Financial Literacy and Ignorance

America built to last

2012-01-25T11:42:00.001-05:00

In his State of the Union address President Obama spoke of an America “built to last.” I am glad that the focus of policy is turning to the long run. One essential component of such a built-to-last idea must deal with education. In an increasingly global and complex economy, citizens need to have the skills to successfully participate in labor markets, not to earn low and stagnating wages but wages that allow them to be part of a solid middle class, to send their children to college, and to save for retirement.

The President did talk of education and the important role of education. But it is going to take more than education reform that allows schools to be creative in their curriculum and to reward good teachers. America needs to invest in education if it wants an economy built to last. While it is good to invite state and local governments to devote more of their budgets to higher education rather than slushing education expenses, it is important to recognize that the federal government has an important role to play to foster education. More funds to research and technology can contribute not only to support higher education but also to fuel innovation and ideas that form the basis of growth (and the growth of well-paying jobs). Good education and solid training are also at the base of innovative entrepreneurship. Access to finance has been mentioned, by the President, too, as one of the major impediments to entrepreneurship, but in my view (and according to my research), education is far more important, in particular if the entrepreneurs we aim to cultivate are innovators rather than self-employed individuals who are trying to make a living. It is also important to recognize that a good education is not built on good colleges or community colleges alone but on a strong educational system, from kindergarten to college and beyond.

President Obama mentioned that college education cannot be a luxury. But with the cost of college rising faster than inflation and faster than the growth in wages, in particular in the lower part of the wage distribution, we are headed in that direction as the purchasing power of workers is not keeping up with the cost of a college education. If we are planning for the future, it is important to find ways to make college affordable and within reach of the many families that aspire to send their children to college. As I have mentioned in many of my previous posts, a college education is often the most important investment that a person can make.

I want to end this post with a statement that President Obama made during his address and that can be summarized as follows: teachers matter. This does not require much comment as it speaks for itself. All of us can name a teacher who has been influential in our life and who has made a difference. For me, it was my high school literature teacher. Her name is Ada Puccini. Even after more than 30 years, I think often of her and of the encouragement she gave me; we have talked on the phone over the years and when I am in Italy, and I go and visit her. Teachers matter, and they matter to what students can do in the long run. They too should be part of the policy for an America built to last.

Wishes for the new year

2012-01-05T10:51:00.001-05:00

As the new year starts, I have many wishes for financial literacy. I list the top three below:

Wish #1. I hope a leader to champion the cause of financial literacy will emerge and help give this topic the national and international attention it deserves. Michelle Obama has been the celebrity behind obesity and has helped not just raise attention around this important topic but also push for relevant programs in schools. There is a striking similarity between obesity and financial illiteracy. According to statistics, one third of the population is obese. Well, the same (and even worse) figures can be cited for financial illiteracy; about half of the population does not know the abc’s of finance and economics. There are severe costs associated with obesity, and there are equally severe costs of financial illiteracy (if in doubt, check the figures resulting from the financial crisis). A lot of initiatives have been undertaken at the national level to address obesity, from a revised food pyramid to limiting the amount of junk food available in cafeterias and vending machines. I may be one of five people in the country to know about the official web site offering financial information (do you want to guess which one it is?). Other celebrities have helped raise awareness of a variety of national and global problems. For example, Al Gore increased the attention on the environment and global warming. While I do not think the Artic will melt in the next few years (if I am wrong, please let me know), we are discussing or taking a lot of measures to address this long-term problem. On the other hand, the problem of financial illiteracy is urgent and pressing.

I do not have a strong preference about who this leader will be, but it would be good if he/she had a face (institutions are great, but it is hard to compete with Happy Feet). He/she should also be substantially liked by the public—a difficult objective in these days of falling financial geniuses, but there are many celebrities that people love. A sports celebrity would be great (Who does not like sports? Raise your hand!), in light of the similarity between success in sports and success with financial matters: it takes dedication, practice, and discipline!

Wish #2. I hope some BIG initiatives will emerge for financial literacy. As I have lamented in previous posts, a lot of the discussion about financial literacy has focused on its cost (as if we should or could offer it for free), and many initiatives to promote financial literacy are limited in scope and objectives. But this is a global problem that is becoming more and more pressing by the day (most of the political leaders in Europe have been ousted as a result of the sweeping financial crisis). This situation needs some big initiatives. How about a national campaign, or even a global initiative on financial literacy? How about a museum for financial literacy? We have declared April financial literacy month, so how about doing something concrete and big during that month (March or October are good for me too; I am not fussy about which month it occurs) that has lasting effects?

