At an international conference in Washington, D.C., on financial literacy last year, the Retirement Commissioner from New Zealand stood up and stated that New Zealand has the best website in the world to promote financial literacy and financial education. I liked her instantly; you need to have a lot of guts to make that statement in front of an international audience of academics and policymakers, and possibly a good website. I checked out that website and good it is! It is called “Sorted,” a term that New Zealanders use to mean figuring things out and getting ready (http://www.sorted.org.nz/). The website is very well organized and provides information for financial decisions at every stage of life. One can find information about managing debt, mortgages, investment, and planning for retirement. And there is a variety of calculators as well to help people figure out the interest payments on their credit cards, how wealth can grow with the power of interest compounding, how much to save for retirement, and much more. On the website one can also take a money personality test “to help you work out your financial strengths and possible blind-spots.” I went through the questions and was told (among several other things) that when it comes to money matters, I am cool and dispassionate! I like that, too.
As I have argued before, citizens in every country could use one reliable, accurate source of information for managing their financial decisions. However, what really puts New Zealand's website over the top is the fact that it is so engaging. The information is not provided in those sterile graphs and statistics that even people with advanced degrees understand only after a bit of head scratching. One can watch a movie about investment, saving, and retirement. The soundtrack is so good that it made me play the movies a couple of times to listen to it again. One can also listen to stories and follow the journeys of Liz, Carl and Jess, Rochelle and Junior, and Raeanna and learn how they used the tools available on the website to help organize their finances. It is not just about information and simplifying decisions, but also about implementation. The website describes the steps that one has to take, for example, to set goals and to do a budget. And there are tips on a variety of topics, including how to cope with today’s financial climate. The information provided online is also available in booklets that can be downloaded or ordered for free.
According to a survey that was just released in June 2009, one-third of New Zealanders had either visited the website of the Retirement Commission or read one of the booklets, and a quarter had done so within the past twelve months (http://www.financialliteracy.org.nz/.) This is an extraordinary result. In my view, there are several reasons for this success. First, the Retirement Commission is an autonomous entity with the mission to “educate and inform New Zealanders from age 5 to 105 about managing their personal finances to ensure adequate provision for retirement.” Thus, the citizens of New Zealand know where to go to get a reliable source of information. We do not need many web sites, we only need one! And both the website and the work of the Retirement Commission are well advertised in the media and New Zealanders know about it. Most importantly, as the Retirement Commissioner remarked, it is a good website!
I visited the Retirement Commission last week to speak at their Financial Literacy Summit. I discovered that they designed a survey of financial knowledge in 2005, well before other countries. The development of a national strategy to lift New Zealanders’ financial literacy was announced at the inaugural Financial Literacy Symposium in Wellington in December 2006 and launched in 2008. And if the new survey in 2009 is any indication, 43 percent of New Zealanders are now scoring high on financial knowledge, and women and low income households are among the groups with the biggest improvements since 2006, when data from the first survey was collected. At the conference last week, the Secretary for Education announced that financial education will become part of the curriculum in schools throughout New Zealand. Moreover, the advisory committee for the National Strategy for Financial Literacy (composed of the Governor of the Reserve Bank of New Zealand, the Chair of the Securities Commission, the Chair of the Investment, Savings and Insurance Association, the Secretary for Education, the Associate Dean for Mâori and Pacific Development at the University of Auckland Business School, and the Retirement Commissioner) will now report to the Minister of Finance twice a year on progress in implementing the strategy.
As you may know, New Zealanders are also called “Kiwis.” The Kiwi is a flightless bird. As the story goes, Tane Mahuta, the lord of the forest, was surveying his ferny domain and became concerned that his children, the trees, were ill from being eaten by bugs. He called the birds together to ask if any might be prepared to eat the bugs, which would entail living on the dark, damp forest floor. The Kiwi put himself forward. As a reward it became the best-known and most-loved bird of all.
It is good to have such a symbol in a country so hard at work to improve financial literacy. Can they improve financial literacy? The answer I heard at the conference was: Yes, we can!
Friday, July 3, 2009
Friday, June 19, 2009
Protecting Consumers: Regulation is not Enough
This week, the Obama administration laid out a financial reform plan that included the creation of a Consumer Financial Protection Agency. This and the Credit CARD Act of 2009, which was passed in Congress last month, are important steps toward improving consumer protection in the marketplace—but without a renewed focus on promoting financial literacy and financial education programs, these initiatives will fall flat.
Financial literacy is an essential tool for consumers trying to navigate today’s world, where they engage in a myriad of financial transactions in an increasingly complex financial marketplace. Consumers require financial literacy to make decisions related to saving, retirement planning, managing credit card debt, and acquiring mortgage loans. The transition in recent decades from defined-benefit to defined-contribution pension plans has meant that the responsibility for securing late-life financial well-being is now placed on the shoulders of consumers. Just like the fundamental skills of reading and writing, financial literacy is a key ingredient for economic success.
Promoting “transparency, simplicity, fairness, accountability, and access,” as the White House report touts, is certainly an essential goal for any effective consumer regulatory regime. However, the mere provision of accurate and clear information is often inadequate to achieve good consumer decision-making. For instance, the Truth in Lending Act of 1968 was designed to protect borrowers by requiring the disclosure of critical loan terms, such as the annual percentage rate (APR); but in fact many consumers do not understand the workings of interest rates. Without knowledgeable consumers, transparency is not enough.
And lack of financial knowledge is alarmingly widespread. In a survey of Americans that Peter Tufano of Harvard Business School and I conducted with the market research firm TNS Global, we found strikingly low levels of financial knowledge across the U.S. population. Only one-third of respondents were able to apply concepts of interest compounding to everyday situations or understand the workings of credit cards. While many American families use credit cards and carry balances, only a minority of respondents knew that borrowing at an interest rate of 20 percent, compounded annually, will lead to a doubling of debt in fewer than five years. Lack of financial literacy is particularly severe in groups that are already financially vulnerable: women, the elderly, minorities, and those who are divorced or separated. And the less financially knowledgeable pay dearly for their ignorance: the credit card fees paid by a low-knowledge individual are 50 percent higher than those paid by an average cardholder.
