Higher Education’s Event Horizon
How Universities Will Collapse Under Their Own Weight
Event Horizon: (1) The point of at which the gravitational pull from a black hole becomes so great as to make escape impossible. (2) The point of no return.
The real crisis in higher education is a lack of fiscal responsibility, not technological change. Any business can only sustain itself as long as its revenues continue to exceed its costs, and unfortunately at universities across the country almost every revenue stream is currently declining (tuition, grant funding, state subsidies, etc.) while their respective cost bases (faculty, infrastructure, etc.) continue to steadily increase.
Universities compete to attract the brightest students in the country, by aggressively investing in new educational, recreational, and research resources; however, much of this institutional growth is increasingly financed through debt and tuition rate hikes, the latter of which also serves to improve the relative prestige of the university (since consumers often assume more expensive products correspond with better quality products).
By making these rational strategic decisions to invest in institutional growth while increasing tuition, university administrators have trapped the Higher Education industry in a prisoner’s dilemma, in which competing institutions must play along in order to avoid losing their best students and potential revenue; however, unabated tuition hikes will eventually eliminate the economic return for nearly all students attending institutions of higher education, which could lead to the collapse of the entire industry.
I have no doubt that universities provide educational value; however, the more important question is, how much value are universities contributing to students and is it worth the societal cost? Given the wide variation in financial earnings by major and also the variation in tuition rates among institutions, the cost-benefit analysis of a single student considering any one program should never be extrapolated to represent the financial benefits of attending college for the whole country. In contrast, a sensitivity analysis of the financial return of pursuing a college degree can indeed reveal important trends applicable to the industry as a whole.
As one might expect, the two most important factors which determine the magnitude of the financial return of pursuing college are the upfront cost of attendance and the expected net increase in lifetime earnings. This makes logical sense: students take on enormous amounts of debt to attend college with the expectation that they will then graduate and earn much more money over the course of their lifetime to make up for paying for college. Therefore, in order to predict how the financial returns of college will change over the next decade, we simply have to evaluate whether or not the rate at which universities are increasing their cost of attendance (thereby reducing the net benefit to students) is outpacing the rate at which the same institutions can increase the lifetime expected earnings of their graduates’ (thereby increasing the net benefit to students).
Given that annual tuition increases get compounded and thus exhibit exponential growth, while inflation-adjusted earnings for the American middle-class has not increased in decades, one can quite conservatively calculate that within the next decade most universities will reach their “Event Horizon,” a phase at which the financial returns for pursuing most bachelor degrees will be less than the financial returns of pursuing community college or simply holding a high-school diploma.
Furthermore, given the ever increasing cost base and debt levels at most universities, it is unlikely that such institutions will be financially capable of significantly reducing their tuition cost once the Event Horizon is reached. In short, at the Event Horizon many universities will become insolvent under the weight of their burgeoning costs, declining revenues, and mass exodus of students.
My hope in publishing this research is to increase public awareness in order to prevent institutions from ever reaching their Event Horizon. I am very optimistic that just as the business model of higher education has adapted to the demands of society over the past few centuries, it will successfully do so again, but not without sacrifice.
While my discussion strongly emphasizes analysis of the financial returns to pursuing higher education degrees, I also respect that the full value of a higher education degree also includes important social and emotional benefits such as job/life satisfaction, increased social networks, amongst others. The decision on whether or not to pursue a degree in higher education is a very personal one, and will reflect the diverse economic and social value judgments of each student.
Public discussion based on hype, anecdotes, or faulty scientific analysis hurt students everyday as they struggle to make the best decisions for their future. I am sure that my own analysis will fall short on some accounts, and I encourage you to challenge my assertions with any opposing research studies or facts, so that together we can help improve the accuracy of the public discourse around higher education.
Part I: Higher Education’s Fiscal Cliff
“..In light of advances in technology, a faltering economy has raised questions in the public’s mind about the value of a college education and every revenue stream upon which institutions of higher learning depend has come under pressure. Harvard has not been immune to these trends and we have to adapt.” Drew Gilpin Faust, President of Harvard University
To begin, let’s evaluate the assertion that universities are facing enormous financial pressures. In light of skyrocketing tuition prices it may surprise many readers that President Faust claims every revenue stream is under pressure. Obviously, any business can only sustain itself as long as its revenues continue to be greater than its costs, so let’s see how these revenue drivers and cost bases are changing at American universities:
Tuition & Fees
Tuition and fees (i.e. cost of attendance) are typically the largest share of operating revenue for both public and private universities, and over the past few decades, institutions of higher education have been able to increase the price of tuition far in excess of the rate of inflation. However, more recently the prospective students, and their financial backers (such as parents), have become increasingly price sensitive which has suppressed the profitability of higher education institutions.
Consequently, in fiscal year 2011, nearly 35% of private colleges and universities rated by Moody’s Investors Service did not achieve tuition revenue growth at the Federal Reserve’s target rate of inflation of 2%.
When looking at the chart above by Moody’s Investors Service 2015 Outlook of US Higher Education, it is important to keep in mind that the expected rate of inflation is around 2%. Therefore, if an institution’s change in net tuition revenue is equal to 2% it means that in “real terms” the institution didn’t increase tuition revenue at all despite increasing their tuition “sticker price.”
This is in stark contrast to the early 2000s when universities were able to increase net tuition revenue 6–8% per year by increasing tuition, which implies that students and their families have become increasingly price sensitive over the past decade, and as a result, many institutions can no longer boost revenue by increasing tuition.
State Subsidies & Grant Funding
Public and private institutions also rely heavily on government funds in the form of research grants and subsidies for public universities. However, increasing budget pressures on the Federal government is limiting the grant funding available for research universities.
According to Nature, Federal spending on R&D grants declined by over 16% between 2010–2013, which was the fastest decline over a three-year period since the end of the space race in the 1970s. Moody’s 2015 Outlook expects NSF and NIH funding to continue to decline on an inflation-adjusted basis as a result of Federal budget pressures.
Additionally, state subsidies to public universities are also under pressure since other state priorities (e.g. pension obligations, healthcare, etc.) are limiting the money that is available to be spent on education. According to Moody’s, state funding for public universities remains below pre-recession levels, and has declined on a funding-per-student basis despite recent increases in state appropriations. As a result, prior to 2009 public universities relied on state subsidies for roughly 30% of their operating revenue, but by 2013 state subsidies dipped below roughly 25% of public university operating revenue.
Medical Services & Healthcare Plan
Many universities also generate a significant share of their revenue by providing medical services in the form of a university-owned hospital or clinics, and in some cases, also by selling their own health insurance plan.
The provision of medical services is often one of the top revenue sources for prestigious American universities; in fact, it is the greatest source of revenue for Cornell University constituting 23% of their revenue compared to just 17% from tuition (Cornell Financial Report, 2013–2014). Similarly, Stanford University earns about $200 million more revenue from the provision of healthcare services than it does from student tuition (Stanford Financial Report, 2013–2014).
Increasingly prestigious universities build or become affiliated with Academic Medical Centers (AMCs). Some of the most notable AMCs and their affiliated universities are: Massachusetts General Hospital (Harvard Medical School), University of Pittsburgh Medical Center (University of Pittsburgh), Weill Cornell Medical Center (Cornell University), and Stanford Hospital and Clinics (Stanford University). The AMCs often serve as both teaching hospitals for the university’s respective medical schools, and as research hospitals to pioneer new biomedical devices or surgical techniques.
