Are ISAs the Solution to Student Debt?

A bold proposal: You go to college for free, then pay back the school after graduation—but only if you get a job in your field of study and make a high enough salary to afford it. It's called an income share agreement, and Austen Allred, the CEO and cofounder of Lambda School, thinks it's the future of education.

• 0:00Speaker 00

  The content here is for informational purposes only, should not be taken as legal, business, tax, or investment advice, or be used to evaluate any investment or security, and is not directed at any investors or potential investors in any A16Z fund. For more details, please see A16Z.com/disclosures.

• 0:19Speaker 01

  Hi, and welcome to the A16Z Podcast. I'm Lauren Murrow, and I'm here with Austin Elred, CEO and co-founder of the skills-based online school Lambda School, and Darcy Kulikin, a partner on the Consumer Tech Team. Today, we're discussing an issue that has saddled much of a generation: student debt. Student debt currently stands at more than $1.5 trillion, which makes it the second-highest consumer debt category behind mortgage debt. The national total for student debt is higher than both credit cards and auto loans. One solution that's been proposed is income-share agreements, or ISAs. It's a concept currently in the zeitgeist that's spurring debate across media and politics. Here's the idea: rather than charging students tuition

• 1:03Speaker 01

  to attend college, often forcing them to then take out loans in the process, they go to school for free. But under an ISA, they are then required to pay back a percentage of their income after graduation, but only if they land a job with a salary that meets a certain amount.

• 1:20Speaker 01

  In this episode, we delve into some of the greater implications ISAs may have for the future of education, the economy, and more. We also touch on some of the challenges of ISAs, why they've been relatively slow to gain traction, why some have failed in the past, and why some in the political sphere are still skeptical. As we begin our conversation, Austin gives his explanation for why ISAs work.

• 1:43Speaker 02

  I think of it as a very, very forgiving type of way to pay for education. So if the education doesn't work, basically, you don't make payments. So at Lambda School, you don't pay the school anything unless you get a job in the field you trained in that pays more than $50K. And if you get that kind of a job, you pay a percentage of your income for a couple of years, and that's it.

• 2:05Speaker 03

  Put this into context for us. If ISAs are the future, what's the big picture potential?

• 2:11Speaker 02

  It just doesn't make sense for a lot of people to attend college anymore. Earnings have stayed flat, basically, since the 80s, and tuition has gone up, basically, 3X. And so that gap is getting bigger and bigger, and it's more and more risky every day for a student to go to college. So there are times when a student will enroll in a school when they're 18, and they'll pick something to study. And when you look at the amount of student debt they're going to have, everybody knows, from the school to the person funding the education, to the government, that that person is unlikely to be successful and ever pay back their student loans. If you look at most of the student debt, a lot of it is from students who didn't graduate or from students who aren't making enough. And almost all of the default in student loans comes from those categories.

• 2:56Speaker 02

  In the world of an ISA, that doesn't happen. Almost by definition, a student who is unable to make payments on their ISA is much, much less likely to happen than a student who can't make payments on their loans. But what it really allows us to do over time is better assess who will end up in the right career path, do everything we can to get them there.

• 3:16Speaker 03

  What do you mean when you say get them in the right career path?

• 3:19Speaker 02

  So you walk in on day one, knowing that if you don't get a good job, you're not paying us anything. Everything is driven to making you successful in the career path that you may choose.

• 3:28Speaker 04

  It also diversifies risk, and it allows people to do things that they otherwise might not have been able to do. If you look at education outcomes, especially if it's vocational schools, where the ultimate outcome is getting a job, it can be relatively binary. You either get a job or you don't. And when you have those things that have a high variance, it can oftentimes feel really risky for the person entering into that. Because if they don't get the job, that risk has then been placed on them. The way that income share agreements work is they're taking that risk from the individual and putting it on the school.

• 3:59Speaker 02

  Say you have a school with a 75% graduation rate. And then of those graduates, 75% end up being successful in the job that they they trained for. Those are not bad rates. In fact, most colleges would take those rates any day. But when you look at the tuition dollars that are flowing into that school, basically 46% of those tuition dollars are coming from people who are unsuccessful. So if those people are saddled with loans, there's no way they're going to be able to pay those off. If you're talking a private student loan, your interest rate could be 10, 11, 12%. If you're only making 30, 40, 50K a year, like, you might be financially ruined forever.