The Credit CARD Act of 2009 makes important strides in that it requires credit card companies to include, in the billing statement, the number of months it will take a consumer to pay off the balance if he or she makes only the minimum monthly payment. Making it easier for consumers to process information is an effective way to aid in financial decision-making.
Simplification can be taken much further: an example is the auto-enrollment IRA, one of the initiatives that the White House pushes for in its report. Automatic enrollment in pensions has been a way to substantially increase workers’ participation in defined-contribution pensions. However, this can fall short of securing retirement needs. Workers who carry credit card balances should reduce their debt rather than enroll in a pension. And automatic enrollment in pensions and IRAs is not a substitute for retirement planning; workers need to ensure they are saving for a retirement that meets their needs and goals, an objective that a one-size-fits-all automatic enrollment program might not achieve.
Increasing regulation of consumer financial products and circumscribing the set of products available to consumers, either by requiring businesses to provide “plain vanilla” financial products or by outlawing products that are deemed manipulative or misleading, as the White House outlines in its report, can be effective in limiting the scope of financial mistakes that consumers can make. However, these measures are not enough to promote long-term financial well-being.
Consumers engage in such a varied and increasingly complex array of financial transactions that it is not feasible to circumscribe and regulate all possible actions in every possible financial area, nor is it desirable. Instead, policymakers need to equip consumers with enough financial knowledge to make them capable of effective financial decision-making.
To this end, the Obama administration’s plan deserves praise for recognizing the importance of promoting financial education: the White House report envisions the Consumer Financial Protection Agency taking a “leading role” in educating consumers about finance. Consumer protection is a two-way street: it requires not just regulation and oversight of businesses but also ensuring consumers are adequately equipped to confront the array of financial choices available to them. Navigating today’s financial markets is not unlike navigating busy roads: putting up more road signs, increasing patrolling, and restricting traffic can limit accidents but if people do not know how to drive, they are still going to crash. Promoting financial literacy needs to remain not just an afterthought, but a top priority.
Financial literacy is an essential tool for consumers trying to navigate today’s world, where they engage in a myriad of financial transactions in an increasingly complex financial marketplace. Consumers require financial literacy to make decisions related to saving, retirement planning, managing credit card debt, and acquiring mortgage loans. The transition in recent decades from defined-benefit to defined-contribution pension plans has meant that the responsibility for securing late-life financial well-being is now placed on the shoulders of consumers. Just like the fundamental skills of reading and writing, financial literacy is a key ingredient for economic success.
Promoting “transparency, simplicity, fairness, accountability, and access,” as the White House report touts, is certainly an essential goal for any effective consumer regulatory regime. However, the mere provision of accurate and clear information is often inadequate to achieve good consumer decision-making. For instance, the Truth in Lending Act of 1968 was designed to protect borrowers by requiring the disclosure of critical loan terms, such as the annual percentage rate (APR); but in fact many consumers do not understand the workings of interest rates. Without knowledgeable consumers, transparency is not enough.
And lack of financial knowledge is alarmingly widespread. In a survey of Americans that Peter Tufano of Harvard Business School and I conducted with the market research firm TNS Global, we found strikingly low levels of financial knowledge across the U.S. population. Only one-third of respondents were able to apply concepts of interest compounding to everyday situations or understand the workings of credit cards. While many American families use credit cards and carry balances, only a minority of respondents knew that borrowing at an interest rate of 20 percent, compounded annually, will lead to a doubling of debt in fewer than five years. Lack of financial literacy is particularly severe in groups that are already financially vulnerable: women, the elderly, minorities, and those who are divorced or separated. And the less financially knowledgeable pay dearly for their ignorance: the credit card fees paid by a low-knowledge individual are 50 percent higher than those paid by an average cardholder.
The Credit CARD Act of 2009 makes important strides in that it requires credit card companies to include, in the billing statement, the number of months it will take a consumer to pay off the balance if he or she makes only the minimum monthly payment. Making it easier for consumers to process information is an effective way to aid in financial decision-making.
Simplification can be taken much further: an example is the auto-enrollment IRA, one of the initiatives that the White House pushes for in its report. Automatic enrollment in pensions has been a way to substantially increase workers’ participation in defined-contribution pensions. However, this can fall short of securing retirement needs. Workers who carry credit card balances should reduce their debt rather than enroll in a pension. And automatic enrollment in pensions and IRAs is not a substitute for retirement planning; workers need to ensure they are saving for a retirement that meets their needs and goals, an objective that a one-size-fits-all automatic enrollment program might not achieve.
Increasing regulation of consumer financial products and circumscribing the set of products available to consumers, either by requiring businesses to provide “plain vanilla” financial products or by outlawing products that are deemed manipulative or misleading, as the White House outlines in its report, can be effective in limiting the scope of financial mistakes that consumers can make. However, these measures are not enough to promote long-term financial well-being.
Consumers engage in such a varied and increasingly complex array of financial transactions that it is not feasible to circumscribe and regulate all possible actions in every possible financial area, nor is it desirable. Instead, policymakers need to equip consumers with enough financial knowledge to make them capable of effective financial decision-making.
To this end, the Obama administration’s plan deserves praise for recognizing the importance of promoting financial education: the White House report envisions the Consumer Financial Protection Agency taking a “leading role” in educating consumers about finance. Consumer protection is a two-way street: it requires not just regulation and oversight of businesses but also ensuring consumers are adequately equipped to confront the array of financial choices available to them. Navigating today’s financial markets is not unlike navigating busy roads: putting up more road signs, increasing patrolling, and restricting traffic can limit accidents but if people do not know how to drive, they are still going to crash. Promoting financial literacy needs to remain not just an afterthought, but a top priority.
Thursday, June 11, 2009
Are You Debt Literate?
Individuals need financial skills—perhaps more now than ever before. Financial competence has become more essential as financial markets offer more complex choices and as the responsibility for saving and investing for the future has shifted from government and employers to individuals. As the credit crisis shows, borrowing decisions are also critical. Rapid growth in household debt and its link to the current financial crisis raises the question of whether lack of financial knowledge led individuals to take out mortgages and incur credit card debt they could not afford.