According to Moody’s 2015 Outlook, while most universities with AMCs currently benefit from their hospital relationship as a result of sustained hospital performance, the implementation of US healthcare reform and changing reimbursement models will slow growth in hospital revenue and will require AMCs to pursue more private funding sources (i.e. philanthropy and industry-sponsored research). Additionally, since AMCs tend to take the challenging patient cases and utilize novel technologies that require high capital investments, some economists worry that AMCs will be adversely impacted by the passing of the Affordable Care Act (Becker, Formisano, Getto 2010).
AMCs and other hospitals already operate at very narrow profit margins, generally between 3–4% of revenue; however, given recent macroeconomic trends US hospital profit margins declined 0.5% between 2012 and 2013. In 2014 Vanderbilt University announced that it would separate itself from Vanderbilt University Medical Center (VUMC) due to financial difficulties.
Endowment Disbursements & Annual Giving
A few institutions of higher education are fortunate to have a large financial endowment to help support their operating expenses. An endowment is a donation of money to a not-for-profit organization that is structured so that the principal amount is maintained, while the investment income off the principal is available for use, so that the donation can continue to provide the organization benefits in perpetuity. Furthermore, many alumni donate towards the endowment of their respective universities with strict stipulations on what it may be used towards (specific department, research initiatives, etc.).
Therefore, an endowment is largely an illiquid asset, because the principal cannot be touched; for example, while Carnegie Mellon University (CMU) had an endowment of roughly $1.25 billion in 2014, it only used $50 million of the investment income in 2014 (Carnegie Mellon Financial Report, 2014). Similarly, most institutions use just a small percentage of the endowment each year to help run the university, generally between 4–6%, which covers 30–60% of their operating expenses in any given year.
While having a large endowment is certainly an advantage it has also proven to be a temporary weakness in the wake of the 2008 financial crisis, when the endowments of many prestigious universities declined roughly 30% (as a result of the decline in financial markets), requiring these institutions to take out billions of dollars of debt to fund their operating expenses at higher interest rates. As a result of this increased endowment volatility many prestigious universities have sought to lessen their operational dependence on endowment disbursements. Additionally, since universities cannot remove the principal on the endowment, it is less helpful in times of dire financial need. As a result, in 2015 Sweet Briar College announced that it would be closing down due to “insurmountable financial challenges” even with $94 million in its endowment which it could not touch (Note: Sweet Briar has since been temporarily rescued by an outpouring of alumni donations, so it will operate for at least one more year as it attempts to balance its budget).
While annual gift giving remains an important revenue stream of many top universities it is also tightly correlated to the macro economy, and therefore cannot be relied upon in an economic downturn. Additionally, as the tuition price of universities increase, more and more students believe that they adequately paid their dues through their tuition and thus feel less indebted to their alma mater after graduating (in fact, in Part II evidence will demonstrate that for many students they have already paid their fair share). In other words, the opportunity to attend university becomes less of a “gift” and more of a “transaction,” as an example of the social theory of Gift Exchange. Also, today’s graduating students tend to be saddled with greater student debt which may limit their ability or their willingness to donate back.
Other Revenue: Technology Licensing, Tech Incubators, & Venture Capital
In light of the aforementioned financial pressures as well as increasing popular sentiment around entrepreneurship and innovation, institutions of higher education have sought to further diversify revenue streams through accelerating technology licensing, operating university tech incubators (through which they receive an equity-stake in startup companies), or even operating as a corporate venture capital investor. Unfortunately, none of these new revenue sources seem likely to be financially sustainable without cross-subsidies from other parts of the university.
While technology licensing sounds like a logical revenue stream, a recent Brookings Institution study found that the technology licensing revenue covers the cost of operating the technology licensing office at only 13 percent of research universities. The cost of patenting university research, identifying valuable patents, and finding suitable buyers is simply too expensive in most cases, and as a result an estimated 95% of patents remain unlicensed. Consequently, many universities have begun selling bundles of their patents to patent-assertion entities, also known as “patent trolls”, which notoriously profit from these patents through extorting small-businesses by suing them for vague patent infringement.
Ironically, while universities proclaim the importance to fostering innovation, recently both the Association of American Universities and the American Council on Education have sided with the patent trolls to stop patent reform legislation in numerous states. This is a nuanced issue, and while on some of these legislative issues universities have sided with patent trolls, I am not claiming that universities are patent trolls. The best clarification on this subject is Stanford Law Professor Mark Lemley’s publication, appropriately titled “Are Universities Patent Trolls?”
While many universities have been rushing to create startup incubators or even venture capital portfolios (e.g. Stanford’s StartX), it is very unlikely that many of these endeavors will provide much, if any, financial return. According to the National Business Incubation Association, the US had nearly 1,250 incubator programs back in 2011, and according to the National Venture Capital Association Yearbook there were 803 venture capital firms in existence in 2014. However, according to Andy Rachleff, co-founder of Benchmark Capital and former CEO of Wealthfront, only about 20 firms, or about 3% of the total venture capital firms, generate 95% of the industry’s returns, and the composition of the top 3% doesn’t change very much over time (some in the venture community debate the exact numbers of this effect but overall everyone agrees on the concentration of returns). Therefore, the vast majority of incubators and venture capital firms consistently provide sub-market returns, while the top few incubators (e.g. YCombinator, Techstars, etc.) and venture capital firms (Sequoia, KPCB, Andreessen-Horowitz, Benchmark, etc.) reap most of the gains, and it is very unlikely that universities will be able to successfully compete in this space.
[Optional reading if you like venture capital math: Even in the most optimistic scenario assuming that university incubators could fund an elusive “unicorn” (startup valued > $1 billion), a crude cost-benefit analysis for the financial viability of such university incubators can be performed by using what Chris Dixon has called the “Babe Ruth Effect of Venture Capital”, which states that the majority of the profits will come from just one investment in the portfolio (i.e. the unicorn). According to the most recent analysis by venture capital investor Aileen Lee, only about 0.14% of venture-backed companies become unicorns, and given that many incubated companies will never receive venture financing, the percentage of incubated-unicorns is probably much lower. Most incubators like YCombinator offer roughly $100K-$120K in capital to startups or equivalent resources (workspace, legal advice, etc.) in exchange for 6–7% equity in a company. Therefore, a very optimistic cost-benefit calculation would show that for every $100K that a university allocates to a startup, an expected return would be less than $98K ($1B x 0.14% x 7%); however, this completely ignores the effect that most returns are concentrated to the top VCs/incubators and that the returns would be discounted by a 7–10 year investment horizon. One way to improve these odds would be to reduce the upfront investment per startup, but this would cause the best entrepreneurs to seek investment elsewhere on better terms (leading to adverse selection bias), and given that many universities are spending tens of millions of dollars to build these incubators, the cost-per-startup is likely to be much higher.]
Cost Bases: Labor, Infrastructure, and the “Law of More”
While almost every revenue stream for higher education is declining, institutions of higher education are increasingly taking on more debt in order to grow. At the same time their cost bases are also increasing. As Bain Consulting summarized in their report entitled “The Financially Sustainable University”:
Much of the liquidity crisis facing higher education comes from having succumbed to the “Law of More.” Many institutions have operated on the assumption that the more they build, spend, diversify and expand, the more they will persist and prosper. But instead, the opposite has happened: Institutions have become overleveraged. Their long-term debt is increasing at an average rate of approximately 12% per year, and their average annual interest expense is growing at almost twice the rate of their instruction-related expense. In addition to growing debt, administrative and student services costs are growing faster than instructional costs. And fixed costs and overhead consume a growing share of the pie.
The main cost bases for operating universities are: (1) administrative and instructive employees (which typically constitutes between 50%-65% of the operational expenses), (2) general supplies and purchased services, (3) maintenance and facility costs, (4) depreciation of infrastructure, and (5) interest expense on the debt.
