Betting on Bob

The next thing in student loans: Investors pay your bills. You give them a share of your future.

(Mario Tama/Getty Images, Globe Staff photo illustration)
By Rebecca Tuhus-Dubrow
November 30, 2008
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IN 1997, DAVID BOWIE applied his well-known penchant for experimentation to finance: He offered to sell shares of his albums' future revenues. If you had faith in the enduring popularity of "Ziggy Stardust" and "Space Oddity," you could purchase Bowie Bonds and receive a percentage of the royalties for 10 years. In return, the aging rock star got an immediate infusion of cash.

When Miguel Palacios, a young Colombian financial analyst, heard the news of this arrangement, he had an epiphany. As a college student, he'd witnessed classmates reluctantly drop out of school because they couldn't afford to continue. Had they been able to offer their own version of Bowie Bonds, perhaps they could have earned their degrees.

"If he could do it," Palacios thought, "why couldn't all those bright, talented students do it as well?"

Other thinkers have begun to ask the same basic question. The result is an innovative way to think about paying for higher education. The idea, sometimes called human capital contracts, is that investors agree to cover the costs of college or graduate school in return for a percentage of the students' future earnings over a fixed period of time. Since payments are scaled to wages, the odds of default - and of financial hardship for the graduate - are greatly reduced. This scheme transfers much of the risk from students to investors. But if the students earn handsomely, the investors stand to gain more than they would under a traditional loan.

Over the last few years, several companies have begun brokering these agreements in Europe and Latin America. One of these, Lumni, which Palacios cofounded, is laying the groundwork for operations in the United States, and its first few clients here plan to sign contracts by the year's end.

The contracts could offer a new way for students and their families to handle the burden of postsecondary education bills. In recent years, rising tuition costs, combined with limits on federal loans, have increasingly forced students to resort to private loans, which have markedly higher interest rates. The challenges of paying for college promise to intensify during the economic downturn. Disruptions in the credit market have caused turmoil for student borrowers, while diminished endowments may force many colleges to jack up tuition rates even higher. Constraints on the federal budget will limit the options of President-elect Obama and the next Congress, regardless of their plans to aid students.

The system is straining, and both students and schools are looking for creative solutions. These contracts, proponents say, would allow more kids to finish college. They would free graduates from crushing debt. And they could liberate youngsters to pursue socially valuable but low-paying work such as teaching.

"We are putting all of the risk burden on students," says Kevin Carey, research and policy manager at Education Sector, a think tank, and coauthor of a recent article promoting this concept in The American, a magazine published by the American Enterprise Institute. "Our idea was to change that and allow students to pledge the most valuable thing they have - their intellectual capital."

The movement for human capital contracts is still small, with only a handful of companies offering them worldwide. And several aspects of this invention could hinder its success in the United States. To function on a large scale, it requires a broad pool of students to spread the risk - tomorrow's doctors and lawyers, not just future artists and nonprofit staffers. The former group, however, has less incentive to participate. The legal details also remain murky, as some advocates admit, prompting worries that graduates could wriggle out of their obligations, among other concerns.

What's more, the core idea strikes some critics as akin to indentured servitude. While they acknowledge that the analogy is in some ways inapt - graduates are free to pursue the careers of their choice, and debt, after all, imposes similar burdens - the notion that investors have a stake in a graduate's income can evoke uncomfortable associations for some.

"The whole thing makes me very nervous," wrote Sandy Baum, a professor of economics at Skidmore College and a policy analyst for the College Board, in an e-mail. "I don't like the idea of someone owning a piece of someone else."

. . .

The concept of human capital contracts was originally the brainchild of economist Milton Friedman. In 1955, he wrote a paper, later reprinted in Capitalism and Freedom, proposing that equity-like instruments, rather than debt, should finance higher education.

For Friedman, equity financing was a way to keep government out of the business of paying for higher education, and even today some supporters see it as an idea that could ultimately lift the taxpayer burden of subsidizing grants and loans. Realistically, however, the current proposals would supplement, rather than replace, federal aid.

The chief benefit, as proponents see it, is that human capital contracts remove the risk of overwhelming debt for students, and mitigate the social costs of trying to repay it. Today, especially as more students take out private loans with high interest rates, many graduates struggle to make their monthly payments. Some of these graduates default, causing long-term credit problems for themselves, and costing lenders money. Others shape their career choices around the need to pay back their loans - for instance, law school students who aspire to do public interest work, but feel pressured by debt into taking corporate law jobs.

By gearing repayment to income, human capital contracts reduce those burdens sharply - a student who earns less money is obligated to pay less back. Of course, there is still a risk of default, and the system all but guarantees that investors would lose money on lower-income graduates - the ones who do take nonprofit jobs, or who fail to land lucrative positions. But investors would temper the risk by diversifying, funding a group of students with a range of future prospects.

"The best analogy is insurance," says Palacios. A car wreck, for example, would ruin an uninsured driver. "But not everybody crashes. If you pool everybody together, you are in a much better position."

In fits and starts, the theory of human capital contracts has begun to be realized in practice. In the spring of 2001, a company called My Rich Uncle launched, offering such contracts to more than 100 students. But the business was located on the 78th floor of the World Trade Center, so the attacks of Sept. 11 dealt it a severe blow. And in the recession that followed, says Raza Khan, one of the cofounders, investors were wary of gambling on unfamiliar ideas. The company has shifted to a more conventional private lending model, although Khan says they hope to resume the income-based contracts someday.