• 4:36Speaker 04

  The more income has spread, that then makes the financing education through debt that much riskier. The winners will win bigger, but the losers will lose bigger. And to the extent that that's financed through debt, that that just can become a massive overhang on somebody that doesn't win, coming out of that education lottery.

• 4:52Speaker 02

  And one of the important things that economists have realized in the past few years, I mean, Kahneman and Tversky, they came up with the notion of behavioral economics. It was basically the realization that humans don't always act in an entirely rational way because their downside risk can be so much greater than the upside. So ISAs are a way of saying, let's say you have a 90% chance of your education working out and a 10% chance of you being financially ruined for life, a rational person will still not play those odds. So as a school holds the risk, it now becomes 90% chance that somebody is successful and pays back and a 10% chance that you have to eat those losses. The school can actually afford the risk in the way that an individual can't.

• 5:34Speaker 02

  And when an individual is de-risked, they can look for more optimum outcomes and not having to weigh in that downside risk is really, really important.

• 5:42Speaker 03

  Are there types of students that ISAs make sense for and don't make sense for?

• 5:47Speaker 02

  Depending on the terms, I think it makes sense for every student. As the ISAs exist today, they're only slightly more expensive than upfront tuition at most schools. So you can take the risk and say, I'll pay $20,000 upfront tuition, or if I'm successful and I get a six-figure job, I'll pay up to 30K. Turns out, if you're successful and you have a six-figure job, that 10K delta doesn't feel as bad, and you would trade that for, and if I don't get a job, I don't pay anything. In my ideal world, you only actually pay the school if it's less than the increase in your income.

• 6:21Speaker 04

  The place where maybe the jury's still out, where we're still trying to figure out whether the economics work is places where there's much lower variance. Traditional finance theory would say that's a place where you should take out debt rather than, rather than some other form of financing. And so in those instances, which to a certain extent is kind of what college looked like in the 1950s and 60s, and that it was much more predictable. And debt was the like natural financial instrument to use then at that point. But now that we're at a place where the risk is so much higher, the outcomes are so much more distributed. Income share agreements are having this moment now because that that's the kind of population that it really makes sense for.

• 6:54Speaker 02

  But I, but I do think it does come back to what is the upside risk versus what is the downside risk? This may not be the perfect example, but say an NBA athlete or someone where if you're successful, the upside is millions and millions and millions of dollars. And you could de-risk that by saying, okay, an ISA will pay me 100K for life in exchange for if I'm wildly successful, I'll give up 10% of my income. And you can use the, the high potential for upside risk to de-risk it for people and cover the downside risk. That's the kind of financial engineering that I find fascinating.

• 7:30Speaker 04

  The easiest way to think about it is just it's insurance. You're saying if something really bad happens, I'm not going to be in really dire straits.

• 7:38Speaker 02

  Insurance is a really good way to think of it. And that's the instrument we use in similar scenarios where, you know, okay, I'll pay a hundred dollars a month. And I don't love paying a hundred dollars a month, but if someone wrecks my car and I now owe $20,000 to get a new car, I would like to not have to pay that because I can't afford to. For the most people, when you're talking houses and cars and potential really high downside risk volatility, it makes more sense to de-risk yourself.

• 8:06Speaker 03

  Let's say you're right and income share agreements become more common. How might that actually shape education?

• 8:13Speaker 02

  So what I hope will happen is you can drive the effective price of studying something that is likely to pay well down. What I really think is missing in the economy is something that will tell you, hey, based on who you are and what you know and your talents and proclivities, here is the best place for you in the economy and we're going to help you get there. I would imagine that the vast majority of the population could actually end up in a better place than they are today if they only had any idea what opportunities are available to them. Universities don't really serve that function today. When you show up at the front door, they're not handing you a book that says, here are the best majors for you to choose. And if they did that, then professors would lose their minds. So I hope that it becomes more transparent when you're a student.