The pie chart below shows just one example from Cornell University’s 2013–2014 Financial Report of how the relative weight of these expenses might be divided:
Reducing an institution’s fixed costs is particularly challenging given that infrastructure/building investments in prior years have led to long-term operating costs, deferred maintenance, and depreciation costs. Furthermore, while it is possible to reduce some supporting administrative staff, it is very difficult to lay off tenured faculty that constitute a substantial portion of the labor cost base.
Conversely, even the variable costs (e.g. general supplies) are difficult to reduce because they are proportional to the number of students taught, and many universities are currently trying to increase the size of their student body in order to bring in more tuition revenue and to more efficiently utilize their fixed investments.
As a result, Bain Consulting found that between 2002–2008 the costs bases of instruction, property/equipment, interest expense, and long-term debt increased at a compound annual growth rate (CAGR) of 4.8%, 6.6%, 9.2%, and 11.7% respectively, which far exceed the top line revenue growth at most institutions:
As a consequence, Moody’s Investors Service has been downgrading the debt of many universities over the past few years, and since 2013 has declared that it has a negative outlook on the US higher education sector.
While most universities highlight new buildings and alumni donation statistics in their respective Annual Reports, their audited Financial Reports (which are typically publically available online) reveal their underlying financials. Unfortunately, it is easy for any institution to highlight successful anecdotes of students and to show off ever increasing growth of new college buildings (while neglecting to tell you that their debt has been downgraded), but the real question is whether such growth is financially sustainable and improves the unit economics of the core business.
In Bain’s report, the firm urges institutions to aggressively focus on reducing unnecessary capital investments, to reduce their cost base, and to focus on creating value from their core. Unfortunately, for strategic reasons most universities have failed to do so, as we will see in the next section.
Prisoner’s Dilemma: The Battle for Prestige
The Heterogeneity of University Business Models
It is important to note that while the aforementioned trends suppressing revenue growth and increasing cost bases exist, they will not impact all institutions equally. Why not? Because the industry of Higher Education exhibits a tremendous heterogeneity of business models as a result of how the sector has continued to evolve in the US over the past 200 years.
In order demonstrate this point, the following chart shows the percent of the total revenue that is derived from each revenue stream at a selected group of public, private, research, and liberal arts institutions (all data pulled from the 2013–2014 financial reports of the respective institutions) :
As can be seen in the in the chart above, while Columbia College of Chicago relies on tuition and fees to cover 93% of their total revenue, Yale University relies on tuition for less than 9%. As an Ivy League school with a huge endowment ($23.9 billion), Yale University relies on its endowment draw to cover 33% of its operational revenues (more than tuition and research combined).
Meanwhile as a prestigious research university, Carnegie Mellon University (CMU) relies heavily on grant/research funding for nearly 36% of its revenue; however, CMU does not have a medical center in contrast to Cornell University which derives the most revenue (23% of total) from the provision of its medical plan and hospital services. [Disclaimer: while CMU had an endowment of roughly $1.25 billion with a $50 million draw in 2014, its endowment disbursement was not clearly separated in the operating revenue of their financial report and is not shown in the above chart].
In essence what we call “Universities” are in reality heterogeneous business models which cross-subsidize their various operations, but each university exhibits different core strengths. As such, one can assume that the impact that the aforementioned trends constraining revenue will impact each institution based upon each institution’s unique reliance upon that revenue stream (i.e. tuition price sensitivity would impact Columbia College Chicago more than Yale, and reductions in federal grant funding would hurt CMU more than Cornell, etc.).
Competitive Strategy in Higher Education
Given how heterogeneous universities are in terms of their geographic location, size, and their organizational mission (vocational training vs. liberal arts vs. research) they tend to compete for very different types of students and faculty. Most universities know which other institutions they directly compete with for the same students and faculty, which they term their “peer group.”
In his book Competitive Strategy, Harvard Professor Michael Porter, outlined two key generic strategies that businesses use to effectively compete: cost-leadership and product differentiation. A cost-leadership strategy requires that a business optimize its operations and leverages economies of scale in order to deliver the greatest value at the lowest cost to the consumer, which allows the company to capture more market share and drive further economies of scale to drive down costs (e.g. Walmart). In contrast, a differentiation strategy requires a business to focus on increasing the “perceived value” of its product by emphasizing additional dimensions which the consumer is willing to pay a higher price for (e.g. Rolex).
In most consumer products markets we tend to assume that there is a positive correlation between price and value (i.e. you can pay more to fly first class or to rent a larger apartment). However, this assumption starts to break down when the value of the good is hard to define or measure, and thus the price of the good becomes more a function of what the seller convinces you the product is worth rather than what the product’s actual utility is. Unfortunately in higher education, the value of attending one institution over another is very difficult to define (further explained in Part II), and therefore institutions prefer to compete by increasing the perceived value of attending their institution than through reducing costs.
In Kevin Carey’s recent book The End of College, Mr. Carey interviews the former President of George Washington University (GWU), Stephen Joel Trachtenberg, and Mr. Trachtenberg candidly details the strategy he used since 1987 to turn GWU into the prestigious university that it is today. In short, Trachtenberg convinced applicants that GWU was worth a lot more money by simply charging a lot more money; however, in contrast to most markets, as the price surged upward so did the number and the quality of applicants to GWU, who assumed that by being more expensive GWU must have been a better school, so the average SAT score of its students also rose. In other words, the higher education market often behaves like a luxury goods market, and the best competitive strategy to succeed in such a market has been increasing the consumers’ willingness-to-pay.
In addition to the positive market signaling effects there are other benefits to increasing the tuition price as well. The most obvious benefit is simply increasing net tuition revenue which universities can then reinvest in more infrastructure projects (such as athletic facilities, visitor centers, incubators, etc.) which will further differentiate them from their peer competitors.
However, even for institutions which have reached the maximum tuition for many of their students (as discussed in the Tuition section), the institutions can still increase the sticker price of their tuition to signal their university’s prestige in the marketplace while then offering a scholarship to the majority of their students so that the net tuition remains the same. This has the added benefit of capturing both the signaling power in the marketplace while simultaneously making the majority of students feel like they got a great deal for attending their university, all without changing any of the underlying business fundamentals.
Additionally, given the international prestige of American universities, many institutions increase their foreign recruiting in order to attract international students who end up paying closer to the maximum tuition price and therefore cross-subsidizing domestic students.
In order to finance this “Battle for Prestige,” while universities’ traditional revenue streams are constrained, universities are turning to debt markets in order to finance construction projects that will further increase their perceived value. Ever since the 2008 recession Federal Reserve interest rates have been held near 0% which makes debt artificially cheap and particularly attractive.
As we saw from Bain’s Report on the Law of More, much of this financing is being used on projects that provide little if any educational or research value (e.g. Northwestern University recently built a $32 million visitor center) and Moody’s has started downgrading many universities’ debt ratings while institutions simultaneously continue to increase their level of debt.
Playing-To-Win: The Endgame
These rational strategic decisions on behalf of university administrators who want to improve their institutions have trapped the industry in a “prisoner’s dilemma” where institutions must play along in order to succeed, or risk losing their best students and potential revenue to competing institutions.
However, unabated tuition rate hikes risk eventually eliminating the return on investment for nearly all students attending their respective institutions, which in the long run could be even more devastating.
Moody’s 2015 Report most succinctly describes how this market dynamic will likely play out:
We expect the divide between market-leading, diversified private universities and tuition-dependent colleges with weak market positions to continue to expand. Elite, wealthy national private colleges and universities will outperform the rest of the higher education sector over the next 12–18 months because their business models are most closely linked to investment returns and philanthropy, which have been robust in recent years. Further, these institutions benefit from global reputations, deep pools of applicants, revenue diversification and larger endowments supporting expanded financial aid. The global brands will allow them to command high net tuition per student and attract the largest gifts.
