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On April 14, 2009, the State of Oregon announced it was suing the national investment company responsible for managing its state-sponsored 529 college savings fund. Oregon Attorney General John Kroger alleges the investment company misled families into thinking they were making rock-solid investments for their children’s future. Instead, Kroger says one of the firm’s funds took undisclosed risks that resulted in a 36% decline in value for 2008. In a transcript from a report aired on NPR, Kroger says Oregon families “lost about $40 million, and we want our money back.”

(Actually, Oregon’s argument is not with the losses incurred, but that some funds supposedly structured to avoid or minimize market losses, particularly for those accounts that would soon be tapped to pay for education expenses, were not invested according to the objectives stated in the prospectus.)

As Jason Zwieg of the Wall Street Journal notes in an earlier March 21, 2009 article, Oregon is not alone in losing money. Of the 3,506 options in 529 college plans tracked by Morningstar, Inc. “93% fell in value over the past year, and 1,098 lost at least 40%.”

The main attraction of 529 plans is the tax advantages during accumulation and distribution, provided the funds are used for qualified education expenses. These benefits also come with restrictions: Investment choices are determined by the sponsoring state, transfers and/or exchanges are limited, and funds withdrawn for non-qualified reasons may be subject to both income tax and penalties.

Under normal circumstances, the combination of advantages and restrictions seems to provide substantial incentive for families to invest long-term for their children’s college education. But when the investment portion goes south, things unravel.

Families whose children are ready to enter college are finding their 529 accounts have sustained losses – their current balances are less than their deposits. For families whose financial situation has taken a turn for the worse (lost jobs, foreclosure, bankruptcy, etc.), education plans may be off the table. Yet deciding to access the funds often still means incurring penalties – along with the investment losses.

Other states are considering legal action against some of their plan managers. And even the IRS is trying to help. In an April 16, 2009 CNNMoney’s Carolyn Bigda noted “in light of the market’s recent volatility, the IRS is allowing savers in 2009 to switch 529 plans twice. Normally, you can only make a move once per year.”

According to Zweig, one of the shortcomings of the state-sponsored plans is that “the public’s faith in 529s appears to be based partly on a false premise: that state bureaucrats are good at managing other people’s money.” Clearly, the politicians were no better (or worse) than the rest of us when it came to investment acumen.

Beyond the assignment of blame, there’s a case to be made that 529s are susceptible to this type of turmoil because of the financial philosophy that underlies them. Many government-sponsored savings programs come with restrictions and incentives to encourage a narrow response from citizens. The 529 is designed for families to invest for college in a list of investment options chosen by state officials – that’s it. As long as everything goes well, both for the investment and the individual, the outcome is usually acceptable.

This compartmental approach – a specific plan with a singular purpose – often conflicts with the fluid nature of individual financial lives. At different times people want education money, or retirement money, or down payment money. And many individuals don’t have enough money to leave unused in separate compartments for several years – they would like to use the money they have for the reason that’s important right now. When things go wrong or priorities change, there’s often not enough money in one compartment, or there’s a prohibitive cost for redirecting the money to another compartment.

Given the choice, most Americans would probably prefer a tax-favored account with unlimited accessibility, similar to life insurance cash values – a larger pool of money available for whatever issues or opportunities may arise. Of course, well-intentioned politicians will fret that giving individuals an unrestricted tax-favored account may result in irresponsible spending. And considering the alleged abuses and failures of the financial professionals with 529s, the expectation may be tighter restrictions.