e-Texas e-Texassmaller smarter faster governmentDecember, 2000
Carole Keeton Rylander
Texas Comptroller of Public Accounts

Recommendations of the Texas Comptroller

Chapter 6: Education

Create a College Savings Plan


In response to spiraling college costs, many states have created prepaid tuition and college savings plans to help families save money for their children’s education. In Texas, the Texas Tomorrow Fund began operating in January 1996, allowing participants to lock in college tuition and fee rates at today’s prices. In recent years, however, the popularity of such programs has waned. In response, many states have created college savings plans that permit parents to invest in mutual fund portfolios, allowing them to earn greater returns on their investments. Texas should establish a plan with these features to supplement the prepaid tuition program.


The 1970s saw little real growth in the cost of college education. Since 1980, however, the cost of college tuition has risen at twice the rate of the increase in the Consumer Price Index (CPI). Because median family income has risen only 22 percent since 1981, low- and middle-income families have been hit hardest by the rapid rate of tuition increases. Student aid also increased over this period, but not fast enough to keep pace with rising tuition. Moreover, most of the increase in student aid came in the form of student loans.[1]

In response to skyrocketing increases in college tuition and fees at both public and private colleges and universities, many states created prepaid tuition programs during the 1980s and 1990s. Such programs allow parents to lock in the future cost of a college education for their children at today’s prices.

When they were first established, the federal tax treatment of state prepaid tuition programs was unclear. The Internal Revenue Service subsequently declared, however, that the Michigan Educational Trust did not qualify for favorable tax treatment because it was not an “integral part of state government” and served a private purpose. This ruling had a chilling effect on other states’ efforts to create similar programs. States with existing programs tried to overcome this hurdle by incorporating structural features designed to meet the IRS’ objections, such as operating the program within a major state agency such as the state’s treasury.

The federal Small Business Protection Act of 1996 added Section 529 to the Internal Revenue Code. This section outlines the criteria a state must meet to establish and maintain a program as a “qualified state tuition program” (QSTP) and describes their federal tax treatment. Section 529 gives states considerable latitude in determining how to structure and administer QSTPs. As a result, programs in different states vary considerably from one another in structure. For example, some states (including Texas) allow the purchase of plans to benefit only current residents. Other states allow purchasers to establish accounts for future students who reside in another state.

After favorable tax treatment was ensured, state-sponsored prepaid tuition programs and savings plans spread rapidly across the United States. In 1996, only seven states had prepaid tuition programs; at this writing, there are 22.

Texas Tomorrow Fund

In response to a proposal by the Texas Performance Review, the 1995 Legislature enacted House Bill 1214, which created the Texas Prepaid Higher Education Tuition Program. The program was placed in the Comptroller’s office, with the Comptroller serving both as chair of the board governing the program as well as its executive director. The program was marketed by the name of the trust fund set up to invest proceeds from contract sales, the Texas Tomorrow Fund (TTF).

The TTF is a constitutionally–protected fund. In November 1997, Texas voters approved Proposition 13, a constitutional amendment that put the state’s official backing behind the program. Investments in the Texas Tomorrow Fund are guaranteed with the full faith and credit of the state. As of mid-2000, the Texas Tomorrow Fund has sold nearly 100,000 contracts, and about 6,000 students are already attending colleges and universities with prepaid tuition funds.

Despite these successes, contract sales have been declining since the fund’s first enrollment period. During the initial enrollment period, more than 40,000 contracts were sold; in 2000, that number fell to just over 12,000. To some degree, this decline could have been anticipated, because sales during the first contract period captured “pent-up” demand for the program. In addition, contract prices have risen, as Texas’ public college and university tuition continues to rise at a rapid clip. A contract for four years (120 semester credit hours) at a state university cost less than $10,000 in 1996. In 2000, that same contract costs $14,759. (The contract now covers 128 semester credit hours; adjusted to 120 semester credit hours, the contract would cost $13,837).

