Friday, January 13, 2017

Six Questions to Help Determine Your Financial Health

This blog post was also posted on the Wall Street Journal and can be found here

Many people, when thinking about their financial health, focus on a single indicator, such as whether they are saving enough for retirement or carrying too much student-loan debt. If personal finances were limited to--or fixed by--a single line item in the balance sheet, that approach would be fine.

But they aren’t.

During an annual physical exam, it is not possible to assess how well a patient is doing simply by checking the heart rate or blood pressure. Rather, a more comprehensive series of evaluations are needed. How well is the patient managing his or her health? Is the patient taking medicines as prescribed? Is the patient exercising and eating well?

The same is true of financial health.

Fortunately, there is a short financial checkup that effectively predicts what I think of as the key components of financial health--including short-term and long-term savings, management of financial products and financial literacy. The six-question test, which is based on a body of national and international research, evaluates four key areas: 1) ability to make ends meet, 2) advance planning, 3) management of financial products and 4) financial knowledge. (More in-depth questions from a national survey on financial capability, now in its third wave, are available online.)

Taken together, the questions below--and their answers--provide a starting point for people to better understand and improve their personal finances.

1. How confident are you that you could come up with $2,000 if an unexpected need arose within the next month?
-  I am certain I could come up with the full $2,000.
-  I could probably come up with $2,000.
-  I could probably not come up with $2,000.
-  I am certain I could not come up with $2,000.

This first question of the test assesses financial fragility--or the ability to mobilize resources when facing a shock. It is a rich measure that goes well beyond availability of or access to liquid assets, taking into consideration that one could deal with a shock by borrowing, by relying on the help of family and friends, by selling possessions or through other strategies. Moreover, it is a summary measure of the balance-sheet situation (not just assets) even as it addresses how one manages resources. Research links the lack of resources or the inability to access them when facing a midsize shock (specifically, answering this question with either of the last two responses) with indicators of financial distress.

2. Have you ever tried to figure out how much you need to save for retirement?

This question measures advance planning by examining the longer-term horizon and whether one has made plans for the future. While simple and intuitive, the question looks yet again at the state of personal finances and, in particular, at the steps taken to accumulate retirement savings, which can take many forms, including keeping within a budget. Academic research shows that those who answer affirmatively to this question have up to three times the amount of wealth as they near retirement as those who have not made any plans.

3. On a scale from 1 to 7 (where 1 = strongly disagree and 7= strongly agree), how strongly do you agree or disagree with the following statement: I have too much debt right now.

The third question turns to the liability side of the balance sheet. There are many opportunities to borrow and a multitude of options for doing so. Many young employees today start their working life in debt. The answer to this question reveals both the extent of the respondent’s debt burden and his or her management of finances. Those who choose value above the median (value 4 ) are found to carry not only several forms of debt, both short term and long term, but also to use high-cost methods of borrowing, such as payday loans.

The next three questions measure understanding of the ABCs of personal finance. They apply to the many financial decisions people have to make and that, ultimately, shape their finances and ability to achieve financial security in the short and long term. The questions address fundamental concepts--interest compounding, inflation and risk diversification--that underlie financial decisions, from day-to-day money management, to saving and investing for retirement, to borrowing.

Those who correctly answer the three questions reported below (the correct answers are the end) are not only less likely to be financially fragile and over indebted, but they are also more likely to plan for the future and to engage in many other behaviors conducive to higher retirement savings.

4. Suppose you had $100 in a savings account and the interest rate was 2% per year.  After five years, how much do you think you would have in the account if you left the money to grow?
-  More than $102
-  Exactly $102
-  Less than $102
-  Don’t know

5. Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After one year, with the money in this account, would you be able to buy…
-  More than today
-  Exactly the same as today
-  Less than today
-  Don’t know

6. Do you think the following statement is true or false? Buying a single company stock usually provides a safer return than a stock mutual fund.
Rather than looking at a single behavior--an approach that usually is inadequate for evaluating how someone is doing financially--this test provides an encompassing measure of financial capability. It also identifies the areas where help may be needed.  Even more, it allows individuals to compare their results to those of the average American. The findings for each question are available here.

