepaid Postsecondary Education Expense Plan ......................... 3 3
A . lllinoisl Individual Education
Accounts Bill .................................. 40
B . Illinois' Tax Exempt Savings
Bond Plan ...................................... 42
C . Massachusettst College Savings
Bond Plan ...................................... 4 7
D . North Carolina's Savings
Bond Plan ...................................... 48
E . Massachusetts' Tuition
Certificate Plan ............................... 50
A . The Parental Assistance For
Tuition Investment Act ......................... 59
B . The National Education
Savings Trust Act .............................. 63
C . Dole's Education Savings
Accounts Acts .................................. 6 5
D . The DeConcini- Lipinski
Education Savings Act .......................... 67
E . The Education Savings Bonds Act ................. 68
I? . Presidential Campaign Proposals ................. 69
A . Desirability For The State ...................... 72 B . Desirability For The Individual ................. 84
A prepaid tuition plan for higher education is a recent development to help
parents prepay for their children's future education. As costs of higher educa-tion
have increased at much faster rate than the general price level in the past
several years, parents, policy- makers and law- makers have very serious concerns
that higher education in the United States is being priced out of the grasp of
most Pmericans and endangering the most precious hrican Dream - educational
opportunity. Rising education costs and cuts in federal student aid have made
pay- as- you- go college almost impossible for most students. In response to this
dilemna, thirty- six state legislatures and Congress have been exploring prepaid
tuition and savings plans in an effort to ensure that students are provided with
educational opportunities beyond the secondary education.
Congress and state legislatures around the country are aware that higher educa-tion
is facing its long- term crisis due to many factors including the following:
( 1) Tuition has risen faster than inflation for the seventh consecutive
year since 1980.
( 2) Students have accumulated massive debt: About half of all students in
the United States now graduate in debt.
( 3) In constant dollars, federal aid to students has been cut signifi-cantly.
To challenge the higher education cost crisis, Congress has proposed various
federal savings plans for higher education:
( 1) The Senate has introduced six bills to establish federal trust and
individual education accounts.
( 2) The House of Representatives has introduced three bills for federal
trust and individual education accounts.
Seven states have enacted sane form of prepaid tuition or savings plans into
law. In December of 1986, Michigan became the first state to create a tuition
guarantee program known as the Michigan Education Trust ( IWT). These plans are
shown in a chronological order:
( 1) Michigan Trust
( 2) Wyoming Trust
( 3) Tennessee Trust
( 4) Indiana Trust
( 5 ) bhine Trust
( 6) Florida Trust
( 7) North Carolina's Education Savings Bonds
In addition, Illinois and Massachusetts are in the final planning stages of
enactment process for similar plans. They are known as:
( 1) Illinois Education Accounts ( vetoed) and Illinois Education Bonds
( 2) ~ ssachusetts Education Bonds and Massachusetts Certificates
The state prepaid tuition plans have four different' types:
( 1) The prepaid tuition contract plans allow parents to pay a specific and
predetermined amount to a state trust fund early in their child's life
in exchange for the trust's guarantee to later pay for that child's
tuition at a state university. Contract price is based upon projec-tions
of tuition inflation and return on investment.
( 2) The education savings accounts plan, in contrast to the prepaid tuition
contract plan, would not require the active involvement of the state.
As an incentive for parents to save, funds deposited in special educa-tion
accounts at private financial institutions would be deductible for
state income tax purposes.
( 3) The tuition savings bonds plan allows the state to sell general obliga-tion
bonds as education savings bonds. Interest earnings are deferred
until redemption. The bonds may pay a bonus rate of interest of up to
one percent if used to pay for educational costs.
( 4) The prepaid tuition certificate plan guarantees to pay for the benefi-ciary's
future tuition by a state trust which offers the certificates
in small denminations in exchange for a specified amount. Certificate
price is based upon current tuition prices.
The federal plans have certain features that are similar to some states' plans.
The payments toward the plans may be deductible from the federal taxable incane,
and interest earnings would not be subject to federal income taxes.
The prepaid tuition and savings plans are an alternative approach to lessen
parent's as well as future students' burden on educational costs. These plans
merit serious and careful consideration by the State of Arizona. Thus, it is
recmnded that a study commission consisting of state legislators, Governor,
university officials, and interested private citizens with experience in educa-tion
and finance be created to engage in an in- depth feasibility study of the
various plans. If any of the Congressional proposals is enacted into law, such
a federal plan can become an alternative to a state plan.
A recent report shows that the annual tuition charges for
1987- 88 increased six percent at four- year public colleges and
universities and eight percent at four- year private colleges and
universities. This marks the seventh consecutive year that the
rate of tuition inflation has exceeded the Consumer Price Index
( CPI) figures for inflation. As a result of this trend, many
parents are increasingly concerned with how they will be able to
pay for their children's college education. In response to
these concerns, many states have either enacted or are con-sidering
a prepaid tuition plan.
Prepaid tuition plans are intended to protect parents of
future college students from tuition inflation by allowing them
to pay for their children's education years in advance. Although
such plans have existed at a few private universities since 1985,
Michigan became the first state to suggest a tuition trust pro-gram
for its public universities. The state of Wyoming, which
developed a similar plan that includes room and board, surpassed
Michigan and became the first state to actually offer parents an
opportunity to prepay their children's higher education costs.
The states of Tennessee, Indiana, Maine, and Florida
followed Michigan and Wyoming's lead and enacted prepaid tuition
plans. The legislatures of West Virginia and California passed
similar bills. The Governor's of those two states, however,
vetoed the plans due to concerns over their practicality.
These concerns have encouraged other states to investigate
alternative plans. Such alternatives have been approved by the
( legislatures of North Carolina and Illinois. A Massachusetts
study commission has also recommended two alternatives to the
legislature which will be considered in the upcoming session. ii
recent study by the Education Commission of the States shows that
in addition to the states mentioned above, twenty- five states
considered a prepaid tuition plan or an alternative in the last
legislative session. ( See Exhibit A at the end of this sec- 3 tion.,
The Michigan- type trust plans are based on the assumption
that the state can earn a rate of return on investment that is
greater than both the rate of return an individual can earn and
the rate of tuition inflation. Parents, or other interested
parties, such as grandparents, can pay a specified amount on
behalf of a beneficiary several years before he/ she will start
college. In exchange for the payment, a newly created state
trust fund guarantees to pay the beneficiary's tuition at a state
college or university. Payments are pooled by the trust and
invested. The prepaid amount and interest earnings are then used
to pay the beneficiary's tuition when he/ she is college age.
Proponents of the plans believe the prepaid price can ac-tually
be lower than current tuition prices. They contend that,
through the investment expertise of trust officials, the pooled
investments can earn a rate of return higher than tuition in-flation.
Through the compounding of interest on investment, the
gap between tuition costs and the accumulated investment value
would widen as time passes'. With careful financial planning, the
trust can offer discounts, knowing that the amount actually re-ceived,
when invested, will grow faster than tuition costs. When
the beneficiary is ready to attend college, the investment plus
interest earnings will match the tuition costs. 3
There are, however, a number of questions concerning the
advisability of such programs. Concerns over the tax status,
financial soundness, and effect on financial aid and tuition are
often raised. Before a state rushes into a prepaid tuition plan,
careful analysis is necessary.
This paper attempts to provide preliminary analysis of pre-paid
tuition plans and alternative education savings plans. either
enacted or seriously considered in various states. Each prepaid
tuition plan enacted into law is first examined and outlined.
Secondly, variations recently proposed in some states are also
examined. The third section reviews similar plans proposed on
the federal level. Finally, the various plans are analyzed, with
attention given to concerns of both the state and the potential
1 Prepaid tuition plan enacted. ( 6)
I Prepaid tuition plan vetoed by governor. ( 2)
. . Prepaid tuition plan introduced into state legislature, but failed to win
approval. ( 26)
State educational savings bonds enacted or expected to soon be enacted ( 2)
( Source: Education Commission of the States study)
If imitation is the sincerest form of flattery, Michigan
officials should be very pleased. Shortly after the introduction
of the prepaid tuition plan in Michigan, the legislatures of 35
other states were considering similar plans. Five of these
states enacted a plan into law.
The following section examines the Michigan plan and similar
plans enacted in Wyoming, Tennessee, Indiana, Maine, and Florida.
Although the plans of the other states closely resemble the
Michigan plan, there are a number of significant differences
between the two plans. Differences exist in how the trusts will
be administered, what education expenses will be covered by the
plan, and what role community colleges and private universities
will play in the plan.
As stated above, Michigan was the first state to introduce a
prepaid tuition program. The Baccalaureate Education Student
Trust ( BEST) was proposed by Michigan Governor Blanchard in early
1986 and was based upon similar plans used by a few private
institutions. After a number of changes, the state legislature
approved the plan under the new name of Michigan Education Trust
( MET), which was signed into law on December 23, 1986 and became
effective immediately. As required by the legislation, the MET
plan must undergo in- depth actuarial analysis and receive a
favorable ruling from the IRS, stating that the plan is free from
taxation, before the actual contracts can be offered. *
The tax status of the prepaid tuition contracts, however, is
questionable. There is a strong possibility that the IRS will
consider the difference between the cost of the tuition paid by
MET and the original payment to be investment earnings subject to
taxation. Many legislators believed such an unfavorable ruling
would discourage participation, making MET financially unsound.
Should the IRS ruling be unfavorable, MET staff would be required
to submit a report to the legislature with suggestions on modifi-cation
of the program. 5
Under the legislation, the trust fund will be administered
by a board consisting of the state treasurer and eight other
qualified individuals appointed by the governor and confirmed by
the senate. - Of the eight, only two may be state employees. In
addition, the law requires the governor to appoint one member
from a list of nominees submitted by the speaker of the. house and
one from a list submitted by the senate majority leader. Of the
remaining seats, three are to be filled by a pubiic college or
university president, a community or junior college president,
and a representative from a private Michigan university. Six of
the eight members are to serve three year terms, while the re-maining
two, who will hold the position of president/ chief exec-utive
officer and vice president of the trust, will serve at the
pleasure of the governor. 6
MET, which is located in the Michigan Department of the
Treasury, has been granted broad authority and a great deal of
independence. The enacting legislation gives MET the authority
to hire staff, establish rules for participation, enter into
necessary contracts, limit the number of participants, and engage
in a wide variety of other administrative activities necessary to
operate the trust. In addition, the board is directed to hire a
' lnationally recognizedu actuary to annually evaluate the finan-cial
soundness of the trust. The law also gives the board the
authority to invest the trust's funds in " any instruments, obli-gations,
securities, or property determined proper. 11'
Assuming the plan receives a favorable ruling from the IRS,
MET will begin offering prepaid tuition contracts to parents of
children ranging from newborn to college age. The contracts, for
a specified amount, will guarantee payment of tuition and fees up
to an amount equal to the cost of the necessary credit hours for
an undergraduate degree at any of the state four- year colleges
and universities. Contracts for credit hours in amounts less 1 than a full four years will also be available. MET officials,
I however, have not decided whether the minimum contract will be
for a semester, year, or two years worth of credit hours. The
1 legislation adds that the existence of a prepaid contract in no
way affects the prospective student's chances for admittance to
( any of the institutions. 8
The actual prepaid price will be determined by the results
of the actuarial analysis currently being completed. The major
factors influencing the price schedule will be the beneficiary's
1 age when the contract is made, the choices of certain options in
the plan, assumptions made by MET concerning the rate of return
on investment and the rate of tuition inflation, and projections
of operating costs. 9
Since more money can be made by the trust if it has a longer I time to invest funds, MET will establish a price scale based upon
the number of years between when the contract is made and when
the beneficiary will reach college age. The younger the child,
8 the lower the purchase price. 10
The Michigan plan also has a number of options which affect
the purchase price of the contracts. The first option concerns
1 refunds in the event the contract is canceled. MET will give
refunds on prepaid tuition contract if the beneficiary dies, is
not admitted to a state university, or, after reaching age 18,
a notifies the trust that he/ she will not attend a state university
or college. Refunds may also be given by MET under other cir-
cumstances approved by the board and specified in the contract.