Alternatively, heavily tuition-dependent private colleges and universities with weaker market positions and regional draws will be increasingly challenged. Lack of clear market niche and demonstrated return on investment could be the downfall for many small heavily tuition-dependent private colleges that have limited pricing power. These lower-rated privates will face increased competition from cheaper public higher education as well as distance learning options.
In summary, the real crisis in higher education is a lack of fiscal responsibility, not technological change. Each university relies on these revenue streams in differing proportions, and therefore each institution’s risk exposure to these economic pressures will vary. However, universities lacking a focused strategy are trapped in a competition for prestige leading to unsustainable costs.
Part II: Declining Financial Value for Students
“An investment in knowledge pays the best interest” — Benjamin Franklin
There has been great debate as to whether attending college is “worth it” for students with many sides citing anecdotal evidence or flawed data analyses in order to defend their claims. This next part is dedicated to objectively analyzing what we know about the value of getting a college education in terms of skills acquisition, social capital, signaling value, and financial returns, and more importantly, what we can predict in the future given what sensitivity analyses can tell us about students’ future financial returns.
How to define and measure value? Common Misconceptions
Net Present Value of Future Earnings
You will often hear universities claim that pursuing a college education is still a worthwhile investment because having a college degree substantially increases your cumulative lifetime net earnings, citing the famous College Board 2013 report entitled “Education Pays: the benefits of higher education for individuals and society.” The College Board report uses this graph to demonstrate the financial benefits of a college degree:
In this model the College Board uses the weighted average of the in-state public tuition & fees and of private tuition & fees, and then assumes a 10 year debt repayment period at a 6.8% interest rate and a 3% discount rate, which seems appropriate. The discount rate weights the value of future earnings so that they are adjusted for expected inflation and the opportunity cost of capital.
However, there are two main concerns with how this chart might be interpreted by aspiring students deciding upon a college: (1) cumulative lifetime earnings are significantly different across choice of major or institution, and (2) the student debt expectations of attending college is more easily visualized by a student/family when the cost of attendance is separated on the plot and not baked into the loan repayment timeline.
The following is another cumulative earnings plot courtesy of the CollegeRiskReport. The CollegeRiskReport has created an online tool which allows a student to generate these plots for any major at any institution and therefore allows for more specific analysis. For example, the following plot shows the cumulative earnings for a student graduating from Northwestern University with a bachelor’s degree in History, based upon the median salary for History majors nationally.
As is evident in this plot, this model visibly accounts the upfront cost in addition to cumulative lifetime net earnings. According to the model a Northwestern history grad would earn as much (inflation-adjusted) as a high school graduate after their 35th high school reunion; however, they would never come close to breaking even with the net earnings of someone who went to a community college over the course of their lifetime. The average alumni salary does differ by institution and Northwestern grads might command a slightly higher salary in the marketplace, but the trend is still the same.
Some of the CollegeRiskReport model assumptions are slightly different from that of the CollegeBoard (e.g. discount rate, cost of tuition, etc.), but we will discuss the relative impact of those assumptions later in the Sensitivity Analysis section. The main point of this section, is that it is crucial to look at investments on an NPV basis, and furthermore it is important to look beyond averages and instead to look at the financial return of going to college by schools, major, and earning distributions.
Distribution of outcomes versus the average
Why is it important to look at distributions instead of averages? Let’s look at differences in earnings distribution by major (while at the same institution) and across institutions. Here is the average payoff of attending Northwestern University for a bachelor’s degree in biomedical engineering:
Note that although the expense incurred (tuition) is the same as that of the History major, the payoff is dramatically different for a biomedical engineering grad versus a history grad due to their earnings potential. A Northwestern biomedical engineering grad would blow past a high school graduate roughly around their 15th high school reunion, and passes a community college graduate just 25 years after high school. Due to this discrepancy some universities attempt to cross-subsidize low-earning majors by providing less scholarship to those entering high-earning majors.
The payoff for college also differs substantially by institution (something which these models don’t include but which sensitivity analysis can capture as we will see later on). According the McKinsey study “Voice of the Graduate,” graduates from the top 100 schools can expect around a 17–19% earnings boost relative to graduates from other universities in the same major:
Finally, the distribution of net earnings among students of the same major also reveals important trends. Through recent tools created by the Hamilton Project one can plot the median annual earnings of a career by major as well as the distribution of lifetime earnings by major. [Note: earnings presented are not calculated net of tuition, so the debt burden of attending college is not factored in. Earnings profiles exclude people with graduate degrees but include part-time workers and those who experience unemployment throughout the year, as the risks of unemployment and underemployment differ across education levels and majors].
The plot of median annual earnings by major is not surprising; namely, some majors command more market value, and therefore Economics majors (blue) tend to earn more than English majors (purple), who earn just above what an individual with an Associate’s degree might make (green), who in turn earn more on average than a high-school graduate (orange), even when accounting for differences in unemployment rates.
However, looking at averages masks the distribution of payoffs and can be misleading, especially as we saw from the McKinsey report that graduates from the top 100 institutions tend to receive a substantial earnings boost. Therefore, what is more revealing is the distribution of total lifetime earnings by quintile:
From the plot above we can see that the big difference in the lifetime earnings of various majors comes in the top 20% (quintile) of each group. While the top quintile of Economics (blue) majors experience huge lifetime earnings, the top quintile of English majors (purple) do not share the same upside potential. Meanwhile the bottom half (50%) of both Economics and English graduates have marginally better lifetime earnings than the bottom half of individuals with just high school diplomas and Associate’s degrees (remember this is not including the cost of attendance and student debt).
It is important to note that this upside potential in the top quintile can be found across the majority of majors (engineering, sciences, etc.), and not just in the two selected. Additionally, we should not assume that all the top quintile of lifetime earners all come from the top quintile of universities; however, given the increased earnings boost as shown in the McKinsey report, it is safe to assume that graduating from a top university significantly increases a graduate’s probability of being in the top quintile of lifetime earners for their major.
Therefore, while the plot of Average Annual Earnings might lead us to believe that studying Economics should provide a good return on investment than without it, the plot of the Distribution of Lifetime Earnings shows us that the probability of attaining significantly better earnings potential is probably true in only 30–40% of the students, especially when taking into account the amount of debt incurred to pursue a bachelor’s degree in Economics. Therefore, by breaking down the distribution of quintiles, one can see that the return on investment of pursuing a specific degree in higher education should be viewed as less as a broad guarantee, and more as an uncertain bet that is contingent upon the payoff distribution of the major.
Furthermore, it is interesting to look at the payoffs for the top quintile of the high-school graduates (orange) and associate degree graduates (green) relative to the college graduates. The top 20% of Associate degree graduates made more lifetime net earnings ($1.3 million) than 68% of students having graduated with an English major, and 43% of the Economics majors. Similarly, the top 20% of high-school graduates made more lifetime net earnings ($0.98 million) than 49% of the English graduates and 29% of the Economics graduates, while paying no tuition.
Misleading Science: Correlation vs. Causation, Sample Bias, & Availability Bias
Institutions of higher education and the College Board espouse the virtues of college graduates not only in terms of lifetime earnings, but also the added societal benefits of greater civic engagement, less smoking, less obesity, more exercise, and more voting (all can be found in the College Board Education Pays 2013 report). While these findings are not untrue, the interpretation of this data can be fairly misleading. As a reputable organization, the College Board provides the following disclaimer in the introduction to their report:
Many of the graphs in this report compare the experiences of people with different education levels. In general, while simple descriptions of correlations provide useful clues, they do not reliably determine causation or measure the exact size of the effects. They are best interpreted as providing broadly-gauged evidence of the powerful role that higher education plays in the lives of individuals and in society.
