Increases in Undergraduate Debt 2003/2004 to 2011/2012

The statistics presented in this post document the dramatic increase in student debt between 2004 and 2012.

Increases in Undergraduate Debt 2003/2004 to 2011/2012

My holiday visit with in-laws included less discussion of politics this year for obvious reasons but I did have a brief discussion on student debt with one relative.   His view of the issue is that since his generation paid for their college no additional cost subsidies are needed. My concern is that the recent increases in costs are having substantial adverse impacts on the current cohort of students.

I am planning several more posts on college costs and their economic and impacts.   This post looks at the trend growth of student debt between the 2003/2004 and the 2011/2012 academic years.

The Data: The source of data for this study is the NSPAS database. I was able to access the data from the NCES Power Statistics Portal.

https://nces.ed.gov/datalab/index.aspx

My variable of interest in this post is cumulative amount borrowed in the undergraduate years by people receiving a bachelor’s degree at four-year institutions.   I have presented separate tables for private and public four-year institutions.

Three statistics are presented – Average debt for borrowers, the percent of students who borrowed, and the percent of students who borrowed more than $25,000.

The data does not include information on borrowing by parents through the PLUS program.

Statistical Results:

The statistics describing change in cumulative student debt are presented in the table below.

 

Cumulative Under Graduate Student Debt at Four-Year Institutions

2004 to 2012
Bachelors Degree Four-Year Public
2003/2004 2011/2012 Diff. % Diff.
Average Debt for Borrowers $11,958 $18,845 $6,887 57.6%
% of Students who Borrowed 56.6 63.5 6.9 12.1%
% of Students with debt greater than $25,000 5.3 16.9 11.6 218.7%
Bachelors Degree Four-Year Private
2003/2004 2011/2012 Difference % Diff
Average Debt for Borrowers 14,536 22,962 $8,426 58.0%
% of Students who Borrowed 66.9 69.1 2.2 3.3%
% of Students with debt greater than $25,000 9.6 22.9 13.3 138.0%
Both Public and Private Four-Year Programs
Average Debt for Borrowers 12,876 20,163 $7,287 56.6%
% of Students who Borrowed 60.8 65.2 4.4 7.2%
% of Students with debt greater than $25,000 6.8 18.7 11.9 176.4%

Summary of Statistical Results:

The growth of cumulative student debt among people receiving a bachelor’s degree from a four-year institution was tremendous during this brief eight-year period.

Total debt incurred by student borrowers receiving a bachelor’s degree rose by around 57% over this eight year period.

The proportion of undergraduate bachelor degree students incurring debt rose by 6.9 percentage points at public institutions and 2.2 percentage points at private institutions.

The proportion of undergraduate bachelor degree students incurring more than $25,000 in debt went from 5.3% to 16.9 percent for students at public schools and from 9.6 percent to 22.9 percent for students at private institutions.

 Other Student Debt Trends:   There are other student debt trends that need to be be addressed including  — the expansion of PLUS loans to parents, increased  use of private debt, changes in debt incurred by graduate students, changes in the number of students with excessive levels of student debt:

Economic Financial and Social Implications:

Economic issues related to the increase in student debt include – (1) A decision by many young people to live with parents and delays in starting a family, (2) a decision to delay home purchases, (3) the choice between a 30-year and 15-year mortgage, and (4) a decision to delay placing funds in a 401(k) plan.

Many older financial experts do not agree with the decision by many in the current generation to delay home purchases and delay saving for retirement.

My view is that the older generation is not in fully touch with the economic realities facing many in the millennial generation from the explosion in student debt occurring over a mere eight years.

Retire Mortgage Debt or Accumulate in Your 401(k) Plan?