To assess how much knowledge individuals have with respect to debt, Peter Tufano of Harvard Business School and I designed and fielded a survey focused specifically on debt literacy, which is an important component of overall financial literacy. (The survey was conducted in partnership with the commercial market research firm Taylor Nelson Sofres [TNS] Global. It was fielded in November 2007, with data collected via phone interviews with a representative sample of 1,000 U.S. residents.) “Debt literacy” refers to the ability to make simple decisions regarding debt contracts, applying basic knowledge about interest compounding to everyday financial choices.
Our approach to measuring debt literacy has two components. First, we asked participants to judge, or “self-report,” their financial knowledge. Second, we devised questions to assess key debt literacy concepts, such as the power of interest compounding. These questions, measuring actual financial knowledge, can be solved with simple reasoning and do not require a calculator. Take a moment to answer the questions below, then compare your results to those we obtained in the survey.
Self-reported financial knowledge:
On a scale from 1 to 7, where 1 means very low and 7 means very high, how would you assess your overall financial knowledge?
Actual financial knowledge:
A) Suppose you owe $1,000 on your credit card and the interest rate you are charged is 20% per year compounded annually. If you didn’t pay anything off, at this interest rate, how many years would it take for the amount you owe to double?
(i) 2 years;
(ii) Less than 5 years;
(iii) 5 to 10 years;
(iv) More than 10 years;
(v) Do not know.
(vi) Prefer not to answer.
B) You owe $3,000 on your credit card. You pay a minimum payment of $30 each month. At an annual percentage rate of 12% (or 1% per month), how many years would it take to eliminate your credit card debt if you made no additional new charges?
(i) Less than 5 years;
(ii) Between 5 and 10 years;
(iii) Between 10 and 15 years;
(iv) Never, you will continue to be in debt;
(v) Do not know;
(vi) Prefer not to answer.
C) You purchase an appliance which costs $1,000. To pay for this appliance, you are given the following two options: a) Pay 12 monthly installments of $100 each; b) Borrow at a 20% annual interest rate and pay back $1,200 a year from now. Which is the more advantageous offer?
(i) Option (a);
(ii) Option (b);
(iii) They are the same;
(iv) Do not know;
(v) Prefer not to answer.
Analysis of responses to these questions is not heartening. We learn that the large majority of Americans do not know about the power of interest compounding, do not realize that one can never eliminate credit card debt by making minimum payments equal to the interest payments on the debt, and do not understand the time value of money. On question A, only about 36% of respondents knew that it would take less than 5 years for debt to double if one were to borrow at an interest rate of 20%. Even though about 80% of individuals have credit cards (and usually more than one card!) and have to decide frequently whether to pay off the card or carry a balance, only 35% knew the correct answer to question B—that one can never eliminate credit card debt by making minimum payments equal to the interest payments on the debt. A meager 7% of respondents chose the most advantageous option of those presented in question C: to buy an appliance and pay $1,200 a year from now. Many preferred to give money early to the retailer. Moreover, as many as 40% of respondents indicated that paying in one lump sum or in 12 monthly payments is the same option, thus overlooking the time value of money.
Notwithstanding the poor scores on these questions, when assessing their own financial knowledge, most respondents picked values of 4 or above: in other words, most people thought they were above the mean in their financial knowledge!
This is only part of the research we have been able to do on these data, but the findings are worrisome. We are confronted every day with decisions about how to shop, how to pay for what we buy, how to manage debt. The results of this study show that Americans are not as debt literate as we think we are. Knowing what we do not know can be a first step in acquiring the knowledge we need in order to make better financial decisions.
To assess how much knowledge individuals have with respect to debt, Peter Tufano of Harvard Business School and I designed and fielded a survey focused specifically on debt literacy, which is an important component of overall financial literacy. (The survey was conducted in partnership with the commercial market research firm Taylor Nelson Sofres [TNS] Global. It was fielded in November 2007, with data collected via phone interviews with a representative sample of 1,000 U.S. residents.) “Debt literacy” refers to the ability to make simple decisions regarding debt contracts, applying basic knowledge about interest compounding to everyday financial choices.
Our approach to measuring debt literacy has two components. First, we asked participants to judge, or “self-report,” their financial knowledge. Second, we devised questions to assess key debt literacy concepts, such as the power of interest compounding. These questions, measuring actual financial knowledge, can be solved with simple reasoning and do not require a calculator. Take a moment to answer the questions below, then compare your results to those we obtained in the survey.
Self-reported financial knowledge:
On a scale from 1 to 7, where 1 means very low and 7 means very high, how would you assess your overall financial knowledge?
Actual financial knowledge:
A) Suppose you owe $1,000 on your credit card and the interest rate you are charged is 20% per year compounded annually. If you didn’t pay anything off, at this interest rate, how many years would it take for the amount you owe to double?
(i) 2 years;
(ii) Less than 5 years;
(iii) 5 to 10 years;
(iv) More than 10 years;
(v) Do not know.
(vi) Prefer not to answer.
B) You owe $3,000 on your credit card. You pay a minimum payment of $30 each month. At an annual percentage rate of 12% (or 1% per month), how many years would it take to eliminate your credit card debt if you made no additional new charges?
(i) Less than 5 years;
(ii) Between 5 and 10 years;
(iii) Between 10 and 15 years;
(iv) Never, you will continue to be in debt;
(v) Do not know;
(vi) Prefer not to answer.
C) You purchase an appliance which costs $1,000. To pay for this appliance, you are given the following two options: a) Pay 12 monthly installments of $100 each; b) Borrow at a 20% annual interest rate and pay back $1,200 a year from now. Which is the more advantageous offer?
(i) Option (a);
(ii) Option (b);
(iii) They are the same;
(iv) Do not know;
(v) Prefer not to answer.
