Monday, May 28, 2018

Innovative Solutions to the College Debt Problem

Innovative Solutions to the College Debt Problem

David Bernstein


The current generation of students is finishing college with more debt than any other generation. More elderly Americans are entering retirement with outstanding student loans. These trends are accelerating.

Excessive student debt reduces the ability of borrowers to save, prepare for retirement, and purchase a house.  Increased student debt burdens are adversely impacting family formation, quality of life, and opportunity in our society.

Proposals offered by the Trump Administration would worsen this situation.  Recent administrative actions have already weakened consumer protections for many student borrowers.

Solutions offered by Secretary Clinton in her 2016 campaign were highly unrealistic, expensive, and burdensome to state governments and universities. 

The paper offers 12 practical policy proposals designed to reduce student debt burdens.  The proposals utilize 4 policy levers – (I) additional targeted financial assistance, (2) debt relief, (3) improvements in information about college outcomes and costs, and (4) policies to improve on-time graduation rates. 

Several of the proposed policies offered here are notably different from current programs and policies under active consideration.

The primary proposal for expanding financial assistance presented here involves expanded aid to first-year students.   Most previous proposals spread all additional assistance over the entire undergraduate population.  The targeting of financial assistance toward first-year students will reduce interest costs on both subsidized and unsubsidized loans and will reduce loans to people who fail to obtain a degree and who are likely to experience repayment problems.

The proposals for assisting overextended borrowers presented here involve modifications to basic student loan contracts and changes in bankruptcy law.  By contrast, most of the current policy discussion revolves around modifications to Income Contingent Loan programs. Some of the proposed bankruptcy reforms presented in the memo, including a proposal to give priority to student loans over other consumer loans in Chapter 13 bankruptcy, assist both student debtors and taxpayers. 

One proposal presented here attempts to partially insulate future students from automatic increases in costs stemming from higher market interest rates.   By contrast, recent discussions in Congress focused on immediate reductions in student loan interest rates for students in the current low-interest rate environment.

The work recognizes improvements in college assistance and debt relief programs will not resolve student debt problems incurred by students who enroll in a subpar academic program or fail to graduate in a timely manner.   Several proposals seek to improve consumer information on school quality and improve on-time graduation rates.  

One proposal calls for the adoption of policies that will increase pass rates on AP exams, especially in underperforming high schools.   A second proposal requires that colleges with students using guaranteed student loans provide some credit to students receive a 4 or a 5 on an AP exam.

The growth of student debt is resulting in an increase in wealth inequality because high student debt reduces the ability of many students to save for other goals, including retirement savings and house ownership. Moreover, tax preferences for 401(k) contributions and mortgage payments persuade many people to delay repayment of student loans.   Failure to adopt policies that would lower student debt burdens may eventually result in reconsideration of current tax incentives and current financial strategies.

The student debt proposals presented here attempt to target assistance towards people who might not otherwise attend college or are highly likely to default without some help.  I hope this analysis demonstrates economic efficiency need not be the enemy of progressive policy.

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Tuesday, May 22, 2018

The path of returns and financial risk for 401(k) investors

The path of returns and financial risk for 401(k) investors

Question Eighteen:  A person has $200,000 in her 401(k) plan.   She contributes $500 per month to her plan. She is planning to retire in 15 years.  Investment scenario one involves 7 percent returns for 90 months followed by -4.0 percent returns to 90 months.  Investment scenario two involves -4.0 percent return for 90 months followed by 7.0 percent returns for 90 moths.

What is the difference in the FV of funds in the 401(k) plan between the two scenarios?  What does this result tell us about impact of path of returns on financial risk for 401(k) investors?

Methodology:   The final balance in the 401(k) plan can be calculated with the future value function.  It is a five-step procedure.

Step One:  Take the future value of the initial $200,000 to the end of the first period.

Step Two:  Take the future value of all first period contributions to the end of the first period.

Step Three:  Find funds available at end of first period (This is the sum of steps one and two.)  Take the future value of these funds to the end of the second period.

Step Four:  Take future value of all second period contributions.

Step Five:  Add results of steps three and four to get FV at retirement.

It is important to use monthly returns and monthly holding periods.   It is also important to input contributions and initial balances as negative numbers so you obtain a positive future value balance. 

Results:    The future value calculation for the two market scenarios is presented in the table below.

The timing of the bull market
401(k) balance at beginning of 15 year period
Monthly Contribution to 401(k)
Annual Return First Period
Annual Return Second Period
Length of First Period in Months
Length of Second Period in Months
FV of initial sum in 401(k) at end of first period
FV of monthly 401(k) contributions to end of first period
FV of funds at end of first period funds to
 end of second period
FV of second period contributions
FV all funds after 15 years

Observations about results:

The return in the overall market is R=(1.07/12)90 x (1-0.04/12)90 for both scenarios.

Even though market returns in the two scenarios are identical the final 401(k) balance is larger when the bull market occurs at the end of the period rather than the beginning of the period. 

The difference in portfolio outcomes is non-trivial.  The difference is around $42,000 or around 12 percent of the average of the two portfolio outcomes.

Analysis and Discussion:  The timing of the bull market matters for 401(k) contributors because more money is exposed to the market at the end of the holding period than at the beginning of the holding period.

Interestingly, timing or returns does not matter when the investment is a lump sum.   For example, the timing of returns does not alter the future value of the initial $200,000 investment.

Financial analysts argue that people need to invest in their 401(k) plan and place funds in equities at the beginning of a career because in the long-term stocks out-perform other asset classes.  However, the long-term performance of stocks will not protect investors from substantial losses when a bull market occurs near the end of a career.

Market timing is a significant risk factor!

Many financial analysts argue that end-of-career financial risk can be mitigated by investing in life cycle funds, which increase allocation of assets towards fixed-income assets as the investor ages.  But if returns are low after the first period should the investor maintain a risky position or reallocate assets as planned under the life cycle account. 

The rebound in the second ninety months is not a sure thing in advance.

 This is question eighteen in my Excel Finance tutorial: