In response to growing concerns over the issue of higher education finance, policy makers, advocates, and entrepreneurs have developed and proposed an array of solutions to address the shortcomings of our current system. Income Share Agreements (ISAs) are one such proposal that deserves more attention. ISAs allow students to raise funds to pay for their degrees by selling “shares” in their future earnings. This solution is sometimes dismissed as a gimmick, akin to indentured servitude, despite the fact that it has the potential to offer improvements over traditional loans in terms of shielding students from risk and providing information about quality, two widely held objectives among advocates and policy makers.
ISAs are financial instruments that can be administered by the government or by private financial institutions, just like loans, savings accounts and insurance policies. Their defining characteristic is that an individual gains access to capital, cash to pay for college, in exchange for a promise that they will pay back a fraction of their earnings for a prescribed period of time to the entity that administered the agreement. Unlike a loan, where the total to be repaid is known up front, individuals who use ISAs to “borrow” money will pay back an amount that depends on their actual earnings. A graduate who earns less than expected will pay back less than the full amount of the initial funding, while graduates who earn more than expected will pay back more than their share. ISAs are not broadly used in the United States, but are being used in a few particular settings, including trade schools that train web developers in exchange of 18% of their first-year income, and a non-profit who funds low-income students in California.
ISAs are not a new invention, with contracts of this nature first proposed in the 1950s by Milton Friedman as a solution to the problem of students being unable to borrow against their future earnings to pay for college.[i] ISAs enable students to effectively collateralize their financing with future earnings, just as home buyers collateralize their mortgage with the house itself. From the student’s perspective, ISAs offer protection similar to the protection offered by the existing Federal Loan programs. In theory, an ISA could be structured such that the cash flows were similar to those of a traditional federal loan with income based repayment, if that were the desired objective. However, the reason to think more carefully about ISAs is that they have the potential to provide benefits beyond those afforded by traditional loans.
Reallocation of Risk
As college becomes more expensive and families are less able to finance college out of their income and savings, there is a growing concern about the risk inherent in investments in higher education. For some, the real risk of facing poor labor market outcomes (low wages or unemployment) but still having to repay educational debt will discourage them from enrolling in the first place. And those who do enroll and borrow to pay for college may end up with excessive risk in their wealth portfolio, a fact that is especially true among borrowers with private debt, due to their lack of safety nets. Investments in education that pay off in heightened future wages are inherently risky and increasingly require relatively large initial investments. The lack of adequate insurance against poor returns to investments in higher education means that these young people are putting all of their eggs in one basket.
Programs like Income Based Repayment and payment deferral for federal loans solve part of the problem by acting as insurance policies for borrowers, transferring some of the financial risk of an educational investment from the student to taxpayers. However, students do not seem to take advantage of these programs, a fact that policy makers and researchers are working to understand. At the same time, however, these programs, which are offered without regard of the student’s future income prospects, create perverse incentives that can lead to tuition inflation.[ii]
ISAs provide an elegant solution to the first problem by allowing students to access their future earnings and simultaneously providing insurance against bad financial outcomes. The fact that payments go up when income is high and down when income is low amounts to an effective “hedge” for the risk associated with the educational investment. Institutions that would administer ISAs have a greater ability to diversify risk than individuals, so agreements can be structured such that they are both advantageous to a student and also profitable to the administering institution (i.e., the taxpayer, or a private entity). In other words, ISAs need not “take advantage” of borrowers in order to be financially sustainable.
Vehicle for Information about Quality
Among the set of challenges facing higher education is that students make decisions regarding enrollment using an insufficient set of information, particularly on the dimensions of quality and financial return. The result is that many students face poor outcomes that could have been predicted and therefore avoided. Correcting this situation requires surmounting two challenges. First, students do not generally have access to the information necessary to make an informed decision. Government databases created to help students decide where and what to study lack information on graduates’ financial outcomes that would be necessary to adequately weigh tradeoffs. Second, the tradeoffs that students shopping for college need to consider can be complex. For instance, students must recognize that they should take into account both price and expectations about future outcomes. ISAs have the potential to help address each of these challenges.