Increasingly, many Americans nearing the end of their work life find they have a large mortgage and must choose between paying off the mortgage or contributing more funds to their 401(k) plan. A large number of financial advisors advise their clients to increase 401(k) contributions rather than pay off their mortgage.

http://www.forbes.com/sites/nancyanderson/2014/01/03/7-reasons-not-to-pay-off-your-mortgage-before-you-retire/

http://www.kiplinger.com/article/real-estate/T040-C000-S002-should-you-pay-off-your-mortgage-before-you-retire.html

http://www.washingtonpost.com/news/get-there/wp/2015/03/26/the-case-for-not-paying-off-your-mortgage-by-retirement/

http://www.foxbusiness.com/personal-finance/2014/06/18/maybe-shouldnt-pay-off-your-mortgage-before-retirement/

http://business.time.com/2013/05/28/the-new-retirement-why-you-dont-have-to-pay-off-your-mortgage/

http://online.wsj.com/ad/article/privatewealthretirement-mortgage

http://www.schwab.com/public/schwab/nn/articles/Should-You-Pay-Off-Your-Mortgage-Early-Before-You-Retire

http://www.principal.com/planningcenter/retirementplanning/nearingretirement/retirementnews/mortgagequestion.htm

My view is that it is essential for people nearing retirement to eliminate their mortgage debt even if this goal requires some reduction in 401(k) contributions.   I have two reasons for this view.   First, as noted and explained in the previous section 401(k) plans are not capable of mitigating the impact of market down turns at the end of a career or during retirement.   Intuitively, a person with no debt is much better able to withstand market downturns than a person with a mortgage.   The Wall Street analysts always say don’t sell on a panic the market will come back.   Well retirees with a large mortgage often have no choice but to sell.

Second, the financial risk considerations interact with another factor, the tax treatment of 401(k) plans. During working years mortgage interest and 401(k) contributions reduce income tax burdens.   During retirement a person with a large mortgage payment and most financial assets inside a 401(k) plan will pay more in tax than a person without a mortgage.

All disbursements from a 401(k) plan are fully taxed at the ordinary income tax rate.   A person with no mortgage disburses enough to cover discretionary expenses and taxes   A person with a mortgage must disburse enough to cover discretionary expenses, the mortgage and taxes.

The disbursement to cover the mortgage leads to additional taxes because all disbursement from the 401(k) plan is taxed. MOREOVER, THE DISBURSEMENT ON FUNDS USED TO COVER THE TAX ON THE 401(K) DISBURSEMENT IS ALSO TAXED.

Part of Social Security is taxed for people with income over a certain threshold. A quick way to find out if part of Social Security benefit is taxable is to compare your income to the threshold for your filing status — $25,000 for filing status single and $32,000 for filing status married.

http://www.irs.gov/uac/Newsroom/Are-Your-Social-Security-Benefits-Taxable

Higher disbursements from the 401(k) plan can increase your adjusted gross income beyond the threshold and increase the amount of the Social Security benefit subject to tax.   Of course any 401(k) disbursement used to pay the income tax is also taxed.

So let’s take a household with all financial assets in their 401(k) plan with a $30,000 annual mortgage.   This monthly mortgage is $2,500, not huge.   Let’s assume that the person has to pay around $1,000 more in tax on Social Security benefits because of the additional disbursement to pay down the mortgage. A first order approximation of the amount of additional tax needed because of the additional $31,000 disbursement is $31,000 x the marginal tax rate for the taxpayer.   For most filers the marginal tax rate would be around 25 percent in 2014.

So the taxpayer with the mortgage and the additional tax burden because of the additional 401(k) disbursement will probably disburse $39,000 more per year from their 401(k) plan.

This analysis puts a whole new wrinkle on the question how much money does one have to save in their 401(k) to have a secure retirement.   The answer is much more if you have not paid off your mortgage.

Note that the disbursement to cover the unpaid mortgage must occur whether the market falls or rises.

Many people who choose to add to their 401(k) plan rather than pay off their mortgage prior to retirement are going to have sell their home and downsize. Downsizing may make sense but most people don’t want to downsize until they are fairly old.

Some people who end up selling their home may choose to rent rather than buy a new home.   The main risk of choosing to rent throughout retirement is that home prices and rents may rise.   This exacerbates longevity risk.

Downsizing should be a choice not an outcome from a failed financial plan or worse the result of financial advisors putting their interests over your interests

Concluding thoughts on mortgage debt in retirement: An increasing number of households are retiring prior to their mortgage being entirely paid off. Surprisingly, the existence of a mortgage in retirement is often consistent with a financial plan developed by a financial planner.   Many financial analysts and planners advise their clients to increase savings in their 401(k) plan rather than retire their mortgage.

