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!

Sunday, June 21, 2015

What advice do you wish you had—or had not—gotten about your finances after graduating from college?

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

For everyone, the memories of life after college are a mix of excitement and trepidation about what is coming next. For me it was also a transition year, as I had some teaching and research assistant work while applying to graduate school. Realizing now how important a time that was to think about finances, my first wish would have been for some advice! As a major in economics, I knew about Edgeworth box and Pareto efficiency, but not much about how to manage my (little) money. My parents thought an education from the best private college in Italy would provide the skills a young person needed to navigate today’s economy, but they never checked.

The advice I wish I had received after graduating from college and graduate school is about the importance of planning for the future—for retirement, for buying a house and so on. I have always been a saver, even during the grueling low-income period in graduate school, but saving equated to what was left over each year without any specific target to achieve. It took me a while to figure out that my savings were either too little or not allocated properly.
Had I planned to buy a home, I would have been able to buy it sooner and a more suitable house as well. But an early start in saving for retirement is where I could have benefitted the most. My retirement is likely to be as long as my working career. I sincerely hope that is true and a lot of savings will be necessary to support those post-employment years—and that cannot be achieved by leaving things to chance.

In my case, three things were needed. First, I had to figure out how much to save in order to retire at a target date. That required calculations, not just relying on the gut feeling about saving I had used after college and graduate school. Second, I needed a proper allocation of those savings. It was inefficient to save without taking advantage of tax-favored vehicles, such as Supplementary Retirement Accounts and IRAs, or to invest in managed funds that generated dividends and charged high fees. Third, I needed a system to keep myself on track and to evaluate how well I was doing. Even though I came late to understanding these future-planning requirements, the changes are paying off. Empirically, it turns out that those who plan for retirement end up with about three times the wealth of those who do not plan.  

One of the keynote speakers at our financial literacy seminar series said that it is very hard to support a 30-year retirement with a 40-year working career. It will be even worse if retirement is extended (longevity keeps increasing) while the working years when one can contribute to retirement savings get shorter. The latter can happen because of graduate school, repaying student loans and the failure to think about contributing to a retirement account.
I now ask the following question to my students when discussing the importance of financial planning: Suppose you do no planning for your vacation, you just show up. What are the chances that you will have a good experience?

Thursday, June 11, 2015

Taking your pension as a lump sum? It comes with risks

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

As employers continue shifting pension responsibilities to workers, a new question has surfaced: Should employees take their pensions as annuities or lump sums? Workers with defined contribution pensions will have to decide this, and employees with defined benefit pensions are increasingly given this choice too, as firms try, for example, to reduce oversized plan liabilities.

Managing one’s pension can bring opportunities, but it also comes with risks. Indeed, the very reason for offering a lump sum is to transfer the risks from the pension plan sponsor to the individual. There are several issues to consider when such option is on the table.
Financial markets: An individual who opts for a lump sum must then manage that money. If investing in financial markets, the individual must decide how much risk to take. Even if the money is tucked under the mattress (figuratively), there is inflation risk—the risk that rising prices will dilute the money’s purchasing power.

Longevity: If a pension is taken as a lump sum, it still must last a lifetime. Individuals can buy annuities in the retail market, and there is a notion that there may be more and better choices in the market than what is offered by a single plan sponsor. However, as the January 2015 report of the Government Accountability Office (GAO) [Private Pensions/ Participants Need Better Information When Offered Lump Sums that Replace their Lifetime Benefits”] emphasized, retail market annuities are likely to be more expensive than group annuities.
Protection: The Employee Retirement Income Security Act of 1974 (ERISA) established protection for pension plan participants and their beneficiaries. For example, ERISA set minimum funding standards for pension plans that are sponsored by private employers. And the Pension Benefit Guaranty Corporation (also established by ERISA) acts as the insurer of private sector defined benefit pension plans by guaranteeing participants’ benefits up to a certain statutory limit. The protection ERISA offers to defined benefit pensions is lost when pensions are taken as a lump sum.