In the current system, there is almost no incentive for any institution outside of the government to collect, analyze and disseminate information on the financial rate of return to various programs of study. A broad market for ISAs could change that. Institutions that administer ISAs would need this information in order to appropriately set the terms of financing agreements. For instance, degrees with large financial returns, due either to low price, high wage reward, or both, could be paid for with only a small percentage of income committed to repayment (PIC). Alternatively, programs that offer little financial value (due either to high price, low wage reward, or both) would prompt an agreement that collected a relatively large PIC. This system might appear to penalize students who choose fields associated with lower pay (i.e., they would be required to pay a higher fraction of their earnings), but it really penalizes students who choose fields for which costs are high relative to future income. Thus, in the long run ISAs could encourage institutions to price programs based on the labor market return (i.e., disciplines that tend to lead student into lower paying occupations could reduce tuition).[iii] The financial success of the ISA-administering financial institution would depend on its ability to accurately predict a person’s future earnings and to price the agreement appropriately. Over time, institutions administering ISAs would generate the data necessary to develop reliable measures of labor market returns, which would be conveyed to students through pricing.[iv]
This pricing mechanism can succeed in easing the challenge faced by students in considering the options for college enrollment. Under a set of simple assumptions, the PIC provides a measure of quality, in terms of financial return, that is comparable across institutions and programs. For example, in a competitive market, the PIC for a student enrolling in a program that is 20 percent more expensive than the average cost of similar programs, but where graduates make only average earnings upon graduation, will be 20 percent higher. The signal received by the student would be quite clear: if you attend the first school, you can expect to pay 12 percent of your income, if you attend the second one you can expect to pay 10 percent of your income. Prospective students who are considering a set of institutions and programs of study can compare the PIC across the agreements offered for each program of study and make inferences about their relative quality (in terms of financial return). This enables borrowers to calculate tradeoffs using only a single, intuitive statistic.[v] It is conceivable that this simplified method of information provision could succeed in getting individuals to make better personal decisions, but could also succeed in enabling forces of competition to rein in tuition inflation by keeping prices in line with value.
Some research has indicated that debt can impose a psychological cost that causes borrowers to act as if debt payments impose more of a burden than other types of expenses.[vi] There is relatively little research on how borrowers respond to education debt in particular, but it is reasonable to wonder how this might be affecting borrower well-being (and even the macro economy). One approach to improving the well-being of borrowers is to alleviate this psychological burden. Research indicates that framing of debt, the way in which the financial obligation is described, can be critical to the borrower’s attitude toward debt.[vii] Given this, it is conceivable that those financing investments in higher education would be better off with an ISA than with a loan, even if the expected cost is the same. This is an important area for further study.
As we face the challenges of reforming our system of higher education finance to meet the needs of today’s students, no potential solutions should be left off the table. Regulatory obstacles that could be easily addressed by Congress are the primary reason that ISAs have not been employed more broadly. These obstacles would be eliminated if Congress would pass legislation that would provide adequate protections for individuals engaging in ISAs as well as regulatory clarity that would give private institutions the certainty necessary to justify investments in this industry. Because of the subsidies in the federal loan program, most students would only elect an ISA over a traditional loan if they were tapping into the private market for loans, which means that ISAs would not displace any of the benefits students currently receive. Enabling ISAs to operate more broadly in the United States will enable policy makers, advocates and researchers to explore their potential for improving the well-being of those who choose to finance investments in higher education.
If the use of ISAs is broadly adopted, it will be important to study how ISAs impact behavior and well-being. The financial crisis leading to the Great Recession taught us the lesson that the advantages of innovative financial products, like collateralized debt obligations (CDOs) and balloon payment mortgages, can vanish if consumer and financial institutions are not savvy enough to utilize them properly. ISAs face a similar challenge. ISAs may not be the silver bullet that will solve all of our collective concerns, but they should have a place in the landscape of services available in the heterogeneous market for higher education.
This piece benefited greatly from conversations with Miguel Palacios, Assistant Professor of Finance at the Owen Graduate School of Management, Vanderbilt University, and Co-Founder of Lumni Inc.
[i] Friedman, M. (1962). Capitalism and Freedom. Chicago: University of Chicago Press.
[ii] Akers, Beth and Matthew Chingos. 2014. “Student Loan Safety Nets: Estimating the Costs and Benefits of Income-Based Repayment,” Brown Center on Education Policy, Brookings Institution.
[iii] Socially undesirable redistribution of enrollment could then be efficiently corrected using subsidies.
[iv] The government has the capacity to carry out this exercise but is prohibited from doing so by a legislated restriction on developing a unit record data system.
[v] Traditional loans that are underwritten based on the program of study could also convey this information through the offered interest rate, but this is likely to be a less salient indicator for borrowers with little financial savvy since the financial burden imposed by a particular interest rate is not immediately apparent.
[vi] For a discussion of debt aversion in higher education see: Caetano, G., Palacios, M., and Patrinos, H. A. 2011. “Measuring Aversion to Debt: An Experiment among Student Loan Candidates”, World Bank Policy Research Working Paper 5737.
[vii] Field, Erica. 2009. “Educational Debt Burden and Career Choice: Evidence from a Financial Aid Experiment at NYU Law School,” American Economic Journal – Applied Economics, January 1(1): 1-21.