Analysis of responses to these questions is not heartening. We learn that the large majority of Americans do not know about the power of interest compounding, do not realize that one can never eliminate credit card debt by making minimum payments equal to the interest payments on the debt, and do not understand the time value of money. On question A, only about 36% of respondents knew that it would take less than 5 years for debt to double if one were to borrow at an interest rate of 20%. Even though about 80% of individuals have credit cards (and usually more than one card!) and have to decide frequently whether to pay off the card or carry a balance, only 35% knew the correct answer to question B—that one can never eliminate credit card debt by making minimum payments equal to the interest payments on the debt. A meager 7% of respondents chose the most advantageous option of those presented in question C: to buy an appliance and pay $1,200 a year from now. Many preferred to give money early to the retailer. Moreover, as many as 40% of respondents indicated that paying in one lump sum or in 12 monthly payments is the same option, thus overlooking the time value of money.
Notwithstanding the poor scores on these questions, when assessing their own financial knowledge, most respondents picked values of 4 or above: in other words, most people thought they were above the mean in their financial knowledge!
This is only part of the research we have been able to do on these data, but the findings are worrisome. We are confronted every day with decisions about how to shop, how to pay for what we buy, how to manage debt. The results of this study show that Americans are not as debt literate as we think we are. Knowing what we do not know can be a first step in acquiring the knowledge we need in order to make better financial decisions.
Saturday, May 9, 2009
Women and Finance
Tomorrow is Mother’s Day and I want to celebrate it by writing about women. As I have documented in previous posts, there is a substantial gender difference between women and men when it comes to financial literacy: women know much less about economics and finance than men. This is true not only among older cohorts but also among younger generations. Moreover, it holds true in many of the countries in which I have studied financial literacy, including Italy, Germany, the Netherlands, and Ireland. This is not good news for anyone because women often have to fend for themselves in an increasingly complex financial world: the divorce rate is much higher than in the past, single motherhood is very high in certain demographic groups, and greater longevity for women calls for more retirement savings for women than for men. And women may be most concerned about children’s education and how to help aging parents. Being a financially savvy woman involves making difficult decisions that have important financial implications.
Despite grim statistics about financial literacy among women, in my view, the evidence about how women fare in financial decision making is far from unfavorable. Research shows that women who hold stocks trade them less frequently than men, thereby paying fewer fees and transaction costs and ending up with more wealth. Women tend to hold more conservative portfolios, and in the current environment this has worked out well. Women are also less likely to be victims of scams that seem to be disproportionately perpetrated against white men.
One reason that women might be better financial decision makers, despite displaying, in general, lower literacy than men, is that women know what they do not know. In studies of financial literacy in which participants were asked to rank their level of financial knowledge prior to being given a set of problems to measure their actual level of financial literacy, women’s low self-evaluations were fairly consistently correlated with fair to poor performance on the literacy problems. This demonstrated lack of overconfidence may prove helpful in financial decision making and in avoiding financial mistakes, and this awareness may help women to take action. As several studies about financial education show, seminars and education programs are disproportionately attended by female participants. Moreover, it is primarily women who report being affected by those programs.
A project I did here at Dartmouth College confirmed many of the findings of larger surveys and data sets. The women I interviewed consistently spoke of finance with humility and considered themselves unsophisticated investors. Yet I was struck by how articulate women were in describing their financial needs, how much they had thought about financial matters, and not only how much they cared about the financial security of their loved ones but also the provisions they made to that end.
In my view, finance is an ideal field for women. The fact that women make decisions with the well being of others in mind, that they steer clear of excessive risk, and that they do not consider themselves “financial geniuses” and “financial wizards” are characteristics that have not been fully exploited. Interestingly, women are often brought in when there is a financial crisis and confidence needs to be restored. For example, after a less than spotless record, the Securities and Exchange Commission is now headed by a woman, and its Office of Investor Education and Advocacy is also headed by a woman. Perhaps one of the ways to ensure the smooth functioning of financial institutions and contracts is to have more women in charge.
On a personal note, my mother taught me a lot about finance, and so in my family, the passion for this topic has been transmitted from mother to daughter. Happy Mother’s Day!
Despite grim statistics about financial literacy among women, in my view, the evidence about how women fare in financial decision making is far from unfavorable. Research shows that women who hold stocks trade them less frequently than men, thereby paying fewer fees and transaction costs and ending up with more wealth. Women tend to hold more conservative portfolios, and in the current environment this has worked out well. Women are also less likely to be victims of scams that seem to be disproportionately perpetrated against white men.
One reason that women might be better financial decision makers, despite displaying, in general, lower literacy than men, is that women know what they do not know. In studies of financial literacy in which participants were asked to rank their level of financial knowledge prior to being given a set of problems to measure their actual level of financial literacy, women’s low self-evaluations were fairly consistently correlated with fair to poor performance on the literacy problems. This demonstrated lack of overconfidence may prove helpful in financial decision making and in avoiding financial mistakes, and this awareness may help women to take action. As several studies about financial education show, seminars and education programs are disproportionately attended by female participants. Moreover, it is primarily women who report being affected by those programs.
A project I did here at Dartmouth College confirmed many of the findings of larger surveys and data sets. The women I interviewed consistently spoke of finance with humility and considered themselves unsophisticated investors. Yet I was struck by how articulate women were in describing their financial needs, how much they had thought about financial matters, and not only how much they cared about the financial security of their loved ones but also the provisions they made to that end.
In my view, finance is an ideal field for women. The fact that women make decisions with the well being of others in mind, that they steer clear of excessive risk, and that they do not consider themselves “financial geniuses” and “financial wizards” are characteristics that have not been fully exploited. Interestingly, women are often brought in when there is a financial crisis and confidence needs to be restored. For example, after a less than spotless record, the Securities and Exchange Commission is now headed by a woman, and its Office of Investor Education and Advocacy is also headed by a woman. Perhaps one of the ways to ensure the smooth functioning of financial institutions and contracts is to have more women in charge.
On a personal note, my mother taught me a lot about finance, and so in my family, the passion for this topic has been transmitted from mother to daughter. Happy Mother’s Day!
