Does More Education Make Sense?
Benefits v. Costs.
It was a typical early morning for Preston Taylor, off to his first job. He spent his signing bonus on a Clive coffee maker and 10 lbs. of Kopi Luwak; just hoping his monthly direct deposit is enough to cover the rest of his non-discretionary expenses. Who cares about the rent, gas, and inflation when the race has begun? A caffeine buzz may not make room for clear thinking. Or maybe just the contrary. Luxury tastes, luxury preferences, a terrific brain, and a curiosity to learn may take Preston’s fueled anxiety toward more education. After all, he knows how to interpret the data. Education and income are positively related.
In my undergrad life-cycle economics class, we examine the education decision because it is one of a handful of fundamental financial planning questions for the under-40 set. It is an ivory tower-ish subject because it will be a few years before class members will confront the question in their lives. Still, social observations and chats with friends build the expectation that more opportunities, higher levels of financial freedom, and more financial flexibility are linked to more education.
The Decision to Pursue More Education
From a prior post, the economic value of more education was foreshadowed by Kate and Jamie, who achieved different levels of post-secondary education. Kate’s higher living standard was attributable to a better-paying job made possible by a university education. As I noted, collected data are clear about the advantages of higher levels of schooling to post-education income, but with the usual qualifier, “on average.”
In today’s post, I explore a new question, surely related to education, but from a different perspective. How should an adult with a certain achieved level of education decide about more education? Does it make financial sense for a 35-year-old with a family to snag a Master’s degree to reach a higher level within her organization? Should an individual with an Associate’s degree pursue a 4-year degree? How about a biology major with a B.S. becoming a physician? Is there economic value to an MBA for a computer science major and recent grad whose first job, by any measure, pays very well? Those questions mirror the question on Preston Taylor’s plate. Each can be answered with the same approach grounded in economic science. I will illustrate with Preston.
Preston went to Washington University with aspirations for medical school. Upon graduation, he took a well-paid scientific job with a biotechnology firm in Santa Clara, California. Preston earns $105,000 and is single. Maybe not Kopi Luwak every day, but a very good salary. After two years of work with the firm, Preston’s brokerage account has grown to $20,000, plus he has $7,000 in a 401(k), mainly because his employer makes 2% of salary contributions.1 Preston portends opportunity in the biotechnology business and believes his chemistry major will serve him well if coupled with an MBA degree. In fact, Preston has applied to numerous schools and was recently accepted at a prestigious nearby business school on the West Coast. He was offered an academic scholarship if he waited one year before enrolling.
Preston’s $105,000 salary job will last for one year, and then he will have to forego two years of earnings to go to school full-time before starting his post-MBA position. Preston is fortunate to have accumulated cash to help finance his educational time. Still, a two-year work hiatus requires Preston to borrow $30,000 nominally each year via a student loan to help offset his “cost of attendance” uncovered by his merit scholarship.2
Factors Important to the Education Decision
Put aside for the moment the psychic value of more schooling for Preston. He has some trade-offs to consider,
Preston has a good job with a 100% probability of a promising future. If he stays the course in this position, he will have a measurable base case living standard.
If Preston returns for his MBA, he gives up 2-years of income and has to borrow $30,000/year via a PLUS student loan for living expenses that will have to be paid back with interest beginning when he leaves school.
Preston is fortunate to have a scholarship that covers his tuition costs. For most returning students, tuition cost is a factor to be considered when determining the value of more education.
Post-MBA, Preston expects a higher income level ($150,000) with a high probability, but not 100%. There is risk in any future opportunity just as there is risk in the future income levels in his future job. We will assume a higher post-MBA salary, but future income risk will not be assumed to differ between the base case scenario and the post-MBA alternative scenario.
Preston’s Actual Expenses
Preston’s budget for the current year is documented in the table below. His studio apartment in Santa Clara is expensive, about one-third of his gross income. Other living expenses and the sum of his tax obligations (line 15) appear to leave room for savings under his current $105,000 of income. Cash-out totals $92,334. But Preston needs to know whether his actual budget this year is his best budget.