These financial planners are not being upfront with their clients.   Retirees with mortgage debt and all or most financial assets in a 401(k) plan are at the whim of the market and have a substantial tax obligation.   The advice that put people in this position is in my view a form of malpractice.

Appendix to Essay on Mortgage Debt and 401(k) Assets in Retirement

The issue of whether to pay off a mortgage or contribute to a 401(k) plan for an older worker is related to the issue of mortgage choice, especially for older homebuyers.   The following question addresses the interaction between mortgage choice and 401(k) investment strategy for an older worker.

Question:   A 50 year-old person is buying a house and must choose between a 15-year mortgage and a 30-year mortgage.   The mortgage choice will impact how much money the person can contribute to his or her 401(k) plan.

The person makes $80,000 per year. The initial mortgage balance is $400,000.   The person’s 401(k) balance at age 50 is $200,000. The 30-year FRM rate is 3.9 percent and the 15-year FRM rate is 3.1 percent.

Discuss the advantages and disadvantages of two strategies (1) taking the 30-year FRM and investing 15% of salary in the 401(k) plan and (2) taking the 15-year FRM and investing 5% of salary in the 401(k) plan.

Analysis:

Let’s start with a reiteration of mortgage choice issues a subject previously broached in essay four.

Observations and Thoughts on Mortgage Choice Issues:

  • The monthly payment on the 30-year FRM is nearly $900 less than the monthly payment on the 15-year FRM. The higher mortgage payment on the 15-year FRM will all else equal require the person who chooses the 15-year FRM to make a smaller 401(k) contribution than the person who chooses the 30-year FRM.
  • After 15 years the 15-year FRM is completely paid off.   The remaining loan balance on the 15-year FRM is around $257,000.
  • Note that gains from the quicker pay down on the 15-year mortgage are not dependent on market fluctuations.   The gain from debt reduction occurs regardless of whether the market is up or down and regardless of when bear or bull makers occur.
Analysis of 15-Year Versus 30-Year FRM
  30-Year 15-Year
Mortgage Interest Rate 0.039 0.031
Mortgage Term 360 180
Initial Loan Balance 400000 400000
Payment -$1,886 -$2,781
Loan Balance after 15 years $256,799 $0.00

 

Observations and Thoughts on Two 401(k) Contribution Strategies:

As noted in essay eight, the final 401(k) balance after 15 years depends on both the rate of return of the market and the sequence of the returns in the market.   Outcomes are presented for two market scenarios.   The first involves 7% returns for the entire 15-year period.   The second involves 7% returns for 10 years followed by -4% returns for 5 years.

  • The difference in the final 401(k) balances (high contribution minus low contribution) under the 15-year bull market scenario is around $211,000.
  • The difference in the final 401(k) balance (high contribution minus low contribution) under the 10-year bull and 5-year bear scenario is around $131,000
Analysis of Different 401(K) Contribution Strategies
5% Contribution Rate 15% Contribution Rate Difference
7.0% Return for 15 Years $675,442 $886,752 $211,309
7.0% Return for 10 years followed by -4.0% return for 5 years $394,339 $525,090 $130,751

The initial balance in the 401(k) plan for both scenarios is $200,000.

 

Additional insights on the tradeoff between 401(k) contributions and mortgage retirement:

 

  • The 30-year mortgage/high 401(k) contribution strategy results in major tax savings during working years compare to the 15-year mortgage/low 401(k) strategy.   All mortgage interest is tax deductible and the 401(k) contribution is not taxed.
  • The 15-year mortgage/low 401(k) contribution strategy results in major tax savings during retirement compared to the 30-year mortgage/high 401(k) strategy.   The previous example in this section demonstrated exposures for the person with mortgage debt in retirement when the person is dependent on 401(k) disbursements.   Remember all disbursements from a conventional 401(k) plan including disbursement used to pay the mortgage and disbursements used to pay taxes are fully taxed at ordinary income rates.   By contrast, the money gained from paying off the mortgage and most capital gains on owner-occupied real estate is not taxed.
  • Financial risks associated with a bull market persist through retirement as long as the saver allocates 401(k) assets into equity.