• 8:58Speaker 02

  And I think about our economy of human labor being the majority of GDP, 52, 53% of GDP, and completely unoptimized. And that's insane. We're our biggest asset class that exists. What most of us spend most of our waking hours do is not optimized at all.

• 9:17Speaker 04

  Education as it is today is this kind of bundled value proposition where it is skills training, it's career development, it's also networking. What ISAs are really good at doing is they will kind of like debundle that and they will atomize the different parts of education and take this part around kind of skills development, training, the ability to focus on optimizing and maximizing your long-term income. And it will make really clear which programs or institutions are optimizing for that.

• 9:47Speaker 02

  I think it's insane that if, for example, there's a factory that goes out of business in Detroit, there are all these people that are unemployed and even if there is huge demand in other parts of the economy that those people could do, there's nothing that matches those two. There's nothing that will take an unemployed factory worker in Detroit and get them, even if there's a company next door that desperately needs something, there's no bridge between those two. So at a higher scale, I hope ISAs will enable a broader economic clearinghouse where we can move people to where they're most valuable in the economy, where they're happier, where they're paid more. Eliminate the friction of doing that. I think it's probably the biggest barrier to economic progress that exists today.

• 10:31Speaker 04

  Assuming you have this ecosystem that's built on top of ISAs, then you will have this much more efficient system that can move people in and out of the workforce and retrain and reskill people much more quickly.

• 10:41Speaker 03

  A critique of ISAs is people say graduates with high salaries might end up paying more under an ISA than, say, a traditional student loan program.

• 10:49Speaker 02

  Yeah, it's a trade-off that you have to make, for sure. But we offer both upfront tuition and an ISA, and 98, 99% of our students pick the ISA. Because in the scenario where you are paying a little bit more, you're fine. And you're making enough money that it's not a big deal. And frankly, for us, you only pay it for a couple of years. So it's actually not a big delta relative to if you had $20,000 on the line and you have no idea whether it's going to work out and you owe interest on it no matter what.

• 11:20Speaker 04

  Yeah, you might end up having to pay a little bit more than you would if you just paid straight up. But you're getting the psychological ease of not potentially having that debt hanging over you. Most ISAs are capped. So no matter if you're making gazillions of dollars, there is a maximum amount you will pay, whether it's like $20,000 or $30,000 or $40,000 over the lifetime of an ISA, you'll only pay X amount of money. You're paying for risk protection on the downside, which can have a bunch of knock-on effects in terms of how you think about your lifetime earnings. If you're able to not only take the risk of going to school or going back to school or taking time away from the workforce, but also thinking about your career over a longer time horizon because you don't necessarily have to service debt immediately upon graduation, that's one thing that can actually change the dynamics of a career.

• 12:05Speaker 02

  Yeah, one of the instances that's been most fascinating to watch is if, for example, you took out a loan to pay Lamb to school, the loan payments start becoming due immediately upon graduation. So we've seen circumstances a couple of weeks ago where a student got a job offer for 70K, and he was saying, okay, like, that's not a bad job offer. I can take that. And we thought he could do a little bit better. So we're like, you know, you might want to turn that down and keep looking at the market because based on what we're seeing, we think you could get more. If you have a debt payment that's about to come in, you take that 70K offer because you have to make those payments. In this circumstance, he waited a couple of months. We waited longer to get paid, but this particular student ended up getting a job for 240K.

• 12:48Speaker 02

  So a massive, massive difference in income just because he had the psychological ability to wait a little bit and to pick the actual optimum outcome for him as opposed to optimizing for I've got these payments that I need to make that are going to be due no matter what my life looks like.

• 13:06Speaker 04

  The financial ability to do that, too. It's like psychological and financially, it's freed him or her to kind of make that better decision. And we all know these people that graduate from university. They take the job in like investment banking or something that's going to give them a high cash component for like three years because they want to pay off their student debt. And then at that point, they're going to go do what they really want to do. And that's like this common thing that you see amongst graduates all over the US. And income share agreements can mitigate that and it can change the immediate incentives you have upon graduation.

• 13:34Speaker 02

  And we're seeing those incentives play out at a broad scale. People are starting families later. They're not buying houses. They're not starting businesses. Y Combinator is trying to do a study right now that determines how many people would be starting businesses if they didn't have student debt. If you have a thousand dollars a month in debt payments, it becomes really difficult to start a company.

