Financial Tips: When should a person use an Individual Retirement Account rather than a 401(k) plan? When should a person leaving an employer convert her 401(k) plan into an IRA?
Analysis:
Most financial advisors believe that workers saving for retirement should invest in a 401(k). rather than an IRA. Many government rules favor 401(k) contributions over iRA contributions. First, employee contribution limits for 401(k) plans are around 3 times higher than limits for IRAs. Second employees are allowed to make additional contributions to 401(k) plans but are not allowed to make similar contributions to IRAs. Third, many employers routinely match employee contributions. Fourth, the IRS imposes limits on deductibility of some iRAs but not the deductibility of 401(k) plans. Fifth, the IRS restricts Roth IRA contributions for higher income households but does not restrict contributions to Roth 401(k) plans.
IRS rules allow 401(k) plans to automatically enroll workers who do not opt out. However, there are situations where people are better off investing in an IRA separate from their employer than in the firm 401(k) plan.
The main factor favoring IRAs over 401(k) plans is the higher administrative costs of 401(k) plans. Fees on 401(k) plans are applied to the entire 401(k) balance and are often between 1 percent or 2 percent per year. These fees can substantially erode a workers 401(k) balance over the course of the workers lifetime.
High 401(k) fees are more prevalent at small firms than large firms. People working at a firm offering a plan charging high 401k) fees and offering little or no employer contributions need to look at other investment options than their 401(k) plan. High 401(k) fees can substantially erode retirement savings. These fees can largely be avoided by using an IRA rather than a 401(k) plan to save for retirement.
I constructed a spreadsheet to estimate the impact of high 401(k) fees at retirement savings. The assumptions in a baseline analysis involved a person with a starting salary of $50,000 who works for 35 years and realizes wage growth of 2% per year over her entire career. This person contributes 10 percent of her salary to a 401(k) plan and earns an annual return of 7%.
When fees are 2 percent of the end-of-year 401(k) balance the total fees over the entire 35-year career are slightly more than $153 k compared to an ending balance of slightly less than $600 k.
By contrast, when 401(k) fees are 0.5 % (a reasonable fee structure that exists at many firms) total fees over the 30-year career are around $48 k and the ending balance is around $830 k.
Note the difference between ending balances of the two scenarios is much larger than the difference in fees because additional 401(k) income from the lower fee compounds at the average rate of 7 percent per year.
One possible strategy for a worker at a firm that match some employee 401(k) contributions is to make a small contribution to the 401(k) to take advantage of the employer match and then invest additional funds in an IRA. This strategy may or may not be feasible depending on IRS rules governing IRA contributions, deductibility of IRA contributions, and the individual’s household Adjusted Gross Income.
The 401(k) fees are applied to all assets in the 401(k) plan. In the current low interest rate environment, the expected return on government bonds adjusted for 401(k) fees is negative. In this circumstance, it may make sense to place more 401(k) funds in equity and accumulate debt investments outside of a 401(k) account where they are not subject to 401(k) fees. One alternative, which many people overlook, is direct investment in Treasury bonds and bill at Treasury Direct.
Firms like Fidelity, Schwab, and Vanguard aggressively ask people who leave their employer to convert their 401(k) plan to an IRA. This is the rare case where aggressive solicitation from financial firms is actually sound advice. Fees on well-designed IRAs are often near 0.2%. The decision to maintain funds in a dormant high-fee 401(k) plan could lead to a substantial loss in retirement savings.
One of the key selling points of conventional 401(k) plans is the ability of these plans to reduce current year tax obligations. By contrast, Roth 401(k) plans and Roth IRAs do not reduce current year tax obligation but do reduce taxes in retirement. A person with low current year tax obligations and the ability to reduce taxes through other means such as contributing to health savings account may choose to reduce or eliminate contributions to a conventional 401(k) plan. This person might instead invest through a Roth 401(k) plan if available at her firm or through a Roth IRA. The lack of a Roth 401(k) option may lead some investors who are concerned about tax obligation in retirement to consider a Roth IRA over a conventional 401(k) plan.
The issue of deciding between a 401(k) plan and an IRA is related to several other issues including – the choice between debt reduction and mortgage savings, the choice between investing in a health savings account or a retirement account, and the choice between a conventional and Roth IRA. Other financial tips on these related issues will follow shortly.
Discusses existing policies
and proposals on college financial aid and student debt and comes up with
several new solutions that promise to reduce the number of overextended
borrowers without imposing large burdens on taxpayers.
Defying Magnets:
Centrist Policies in a Polarized World
This generation of workers is
getting screwed – higher student debt, multiple problems with health insurance
coverage, and difficulties saving for retirement. Three policy primers discusses these inter-related
problems.
Things to Consider Before Purchasing Long Term Care
insurance
Most people can’t afford long
term care insurance. Insurance companies often raise premiums and
cut benefits, years after a policy is purchased. The possibility of needing Long term care is
a major risk. But you need to solve
other problems first. Best to minimize
debt, increase 401(k) savings, buy life insurance ahead of covering this troubling
risk.
Statistical Applications of Baseball
Book teaches introductory statistics
through baseball. A bit dated but
baseball is and statistics are constants and book has a number of Interesting
real world examples.
Most of the current health care debate in the
Democratic party revolves around the adoption of a single-payer health care
plan or the addition of a public option to the current system.
The Medicare for-all-option offered by Senator
Sanders is on paper a comprehensive solution fixing all health insurance
problems. While many countries have high-quality
public health insurance, there has never been an example of a country with an
advanced private system abruptly replacing it with a public system
The proposals to expand Medicaid or Medicare
currently circulating in Congress could help certain communities or
groups. The provision of Medicaid on state
exchange market places would be useful in several rural counties where few
private insurance companies choose to compete.
A reduction in the Medicare age or a Medicare buy-in option would
benefit older workers who do not have access to employer-based health insurance
coverage.
The adoption of a public option, unlike single-payer
proposals does not purport to be a comprehensive solution. The task of fixing health care system without
simply blowing up the current system is difficult. President Trump, famously observed “Nobody knew
that health care can be so complicated.”
There are multiple inter-related health problems with our current health care
system. A policy that fixes one problem (say
high premiums) can worsen another (say high out-of-pocket costs).
A centrist health care plan must do more than
shore up state exchange market places through new public options. The ACA expanded coverage to millions of
people but even after the enactment of the ACA many Americans lacked health insurance
and under the Trump Administration the number of Americans without health
insurance has increased.
This article reports that the uninsured rate
went from 10.9 percent in late 2016 to 13.7 percent in December 2018.
Moreover, even after the enactment of the ACA many Americans saw higher premiums, higher
out-of-pocket expenses, and reduced access to specialists. Increasingly, many Americans covered by insurance
choose to forego procedures rather or prescription drugs because of high out-of-pocket
costs. Simply adding a public option
does not fix these problems.
The remainder of this essay outlines health
care problems and centrist solutions.
Health Care Problems and Solutions
Problem
One The Erosion of the Individual Mandate: The ACA individual mandate was repealed in a
recent tax law. As a result, some people
with pre-existing conditions have an incentive to delay the purchase of health
insurance until they become sick. The
repeal of the individual mandate undermines state exchange market places and
increases health insurance premiums.
Potential
Solution: There
are two potential solutions to this problem.
The first potential solution involves the
reinstatement of the individual mandate.
Politically, this is a difficult option because the individual mandate
is unpopular and strongly opposed by libertarians and other conservatives who
believe that government has no right demanding people spend money in a particular way.
The second
approach involves creating new financial incentives in the form of tax
credits and other subsidies contingent on people holding continuous health insurance
coverage.
Subsidies that could be made available only to
people with continuous health insurance coverage include: (1) a tax credit for contributions to health
savings accounts, (2) a partial subsidy for high cost out-of-network treatments,
and (3) subsidies for some prescription drugs.
Note that a tax credit for health savings account contributions would
not even require an additional explicit linkage between the tax credit and
health coverage because under current law contributions to health savings
accounts are only available to people who have health insurance coverage.
Problem
Two: Distortions caused by growing use of health savings accounts and high
deductible health plans:
The growing use of health savings accounts coupled with high deductible
plans has exacerbated three problems – (1) higher out-of-pocket health care
costs, (2) increase in patients forgoing prescribed medicines and medical
tests, and (3) reduced funds placed in 401(k) retirement plans.
Potential
Solutions: The distortions
caused by the increased use of health savings accounts and high deductible health
plans can be mitigated by several policy changes.
First, lower income households would benefit
from a refundable tax credit for contributions to a health savings account. (Current law only allows deductibility of
contributions to health savings account, a feature that provides less benefit to
low-income low marginal tax rate households.)
Second rules governing contributions to health
savings account could be altered.
Current rules only allow contributions by people with a high-deductible
health plan. The revised rule would
allow health savings account contributions by people who have a plan with a lower
deductible but a high coinsurance rate.
(People with high coinsurance rate plans can have substantial cost sharing
obligations but may be less likely to forego needed treatments prior to the deductible
being met.)
Third, many existing high deductible health
plans now forego all payments on prescription drugs until health expenses exceed
the deductible. By contrast, many traditional
health plans with lower deductible pay some prescription drug costs prior to
the patient paying the deductible. The
combination of high deductible and absolutely no reimbursement for prescription
drugs until the deductible is met results in many people with chronic health
conditions like diabetes forgoing needed medicines. This worsens health conditions and increases
costs.