The size of the refund, however, depends upon whether the buyer
selects Plan A or Plan B at the time of purchase. 11
The terms of Plan A and Plan B differ only in the cost and
the refund amount. Under the less expensive Plan A, the trust
guarantees to pay the beneficiary's tuition at a state university
for the number of credit hours specified in the contract, up to
the number of credit hours required for a baccalaureate degree.
The purchaser, upon cancellation of the contract, would be en-titled
to only the original payment, less a service charge. Any
investment earnings would be retained by the trust. 12
Plan B offers the same tuition guarantee. If, however, the
contract is canceled, the purchaser would receive his/ her origi-nal
payment and at least some of the interest earned. The spe-cific
rate of return is still to be determined by MET, but the
total refund will not exceed the average cost of tuition, regard-less
of the interest yield. Once again, a service charge would
be deducted. l3
The second major option concerns the extent of the tuition
guarantee. Due to the discrepancy in tuition prices between the
more expensive and the less expensive Michigan public univer-sities,
two differently priced plans will be available. Parents
may select an option which will guarantee the . full cost of
tuition at any public universities in Michigan, regardless of the
tuition costs. 14
For a lower price, parents would be able to choose a plan
which will guarantee to pay full tuition only at universities
that do not charge more than 105 percent of the average tuition I. at all Michigan universities. Beneficiaries covered by this
option who attend universities in excess of 105 percent of the
average would be required to pay the difference between the cost
of tuition and what the contract will pay. Although it has not
yet been determined what the contract will pay in this situation,
it will be between the average cost of tuition at all Michigan
universities and 105 percent of this average. 15
Currently, the University of Michigan, Michigan State, ' and
Wayne State University are the only institutions with tuition in
excess of 105 percent of the average of all state universities.
Parents who anticipate their child may attend one of these insti-tutions
could pay the additional price for a full guarantee.
This option is available under both Plan A and Plan B, discussed
above. 16
A third option concerns the method of payment. Participants
will be given the choice of buying the contract for a lump sum at
the time the agreement is made, or spreading payments out over
time periods, such as yearly, monthly, or payroll deduction pay-ments.
The multi- payment plans will be more expensive. The
payment amounts, however, will be established at the time the
contract is purchased and cannot be adjusted by the trust. .17
Beneficiaries not wishing to attend a Michigan state univer-sity
have a number of options in addition to the refunds dis-cussed
above. Students may choose to attend a 2- year community
college. MET would pay for the benef iciary' s tuition at a com-munity
college . up to an amount equal to the dollar value of the
contract, had it been used at a state university. Any surplus
could be used by the beneficiary to finish their education at a
state university. 18
Those beneficiaries not wishing to continue their education
after completing a two- year degree would be entitled to a refund.
The refunded amount would be determined by subtracting the amount
paid to the community college from the amount that would have
been due if a full refund had been chosen. The refund amount,
therefore, would depend upon whether the purchaser chose Plan A
or Plan B. If the beneficiary is covered under plan A, which
does not include interest earnings upon cancellation, there'would
be little or no refund.''
Beneficiaries may also apply the MET agreement to cover part
of the tuition at Michigan private institutions. If the bene-ficiary
decides to attend a private higher education institution
in Michigan, MET, on the student's behalf, will pay that insti-tution
an amount equal to the average cost of tuition at Michigan
state universities. No provisions exist, however, for bene-ficiaries
who wish to attend out- of- state universities. Bene-ficiaries
seeking an out- of- state education would only be en-titled
to a refund under the terms of their contract. 20
In addition to the age of the beneficiary and the specific
plan options chosen, assumptions about the rate of return on
investment and the rate of tuition inflation will also influence
the - purchase price. MET officials hypothesize that the rate of
return on investment will be higher than the rate of tuition
inflation, allowing participahts to purchase prepaid tuition
contracts at a price lower than present tuition. Actuarial pro-jections
of the rate of tuition inflation and return on invest-ment
will determine how much of a discount will be offered.%'
Operating costs for MET will also influence the contract
price. After its initial start up period, MET, under law, is to
be totally self- supporting. MET officials must, therefore, ad-just
the contract prices to cover administrative costs. 22
MET officials, in order to maintain the actuarial soundness
of the program, may annually adjust the cost to new participants.
If previous estimates proved to be too optimistic, MET would
recover the loss by upwardly adjusting the price for new ent-rants.
If previous estimates proved to be too conservative, the
surplus would be dispersed by lowering the price for new partici-pants.
Another important aspect of prepaid tuition plans concerns
the transferability of the contract and substitution of bene-ficiaries.
The law allows MET to establish rules limiting the
purchaser's ability to transfer prepaid tuition contracts to
other purchasers and the substitution of one beneficiary for
J another. Although the rules have not yet been established, MET
officials intend to prevent the contracts from being bought and
sold like a security. 2.4
The substitution of one beneficiary for another will most
likely be limited to family members. A parent, for instance,
will be allowed to substitute another child for the one
originally named in the contract. Transfers from one purchaser
to another to be used on behalf of different beneficiary will
most likely be limited to transfers not involving compensation.
A purchaser, for instance, who bought a prepaid contract on be-half
of a beneficiary who does not attend college may donate the
contract to a charitable organization, which will use it for a
needy child's college education. 25
A final note on the Michigan Education Trust concerns the
effect of the legislation on the state income tax code. As with
all states that have enacted a prepaid tuition plan and also have
a state income tax, the interest earnings are exempt from state
income taxation. The Michigan law, however, will also allow
participants to deduct their payments to the trust from their
taxable income for state income tax purposes. This provision, of
course, will not affect the individuals federal income tax. 26
The states which followed Michigan's lead and enacted their own
prepaid tuition plans chose not to include this provision in
their legislation.
The Governor of Wyoming signed legislation on February 19,
1987 creating the Advance Payment of Higher Education Costs
( APHEC) program. In addition to tuition, the Wyoming plan also
guarantees room and board for a prepaid amount. Wyoming, unlike
Michigan, chose not to wait for a favorable ruling from the IRS
and has begun offering prepaid tuition contracts to parents of
potential college students. The prepaid tuition contracts in-clude
a stipulation that, should the IRS rule interest earned
from the contract is taxable, the individual participants must
meet the obligation from their own funds, separate from the
trust. 27 The enabling legislation was effective May 27, 1987 ,
with the first contracts offered in mid- July of 1987.
In essence, the Wyoming plan is a simplified version of the
Michigan plan. Instead of creating a new agency to administer
the program, as in Michigan, the legislation directs the Univer-sity
of Wyoming to administer the program. The deputy treasurer
of the University of Wyoming is directed to serve as program
administrator. Rules and regulations concerning the payments
from purchasers, accounting to purchasers, payments to institu-tions,
termination of contracts, and other rules necessary for
administration are to be made jointly by the program administra-tor,
the state treasurer, and the executive director of community
colleges. These three individuals constitute the governing
board. Proposed rules must also be approved by a majority vote
of both the University of Wyoming Board of Trustees and the
Wyoming Community College Commission. 28
The program administrator is directed to deposit the' prepaid
education funds into an account within the University of
Wyoming's permanent endowment fund and invest it in the same
manner as other endowment fund accounts. The governing board is
instructed to review the status of the investments every three
months and report the financial condition of the trust fund to
the legislature every year. In addition, the administrator is
instructed to hold operating costs to no more than two percent of
the investment earnings of the account. 29
The Wyoming prepaid price, like the Michigan plan, is deter-mined
by the number of years between when the contract is made
and when the benefiqiary will attend college, choices of certain
options in the plan, assumptions about the inflation of educa-tional
costs and rate of return on investment, and anticipated
administrative costs. 30
Once again, the time when the contract is made and when the
beneficiary will begin college is crucial to the price of the
contract. The Wyoming plan, however, deals with the issue in a
different manner than the Michigan plan. The Wyoming plan re-quires
purchasers to enter into the contract at least ten years
before the beneficiary is college age. In addition, the trust
officials set a price for beneficiaries between birth and age one
and add an additional charge for older beneficiaries. For every
year that the beneficiary is older than one, the original cost is
increased by a compound interest rate of 10 percent. 31
For example, if a resident beneficiary is currently eight
years old, the purchaser would have to pay $ 9,966 to guarantee
four years of room, board, and tuition at the University of
Wyoming. This is determined by multiplying the current prepay-ment
price for a one- year- old beneficiary of $ 5,114 by ten per-cent
compounded interest for seven years, since the beneficiary
is seven years older than age one.
The Wyoming plan also requires participants to choose one of
four different options concerning residency and institutional
choice. Unlike the Michigan plan, the Wyoming plan allows non-residents
to participate in the program. In addition, purchasers
must choose between the University of Wyoming or the Wyoming
community college system. 32
The purchasers must, therefore, select a contract to cover
educational costs at Wyoming community colleges at resident
tuition rates, Wyoming community colleges at non- resident rates,
the University of Wyoming at resident rates, or the University of
Wyoming at non- resident rates. Since the community colleges have
lower tuition rates and grant only two- year degrees, the cost of
their contracts will be cheaper than the University contracts.
Due to the lower tuition costs for residents, the contract for
residents will be cheaper than the contract for non- residents in
the community college system. Contracts for the University of
Wyoming will, of course, also be cheaper for residents. 33
Purchasers also have options concerning how many semesters
they wish to prepay. The Wyoming plan allows purchasers to pre-
pay room, board, and tuition in semester units. Purchasers who
select the community college system may prepay for one to four
semesters. Those choosing the University contracts may purchase
one to eight semesters. 34
As for assumptions about tuition inflation, Wyoming of-ficials
predict that tuition, room, and board for four years at
the University of Wyoming will increase from the current $ 13,760
for residents to $ 24,272 in the year 2003. Costs for non- resi-dents
are expected to rise from a current $ 20,416 to $ 41,791 for
the year 2003. The predictions were based on curvilinear analy-sis
of tuition, room, and board costs for the last twenty- one
years. It should be noted that increases in costs at the Univer-sity
of Wyoming for this period were well below the national
average. 35
Predictions for return on investment were based on past
performance of the University of Wyoming endowment fund and cur-rent
and projected economic conditions. The trust estimates that
it. can earn at least 8.25 percent return, which, according to
projections, would be sufficient to maintain the financial sta-bility
of the trust under current prepaid contract prices. 36
As stated above, Wyoming is the only state to actually set a
price and offer contracts. The prepaid price for the University
of Wyoming is $ 5,114 for residents and $ 8,806 for non- residents,
which will purchase tuition, room, and board starting in the year
2003. The cost of these items in the year 2003 has been esti-mated
at $ 20,416 for residents and $ 41,791 for non- residents.