• 13:55Speaker 01

  So you're saying the impact of ISAs may extend beyond the issue of student debt?

• 13:59Speaker 04

  I think a lot of the reason that people get excited about ISAs is because of the second, third level effects of it. The ISAs are kind of like the building blocks, but then you do need this robust ecosystem built on top of it. And I think we're in the early days of building that ecosystem right now.

• 14:14Speaker 01

  What else is in the ecosystem?

• 14:16Speaker 04

  If you think about ISAs broadly, there's places where you can use ISAs beyond skills training. You can think about it as I can move you from place A to place B and pay for that and take those upfront costs and then take an income share agreement on the back end and that's the way to finance that. Right now mentorship exists in this informal, nice people do it type thing, but you can think of a way where that gets much more formalized. There's tons of value propositions that can be layered on top of income share agreements that I think people get very, very excited about.

• 14:43Speaker 02

  I've seen things go as far as an ISA for immigration where we'll pay for all of your legal fees. We'll do everything that we can. And then if you end up in a certain country where you're making way more money, you pay a percentage of income for a few years, but net, net is going to be more than you were making wherever you were and you can create a new life.

• 15:03Speaker 03

  The design of it is so important. You really have to consider the details when structuring it.

• 15:08Speaker 02

  You're 100% right that the devil's in the details. So in theory, you could make an ISA that makes a lot of sense, or you could make an ISA that makes no sense whatsoever. And my hope is that as there is more competition in the ISA space, and as there becomes better regulation, more regulatory guidelines, more repayment history on these things, we can start to figure out what the optimum rate is. Right now, it's a little bit up in the air. When we started, we were basically guessing about what repayment rates would be. And we created terms that made sense in this imaginary model. A loan has a par value, it has an interest rate. You know what payments are going to be coming in every month.

• 15:52Speaker 02

  And then if they don't come in, then you call that a default and you report it to the credit bureau. With an ISA, there are times when a payment is not coming in, and that's OK, because it's built into the agreement itself. In an ISA world, that's actually not a default. That may be exactly what the instrument intended for. The entire ISA market today is maybe a couple hundred million dollars a year. It's not big relative to basically any other asset class, whereas student loans are in the trillions.

• 16:21Speaker 03

  You bring up a good point in that ISAs, though they're getting a lot of buzz in politics and in the media, are still a relatively small percentage of schools that are actually pursuing this. Why aren't they gaining more traction?

• 16:34Speaker 02

  Well, as a school today, you will make less money with an ISA than you will with a loan. The way the ISAs are structured today, if my upfront tuition is $20,000, I'm actually not planning to make $20,000 on average from an ISA, and I might have to wait a couple of years for that to happen. So it's actually a worse deal for the school in many cases. But the important flip side of that is it opens up access to students who wouldn't otherwise be your students. So Lambda School is based on saying, what if we increase accessibility to the point where basically anybody with a laptop can attend? So now they're Millions and millions of people who wouldn't be willing to take the risk upon their own financial

• 17:19Speaker 02

  future to go to a code school. And we say, try it out, see if it works for you. And if it works for you, you're going to pay us back, but you have a great job now. So it all works out. But the cost of capital is high enough and they're different enough from loans that you, on average, expect to make less. So the reason that so few schools are doing it is because you really have to design the school around making that work.

• 17:45Speaker 03

  So do you think then that ISAs work well for vocational schools and coding schools, but the jury's still out on more traditional higher education?

• 17:55Speaker 02

  Well, one of the ways they're being used in traditional universities, which is interesting, is as a tool to help people stay in school. The biggest problem that all the universities deal with is retention, retention, retention. A university looks at how much financial aid they have. Some is from the government, some is internally. And you can pretty well identify the students that are going to need that student aid or they're going to drop out. That student aid is not enough to cover everybody. So there are people who it's basically either they're going to drop out of a university or you're going to give them an ISA. So even if you don't get full tuition value dollar on the dollar, it's better to have those students pay you, maybe it's 90 cents on the dollar, maybe it's 75 cents on the dollar,

• 18:40Speaker 02

  to allow them to not drop out. Obviously, that approach is different than a vocational school like ours that is built in such a way that you don't pay unless you get a job.