A rule requiring partial reimbursement for
prescription medicines needed to prevent expansion of certain diseases would reduce
the incentive for people to forego prescribed medicines. It might be possible for HHS to adopt this
rule change without input by Congress because the current ACA allows high-deductible
health plans to reimburse patients for certain preventive health care measures
prior to the deductible being met.
Problem
Three: The limited role of state exchange
market places.
State exchange health care markets are much smaller and much less robust
than the employer-based health insurance markets. Around 8 million people are covered by state
exchange market places compared to around 155 million people covered by
employer-based insurance.
Household
receiving health coverage from state exchange markets tend to be less affluent
than people obtaining health insurance from employer based market. Go to this post on my math blog for
statistics on this point.
There are relatively few young adults under
age 26 in state-exchange markets
compared to employer-based markets. Go
to this post in my finance blog for a discussion of this issue.
There is less choice and fewer high quality
products in state exchange markets than in employer-based markets. In some counties few health insurance
companies offer coverage and often there is concern that no health insurance
companies will offer health insurance in a county. There is evidence that state exchange
insurance policies are more likely to restrict access to certain hospitals and
specialists.
Potential
Solutions: It
should not be a surprise a small health insurance market with relatively few young
adults, and relatively few affluent households will provide less desirable outcomes
than a larger health insurance markets with more younger adults and a lot of
affluent people.
The characteristics and limitations of ACA state
exchange market places are largely a result of the rules laid out in the ACA.
First, the ACA contains an employer mandate,
which provides a financial penalty on employers with more the 50 full time equivalent
employees who do not provide health insurance to their employees. The employer
mandate could be modified to allow and encourage employers to pay for health
insurance on state exchange market places rather than offer a company-specific
plan.
Second, the ACA eliminates tax credits to
people once they obtain a position offering employer-based insurance
coverage. The rule eliminating tax credits
for people with employer-based health plans would be eliminated.
Third, state exchange market places do not
provide any preferential tax treatment for the 41 percent of American households
with income greater than 400 percent of the federal poverty line. Households in this income group receive
untaxed health insurance from their employer.
This rule reduces political support for state exchange marketplaces. Support for state exchange marketplaces could
be increased through an expanded tax credit.
A
Political Note on the Role of State Exchange and Employer-Based Health insurance
Marketplaces:
The introduction of state exchange market
places to compete with employer-based health insurance is the central aspect of
the ACA, a law that was strongly opposed by conservative economists and
Republican politicians. However, the
provision of health insurance through private markets separate from the employer
was an idea originated by conservative economists and supported by Republican
politicians. To be fair, there were
major differences between Republican proposals, which allowed underwriting of
premiums and denials of insurance for people with pre-existing conditions and
the ACA.
Republicans are on record of supporting reductions
in the use of employer-based health insurance.
In fact, a health care plan offered by Senator McCain replaces the
entire current employer based tax preference with a tax credit for the purchase
of health insurance through state market places.
The protections for pre-existing conditions
and the limitations on underwriting of premiums increase access to health
insurance for many people who would otherwise be uninsured. (The election results of 2018 indicate the
Democrats largely won this debate.) There
is some Republican support for moving the purchase of health insurance from the
employer to private markets. Could Republicans
support proposals that move more people from employer-based insurance to
current ACA state exchanges?
Problem
Four The introduction of short-term
bare-bones health plan has increased household financial risk and undermined state
exchange market places. The Trump Administration has enacted rules that
allow use of short term health plans.
These health plans often do not cover many services that are considered
essential health benefits in an ACA plan. The coverage gaps result in unanticipated
bills and financial exposure. The short
term option reduces demand for ACA policies.
Potential
Solutions:
There are two way to address problem caused by the introduction of ACA
plan.
The first approach is to repeal the Trump era regulation
and return to a system where short term health plans are prohibited. Repeal creates a situation where people who
took out short term health plans will either lose coverage or purchase an ACA
plan with a higher premium.
The second approach involves modifying short
term plans to allow for an annual cap but to require coverage of all essential
health benefits. People with expenditures
over the annual cap would get automatic Medicaid coverage once the cap was
reached.
This policy essentially converts Medicaid into
a reinsurance program responsible for health care costs over the annual limit. I loosely describe this approach in a 2008
paper on SSRN. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1162887)
Problem
Five: Lack of access to elite out-of-network
hospitals and specialists. Typically,
narrow network HMOs provide excellent health care and charge lower premiums. However, people who get extremely sick with
certain illnesses require treatment by specialists that are only offered at certain
hospitals. This is called the “breaking
bad” problem as portrayed by the fictional high school chemistry teacher who
chooses to make meth to pay for his cancer treatments.