Preston’s Optimal Spending w/o More Education
The first step to assist in Preston’s education decision is establishing a benchmark living standard route, assuming a “static Preston” who doesn’t pursue additional education but otherwise has promising prospects. In Personal Finance Economics, an initial, optimal living standard path is often established against which sound financial judgments can be made. This is done for Preston with additional financial details about his current financial condition, preferences, and expectations.
Preston is interested in retiring someday and intends to work through age 69, then begin drawing social security retirement benefits and pulling 401(k) distributions until his max year of life, age 90. These two prospective cash flow sources during retirement are important considerations that raise Preston’s living standard this year. Given Preston’s age, he expects to work twice as long as he will be retired. He has more than 45 years of work life for his 401(k) to accumulate funds, and his social security benefits will be indexed for inflation under current law. I assume Preston will earn a 1.75% return above expected inflation on his 401(k) assets, and any bank savings or brokerage account funds earn a return that keeps pace with inflation, e.g., a 0% real return. The developed plan and Preston’s data and assumptions may be found here.
Preston’s optimal spending total under this “no more education” benchmark case for the current year is reported in line 21 below. Without considering education effects, Preston can raise his living standard by about $12,000 in the current year. A nicer apartment, putting some extra money aside dedicated to a down payment on a new home, 20 rounds at Pebble Beach, or travel. His choice.
Does More Education Make Sense for Preston?
Now, we are ready to contrast this current living standard with the one created by more education. Preston will lose income for two years, a student loan that will have to be paid back, and a better-paying job. Does more education make sense?
The short answer is yes. Preston’s prospects with more education are promising. A no-brainer. The table below summarizes Preston’s projected lifetime income and spending for the Base Plan and the More Education plan.3 Higher income levels generated because of more education yield more substantial social security retirement benefits and employer 401(k) contributions to be withdrawn during retirement. Taxes are higher, too, by an additional $1.057 million over Preston’s lifetime under current tax law. Nonetheless, the aggregate lifetime living standard noted by the additional discretionary spending nearing $1.256 million shows how different Preston's life can lead with more education. Given education costs and income prospects, education is life-changing economically.
What are the drivers of the change? Fundamentally, Preston received a student loan to finance living expenses during his MBA years, then had to spend to pay it back over the next 10 years after graduation. Because of interest costs, the student loan payoff amount is more than the student loan receipt, but the cost pales in comparison to the change in labor earnings, social security benefits, and 401(k) funds to be withdrawn during retirement. Sure, Preston’s aggregate taxes increased by about $1 million, but he is still better off with his MBA.
Annual Living Standards over Preston’s Life
The chart below moves the analysis from the aggregate to an annual tracking of Preston’s optimal living standard from his current age to his max-age. As noted by the orange line, Preston would have a base case living standard, in today’s dollars, of about $40,000 for the balance of his life without additional education. By contrast, in the near term, the education decision is painful because the living standard takes a hit during the MBA years (the A arrow), then after post-grad completion, jumps immediately. After Preston pays off his student loan, his optimal living standard becomes level for the balance of his life. The living standard difference, the B-arrowed differential, creates a living standard 50% higher with more education than without. The sum of these differences is $1.256 from the table above.
To wrap up, Preston’s decision is easy for his set of financial details. But his financial outcome could have been different if he had to bear the tuition cost at a top 10 school and graduated into a tough economy. That scenario can be modeled, too. Technically, the approach is the same. More importantly, the Preston case study motivates how to better think about the education decision in the spirit of Personal Finance Economics. Personalized inputs and a life-cycle approach that embodies tax law and all the relevant institutional details as we know them today give individuals, households, and planners the best chance to make a well-informed decision. That is a major buzz whether one drinks coffee or not.
The payback of the student loan assumes a 6.28% APR and ten years.
Values in today's dollars with an annual discount rate equivalent to the real return on cash assets.