 

 

Review of Retirement Heist

Review of Retirement Heist:  How Companies Plunder and Profit from the Nest Eggs of American Workers

Ellen Schulz describes the different ways companies have reduced worker’s pension benefits in order to increase profits, manipulate earnings, cut costs, or fund pension benefits for top managers instead of workers.

http://www.amazon.com/Retirement-Heist-Companies-Plunder-American/dp/B00AK3WCZ8

Some highlights:

Chapter two describes how companies cut or froze benefits in the traditional defined benefit plan without antagonizing workers or creating bad publicity for the firm.   The replacement of a generous defined benefit plan with a new less generous plan is generally introduced in a way where changes are not transparent to workers.   Phillip Strella a lawyer with Mercer consulting advised the industry to “Pick your words carefully.  The law doesn’t require you say, “We’re significantly lowering your benefit,” “

Chapter three discusses how pension reductions allow companies to report greater earnings to shareholders. Management has a strong incentive to report good and stable earnings because their compensation is often tied to the stock price of the firm.  Pensions are often cut to increase earnings when the company suffers losses from its core business activities.  One of the main problems is that actuaries have great latitude in the assumptions used to price health and retirement benefits hence; official accounting standards allow management to reduce or increase the value of pension and health benefits in order to report whatever income figure it needs to report.

The drop in pension and health benefits and the increase in health premiums have significant impacts on workers, retirees and their families.  The most difficult situations revolve around the loss of health benefits because Medicare does not begin coverage until age 65.  According to a Department of Labor Review cited by Schulz by the late 1990s around two-thirds of retired workers with employer sponsored health coverage were dropping coverage when costs of the health plan rose.  The departure of individuals from employer sponsored health plans resulted in adverse selection or a “death spiral” because sicker workers and families tended to maintain coverage while healthier workers tended to exit.  One of the more important aspects of the still not fully implemented and tested Affordable Care Act was to fix this problem by mandating that all people be covered and by establishing age-rated premiums that will be unaffected by health status.

Schulz’s book includes a lot of personal stories.  Some of the anecdotes involved overpayments to workers that companies tried to reclaim.  Often companies that acquire other firms and their pension obligations look for past overpayments to retirees in order to claw the overpayments back.  This can create large problems for households who created a budget based on their anticipated and previously receive pension.

Chapter 11 discusses denial of benefits with a focus on disability claims in two industries -– energy and football.  The discussion of how the NFL aggressively denies claims to injured players was especially revealing.  It demonstrates that even in a small high-profile industry with a strong union the system is rigged against workers.

The pension system based on company-run defined benefit plans is experiencing a slow death.  The 401(k) has become the dominant pension vehicle for current workers.  There are a lot of problems with 401(k) plans including inadequate contributions by workers and a high degree of investment risk.  Schulz’s disturbing book vividly reminds us that there are also problems with traditional defined-benefit pension.

Understanding the four percent rule

Question:   Is the 4.0% rule an appropriate guideline for determining the amount of savings a retiree should spend each year?

Background on the 4.0% rule:  Under the four percent rule (as I understand it ) the retiree’s expenditure in her first year of retirement is four percent of wealth in certain accounts.  It is more difficult to apply the 4.0% rule to total household wealth because house equity, a major component of wealth is not liquid.  (The application of the 4.0% rule to total wealth including house equity would at some point require the sale of the home.)

Whether strict adherence to the 4.0% rule leads to a smooth, stable, and sustainable consumption pattern for the household depends on asset returns, inflation, and the timing of inflation and asset returns.  A sharp decrease in returns at  the beginning of retirement could lead to a relatively quick depletion of assets.  A sharp increase in returns at the beginning of retirement could allow retirees to spend more than allowed or provide a bequest to heirs.

The 4.0% rule may result in retirees too quickly depleting their resources in the current financial environment where the risk free return is lower than inflation.

http://financememos.com/2013/02/15/chasing-yield-by-investing-in-long-term-bonds/

Illustrating the 4.0% rule:  We consider four scenarios — (1) 2.00% returns and 3.0% inflation all years, (2) 4.0% returns and 3.0% inflation rate for all years, (3) a -20% return the first year followed by 2.0% returns and 3.0% inflation, and (4) -20% return the first year followed by 4.0% return and 3.0% inflation.