Potential
Solutions: The “breaking
bad” problem can be solved by having the government share part of the costs of expensive
specialized out-of-network care. Having the
government pay for a portion of complex treatments that could only be handled in
sophisticated out-of-network hospitals would reduce premiums for limited network
HMO plans. This reduction in health care
premiums would also reduce tax subsidies on health care purchases both on the
ACA state exchange subsidies and the employer-based health insurance subsidies.
This proposal offers two benefits – lower premiums
on basic narrow-network health care and access to more expensive out-of-network
care should the narrow network be unable to treat certain health conditions.
Problem
Five: A lack of
affordable health coverage for people nearing the end of their careers who are
not eligible for Medicare.
Potential
Solution: One approach to
this problem is to allow the purchase of Medicare by individuals 50 or over without
an offer of employer-based health.
An expanded Medicare option for people over the
age of 50 could be combined with a higher (old-young) age-rate premium ratio to
lower costs for younger households.
Problem
Six: Limited State Exchange Offerings and
High Premiums for Certain Counties. Some counties have few health insurance
companies offering ACA coverage. It has
been reported that in 2018 around half of counties had only insurance company offering ACA coverage.
Heritage Foundation article on counties with
limited health insurance coverage
Potential
Solution:
Senator Schatz’s health insurance bill allowing states to offer health
insurance on state exchanges would create another option in many counties with
only one or relatively few ACA providers
Go here for a description of the Schatz-Lujn legislation:
A comprehensive centrist health care plan
might both expand and improve health insurance coverage. It would lower premiums and reduce
out-of-pocket expenses. The simultaneous
achievement of these two goals is often difficult because many policy changes that
reduce premiums increase out-of-pocket costs while policies that reduce out-of-pocket
costs often increase premiums.
Here are some aspects of the plan:
Link
all new tax subsidies and the standard deduction to a requirement that people maintain health care coverage.
Change
rules governing health savings accounts to allow for contributions by people
who have high-cost sharing plans even if the plan has a low deductible.
Create
tax credits for contributions to health savings accounts
Require
partial insurance coverage for prescription drugs used to treat chronic health
care conditions prior to health expenses exceeding plan deductible.
Modify
the employer mandate to encourage businesses to subsidize state exchange
insurance rather than choose and administer an employer-based policy.
Modify
rules governing tax subsidies for insurance on state exchanges to allow people
to keep their state exchange policy after obtaining offers of employer-based
coverage.
Repeal
current short-term bare bones health plans.
Create
health plans with an annual cap while guaranteeing Medicaid coverage once
health expenditures exceed the cap.
Create
a new subsidy for out-of-network costs for people with narrow-network plans who
require procedures not covered in the narrow network.
Allow
people over 50 without access to employer-based health plan the right to buy into
Medicare.
Modify
the age-rate premium formula to lower costs for younger households.
Allow
states to authorize the sale of Medicaid policies on state exchanges.
Authors
Note: A lot
of these ideas and proposals are discussed in greater detail in the second chapter of my policy primer “Defying
Magnets: Centrist Policies in a
Polarized World”
Defying Magnets: Centrist Policies in a Polarized World
The first chapter of the book examines student
debt policies. The third chapter
examines retirement income.
I believe you will find the analysis and
proposals innovative, potentially useful, and drastically different than what
is being offered in Washington.
Republicans are seeking to
repeal and replace the affordable care act, even as Republican candidates for
office profess support for many parts of the act including protections for
people with pre-existing conditions. The primary Republican achievement since
2016 involves a tax law that repealed the individual mandate and a Texas
federal court ruling currently under appeal that voided the entire law because
of the individual mandate repeal.
Democrats have robustly
opposed Republican efforts to repeal the ACA but are now split between fixing
the Affordable Care Act or moving towards a single-payer system. Many 2020 Democratic candidates have
endorsed Medicare for all without fully considering details of and implications
of their proposals.
Some Democrats are now
advocating proposals that would allow some private firms or some individuals to
buy into Medicare or Medicaid. One advantage of adding a government (Medicare
or Medicaid) option is that these options allow people to keep private
insurance.
This section starts with a
review of the current health care policy debates. The analysis reaches the following
conclusions.
Republican efforts to repeal the ACA would substantially
increase the number of uninsured people in the United States.
Democratic Medicare for all proposals have not
been fully vetted, would leave many people with private insurance worse off and
would be more expensive than anticipated.
The combination of a decrease in the
eligibility age for Medicare combined with a higher ratio of insurance premiums
for older households relative to younger households could decrease the number
of uninsured people in all age groups.
The section contains
discussions of three technical health insurance issues with important
implications for health insurance markets that have not received attention
during the debate over repeal of the ACA.