While increased cost is a factor, part of the recent enrollment decline also reflects the popularity of alternative savings vehicles such as mutual funds and stocks. Many potential purchasers may be foregoing participation in the TTF because they believe that they can get a higher rate of return investing on their own, even after allowing for the favorable tax treatment the TTF receives.

Because a TTF contract is tied to actual tuition costs, its value rises only as tuition and fees rise. If tuition inflation slows, the return on a TTF investment will decline. Holders of TTF prepaid tuition contracts have an investment that is backed by the state, something not true of any investment in the stock market. Nevertheless, that guarantee is less attractive when potential purchasers can earn greater returns through alternative investments.

College Savings Plans

Federal law allows states to sponsor savings programs that allow purchasers to save for college in tax-deferred investment accounts. These accounts are managed by a private investment manager and can be invested in a combination of portfolios including both equity and fixed-income investments. As with a 401(k) plan, this combination can vary based on the age of the child, with a greater proportion of the account invested in equities at a young age, shifting to fixed-income investments as the beneficiary nears college.

Many states are choosing to create college savings plans, allowing participants to invest in portfolios managed by respected investment firms such as Vanguard, Fidelity Investments, and Merrill Lynch. (Section 529 does not permit individuals to direct their own investment accounts.) Thirty-four states now offer college savings plans; Texas does not.[2]

New Hampshire’s UNIQUE College Investing Plansm is managed by Fidelity Investments. Contributions are invested in one of the UNIQUE Plan portfolios, which in turn are invested in Fidelity mutual funds. Fidelity automatically adjusts the balance of stock, bond, and money market mutual funds in the portfolio according to the beneficiary’s age. When the beneficiary is 10 or more years away from entering college, the portfolio is heavily invested in equity mutual funds to increase the account’s capital. As the beneficiary nears college age, the portfolio gradually shifts to bond and money market mutual funds to preserve capital that will be needed for college expenses.

Colorado’s program, CollegeInvest, operates both a prepaid tuition plan and a college savings plan. The savings plan, Scholars Choicesm, allows participants to select one of three investment options. Under Option 1, contributions are invested based on the age of the child, as with New Hampshire’s program. Option 2 is a “balanced option” with 50 percent invested in equity mutual funds and 50 percent in fixed income funds. Option 3 is based on the number of years remaining until enrollment, rather than the beneficiary’s age; this involves more aggressive investments early in the plan and may be more appropriate for older children or adults planning to further their educations. Option 1 and 3 contributions are invested in a series of portfolios that shift from equity mutual funds to bond and money market funds as the student approaches college enrollment. Salomon Smith Barney manages the investments for all three options.

Reviews of the TTF in investment periodicals, such as Kiplinger’s Personal Finance magazine, have criticized Texas’ program because it lacks some of the flexibility and potential for higher returns offered by other state-sponsored programs. Investors in TTF cannot earn more than the actual cost of tuition; some other programs offer the potential to earn money above future tuition costs.

Kiplinger’s also notes that, because contract prices are based on weighted average tuition and fee rates (which vary considerably among Texas colleges and universities), the parents of a child who select a less-expensive college or university can come out ahead by canceling the tuition contract, even after paying the 10 percent penalty assessed on prematurely withdrawn earnings. Kiplinger’s cites a recent analysis of college savings programs that noted that nearly all participants in the Texas plan earned less than the rate of tuition and fee inflation over the last two years, because the program prices contracts at a premium over current rates to cover administrative expenses. The magazine recommends that parents select a college savings plan offered by other states instead.[3]

When the TTF was created, uncertainty concerning the program’s IRS status caused its sponsors to be cautious about its features. In addition to its investment structure, the program is limited to Texas beneficiaries who are under 18 years old. Today, 19 states have no residency requirement. No such limitations are required by Section 529, which had yet to be enacted when HB 1214 was passed in 1995. The time has come to revisit TTF’s structure and provide more options than are available under existing state law.

