Higher education needs a financing overhaul

“This hat cost me $110K.” That was the message a 2012 graduate displayed on her mortarboard at her university commencement.

The recent flare-up over huge student-loan balances, especially among jobless recent college graduates, is exposing deep flaws in the way higher education is financed. Historically, the U.S. has always emphasized education as the route to financial success. In much of Europe, the link between education and economic achievement has never been as deeply ingrained.

This U.S. zeal for schooling has been so vigorous that it has blurred the distinction between education (the development of the mind and the thinking process) and training (the preparation for a job or career). Today, a person studying for a doctorate, a pursuit that traditionally drew those with a thirst for pure learning, may well be aiming for a career in business in the same way as a candidate for a medical degree or a master’s in business administration. Middle-class American parents have long believed that the more degrees their offspring collect, the higher they will end up on the social and economic scale.

The raw numbers support the idea of a link between college education and financial well-being. All education levels now have elevated unemployment rates. Nevertheless, for those with less than a high-school diploma, joblessness leaped to 12.6% in May this year from 6.6% in May 2007, when the overall rate was at its 4.8% low. The rate for those with a bachelor’s degree or higher climbed to 4.1% from 2%.

The gap in lifetime earnings is also wide: Those lacking a high-school diploma average $973,000 in 2009 dollars and advanced-degree holders can expect to make $3 million or more during their careers.

TUITION COSTS SKYROCKET
As most people are eager for employment and wealth, the demand for higher education has been enormous, especially for admission to the most prestigious schools whose graduates get the top jobs. As a result, these institutions have become extremely wealthy and powerful. They are so sought-after that the demand from qualified candidates vastly exceeds the supply of admission slots.

Tuition costs continue to skyrocket. At top schools, tuition and fees need to increase sharply to match supply and demand. That is partly because colleges and universities don’t charge everyone the same amount. Scholarship aid is used to redistribute some money from those more able to pay to those less able, so the actual charges range from full tuition and fees to zero for students on full scholarships.

This price discrimination, as economists call it, works for two reasons. First, it largely isolates the students of poorer families from higher tuition because a big part of the price increase is used to increase scholarship aid. So, regardless of high tuitions, colleges get the student-body mix they want.

Second, only the wealthiest parents pay the full tuition, and they are quite ready to pay even higher prices for a prestigious educational product. This willingness by parents to ante up for what they imagine is in their kids’ best interests is the reason top-flight colleges have been able to raise their prices far in excess of the inflation rate. If Harvard University put a $1 million price tag on annual tuition, some parents would pay it.

The difference between gross and net college costs is considerable. The College Board reports that average published tuition and fees, excluding room and board, at four-year public colleges is now $8,240, up 72% from $4,790, adjusted for inflation, 10 years ago. But after scholarships and grants along with tax deductions and credits, the average net cost is $2,490, still up 115% from $1,160 a decade ago.

ALUMNI GIVING, ENDOWMENTS
The college-financing model worked in earlier years because of loyal alumni. American colleges and universities, notably the top private institutions, relied on graduates to contribute generously to annual campaigns, incessant capital appeals and through various trusts and bequests. Possibly except for local churches, Americans’ strongest ties appear to be with their alma maters. Interestingly, such ties mostly don’t exist in Europe, perhaps because universities there are state-financed and graduates figure they don’t need extra cash.

The third major source of additional money for higher education has been returns on endowment investments. Most institutions draw about 5% of endowment value each year for operating expenses, so the remainder goes to offset inflation and build the principal in real terms. Many have done quite well on their investments in earlier years.

Even with the huge losses in 2008, which eliminated 19% from educational endowments, a number of institutions have had considerable success in the last 21 years, with returns that comfortably exceeded the combined 5% withdrawals and the 2.6% average increase in the consumer price index. This is partly because many university endowments have moved beyond conventional investments and use alternative strategies, such as private equity, hedge funds, real estate and commodities. Larger endowments have been particularly aggressive in this movement. When an endowment exceeds the gross domestic product of many smaller countries, the returns are significant.