As the College Board appropriately highlighted, correlation does not equal causation. Yes, college graduates exhibit less smoking, less obesity, and civic engagement; however, that doesn’t mean that the universities themselves “instilled” that change amongst their students. In fact, nearly all of these traits are strongly correlated with socioeconomic status (SES), and those in poverty or from low-SES backgrounds are far less likely to graduate from good K-12 schools, let alone be able to afford to attend university.
Caroline Hoxby’s research presented in the 2013 Brookings Paper on Economic Activity found that even high-achieving low-income students who are good candidates for financial aid packages are often missed because universities prefer to concentrate their recruiting efforts in geographic areas with high-achievers (i.e. good schools, affluent neighborhoods). As a result, there is an inherent sample selection bias in many of these findings regarding societal benefits which should not be discounted.
Finally, it is important to recognize the significance of availability biases in the decision to attend a certain college. Just as it is not true that everyone can drop out of school and expect to become the next Mark Zuckerburg, it is also not true that every student who stays in school can expect to achieve the lifetime returns of a star “poster child” alumnus who is highlighted on college brochures. An anecdote is a sample size of one person, and as we saw with the Hamilton models, statistically 80% of students will not receive the huge upside earnings in their discipline.
Therefore, when universities selectively choose a wildly successful alumnus to feature on their brochures or to speak at commencement (which is a logical marketing strategy), this creates an availability bias. Realistically, only less than 5% of the students will ever achieve the same level of success as the alumni they see blanketed across their campus.
The public perception would be radically different if all the alumni from 4-year institutions who had to settle for a job outside of their desired discipline (42%), or felt that university hadn’t properly prepared them for the workplace (30%), or wished they had chosen a different school (36%), or wished they had chosen a different major (35%) came to campus to speak (McKinsey, Voice of the Graduate).
Furthermore, according to a recent book (Aspiring Adults Adrift) published by researchers Richard Arum and Josipa Roksa, of 1,000 graduates from the class of 2009, 7% were unemployed, 16% were working part-time, 30% were working full-time in jobs paying less than $30,000/year, and around 15% of students were working full-time earnings less than $20,000/year. Not surprisingly, nearly ¾ of graduates were still receiving financial assistance from their parents and ¼ were living with their parents still 2-years after completing college.
This would be a more accurate representation of the probability of life outcomes that our aspiring college students might experience after graduation, and which families should be aware of when making financial decisions about higher education programs.
Signaling Effects vs. Skills Acquisition
A few times thus far we have mentioned the “signaling effects” of a degree or institution. Signaling is an important economic phenomena which pertains to the dynamics of information flows and market development, and which won economists Michael Spence, George Akerlof, and Joseph Stiglitz the Nobel Memorial Prize in Economic Sciences in 2001.
Degrees serve as a signal to the labor market that a certain individual is qualified or competent enough to be trained for a job opening which improves the efficiency of corporate recruiting. In other words, irrespective of whether or not the candidate does actually possess the expected skills for the job, the degree serves as a signal to the employer that the candidate is probably a good investment, so the employer doesn’t have to interview thousands of candidates or waste time training a new employee who turns out to be incompetent. As a result, employers are more likely to interview and to compensate a college graduate more, than another candidate with the same number of years of education and similar skills.
The logical argument for this is that in order for a student to be accepted to and to graduate from a rigorous 4-year institution, the student must have demonstrated considerable cognitive abilities, persistence, and the ability to learn new skills. Therefore, in an efficient labor market, a market signal would quite accurately represent the ability of a candidate, and help an employer efficiently filter among many candidates.
It is important to note that both a degree and the institution that confers the degree create their own separate market signal. For example, prior to the Second World War (WWII) relatively few individuals graduated from a 4-year university; therefore, any bachelor’s degree commanded a significant market signal. However, after WWII and the signing of the GI Bill (which covered tuition for many of the returning soldiers), the market signal of a Bachelor’s degree became diluted since many more individuals graduated from college leading to “credential inflation.” The result of this was that the market signal of the degree itself weakened, meanwhile the signal of the institution which conferred the degree became much more important (Goyette, Mullen 2006).
Universities claim to provide significant educational value and many imply that the increased earnings potential of their graduates is a direct result of their excellent instruction and resources; however, some of this increased earnings boost is surely due to degree signaling effects, and as we saw with sample selection bias, the high performance of their graduates might simply be the result of being a highly selective institution and therefore simply starting with a cohort of students who exhibit the highest cognitive ability and ambition.
I have no doubt that universities provide some educational value; however, the more important question, is how much value are universities contributing to the students and is it worth the cost? Therefore, for universities to claim responsibility for the financial success of their graduates it is important to separate the signaling value of a degree from the skills or cognitive abilities developed at their institution.
Luckily, a body of research already exists which separates the influence of “diploma effects” (or “sheepskin effects”), from that of the number of years of education a student has obtained, as seen in the plot below by researchers David Jaeger and Marianne Page back in 1996.
What the following plot shows us is the amount of the earnings potential of a college graduate without controlling for Diploma Effects, and the amount of the earnings potential of a college graduate while controlling for Diploma Effects, which therefore is likely attributed to competencies/skills. According to this study:
“a substantial part of the total return to education appears to be due to the sheepskin effects…..sheepskin effects explain more than half of the return to completing 16 years [of education] relative to 12 years.”
Therefore, according to this one study it would seem that the majority of the increased earnings benefit derived from a bachelor’s degree is actually due to market signaling and not due to the cognitive abilities of the graduate.
These are just the findings from one study, and it is likely that other research studies will provide different estimates for the magnitude of the degree signaling effects; however, what is important is to be aware that degree signaling effects exist and that they contribute a significant amount to the success of the graduate.
Furthermore, the power of the signaling effect is both a function of the degree itself and the institution, and requires that employers consider the degree conferred by the particular institution to be a good surrogate for the competency of its graduates. Through credential inflation or loss of trust from industry, the value of the degree effects from any particular institution can change over time. For example, according to the McKinsey Voice of the Graduate study, only about half of employers think that college graduates are adequately prepared for the workplace; if this trend continues, then employers will start to discount the signaling value of college degrees from certain institutions, with the result that the employability and/or earnings potential of the graduates from certain institutions will suffer regardless of whether or not the quality of the graduates has changed.
Do university rankings help to determine value?
Many American families turn to ratings agencies in order to provide guidance on the quality of the education their kids might be getting. The most widely recognized way the media holds universities accountable is through the US News & World Report (USNWR) rankings which focuses on university inputs that it believes are indicative of the performance of a university (peer assessment, faculty resources, and financial resources). This serves as a form of accountability insomuch as prospective students (or their parents) believe in the value of the rankings, and universities adjust their operations to conform to the ranking system in order to attract students. Barron’s also provides a ranking system based solely on standardized test scores (ACT, SAT, etc.).
Unfortunately, such rankings have no scientific data supporting that they serve as useful indicators of university performance (Confessore 2003), so USNWR’s indicators are really just “vanity metrics.” In the case of Barron’s rankings, they only provide data on the exam scores of the students who attend each school (inputs), but provide no data on outputs, so it is impossible to tell whether the university actually provides any value to the students or is just able to recruit smart students.
Rather than improving the higher education sector, it would seem that such rankings tend to preserve the status quo because they heavily weight the importance of financial resources, faculty resources, and alumni giving (which the wealthy and prestigious universities already have), even though there is little to no evidence showing that those metrics are correlated with university performance or outcomes (Confessore 2003).