As employers and others look for ways to help employees become financially fit, this test may provide them with a tool to measure, assess, and reconsider what they are doing. Perhaps it is something to add to employee benefits in 2017.

(Answers: 4. More than $102;  5. Less than today; 6. False.)

Friday, April 1, 2016

Happy Financial Literacy Month!

This is a slighly modified blog that was published in Forbes. The link is here:
April is Financial Literacy Month. You might suspect there is a problem with financial literacy in America, if an entire month is dedicated to it! And you would be right.

The S&P Global Financial Literacy Survey released last fall showed that only 57 percent of adult Americans know basic financial literacy concepts such as interest compounding, inflation, and risk diversification. And high school students do no better: the Programme for International Student Assessment (PISA) reported that 18 percent of US students do not reach the baseline level of proficiency in financial literacy. Moreover, Millennials don’t learn much about financial literacy after they leave high school, according to the National Financial Capability Study.

For this reason, April is an opportune time to look at three efforts that may have a chance to combat financial illiteracy. These are chosen because of their scalability and capacity to make a real difference for financial literacy in America.

Financial literacy in school: According to the Council for Economic Education, only 19 states require schools to offer a personal finance course. This does not bode well, considering that the student loan market has now surpassed $1 trillion, and student loans are a deep worry for many young adults.

Teaching kids about financial matters in school can help. For instance, students exposed to a rigorous financial literacy program are much less likely to get into trouble with debt after they graduate, according to recent research. We don’t need a federal or state mandate to add financial literacy in schools: parents can simply ask their school districts for such courses. After all, nations around the world have now agreed: financial literacy is essential to participate in society in the 21st century.

Financial literacy in the workplace: Many companies today offer defined contribution pensions, which put workers in charge of deciding both how much to save and how to invest their pension assets. And health plans also require participants to be more financially savvy, to manage high deductibles, copays, and Health Saving Accounts, and to compare prices for medical care.

For this reason, workplace financial education programs are often provided to educate employees on how to manage these decisions. Yet employers can benefit as well, since the stress generated by money problems can translate into lower worker productivity, higher absenteeism, and more turnover. In our tightening labor market, an employer who offers help with money management or debt can readily attract and retain workers. Some firms have even stepped up to help relieve employees of student loan obligations, which can improve worker loyalty.

Financial literacy in the community. One particularly noteworthy program, both for its potential impact and scalability, comes from the American Library Association. Every community, big or small, has a library—a place where anyone, young or old, can go to learn, including via easy access to the Internet. As hubs for knowledge and information, libraries are ideal venues in which to provide financial education. Through the Association, programs that prove especially effective in one place can be extended nationwide. Libraries can also complement school or workplace financial literacy programs.

Financial literacy won’t change overnight, nor in a month or even a year. Yet initiatives taken in schools, workplaces, and in communities add up. My hope is that someday, in the future, the month of April can be re-dedicated to another topic!

Sunday, February 7, 2016

Looking for a Super Bowl cheer that lasts a lifetime

This a slighly modified version of the blog I wrote for the Wall Street Journal in collaboration with Colin Camerer. The WSJ blog is posted here :