The first issue involves
modifications of rules governing health savings accounts and high deductible
health plans. Proposals designed to
mitigate problems created by the increased use of health savings accounts and
high deductible plans include:
Creation of a tax credit for contributions to
health savings account by low-income and mid-income households.
Expansion of the type of health plans, which
allow contributions to health savings accounts.
Require high deductible health plans pay a
portion of prescription drugs used for chronic diseases prior to deductible
being met.
The second issue involves
modification of rules and incentives governing the use of employer-based
insurance versus state exchange insurance.
Proposals designed to
strengthen state exchange insurance and to allow more firms to replace
employer-based coverage with state exchange coverage include:
An expansion of the tax credit for premiums on
health insurance policies purchased through state exchanges.
An alternative to the employer mandate for
employers subsidizing the purchase of health insurance on state exchanges.
Financial incentives for young adults to leave
their parent’s health insurance policy and obtain health insurance on state
exchanges.
The third issue involves how
to mitigate financial distortions caused by extremely expensive and complex health
care cases. Proposals designed to
mitigate problems associated with the most expensive health care costs include:
Government and private firms sharing health
care expenses over a certain threshold.
Automatic Medicaid enrollment for people
purchasing a health plan with an annual benefit cap once expenditures exceed
the cap.
Government assistance for certain health care
cases that are difficult to treat in narrow-network HMOs.
The health care debate is
eerily analogous to the student loan debate with each side taking extreme
positions. Republican efforts to repeal
the ACA would increase the number of uninsured.
Democratic initiatives would crowd out private insurance for many households
that are well served by the existing system.
The road to improving health care like the road to reduce student debt
problems involves the analysis of arcane rules and incentives and the design of
economically efficient alternative regulations.
Question: How has the use of PLUS loans for parents changed over time for parents of student attending undergraduate institutions and for students attending graduate schools? What is the share of PLUS loans taken out by parents with income in the bottom quartile?
Does it appear that parents taking out PLUS loans for students have adequate income to repay their obligations?
Why this issue is important: Parents who have problems repaying PLUS loans are not allowed to default on the loan. Increasingly, many parents with PLUS loan obligations have had problems repaying and in some cases the government has garnished Social Security benefits from these borrowers. It is possible that many of the financial problems caused by use of PLUS loans could have been prevented if lenders had considered the adequacy of parent income prior to making the loan.
Data and Methodology:
I addressed this issue with TRENDSTATS from the NCES DATALAB.
TRENDSTATS allowed me to get data on use of parent plus loans by income quartile for five different survey years — 1996, 2000, 2004, 2008 and 2012.
I created separate analysis for parents of undergraduate students and parents of graduate students.
The table on PLUS loans for undergraduates only involves parents of dependent students.
The table on PLUS loans for graduate students uses the combined income of the student and the parent.
Results: Two tables on PLUS loan use and income quartiles over time are presented below.
Percent of Dependent Parents with PLUS Loans by Income Quartile
Year
Lowest 25th Percent
Lower Middle 25th Percent
Lower Upper 25th Percent
Upper 25th Percent
Total
1996
2.96
5.56
6.38
5.65
5.06
2000
3.56
5.48
8.61
6.76
6.07
2004
3.92
6.53
9.34
8.34
6.98
2008
4.33
6.73
9.37
8.86
7.25
2012
6.22
9.17
11.33
10.87
9.27
Percentage Growth 1997 to 2012
109.91%
64.96%
77.57%
92.49%
83.27%
Sample is all parents of dependent undergraduate students
Parent Plus Loans for Graduate Student by Quartile of
Sum of Parent and Student Income
Year
Lowest 25th Percent
Lower Middle 25th Percent
Upper Middle 25th Percent
Upper 25th Percent
Total
1996
6.83
3.94
2.36
0.80
3.48
2000
7.37
5.75
4.14
2.90
5.07
2004
7.98
6.18
3.44
3.87
5.51
2008
9.82
8.14
5.48
3.88
6.76
2012
11.47
7.87
5.23
3.27
7.13
% Change
67.85%
99.63%
121.73%
308.91%
104.82%
Analysis of Percent of Plus Loans Across Income Quartiles:
Undergraduate Students:
The lower upper 25th percentile had the highest share of students dependent on PLUS loans for parents in all years.
Growth rate in use of PLUS loans for parents is highest in the lowest 25th percentile.
Graduate Students:
The lowest 25th percentile consistently had the highest percent of people dependent on PLUS loans for parents.
The upper 25th percentile had the highest growth rate in the use of PLUS loans for parents; although, the PLUS loan share for this quartile remained lower than all other quartiles in 2012.