The cost for prepaid tuition at Wyoming community colleges has
been set at $ 2,414 for residents and $ 3,579 for non- residents. 37
The program administrator may adjust these prices for new par-ticipants
every year in order to maintain the financial soundness
of the trust fund. 38
The Wyoming plan also allows purchasers to cancel the pre-paid
tuition contract if the beneficiary dies, applies but is not
admitted to the university or community college, or, after
reaching age 18, informs the trust that he/ she will not attend
either the University of Wyoming or a Wyoming community college.
The purchaser is entitled to the return of the original contract
price plus four percent annually compounded interest. 39
In addition to the refund, . the plan also has some options
for beneficiaries under a community college contract who wish to
attend the University of Wyoming and those covered by a Univer-sity
of Wyoming contract who wish to attend a community college.
Beneficiaries under a community college contract may have the
value of their contract applied toward the costs of tuition,
room, and board at the University of Wyoming. If, for instance,
a beneficiary who is covered by a community college contract for
the maximum of four semester chooses to attend the University of
Wyoming, the dollar value for four semesters in the community
college system is applied toward costs at the University of
Wyoming. 40
If a beneficiary covered by a University of Wyoming contract
chooses to attend a community college, the contract value is
applied toward costs at the community college. If, however, the
value exceeds the costs at the community college, the beneficiary
is not entitled to a refund. Any surplus is retained by the
trust fund. 41
Tennessee became the third state to enact some type of pre-
E paid tuition program. The bill, which created the Baccalaureate
Education System Trust ( BEST), was signed by the governor on May 1 4, 1987 and became effective immediately. Contracts, however,
I will be offered by the trust no earlier than July 1, 1988. Like
the Michigan plan, the legislation also requires the trust to
( obtain a ruling from the IRS on the tax liability of the interest
earnings. The ruling, however, does not have to be favorable in
( order for BEST to continue. The law only requires BEST officials
inform the participants of whether or not the interest earnings
are subject to federal income taxation. 42
I The legislation directs six state officials to serve as the
board of trustees for the newly created trust. The state com-missioner
of finance is to serve as chairman. The other of-
! ficials selected to the board are the state treasurer, comp-troller
of the treasury, secretary of state, chancellor of the
state board of regents, and the president of the University of
Tennessee. 43
8 The treasurer is instructed to invest the funds of the trust
in accordance with the investment policy established by the board
I of trustees. The policy, however, is governed by the same laws,
guidelines, and restraints that govern the state retirement sys- 8 tem. 44
I The administrative powers granted to the Tennessee BEST
I governing board are much more extensive than those granted to the
Michigan or Wyoming governing bodies. In addition to the ability
to hire staff, limit participation, and establish rules for
participation, the legislation allows the board to set all of the
specific details of the plan. 45
Unlike the Michigan and Wyoming laws, Tennessee's enacting
legislation does not set refund policy and does not determine
what role, if any, community colleges and private universities
will play in the plan. These and all other details concerning
the actual prepaid contracts are left to the discretion of the
board. 46 The board has not yet met to resolve these issues. 47
Indiana, on May 6, 1987, became the fourth state to enact a
prepaid tuition program. The legislation, which became effective
on July 1, 1987, created the Baccalaureate Education System Trust
( BEST). Like the Michigan and Tennessee plans, Indiana's plan
must receive a ruling from the IRS on the tax liability of the
interest earnings before offering contracts to the public. As
with Tennessee's plan, the ruling does not have to be favorable
in order for BEST to continue. The legislation only requires
BEST officials to obtain the ruling and inform the participants
of whether or not interest earnings are subject to federal income
taxation. 48
Indiana's BEST program is a division of the Indiana State
Board of Finance and is supervised by a seven member board of
directors. The state treasurer is to serve as one member, with
the governor appointing the other six members to two year terms.
At least one member must be a representative of a private Indiana
college or university, and no more than two members can be state
employees. In addition, no more than three of the appointed ,
board members may be members of the same political party. 49
The legislation gives the board the authority to establish
rules for participation in the program, hire staff, limit the
number of participants in the program, enter into contractual
agreements, and engage in a wide rage of other administrative
duties. The legislation also directs the board to annually
evaluate or hire an outside firm to annually evaluate the
actuarial soundness of the trust fund, the results of which are
to be reported to the governor and the legislature. 50
Although the board has been granted broad administrative
powers, its freedom to make investment decisions is limited. The
legislation, unlike the Michigan, Wyoming, and Tennessee acts,
sets specific limits on the board's author. ity to invest the funds
of the trust. The board may make long- term investments in U. S.
government securities, securities issued by federal agencies, and
corporate bonds, notes, and debentures. Limits, however, are
placed on the amount of federal agency securities and corporate
investments the trust may hold. 51
No more than 50 percent of the total assets managed by the
trust may be held in federal agency securities guaranteed by the
United States government. No more than 25 percent may be held in
federal agency securities not fully guaranteed by the federal
government, such as securities issued by Federal Land Banks,
Federal Home Loan Banks, and Federal Farm Credit Banks. 52
Corporate investments can amount to no more than seven per-cent
of the total assets held by the trust. In addition, the law
instructs the board to give preference to investments in cor-porations
based in or doing business in Indiana whenever the
quality and yield of such investments are " equal to or better
thantfi nvestments in out- of- state corporations. 53
Short term investments, which can amount to no more than 50
percent of the total assets held by the trust, can be invested in
U. S. Treasury obligations, repurchase agreements secured by the
U. S. Treasury obligations, Prime- 1 commercial paper, and certifi-cates
of deposit. 54
As with Michigan's MET plan, officials of Indiana's BEST
program are waiting for the results of a detailed actuarial anal-ysis
before actually establishing a price schedule for par-ticipants.
Once again, price will be determined by age of the
beneficiary at the time of enrollment in the program, the options
chosen by the purchaser, assumptions about the rate of tuition
inflation and return on investment, and anticipated adminis-trative
Under Indiana BEST, purchasers must choose one of three
plans. The plans, Plan A, Plan B, and Plan C, differ in the
institutions covered and the policy toward refunds upon cancel-lation.
Plan A, in exchange for a lump sum payment or periodic
payments, guarantees to pay tuition at any state college or uni-versity
for the lesser of either the average number of semester
credit hours required for a baccalaureate degree or the number of
credit hours required for a degree in the specific field pursued
by the beneficiary. If the prepaid contract is canceled, the
purchaser is entitled to a refund of the purchase price, less a
service charge. All investment earnings, however, will be re-tained
by the trust. 55
Beneficiaries covered by Plan B would receive the same
guarantee of tuition payments as those covered by Plan A. Upon
cancellati. on of the contract, however, the purchaser would be
entitled to a refund of the purchase price, less a service
charge, and at least some of the interest income earned by the
investment. The specific rate of return is yet to be determined
by the board. 56
Plan C applies to Indiana community colleges. The trust, in
exchange for a lump payment or periodic payments, guarantees to
pay the beneficiary's tuition at any Indiana community college in
an amount equal to the cost of the number of credit hours re-quired
by the institution for completion of a two year degree.
Upon cancellation of the contract, the purchaser is entitled to a
refund of only the purchase price, less a specified adminis-trative
service charge. As in Plan A, any investment earnings
would be retained by the trust. 57
Plan B, because it covers the tuition for four years at a
state university and gives larger refunds upon cancellation, will
be the most expensive of the three plans. Plan C will be the
least expensive since it only applies to the two year community
colleges and refunds only the purchase price. Under each plan,
refunds will be given if the beneficiary dies, is refused admit-tance
after making proper application, or, after turning 18,
informs the trust that he/ she will not attend an institution of
higher education. The legislation also allows the board to es-tablish
additional circumstances under which refunds may be
granted. 58 .
A number of issues are not addressed by the Indiana legis-lation.
The legislation permits the board to set policies con-cerning
beneficiaries covered by a community college contract who
wish to attend a state university, beneficiaries covered by a
state university contract who wish to attend a community college,
and beneficiaries covered by either a community college plan or
state university plan who wish to attend a private university.
The board will also have the authority to set policies for trans-fer
of the prepaid contract from one purchaser to another and the
substitution of one beneficiary for another. 59
The Governor of Maine signed legislation on June 30, 1987
which created the Student Educational Enhancement Deposit ( SEED)
program. The legislation, which was modeled after the Michigan
law, became effective immediately. As with all previous plans,
excluding Wyoming's program, the Maine legislation requires the
newly created trust to obtain a ruling on the tax issues of the
plan before entering into prepaid tuition contracts. The law,
however, follows the Tennessee and Indiana approach, requiring
the trust only inform participants as to whether or not the in-terest
earnings are subject to federal income taxation. 60
The legislation creates a board of directors to administer
the SEED program, consisting of the state treasurer and six indi-viduals
appointed by the governor, with skills and experience in
either the academic, business, or financial field. Of the six
appointees, no more than two can be current state employees. In
addition, four of the six appointees will serve three year terms.
The other two shall serve at the pleasure of the governor. One
of the six will be designated by the governor to serve as the
chairman. 61
The trust is located in the state treasury, but is directed
to function as an independent agency, and has been granted broad
authority to administer the trust. The enacting legislation
gives the board the authority to hire staff, establish rules for
participation, enter into necessary contracts, limit the number
of participants, and engage in a wide range of other adminis-
trative activities. The board is also instructed to annually
evaluate or hire a private firm to evaluate the actuarial sound-ness
of the trust and to report the results to the governor and
the legislature. These actuarial evaluations are also to be used
to annually adjust the purchase price of the prepaid contracts. 62
The legislation also grants the board broad authority to
direct the investments of the trust. As stated by the legis-lation,
the board may invest the funds of the trust in " any in-struments,
obligations, securities or property determined proper
by the board. 1163
As in Michigan, Tennessee., and Indiana, trust officials
intend to establish a price schedule based on the results of a
detailed actuarial analysis. Once again, the factors which will
determine price are the number of years between when the contract
is made and when the beneficiary will be college age, options
chosen by the purchaser, assumptions about the rate of tuition
inflation and return on investment, and estimations of operating
Under the SEED program, purchasers will have to choose
either Plan A or Plan B. The two plans differ only in price and
refund policy. Under both plans, refunds will be given to the
purchasers if the beneficiary dies, is not accepted to a state
university, or, after reaching age 2 5 , informs the board that
he/ she will not attend college. The legislation also allows the
board to determine other circumstances under which refunds will
be given. These additional circumstances, however, must be
specified in the contract. 64
Plan A guarantees to pay a state university an amount equal
to the cost of the number of credit hours necessary for a bac-calaureate
degree on behalf of the beneficiary. If, however, the
contract is canceled, the purchaser will receive a refund of only
the original purchase price. Any investment income is retained
by the trust. 65
Beneficiaries covered by Plan B have the same tuition guar-antee
as those in Plan A. If, however, a refund is granted, the
purchaser receives the original investment plus some of the in-terest
earnings. The actual amount will be determined by an
annual compound interest rate set by the board and specified in
the contract. This because the added option, will
more expensive than Plan A. 66
Purchasers will also have the option of paying for the pre-paid
tuition contracts in one lump sum or through periodic pay-ments.