This can lead to unnecessary spending, a sure sign of opulence for a family, corporation or institution. Sure, top- flight colleges and universities offer excellent educations, but they also spend lavishly, and sometimes on questionable activities. Some college presidents are paid $1 million or more. Professors’ salaries are no longer in the poverty category, especially for those in fields such as finance, law and science, which offer lucrative consulting opportunities.

FACULTY ISSUES
And the faculty has plenty of time for outside work. Gone are the 8 a.m. and Saturday-morning classes some of us remember. As further evidence of this trend toward more pay for less work in recent years, consider the widespread phenomenon of January terms with no regular classes and extra pay if faculty members do teach.

Prestigious and wealthy educational institutions also spend on services that have little to do with basic education. These include special library collections that only a few professors and graduate students know about, much less appreciate or use. They may be important for civilization, but would those costs be incurred if money weren’t in ample supply?

Then there are elaborate athletic facilities, the many counselors for troubled students, and the layers upon layers of deans, sub-deans, provosts, proctors, and so on. From 1993 to 2007, college administrative outlays per student grew twice as fast as spending on instruction.

THE HOME EQUITY ATM
Earlier, the home equity of parents was another source of funding for tuition and expenses that allowed many colleges and universities to spend lavishly and operate inefficiently. Many treated this equity in their homes as an ATM and withdrew cash liberally to pay the tuition of their offspring. Back in the boom days, some people believed those ATMs would be continually refilled by ever-higher house prices.

Furthermore, in the 1982-2000 bull market for equities, many came to believe that appreciation in their stock portfolios would provide money for their kids’ educations and other expenses normally covered with savings out of current income. As a result, Americans systematically reduced their saving rate to less than 1% before the recent rebound, from 12% in the early 1980s.

Student loans, which now equal almost $1 trillion, have been another source of funding. They have continued to increase while households in recent years have reduced mortgage debt, auto loans and credit-card borrowing. Student loans rose 3.4% in the first quarter compared with the previous three months, and 8% from a year earlier as the weak economy encouraged more people to enter or return to school, and as tuition kept rising. Since the fourth quarter of 2008 peak, credit-card borrowing fell 22% and student loans leaped 41%. About 34% of families with college students took out federal student loans in the 2011-2012 academic year, up from 25% in 2008-2009.

STUDENT LOAN SUPPORT, DEFAULTS
The federal government has been very aggressive in providing student-loan money and guarantees with the goal of making college accessible for more Americans. Federal-backed loans account for more than 90% of student borrowing in the 2010-2011 academic year. Nonfederal loans by states, banks and credit unions covered 7%.

Nevertheless, more student loans tend to result in higher tuition costs as colleges absorb the additional money. Legislators may believe they are making college more affordable by promoting student loans, but they are also simply allowing colleges and universities to charge more and spend more.

State support has been a major source of funding for public universities. This has helped many state schools become powerful institutions, which, in turn, gives them considerable influence over state legislatures and budgets. That clout is magnified when a state university has a winning football team that also attracts financial support.

Given the earlier widespread belief that college is the route to financial success, and the ample availability of financing, it’s no wonder that higher-education institutions have sprung up to service every level of mental capacity. The attraction of that money combined with the zeal of many liberal college administrations and faculties to foster greater economic and social diversity has resulted in a weakening of admissions criteria and academic standards. No wonder that more than a third of college freshmen now take remedial courses.

High private-university tuitions and plentiful student loans have created a mushrooming niche for for-profit schools such as the University of Phoenix.

These businesses receive as much as 90% of their revenue from Pell grants, federally guaranteed student loans and federal assistance for veterans. They recruit the less-affluent to qualify for this government money. These schools have a poor track record of high dropout rates and poorly prepared graduates. They account for about 10% of the higher-education population and 40% to 50% of student-loan defaults.

The Education Department found that in 48% of for-profit schools, fewer than 35% of recent graduates are repaying their student loans. That compares with only 18% of public and nonprofit institutions. In 2008, about 53% of those who earned bachelor’s degrees at for-profit institutions owed $30,500 or more in student loans compared with 24% at private schools and 12%  at public universities and colleges.

In Part 2, I will examine the effects of the recent recession on higher education and what some schools are doing in response.