How Student Debt Affects Retirement Wealth

Student loans have become a hot-button issue recently. Anecdotes of recent college graduates buried in debt abound in the news, and academics have associated student loans with a number of negative life outcomes, including decreased likelihood of getting married, owning a home, and applying to graduate school.

Some of this attention is attributable to the proliferation of loans. In 1992, 10% of all households in the United States and almost 30% of households headed by someone younger than 30 held student loans. Two decades later, those proportions increased to 20% and 42%, respectively. Additionally, the average student loan balance has increased. Roughly tripling in real, inflation-adjusted terms during that same time span, the average student loan balance has ballooned to $27,300 from $9,400.

Impact on Retirement What sort of impact does this have on young workers participating in workplace retirement plans? To answer this question, we examined the choice workers make when deciding whether to use their discretionary dollars to pay off their student loan debt ahead of schedule or instead use them to save for retirement through a workplace-sponsored plan, such as a 401(k).

To examine the relationship between student loans and retirement savings, we looked at two sources of data: HelloWallet user data and the Federal Reserve Board's Survey of Consumer Finances. Additionally, we built a model to examine the situations in which it might make sense to pay down student loans ahead of schedule.

One strength of HelloWallet's user data is its accuracy. Once an account is connected through our application, balances are updated continuously. Also, in contrast with surveys, no bias is introduced when respondents are asked to estimate their balances or to recall them through memory. However, these data do have drawbacks. In particular, the user population is not representative of the U.S. working population as a whole. Therefore, we used both data sources.

After analyzing the evidence from the HelloWallet data and the Survey of Consumer Finances, we found that student loans do appear to have a small crowding-out effect on retirement savings. Using HelloWallet's data, we found that after controlling for age and income, an additional dollar in student loan debt was associated with a decrease of $0.17 in retirement savings. Within the Survey of Consumer Finances, a similar analysis revealed a decrease of $0.35. Both results are statistically significant at a 1% level. That these two data sources produced directionally similar results suggests a crowding-out effect of student loans on retirement savings.

Pay Off Loan Early? Are there circumstances in which it might make sense to prioritize paying off a student loan ahead of schedule? To answer this question, we built a model that projected net wealth at retirement under a number of varying assumptions, including salary, age, loan balance, and market returns.

We find that there are few scenarios in which paying off student loans ahead of schedule instead of investing in a workplace-sponsored retirement plan results in a higher net wealth at retirement, particularly if the employer provides a match. For the case of a 25-year-old worker with a starting salary of $50,000, a student loan of $20,000, and an effective employer match of 5%, paying off a student loan ahead of schedule such that only half of the employer match is realized results in a $242,000 reduction in net wealth at age 65.

If they have the benefit, it is imperative for workers to maximize their employer’s match. Even extraordinarily low expected rates of return coupled with an extraordinarily high interest rate on their loan do not outweigh the benefit of employer matches.

One notable exception: Workers who are very close to retirement (as in, they plan to retire around the time their student loans are paid off) and who do not receive an employer match can achieve a higher net wealth by paying down their student loans ahead of schedule.

Contrary to popular wisdom, it does not always make sense to prioritize student loan debt over saving for retirement if the expected rate of return is lower than the interest on the loan. Particularly if the worker is young, saving an extra dollar is more valuable than using it to pay down student loans because it compounds longer in the market. Additionally, interest on student loan debt is tax-privileged for workers with a modified adjusted gross income of less than $80,000.

Importance of Saving Our findings stress the importance of saving at least as much to maximize the employer match. Even in the absence of an employer match, there are few circumstances in which paying off a student loan early results in a higher net wealth at retirement.

Student loans have become increasingly prevalent as a means of financing higher education, and today’s college graduates are carrying larger loan balances. As this trend shows little sign of abating, the calculation of using discretionary dollars to pay off student loans early or investing in a workplace retirement plan becomes increasingly important.

This article originally appeared in the April/May 2016 issue of Morningstar magazine. To subscribe, please call 1-800-384-4000.