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?).