The winners of this Sunday’s Super Bowl will have much to celebrate. In addition to their team victory, the players will see substantial financial bonuses, including potentially richer contracts and future sponsorships. Even the players who lose at football will be financial winners. After all, they, too, made it to the Super Bowl, one of the world’s most-watched sporting events.
The 2016 championship game may mark the career finale for some of these extraordinary players. Will Peyton Manning retire after this year? Will anyone else leave football? If they do, sad to say, they may be in for some bad news. Our research shows that a surprising number of NFL players declare bankruptcy not long after they retire.
For our research published last year in the American Economic Review, we collected data on more than 2,000 players—all of those who were drafted by the NFL from 1996 to 2003—and followed them until 2013. We were interested in seeing how well football players do, financially, after they leave the game. Because it is very hard to find out how much they earned and spent after they retire, we looked at a simple measure of financial distress which is publicly available: bankruptcy filings. And we found that things did not go well at all.
Football players, even those with short careers, usually earn more than what most college-educated workers earn during a lifetime. Because NFL careers are so short, the players’ post-NFL retirements can be long. Many get other jobs, but only a tiny percentage end up with coveted high-salary jobs such as sportscasting. Following all the players together as a group, as they retire, players start going bankrupt.  After 12 years in post-NFL retirement, more than 15 percent of the players we followed had declared bankruptcy. We also found that bankruptcy does not depend on how much an NFL player earned in their career or how long he plays. Amazingly, higher income or longer careers seem to offer little protection against bankruptcy.
These findings have been documented, with some variation, by other sources. There are numerous news stories and interviews describing instances where players have lost all the money they earned. Unfortunately, we continue to witness this phenomenon each year.
We offer three recommendations that could help keep these professional athletes celebrating financial success long after the Super Bowl. These guidelines apply to anyone who finds himself/herself with a lot of money earned in a very lucrative short-lived career.
First, become financially literate. Exposure to basic financial knowledge helps young people understand not just the workings of interest rates and financial markets, but it also builds healthy habits around money and money management. The opportunity to become financially literate before contracts are signed and large sums of money are earned is probably the best medicine for the financial health of these high-earning young professionals.
Second, learn to manage money. Money-management training could be a key part of contract signings or receipt of bonuses. Athletes are used to the kind of training that requires enormous discipline, and they are very good at it. Comprehensive money-management training could offer information that goes beyond simple recommendations for investments or rookie camps. Players could get training that helps them to figure out how far into the future their money can last, how to build a budget that allows them to achieve their objectives, and how to help their families and friends without putting themselves at financial risk. An extra benefit is that managing their own money well makes them into financial role models in addition to athletic role models. The same traits that make players successful on the field—practice, persistence, and the ability to overcome setbacks—can make them successful in managing their finances.
Third, choose a pay structure wisely. Financial advisors often tell big lottery winners to arrange their winnings to be paid over decades, rather than in one tempting lump sum.  How about a system that offers remuneration as a series of payments over a long period of time? This option could generate a stable standard of living for those players who prefer not to engage in complex money management decisions. It also has the benefit of showing how far the money that athletes receive in a single contract can, indeed, go.  After all, the income earned by college-educated people who are not professional athletes is distributed over a lifetime. And it is a way to tie ones’ hand and resist the temptation to spend it all. A lot of research has shown that these types of commitment devices work like wonder.
Wouldn’t it be something if the winners in this year’s Super Bowl could wear their Super Bowl ring proudly for the rest of their lives, rather than having to sell it some day to stay afloat?
Colin Camerer is a neuroeconomist and the Robert Kirby Professor of Behavioral Economics at the California Institute of Technology. In 2013, he was awarded the MacArthur Fellowship

Friday, January 22, 2016

Understanding the Implications of an Interest Rate Hike

This is a slightly modified version of the blog I wrote for Forbes.

Pundits keep a close watch on the U.S. Federal Reserve as it meets to raise interest rates after seven years of effectively zero rates. Yet the reality is that many Americans know little about interest rates, and much less about the implications of a rate hike for their finances!  This was one key finding from the recently released S&P Global FinLit Survey, gathered with the support of McGraw Hill Financial.

The goal of the international study was to compare adult financial literacy levels across more than 140 nations. Financial literacy was measured using questions assessing basic knowledge of four fundamental concepts: numeracy or capacity to do simple calculations in the context of interest rates, interest compounding, inflation, and risk diversification. Respondents were deemed “financially literate” if they could correctly answer three of the four questions. The Global Financial Literacy Excellence Center helped design the survey and analyze the results.

Staggeringly, we found that only one in three adults is financially literate around the world. While Americans far a bit better, only a little more than half of US adults scores this well, a finding that bodes ill for one of the world’s most advanced financial markets.

