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.)
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