Since prospective students and their families rely on the USNWR as signals of value, the students apply to the highly ranked universities which further increases the selectivity of those schools and further improves the university’s ranking. Therefore, this self-reinforcing cycle protects the position of the already top ranked universities with large endowments which are already the most selective, while universities which are not already at the top of the ranking will have a tough time competing.
Declining value in skills acquisition & social value?
Academically Adrift?
Now that we have discussed misconceptions around how to measure or analyze the value of a higher education by looking at data, understanding the distribution of outcomes, and being aware of various biases in data analysis, let’s evaluate whether students at universities are receiving the valuable skills they need to succeed.
In a study back in 2011 (and published in their book Academically Adrift), Richard Arum and Jospia Roksa researched the skills acquired during college using the Collegiate Learning Assessment (CLA) exam which is designed to measure gains in critical thinking, analytical reasoning, and other high level skills taught at college. Arum and Roksa had over 2,300 students of traditional colleges enrolled at a range of 4-year institutions take the CLA exam at various points before and during their college education.
The researchers found that 45% of students “did not demonstrate any significant improvement in learning during the first two years of college,” and 36% of students “did not demonstrate any significant improvement in learning over the course of 4-years of college.” Additionally, of those students who did show improvements, they only experienced modest improvements of 0.47 standard deviations over the course of 4-years. This means that for the students who showed any signs of learning, if they had entered college in the 50th percentile of all students then they would have graduated 4-years later in the 68th percentile of all students, but that is the 68th percentile of all students including freshman who hadn’t experienced any college learning.
The main culprit for these poor learning outcomes according to the authors was lack of academic rigor. For example, 32% of students each semester did not take any courses with more than 40 pages of reading per week, and 50% of students did not take a single course in which they had to write more than 20 pages over the course of a semester. The authors also found that students spent on average only 12–14 hours per week studying and mostly in groups.
One may find recent studies backed by the Council for Aid to Education have challenged these findings, which show a 0.73 standard deviation gain in CLA exams; however, these sponsored research studies suffer from poor experimental design and sample bias; most notably, the studies rely on cross-sectional data comparing a random sample of freshman and seniors at college; however, it doesn’t track the progress of the same student across time. Given the high rates of attrition (dropout) in higher education, essentially this experimental design tests all of the freshman, but then only tests the high-performing seniors who haven’t dropped out, which biases up the estimates.
As we saw previously, averages must be analyzed carefully, and the results from these studies were taken from students across a multitude of four-year institutions. It is likely that the choice of institution may significantly impact the magnitude of these learning outcomes. Therefore, the important takeaway from these studies is that one should make sure that an institution is providing a rigorous education, not just conferring degrees.
Declining financial value?
Sensitivity Analysis around Net Present Value Projections
In previous sections we saw a few plots of the net present value of cumulative earnings of pursuing a couple majors at Northwestern University. While Northwestern is just one school and cannot be extrapolated to represent other higher education institutions, by performing a sensitivity analysis on these models we can reveal trends that are broadly applicable to all institutions. For example, the cost of tuition varies tremendously across four-year institutions (ie. in-state public vs. private) and in time (% tuition increase / year), or graduates from elite institutions may command much higher salaries in the marketplace than average. However, we will account for all these factors and see how they influence the financial returns of attending college.
Instead of looking at an expensive private school, let’s see how the payoff looks for a student studying a natural science (Biology) at a relatively affordable in-state public school, the University of Illinois (Urbana-Champaign):
Similarly to the previous cumulative earnings plots we saw, you will notice that for this particular degree at University of Illinois the net present value of attending college is far better than simply having a high-school degree; however, it is not quite as good as attending a 2-year college. In other words, while statistically undergraduate Biology graduates earn slightly more money than Associate degree holders on average, the present value of the net increase in lifetime earnings from holding a BS in Biology relative to an Associate’s degree is less than the increased cost of tuition of completing a bachelor’s degree at the University of Illinois.
In strong contrast to the plots simulating the return for attending Northwestern, you will notice that the average cost of attendance for a graduate at University of Illinois was just over $100K (total for 4-years) versus nearly $233K for Northwestern, which allowed the University of Illinois graduate to break even much faster.
The most valuable tool of the CollegeRiskReport, is not necessarily visualizing these cumulative earning plots per institution per major (as we saw the payoff distribution can vary wildly within the graduates of the same major), but rather to analyze the sensitivity analysis of the model in order to identify how changes in assumptions around tuition hikes, increased earnings after college, and discount rates change the model.
Discount Rate
Calculating an appropriate discount rate is more of an art than a science and is widely critiqued in the world of finance. Essentially, the choice of the discount rate helps determine what the “time-value of money” is so that earnings in the future are discounted to present day value both in terms of expected inflation and various other factors.
As can be seen in the figure below, assuming a smaller discount rate often makes college look more attractive since this lessens how much the value of your future earnings (presumably higher with a college degree) will be discounted, while raising the discount rate will make college look less attractive.
The CollegeBoard model assumed a 3% discount rate, while CollegeRiskReport assumes a 5% discount rate, but as we can see in the Figure above, the difference does not have a huge impact on this model’s outcomes: at a 3% discount rate completing a BS in Biology at University of Illinois barely breaks even with just pursuing a degree at a 2-year college.
College Expenses
Earlier we pointed out the difference between the debt burdens of the University of Illinois graduate and the Northwestern graduate; in the Figure below we can see how the net present value of studying Biology at University of Illinois would change as a result of increasing college tuition and fees.
We can see from the sensitivity analysis that the cost of college expenses would have to decrease almost 70% in order for it to break even with attending a community college. Additionally, we can predict how soon we will reach a point at which pursuing a specific college degree would not even breakeven with holding a high-school diploma if tuition rates keep skyrocketing.
According to the US Department of Education College Affordability and Transparency Center, the average rate of tuition increase for public 4-year institutions is 7.7% while the average rate of tuition increase for a private non-profit 4-year institution is 7.9%. Therefore, if the University of Illinois increased its tuition and fees at the national average rate for public 4-year institutions, it would be 25% more expensive within just 3 years and 56% more expensive within 6 years, and within 10 years it would be 210% more expensive (as a reference, average wages would only increase approximately 22% over the next 10 years).
It is evident from the sensitivity analysis above that such rate hikes rapidly eliminate the cumulative lifetime economic value of such a degree, with the end result that within the next decade not going to college and simply having a high-school diploma may provide better long-term financial returns than pursuing many college degrees even at relatively affordable in-state public institutions.
It is important to note that while the trend is the same, the rate at which we reach the Event Horizon (the point at which attending college will no longer provide positive financial returns even at the most affordable public institutions), largely depends on the presumed annual tuition rate increase in the future.
The College Board has also done research on this trend over the years, and presents very different numbers in contrast to the US Department of Education estimates (Note: it is currently unclear why this is the case, but I would appreciate any insight on this discrepancy):
The CollegeBoard found the average annual percentage tuition rate increase at private nonprofit 4-year institutions, and public 4-year institutions to be 2.2% and 3.5% respectively. Again, this doesn’t change the overarching trend, but does impact whether or not it takes one decade or possibly two decades to reach the Event Horizon for many public degrees.
Finally, this trend should be particularly alarming for private non-profit institutions that are locked in the Battle for Prestige through debt financing and ever increasing tuition hikes. For example, in the following figure we can see the sensitivity analysis of the same Biomedical Engineering graduate from Northwestern University we saw previously:
What is particularly alarming from this analysis, is that even for a student pursuing a highly employable major (biomedical engineering) at a very selective and prestigious university (Northwestern), the financial returns to actually attending Northwestern versus attending a community college will be essentially eliminated within the next 7 years if you trust the Department of Education’s estimates on tuition hikes.