The total cost will be higher for those who choose the
periodic payment option. Trust officials, however, have not yet
determined the specific payment options. 67
In addition to the refunds discussed above, the SEED program
has provisions for beneficiaries who choose a community college
or a private university. If a beneficiary chooses a community
college, the trust will pay his/ her tuition at that institution,
up to the dollar value of the contract, had it been used at a
state university. Upon completion of the two year program, the
beneficiary may apply the remaining value of the contract to
tuition at a state university. 68
The beneficiary, after completing the two year program, may,
instead, choose a refund. The refund amount will be determined
by whether the beneficiary is cover by Plan A or Plan B. The
amount of money transferred to the community college or junior
college, however, will be deducted from the refund amount.
Therefore, those beneficiaries covered by Plan A would receive
little or no refund. 69
There are also provisions for those beneficiaries who wish
to attend a private university, either in Maine or out- of- state.
The trust will pay that institution an amount equal to the
average tuition at state universities on behalf of the bene-ficiary.
It is this last point which distinguishes Maine's plan
from the other enacted plans. Michigan, Wyoming, and Florida
have no provisions for beneficiaries wishing to attend out- of-state
universities, other than refunds for withdrawal from the
program. Depending upon the contract terms in these states, the
resulting refund may include little or no interest earnings.
Tennessee and Indiana have yet to determine their policy on this
Florida, like Maine, enacted a prepaid tuition plan on June
30, 1987. In addition to tuition, the Florida plan allows to
individuals to also prepay room and board expenses. Contracts,
however, will not be offered until an IRS ruling on the fund's
tax status is received. As in. Tennessee, Indiana, and Maine, the
ruling does not have to be favorable. Florida officials will
only be required to inform purchasers of whether or not interest
earnings are taxable. 70
A board composed of a combination of state officials and
governor's appointees is established to administer the program.
The state officials selected as members of the board are the
insurance conunissioner and treasurer, the comptroller, the chan-cellor
of the board of regents, and the executive director of the
state board of community colleges. Three additional members with .
knowledge and experience in accounting, actuary, risk management,
or investment management will be appointed by the governor and
confirmed by the state senate. The appointed members will serve
three year terms. 71
The board, which is located in the division of treasury in
the Florida Department of Insurance, is granted a great deal of
independence in the operation of program. The board is allowed
to limit the number participants, establish additional rules
for participation, enter into contractual agreements, select an
executive director, and engage in a wide range of other adminis-trative
duties. 72
The selection of staff is ' the most distinguishing feature in
the Florida plan. In addition to a small staff, the legislation
directs the board to hire private firms to maintain the trust's
records and to invest the funds of the trust. The law also re-quires
the private firms involved in investing the funds of the
trust to agree to cover cash deficiencies, should the funds fail
to meet the trust's obligations because of " imprudent in-vesting.
The cost of the prepaid contracts will be based on the re-sults
of a detailed actuarial analysis. As with the plans in
other states, the major factors will be the beneficiary's age
when the contract is made, choices of options made by the pur-chaser,
assumptions about the rate of tuition inflation and re-turn
on investment, and anticipated administrative costs. 74
As with several other states, the Florida plan allows pur-chasers
to choose between paying for the prepaid contract in one
lump sum or spreading payments out over a period of time. Once
again, the board will determine the specifics of the multi- pay-ment
plan. 75
Participants, . at time of purchase, will choose betbeen
either a plan for the conununity college system or a plan for the
state university system. Under the community college plan, par-ticipants
can prepay the beneficiary's tuition at any state com-munity
college. The contracts can cover the cost of the number
of credit hours required for a two year degree. Contracts for
smaller blocks of credit hours, such as one year's worth or one P semester's worth, will also be available. The board is yet to
determine the smallest number of credit hours to be offered. 76
The price, of course, will be based on the number of credit hours
I purchased.
The university plan has a similar structure, allowing pur- 1 chasers to prepay the beneficiary's tuition at any state univer-sity.
Contracts will be available to pay for credit hours in
blocks up to the number necessary for a baccalaureate degree.
Once again, the board will determine the minimum number of credit
I hours available for a prepaid contract. "
Those who prepay tuition under the university plan may also
prepay the beneficiary's room and board at a state university
8 residence hall. Students covered by the residence hall plan will
be given a preference in placement over students not covered by
4 such a contract. If space is not available, the beneficiary will
receive a refund equal to the cost of residence hall room and 1 board at the time he/ she attends college. 78
I The legislation allows the board to determine the circum-stances
under which the purchasers can terminate a prepaid con-tract.
The legislation seems to limit the size of the refund to
6 only the original prepaid amount, with any investment income
being retained by the trust. Florida officials, however, differ C on the interpretation of this provision, with some believing the
board has the authority to refund purchasers part of the interest
earnings. This issue will have to be resolved by the board and
other Florida officials. 79
The Florida plan does have provisions for beneficiaries
covered by a community college contract who wish to attend a
state university, and for beneficiaries covered by a university
plan who wish to attend a community college. If a beneficiary
covered by a community college contract chooses to attend a state
university, the trust will pay the university an amount equal to
the value of the community college contract. 80
Beneficiaries covered by a state university plan who wish to
attend a community college may have the value of the state uni-versity
contract transferred to the community college. If the
value of the university contract exceeds the cost of tuition at
the community college, the beneficiary can use the remaining
amount to attend a state university or may request a refund. The
amount transferred to the community college, however, will be
deducted from the refund amount. 81
The Florida plan also has provisions for beneficiaries who
wish to attend in- state private colleges or universities. Under
the plan, the beneficiary may have the trust transfer the value
of the prepaid contract to the private college or university.
This applies to the residence hall contract as well as either the
university or community college tuition contracts. 82
The board has a number of issues to address in addition to
the ones mentioned above. Among them, the board will determine
the policy toward transfers from one purchaser to another, the
policy toward substitution of one beneficiary for another, and if
there will be any limitations on how old the beneficiary can be
at the time the contract is made. The board has not yet met to
address these issues. 83
From the proceeding review of the enacted legislation, it is
clear that Wyoming, Tennessee, Indiana, Maine, and Florida have,
to a great degree, followed Michigan's example. All bills direct
a trust fund to collect funds from purchasers, invest the funds,
and later distribute those funds plus interest earnings to pay
the beneficiaries1 higher educational expenses. A number of
other states, however, are investigating alternative methods of
helping parents save for their children's college education.
The alternative plans that have generated the greatest in-terest
and support can be classified as the individual education
account plan, the educational savings bond plan, and the tuition
certificate plan. The Illinois legislature passed both an indi-vidual
education account plan and an educational savings bond
plan. The Governor of Illinois vetoed the individual education
account plan. He, however, signed the educational savings bond
bill after using his authority to delete certain sections of the
bill. The legislature must approve these changes before the bill
will become law.
North Carolina has enacted an education savings bond plan
similar to the Illinois legislation. State officials hope to
start selling bonds in the near future.
In Massachusetts, a commission created by the Governor to
study prepaid tuition plans has released a preliminary report
supporting an educational savings bond plan and a tuition cer-tificate
plan. This section examines the details of each of
these alternative state plans.
As stated above, the Illinois legislature passed an indi-vidual
education account bill. The Governor, however, vetoed the
bill, believing that the state income tax deduction provided only
small incentive to save, but would significantly reduce state
revenues. 84 Similar legislation was introduced in Missouri, but
failed to win legislative approval. 85 The plan is included in
this paper, however, because it represents an alternative to the
Michigan- type prepaid tuition contract plans.
The Illinois individual education accounts bill was intended
to give parents an opportunity to invest in an account similar to
an individual retirement account ( IRA). Under the plan, parents,
grandparents, and others interested in helping finance a child's
education could have deposited money in an account with a bank,
savings and loan, insurance company, or some other financial
institution until the child reached age 18. The money would have
earned interest, and would have been available to help pay for
educational expenses when the beneficiary was ready to attend
college. 86
As an incentive for investment, the donors would have been
allowed to deduct the amount invested, up to $ 2,000 per year,
from their taxable income for state income tax purposes. The
interest earnings from- the account would also have been exempt
from state income taxation. Both provisions, however, applied
only to state income taxes. The contributions would not have
been deductible for federal income tax purposes, and the interest
earned would also have been subject to federal taxation. 87
Upon reaching college age, the beneficiary could have used
I the proceeds from the account to pay for educational costs at any
postsecondary institution, either in Illinois or out- of- state.
If the beneficiary died or did not attend college, the tax exemp-tion
would have been lost. The contributors would have been
entitled to the return if their investment plus interest
earnings, but would have been required to pay state taxes on both
the income that had been excluded and the interest earnings. 88
This plan was distinctive from the Michigan style state
trust fund by the very limited role of the state. The state
would have given no guarantee that the interest rate offered by.
the private financial institutions would have kept pace with
tuition inflation. The legislation would not have created any
new state agencies and would only have required the Illinois
Department of Revenue to monitor the use of the new tax exemp-tion.
Another alternative to the Michigan type trust fund is the
college savings bond approach. The Illinois legislature passed a
bill establishing such a plan, which was recently approved by the
Governor. As mentioned above, certain sections of the bill were
first deleted by the Governor with an I1amendatory veto. Under
Illinois law, a governor may make changes in a bill passed by the
state legislature before signing it. The changes, however, must
be approved by the legislature before the bill becomes law. If
the legislature approves the changes, the law will be immediately
effective. The first bonds would then be sold in early 1988. 90
Under the Illinois act, the state would sell a new general
obligation bond under the name of Illinois College Savings Bonds.
The bonds would be zero coupon bonds, meaning there are no cur-rent
interest payments. The bonds, instead, pay a specified
compound interest rate on a specified date of maturity. The
bonds will be available to anyone, and would be sold in small
denominations to encourage participation by low and middle- income
families. 91
The college savings bonds would pay at least the same in-terest
rate as other Illinois general obligation bonds. In ad-dition,
the bonds may also pay up to an additional 1/ 2 of one
percent compounded interest if they are used to pay educational
costs at either a private or public institution of higher educa-tion
located in Illinois. The amount of additional interest
given, if any, will be determined by the governor and the direc-
tor of the Illinois Bureau of the Budget, and specified at the
time of sale. As with other general obligation bonds, the in-terest
earnings will be exempt from federal and state income
taxes. 92
The legislation also creates a Baccalaureate Trust Authority
to aid in the administration of the new bond program. The
authority will be composed of the state treasurer, the director
of the Illinois State Scholarship Commission, the executive
director of the Illinois Board of Higher Education, the director
of the Illinois Bureau of the Budget, the director of the
Illinois Economic and Fiscal Commission, and eight appointed
members. The speaker of the state house of representatives, the
house minority leader, the president of the, state senate, and the
senate minority leader will each appoint one of the eight mem-bers.