Wish #3. I hope the new year will see financial literacy in the schools; if not in the United States, then at least in a sizeable number of countries. Financial literacy is an essential tool for anyone who wants to be able to succeed in today’s society, make sound financial decisions, and—ultimately—be a good citizen. The financial crisis has put economic news on the front pages of newspapers almost daily, requiring individuals not just to be abreast of concepts such as deficit, national debt, and interest rate spread but also to evaluate the economic reforms that political leaders are proposing. Moreover, the cost of college education has been increasing at a rate faster than inflation, requiring students and their families to start planning for college as soon as possible, to be savvy about financial aid, and to manage student loans effectively. And young people are required to make one of the most important decisions of their lifetime—whether to invest in higher education—during high school, and they should make it in conjunction with a good understanding of the costs and benefits of that decision.

Perhaps I am only dreaming, but dreams are good. And my fourth wish is that all of you have a happy new year. Be in good financial health!

The new financial literacy seminar series

2011-12-27T12:40:00.002-05:00

As December comes to an end, I am thinking of some initiatives undertaken this year. One stands out, as it is rather recent and it is in the process of being evaluated to make it even better: our Financial Literacy Seminar Series. Started last October, this is a joint project between the George Washington University School of Business and the Federal Reserve Board (FRB) with the goal of hosting cutting edge research on financial literacy. We invited all individuals and institutions interested in financial literacy in the Washington, DC, area, and because presentations have been taped and posted on the web, everybody who is interested in financial literacy can watch the presentations or read the papers. They are posted on the seminar’s web page: http://business.gwu.edu/flss/.

We had a distinguished group of speakers in the fall term. Our inaugural seminar was given by Olivia Mitchell from the Wharton School, whose talk examined the link between financial literacy and wealth accumulation. Her talk was followed by a panel of policy experts, including Gail Hillebrand from the Consumer Financial Protection Bureau, Karen Dynan from Brookings, and Jason Fichtner from George Mason University (formerly the Deputy Commissioner of SSA). In subsequent seminars, Robert Clark from North Carolina State University presented his work on workplace financial education, a very important topic when looking at financial education for the adult population; Stephan Meier from Columbia Business School examined the link between financial literacy and subprime mortgages, showing that numerical ability is strongly associated with mortgage delinquency and default; Bilal Zia from the World Bank presented an evaluation of financial literacy programs in India; and Jonathan Zinman from Dartmouth College examined household debt and, in particular, credit card debt and the way it could be managed better. Our last speaker was Brigitte Madrian from Harvard University. She reported on some important features of default options, i.e., the fact that when employees are automatically enrolled into pensions, many of them stay enrolled at the default rate, even when that rate is a “bad” one and unlikely to correspond to a rate that the individual would have chosen had he/she made an active choice. Most importantly, the employees who tend to stick to the default are disproportionately those with low income, which is often a proxy for low financial literacy.

Different seminars in the series had different formats. While the majority of talks were given by academics, at times we had a discussant or, as mentioned above, a panel of policy experts. Even without a discussant, our audience had so many experts in this field that there always was a very lively discussion with many questions asked of the speaker. To continue the discussion in a less formal setting, we held a reception after the seminar so that participants could continue the discussion with either the presenter or other attendees (sometimes with the help of a glass of Italian wine). The Dean of the Business School would also stop by the reception to greet the speaker or meet the attendees and to hear how the School could continue to promote financial literacy.

One of the privileges of organizing the seminar series is that I get to meet with the seminar speakers, discuss their paper in depth, hear in more detail their views and their insights as well as learn about their future projects. Another equally important privilege was getting to know and work with a group of researchers from the Federal Reserve Board. They have been a great group to work with: they combine an interest in theoretical and empirical research with a focus on policy; they ask important questions and have very high standards for research. Together, we were unstoppable; we started to work on the series in August and in October we were ready to start.

And speaking of privileges, last June, I had the opportunity to meet with Chairman Bernanke. Sitting in his elegant office at the FRB, I told him about the projects that our teams at the Financial Literacy Center (FLC) were working on and what we were doing to promote financial literacy. He proposed more interaction between the researchers working on financial literacy and the researchers from the Federal Reserve Board and suggested organizing some joint activities. As a result, the Financial Literacy Seminar Series was born, and it benefits from the financial support of the Federal Reserve Board. Because the end of the year is a time for evaluation, I have to say I am very proud of our new Financial Literacy Seminar Series. And I am especially proud of being a student of Ben Bernanke.