Whether to take a lump sum payment is not an easy decision. One of the greatest risks is perhaps the failure to understand the risks involved. When I testified about this issue before the ERISA Advisory Council on May 28, 2015, I discussed the empirical evidence we have about financial literacy and how little people know about risk and how to manage risk. This is why it is so important to provide not just information but also tools that make it easier for individuals to tackle this decision. One such tool is a calculator that shows how different interest rates and mortality tables translate into different lump sum payments.
Lump sum payments can sound attractive, and for some workers they may be better than annuities, but this is a serious decision that requires careful thought, clear planning and an understanding of how markets work

Monday, June 1, 2015

What information do participants need to make informed decisions in pension risk-transfer transactions?

This is an abridged version of my testimony before the ERISA Advisory Council. The full testimony is posted here:

Thank you for inviting me to testify about information that participants need to make informed decisions in pension risk-transfer transactions. This is an important issue, and I am grateful for the opportunity to testify.  My name is Annamaria Lusardi and I am the Denit Trust Chair of Economics and Accountancy at the George Washington University School of Business and the founder and academic director of the Global Financial Literacy Excellence Center (GFLEC).

In my testimony, I would like to make four main points. First, this is a very important and timely issue. With the shift from defined benefit (DB) to defined contribution (DC) pensions, most of the risks regarding pensions have been shifted from employers and pension providers to pension participants. We have focused a lot on the accumulation of pension wealth versus the drawdown of that wealth, but what people do with their accumulated pension wealth is important and consequential. Moreover, as mentioned in the January 2015 Report of the General Accountability Office (GAO), even in traditional DB pensions, pension providers have offered participants the choice to take their pensions as a lump sum, thus shifting the responsibility for managing pension wealth after retirement and insuring for longevity and other risks to pension participants. As I have argued in many of my research papers, participants are ill-equipped to deal with this new responsibility, in particular when it comes to understanding and managing risk. The second point I would like to make has to do with the information that participants need when asked to choose to take their pension as a lump sum versus an annuity. While the information is listed and discussed in the GAO Report, it is also critically important to consider the ways that information is provided, particularly when faced with participants who display very low levels of financial literacy. Third, I would like to offer some suggestions on the provision of information, in particular about risk. Fourth, I would like to make some remarks on ways to improve the current retirement system so that participants are more empowered to make the decisions they now face and that are going to become even more important going forward.

The first point I would like to make with regard to the decisions that participants face when given the option to take their pension as a lump sum is that the level of financial literacy of most participants is very low. This fact is barely mentioned in the GAO Report but, in my view, is important. For more than ten years now I have documented that most individuals do not possess the knowledge of the fundamental concepts that form the basis for financial decision making, for example, knowledge of the workings of interest compounding or the effects of inflation. Moreover and most importantly for the topic of this testimony, individuals have the most difficulty grasping the concept of risk and understanding the workings of risk diversification. In my recent paper titled “Risk Literacy,” I document that people not just in the United States but also around the world display very little understanding of risk. This lack of “risk literacy” is particularly worrisome when we consider the choice between a lump sum or an annuity and the decisions involved in managing that lump sum.

The research on financial and risk literacy offers two additional findings for the topic under considerations. First, there are subgroups of the population that are particularly vulnerable when it comes to understanding risk and the workings of risk diversification; these subgroups are women and older adults. Women display much lower financial literacy than men. Moreover, when confronted with questions assessing knowledge of risk, women disproportionately tend to respond “I do not know” to the questions, a finding that is consistent in all surveys I have studied and that holds true across countries. The proportion of “do not know” responses is particularly sensitive to the way the questions—in particular the questions assessing risk—are framed. For example, questions that are heavy in economic and financial jargon elicit a very high share of “do not know” responses among women. Older adults, in particular those 60 and older, also display very low levels of financial and risk literacy. We do not know whether this is an age effect, due perhaps to a decline in cognitive abilities, or a cohort/generation effect due, for example, to the fact that older individuals lived in different economic circumstances and may not have been exposed to financial education in school and/or the workplace. Unfortunately, decisions about whether or not to annuitize wealth are made at older ages. Second, notwithstanding this severe lack of financial knowledge, when asked to assess their own financial literacy, most individuals (as many as 75%) gave themselves very high scores, well beyond what the scores resulting from the financial literacy questions would imply. The biggest mismatch between self-assessed and objective knowledge is found among older respondents; not only do they score lowest on the financial literacy questions (in comparison to other age groups), but they also give themselves the highest scores in terms of self-assessed knowledge. This mismatch could result in older individuals relying on their limited knowledge and skills and not asking for advice or consult advisors about managing their pension.