The governor will appoint the four other members. Each
appointed member will serve a six year term. 93
The duties of the authority are mostly limited to advising
the governor and the director of the bureau of the budget on a
number of policy issues. The authority will make recommendations
on what denominations the bonds will be sold in, how the maturity
dates should be scheduled, what, if any, limits should be placed
on the amount of bonds that a single household may purchase, how
the bonds should be advertised, and what additional rate of
interest should be given for redemption at an in- state
postsecondary institution. 94
Although the interest rates and the denominations of the
bonds have not been set, hypothetical examples have been offered
to illustrate how the bonds would work. One example uses the
interest yield of seven percent compounded semi- annually and
$ 5,000 as the value of the bonds at maturity. The example shows
bonds maturing in five years, ten years, and fifteen year, each
being worth $ 5,000. Since interest accumulates over time, the
bonds would be sold at a discount, with lower prices for bonds
maturing at later dates. In this example, bonds maturing in
five, ten, and fifteen years would cost $ 3,545, $ 2,513, and
$ 1,781, respectively. As stated above, the interest earnings
would not be subject to federal and state income taxes. 95
To expand this example, bonds used to pay for educational
costs might be redeemed for a value greater than $ 5,000. As-suming
the governor and the director of the bureau of the budget
set the bonus rate at the maximum allowed rate of 1/ 2 of one
percent, the fifteen year bond would be worth $ 5,374 at maturity.
The ten and five year bonds would be worth $ 5,248 and $ 5,123,
Although the state plays a greater role in this plan than in
the individual education accounts discussed above, its role is
still more limited than in the tuition trust plans. As with the
education accounts, there is no tuition guarantee. The parents,
not the state, will bear the additional financial burden if the
rate of tuition inflation exceeds the rate of return on invest-ment.
Illinois officials, however, believe the program will ac-
complish two very important goals. First, the plan will focus
parent's attention to the need to begin saving for their child's
future educational needs. Publicity about the growing costs of a
college education and available methods of saving to meet these
costs is an expected result of the program. 96
Officials also believe that, in combination with this in-creased
awareness, the incentives of the program will encourage
parents to start saving. The parents will have a tax free, low
risk investment that pays a bonus if the child attends college in
Illinois. If, however, the child does not attend college or
chooses an out- of- state university, the parent will only loose
the bonus amount of interest. 97
The tax status and flexibility of the college savings bonds
plan is a big distinction from the trust plans. Once again, due
to the the tax- exempt status of state general obligation bonds,
the interest earnings are exempt from taxation, regardless of
what the funds are used for. Although the tax questions for the
trust plans are still being reviewed by the IRS, it is widely
agreed that, in the event of a withdrawal from the trust program,
any interest earnings paid as part of the refund would be subject
to taxation.
The college savings bonds would also have a more flexible
withdrawal policy than the trust programs. Parents who use the
bonds for purposes other than their children's education costs
will loose only the bonus interest. 98 Under the trust programs,
withdrawals are limited to certain circumstances determined by
the enabling legislation or the governing board. Refunds, de-pending.'
on the particular trust plan, may be limited to only the
initial purchase price.
As a final point, it should be noted that the Illinois
savings bond plan, unlike the trust plans, does address the issue
of what impact the program will have on financial aid. The
legislation contains a clause that allows families to have up to
$ 25,000 in college savings bonds without it adversely affecting
the children's eligibility for scholarships, grants, or
guaranteed loans offered by the Illinois state Scholarship Com-mission.
The college savings bonds would simply not be included
in the determination of the family's resources. 99 This clause,
however, would not be binding of federal financial aid programs,
such as the Pel1 Grant program.
As discussed above, the , Massachusetts Board of Regents
recently released a preliminary report on the results of its
study of prepaid tuition plans and other education savings plans.
One of the two plans recommended by the study commission was a
college savings bond plan similar to the Illinois plan. Once
again, the bonds would be zero- coupon general obligation bonds,
offered in small denominations, exempt from federal income
taxation, and would pay a bonus if redeemed for higher education
costs. 100
There are only two significant differences between the
Illinois law and the ~ assachusetts'plan. The Illinois law allows
the state to pay a bonus interest rate of no more than 1/ 2 of one
percent above the specified market rate. The Massachusetts
report recommends the bonus rate be one percent higher than the
bonds' market rate. In addition, this bonus interest would be
available at universities outside of Massachusetts as well as
those in state. 101
Using the same example as in the discussion of the Illinois
college savings bond plan, the cost of a bond with a face value
of $ 5,000 at maturity would'be $ 1,781 for a fifteen year bond, I
$ 2,513 for a ten year bond, and $ 3,545 for a five year bond. If,
however, the bonds are used for higher education costs, the
additional one percent compounded interest would make the 15 year
bond worth $ 5,776 at maturity. The ten and five year bonds would
be worth $ 5,506 and $ 5,247, respectively.
The state of North Carolina surpassed Illinois and Massachu-setts
and became the first state to enact a college education
savings bond plan. The legislation was enacted on July 21, 1987
and became immediately effective. The state expects to begin
selling the bonds in late November or early December of
1987. 102
Since the bonds are state general obligation bonds, the
interest earnings are exempt from federal income taxation. No
restrictions are placed on the use of the bonds and anyone may
purchase them. Unlike the Illinois law and the Massachusetts
plan, - no bonus rate of interest will be paid for bonds redeemed
to pay for higher education costs. 103
Before the development of the educational savings bonds, the
smallest denomination of state general obligation bonds was
$ 5,000. The educational savings bonds will be sold with a face
value of $ 1,000. The actual cost of the bonds will be determined
by the bonds rate of interest, which has not yet been determined.
State officials believe, however, that the rate of interest on
the bonds will be approximately nine percent. 104
If the interest rate is set at nine percent, the cost of a
bond with a face value of $ 1,000 upon maturity would be $ 274 for
a fifteen year bond, $ 422 for a ten year bond, and $ 650 for a
five year bond. Supporters hope the low investment cost, the tax
free status of the interest earnings, and the publicity resulting
from the creation and sale of- these bonds will encourage parents
' to invest in the bonds as a means of saving for their children's college education. 105
In addition to a college savings bond plan, the Massachu-setts
report also recommends the creation of a tuition certifi-cate
plan similar to the prepaid tuition contract plans. As
with the prepaid tuition plan, the certificate plan, for a pre-paid
amount, would guarantee a specified beneficiary's tuition at
a state university or community college. The payments are pooled
and invested in a trust fund, with the payments and interest
earnings later used to pay the beneficiary's tuition. 106
There are, however, a number of interesting differences
between the two plans. The most significant of these are how the
prepaid price is determined, what options will be available for
those beneficiaries who attend a community or private college,
and how refunds will be determined.
Under the tuition certificate plan, the newly created trust
would sell certificates in denominations of $ 50 and up. The low
minimum price is intended to encourage lower and middle- income
families to participate in the program. A chart on the back of
the certificate would indicate the percent of tuition the cer-tificate
would pay at each participating college or university
upon redemption. The plan would cover all state institutions of
higher education. In addition, private universities, both in and
out of Massachusetts, could choose to participate. 107
The listed redemption values would be determined by tuition
charges at the time the certificate is purchased. The certifi-cates
would pay the same percentage of tuition upon redemption as
the purchase price would have paid for in the year it was issued.
For instance, if $ 500 would pay for 25 percent of a years tuition
at a specified state university in 1987, a $ 500 dollar certifi-cate
bought in 1987 would pay for 25 percent of a years tuition
when it is redeemed, regardless of the actual tuition costs at
that time. If, in 1987, $ 500 would pay for 10 percent of annual
tuition costs at a participating private university, a $ 500 dol-lar
certificate purchased in 1987 would pay for 10 percent of the
annual tuition costs at that private university upon redemption.
The money collected from the sale of the tuition certifi-cates
would be pooled and invested in a newly chartered state
trust. The Massachusetts report does not detail how the trust
would be managed, except that the governing board would include a
representative of the state and officials from state post-secondary
institutions and participating private universities.
The board would be responsible for the administration of the
program and investment of the collected funds. 108
The job of the board would be much easier under the tuition
certificate plan than under the Michigan type prepaid tuition
contract plan. Under the tuition contract plan, the prepaid
price would primarily be determined by projections of the rate of
tuition inflation and the rate of interest earnings. Assuming
the projections predict interest earnings will grow at a rate
faster than tuition inflation, the trust would offer discounts at
time of purchase. Discrepancies between the actual rates and the
projected rates, however, could cause serious financial diffi-
culties for the trust. 109
Under the tuition certificate plan, the trust would only
have to achieve a rate of return equal to the rate of tuition
inflation. Unexpectedly high tuition inflation would not be a
problem as long as it was matched by the return on investment.
This more limited goal is certainly not an unreasonable expec-tation.
Many colleges, based upon past experience, predict the
rate of tuition inflation to be 2- 3 percent higher than the CPI
figure for general inflation. The rate of return on investment
is estimated to be five percent higher than the CPI figure for
inflation. 110
Even with the more conservative approach of basing the cost
on current prices, there is still a danger that the rate of re-turn
on investment would not equal the rate of tuition inflation.
There is also the possibility that the rate of return will exceed
the rate of tuition inflation. The Massachusetts plan would
require the public and participating private universities to
share the financial burden if the rate of tuition inflation is
higher than the rate of return. The plan would also allow the
universities to benefit if the rate of return is higher than the
rate of tuition inflation. 111
When the universities redeem the tuition certificates they
have received from the students in lieu of tuition payments, the
certificates are treated like shares in a mutual fund. If the
rate of return on investment fails to match the rate of tuition
inflation, the trust would be able to reimburse the universities
for only part of costs of the beneficiariest tuition. The uni-versities,
however, would be entitled to at least a minimum rate
of return. This minimum rate would be determined on the basis of
the rate of tuition inflation at the particular university and
the CPI rate of inflation. The universities would be entitled to
redeem the certificates for the original purchase price plus a
rate of return on investment equal to the lesser of the rate of
general inflation measured by the CPI or the universityts rate of
tuition inflation. If the trust was unable to pay this minimum
rate of return, the state would loan the necessary funds to the
trust. 112
If, however, the rate of return is greater than tuition
inflation, the universities would be entitled to the original
purchase price of the certificate plus the accumulated interest
earnings, even if that amount exceeds the cost of the tuition
that the certificate purchased on redemption by the student. 113
There would, of course, also be certain limitations on this
policy to protect the trust and the state. First, the trust
would be entitled to pay for its administrative costs from the
interest earnings. Secondly, the trust would keep track of the
money paid to each university in excess of the cost of tuition it
provided to the beneficiaries. If, in future years, the trust
had financial difficulty, the surplus money paid earlier to the
university would be deducted from the amount of money owed to
the university under the guaranteed rate of return, discussed
above. Likewise, if the trust had previously paid any money to
the university under the guaranteed rate of return, the univer-
sity would be required to return that money out of future sur-pluses.
