Saving Up for College Tuition and Hedging, Part 3

Ever since the government permitted it, many private colleges have been hopping onto the tuition prepayment plan bandwagon. Unlike the College Board's IC 500 index, tuition prepayment often does not include room and board increases. Colleges including some of the Ivies (e.g., Dartmouth, Penn, Princeton), MIT, Stanford, UChicago, and USC tout the private college prepaid plan. For a complete list of the 270+ private schools using this plan, see the consortium's website (managed by OppenheimerFunds, which also happens to manage many of the state 529 plans). States sponsor their own, but some are portable and can be used to fund tuition at out-of-state private schools or even select foreign ones.

According to Bankrate, college savings and prepaid tuition plans are treated differently when it comes to financial aid calculations. This is a big gotcha.

The private college plan has a considerable amount of counterparty risk. It is not FDIC insured or guaranteed by state or federal governments. The fund has an annualized investment performance bracket of +/- 2%, in case one asks for a refund of the purchase. Most of the portfolios associated with college savings as offered by Oppenheimer Private Investments are just a mix of stocks, nominal bonds, a good helping of TIPS (up to 25% in some portfolios), and money market funds. I see no a priori reason why this would outperform or meet the payout requirements. Indeed, all the portfolios lost money during the past few years, hardly the 4-5% return needed to keep up with even moderate increases in tuition costs. Morningstar has an article about what happened to 529 plans during the onset of the financial crisis, which was not a pretty picture. What happens with the Private College Prepaid Plan is that the universities and colleges bear the market risk.

Market risk has greatly affected many state prepaid plans, leaving many significantly underfunded. That leaves us with both a consortium of private colleges and universities and state governments on the hook for market risk, higher education cost increases, and counterparty risk. I recall that university bonds are really difficult to come by because they as entities are considered rock solid, but at the rate the markets are going, they are putting themselves at significant risk if they or their investments managers do not have a formula for hedging costs.

WSJ's article on college savings and prepayment debacle. One academic paper studied the returns and volatilities of 529 plans versus the general market.

Research grants are an interesting component of a university's revenues. Since government research funding to academia takes at least two routes, we can follow the money. Some government research grants go directly to research groups and professors such is the case with NSF and NIH. Larger grants, however, may go through the coffers of defense contractors and private research firms before being disbursed to a subcontractor, which is often a university. So say you invested money earmarked for tuition in ITA (iShares Aerospace and Defense ETF) for the 5 years from 2006. Tuition would have increased 24% while your investment would have increased 21% with a big hiccup in 2007 when it slide 35%. Again, the volatility is just too much to be a reliable hedge for tuition increases. The problem is that universities tend to increase fees when grant revenue takes a downturn, but the return from shorting ITA would be disastrous.

Although as a part of total household debt, student loan debt is only sliver (5% in 2010 according to the NY Fed [PDF]), it is the fastest growing component of household debt when other forms of debt are falling or flat.