Sunday, April 26, 2009
Some Suggestions to Address the Retirement Saving Crisis
As millions of American families have witnessed their retirement savings vanish and their prospects for retirement become grimmer and grimmer, it is important to find ways to help people secure a comfortable retirement. My newly published book, Overcoming the Saving Slump: How to Increase the Effectiveness of Financial Education and Saving Programs, and much of my research work identify reasons people do not prepare adequately for retirement and offer suggestions to address this saving crisis. Here is a list of 5 important points:
1. Workers are in charge but information about pensions is needed.
Retirement accounts such as IRAs and 401(k)s currently constitute a large share of retirement wealth in the economy. Because these are individually managed accounts, individual decisions about these accounts will determine how this wealth grows. But research shows us that individuals know very little about pensions: half of older workers in the United States do not even know which type of pension plan they have, let alone the amount so far accumulated in their retirement accounts. Workers also display a lack of knowledge about another important source of retirement income: Social Security. While the increase in individual responsibility should work as an incentive for individuals to become more knowledgeable and informed about their retirement plans, we must be cautious about relying simply on individual initiative. Lack of understanding of critical components of pensions is widespread even in economies where personal retirement accounts have been in place for much longer than they have in the United States. In Chile, which adopted personal retirement accounts more than 25 years ago, fewer than half of participants know how much they contribute to the system, even though the contribution rate has been set at 10 percent of pay since the system’s inception. In Sweden, which implemented comprehensive pension reform during the 1990s, the level of knowledge is also low. Providing information about the characteristics and features of pension plans and Social Security should be a priority. This information will help individuals successfully plan for their retirement and better prepare for their future.
2. Financial literacy is an essential tool for making financial decisions, but the majority of individuals are not financially literate.
Most individuals lack knowledge of the basic principles underlying saving and investment decisions: concepts such as the power of interest compounding, the effects of inflation, and the workings of risk diversification. Knowledge of more advanced concepts, such as basic asset pricing and the difference between bonds and stocks is even scarcer. When asked to rank their knowledge, many employees rank themselves as simple investors who know little about stocks and mutual funds. This lack of knowledge is problematic in a pension system where workers have to decide not only how much to save but also how to invest their pension wealth. Given the complexity of current financial instruments and of the financial decisions required in everyday life, individuals need to be financially literate. Just as it is impossible to live well and operate effectively in the modern world without being literate, i.e., knowing how to read and write, so it is becoming increasingly difficult to live well and operate effectively in today’s world without financial literacy. We need to find ways to improve financial literacy and schools seem a good place to start.
3. Financial education is important and can be made more effective.
Lack of information and lack of literacy hardly exhaust the list of variables that can affect individual behavior. The many differences among individuals must be taken into account for successful implementation of financial education programs. Targeted education programs may better serve the needs of specific groups of the population, such as women, younger and older individuals, and those with low income. The workplace seems an ideal venue for the delivery of financial education. However, one-time financial education seminars—typical of the programs offered by many employers—are insufficient to address widespread financial illiteracy and lack of information, so we need to consider better ways to educate people. One way to increase the effectiveness of financial education is to deliver it at “teachable moments.” For example, new hires are particularly receptive to information and education since they have to make decisions about their benefit and pension plans at the start of a new job.
4. Saving for retirement means taking care of the family finances.
Automatically enrolling people in pension plans (what is currently done by many firms) does not mean that we are helping families save for retirement. If families are carrying credit card or other high-cost debt, they should first try to take care of their debt and then put money away for retirement. My recent research shows that many families carry credit card debt and pay not only interest charges but also high fees. In my view, debt management can be an effective way to help people save for retirement. Similarly, helping families save for their children’s education is another way in which we can promote saving, including saving for retirement. Some credit card commercials are suggesting that spending is actually a way to save for retirement. In this case, I am pretty sure they have the equation wrong!
5. Keep it simple.
Saving decisions are complex. They require calculations that look pretty nasty (they are) and the ability to make a lot of assumptions about variables in the future (nasty too). They require collecting a lot of information and, in the current economy, making sense of this crisis. Let’s simplify this process as much as possible by, for example, providing easy to access information, planning aids, and financial advice. Since April 15 has just passed, let me end by saying that we already have complicated taxes; we do not need our saving to be equally complicated (got Roth IRAs?).
1. Workers are in charge but information about pensions is needed.
Retirement accounts such as IRAs and 401(k)s currently constitute a large share of retirement wealth in the economy. Because these are individually managed accounts, individual decisions about these accounts will determine how this wealth grows. But research shows us that individuals know very little about pensions: half of older workers in the United States do not even know which type of pension plan they have, let alone the amount so far accumulated in their retirement accounts. Workers also display a lack of knowledge about another important source of retirement income: Social Security. While the increase in individual responsibility should work as an incentive for individuals to become more knowledgeable and informed about their retirement plans, we must be cautious about relying simply on individual initiative. Lack of understanding of critical components of pensions is widespread even in economies where personal retirement accounts have been in place for much longer than they have in the United States. In Chile, which adopted personal retirement accounts more than 25 years ago, fewer than half of participants know how much they contribute to the system, even though the contribution rate has been set at 10 percent of pay since the system’s inception. In Sweden, which implemented comprehensive pension reform during the 1990s, the level of knowledge is also low. Providing information about the characteristics and features of pension plans and Social Security should be a priority. This information will help individuals successfully plan for their retirement and better prepare for their future.
2. Financial literacy is an essential tool for making financial decisions, but the majority of individuals are not financially literate.
Most individuals lack knowledge of the basic principles underlying saving and investment decisions: concepts such as the power of interest compounding, the effects of inflation, and the workings of risk diversification. Knowledge of more advanced concepts, such as basic asset pricing and the difference between bonds and stocks is even scarcer. When asked to rank their knowledge, many employees rank themselves as simple investors who know little about stocks and mutual funds. This lack of knowledge is problematic in a pension system where workers have to decide not only how much to save but also how to invest their pension wealth. Given the complexity of current financial instruments and of the financial decisions required in everyday life, individuals need to be financially literate. Just as it is impossible to live well and operate effectively in the modern world without being literate, i.e., knowing how to read and write, so it is becoming increasingly difficult to live well and operate effectively in today’s world without financial literacy. We need to find ways to improve financial literacy and schools seem a good place to start.