Also in 2001, Palacios and his partner, Felipe Vergara, founded Lumni, which has financed a total of about 150 students in Chile, Colombia, and Mexico. Students pay no more than 15 percent of their income, and in some cases as little as 1 percent, for up to seven years. The company's US branch, based in San Francisco, is working with investors, foundations, and institutions to start offering contracts here. Next semester, Lumni's first clients in the United States - several MBA candidates - will begin to receive funding.

A far larger company following this model is Career Concept, based in Germany. Started in 2002 by three business school graduates, the company now finances about 2,000 students at 180 universities in more than 20 countries, mostly in the EU. Typically, students are obliged to repay between 3 percent and 10 percent of their income over a period of between four and six years.

"We've proven that the model is working," says Rolf Zipf, one of the board members. Last year, a new company, Deutsche Bildung, started up in Germany to offer similar contracts.

The US government has recently enacted policies to tackle some of the problems caused by student loan debt. Legislation passed last year introduces a cap on debt repayment for federal loans - students who opt for income-based repayment will not be required to pay more than 15 percent of their discretionary income - and forgives federal loans for graduates who spend 10 years in public service. These measures, which take effect next year, will surely help graduates, but they do not offer a comprehensive solution. There are still limits on federal loans, which means many students still need to turn to the private lending market.

The potentially lower payments explain why human capital contracts would draw students, but there are attractions for investors as well.

Human capital companies would essentially be creating a new type of asset, based on the wages of college graduates, offering investors another way to diversify their portfolios. An "educational fund offers you as an investor a very steady flow," said Zipf. "There is a protection against inflation. If inflation goes up, the income will go up."

The contracts could also provide a more targeted hedge for large employers. For example, a hospital could invest in medical students, thereby protecting itself against a rise in salaries for doctors; if salaries grew, the rising cost to the hospital would be partly offset by the higher returns on the investment. In the same vein, Google might invest in computer science students, and Boeing in engineering majors.

Other investors could be motivated by philanthropic goals. Wealthy alumni might see this as a way to help students attend their high-priced alma maters. Certain foundations, which are working with Lumni in Latin America, see these contracts as a more sustainable alternative to scholarships.

Instead of doling out money with no strings attached, as in a conventional scholarship, foundations could require students to sign contracts. These would state that nothing is owed up to a certain point, but high-earning graduates would repay a percentage of their income, allowing the foundation to recycle that money into later classes. Schools themselves could also incorporate this strategy into their financial aid packages.

For all the potential benefits of human capital contracts, however, they pose multiple challenges in practice. They create an incentive for graduates to hide their income; they also make it easier for graduates to loaf on their couches instead of working, since no fixed payment is required. Lumni, Career Concept, and My Rich Uncle all say that they have addressed this risk with intensive evaluations - Lumni even employs psychologists - and rigorously designed contracts.

The other danger is what economists call "adverse selection." Why, after all, would students who anticipate fabulous success sign up to subsidize their less go-getting peers? A student who intends to be a high-flying investment analyst might calculate that the payments on a traditional private loan are likely to take a smaller bite out of her salary than those for a human capital contract would.

Companies have dealt with this problem by offering more favorable terms to likely high earners. A Harvard student majoring in economics, for example, would repay a lower percentage of future income than would an art major at a community college. Ultimately, the graduates who prosper still must subsidize the graduates who flounder, or who choose unprofitable careers. But proponents point out that all insurance works this way. Life insurance, for example, requires contributions from the healthy and the lucky in order to operate. "You don't say, I just wasted my premium because I just subsidized someone who died," says Ian Ayres, an economist and Yale law professor who supports the idea of human capital contracts.

Another worry is that the companies would discriminate against students from low-income backgrounds, either by offering them unfavorable terms or no contract at all, since they are less likely to enroll at prestigious institutions and excel academically. Proponents acknowledge that the contracts are not a panacea for higher-education financing, and that government financial aid would still play an important role. But if contracts help some students, they say, government funds can be diverted to others. Altruistic investors may also target low-income students.

There are legal questions, too. It's not clear how the contracts would be enforced, how the IRS would treat them, and what would happen in the case of bankruptcy. My Rich Uncle declined to discuss the details of their contracts, but said that, having meticulously consulted lawyers, they did not encounter legal obstacles. If more companies begin to offer the contracts, these issues will no doubt be tested in court.

In addition to the benefits for students and investors, proponents believe that if human capital contracts became widespread, they could actually influence higher education itself, by pushing schools to better prepare students for professional success. As investors became more sophisticated, they would offer better terms to students at schools that offer good value - measured in terms of the boost to earning power per dollar of tuition invested. Today, information about the economic worth of an education - about the jobs, promotions, and salaries of graduates - is surprisingly inaccessible for applicants. But companies would have the incentive, and the resources, to find those data, which would be reflected in the contracts they offered for different institutions. In theory, this could eventually pressure schools that are low-performing, at least in this economic sense, to tackle their failings or lower their tuition.

"If college is doing a really bad job at all these things, students would start to see that," says Carey, author of the recent article in The American. "That will force colleges to pay more attention."

Rebecca Tuhus-Dubrow is a contributing writer for Ideas. She can be reached at

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