The American dream is slipping away from the younger generations. Rising student debt and falling rates of homeownership and marriage indicate that the economic prospects for millennials (and Gen Z) are down. A 2018 Federal Reserve study found that millennials actually earn about 20 percent less than their parents did (when adjusted for inflation and debt service). This drop in income comes despite the fact that Americans are increasingly pursuing college, which used to be a strong indicator of future affluence. In fact, the percentage of Americans who earn more than their parents has fallen significantly since the end of World War II.
Source: Equality of Opportunity Project
Most students at elite colleges earn less than their parents over their careers
College is a path to the American middle class, but where affluent families go wrong is in assuming that it's the ticket to earning in the top 1 percent of income for their children. Colleges like to tout the difference in earnings between high school graduates and college graduates, but they don't typically quote the numbers after debt service or account for third variables like social class or intelligence (which correlate with future income). In fact, there is a great deal of mean reversion in income over generations that can outweigh the opportunities that education provides.
Economists measure this mean reversion by a metric called intergenerational income elasticity (IGE). IGE measures the persistence of household income from parents to their children. There's actually a huge body of sociological research on this topic, much of it from long-running Scandinavian studies over the last 50 years. For a good overview of the research, start here.
Typically, for the United States, the IGE is around 0.5, meaning that half of the difference in income compared to the mean tends to persist from father to son (IGE holds for fathers and daughters as well, but most of the body of long-running research focuses on fathers and sons). For example, the typical father in the 95th percentile of personal income (about $175,000 per year) will have a son in the future 78th percentile of personal income, which corresponds to about $75,000 per year. Note that these figures are for individual earnings, not household income. Mean reversion goes the other way for poorer families, as the children of working-class parents are more likely to improve their relative position in society compared to those children who are already affluent. One of the greatest ironies of college is that the people who would benefit most from it (at least if they attend an affordable school) are the least likely to attend.
You can verify that these figures aren't far off from reality by looking at the average earnings of college alumni at age ~35. For example, here are links to the average earnings of SMU, Harvard, and University of Texas grads. You can see that indeed, the children of affluent families consistently earn less than their parents on average. Why are the children of affluent families consistently doing worse than their parents? I argue that it's because of poor allocation of capital by affluent families.
One interesting thing you find when you dig into the aforementioned intergenerational income studies is that the numbers change once you get up above the 99th percentile of income earners. The researchers from Swedish study I found noted that while there was a great deal of mean reversion in the income of sons of affluent families, there was little to no mean reversion in the income of the sons of the top 0.1 percent of families by household income (currently corresponding to roughly $1.5 million to $2 million per year in the US). This is because while income from salary is mean reverting over generations, income from investments tends to compound over time.
Feel free to explore some related data in the link below (you can even look up your own college!).
Source: The Upshot/The New York Times
Opportunity cost hurts the ROI of college
As we know in advance what debt service for student loans will cost, it's not hard to see that the gap between the earnings of college graduates and the earnings of high school graduates narrows or reverses once you account for the time value of money. Students loans must be paid back with interest and even parents who pay cash for college are foregoing the average time value of money on their investments, which amounts to a CAGR of roughly 9 percent per year if invested in the S&P 500.
A hypothetical student leaving college with $100,000 in student loans can expect to pay about $150,000 in principal and interest over the course of their career. If they pay the loan off over 15 years, their disposable income will be lower by about $10,000 per year until age 36-37. The calculations are harsher for those borrowing for medical or law school - a widely circulated article even once claimed that the average hourly earnings of doctors are the same as teachers when you account for time spent in school.
It's difficult to determine the value of college compared to the cost due to the impossibility of separating earnings factors that are related to college and not to hidden third variables like social class and intelligence. However, it is relatively easy to forecast the investment returns you could get over 20+ year timeframes in the financial markets. The takeaway is that inexpensive schools easily win if you care about your financial ROI on college (you might not care if you're already rich, but you likely care a lot if you're considering borrowing). The difference can then be invested. This is a much more effective strategy for preventing erosion in your family's standard of living over the next generation.
When you combine the low expected ROI on college compared to stocks with the fact that most students don't graduate college in four years, expensive colleges can quickly become a punishing financial burden for families not already well into the top one percent of the income distribution.
Why investing is likely a better strategy than paying up for college
Affluent families who spend too much of their capital on college tuition run into a basic economics problem. If you lack capital but make your income from labor, the owners of the capital you need tend to extract a greater share of your income over time. Imagine you're a dentist who leases a building for your practice. You install a bunch of equipment in your office, and then the next time your lease is up for renewal, you're shocked that your rent is going up 15 percent! This didn't start happening yesterday. Landlords and bankers have been extracting profits from businesses like this since the days of the Romans.
To give an example from game theory, Native Americans in the 1800s went into the business of trading goods like animal hides for guns and ammunition to earn a living, which seemed like a great deal at first. However, after a few years, the problem they faced is that the white settlers controlled the price of ammunition and could raise prices at will, so the natives saw an ever decreasing return to their labor. The natives effectively became employees of the settlers due to their lack of capital. Today, Americans who attend college but don't own real estate and stocks effectively find themselves in the same position as the native hunter did long ago. The price of their labor has barely budged in real terms, but the rise in the cost of housing, healthcare, and college means that they're effectively employees of their landlords, health insurance companies, and student loan providers.
The "conflict theory" of colleges is as follows. Colleges hang the price of tuition at a rate that most students can't pay, so the students borrow the money en masse, directly or indirectly from the US Treasury, depending on their loan provider. When this isn't enough, the students supplement the bill with the meager income from their jobs. Colleges then buy huge amounts of stocks and real estate with the money, using the dividend/interest/capital gain income to pay professors and administrative expenses. Students buy themselves a lifetime of work and the colleges accumulate capital, further increasing their power. Colleges then can use their profit to lobby Congress for favorable legislation to maximize their future profit. If the conflict view is correct, colleges effectively are able to transfer wealth from taxpayers into private hands. This is a cynical view of college-I'm not quite this negative on school, but the theory is more right than it's wrong. To some extent, students should do what colleges themselves do rather than what they preach their students to do.
Despite this, I think everyone should go to college who would like to attend, but that it's essential to choose a school that is appropriate for your ability to pay and aligns with your values. Most of your (or your kids') classmates will be living paycheck to paycheck at age 35 regardless of what college you choose. If more families used a data-driven approach to choosing a school, there would be less debt, less stress, and students would be happier overall.
1. For both students and parents, I advise against borrowing money to attend school. This applies to graduate school/law school as well, where debt burdens are significantly higher for graduates. I would be very hesitant to borrow money for medical school also, given increasing societal pressures to rein in healthcare costs and the potential for outsourcing and AI to threaten job safety.
2. For students, your future salary income is likely to revert to the mean compared to your parents. In my opinion, your best bet for maintaining your standard of living is to find a way to start a successful business before age 30. Inferring from the statistical distribution, it's likely that over 95 percent of kids whose parents earn $200,000-$400,000 per year will earn less in salary than their parents.
3. The key to build lasting wealth is to systematically take calculated risks with a positive expectation and manage those risks well. This is true both in business and in the financial markets.
4. For parents, you should prioritize your retirement over your kids' college (or at least choose less expensive schools for your kids), because the residual family wealth is higher for money that is invested in the financial markets than it is for money that is invested in tuition at any reasonable discount rate.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.