Under this plan, as with the prepaid tuition contract plans,
the individual educational accounts, and the college savings
bonds plans, there will be participants who will wish to withdraw
from the program. The Massachusetts proposal would refund the
purchaser the original purchase price plus a specified rate of
return. The rate of return would vary with the reason for the
participant's withdrawal. If the withdrawal was due to the death
or disability of the beneficiary or family financial hardship,
the purchaser would receive the original purchase price of the
certificate plus all accumulated interest earnings. If the bene-ficiary
wished to attend a college or university not partici-pating
in the program, the refund would be the original payment
plus a compound rate of return. This rate would equal either the
rate of return on investment or the average rate of tuition in-flation
at participating universities, whichever is less. This
figure would be reduced by two percent if the refund was re-quested
for some reason other than the ones mentioned above. 115
In addition to the lower risk of linking the purchase price
for certificates to current tuition prices instead of actuarial
projections, proponents of this plan contend it will be much
easier to administer than the prepaid tuition contract plans.
Under the prepaid tuition contract plan, the transfer of a bene-ficiary
from a university to a community college plan, for in-stance,
would be administratively cumbersome, usually requiring
8 the cancellation of the contract and the calculation of what
should be transferred to the community college and what should be
refunded to the original purchaser.
The tuition contract plans also require the trust to create
a complex price schedule based on the beneficiary's age and the
choice of certain options in the contract. The tuition certifi-cate
plan, with its conversion chart for each participating col-lege
or university, would easily handle those students who trans-fer
from one institution to another. There would also be no need
to separate pricing for different ages. This simplified adminis-tration
would save the trust a great deal in operating costs. 116
A final note concerns federal income taxes. Because of the
similarity between the prepaid tuition contract plans and the
tuition certificate plan, the ruling from the IRS on the tax
status of the Michigan plan will have a great impact on the tui-tion
certificate plan. Supports contend, however, that if the
IRS rules such programs are subject to taxation, it would still
be possible to write the law in such a way that the tax liability
will be assessed upon use. It may also be possible that the
liability will be the beneficiary's responsibility and, there-fore,
subject to a lower tax rate. If either of these pos-sibilities
became a reality, it would greatly increase the plan's ! attractiveness. 117
In addition to the number of states which have enacted or
are considering some type of state sponsored savings plan, there
have been a recent number of similar federal proposals. Bills
have been introduced into Congress which would create a tax-exempt
tuition trust plan, a federal tax exemption for individual
education accounts, and a federal education savings bond program.
In addition, two current presidential candidates have made simi-lar
proposals as part of their campaign platforms. 118
It is difficult to estimate how these proposals will fair in
the United States Congress. Legislation has been proposed by a
number of members from both parties. Some doubt, however, that
Congress would be willing to make a new tax preference so soon
after enactment of the Tax Reform Act of 1986, which sought to
reduce tax exemptions. It is also important to note that earlier
proposals to make higher education expenses deductible from
federal income taxation failed to gain approval. 119
The following section examines proposals recently introduced
in Congress. The first proposal was introduced in the House of
Representatives by Congressman Pat Williams of Montana and would
create a federal education trust fund similar to Michigan's MET
plan. It is followed by a similar proposal introduced by Senator
Claiborne Pel1 of Rhode Island. The third proposal was intro-duced
by Senator Robert Dole of Kansas and would create tax in-centives
for investing in education accounts at private financial
institutions. It is followed by a similar proposal supported by
Senator Dennis DeConcini of Arizona and Congressman William
Lipinski of Illinois. The fifth proposal was also introduced by
Senator Dole and would authorize the federal government to issue
college savings bonds. The final proposals were offered by two
presidential candidates, Vice- President George Bush and Repre-sentative
Richard Gephardt.
This act, introduced by Representative Williams, would
create the National Postsecondary Education Savings Trust pro-gram,
enabling parents or other interested parties to contribute
to a federal trust fund to save for a beneficiary's future col-lege
education. In brief, the Trust would establish guidelines
of how much should be invested to cover future tuition based on
projections of the rate of return on investment and the rate of
tuition inflation. The Trust would apply the invested amounts
and interest earnings to the beneficiary's college education.
The most attractive aspect of the plan for investors is the
proposed changes in the federal tax policy. Depending upon the
income of the investor, all or portions of the contributions to
the fund would be. deductible from adjusted gross income for
federal income tax purposes. The interest earnings would be
exempt from income taxation for all investors. 120
To administer the new trust program, the legislation estab-lishes
a Board of Trustees comprised of cabinet officials, rep-resentatives
from public and private colleges and universities,
and individual citizens. The Secretary of Education and the
Secretary of the Treasury will serve as ex- officio members of the
Board. The president will appoint ten members to serve four year
terms. Of the ten, five will be representatives of institutions
of higher education and five will be members of the general pub-lic.
No more than five of the ten may belong to the same politi-cal
party, and all ten will be subject to Senate confirmation. 121
Although the legislation grants the Board of Trustees broad
administrative powers, it limits the Board's authority to deter-mine
investment policy. Investments would be limited to United
States government obligations guaranteed in both principal and
interest. The Secretary of the Treasury, serving as managing
trustee of the Board, would manage the investments. 122
The Board, using projections of the rate of tuition infla-tion
and return on investment, would also establish a schedule
estimating how should be invested to cover average tuition for
beneficiaries ranging in age from newborns to college age. Sepa-rate
schedules would be prepared for the different types of post-secondary
institutions, such as private four- year universities,
public four- year universities, and community colleges. Parents
would be able to invest a suggested amount, a smaller amount, or
a larger amount in a lump sum or in periodic payments, such as
yearly, monthly, or payroll deduction payments. 123
The beneficiary, upon reaching college age, can direct the
Trust to make payments from the fund to pay tuition at any post-secondary
education institution in the country. There is,
however, no guarantee that the Trust will pay the full tuition at
the particular institution. The payments will only equal the
original investment plus accumulated interest earnings. 124
As stated above, the legislation offers exemptions from
federal income taxes as an incentive to investors. All interest
earnings used to pay educational costs would be exempt from in-come
taxes. 125
In addition, the investor would be allowed to deduct from
zero to 100 percent of the amount contributed on behalf of a
legal dependent from the taxable family income, depending upon
the family's adjusted gross income. Under this plan, families
with adjusted gross incomes below $ 125,000 could deduct 100 per-cent
of their contributions to the Trust from their annual
taxable income, up to the maximum allowed deduction of $ 2,000 per
beneficiary. Total deductions would also be limited to $ 48,000
for all years, per beneficiary. For those families with income
greater than $ 125,000, the $ 2,000 cap is reduced by ten cents for
every dollar of gross income over $ 125,000. A family with income
of $ 135,000, for instance, would only be able to deduct the first
$ 1,000 of contributions to the Trust for each beneficiary. No
deductions would be allowed for families with gross incomes of
$ 145,000 or more. After 1988, these income levels would be in-dexed
to inflation. 12 6
As with the state plans discussed above, the policy toward
refunds in the event of- withdrawal from the plan is an important
consideration. Under the law, the investor will receive a refund
of the original investment amount plus accumulated interest
earnings if the beneficiary dies, or after reaching age 21, in-forms
the trust that he/ she will not attend a postsecondary edu-cational
institution. The Trust is also allowed to establish
additional circumstances under which refunds may be granted. The
investor will also be entitled to a refund of any funds available
to the beneficiary that are in excess of the educational
costs. 127
There would be a tax liability for the investor, however, if
a refund is obtained. The interest earnings would be subject to I taxation. There would also be an additional tax penalty in order
I for the federal government to recover the money lost from
exempting the original investment. Ten percent of the interest
I earnings would be forfeited to the IRS as- the penalty. This
penalty, however, does not apply if the refund is a result of the 1 death of the beneficiary. 128
This act introduced by Senator Pel1 is intended to serve as
the Senate version of Representative Williams1 bill, discussed
above. Most of the differences between the two bills are minor.
There are, however, significant differences concerning the de-ductibility
of the contributions to the Trust.
Under the Senate version, less tax deductions would be
allowed for higher income families. Families whose adjusted gross
income does not exceed $ 25,000 would be entitled to deduct 100
percent of the contributions from their taxable income. Those
families whose gross income is between $ 25,000 and $ 60,000 may
deduct 50 percent of the contribution to the trust fund. Con-tributors
whose family's adjusted gross income is greater than
$ 60,000 but less than $ 100,000 dollars would be allowed to deduct
25 percent of their payments to the Trust. No deductions would
be allowed for contributors with adjusted gross incomes of more
than $ 100,000. As in the House bill, these income levels would
be indexed to inflation. 129
The Senate bill also contains additional items not included
in the House bill. One important addition concerns financial
aid. The legislation states that, when calculating a bene-ficiary's
eligibility for student financial aid, only 75 percent
of the value of the student's trust fund will be considered as
his/ her financial resources. 130
Another interesting addition concerns the use of the fund
for the education of the investor in an emergency situation. If
the investor has been unemployed for over a year and has been
eligible for unemployment compensation, he/ she may use the trust
fund to pay for the cost of job retraining at an acceptable post-secondary
educational institution. 131
Senator Robert Dole has introduced four bills designed. to
encourage individuals to save for their children's college edu-cation.
Three of the bills would change the federal tax code to
encourage parents to deposit money in education savings accounts
at private financial institutions on behalf of their children.
The multiple number of bills is designed to " encourage discussion
on how to create the most effective and efficient incentivesvv for
saving for higher education. 132
Under the plan most strongly endorsed by Dole, parents, or
other individuals concerned with a child's education, could open
an account at a bank or other acceptable financial institution on
behalf of a child. Federal income taxes on interest earnings
would be the responsibility of the beneficiary and would be de-ferred
until he/ she reaches age 25. Upon reaching age 25, ten
percent of the interest earnings would be added to the bene-ficiaries
gross income and, therefore, subject to income taxes at
the individual's tax rate. This would continue for the next nine
years, covering all interest earnings of the account. 133.
In addition to this benefit, fifteen percent of the contri-bution
could be subtracted from the amount the investor owes in
federal income taxes for the year. 134 ( This tax credit applies
to the dollar amount paid as taxes and should not be confused
with a tax deduction, which reduces adjusted gross income.) The
tax credit, however, would be limited to $ 150 per beneficiary for
1987. Beginning in 1988, the $ 150 limit would be indexed to in-
f lation. 135
Although there are no restrictions for participation based
on income, there are a number of requirements and limitations.
Under the proposal, there can only be one beneficiary per ac-count.
If more than one taxpayer contributes to the account, the
$ 150 dollar tax credit is distributed among the contributors in
proportion to the amount of their contribution. 136
In addition, the funds from the account must be used to pay
for the beneficiary's tuition, fees, books, supplies, room, and
board at an acceptable institute of higher education. ' If the
funds are used for other purposes, the interest earnings of the
account are included in the investors gross income at that time.