• 18:49Speaker 04

  There's a bunch of things probably throttling the ISA market right now. I think regulatory uncertainty is probably one of those. The investor side likes to invest based off of data and they like to invest into things that are very predictable. The nature of ISAs is that they just take years and years and years to really build out that data set. So I think The nature of ISAs is just something where it's destined to grow relatively slowly just because the capital markets don't unlock without predictability.

• 19:16Speaker 02

  Not to mention the fact that if you're a university, your COGS are so high that you can't create an ISA with a two-year repayment window. They're all eight years, 15 years. So that's going to take a very long time to know what the repayment predictability is like. So the number one thing holding us back from creating a bigger data set is there just fundamentally aren't enough ISAs to get the capital in so you can watch the data roll through. If you look at the history of lending, it was very similar. Nobody knew what the right interest rate would be. Nobody knew how to securitize loans and turn them into a bond and start selling them. Today, there are trillions of dollars that are looking

• 19:57Speaker 02

  for returns, but they have to be very, very sure returns before you'll put those trillions of dollars in. So our hope is that we can make that data happen faster and bring down the risk faster.

• 20:09Speaker 03

  You bring up an interesting point in that ISAs, they're very buzzy right now, are not a new concept. People have tried this before, maybe failed. What are you doing differently?

• 20:19Speaker 02

  The most popular experiment with ISAs was done by Yale in the 70s. And they did it in a very interesting way, which was they said, okay, this class will cost us N dollars in tuition, and everybody's going to pay a percentage of their income until we've reached that amount plus a little bit of interest. But it was as a pool, not as an individual. And it was very explicitly, once we've hit that amount, then everybody's done. Not an individual ISA with a cap, it was the cap for a class, which feels much worse if you're a high earner. And so that actually didn't work.

• 20:55Speaker 04

  Importantly, they also gave people the opportunity to buy out early. So not only did they structure it as a class, and there was this rate of return that the class had to hit as a cohort, but also they gave people the ability to pay, I think it was like 150% of the cost of their tuition. So the people who would have been the really big earners later on in life had the ability to buy out early. And then, obviously, people who weren't doing Well, we're paying a smaller percentage of their income. So it really got burdened on this middle class experiment. And so I think the lesson from the Yale experiment, which I think is the lesson of all ISAs in general, is that design is really, really, really, really.

• 21:30Speaker 02

  All financial instruments in general.

• 21:31Speaker 04

  Exactly. It's like, are you giving people the option to like opt in or opt out? And when is that happening? And how is that creating adverse selection in your pool? How is that changing everybody else's burden? These things matter a lot. And so I think ISAs are extremely exciting at the conceptual level. But I think also whether it's the Yale experiment, or there was a series of companies in the 2000s, the nearly 2010s that came and went, and they were using ISAs, but they didn't get those details right.

• 21:57Speaker 02

  I think another big difference between kind of ISAs today versus ISAs in the early 2010s and in the past is most of the ISAs today are used in vehicles that are meant to shift your income. I sometimes refer to ISAs as like selling an out of the money call option against yourself. Right? So you'll pay, but only in a circumstance where your income changes so much that you don't care. In the past, when it's just been, hey, anybody can get an ISA. There's the selection bias, right? Of why would I take out an ISA if I can take out a loan? But when tied to an educational institution, the reason you take out an ISA as opposed to a loan is because the institution is promising to shift your income or you don't pay,

• 22:41Speaker 02

  which is very different than just a raw ISA to pay for a car repair or something like that. They're not lending you dollars. They're lending dollars to a school that's going to shift your income.

• 22:52Speaker 04

  Which is one of the things that was new about this generation of

• 22:56Speaker 02

  Yes.

• 22:56Speaker 04

  income share agreements that didn't exist in the previous generations.

• 22:59Speaker 03

  So I want to get into the political spectrum a little bit. So the student debt crisis is something that has gotten a lot of attention in the media, particularly leading up to the upcoming election. In June, a member of Congress sent this letter to Secretary of Education. That read, in part, ISAs carry many common pitfalls of traditional private student loans with the added danger of deceptive rhetoric and marketing that obscure their true nature. What would you say to skeptics?