Furthermore, the economic value of pursuing less applied majors has already been eliminated or will be eliminated within the next few years at similarly expensive institutions.
Lifetime Earnings
Elite universities will argue that such prices are justified because their graduates command a higher salary in the market place. As we saw from the McKinsey report (Voice of the Graduate), this is certainly true, and graduates of such institutions may expect to command as much as a 20% increase in salary.
Fortunately, we can use the sensitivity analysis to also model the impact to which such a salary premium would have on the financial return of an institution’s graduates, as seen in the following figure for the same Biomedical Engineer from Northwestern University:
As we can see in the Figure above, an increase of earnings potential of 20% ultimately increases the present value of financial returns to college for this graduate by nearly $200,000. In other words, graduating from one of the top universities does increase your chances of being in the top quintile of lifetime earners graduating from your major.
Therefore, as we might expect, the earnings boost that graduates receive from attending the top tier universities will allow top universities to continue providing positive financial returns to their graduates for a longer period of time when compared to equally expensive universities which are not considered to be in the top 100 institutions in the country.
The more important question therefore is whether or not the rate at which universities are eliminating the financial returns of attending their college through tuition hikes is outpacing the rate at which the same institutions can create more value for their students through increasing their graduates’ lifetime earnings potential.
Given that annual tuition increases compound and thus exhibit exponential growth, while for most workers in the US real wages (inflation-adjusted) have barely budged in decades (Pew Research Center), one can quite safely assume that even top universities will not be able to continue increasing the salary premium of their graduates as fast as they are reducing the financial return of attending their institutions through runaway tuition inflation.
Therefore, the earnings premium of graduates from the top institutions will certainly provide a longer runway for the top universities before they reach the Event Horizon; however, it by no means prevents them from reaching it. In summary, the rate at which universities are reducing the financial returns of attending their college through tuition hikes is outpacing the rate at which they can create more value for their graduates through increased earnings potential.
These analyses should be particularly alarming for universities which are not considered to be in the Top 100 yet are equally expensive. Such a combination eliminates the financial return of attending the institution, without providing significant gains in earnings potential, so such institutions are effectively eliminating the financial return of their students much faster than at universities which either can promise an earnings boost (i.e. elite institutions) or are of lower price (i.e. in-state public institutions). This corroborates the guidance from Moody’s Investors Service shown previously (Playing-to-win: The Endgame), which predicts the divide between elite institutions and non-elite institutions to widen over the course of the next few years.
Beyond the Numbers
Before finishing this section I would like to reiterate that a net present value calculation of cumulative lifetime earnings alone does not capture the nuances of the societal and financial returns to college. To be sure, I believe the present value calculation to be one of the most important and fair ways to judge a return on investment; however, there are certainly other factors to take into consideration.
For example, while such calculations evaluate net earnings, they do not take into account the costs of living without a college degree. As has been widely documented, there exist structural barriers to overcoming poverty, such as not having access to affordable credit (i.e. high interest rates). Therefore, while the net earnings between a college graduate and high-school graduate might be equal, in some situations a high-school graduate may have a higher cost of living. Conversely, it is also possible that college graduates may come to expect a higher quality of life post-graduation (e.g. individual apartment, car, etc.) which could increase their voluntary cost of living.
Additionally, the societal or emotional stressors of living in poverty are also not accounted for. For example, an individual working with a high-school diploma might experience negative cultural stigma, while a college graduate with huge student loan debt may have the same present value of lifetime earnings as the high-school graduate, but might not feel the same negative societal stigma. These are important considerations that likely would impact job and life satisfaction.
Finally, for many people attending college is perceived as the first step at improving economic mobility, especially for first generation college graduates. Economic mobility and wealth inequality are complex phenomenon and are a result of many societal factors which I am not qualified to discuss. I encourage readers not to extrapolate policy implications around economic mobility from these analyses, as they are similar yet very different domains. Again, my motivation for this research was simply to shine a light on trends that may ultimately hurt the higher education sector and to encourage society to take action.
Part III: Avoiding the Event Horizon
An objective analysis of tuition inflation, lifetime earnings, and the competitive dynamics among institutions of higher education have shown us that, if left unchanged, within the next decade attending a 4-year college for most majors will no longer provide a positive financial return relative to 2-year colleges, or even in some cases, to simply attaining a high-school diploma. I believe that if this moment were to occur it would represent an Event Horizon in the industry, and institutions would be forced to respond suddenly with very few strategic options.
Reaching the Event Horizon: what might happen?
If we were to reach the Event Horizon over the course of the next decade it would be very difficult for most institutions to respond strategically and to remain solvent; however, as we saw in previous sections, not all institutions would reach their Event Horizon at the same moment as this depends on the balance of their cost of tuition versus the expected financial returns of their students post-graduation.
Furthermore we determined from the sensitivity analysis that the first class of institutions to reach the Event Horizon would be the overpriced Tier-2 and Tier-3 private institutions (high price with average earnings potential), followed by the in-state public institutions (“relatively” affordable and with average earnings potential), and ultimately ending with the elite institutions (high price but with significantly higher earnings). Therefore, it may be helpful to think about the market dynamics of reaching the Event Horizon in three separate market segments:
Impact on Private, Not-for-profit Tier-2 and Tier-3 Institutions
Many students who attend private 4-year institutions do so because they believe the perceived value of attending such an institution merits the increased cost relative to attending their in-state public university. However, what happens when students begin to doubt that attending such an institution is worth the cost?
If the students can’t attend a Tier-1 school (which statistically most students can’t), then they will start increasing their preference for in-state public universities. This has the result of increasing the student’s price sensitivity of attending private Tier-2 and Tier-3 institutions, which means that these institutions will ultimately have to provide more scholarship money or risk losing many prospective students. This is already happening as we saw from Moody’s that nearly 35% of private institutions did not achieve real net tuition growth in 2011, and more recently, the industry as a whole is not showing any real inflation-adjusted tuition growth.
However, these universities also need to continue investing in new amenities and buildings in order to increase the perceived value of their college and to effectively compete against other universities in their peer group. With nearly all of their revenue streams constrained (Part I), their costs of operations increasing, and their debt-fueled growth becoming more expensive to finance, the universities’ strategic options will be constrained.
Therefore, either such universities won’t be able to continue to offer substantial scholarships to offset their increasing sticker price and students will migrate to in-state public universities, or the universities will have to cut back on making investments which will lower the reputation of the campus, at which point students will perceive the university’s quality to be less, and will therefore end up still migrating to the public institutions.
When universities reach dire financial conditions a few things happen. First of all, they launch capital campaigns to convince students and alumni that their cost of tuition only covered half the value of their degree. However, as we have seen in Part II, at the Event Horizon many institutions will be charging their students the same if not more than the net present value of all increased earnings over the course of the student’s lifetime! Therefore, convincing alumni that they still owe their alma mater something becomes an increasingly tough sell at the Event Horizon.
Secondly, the cost of financing operations increases because the institution’s debt will likely be downgraded by agencies such as Moody’s. Finally, the university’s Financial Responsibility Composite Score, which it is required to deliver to the US Department of Education each year in order to qualify for Federal Student Aid programs, will start to decline (you can check the composite score for any university on their website). As an institution’s finances gets worse, their composite score will begin to decline and they will receive a warning by the US Department of Education.
If the university cannot turn their finances around and their composite score drops even further then the Department of Education will refuse to let that institution participate in any Federal Student Aid programs, making any future student applicants ineligible for financial aid (i.e. subsidized loans) to attend that university. Without access to Federal financial aid, students will quickly turn to a different university instead, and the institution will likely not remain solvent for long.