More importantly, our research has also identified what people don’t know about their finances. One giant void has to do with compound interest, despite the fact that many are quite vulnerable to interest rate changes. For example, when combining information with the Global Findex data, we find only 66% of Americans who hold credit cards understand interest compounding. In Brazil, Latin America’s largest economy, only about half of credit-card holders can accurately answer our interest-compounding question. Similar results apply to borrowers elsewhere. The logical implication is that, whatever the Federal Reserve decides, most people will snooze through the news. This, of course, can be dangerous to debtors everywhere.

There are a few financial concepts that people do tend to understand, particularly inflation. Naturally, this topic is one where experience matters: having struggled mightily with hyperinflation in the late1980s and early 1990s, two-thirds of Argentinians can answer an inflation question accurately. Similar patterns are observed in Georgia, Bosnia and Herzegovina, and Peru, all of which also suffered under hyperinflation in the past. By contrast, only half of Japanese adults understand the corrosive power of inflation, having suffered deflation over the past few decades. In the U.S., the figure is just shy of two thirds (63%).

Monetary policy affects households and household finances, yet what people know about some of its levers is limited. As interest rates start rising, some people will learn about interest compounding. But this begs the question: should experience alone be our teacher?

Sunday, December 27, 2015

What’s Behind the Financial Literacy Gender Gap?

This is a slightly modified version of the blog I wrote for the Wall Street Journal, which is posted here:

If asked three simple questions designed to measure financial literacy, more than half of Americans will answer incorrectly. But there is another disturbing finding in the data from the U.S. National Financial Capability Study: Women know even less than men.
This gender gap is not limited to the United States. Women in countries as different as Germany, Australia, Canada, Italy, Sweden, Switzerland, New Zealand, Japan and the Netherlands all display lower levels of financial literacy than men. As additional countries are added to the financial literacy comparison, this evidence grows even more persistent.
This disparity is important because women tend to live longer than men. Moreover, women have less attachment to the labor market, with interrupted careers because of childbearing, and potentially fewer financial resources over the life cycle. Thus, women’s financial acumen is particularly important for their well-being before and after retirement.
Together with our international collaborators, we set out to study this gender difference in a paper that covers data from the most comparable countries: the United States, Germany and the Netherlands. Even accounting for different workforce participation, educational levels and parenting responsibilities, the gender gap cannot be fully explained. For example, although younger generations of women are more likely to be in labor market, to have college degrees and to move away from traditional societal roles, young women in all three countries were less financially literate than young men.
One might argue that there is specialization within a household, and women have delegated the acquisition of financial knowledge and financial decision-making to their partners. However, even in households where women are the financial decision-makers, they know less than men. And women do not know less because they opt to rely on financial advisers who supplement their lack of knowledge. Indeed, they are lesslikely than their male counterparts to consult advisers or online resources for information.
In looking at the channels through which financial literacy may be acquired, we examined data from what was East Germany vs. that from West Germany, since residents of these two regions were exposed to different financial markets and institutions. Although 25 years have passed since unification, we find large differences in financial literacy between the East and the West. This supports evidence that learning can take a long time. But it also tells us something more: There is a gender difference among respondents in West Germany but no knowledge gap between men and women living in East Germany, even after accounting for many demographic and economic characteristics. In other words, as financial institutions and markets develop, there is no guarantee that women will acquire financial literacy in the same way that men do.
One takeaway from this study is that learning from experience or from participating in financial markets is not enough. Women are still left behind. Perhaps women simply have less opportunity to learn. One simple way to equip everyone with basic financial skills—and close the gender gap—is to start at the beginning, adding financial literacy in school.

Sunday, November 29, 2015

Millennials and their struggle with debt

This is a slightly modified version of the blog I wrote for the Wall Street Journal, which is posted here:

Much has been written about Millennials—if they are moving back with their parents, whether they are buying cars or homes, how much they are saving for retirement. There may not be consensus on all these issues but one thing is clear: Millennials and debt go hand-in-hand.
Our research using data from the National Financial Capability Study shows that two-thirds of Millennials (those aged 23-35 in 2012) have at least one source of outstanding long-term debt—whether student loans, home mortgages, or car payments—and 30 percent have more than one. Among the college-educated, a staggering 81 percent have at least one source of long-term debt
Not only do Millennials carry debt, but they struggle with it. A majority report having too much debt, difficulty in making payments, and worries about it. Specifically, the ability to pay off student loans troubles more than half of Millennials who have such loans. Low-income respondents tend to be more concerned than higher-income earners, but even 34 percent of Millennials with annual household income above $75,000 doubt they will be able to repay their student loans. Moreover, even several years after college, the percentage of those worried about repaying student loans remains high. Fifty-four percent of Millennials who are over age 30 and have student loans are worried about repaying them.