The investor would also have to pay a tax penalty. Ten percent
of the interest earnings would be forfeited to the federal
government as the penalty. This penalty, however, would not
apply if the beneficiary had died or had been disabled. 137
As stated above, two similar proposals have been made by
Senator Dole which closely resemble the first proposal. One plan
would differ from the original only in that there would be no tax
credit on the amount contributed to the account. Tax on interest
earnings, however, would again be deferred until the beneficiary
reaches age 25. The final version of the education savings ac-count
plan would allow the tax credit as in the original, but
would require the interest earnings be subject to income tax at
the time they are earned. 138
D. THE DeCONCINI- LIPINSKI EDUCATION SAVINGS ACT
Senator DeConcini has recently introduced a bill similar to
Senator Dole's plans, discussed above. An identical bill has
been introduced in the House of Representatives by Congressman
Lipinski. It would offer federal income tax breaks to encourage
parents to open individual education accounts at private finan-cial
institutions on behalf of their children. This version,
however, differs from the Dole proposals in exactly how the tax
law will be changed.
The DeConcini- Lipinski plan, instead of deferring the tax
liability until the beneficiary reached age 25, would make in-terest
earnings exempt from federal income taxation. The bill
would also allow parents and other contributors to deduct the
amount of money invested in the account from their adjusted gross
income. The annual amount of income that can be deducted,
however, is limited to $ 1,000 per beneficiary. These tax breaks
are available to all taxpayers, regardless of income. 139
As with the other federal plans, the tax advantages are lost
if the proceeds from the account are not used to pay for the
beneficiary's tuition, books, and living expenses at a post-secondary
educational institution. Interest earnings from the
account would be subject to taxation. In addition, 10 percent of
the interest earnings would be forfeited to the government as a
penalty. 140
The last bill introduced by Senator Dole concerning saving
for higher education would authorize the federal government to
issue educational savings bonds. The bonds would be issued in
the name of a beneficiary, bear an interest rate equal to federal
long term interest rates for bonds, and would pay interest only
upon redemption. 141
addition, the interest earnings the education bonds
would not be subject to taxation as long as the bonds were used
to pay for tuition, fees, books, and reasonable living expenses
at an institution of higher education. No more than $ 1,000 dol-lars
worth of bonds, however, could be purchased per year on
behalf of a single beneficiary. 142
A similar bill has been introduced in the House of Repre-sentatives
by Congressman Paul Henry of Michigan. This bill,
however, sets no limits on the amount of bonds that can be pur-chased.
Two presidential candidates have also proposed a type of
educational savings plans as part of their campaign platforms.
Vice- President George Bush supports a college savings bond plan,
similar to savings bond plan introduced in Congress by Senator
Dole. Interest from the federal education bonds, if used for
educational purposes, would be exempt from federal income taxa-tion.
Representative Richard Gephardt, Democratic candidate for
president, has discussed the creation of the Individual Develop-ment
and Education Account ( IDEA) program. The plan would allow
parents to establish educational savings accounts for their chil-dren.
Federal matching funds would be provided to low- income
families. 145
It is clear from the above discussion of legislation enacted
into law in Michigan, Wyoming, Tennessee, Indiana, Maine, and
Florida, the multiple plans passed by the Illinois legislature,
the North Carolina plan, the proposals from the Massachusetts
Board of Regents study commission, and the bills introduced in
both houses of Congress, there is a great deal of interest in
establishing governmental programs designed to assist citizens in
saving for their children's college education. Before rushing
into a program, however, a number of issues must be examined.
The most ' important questions concern desirability of such
programs for both the state and the individual. This section
will address this' issue with attention given to the various state
and federal proposals. Attention will also be given to the views
of both proponents and opponents of such plans.
A number of factors must be considered by state officials
when determining what ( if any) type of advanced tuition payment
plan should be pursued. The issues of whether the program is
needed, which citizens will benefit, cost of the program to the
state, benefits to state resulting from the program, and finan-cial
dangers for the state must all be considered.
There are some critics of prepaid tuition plans who believe
such programs are unnecessary. They contend that there are a
number of investment opportunities currently available to parents
who wish to invest for their children's education, making any
state plans redundant. 146
This argument, however, fails to consider the difficulty of
finding investments that will keep pace with tuition inflation.
The average rate of tuition inflation for public and private
colleges and universities from 1965 to 1985 was 2.7 percent
higher than the CPI measure for overall inflation. In com-parison,
stocks increased 2.1 percent over the CPI rate for in-flation
in the same period. The more secure investment of five-year
treasury bonds would have only attained a rate of return
0.12 percent greater than the CPI inflation rate. 147
Clearly, finding investments to keep pace with tuition in-flation
would be very difficult for the average investor. In-vestments
offering high rates of return also involve increased
risk. In addition, the interest earnings on most investments are
subject to federal income taxes, reducing the amount of money
available for funding of a child's college education. 148
The state can provide assistance to the great majority of
parents who lack investment expertise in a number of ways.
First, the state can hire professional money managers with exten-sive
investment experience. In addition, with the pool of money
collected from the individual participants, the state can
diversify investments, reducing the chance of serious damage
caused by a single bad investment. The state is also in a better
position to absorb the effects of years in which the rate of
return is lower than anticipated. Such years can be offset by
years in which the rate of return exceeds expectations. 149
Questions have also been raised about which individuals
would benefit from prepaid tuition plans. Critics contend that
such programs would only be of benefit to higher and middle-income
individuals, since lower- income individuals find it diffi-cult
to save money. 150
Proponents of prepaid tuition plans concede this point, but
add a number of qualifications. They contend that although
higher- income families will have the resources to participate,
there will be far less incentive for them than middle- income
families. Since higher- income individuals would likely be able
to pay for their children's college education out of their annual
income, they would not be attracted to such a specific investment
plan. They would, instead, seek investments offering more flexi-bility.
Proponents also contend that middle- income families are in
need of assistance. In addition to the rising costs of a college
education, the amount of financial aid available to middle- income
families is on the decline. Prepaid tuition plans would en-courage
and assist middle- income families to save for their chil-dren's
college education, at no cost to the state. Once estab-lished,
tuition trust funds would be self- financing and would
also repay the state the original funds used to start the pro-gram.
Although a prepaid tuition program would, as the above dis-cussion
indicates, primarily be provided as a service to its
citizens, there would also be some benefits for the state. Citi-zens
who are aided by the state in saving for their children's
college education are likely to be grateful to the state for the
assistance. The program would also promote enrollment in- state
universities by making it possible for more students to afford
the costs of higher education. The state would then be the bene-ficiary
of a better educated population. 153
The crucial question, however, is whether or not prepaid
tuition plans will be financially stable. An unstable plan could
damage the state higher education system and/ or cost the state a
considerable amount of money. The stability of the plan will
depend upon the type of prepaid tuition plan selected and how
well it is managed.
Of the plans discussed above, the Illinois independent edu-cation
accounts plan and the various plans introduced on the
federal level are the least likely to encounter financial diffi-culty.
This ' is for the simple reason that the individuals, not
the state or federal government, must bear the risk that tuition
inflation may grow faster than the rate of return on investment.
Under these plans, the investor receives only the interest
earnings actually made by the private financial institutions or
the federal trust.
As mentioned above, North Carolina has enacted an education
savings bond plan. A savings bond plan has also been approved by
Illinois legislature and is being considered in Massachusetts.
These plans involve very little risk to the state. The bonds,
which would guarantee a specified rate of return, would be part
of the state's general obligation bonds. Presumedly, these bonds
are in little danger of financial instability. If, however, the
bonds pay a bonus rate of interest when redeemed to pay for edu-cation
expenses, the state would have to plan to cover the ad-ditional
A greater degree of risk for the state is associated with
the Michigan- type tuition contract and the Massachusetts- type
tuition certificate plans. Both of these plans require the state
to guarantee tuition. Of the two, the tuit- ion contract plan has
the higher risk.
In review, prepaid tuition contract plans will establish
price schedules for participants with different prices for dif-ferent
ages. The actual prices will be determined by a detailed
analysis of tuition inflation and likely rates of return on in-
vestment. Proponents of tuition trust plans contend that the
rate of return will exceed tuition inflation and, therefore,
trust officials would be able to set the price for prepaid tui-tion
contracts below current tuition costs. Wyoming, the only
state having set prices, is currently offering contracts for
future tuition, room, and board for 37 percent of current costs.
When the Michigan plan was introduced, state officials
pointed to the high rates of return on investment earned in re-cent
years by the state pension fund. Under the direction of the
Michigan Department of Treasury, the state pension fund earned a
23 percent rate of return on investment in 1985 and has
maintained an average rate of return of nearly 19 percent for
every year since 1981.154 An average rate of return of 13
percent has been earned by the pension fund for the last nine
years. 155
Recent projections of the possible rate of return on invest-ment
for the Michigan Education Trust have not been as optimistic
as earlier projections. Although trust officials have not yet
completed the actuarial study, preliminary results are available.
The study predicts the average rate of return on investment for
the next 18 years will be between nine and 11 percent. Tuition
inflation is anticipated to increase by an annual rate of 6.5
percent. 156
Under these assumptions, tuition costs for four years of
education at Michigan public universities will increase from the
current average of $ 8,000 to $ 24,853 in eighteen years. The
amount of money that must be invested on behalf of a newborn
child depends upon the projected rate of return on investment.
For a nine percent rate of return or investment, a parent would
have to invest $ 5,269 dollars. With a 10 or 11 percent rate of
return, a parent would have to invest $ 4,470 or $ 3,798, respec-tively.
These prices are only rough estimates and do not include
funds needed to cover administrative costs and numerous options
available in the Michigan plan. The graph at the end of this
section illustrates the growth of investments at nine, 10, and 11
percent to meet the growth of tuition inflation at 6.5 percent.
Critics of prepaid tuition plans have pointed out financial
dangers in giving discounts based on actuarial pro j ections . An
underestimation of the rate of. tuition inflation or an overesti-mation
of the rate of return on investment may cause serious
financial problems for the trust. In addition, administrative
costs may be higher than anticipated, which could create or in-tensify
financial problems. 157
The possible danger is illustrated by an example offered as
testimony before an Illinois task force created to study prepaid
tuition plans. The witness uses a hypothetical example of a
prepaid tuition plan offering a price discount to newborns based
on the assumptions of a 10 percent rate of return on investment
and a six percent rate of tuition inflation. If the actual rate
of return on investment is just one percent less than the pre-dicted
10 percent rate of return, the trust would be short $ 2,848
per beneficiary when they reach college age. Likewise, if the
actual rate of tuition inflation is only one percent higher than
the predicted rate of inflation, the trust would be short $ 2,345
for each beneficiary. 158
Supporters of prepaid tuition plans contend that such short-falls
can be avoided by increasing the cost for new participants
once it is clear that the original assumptions were incorrect.
The new price would be high enough to recover the shortfall for
the original participants as well as to cover the costs of the
new participant's education needs. This, it is argued, would be
similar to pension funds, which can require higher contributions
by participants when financial difficulty is encountered. 159
Critics, however, consider this analogy to be flawed. Un-like
pension funds, in which membership is a condition of employ-ment,
enrollment in a prepaid tuition plan is completely volun-tary.
