Does PACT Make Sense?

My clients in Alabama often hear that they should be investing in the Prepaid Affordable College Tuition (PACT) program, so their children’s college costs will be covered. After researching the PACT program, I added this page to summarize what I learned. For most students, PACT is a bad idea.

PACT offers a way for parents, grandparents, and others to prepay the expenses of tuition and fees for a child to attend a public college in the state of Alabama. There are three funding options, a single payment plan, a 5-year monthly payment plan, and an extended monthly payment plan. PACT pays tuition and mandatory fees, which make up about 25% of the cost of attending public college in the state of Alabama. PACT provides no benefits for books, transportation, room and board, or other expenses. PACT provides no assurance of admission to college; it only provides funding once the student is admitted. Click here to go to the PACT website to learn more about how it works.

The cost of PACT varies according to the age of the child. The monthly payment cost for an infant is about 70% of that for a first grader and about a quarter of that for a ninth grader.

For analysis purposes, let’s compare an investment in PACT with an equivalent investment in a Section 529 Plan. It assumes funding for a 1st grader who is going to attend college in a public college in Alabama upon graduating from the 12th grade. It also assumes that savings in the Section 529 Plan grow at 10% per year before tax and are taxed at 15% (the student’s rate) upon withdrawal from the Section 529 Plan. The discount rate for all present value calculations is 8%.

The cost for PACT using the 2000 fee is $122 per month. Per the PACT funding plan, this payment will continue until the child enters college in August following graduation from high school. Also per PACT’s funding assumptions, the child will attend college at a public college in the state of Alabama whose costs are at the weighted average for all colleges in the state.

What we learn in the comparison analysis is that if you assume that college costs will continue to increase at 7.1% per year as PACT does, and if you assume the child will be admitted to and will attend college immediately after high school in the sequence assumed by PACT, PACT has an incremental benefit over an equivalent investment in a Section 529 plan.

If a person were to take the $122 per month required by PACT and invest it instead in a Section 529 Plan yielding 10% on average before tax, the Plan would build up to a balance of $31,760 by the time the child enters college. If the Plan were then tapped for 30 semester hours per year for four years and an additional 15 semester hours in the fifth year (this is PACT’s assumption), priced at the then weighted average of tuition and fees for all public colleges in the state of Alabama, the fund would be exhausted by the beginning of the last semester, leaving about $2,100 that would have to be paid from other sources. That is, there is a funding advantage for PACT over the Section 529 Plan.

This funding advantage is also present for a 9th grader. If a person were to take the $348 per month required by PACT for a 9th grader and invest it instead in a Section 529 Plan yielding 10% on average before tax, the Plan would build up to a balance of $$17,907 by the time the child enters college. If the Plan were then tapped for 30 semester hours per year for four years and an additional 15 semester hours in the fifth year, priced at the then weighted average of tuition and fees for all public colleges in the state of Alabama, the fund would be exhausted during the fifth year, leaving about $1,900 that would have to be paid from other sources. Again, a slight advantage for PACT over the Section 529 Plan.

If you’ve elected to use PACT, and if you have plenty of cash, the one-time payment has a slight advantage for funding the college costs of a 1st grader over the monthly payment. This advantage does not carry over to the 9th grader, however. For the older student, the monthly payment has about the same funding efficiency.

If there is a slight advantage for PACT over the Section 529 Plan, why would I tell you it’s a bad idea? It’s about those “ifs” we talked about. Let’s take them in order. First, PACT assumes that college costs will continue to increase at 7.1% percent per year, or roughly twice the rate of inflation for everything else. Let’s run that assumption out 12 years as we would for a 1st grader now. This means that the cost of attending Auburn University will have increased from $2,951 to $5,471, an increase of a hefty 85%, while the cost of everything else will have increased by a more modest 30%. Each year, as the cost of attending college increases in relation to everything else, prospective students and their parents will search for alternatives.

One of the alternatives they will explore is online learning. Online learning offers the prospect of drastically improved efficiencies and improved instructional quality. Going online, a student can get access to the finest thinkers in the field, the finest teachers in the field. Economies of scale will drive down the cost of this instruction as well.

Let’s be frank. Online learning will not force the end of traditional residential colleges as some have speculated. However, it will place severe cost pressures on traditional residential colleges, pressures they can only begin to imagine now. Consequently, the assumption that costs will continue to increase at twice the rate of general inflation seems naive.

The second “if” relates to the likelihood that the student will be admitted to and will choose to attend college to completion immediately after high school. PACT pays a benefit even if the child attends a private college or attends a college outside the state. That benefit is the average cost per hour for college costs among public colleges in Alabama. The problem is that if the student takes a year off (our friends in Europe call this a “Gap Year”), PACT provides no compensation for that year of waiting.

PACT is also less flexible. A person funding a Section 529 Plan can double up funding in one period and decrease funding in the next period. PACT allows no such flexibility. A person can make a payment early but receives no interest benefit for doing so.

Given all these factors, PACT seems an imprudent investment. If a grandparent or other loved one wants to purchase the PACT plan for your child, by all means accept their generosity and be grateful. Spending your own money, however, seems like a mistake. Better to take that same money and invest in a Section 529 Plan that allows more flexibility, no matter what college choice the student might make.

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