There’s a new alternative to student loans that aligns the incentives of students and educators. Say goodbye to the old education model, where students pursue education at any cost. It’s the dawn of Transparent Education.
You know there’s a problem with higher education in the United States when a recent best seller has the following title: The Case Against Education: Why the Education System Is a Waste of Time and Money. Higher education in the U.S. is at a crossroads, and a major reason why is debt.
The Debt Disconnect
Debt is a financial innovation that has driven capitalism for several hundred years. The chart below illustrates the overall level of household debt in the United States. Excluding around $9 trillion for mortgages to buy homes, the chart shows that Americans borrow the most to pay for college degrees, cars, and everyday spending on their credit cards.
There is nothing inherently wrong with debt, per se. All this debt is “good” to the extent in enables Americans to have a roof over their head, drive to work, and buy groceries. With regards to education, the $1.2 trillion dollars of debt would be “good” if American’s with college degrees earned enough after graduation to pay off the amount of debt necessary to obtain a college degree in the first place.
Unfortunately, this doesn’t seem to be the case.
Earnings, relative to student loans, have remained largely flat over the last 15 years. There is a Debt Disconnect in higher education: the cost to provide students with new knowledge, skills, and tools, using traditional education models is “disconnected” from the wages that employers are willing to pay these students after graduation.
Low Visibility Education
The reasons for the Debt Disconnect are misaligned incentives between educators and students.
First, schools have better information than students about employment outcomes after graduation, but are often not incentivized to share this knowledge with students. Instead, schools are incentivized to focus on maximizing enrollment levels. In our article on higher education’s competitive moat, we described how this is partly explained by the need to utilize fixed assets like tenured professors, classroom buildings, and campuses. In other words, the drive to maximize enrollments is embedded in the distribution model of higher education.
The second reason for the misaligned incentives is low accountability at the Federal level for performance of student loans that are often used to finance education. Schools can offer students Federally subsidized loans without any practical limits. Student loan default rates post-graduation have to rise to the enormous level of 25% before colleges are at risk of losing the ability to offer these loans to students.
Finally, schools have no “skin in the game” as to whether or not students make a lot of money after graduation, or if they even graduate at all. Whether a student graduates or not, schools are still paid for the courses they provided. For evidence, consider that nearly 50% of students fail to get a degree or certificate within 6 years. Similarly, the exact level of a student’s income after graduation doesn’t impact the school, so long as the student is making a sufficient amount of money to pay back their loans.
The result of these factors is Low Visibility Education: students have low visibility about the career pathways and salaries their education will ultimately provide. Similarly, they have low visibility into the overall costs of their education and the duration of time required to complete it. The lack of transparency and misaligned incentives drive up costs, with subsidized Federal student loans adding even more fuel to the fire.
Making Post-Graduation Earnings “Visible”
To combat the problems above, over the last 10 years a small group of think tanks, lawyers, and politicians, have been refining an idea first proposed by Milton Friedman in the 1950’s: that students could finance their education through “equity investments such that [Investors] could ‘buy’ a share in an individual’s earnings.” The basic idea would be: invest in a student to learn a skill, and then share in upside as the student earns more money after graduation.
In 2009, a series of finance startups codified this idea using a new legal structure and began offering it to students in lieu of private or Federal student loans. The new legal structure is an agreement between investors and students called an Income Share Agreement (ISA). ISAs provide cash directly to a student to pursue a certain educational pathway. The cash is then paid back to the investor after graduation over a fixed amount of time. Repayment to the investor is only made when the student’s post-graduation income is above a certain threshold. Payments are limited to a modest % of the student’s post-graduation income. Finally, the repayment is capped in terms of years of repayment, and/or amount repaid.
The CEO of education startup, Lambda School, offers the most lucid explanation currently available in video form:
Initially, companies such as Lumni, Upstart, and SoFi offered equity investments to students directly, who would then pursue the educational opportunities approved by the investor. In this model, ISA investors were effectively competing against Federally subsidized student loans offered through the colleges and universities directly. Given the subsidized competition, this was never a fair fight for investors, and offering ISAs as a stand alone financing option doesn’t seem to have gained substantial traction.
Instead, the 3rd party investor model above is being supplanted by a far more exciting model of higher education.
