Higher Education Reforms Aim for Greater Accountability

By Kenneth Megan

Wednesday, August 5, 2015

With total student debt standing at over $1.2 trillion, and average four-year graduation rates at a paltry 39 percent, lawmakers on both sides of the aisle agree that the U.S. higher education system needs to change. Today, Sens. Jeanne Shaheen (D-NH) and Orrin Hatch (R-UT) introduced the Student Protection and Success Act, a bipartisan bill to bolster accountability in the higher education system. This bill adds to a growing body of like-minded legislation, including the Protect Student Borrowers Act, sponsored by Sen. Jack Reed (D-RI). Both of these bills propose to establish new risk-sharing mechanisms that would strengthen incentives for institutions to focus on ways to improve student outcomes.

The Problem

The federal government spent $145 billion last year on postsecondary student aid. While over 7,000 institutions were allowed to accept these dollars, little was requested of them in return.1 This hands-off approach to higher-education financing is nothing new. For years, students have been offered a smorgasbord of federal grant and loan options to use at the school of their choice. Though noble in its aim, the federal government has paid little attention to the performance of the institutions receiving these funds. This lack of oversight has led to a serious accountability gap, with institutions remaining largely “off-the-hook” for poor student outcomes.

Currently, federal aid eligibility is tied to default rates. If a high percentage of students default on their federal loans, the government can revoke the ability of that school to receive future federal loans and grants. Specifically, the federal government uses a metric called the cohort default rate (CDR), which measures the percentage of any given incoming class that defaults on their federal loans within three years of entering repayment. If a school’s CDR exceeds a certain threshold—currently 40 percent for a single incoming class (known as a cohort), or 30 percent for three consecutive cohorts—that institution can lose the ability to accept federal aid. This system ultimately rests on the belief that schools should bear some responsibility for high default rates. If a large percentage of a school’s students are unable to meet their loan obligations, then that institution has failed, and it should therefore not be allowed to accept federal aid dollars.

While this system makes sense in theory, it is fundamentally flawed due to the many options that students in need of financial assistance have to avoid technical default. For example, debtors can claim economic hardship and move onto forbearance or deferment, which temporarily relieves them of their monthly payments—though interest continues to accrue. Debtors also have the option of enrolling in an income-driven plan, which limits monthly payments to a percentage of one’s earnings. Many students who narrowly avoid default are unable to put a dent in their loan balances, but universities serving large numbers of these students face little in the way of consequences. In fact, some institutions have gone so far as to hire default management firms to push students at risk of default onto forbearance, effectively relieving the schools of accountability and ensuring their ability to continue accepting federal aid.

The result is an accountability system that is anything but. In 2014, just 21 schools were sanctioned by the Department of Education for high default rates—half of them were cosmetology schools, and 20 of the 21 were for-profits. Meanwhile, up to $68 billion in federal loans are currently in forbearance or deferment due to the student’s unemployment or economic hardship.

Legislative Solutions

The Student Protection and Success Act would eliminate the CDR and replace it with a new “repayment” metric tying federal aid eligibility to loan repayment rates – specifically, the percentage of an institution’s incoming class that makes at least a one-dollar principal reduction on their loan balance within three years of entering repayment.2 The threshold would be set at 45 percent for the first cohort, meaning that an institution would lose aid eligibility if less than 45 percent of that incoming student class reduces their principal balance over a three-year timeframe.

For subsequent classes, however, the repayment threshold would change. With data available to calculate the repayment rate of the first incoming class, the threshold would move from 45 percent to 10 percentage points less than the average cohort repayment rate.3 For example, if the average repayment rate over three years was initially 75 percent, the threshold for the following cohort would be 10 percentage points less, or 65 percent. The bill also calls for a 70-percent hold-harmless level, meaning that any institution with a repayment rate above that level would remain eligible for federal aid even if the institution’s repayment percentage was more than 10 percentage points below the national average. The new system would also set a floor at 45 percent, meaning that the threshold would not be allowed to dip below this level, even if the average cohort repayment rate turned out to be lower than 55 percent. Furthermore, if the repayment threshold in subsequent years was calculated at a level higher than 45 percent, this would become the new floor, meaning that the threshold would only be allowed to increase over time.

In addition to creating a new repayment metric, the Student Protection and Success Act would also establish a risk-sharing regime. Under this system, institutions would pay a fee based on the percentage of an incoming class’s non-repayment balance, defined as the portion of a cohort’s loan balance whose principal has not been reduced by at least $1 over the course of three years. This fee would be adjusted for the national unemployment rate, meaning that schools would incur a lower penalty during economic downturns. Specifically, institutions would be required to pay 20 percent of the following:

(Cohort’s non-repayment balance) – (national unemployment rate * cohort’s total loan balance)

Specifically, if an incoming class were to enter repayment in 2015, an institution’s risk-sharing burden for that cohort could be calculated by 2018. If the national unemployment rate averaged 5 percent for those three years, the incoming class’s total loan balance was $10 million, and the balance that had not seen a principal reduction totaled $1 million, the institution would be required to pay the Department of Education $100,000.

$1 million – (5% * $10 million)  =  $500,000

$500,000 * 20%  =  $100,000

A final aspect of the Student Protection and Success Act involves the advent of a “College Opportunity Bonus Program,” designed to incentivize the enrollment of low-income students. Under this provision, schools would receive a bonus for each Pell-eligible student they serve. All of the revenue generated from the risk-sharing program would be channeled into this bonus program, meaning that schools penalized for low repayment rates but that  also serve a high percentage of low-income students would not be adversely affected by the risk-sharing provision. In fact, schools that serve a high percentage of low-income students and also exhibit high repayment rates would gain from this new system, as they would benefit from the bonus but would not be penalized via risk-sharing.  Ultimately, the College Opportunity Bonus Program would give schools an incentive to continue serving low-income students (who may, all else equal, be less likely to repay their loans), even in the context of increased accountability and risk-sharing.

As mentioned previously, the Student Protection and Success Act is not the only piece of legislation designed to strengthen higher education accountability. Another example is the Protect Student Borrowers Act, sponsored by Sen. Jack Reed (D-RI), which was originally introduced in the 113th Congress, and would establish a risk-sharing program where institutions pay a fee equal to a percentage of their cohorts’ loans that are in default. Unlike the Student Protection and Success Act, this bill would not create a new metric, and would instead continue to link accountability to the CDR. However, it would tighten standards by lowering the threshold at which institutions incur a penalty. Whereas the current system revokes federal aid for schools with a three-year CDR above 30 percent, this bill would require schools with a CDR between 15 and 20 percent to pay a fee equal to 5 percent of the total amount in default for that cohort. Similarly, institutions with a CDR between 25 and 30 percent would be required to pay a fee equal to 15 percent of the total amount in default. This legislation would ultimately force institutions to bear a certain degree of default risk, and could incentivize schools to invest more heavily in completion and skills acquisition.

With billions of dollars in federal aid flowing to the higher education system each year, and with students forced to shoulder increasing debt loads, colleges themselves are subject to weak oversight and low levels of accountability. Both of these bills propose a solution to this problem, and deserve careful consideration among policymakers seeking to address the many challenges related to higher education financing in the context of lax accountability standards.

1 The $145 billion figure includes the federal government’s 2014 expenditures for all of its student loan and grant programs, the vast majority of which go towards Pell Grants, Stafford Loans and PLUS Loans.

2 The bill makes exceptions for students enrolled in graduate programs and military service.

3 The average cohort repayment rate is defined as the national average for every institution in the higher education system. The rate would be calculated separately for two-year and four-year schools, meaning community colleges would not be held to the same standard as four-year institutions.