3. Financial education is important and can be made more effective.
Lack of information and lack of literacy hardly exhaust the list of variables that can affect individual behavior. The many differences among individuals must be taken into account for successful implementation of financial education programs. Targeted education programs may better serve the needs of specific groups of the population, such as women, younger and older individuals, and those with low income. The workplace seems an ideal venue for the delivery of financial education. However, one-time financial education seminars—typical of the programs offered by many employers—are insufficient to address widespread financial illiteracy and lack of information, so we need to consider better ways to educate people. One way to increase the effectiveness of financial education is to deliver it at “teachable moments.” For example, new hires are particularly receptive to information and education since they have to make decisions about their benefit and pension plans at the start of a new job.
4. Saving for retirement means taking care of the family finances.
Automatically enrolling people in pension plans (what is currently done by many firms) does not mean that we are helping families save for retirement. If families are carrying credit card or other high-cost debt, they should first try to take care of their debt and then put money away for retirement. My recent research shows that many families carry credit card debt and pay not only interest charges but also high fees. In my view, debt management can be an effective way to help people save for retirement. Similarly, helping families save for their children’s education is another way in which we can promote saving, including saving for retirement. Some credit card commercials are suggesting that spending is actually a way to save for retirement. In this case, I am pretty sure they have the equation wrong!
5. Keep it simple.
Saving decisions are complex. They require calculations that look pretty nasty (they are) and the ability to make a lot of assumptions about variables in the future (nasty too). They require collecting a lot of information and, in the current economy, making sense of this crisis. Let’s simplify this process as much as possible by, for example, providing easy to access information, planning aids, and financial advice. Since April 15 has just passed, let me end by saying that we already have complicated taxes; we do not need our saving to be equally complicated (got Roth IRAs?).
Sunday, March 8, 2009
Overcoming the Saving Slump: How to Increase the Effectiveness of Financial Education and Saving Programs
In the previous blog, I have described a specific program about how to help people save. I would like to describe now a set of ideas I have pursued in my newly published book: “Overcoming the saving slump: How to increase the effectiveness of financial education and saving programs.”
This book explores the many challenges that have arisen in the transition to a pension system that requires more individual responsibility, focusing on micro behavior as it relates to saving and pensions and illustrating the impediments and barriers to saving. The issues at hand have not gone unnoticed. The financial industry, employers, and the government have taken initiatives to promote saving and financial education programs. The financial industry has developed and provided products that can better suit the needs of investors. In addition, financial education programs have been offered in different forms and from different institutions. This book tries to evaluate whether and how these developments are helping to effectively bridge the way to a new system. The authors who have contributed to this book have analyzed programs that are in place, examined available investment products, and taken a close look at the experiences of countries that have privatized their pension systems or experienced changes in their Social Security systems. From these contributions emerge what is perhaps the most important objective of this book: to provide suggestions on how to improve the effectiveness of these programs and products, thereby enabling the United States to make the transition to this new system more smoothly.
The economic changes that are occurring in the pension landscape in the United States are well documented in the first chapter of this book, which traces the increase of individual retirement accounts that has occurred in recent decades. Workers retiring before the 1980s relied mostly on Social Security and employer-sponsored defined benefit pension plans for their retirement income. The situation is very different for current workers, who will reach retirement with a different mix of funds—not only Social Security and defined benefit plans, but also personal retirement accounts, including IRAs and defined contribution pension plans. One characteristic of these accounts is that individuals are in charge of deciding how much to contribute and how to allocate their retirement savings. Moreover, individuals must decide how to decumulate their wealth when they reach retirement. A comprehensive retirement planning strategy requires consideration not only of how to save but also how to spend down wealth. Individuals have to make sure that retirement wealth lasts a lifetime (chapter six). The risk of individuals making costly mistakes in their saving and retirement planning are real. Throughout the book, evidence is shown of widespread financial illiteracy in the United States (chapters nine and thirteen). In addition, workers are found to be sorely lacking knowledge about their pensions. Chapter two documents that only about half of older workers know about their pension plans.
Lack of information and lack of financial literacy provide fertile ground for financial errors. Left to their own devices, employees may choose to invest their pension wealth in either too-conservative or too-aggressive assets. An analysis of portfolio allocation from a large sample of Vanguard investors (2,000 defined contribution plans and nearly 2.9 million 401(k) participants) in chapter four offers compelling evidence that portfolio allocation can be improved upon. Economic theory also suggests that life annuities can substantially increase welfare by eliminating the risk associated with uncertain life expectancies and providing consumers with a higher level of lifetime consumption. Yet, as described in chapter six, most individuals do not annuitize as often as the theory predicts, if they annuitize at all. And there are problems in relying on financial advice, as explained in chapter three, as the incentives of financial intermediaries do not always line up with the incentives of investors.
One of the key objectives of this book is to provide suggestions on how to increase the effectiveness of financial education programs. Effectively designing education and saving programs needs to take into account a number of factors: identification of barriers to effective saving, differences among demographic groups, and flexible program design. A variety of barriers are described throughout the book, from lack of literacy to lack of information to behavioral biases. However, this hardly exhausts the list of things that can affect individual behavior. The research that deals with increasing the effectiveness of financial education and saving programs, discussed in chapters seven, eight, ten, and thirteen, points to a variety of factors that need to be considered. Because individuals differ widely in their barriers to saving, it is important to develop methods to uncover those barriers. In designing effective programs, approaches such as in-depth interviews, focus groups, and ethnographic studies may need to be employed. The many differences among individuals must also be taken into account for successful implementation of financial education programs. Targeted education programs may better serve the needs of specific groups of the population, such as women, younger and older individuals, and those with low income. Chapters throughout the book document the many differences that exist among these groups. Furthermore, chapter seven shows that, to both understand and exploit differences in individual behavior, it is important to incorporate concepts of marketing and psychology into economics.