We calculate the number of years it would take for the retiree to deplete all assets under the four scenarios.  Results presented in Table Four indicate that years until depletion range from 19 years for scenario three to 30 years for scenario two.

Adequacy of resource for 4% rule under four scenarios
Shock Return Inflation Rate Year Balance goes to $0
None 2.00% 3.00% 23
None 4.00% 3.00% 30
-20% first year 2.00% 3.00% 19
-20% first year 4.00% 3.00% 23

I suspect that these calculations understate the financial risk associated with adherence to the 4.0% rule.   Some analysts suggest that investors who use the 4.0% rule should maintain a larger portion of their portfolio in equites.  I disagree.  The worse case scenario for the 4.0% rule involving poor stock returns in a period of inflation actually occurred during the 1970s.

Initial Balance $100,000
Disb. Rate 4.00%
Rate of return Inflation rate Real Value of initial balance Beginning of year balance Disbursement End of year balance
1 2.00% 3.00% $100,000 $100,000 $4,000 $98,000
2 2.00% 3.00% $103,000 $98,000 $4,120 $95,840
3 2.00% 3.00% $106,090 $95,840 $4,244 $93,513
4 2.00% 3.00% $109,273 $93,513 $4,371 $91,013
5 2.00% 3.00% $112,551 $91,013 $4,502 $88,331
6 2.00% 3.00% $115,927 $88,331 $4,637 $85,460
7 2.00% 3.00% $119,405 $85,460 $4,776 $82,393
8 2.00% 3.00% $122,987 $82,393 $4,919 $79,122
9 2.00% 3.00% $126,677 $79,122 $5,067 $75,637
10 2.00% 3.00% $130,477 $75,637 $5,219 $71,931
11 2.00% 3.00% $134,392 $71,931 $5,376 $67,994
12 2.00% 3.00% $138,423 $67,994 $5,537 $63,817
13 2.00% 3.00% $142,576 $63,817 $5,703 $59,390
14 2.00% 3.00% $146,853 $59,390 $5,874 $54,703
15 2.00% 3.00% $151,259 $54,703 $6,050 $49,747
16 2.00% 3.00% $155,797 $49,747 $6,232 $44,510
17 2.00% 3.00% $160,471 $44,510 $6,419 $38,982
18 2.00% 3.00% $165,285 $38,982 $6,611 $33,150
19 2.00% 3.00% $170,243 $33,150 $6,810 $27,003
20 2.00% 3.00% $175,351 $27,003 $7,014 $20,529
21 2.00% 3.00% $180,611 $20,529 $7,224 $13,715
22 2.00% 3.00% $186,029 $13,715 $7,441 $6,548
23 2.00% 3.00% $191,610 $6,548 $7,664 -$985
24 2.00% 3.00% $197,359 -$985 $7,894 -$8,899
25 2.00% 3.00% $203,279 -$8,899 $8,131 -$17,208
26 2.00% 3.00% $209,378 -$17,208 $8,375 -$25,927
27 2.00% 3.00% $215,659 -$25,927 $8,626 -$35,072
28 2.00% 3.00% $222,129 -$35,072 $8,885 -$44,659
29 2.00% 3.00% $228,793 -$44,659 $9,152 -$54,704
30 2.00% 3.00% $235,657 -$54,704 $9,426 -$65,224

 

Downsizing and the Social Security Claim Decision

I am making up and answering my own financial questions.  Please send your actual questions to me.

Question:  I am turning 62 in 2013 and it is definitely my time to retire.   I am single and would like to do something other than work.  I have modest means.  My main assets are my house, my 401(k) plan and a small amount of liquid assets.  The current value of my home is $450,000.   My 401(k) balance is $250,000.  I have a mutual fund with $30,000.  I have no loans on my car, which is eight years old and has 100,000 miles.

I will be entitled to a Social Security benefit of $1,000 as soon as I reach age 62.  I need to leave my job and have some fun but I am worried that I will outlive my savings.  What is your advice?

Caveat:   Your situation may be similar to my fictional questioner but there are always more details to be considered.   Please consider but do not over rely on this advice.