Share of PLUS Loans Taken Out by Parents in First and Second Income Quartile:
Above I discussed the percent of students in each quartile that used a PLUS loan.
Here I look at the percent of students using PLUS loans that are in particular quartiles in each income quartile.
PLUS Loans for Parents Usage
Number out of 1,000 per income quartile
Q1
Q2
Q3
Q4
Total
Undergraduates
62.2
91.7
113.3
108.7
375.9
Graduates
114.7
78.7
52.3
32.7
278.4
Share in Each Quartile
Q1
Q2
Q3
Q4
Total
Undergraduates
16.5%
24.4%
30.1%
28.9%
100.0%
Graduates
41.2%
28.3%
18.8%
11.7%
100.0%
Calculations above are for 2012
Observations on use of Parent PLUS Loans Across Income Quartiles:
Lower-income people take out a lot of PLUS loans.
16.5 percent of PLUS loans taken out by parents of undergraduates are in the lowest income quartile.
41.2 percent of PLUS loans taken out by parents of graduate students are in the lowest income quartile.
Methodological Note:
I wanted the software to provide numbers of students in each income quartile based on population weights. I would have obtained contingency tables based on population weights in SAS or STATA if I had access to the raw data files. TRENDSTATS does not appear to have this capability. Alas, I don’t have access to the raw data so this could not happen.
I attempted to switch the row and column variables in TRENDSTATS but the TRENDSTATS software does not allow for automatic creation of income quartiles when parent income of dependent variable is the column variable.
How then did I get the share of loans for all income quartiles?
By definition, each quartile has the same number of observations so I assumed each group had 1000 students. I multiplied 1000 by share of students using PLUS loans for each quartile to get PLUS loan use per 1,000 students.
The sum of these numbers is total PLUS loan use across all students. I divided PLUS loan use by income quartile by total PLUS loan use in the population to get quartile shares.
I am very interested in understanding the advantages and limitations of the POWERSTATS and TRENDSTATS education department software and will continue to make comments that might lead to improvements in the on-line databases.
Concluding Thought:
Barring really exceptional circumstances, student debt including PLUS loans obtained by parents is not forgiven or discharged even in bankruptcy. Lenders happily give PLUS loans to lower-income parents because the loans are guaranteed even if the lender cannot make repayments.
The combination of government guarantees for loan payments and a prohibition on discharge of loans in bankruptcy has led to a thriving debt market geared towards people with little chance of repayment.
The Trump Administration is proposing the elimination of subsidized student loans. This post provides estimates of the additional costs of this proposal based on the number of years students stay in school.
Introduction: Currently, low-income undergraduate students can take out a total of $31,000 in federal student loan. Subsidized student loans are only available to people in low-income households. The main difference between subsidized and unsubsidized student debt is that the government pays all interest costs on subsidized debt when the student is in school while interest accrues on unsubsidized loans.
The current limit on subsidized student loans is $23,000. The total limit on undergraduate federal student loans is $31,000.
The Trump Administration is proposing to eliminate all subsidized student loans.
The purpose of this post is to model and analyze the impact of this policy change for a student who is planning to take full advantage of subsidized student loans. I also examine how this financial cost depends on the number of years it takes for the student to graduate.
Methodology: I set up a spread sheet where the key model inputs are number of years it takes for a student to graduate, the interest rate on the student loan, and the maturity of the student loan.
Key Assumptions:
In this model, I assume the student borrows $31,000/n each year where n is the number of years it takes for the student to graduate. When subsidized loans exist the annual total borrowed for subsidized loans is $23,000/n and total unsubsidized loans for the course of the person’s undergraduate career is $8,000.
(An expanded version of this model will consider uneven borrowing scenarios, where student borrows a different amount each year or perhaps drops out from school for a few years.)
Student remain in deferment until six month after graduation or leaving school.
Student does not apply for loan deferments for economic hardships or when unemployed.
The interest rate is 5 percent.
Student loan maturity is 20 years.
The procedure to calculate lifetime costs involves two steps.
Step One: Calculate the total loan balance on the day the student borrower starts repayment. The subsidized loan at time of repayment is equal to the balance when issued since all interest is paid for. The FV of the unsubsidized loan is determined at time of graduation and multiplied by (1+0.05)0.5 to account for the six-month delay in repayment after graduation.
Inputs of FV function:
INT interest rate 0.05 or some other assumption.
NPER number of periods in this case number of years in school.
PMT is payment in this case the annual loan amount.
PV in this case 0
Type is ! for end of period.
The FV gives the value of the loan at graduation. Repayment is six months later. The value of the loan at repayment is FV0.5
The total loan balance is the sum of the subsidized and unsubsidized loan balance at time of repayment.
