This is an abridged version of my testimony before the ERISA Advisory Council. The full testimony is posted here:
http://gflec.org/research/?type=policy-briefs
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.