Analysis:  Many people are in this situation.  Their total assets are relatively modest and most of their assets are tied up in their home.  Some liquid assets are needed for emergencies.  A new car purchase may not be far off

Since you were born in 1951, your full retirement age is 66 years.  The decision to claim Social Security early will result in a reduction in your Social Security benefits of around 25% relative to the benefit that could be obtained by delaying a claim until age 66.

http://www.ssa.gov/oact/quickcalc/earlyretire.html

Your financial security would be greatly enhanced if you could delay claiming Social Security benefits.  In order to delay claiming Social Security you need to either take disbursements from your 401(k) plan or somehow tap your housing equity.

 

Your 401(k) plan is modest and taking immediate disbursements is not a wise financial strategy.  First, the 401(k) balance might grow more if disbursements are delayed.  Growth in 401(K) assets is of course determined by market outcomes.  Second, a delay in 401(k) disbursements will allow you to either receive 401(k) benefits later in life or take a larger disbursement each year.

While your marginal tax rate is low it is important to remember that 401(K) disbursements are taxed as ordinary income.

Let’s consider the possibility of tapping home equity to fund your retirement.  In particular, let’s consider five options – (1) selling your home and renting, (2) selling your home and buying a smaller home, (3) renting your home to a tenant and renting a smaller place for yourself, (4) finding a roommate, and (5) taking out a reverse mortgage.

Selling your home and renting:    The viability of this option depends on the rent you must pay in your new place.  Moreover, you become susceptible to rent increases, which could be significant over time.   Work by Jonathan Skinner cited in a previous post indicates that renters must save more to have an adequate retirement income than do homeowners.

http://econweb.rutgers.edu/killings/Econ_364/7_Skinner_lecturenotes.pdf

http://www.nber.org/papers/w12981

The capital gain up to $250,000 on owner-occupied homes is not taxed.

Selling your home and buying a replacement home:  The viability of this option depends on the cost of the replacement home.  The replacement home could be in a place with a lower cost of living.  There are lots of articles on the web listing affordable retirement locations.

http://www.aarp.org/home-garden/livable-communities/info-07-2011/affordable-cities.2.html

http://money.cnn.com/galleries/2011/real_estate/1109/gallery.retirement_home_deals/index.html

One risk of relocating is that you may be unhappy in your new location, especially if you move away from family and friends.  You may want to keep your home and rent until you are sure you are happy at your new location.  However, you may have to pay capital gain tax on your old home if you delay its sale and it becomes an investor-owned property.

Renting your home to a tenant and renting your own place to live:   The viability of this option depends on the amount of rental income you will get. This option would allow you to move to a new location and determine if you like it.  There is a risk that your home will be vacant some months.   There is also a risk that your tenant will trash your home.  (I heard of one family who rented their home and had their home destroyed by their tenant’s six dogs.  The insurance company refused to pay.)  You will need to hire a reliable property manager.  You will be subject to unexpected expenses.  Rental income is of course taxed but your marginal tax rate is low.

Under this option, you may have to pay capital gains taxes on the gain on your home.

A roommate:  The viability of this option depends on the amount of rental income obtained from the roommate.  You need a compatible or at least non- disruptive tenant.

Reverse mortgages:  Many financial advisors advocate that individuals in your situation stay in their home and take out a reverse mortgage.  Reverse mortgages entail risk.  A recent New York Times article documents problems with reverse mortgages uncovered by federal and state regulators.

http://www.nytimes.com/2012/10/15/business/reverse-mortgages-costing-some-seniors-their-homes.html?_r=1&

Increasingly, the reverse mortgage market is dominated by smaller mortgage brokers and firms that were formerly subprime lenders.  Fees tend to be high and are often unrevealed.  There have been several cases where a spouse that was not on the reverse mortgage loans was required to repay the entire loan in order to remain in her home.  The rate of default on reverse mortgages is at a record high, 9.4%.  Moreover, an increasing number of people obtaining a reverse mortgage are doing so at a younger age; thereby, adding to their financial risk.

Concluding thoughts:  In my view, you need to delay claiming your Social Security benefit and delay disbursing funds from your 401(k) plans.   This could be accomplished by tapping your home equity.  There are a variety of ways to tap your home equity.

Avoid taking out a reverse mortgage.

Also, your retirement could be made much more secure if you found a part-time job.