This brings me to my second point: it is unlikely that providing people with more information or the types of information that the GAO  Report found missing when participants were offered a choice between a lump sum and annuitized benefits is going to substantially enhance the choice that participants will make. Simply stated, most people can hardly do a 2% calculation, let alone understand how different interest rates and mortality tables will translate into different lump sums. The research I have mentioned provides instead three basic recommendations:
1)      The information has to be readily available and easily accessible as individuals are unlikely to even be looking for it. The GAO Report mentioned that participants had to actively look for information, and that it was often hard to find.

2)      The information has to be provided in very simple ways and in plain English; in other words, complex financial jargon has to be avoided as many individuals, in particular women, find it difficult to understand that type of information.

3)      Help has to be provided to conceptualize the information; for example participants may not understand that taking a lump sum means not just having access to and managing their pension but also taking up many risks, including the risk of outliving one’s resources. This help should include providing tools that makes it easy for people to do calculations or make comparisons.

This all may seem very daunting, and many have interpreted lack of financial literacy to mean that people should not be in charge of making complex financial decisions, but in fact our research also shows there are simple yet effective ways to provide information that help people in financial decision-making.

In my research, in collaboration with a group of co-authors I have designed short videos to explain, in very simple ways, concepts such as the power the interest compounding and the workings of inflation and risk diversification. Concepts are embedded into a simple narrative that highlights not simply what the concept means but also how to conceptualize it. For example, the video about risk explains the concept of risk diversification using the metaphor of not putting all of one’s eggs in a single basket to make clear what it means investing in just one asset or one’s own company stock. We have tested the effectiveness of these videos by assessing whether financial literacy and self-efficacy (i.e., confidence in making decisions) change when exposed to the videos. We divided our participants into several groups, those exposed to the videos, those exposed to a written narrative (rather than watching the video, participants had to read the story) and a control group who was not exposed to this information. We found that the videos increased financial knowledge and self-efficacy more effectively than did the print narrative. This study suggests there are ways to provide information that can be more useful and effective than the long list of documents and files that people are normally offered by pension providers.

The final point I would like to make is that the decisions that people have to make about their pensions are hard, and decisions about whether to take pensions as a lump sum or an annuity are particularly difficult. But people have to make these types of decisions and more so with defined contribution pension plans. Financial products that are similarly complex, such as reverse mortgages, are now available to consumers, and people are faced with the choice of whether or not to annuitize their housing wealth. Another important decision is when to start withdrawing Social Security benefits, a decision which requires the same skills needed to make a decision about taking a pension as a lump sum or an annuity. We need to do a better job equipping people to make these decisions. It is going to be hard to even provide information when financial illiteracy is so widespread. Building a robust pension system starts with adding financial literacy in school, so that individuals have at least basic financial knowledge. Without such a knowledge base, it is going to be very hard (and expensive) to help people make financial decisions. The workplace is another ideal place for providing financial education. In a world in which individuals are asked to take on the responsibility and risks connected with their own financial security, it is imperative that we find ways to equip them with the skills and the knowledge needed to make these important decisions.

Wednesday, May 13, 2015

The cost of sofas and mutual funds

This is the original and longer version of the blog I wrote for the Wall Street Journal. You can see the posted blog at:

Starting out as an assistant professor more than 20 years ago was truly exciting, even though the move was full of problems and it took months to settle into a new place. The day I showed up in the Human Resources office to enroll in health and pension plans, I was handed a bunch of brochures and asked to fill out a stack of forms. I spent most of the time focused on the health plans and their varied coverage.
When I turned to the pension plans, I had to choose among three providers and a long list of investment funds, from money markets to stock funds. I am not exaggerating when I say I took less time to choose where to put my retirement savings than I did to buy a sofa that morning. As an economist, I thought I should know about investment. I selected a global stock fund, looking at nothing else but where it was invested.
Months later, my colleagues in the economics department told me about the Supplementary Retirement Account (SRA) that the college offered. That’s where I could put money, tax-free, for retirement. Signing up for it was extraordinarily cumbersome. I needed my employee ID (a number I still cannot remember, let alone find easily) and was rushed to fill out all of the information in 20 minutes before the online system closed for security reasons. It took me several attempts to sign up and, again, little attention was devoted to where the money was invested.
I blame the harsh life of an assistant professor that I paid so little attention to my retirement savings and investment decisions. It was not until I received tenure and started my research work on financial decisions that I revisited what I had done with my personal finances. Changes were much needed. I began contributing the maximum amount to the SRA, I opened a Roth IRA and I moved all of my savings from high-fee international funds to index funds and built a more diversified portfolio.
Smart choices matter in finance. Small investment mistakes we make early in life, such as ignoring fees or failing to take advantage of tax-favored investments, compound over time and become large. I tell my investment-choice story to students in the personal finance course I teach to show them that finance truly is personal—and we must make time for it. I still have that sofa I bought in my first year as an assistant professor. If I had taken time to compare mutual funds in the same way I compared the cost of sofas, I would have the money today to refurnish my entire house.

Sunday, April 19, 2015

Financial Savvy Key to a Secure Retirement

I have started to write a blog for Forbes, and I hope you will follow my blogs there. I provide the link below. However, I will keep posting the blogs here as well as I sometimes write a longer text than what is published online.

Over the last 40 years, we as individuals have been given increasing responsibility for ensuring our own financial well-being in retirement. But it’s gotten quite complex, with an alphabet soup of retirement saving vehicles – from 401(k) to 403(b) plans to IRA and Roth IRAs – and our responsibilities loom large. Not only must we figure out how much to save and how to invest our retirement assets, but we also must take advantage of a variety of tax-favored assets, employer matches, payout options, and much more.  

In my research, I investigate how well-equipped we are to make such complex financial decisions. For instance, how much do we know about the power of compound interest, so we can appreciate how critical it is to save early and grow our money tax free? Do we know how to diversify risk? Such knowledge provides a firm foundation for good financial decision-making over the entire lifetime.

To gain an understanding of the level of financial literacy in the population, Olivia S. Mitchell and I designed and fielded three key questions which have now been used in a large number of national and international surveys. We have also administered the survey to a variety of employees at large companies, to see exactly what they know – and don’t know.  

Try the quiz yourself (right answers are in bold)

1. The Interest Rate question (Numeracy)
Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 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
Do not know
Refuse to answer

2. The Inflation question
Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, how much would you be able to buy with the money in this account?
More than today
Exactly the same
Less than today
Do not know
Refuse to answer

3. The Risk Diversification question
Please tell me whether this statement is true or false: “Buying a single company’s stock usually provides a safer return than a stock mutual fund.”
Do not know
Refuse to answer

Our findings in the US and around the world proved to be shocking! Only one-third of Americans can answer all three questions correctly. And while one might expect that the more experienced would be substantially more financial literate, this is not the case. In fact, older adults are not much savvier than the young, despite their having had to make many financial decisions including about retirement savings. We also find that financial illiteracy is particularly severe among certain demographic groups, such as the low paid, women, and young adults. Moreover, when we take our financial literacy survey abroad, the results are not much better! Respondents in Australia and Germany do perform better, while thus far we see respondents in Eastern Europe and Russia are the least financially savvy. But all of us have a long way to go.

I worry a great deal about such low levels of financial literacy, because retirement planning requires a modicum of financial sophistication -- and planning is a strong predictor of retirement wealth. According to our research, those who plan accumulate up to three times the amount of wealth of non-planners. The data shows the link to financial literacy is very strong; it is those who are financially literate that plan for retirement. And without basic financial skills, people get into trouble young, taking out payday loans and overdrawing their credit cards, and they stay in trouble later, by failing to pay down their mortgages and borrowing against their retirement accounts.

Granted, raising our nation’s financial savvy will require costs and effort. Nevertheless, there are costs of ignorance, including not saving, not being able to retire, and being poor during one’s later years.