Fundamentally, to overcome the saving slump, as is discussed in chapter ten, it is important to create an infrastructure that promotes saving and asset accumulation. Such infrastructure would include not only effectively designed financial education and saving programs but also a variety of policies and initiatives to stimulate saving. For example, access to saving opportunities can be fundamental. About half of private-sector workers have jobs that do not offer pensions, making it particularly difficult for those workers to accumulate retirement wealth, and it is important to find ways to facilitate saving among those individuals. Low income households also display little or no savings. However, specific programs targeted to the poor have been proven to be effective in stimulating saving among this group of the population. Another important policy demand, given the findings of widespread financial illiteracy among high school students reported in chapter nine, is to prepare young people for financial life. This is a challenging task and a lot more has to be done to find effective ways to teach financial education in schools. As discussed in more detail in chapter ten, such infrastructure should pay attention to program design. For example, centralized and efficient accounting, low-cost investment options, and outreach can play important roles in stimulating saving. Moreover, the experiences of other countries offer important lessons for the United States. While the increase in individual responsibility that is required in the system we’re transitioning to provides incentives for individuals to become knowledgeable and informed, one has to be cautious about relying simply on individual initiative as the experiences of Chile, Sweden, and OECD countries described in chapters eleven, twelve and thirteen can teach us.
My aim in editing this book is to illuminate the issues facing so many Americans in regards to saving and retirement planning and to evaluate the existing programs and products that have been designed to facilitate saving. My hope is that such a close look at the situation faced today by individuals, businesses, and policymakers will help to provide a foundation to continue to devise effective financial education and saving programs, which can contribute to overcoming America’s saving slump.
More information about the book is available at: http://www.dartmouth.edu/~alusardi/book.html
This book explores the many challenges that have arisen in the transition to a pension system that requires more individual responsibility, focusing on micro behavior as it relates to saving and pensions and illustrating the impediments and barriers to saving. The issues at hand have not gone unnoticed. The financial industry, employers, and the government have taken initiatives to promote saving and financial education programs. The financial industry has developed and provided products that can better suit the needs of investors. In addition, financial education programs have been offered in different forms and from different institutions. This book tries to evaluate whether and how these developments are helping to effectively bridge the way to a new system. The authors who have contributed to this book have analyzed programs that are in place, examined available investment products, and taken a close look at the experiences of countries that have privatized their pension systems or experienced changes in their Social Security systems. From these contributions emerge what is perhaps the most important objective of this book: to provide suggestions on how to improve the effectiveness of these programs and products, thereby enabling the United States to make the transition to this new system more smoothly.
The economic changes that are occurring in the pension landscape in the United States are well documented in the first chapter of this book, which traces the increase of individual retirement accounts that has occurred in recent decades. Workers retiring before the 1980s relied mostly on Social Security and employer-sponsored defined benefit pension plans for their retirement income. The situation is very different for current workers, who will reach retirement with a different mix of funds—not only Social Security and defined benefit plans, but also personal retirement accounts, including IRAs and defined contribution pension plans. One characteristic of these accounts is that individuals are in charge of deciding how much to contribute and how to allocate their retirement savings. Moreover, individuals must decide how to decumulate their wealth when they reach retirement. A comprehensive retirement planning strategy requires consideration not only of how to save but also how to spend down wealth. Individuals have to make sure that retirement wealth lasts a lifetime (chapter six). The risk of individuals making costly mistakes in their saving and retirement planning are real. Throughout the book, evidence is shown of widespread financial illiteracy in the United States (chapters nine and thirteen). In addition, workers are found to be sorely lacking knowledge about their pensions. Chapter two documents that only about half of older workers know about their pension plans.
Lack of information and lack of financial literacy provide fertile ground for financial errors. Left to their own devices, employees may choose to invest their pension wealth in either too-conservative or too-aggressive assets. An analysis of portfolio allocation from a large sample of Vanguard investors (2,000 defined contribution plans and nearly 2.9 million 401(k) participants) in chapter four offers compelling evidence that portfolio allocation can be improved upon. Economic theory also suggests that life annuities can substantially increase welfare by eliminating the risk associated with uncertain life expectancies and providing consumers with a higher level of lifetime consumption. Yet, as described in chapter six, most individuals do not annuitize as often as the theory predicts, if they annuitize at all. And there are problems in relying on financial advice, as explained in chapter three, as the incentives of financial intermediaries do not always line up with the incentives of investors.
One of the key objectives of this book is to provide suggestions on how to increase the effectiveness of financial education programs. Effectively designing education and saving programs needs to take into account a number of factors: identification of barriers to effective saving, differences among demographic groups, and flexible program design. A variety of barriers are described throughout the book, from lack of literacy to lack of information to behavioral biases. However, this hardly exhausts the list of things that can affect individual behavior. The research that deals with increasing the effectiveness of financial education and saving programs, discussed in chapters seven, eight, ten, and thirteen, points to a variety of factors that need to be considered. Because individuals differ widely in their barriers to saving, it is important to develop methods to uncover those barriers. In designing effective programs, approaches such as in-depth interviews, focus groups, and ethnographic studies may need to be employed. The many differences among individuals must also be taken into account for successful implementation of financial education programs. Targeted education programs may better serve the needs of specific groups of the population, such as women, younger and older individuals, and those with low income. Chapters throughout the book document the many differences that exist among these groups. Furthermore, chapter seven shows that, to both understand and exploit differences in individual behavior, it is important to incorporate concepts of marketing and psychology into economics.
Fundamentally, to overcome the saving slump, as is discussed in chapter ten, it is important to create an infrastructure that promotes saving and asset accumulation. Such infrastructure would include not only effectively designed financial education and saving programs but also a variety of policies and initiatives to stimulate saving. For example, access to saving opportunities can be fundamental. About half of private-sector workers have jobs that do not offer pensions, making it particularly difficult for those workers to accumulate retirement wealth, and it is important to find ways to facilitate saving among those individuals. Low income households also display little or no savings. However, specific programs targeted to the poor have been proven to be effective in stimulating saving among this group of the population. Another important policy demand, given the findings of widespread financial illiteracy among high school students reported in chapter nine, is to prepare young people for financial life. This is a challenging task and a lot more has to be done to find effective ways to teach financial education in schools. As discussed in more detail in chapter ten, such infrastructure should pay attention to program design. For example, centralized and efficient accounting, low-cost investment options, and outreach can play important roles in stimulating saving. Moreover, the experiences of other countries offer important lessons for the United States. While the increase in individual responsibility that is required in the system we’re transitioning to provides incentives for individuals to become knowledgeable and informed, one has to be cautious about relying simply on individual initiative as the experiences of Chile, Sweden, and OECD countries described in chapters eleven, twelve and thirteen can teach us.