Impact on Public Universities
While public universities provide relatively affordable in-state tuition for students, we saw earlier how reduced funding from state subsidies and other revenue streams, are forcing public universities to raise the tuition even faster than at some private schools.
Given the role of public universities in American society (i.e. to provide affordable access to higher education for its citizens), if such institutions were ever to reach their Event Horizon there would likely be far greater societal upheaval than with the bankruptcy of the Tier-2 and Tier-3 private institutions. At least when Tier-3 private schools close, students could always migrate to the subsidized in-state public institutions. However, when the cost of attending a public university is greater than the present value of the increase of cumulative lifetime earnings, what are students supposed to do?
The financial struggles of the public institutions would be much like those of the private Tier-2 and Tier-3 institutions; however, with the additional concern of reduced state funding on a per-student basis given the influx of students avoiding private Tier-2 and Tier-3 institutions.
I would also expect that students would continue to attend public universities for a little while after passing the Event Horizon, with the hope that they might be one of the students who graduates at the top of their class and enters into the top quintile of lifetime earners for their major (for whom attending university could still provide positive returns).
Impact on Elite Private Institutions
Finally, if the elite private institutions were to reach their Event Horizon I expect that they would be unusually resilient.
First of all, their ever-increasing and enormous endowments will allow them to continue to subsidize tuition for many of their students far beyond the capabilities of Tier 2 and Tier 3 universities.
Secondly, given the increased earnings premium of their graduates, it will take them longer to reach their Event Horizon. Furthermore, since the distribution of lifetime earnings by major becomes increasingly exponential in the top 5% of 1% of the population, the most elite institutions of the nation (e.g. Ivy Leagues, Stanford University, etc.) could likely claim that their institutions still provide great value for money assuming that attending one of their institutions significantly increases your chance of ending up in the top 5% of lifetime earners for your major.
Thirdly, if a student were lucky enough to be accepted to one of these highly-selective institutions, it is unlikely that the student would turn it down if there existed no other educational opportunities which could provide positive financial returns. I think it is more likely that the student would still elect to attend the elite university and would work hard in hopes of graduating near the top of their class and beating the average earnings distribution.
Obviously, these are all simply predictions on the impact that reaching the Event Horizon in higher education might have on society. In reality, things might turn out much better (or worse). However, I don’t think any member of society wishes for us to get to that point, and I am confident that with greater public awareness and civic engagement we can avoid it entirely.
Avoiding the Event Horizon: what can we do?
As we saw from the sensitivity analysis, the two major levers that impact the financial value of pursuing a four-year college degree are the upfront cost of attendance and the net increase in cumulative lifetime earnings.
Some may wish to focus on policies to increase earnings for college graduates; however, controlling wages is far more difficult to control in both a global economy and in a digital society where labor wages are bounded by the cost of labor internationally (companies will move jobs overseas) and also by the cost of new software/robotic solutions to increase labor productivity (which thereby reduce the required number of workers for equivalent output). Therefore, I think our societal goal should be to slow and to reverse the trend of tuition inflation.
In order to reverse the trend in tuition inflation we have to first understand why universities have been thriving when increasing tuition. In other words, why does the higher education market exhibit dynamics of a luxury goods market? The reason is because to date it has been extremely difficult to measure the “value” of a higher education degree. In markets where the product value is very one-dimensional and quantifiable, companies aggressively pursue cost-leadership strategies to deliver a better product at a lower cost. For example, nobody would buy a 10 GB hard drive for $100 if a 100 GB hard drive cost $10.
While the value of education may seem challenging to ascertain, we saw earlier that it is indeed possible to test for graduates’ acquired cognitive skills and increased financial earnings while controlling for sample selection and normalizing for sheepskin signaling effects. All we need is the right data.
Unfortunately, the industry’s failure to routinely perform these analyses has led consumers to simply focus on the perceived value of university branding, instead of empirical evidence of proven financial value. This behavior then rewards universities who logically implement a competitive strategy that increases their prestige. However, while determining the economic value of attending college may have been prohibitively difficult in another era, we now live in a digital society where data and analytical tools are ubiquitous and such analyses should be required.
It is my belief that in order to reverse the trend of tuition inflation, we first need to prioritize what value we want universities to deliver most of all (educational outcomes, financial returns, etc.), which will reward universities who focus on delivering the most value at the least cost, rather than rewarding universities for raising their prices.
This is not to say that the other outcomes aren’t important; after all, even in industries driven by intense cost-leadership strategies, companies still gain your business through improved customer engagement, design, etc. As such, while I expect universities will have to streamline their services and cut some amenities, I still believe that delivering a holistic educational experience will continue to be a differentiating factor of competing universities, but will be contingent upon proving good value outcomes first.
The more difficult question for each of us becomes, what “value” or “outcome” do we want universities to prove? Do we care more about pursuing higher education for our intellectual pursuits (i.e. knowledge acquisition), or do we see pursuing higher education simply as a means of achieving a good career and increased financial returns? The answer to this values judgment might be different for each of us; however, we each should still attempt to prioritize one and force universities to compete primarily on that dimension.
Universities and government should increase tracking on educational attainment while in college (pre and post examination), as well as increase tracking on the distribution of career earnings by major AND by institution, which would provide necessary data to educate the families of aspiring student applicants. Furthermore, in order to restrain tuition inflation, states should begin to tax not-for-profit institutions on their tuition revenue once a university’s cost of attendance has empirically surpassed the net present value of lifetime earnings of their graduates. At the Event Horizon, such academic institutions are no longer providing a positive societal benefit worthy of their tax exempt status.
As prospective students and alumni we already have a lot of power to shape the future of our institutions through the power of our purse. As prospective students, do not attend private institutions that cannot provide you with sufficient statistical data on student and alumni outcomes that you feel comfortable “betting” your future on their institution; walk away, and attend a great public university instead.
As alumni, do not donate back to your alma maters who claim that you only paid them half the value of your education; this is statistically untrue for most graduates. Instead, donate back to them contingent upon reforms that focus on tracking student and alumni statistics on educational and career outcomes which should be made publically available (and not kept as institutional secrets), and avoid donating to any capital campaigns which involve a new building that does not materially improve educational or research value.
Finally, in light of trends in the 21st century it is important for us to think as a society whether or not we can meet our educational, scientific, healthcare, and employment objectives through more efficient utilization or allocation of our existing resources. As previously stated, the question is not whether or not institutions of higher education provide ANY value, but whether or not they provide sufficient value commensurate with the societal costs.
It is time to evaluate what the core competency of a university truly is, and to focus on encouraging our respective institutions of higher education to generate more value for society.
Acknowledgements: This paper would not have been possible without the support of my brilliant wife, Daniya Kamran-Morley. She has an incredible ability to critique my thinking while simultaneously lifting my spirits.
About the author: I will be joining McKinsey & Company as an Associate this fall, after having previously served as a guest instructor at the Illinois Institute of Technology, a visiting professor at La Universidad de Los Andes, and a Senior Engineer at EPIR Technologies. I have scientific publications in numerous fields spanning across tissue engineering, drug delivery, prosthetic devices, micro-electro-mechanical-systems, thermal imaging, and solar photovoltaics. I hold an MBA from the Stanford Graduate School of Business, an M.S. degree in Biomedical Sciences from La Universidad de Los Andes, and a B.S. Biomedical Engineering from the Illinois Institute of Technology. I currently sit on the Biomedical Engineering Department Advisory Board at the Illinois Institute of Technology, as well as the International Space Station Utilization Committee (LinkedIn).