State-operated college savings plans are relatively new, making it hard to assess their popularity compared to prepaid tuition programs. Nonetheless, some evidence suggests that they will prove popular to savers. Massachusetts operates both a prepaid tuition program and a college savings plan. The state’s college savings plan, known as the U.Fund, gathered $130 million in 18,000 separate accounts during its first 13 months of existence. By comparison, the U.Plan, the state’s prepaid tuition program, has collected just $95 million in its five-year existence.[4]

Using private firms to manage investment accounts for college savings plans creates opportunities for joint marketing efforts. For example, Salomon Smith Barney’s (SSB’s) brokers and Citibank customer service representatives are promoting Colorado’s program. SSB markets the program to existing and potential clients nationwide and will likely work with the State of Colorado to develop a television campaign. The state and SSB also share some of the costs related to print media advertisements.[5]

If marketed successfully, state college savings plans have been popular beyond their sponsoring state. For example, the Montana Family Education Savings Program has 1,752 accounts, 637 of which are out-of-state accounts. The program has $11.1 million in deposits, with $3.5 million from Montana families.[6]

Texas and other states only have begun to answer the widespread need for college savings vehicles. A recent survey by the College Savings Plan Network, an organization of state plans, found that 73 percent of parents are saving for their children’s education. Just 4 percent are using qualified state tuition programs, even though 54 percent of the survey’s respondents are aware of these programs.[7]


The Texas Education Code should be amended to create a college savings plan to provide purchasers with greater flexibility and potentially higher returns than are available through the Texas Tomorrow Fund.

The plan would be administered by the Texas Tomorrow Fund, with investments managed by a private firm to be selected through a competitive bid. As with savings programs in other states, investments would be held in accounts that allocate a greater proportion of the investment to equity funds for younger beneficiaries, shifting to relatively safer, fixed-income investments as beneficiaries near college enrollment.

Section 529 of the Internal Revenue Code does not specify a limit on the amount of funds that can be invested for a beneficiary, but does require that the state set a limit. The purpose is to prevent purchasers from investing funds far in excess of those that are required to finance a college education. A limit should be established that takes into account any funds invested in the prepaid tuition program. For example, Colorado limits investments in its prepaid tuition and college savings programs to a combined total of $150,000.

The college savings plan should accept beneficiaries from any state, rather than restricting participation to Texas residents. In addition, the plan should have no age limit for beneficiaries. This change would allow adults to use the plan to save for their own education, an important feature since lifelong learning will be critical to the state’s future economic success.

The constitutional provisions that guarantee the payment of prepaid tuition contract benefits should not apply to the college savings component of the program. While funds should be safeguarded because they could not be diverted by the Legislature for other uses, the plan would not offer a guaranteed rate of return. Purchasers could select from either the prepaid tuition program, with its guaranteed benefits and potentially lower rate of return, or the college savings component, with potentially higher returns but no guarantee. Participants could contribute to both plans, but total contributions should be capped.

Fiscal Impact

The Education Code requires TTF to be self-supporting. The program’s operating costs are paid for from the sale of contracts, administrative fees and investment income.[8] Although the state will incur some additional costs by creating a college savings component, these expenses would be paid from the fund. No additional state appropriations would be required.

[1 ] College Board, Trends in College Pricing 1999, New York, 1999, p. 3.

[2 ] College Savings Plan Network, “State of the States: State College Savings Plans Overview,” April 11, 2000 (http://www.collegesavings.org/state-table.htm). (Internet document.)

[3] Kristin Davis, “College Bound,” Kiplinger’s Personal Finance (August 2000), p. 110-117.

[4] Chris Pope, “U.Fund at head of class; College savings participation high,” Worcester Telegram & Gazette (March 9, 2000).

[5 ] “SSB Plugs New College Savings Plans on Web Site,” Financial NetNews (June 5, 2000), p. 1.

[6 ] “Montana Family Education Savings Program Exceeds Expectations By Threefold During First Two Years of Operation,” PR Newswire, March 24, 2000. (Press release.)

[7] “College Saving Made Easy,” Journal of Accountancy (November 1999), p. 27.

[8 ] V.T.C.A., Education Code §54.640(a).

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Post Office Box 13528, Capitol Station
Austin, Texas

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