Increasing the cost of prepaid tuition contracts would
decrease their attractiveness to potential investors. It . is
contended that a trust may be forced to increase prices due to
inaccurate forecasts only to find itself unable to attract enough
new participants under the revised price schedule to remain fi-nancially
solvent. 160
Under this scenario, the trust and the state, would have a
number of options. Unfortunately, none is very attractive. The
first option would be for the trust to default on its obligation
to the beneficiaries. Such a serious step, however, would cer-tainly
have legal and political consequences for the state.
Another option would involve the state appropriating the
funds necessary for the trust to remain solvent. This, however,
would result in less money available for funding of other state
needs. 161 It would also be contrary to the goal of providing
assistance to middle- income families without additional cost to
the state.
A third option available to a state with a tuition trust
fund !. n financial difficulty would be to require the state uni-versities
and colleges to accept the beneficiaries at a reduced
rate of tuition. The universities would then have the burden of
recovering the lost revenues from other sources or reducing
costs. Additional funds could be raised by increasing certain
student charges, such as nonresident tuition. This would require
one group of students to partially subsidize the education of
another group of students. Universities could also request more
funds from the state legislature. Such requests, if granted,
would again mean less state money available for other needs. If,
instead, the universities are forced to decrease their costs to
cover the deficit, the result may be a reduction in the quality
of education for all students. 162
Critics also believe that a prepaid tuition plan can cause
problems in less obvious ways than a major financial crisis. A
prepaid tuition plan, they contend, would serve as an artificial
influence on the price of tuition. If, for instance, the trust
had based the prepaid price on a projected annual compound rate
of tuition inflation of six percent, officials may be reluctant
to increase tuition at a greater rate, even though such an in-crease
may be warranted by other factors. This, once again,
would result in the need for higher appropriations. from the state
general fund. 163
Supporters of prepaid tuition plans believe the financial
dangers are not as great as suggested. The state, it is con-tended,
can also reduce its risk by setting limits on the number
of participants in the early years and by imposing penalties for
withdrawal from the program. By limiting the required number of
participants needed in the program, the state limits the amount
of money necessary to cover the obligations of the trust in the
event of financial difficulty. It will also make it easier to
find the required number of additional participants under in-creased
prices needed to offset any deficit caused by previous
inaccurate pro j ections . The legislation of every state that
has enacted a prepaid tuition plan includes a provision allowing
the governing board to limit the number of participants.
In addition to limiting participation, the boards can also
impose penalties for individuals who withdraw from the plan. The
penalties involve the trust withholding a portion of the interest
earnings made from the participant's original investment and vary
in severity. The funds not returned upon withdrawal can be left
in the trust to earn additional interest earnings until a finan-cial
crisis requires their use. 165
Concerned about the risk assumed by the Michigan- type pre-paid
tuition plans, some state officials have attempted to design
programs that limit the risk to the state but still, give parents
a tuition guarantee. The Massachusetts certificate proposal,
discussed above, was designed with this goal. Since the Massa-chusetts
plan sets the cost of the prepaid tuition certificates
at the current price for tuition, the rate of return on invest-ment
only has to match the rate of tuition inflation. The
Michigan- type plan, in contrast, requires the return on invest-ment
exceed inflation by a predicted rate. 166
States must also be concerned with the effect of a prepaid
tuition plan on revenue collections. For states with state in-come
taxes, each plan would have an impact on revenues, since the
plans exempt interest earnings from state income tax. If indi-viduals
would have saved in some taxable savings plan, a portion
of their interest earnings would be owed to the state. Propo-nents
contend, however, that many individuals would not have the
ability or inclination to save without the state plan. The bene-fits
of such plans, they add, far outweigh the relatively small
loss of income to the state.
In addition to the loss of taxes on interest earnings, some
plans would result in greater losses in revenue to the state.
The Michigan plan, unlike the other trusts, allows program par-ticipants
to deduct the contract purchase price from taxable
income for state income tax purposes. The other states that
enacted a prepaid tuition trust chose not to include this pro-vision.
The Illinois individual education accounts plan would have
allowed participants to deduct investments in education accounts
from gross income for state income tax purposes. The Governor of
Illinois, however, vetoed the bill because of this tax exemp-tion.
In review, it is in the interest of the state to assist its
citizens in saving for their children's higher education needs.
Such assistance is of particular help to middle- income families
who find it difficult to pay for their children's education and
have difficulty qualifying for financial aid. The state is re-warded
with good will from the public and a better educated
society. This, however, involves some risk to the state. The
degree of this risk depends on the type of program chosen by the
state and how well it is managed. For these reasons, a prepaid
tuition plan must be carefully designed and administered.
As stated above, saving for a child's college education is
not an easy task. Parents are often bewildered by the numerous
investment decisions involving risk, rate of return, and income
taxes. Prepaid tuition plans have sparked a great deal of in-terest
in the states which have either enacted or are considering
such legislation. Critics of prepaid tuition plans, however,
question how good of an investment such plans will be for the
participants. The attractiveness of prepaid tuition plans de-pends
upon a number of factors including tax status of the plan,
the rate of return, provisions for withdrawal from the plan, the
effect on financial aid, and limits institutional choice.
An important question' not yet resolved is the tax status of
prepaid tuition plans. As with the question of risk to the
state, the tax status of the prepaid tuition plan varies with the
type of plan. The tax issue was originally raised when the
~ ibhi~ apnre paid tuition trust plan was introduced. There is a
strong possibility that the difference between the original pay-ment
and the appreciated value of the prepaid plan will be con-sidered
interest earnings and, therefore, subject to taxation.
Such a ruling would have and adverse affect on prepaid tuition
plans. If the interest earnings are subject to taxation, the
purchaser or the beneficiary will have to pay in federal taxes an
amount which could be as much as 28 percent of the interest
earnings, depending upon whether the tax liability is the pur-chasers
or the beneficiaries and what his/ her tax rate is.
Many believe an unfavorable ruling by the IRS would dis-courage
participation in the plan, making the trust financially
unsound. For this reason, Michigan legislators included a pro-vision
in the enacting legislation which would prevent the trust
from becoming operational in the event of an unfavorable ruling.
The legislature would then decide whether to modify the plan in
hopes of gaining IRS approval, offer contracts even though there
would be a tax liability, or allowing the plan to die. Although
none of the other states that have passed similar legislation
include this provision, officials in both Indiana and Tennessee
have expressed opinions that the legislature may repeal the plan
if an unfavorable ruling is received.
Michigan trust officials are currently waiting for a private
letter ruling on whether or not the difference between what was
originally paid and the appreciated value of the tuition contract
is subject to taxation. They contend that their plan is nothing
more than the purchase of goods in advance, not an investment.
The advanced purchase of an airline ticket is a commonly used
analogy. ~ ndividuals may purchase tickets months in advance.
If, later, the cost of tickets for the same flight increases, the
fortunate individuals who bought tickets at the lower rate are
not required to pay taxes on the difference between the new price
and what they originally paid. Therefore, it is reasoned, there
should be no tax liability on the prepaid tuition plan. 168
A number of tax experts, however, are skeptical about
Michigan's chances of getting the favorable ruling from the IRS.
The major flaw in the preceding airline ticket analogy concerns
refunds in the event of withdrawal from the plan. Michigan and
the states with similar plans that have set a refund policy,
offer at least one plan that returns a portion of the interest
earnings to the participant upon cancellation of the contract.
Such interest earnings will clearly be subject to taxation. In
addition, the availability of this option may result in the IRS
declaring the plan an investment and requiring everyone enrolled
in the plan to pay taxes on the plan. 169
It is also possible, however, that the alternative plan,
which returns only the original payment in the event of a refund,
will not be subject to taxation. This may give the purchaser
a tax advantage, but would seriously limit the flexibility of the
plan. Participants with a beneficiary that dies or decides not
to go to college would have only the original purchase amount
which, if invested somewhere else, would have earned interest.
Officials in a number of states are anxiously waiting to see
the results of the IRS ruling on the Michigan plan. In addition
to Wyoming, Tennessee, Indiana, Maine, and Florida, which have
enacted prepaid tuition contract plans, officials in Massa-chusetts
will be very interested in the Michigan ruling due to
the similarities between the Michigan legislation and their
proposed certificate plan.
In addition to whether or not there will be a tax liability
on the interest earnings, there are also questions of when will
I the tax have to be paid and who will have to pay it. Tax experts
feel more confident about the possibility of designing a plan I
that can defer taxation until the contract is used to pay for
educational costs, rather than creating one that will be exempt
from taxation. In addition to the advantage of deferring taxes,
tax experts believe it may also be possible to transfer the tax
liability to the beneficiary. Assuming the student beneficiary
will be taxed at a rate lower than the parent, the tax savings
could be considerable. 17 1
With the Illinois and North Carolina education bonds, the
tax status is more definite, as well as more encouraging. Due to
the tax- exempt status of state and municipal bonds, the interest
earnings on this type of general obligation bond would also be
free from federal income taxes under current law. The Illinois
individual education account plan, however, does not fair as
well. There is no question that the interest earnings would be
subject to federal taxation. 172
The federal plans, as discussed above, would exempt interest
earnings from federal income taxation. In addition, each plan
offers some type of additional tax incentive, making them very
attractive to investors.
In addition to the possible tax liability associated with
the plan, potential participants must evaluate the plan on a
number of other issues. A crucial issue concerns whether or not
the individual would be able to find alternative investments
offering a rate of return equal to the particular prepaid tuition
plan. Once again, the answer will vary with the type of plan.
The Michigan- type prepaid tuition trust plans offers a rate
of that will at least equal the rate of tuition inflation, since
the trust guarantees to pay the beneficiaryts tuition at a state
university. The supporters of the trust plan also hope to offer
the prepaid contracts at a price below current tuition costs,
giving beneficiaries a rate of return that exceeds tuition infla-tion.
As stated above, tuition inflation has consistently ex-ceeded
the rate of general inflation as measured by the CPI by 2-
3 percent each year. It is very difficult for individual
investors, particularly those without a great deal of financial
expertise, to find investments paying this high of a rate of
return. There is also a question of risk involved. Those in-vestments
with a' potential of paying a high rate of return on
investment are also involve greater risk. 173
The education savings bonds plans and the individual edu-cation
accounts plan would not guarantee tuition. The education
savings bonds would pay a specified rate of return equal to. the
rate of return for state long- term general obligation bonds. In
addition, a bonus rate of interest up to one percent would be
paid on certificates redeemed to cover educational costs. The
desirability of this investment, therefore, would hinge on the
condition of the bond market.
The rate of return paid by an individual education account
would vary with the different financial institutions offering the
account. Investors, therefore, would have to look for the insti-tutions
offering the highest rate of return on such accounts. 174
The Massachusetts tuition certificate plan would give inves-tors
a rate of return tied to tuition inflation, since the cer-tificates
guarantee tuition and are priced at current tuition
prices. If, for instance, tuition increased at a compound rate
of seven percent from the tim
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