Wednesday, February 1, 2012

Saving Up for College Tuition and Hedging, Part 2

To answer the question of college tuition hedging, we need to determine the amount of tuition increases and the variability in that change. Generally, higher education revenues come from federal and state aid, alumni giving, endowment returns, and tuition. For research universities, a big chunk comes from research grants. Thus, changes in funding levels for each of these components must be compensated by the others. How have these factors evolved in the past few decades? Can we explain tuition inflation in terms of these other factors?

This is second in my on-going series of posts on college tuition and investment. See the first post.

Let's begin by characterizing college tuition itself as a benchmark. For the period 2001-2011, the CPI-based measure for tuition returned 6.7% annualized with a standard deviation of 1.7%. For the same period, the College Board's Independent College 500 Index (IC 500) [Trademark of the College Board], which measures tuition, fees, plus room & board, returned an annualized 6.04% with a standard deviation of 0.7%. In contrast, the S&P barely returned anything this past decade and had a double digit standard deviation. The standard deviation in bond returns also exceed that of tuition growth by a considerable amount (see the figure below for an annual t-bill, t-note, and college costs comparison). If an asset mix can match these returns even in the midst of the lost decade for the stock market, it would be quite an interesting low volatility investment indeed.

Saving for college is really big business ($157B in 529 savings in Dec. 2010 []). Consider's data on the amount of money in 529 savings plans. Some state governments and private colleges offer prepaid tuition plans which are "guaranteed" to increase at the rate of tuition at the respective schools (the caveat is that you may have to pay a considerable premium to current tuition rates depending on the state). There is even something called a CollegeSure CD which is FDIC-insured yet claims to be linked to the IC 500 and one of those equity-linked CDs they call InvestorSure. Maturities apparently range from 1-year to 22-years. Now an institution is running each and every one of these programs and I doubt they are doing it out of the goodness of their heart. So the question is, how are they hedging college tuition increases? An alternative possibility is that they don't have any magic wand of investment and are in reality exposing themselves to a lot of risk (mainly market and investment risk), a kind of pension-funding crisis in the making.

The IC 500 indexes tuition, fees, and room/board for 1st year students at the 500 highest priced colleges and universities. The index is calculated annual by mid-summer. There are a number of caveats here. Costs obviously vary from region to region. There are plenty of costs outside of the realm of tuition, fees, and room/board. The amount of financial aid available impacts the true bottom line, which is not considered in this index. The index's components may also be replaced from time to time, just as they would in a market index. Interestingly, the way the index is calculated is closer to the price-weighted Dow rather than market-weighted S&P.

Given that the index itself is a mere approximation, the CollegeSure variable-rate CD has specific characteristics one must be aware of. There is a maximum interest rate cap set a 4.81% for the 5+ years variety. Given that the latest IC 500 return was 4.36%, we are really not that far from the limit. The minimum rate is 3.00%, which isn't all that bad considering where the 10-year note and 30-year bond are right now. Unfortunately, the actual interest rate paid is the IC 500 change minus a margin rate determined at time of purchase (currently at 2.55% for 5+ years). 0% returns are certainly possible. Even at 2.26%, these CDs do exhibit a considerable spread versus your regular, run-of-the-mill CD at this time. Interest rate risk poses a considerable challenge if nominal rates do eventually rise without a similar rise in the IC 500. Still, the return will fall far short if cost of education rises by 8-13% annually, as it had before.

Government spending alone is difficult to hedge against. The simple way out would be gold and inflation-protected bonds (TIPS), but these only benefit when inflation visible in the CPI shows up. Moreover, they are only effective in periods of massive inflation.

Since tuition growth outpaces CPI growth, one might naively consider levering up TIPS, which is supposed to follow the CPI. Unfortunately, leverage is too blunt of an instrument here. The relationship between tuition and CPI growth varies enough that leverage may work against the saver.

Please stay tuned for next week as I further unravel the mystery that is college tuition.

No comments:

Post a Comment

Note: Only a member of this blog may post a comment.