Tuition Inflation: Indexing the Rising Cost of College

Costs associated with college tuition and fees have far outpaced general U.S. inflation, so for individuals saving for college, the ability to accurately measure and potentially keep pace with tuition inflation is important. 
Recently, in this video, S&P Dow Jones Indices joined with Enduring Investments to discuss the newly launched S&P Target Tuition Inflation Index.  Below is a summary of the questions and answers discussed in the interview that may be interesting for college savers:
What are the economic underpinnings and thinking behind the strategy?
In designing a strategy and index to track college tuition inflation over time, it is important to understand how college tuition is set.  Colleges are producing a product just like any other business, but the product is education.  Just as in any business they have expenses and revenues so understanding what are driving those expenses and revenues is an important part of understanding how the how to build such an index.  On the expense side colleges have mostly labor costs, but they have a number of other things that are that go into creating the educational product, and collectively those things act like general inflation.  Though, on the revenue side, colleges have really two sorts of revenues – internal revenues and external revenues.  The internal revenues are government appropriations if it’s a public university, or the endowment returns if it’s a private university.  The external revenues come from college tuition.  So understanding how college tuition varies depending on how the appropriations or the endowment returns behave is where the rubber meets the road in terms of getting this index to target college tuition inflation.
How does the index design help capture the thesis behind the strategy?

Again, the key is in understanding the relationship on the revenue side between the  endowment returns and appropriations versus the tuition inflation growth.  Recognizing that there’s this large spread of tuition inflation that’s above the general inflation as measured by the CPI is the starting point.  Using the CPI as the base and measuring the driver of that spread can be done by knowing something about the relationship of the revenue components.  What the research behind the index shows is that tuition inflation is a function of the real return plus a break-even inflation, plus a corporate spread, minus an equity risk premium.  This combination has grown in-line with the tuition inflation that is inverse to the endowment or appropriation growth, so that’s the mix that make the mechanics work.

Source: S&P Dow Jones Indices. S&P Target Tuition Inflation Index Methodology. http://us.spindices.com/documents/methodologies/methodology-sp-target-tuition-inflation-index.pdf?force_download=true

How does the index data track tuition inflation compared to a more traditional 60/40 mix?

The 60/40 mix is really designed for optimal diversification in most risk-adjusted return portfolios, but the idea of a college liability is not taken into account in a 60/40 mix.  Since there is a relatively short time frame for college savings, the 60/40 mix may be very volatile, so at moments there is a high chance that tuition inflation is not met.  By moving to the S&P Target Tuition Inflation Index, the probability of tracking tuition inflation increases, and even more so the longer the holding period.

Hypothetically, the S&P Target Tuition Inflation Index is within 2% of the BLS College Tuition and Fees U.S. City Average Inflation more often than the 60-40 mix of stocks and bonds.

In which economic environments might the strategy track tuition inflation most closely?
The index design intends to track college tuition in many different economic environments.  Since any economic environment may be predominant when a child goes to college, it is important to understand that means that the index itself varies with the drivers of fundamental drivers of college tuition inflation.  When overall inflation is accelerating, and the stock market is falling, it is likely endowments aren’t doing very well, so the costs of the university are going up a little faster.  That is when the index is expected to also rise faster.  Conversely, if the stock market has been doing very well for a while, so that endowments are flush, and yet overall inflation is low, then college tuition may not be going up as much.  Therefore, the index may not go up as much either.  Again, the idea for success is for the index to perform over the long run in a comparable way to the college tuition inflation.

The posts on this blog are opinions, not advice. Please read our disclaimers.

2 thoughts on “Tuition Inflation: Indexing the Rising Cost of College

    1. Jodie GunzbergJodie Gunzberg Post author

      The index uses a combination of TIPS, corporate bonds, equities and cash to target the tuition inflation measured by the BLS.

      Reply

Leave a Comment

Your email address will not be published. Required fields are marked *

You may use these HTML tags and attributes: <a href="" title=""> <abbr title=""> <acronym title=""> <b> <blockquote cite=""> <cite> <code> <del datetime=""> <em> <i> <q cite=""> <s> <strike> <strong>