How 'Merit' Aid Hurts the Needy—and Colleges

September 16, 2013

College students, their parents, government officials, and higher-education experts dwell, with tedious repetition but to no apparent effect, on the issues of college tuition and financial aid. First, they condemn annual tuition increases that greatly exceed the nation's inflation rate. Second, they lament the paucity of financial aid and the accumulated debt of present and former students.

What are the connections, if any, between these two issues: tuition and financial aid? Of course higher tuition increases the demand for tuition assistance. But something close to the reverse is also happening: Sweeter financial-aid packages are permitting tuition to increase.

Tuition rates are not a function of the cost of higher education. Rather, as in all competitive markets, the forces of supply and demand set prices—in this market, tuition.

But colleges do not compete on published tuition rates. Nor do they compete on educational outcomes for students, in part because outcomes are devilishly difficult to measure and report. Increasingly they compete on (a) student amenities and (b) the quality of their student bodies. Amenities include beautiful campuses, student lounges, sports and recreation facilities, and a high-quality food service.

Measuring student-body quality in terms of educational inputs—the capabilities of incoming students and thus the quality of the student body—is relatively easy: High-school grade-point averages and standardized-test scores are gathered by all admissions offices. These are widely reported and used by those who rank colleges.

But while colleges don't compete on published tuition rates, they do compete strenuously on tuition discounts. College-admissions staff members refer to stated tuition as the "sticker price." The tuition actually paid is the sticker price less financial aid. The difference is referred to as the "discount."

Most colleges compete for applications from the best-qualified students. Then they compete to enroll the most able kids they admit. At this second stage, a key competitive tool is the "merit" scholarship: financial assistance based not on the family's financial position (income and assets) but rather on the applicant's attractiveness as a student-body member: intellectual, artistic, or athletic ability; enhancement of socioeconomic diversity; demonstrated leadership ability; and other factors. Not only do those scholarships lower a family's outlay for college, but they also provide the applicant and his or her family with bragging rights.

Merit scholarships are one of the fastest growing categories of college expense. For some colleges, competing strenuously for better students, the discount rate now runs about 50 percent. Simple math tells us that if a college with a 50-percent discount could enroll only full-pay students and offer no merit scholarships, it could reduce its sticker price by half. But, of course, no college would take that step, since colleges don't compete on sticker price.

It follows, then, that all financial-aid awards—both those based on financial need and those based on perceived merit—are a major factor in pushing up tuition rates across all of higher education.

Keep in mind that money arriving at a college is largely fungible. To the extent it offsets funds being spent on expense-category A, the money received may be devoted to category B or C.

Suppose the federal government raises the dollar amount of its Pell Grants, the primary form of student-based financial assistance. (This assistance is all need-based, not merit-based.) Such a sweetening of Pell Grants offsets some of the college's own funds devoted to need-based financial aid. While those savings could be reflected in lower sticker-price tuition, colleges don't compete on list price. Therefore the freed-up funds are more likely to go to merit scholarships or to those amenities that will be particularly attractive to applicants.

Or suppose a small college with a 50-percent discount rate receives an unrestricted $10-million endowment gift from a generous donor. Earnings on that endowment could be used to offset educational expenses and thereby permit a modest decrease in tuition. But again, competition in the college-education market does not turn on price. Thus, those new funds are more logically employed to increase merit scholarships—that is, raise the college's price discounting—or to enhance the nonacademic aspects of its students' experience.

Also note that the wealthiest higher-education institutions set family-income thresholds below which the family's offspring are given "full" scholarships; they pay no tuition. For more than a few colleges, that threshold is now $100,000 or more. Families with incomes below that level are indifferent to current and future sticker prices, just as are very wealthy families.

These conditions lead me to make three suggestions:

  • Any sweetening of (a) Pell Grants or (b) other state- or federal-government financial-aid awards serves to offset institutional funds. To the extent these offset funds are used for merit scholarships, the Pell Grant program's objectives are being thwarted: Some or all of the funds may in fact be going to non-needy students. This is certainly not an appropriate use of taxpayer dollars. Governments should restrict their granting of need-based scholarships to those colleges that do not "buy" students by granting merit scholarships.
  • When generous donors restrict their gifts to the support of need-based student financial aid, they are really making "unrestricted" gifts. That is, their gifts replace the institution's own financial-aid funds, and those funds can then be used for any—that is, unrestricted—purposes. Donors of student-aid funds, then, would be wise to insist that their funds add to the total of need-based aid and are not used for merit scholarships, either directly or by substitution.
  • Merit-scholarship programs simply take from the families of the academically less-qualified students and give to those who are more qualified, perhaps solely because they had access to better high schools. Families asked to pay the full sticker price should wise up; they should realize that financial-aid offices at many colleges routinely negotiate discounts.

Colleges need to wean themselves from dependence on tuition discounting to attract students and should exercise greater pricing discipline. A continuation of current practices will result in increased cynicism, and perhaps rebellion, on the part of students and their parents who pay full sticker price, donors who will recognize that the plea for student-aid gifts is somewhat disingenuous, and the public and elected officials who are coming to recognize that sticker-price tuition is meaningless and the need for more government financial-aid assistance is overstated.

Henry E. Riggs is president emeritus of Harvey Mudd College and an emeritus professor and former vice president of Stanford University.