Step Two: Calculate total payments over the lifetime of the loan. This is done by using PMT function to get monthly payment and then multiplying by the total number of payments.
Spreadsheet for person who graduates in four years:
row
Subsidized Loans
No Subsidized Loans
2
Date of First Loan Payment
9/1/10
9/1/10
3
Subsidized Loan
$23,000
$0
4
Unsubsidized Loans
$8,000
$31,000
5
Interest Rate
0.05
0.05
6
Number of years In school
4
4
7
Date Repayment Starts
3/2/15
3/2/15
8
FV of subsidized loans
$23,000
$0
9
FV of unsubsidized Loans
$9,275
$35,940
10
Total Loans
$32,275
$35,940
11
Loan Maturity
20
20
12
Loan PMT
-$213
-$237
13
Lifetime Payments
-$51,120
-$56,925
The elimination of subsidized loans increases lifetime repayment costs of the loan by $5,805 when the person graduates in four years and starts repayment six months after graduation. (The other key assumptions are a 5% student loan interest rate and a 20-year student loan.)
Impact of delays in finishing schools:
The addition cost stemming from the loss of the subsidy can be obtained by changing line 6 of the spreadsheet number of years in school. Below we present results for # of years in school for 4, 5, and 6.
Calculations are below:
# of Years in School
Payments with Subsidized Loans
Payments with No Subsidies
Difference
4
$51,119.83
$56,924.81
$5,805
5
$51,496.04
$58,382.62
$6,887
5
$51,884.94
$59,889.61
$8,005
The elimination of subsidized loans leads to even higher costs for the person who spends more years in school. Additional lifetime costs of loans are $6,887 for the person who graduates after 5 years and $8,005 for the person who graduates after six years.
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Issue: Under an asset allocation investment strategy, an initial allocation is assigned to all assets in a portfolio and the portfolio is rebalanced from time to time to maintain the original composition of assets. The rebalancing can be at scheduled dates or whenever the portfolio manager observes large changes in relative asset prices.
The original allocation of assets is maintained by selling assets that do well and buying assets that do poorly. This approach can backfire. A hedge fund manager who bought horse and buggy stocks and sold car stocks after the introduction of the car would not have done well. However, asset allocators who sold internet firms prior to the tech bubble in the late 1990s did quite well.
Question: Table one below has stock price information on 12 sector ETFs offered by Vanguard for three dates – 7/1/13, 7/1/16, and 6/29/18.
Using this price data, calculate the average annual return between 7/1/13 and 7/116 and the average annual return from 7/1/16 to 6/29/18 for the 12 funds.
What do these annualized return statistics suggest about the likelihood of success of an asset allocation strategy, which starts out with equal shares of the 12 ETFs on 7/1/2013 and rebalances on 7/1/2016.
Adjusted Close Stock Price for 12 Sector Funds
Symbol
Fund Description
7/1/13
7/1/16
6/29/18
VDC
Consumer Stables
93.55
133.53
134.27
VDE
Energy
103.12
88.25
105.08
VFH
Financials
38.12
47.48
67.45
VHT
Health Care
86.84
133.78
159.14
VIS
Industrials
79.06
106.53
135.81
VGT
Information Tech
73.07
112.61
181.42
VAW
Materials
82.52
104.33
131.56
VNQ
Real Estate
56.70
84.58
81.46
VOX
Communications Services
68.28
94.02
84.92
VPU
Utilities
72.52
106.33
115.96
GLD
Gold
127.96
128.98
118.65
SLV
Silver
19.14
19.35
15.15
A note on calculations: The return between two dates is obtained from the formula (APt/ APt-n) (1/n)-1
The first period is three years and the second period is two years. (n is 3 for first period and 2 for second period.)
The table below sorts the funds from least to highest annualized return during the first period.
Annualized Rate of Return for 12 Funds
Symbol
Fund Description
July 2013 to July 2016
July 2016 to July 2018
Diff.
VDE
Energy
-5.1%
9.1%
14.2%
GLD
Gold
0.3%
-4.1%
-4.4%
SLV
Silver
0.4%
-11.5%
-11.9%
VFH
Financials
7.6%
19.2%
11.6%
VAW
Materials
8.1%
12.3%
4.2%
VIS
Industrials
10.5%
12.9%
2.5%
VOX
Communications Services
11.3%
-5.0%
-16.2%
VDC
Consumer Stables
12.6%
0.3%
-12.3%
VPU
Utilities
13.6%
4.4%
-9.2%
VNQ
Real Estate
14.3%
-1.9%
-16.1%
VHT
Health Care
15.5%
9.1%
-6.4%
VGT
Information Tech
15.5%
26.9%
11.4%
Observations:
Information Technology, the best performing fund in the first period, was also the best performing fund in the second period. This asset allocation strategy would have reduced holdings of an asset, which continued to out-perform all other assets in the portfolio.