Along with long-term debt, Millennials also carry short-term debt, most often from credit cards. This debt can be costly. More than half of Millennials’ credit card users say they carried over a balance—for which they were charged interest—in the last 12 months. A sizable share has been hit with late fees (22 percent), over-the-limit fees (13 percent), and fees for cash advances (14 percent).

The use of alternative financial services (AFS), such as auto title loans, payday loans, pawnshops, rent-to-own loans, and tax refund advances, represents another significant source of short-term debt. More than two-in-five Millennials in the study relied on AFS at least once during the five years prior to the survey. Those turning to these services are not always low income: More than a quarter of Millennials with annual household income higher than $75,000—four times the poverty level for a standard household of three—have used AFS.

It doesn’t end there. Millennials are tapping their bank and retirement accounts. Twenty-nine percent with bank accounts report occasionally overdrawing them, and 22 percent of retirement-account owners took loans or hardship withdrawals in the 12 months prior to the survey.

While these findings should worry Millennials, there is something that should concern all of us: This next generation is not prepared for the financial engagement it faces. Millennials give themselves high marks on their financial knowledge. Yet the data show that only 8 percent of them could correctly answer five questions used to assess understanding of the fundamental concepts that define financial literacy.
They owe a lot. They know too little. Millennials’ struggle with debt may eventually become our problem, too.

Friday, November 27, 2015

“Just in time education”? Just in time is too late

This is a slightly modified version of the blog I wrote for the Wall Street Journal, which is posted here:

Several people and institutions have been advocating for “just in time” education as an alternative to financial education. I take this to mean that financial education should be provided at the point of sale. Academic studies have found that financial knowledge decays over time, and “just in time” proponents see on-the-spot education as a way to address that challenge.
But there are problems with the “just in time” concept. For starters, all education—not just financial knowledge—erodes over time. If I were to re-test my undergraduate and graduate students a few months after they finish a course (any course!), the results would deviate from those of their final exams. This hardly means we should sidestep teaching entirely, to replace it with targeted information that is dispensed only as needed. Do you want to go to a Shakespeare play tonight? Here is what he wrote and why he is so famous. No need to bother with a literature course in college. “Just in time” ignores the value that comes from education.   
The second reason I question “just in time” is that my academic research shows that financial literacy brings benefits. Financially knowledgeable individuals are more likely to plan for future events, to save, and to invest in higher return assets. But that knowledge is important before they take those actions. Indeed, it is what positively influences their behavior.
For example, those who know about the power of interest compounding understand the importance of starting to save early. For those with no financial literacy, there is really no point of sales benefit – no big sign that states “Come here if you have not started to save yet.” If “just in time” is their only option, these people will not receive any education. They will learn about the value of saving when they are close to retirement, when it is already too late.
This underscores the more basic problem with the “just in time” argument: Most financial decisions are not made at the point of sale. Consider a home mortgage. By the time buyers come to a broker or a loan officer at the bank, many decisions have already being made. The buyers may have decided on the house they want to buy. But what if they have chosen a property they cannot afford or they have not searched for the best offer? At that point, “just in time” education is again too late. Consumers need financial knowledge before the dream of home ownership is formed.
“Just in time” education reflects a pretty grim view of financial education, which it seems to see as a bitter medicine that should be dispensed in a targeted dose—nothing more—and only when needed. The prevalence of financial illiteracy, combined with the many financial decisions we constantly must make, demands a more comprehensive cure than that.
I was inspired to write this post after I was contacted by a student in the personal finance course I have been teaching at the George Washington University. He asked whether I was also teaching an advanced course on the subject. That message came just in time!