• 23:25Speaker 02

  A world of ISAs, I think, would be demonstrably better, net-net, than a world of the existing student loan arrangement. I've spent a lot of time on Capitol Hill, talking to congresspeople and senators on both sides of the aisle. And what I've generally found is just a lack of understanding and a curiosity and kind of just a fear and skepticism that's probably healthy of, hey, there's this new financial instrument. And one of the reasons we're pushing so hard for regulation in the space is because it's not hard to imagine an ISA that would be predatory, right? The same way, if there were no lending regulations, there are a million different ways that you could abuse loans.

• 24:07Speaker 02

  You could say, this loan has a 9,000% interest rate, but you get your car today. That's not a win for anybody. So I haven't seen anybody abusing ISAs, but I think politicians are skeptical. What the Department of Education is saying is, let's look at this deeper. So similarly, we still, at the federal level, haven't seen that data yet. We haven't seen what the returns are like. We haven't seen what will happen to student repayment. We haven't seen what the burden is like. We haven't even created rates as the federal government for what ISA repayment ought to be. So I think it makes sense that there's skepticism.

• 24:44Speaker 03

  Let's say someone completely wipes out existing student debt. Does that affect the outlook for ISAs at all?

• 24:49Speaker 02

  Well, if you wipe out the existing student debt, based on the way we're pacing, we'll be basically where we are today in about 10 years.

• 24:57Speaker 03

  That's depressing.

• 24:58Speaker 02

  So you can wipe out the student debt, but the bigger question is, who pays for the education and how? And is it just the federal government will now make all university tuition free? Which I suppose is an option. I'd be shocked, but that's an option.

• 25:15Speaker 04

  Even in that world, there's still probably a place for ISAs. I'm from Canada, and healthcare is free, but there's still for fee medical service.

• 25:22Speaker 02

  One of the things that's really interesting is, one of our Bigger markets right now is in the EU. And in a lot of countries, there's free education. But it takes a long time. It's low quality. And a lot of our students are saying, even though I have the opportunity to go to college for free, Lambda School is still providing a better return because it gets me the things that I need. It gets me into the career faster. And our ISA in the EU is, you know, 10% for four years. And so we can make everybody's income, I think, 10% higher than it would be at a university over the same lifetime.

• 25:54Speaker 04

  It makes sense that even if there's a free option, there would be a premium option that would exist that would attract a certain segment of the population. The fact that you're offering an ISA is a signal that we believe we can fundamentally change your outcome in a way that's a delta to the free system, right?

• 26:09Speaker 01

  Could there then be unintended consequences?

• 26:11Speaker 04

  To the extent that ISAs become dominant, majority, exclusive way to finance education, the entire education system then will reorient itself around this idea of maximizing future income, which for a lot of students, that is what they want. For some students, that is not what they want. And so it would have these knock on secondary effects of income is the thing we can measure. It's the thing we can optimize against with this financial instrument. There's all kinds of other value being created within the current educational system. And where and how those things would slot into this new, different world of exclusively ISAs is an open question. So I think when we talk about kind of secondary effects of this world,

• 26:54Speaker 04

  I think that is probably one that is worth paying attention to.

• 26:58Speaker 02

  Agreed.

• 26:58Speaker 01

  We talked about immigration earlier. Is there potential for this model to play out in fields beyond education?

• 27:03Speaker 04

  I think about the excitement around ISAs and education is one big piece of it. The idea of extending it out into other layers of the educational sphere is exciting, but more unproven. And then you trace it out farther and farther and farther. And you have this version where you can be using ISAs for all these other things. So whether it's immigration, whether it's diversifying risk amongst athletes and artists, which is another use case that people are talking about. You can also think about how that plays out in larger and larger contexts. We're IPO-ing cars. We're IPO-ing pieces of art. There is this kind of trend towards more and more securitization of different types of assets. And so it makes sense that the ability to finance advancements in human capital would naturally tend towards some version of that.

• 27:47Speaker 01

  Well, thank you so much for joining us.

• 27:49Speaker 02

  Yeah, thanks for having me.

• 27:50Speaker 04

  Thanks.