My aim in editing this book is to illuminate the issues facing so many Americans in regards to saving and retirement planning and to evaluate the existing programs and products that have been designed to facilitate saving. My hope is that such a close look at the situation faced today by individuals, businesses, and policymakers will help to provide a foundation to continue to devise effective financial education and saving programs, which can contribute to overcoming America’s saving slump.
More information about the book is available at: http://www.dartmouth.edu/~alusardi/book.html
Saturday, February 21, 2009
New Ways to Help People Save
As I have pointed out in previous posts, it is not easy for people to save. There are many barriers that prevent us from saving. Some are really hard to overcome, such as the size of our income, having a large family, or being hit with unexpected expenses. But other barriers may be reduced or even eliminated. I learned a lot about saving decisions in an initiative I did (together with other co-authors) here at Dartmouth College. Our aim was to foster participation in the Supplementary Retirement Accounts (SRA) that Dartmouth offers but that many employees do not take advantage of. We conducted focus groups and in-depth interviews and distributed surveys to enable us to hear what employees had to say about their savings. It was a humbling experience. It is remarkable and exciting to see how smart people are about their objectives and how articulate they are about what is important to them. On the other hand, there was a gulf between what people aimed for and their perceived ability to get there. We heard over and over, “I am not a sophisticated investor,” and “I do not know where to start.” We thought we could do something about that: we have Ph.D.s in this place and we could put them to use.
We provided a group of employees with a planning aid—a one page document—to help with saving in several ways. First, the planning aid provided the information that employees needed to set up an SRA, such as maximum and minimum contribution amounts and the list of the College’s pension providers. Second, it broke the SRA enrollment process into simple steps with an estimate of how much time each step would take. It also provided information about whom to contact for help, where computers would be available (the enrollment had to be done online), and how to avoid problems with the online registration timing out. Finally, the aid included a reminder about why it is important to save. We adhered to what the employees had told us over and over: they save for their family (I could not agree more; this is why I save, too), and we included a picture on the back of the planning aid of a family exchanging gifts.
We distributed the planning aid to new employees during employee orientation. Our objective was to provide information and facilitate decision making at the time decisions needed to be made. We also set up a method for evaluating this initiative. What good is a program if you do not know whether it works?
This simple and rather inexpensive aid proved to be very effective. The new employees who received the planning aid were more than twice as likely to participate in SRAs as those who were not exposed to the planning aid. This initiative was undertaken well before the onset of the current financial crisis and we do not yet know how the crisis will affect individuals’ decision to participate in an SRA. But our data collection process is continuing and we will soon find out.
There are a few things about this project that really resonate with me. I remember one focus group participant who told us about his dreams for retirement and how important it was for him to plan for retirement. Another, echoing so many others we interviewed, explained to us how her saving was shaped by the experience of her family. We asked one young man we interviewed over the phone what he would have liked to see done to help him save. He hesitated a little and then said, “You know, this phone call is already helpful.”
I have worked on many projects, written many papers, and worked with many data sets, but only with this project could I finally see and hear the depth and richness of individual stories about the importance of saving. The faces behind the numbers, the distinct reasons for saving or not saving, and the struggles behind people’s decisions became so vivid and have enriched my research work in a unique way.
There is not a simple way to help people save. But what I learned from this project is that simplification should not be undervalued, and we should not assume that people have all the necessary, basic information at their fingertips. I have also learned that people are very different and that those differences should be taken into account when devising saving initiatives. And there are simple things that can be done to remind people about the importance of saving, things as uncomplicated as a phone call.
If you are interested in reading a copy of the paper that describes this project, it is available on my web page at: http://www.dartmouth.edu/~alusardi/Papers/Lusardi_Keller_Keller.pdf
We provided a group of employees with a planning aid—a one page document—to help with saving in several ways. First, the planning aid provided the information that employees needed to set up an SRA, such as maximum and minimum contribution amounts and the list of the College’s pension providers. Second, it broke the SRA enrollment process into simple steps with an estimate of how much time each step would take. It also provided information about whom to contact for help, where computers would be available (the enrollment had to be done online), and how to avoid problems with the online registration timing out. Finally, the aid included a reminder about why it is important to save. We adhered to what the employees had told us over and over: they save for their family (I could not agree more; this is why I save, too), and we included a picture on the back of the planning aid of a family exchanging gifts.
We distributed the planning aid to new employees during employee orientation. Our objective was to provide information and facilitate decision making at the time decisions needed to be made. We also set up a method for evaluating this initiative. What good is a program if you do not know whether it works?
This simple and rather inexpensive aid proved to be very effective. The new employees who received the planning aid were more than twice as likely to participate in SRAs as those who were not exposed to the planning aid. This initiative was undertaken well before the onset of the current financial crisis and we do not yet know how the crisis will affect individuals’ decision to participate in an SRA. But our data collection process is continuing and we will soon find out.
There are a few things about this project that really resonate with me. I remember one focus group participant who told us about his dreams for retirement and how important it was for him to plan for retirement. Another, echoing so many others we interviewed, explained to us how her saving was shaped by the experience of her family. We asked one young man we interviewed over the phone what he would have liked to see done to help him save. He hesitated a little and then said, “You know, this phone call is already helpful.”
I have worked on many projects, written many papers, and worked with many data sets, but only with this project could I finally see and hear the depth and richness of individual stories about the importance of saving. The faces behind the numbers, the distinct reasons for saving or not saving, and the struggles behind people’s decisions became so vivid and have enriched my research work in a unique way.
There is not a simple way to help people save. But what I learned from this project is that simplification should not be undervalued, and we should not assume that people have all the necessary, basic information at their fingertips. I have also learned that people are very different and that those differences should be taken into account when devising saving initiatives. And there are simple things that can be done to remind people about the importance of saving, things as uncomplicated as a phone call.
If you are interested in reading a copy of the paper that describes this project, it is available on my web page at: http://www.dartmouth.edu/~alusardi/Papers/Lusardi_Keller_Keller.pdf
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