Energy, the worst performing fund, in the first period, had a return 3 percentage points over average of the 12 ETF returns in the second period.
Four of the six worst-performing sectors in the first period realized improved returns in the second period.
Five of the six best-performing funds in the first period had worse returns in the second period. (The only exception is the previously mentioned information technology fund.)
The median annualized return in first period was 10,9 percent. Only four funds had annualized returns over this level in the second period.
Two sectors – financials and information tech – are positive outliers in the second period. However, financials have underperformed in last few months.
Concluding Remarks: Information Tech, the best performer in both time periods, did spectacularly in the second period. Asset allocators sold the best fund.
Asset allocation strategies tend to work more consistently when the investor holds broader funds, including both the overall stock market and debt funds. Subsequent research will look at situations where asset allocation provides better results.
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He supports this argument with the observation that the PE ratio of Tech stocks in the S&P 500 is still under 20.
What are the limitations of using the PE ratio for a basket of stocks to measure the valuation of the portfolio when some stocks in the portfolio have negative earnings?
Does an analysis of the PE ratios of the stocks in the Vanguard Information Technology ETF support or contradict Professor Siegel’s view on the valuation of Tech stocks?
Is Professor Siegel correct in his assertion that tech stocks are valued correctly?
Discussion of ETF PE Ratios:
Professor Siegel pointing to a PE ratio for a basket of tech stocks in the S&P 500 has argued that the sector is valued fairly. My problem with this argument is that published statistics on ETF PE ratios often fail to accurately include information on firms with negative earnings.
Firms with negative earnings have negative PE ratios. These firms often have a lot in common with high PE firms. Often startups have negative or low earnings. If earnings are negative the PE is negative. If earnings are slightly positive the PE is large.
It would be incorrect to average negative PE firms with positive PE firm because the result would be to reduce the PE of the portfolio even though the negative PE firms have high valuations compared to their income. Some web sites including yahoo finance report and include negative PE ratios. Most analysts omit negative PE ratios from their calculation of the portfolio PE. However, this procedure will also understate valuation relative to income because firms with negative PE ratios have high valuation compared to earnings.
PE ratios have no clear economic interpretation when earnings are negative. When earnings are slightly below zero (a small loss) the PE ratio is a very large negative number. When a company has a larger loss the PE ratio is a smaller negative number.
Why PE ratios make no sense for firms
with negative earnings
Earnings per share
Price per share
PE ratio
(0.10)
3.00
(30.00)
(5.50)
3.00
(0.55)
In short, PE ratios incorrectly rank firm valuation when earnings are negative.
It would be incorrect to average negative PE firms with positive PE firm because the result would be to reduce the PE of the portfolio even though the negative PE firms have high valuations compared to their income. Some web sites including yahoo finance report and include negative PE ratios.
Most analysts omit negative PE ratios from their calculation of the portfolio PE. However, this procedure will also understate valuation relative to income because the firm with a negative PE ratio has a high valuation compared to earnings.
I am not the first to write about the problem of measuring ETF PE ratios. Here are some additional resources.
Vanguard Technology Fund VGT has a total of 356 firms. This study examined the PE ratios of all firms where the equity investment was greater than or equal to 0.1 percent of the value of the VGT portfolio. There were 109 such firms.
Results: The frequency distribution of dollar share values invested and number of firms for five PE categories – less than zero, 0 to 15, 15 to 30, 30 to 40 and over 40 – are presented below.
Shares of Firms in VGT by PE category
PE Category
Dollar Share Invested by PE Category
Percent of Companies
<0
6.31
17.43
0-15
5.74
6.42
15-30
36.19
34.86
30-40
31.16
12.84
40<
13.12
28.44
Total
92.52
100
Sample consists firms in VGT where the equity position was greater than or equal to 0.1 percent of the total value of the VGT portfolio. There were 109 firms meeting this criterion. These 109 firms represent 92.5 percent of the value of the VGT Portfolio.
Observations:
Around 6.3 percent of dollars invested in the 109 positions of VGT are in firms with negative earnings. Around 17.4 percent of the 109 firms had negative earnings.
Over 13 percent of dollars invested in the 109 VGT positions had PE ratios over 40. Over 128 percent of the firms in this group had a PE ratio over 40.
Analysis:
What can we conclude about the question of whether tech stocks are overvalued after examining the distribution of stocks in VGT?
The large number of tech stocks with high PE ratios or worse yet negative earnings is consistent with a bubble. Perhaps the bubble is in the early stages and some people can buy, sell, and make money before the crash. However, there are a lot of overtly optimistic analysts and a lot of inaccurate or misleading information out there.