Integrating Education and ISAs
While ISAs haven’t taken off as stand alone financing options, they are being rapidly integrated into educational institutions including colleges, universities, and startups focused on “bootcamps” to train workers in specialized skills in 6-12 months.
More traditional college and universities, starting with Purdue University, Clarkson University, Messiah College, and soon to include the United States Collegiate Athletic Association, are working with startups such as Vemo to provide ISAs to students attending their programs. Unlike the 3rd party investor model, educators and investors are now partners working together to achieve a positive rate of return for their investment. This rate of return is highly dependent on the learning pathway (e.g. college major) a student pursues, and hence their future income. The rate of return is also dependent on the cost of the education itself. ISAs are going to begin to align incentives between students and schools, bringing transparency to student outcomes and educational costs.
For example, using Purdue’s ISA calculator, a student can easily see that a Finance major graduating in 2021 would earn an average of $45,000 upon graduation. On the other hand, a Math Education major would only earn $33,000 at graduation. Similarly, investors at Purdue are willing to invest $12,000 in a Finance major, but only $9,000 in a Math Education major. Obviously, if enrollments in Math Education begin to decline precipitously, Purdue will need to begin to tailor its education model to lower costs for students. Welcome to…
The Dawn of Transparent Education
In the Transparent Education model, student and educator incentives are completely aligned: spend the least amount of time in school, learn the most possible, and get the highest paying job possible after graduation. Transparent Education stands in stark contrast to the Low Visibility Education where a student can obtain a traditional Federal student loan, for the same amount of money, no matter the major, and no matter the expected post-graduation salary. New education startups, such as Lambda School and App Academy, offer the most exciting examples of Transparent Education.
These schools start with modern education distribution technology. Instead of classrooms and tenured professors (old distribution tech), these schools have remote or part-time instructors, online instruction, and digital course material. Furthermore, these schools have “skin in the game” with their students because ISAs are the primary form of tuition. This means that if a student doesn’t finish the program, the educator doesn’t get paid. On the other hand, the more money their graduates make per dollar of training spent, the faster and higher the rate of return for their own investment in their own students.
In addition, ISA and education integration will enable competition between schools to offer students the best financing terms. For example, today, Lambda School only gets paid above a $50,000 threshold. This is their signal to students of their confidence in getting them a job above this salary level. App Academy could compete with Lamda School by offering an ISA with a $75,000 salary threshold, signaling their confidence in superior training quality. Students would then be able to choose the best financing terms available, subject only to their ability to be accepted to these programs.
Mining the Skills Gap
The most exciting aspect of Transparent Education is the potential to enable schools to effectively “mine the Skills Gap”. In other words, if there are lucrative employment opportunities in one region or industry, but few workers with sufficient training to fill these roles, educators could step in to provide training and pursue the economic rewards of minted new graduates. For example, if web designers are in high demand in Nashville, Tennessee, with salaries to match, schools could invest in local students to pursue these job opportunities. Alternatively, if the value of the skills gap was substantial, schools could provide students with larger investments to pay for housing and transportation, effectively eliminating barriers to education for the most talented applicants.
Imagining the Future of Transparent Education
In the future of Transparent Education, imagine that venture capitalists and hedge funds analyze the labor markets to identify lucrative skill gaps, where low cost training can yield substantial student and investor ROI. Funding could be unleashed for new education businesses with ISA tuition models that begin to supply workers to desperate employers. Employers could then become acclimated to hiring these graduates, many without four year college degrees, who nonetheless perform as well (or better) than their traditionally educated coworkers.
As skill gap mining opportunities become more competitive, these same investors might begin to reconsider why two year MBA programs, and four year undergraduate degrees in Finance should have all the fun providing qualified workers to management consulting firms and investment banks. A second “skills rush” could be unleashed to fund schools to massively disrupt existing higher education models. Employers, already embracing “unconventional” graduates from the first “skills rush”, are more than willing to run the experiment again in the hopes of achieving similar results.
The dawn of Transparent Education has just begun, but we imagine that it has a bright future ahead.
- The Economist: Income-share agreements are a novel way to pay tuition fees
- Purdue – Back a Boiler
- Vemo Education
- The Atlantic: Code Now, Pay Tuition Later
- Lambda School
- Senate Committee on Health, Education, Labor and Pensions
- The Hamilton Project: A Risk Sharing Project for Student Loans