Tuition Inflation, Prepayment Programs, and the Mispricing of Tuition Prepayment Contracts

Abstract

Twenty-two states and a consortium of more than 250 private colleges have designed tuition prepayment contracts to help families manage their tuition inflation risk exposure by prepaying the future cost of college. Nine of these states have either suspended enrollments (one temporarily) or terminated their plans, and at least 12 programs are balance-sheet insolvent. This paper analyzes college tuition inflation, describes tuition prepayment contracts, and develops a contingent-claims model to price them. The model allows for the adverse selection risk that program sponsors face, the moral hazard risk that contract purchasers bear, and the large discontinuous jumps that characterize tuition inflation especially in recent years. I find that the contracts in the largest, most popular public (Florida and Michigan) and private (Independent 529 Plan) programs are mispriced. The Florida and Independent 529 Plan contracts are underpriced, and Michigan's contracts are underpriced for the youngest beneficiaries and overpriced for the oldest beneficiaries even after allowing for adverse selection risk. Florida and Michigan have reduced their underpricing in the last three years, which coincide with public universities in many states announcing large jumps in tuition in response to cutbacks in state subsidies for higher education.