Learning from Elsa Fornero

2011-12-08T22:03:00.001-05:00

The front page of the Wall Street Journal last Monday, December 5, had three pictures of a woman in tears. That woman is Elsa Fornero, the Welfare Minister in the new “technocratic” government of Italy. The fact that she was in tears was truly remarkable and it deserved to be on the front page of a major business newspaper. This is something new, and there is a lesson to be learned from it.

Elsa Fornero, a professor of Economics at the University of Turin, is an international expert on pensions. In charge of one of the most difficult reforms, i.e., changing the pension system in Italy, she has set out to implement a set of new and severe measures that nobody before her has been able to do, even though the current system is unsustainable.

Reforms might be right, but they are painful, and the fact that they are necessary does not alleviate any of the pain they inflict. Technocrats normally describe necessary reforms as the inevitable medicine that a country has to swallow to get better; the numbers are on their side, and no one had ever shed a tear when reform might mean that someone wouldn’t be able to pay their bills at the end of the month. But not Elsa Fornero. The woman who, for more than forty years, has done the calculations about the pension system in Italy; has shown in many scholarly papers that the Italian pension system is unfair, inefficient, and too expensive; has set up a center to study this topic in the most rigorous way, looking at data both in Italy and in other countries, was there at center stage to announce her reforms. The new Minister, who was appointed for her unique expertise, stopped speaking at the very moment she had to pronounce the word “sacrifice”—and cried.

This is not only a sign of humanity, a recognition that reforms often equal pain, but also an act of humility and of immense courage. It took a woman to attack reform of one of the most difficult and stubborn pension systems. She had one week to do it. She knew what to do and what was necessary. And when she described it, she told it as it is, and she cried.

I hope this is the start of a new phase both for politics and for women. Politicians need to have the skills and good judgment to set countries on sustainable paths and (financially literate) citizens should hold them accountable. And I hope we are done with the “iron lady” and similar clichés about women in command. I highly recommend that other Italian politicians be so bold in their actions as the Fornero reforms, as well as show that they care about the well-being of their fellow citizens. We all can learn from Elsa Fornero to be ourselves; in her case, a woman who cares. When I grow up, I want to be Elsa Fornero.

Getting ready with PISA’s new module on financial literacy

2011-11-21T12:53:00.002-05:00

I am turning in this blog post to the new financial literacy module that will be added to the Programme for International Student Assessment (PISA) in 2012. PISA’s group of financial literacy experts met in Melbourne at the end of September and finalized the questions that will be asked of 15-year-old high school students in 18 countries. I wrote about this module in a previous post (see link below) and it is time for an update.

I have the honor of chairing the financial literacy experts group, and an honor it is because the group is composed of some of the most accomplished and knowledgeable people in the field of financial literacy from a number of countries. Because the importance of financial literacy was first acknowledged outside the school system and was first dealt with by policy makers and regulators, many of these experts come from Treasury departments or hold jobs in central banks, regulatory authorities, or are involved with other government agencies. Nonetheless, the work has been academic in nature, meaning we went through a very rigorous process of designing a set of questions that can measure financial literacy in many different countries.

Our first task was to design a financial literacy framework to help us define the objectives of the module and the areas to cover when designing questions (The framework can be accessed on the OECD web site—the link is below). The development of the framework followed a sequence of six steps:
• Development of a working definition for the domain and description of the assumptions that underlie that definition;
• Identification of a set of key characteristics that should be taken into account when constructing assessment tasks for international use;
• Operationalization of the set of key characteristics that will be used in test construction, with definitions based on existing literature and experience in conducting other large scale assessments;
• Evaluation of how to organise the set of tasks constructed in order to report to policy makers and researchers on achievement in each assessment domain among 15-year-old students in participating countries;
• Validation of the variables and assessment of the contribution each makes to understanding task difficulty across the various participating countries; and
• Preparation of an interpretative reporting scheme for the results.

It was a long journey for all of us. We started this work in June 2010 with a meeting in Boston and we worked steadily for a year and a half. We met at regular intervals, each time in a different country, which also reminded us that our focus was to design questions that could be answered in different economic settings and different educational systems.

The OECD has been a pioneer in financial literacy and adding a new module on financial literacy in 2012 in PISA in countries that have not even formally introduced financial education in school speaks of their long-term vision and their capacity to lead and draw the attention of countries toward important topics such as financial literacy. I particularly like the statement that the OECD displays on the top of their PISA webpage:

“Are students well prepared for future challenges? Can they analyse, reason and communicate effectively? Do they have the capacity to continue learning throughout life? The OECD Programme for International Student Assessment (PISA) answers these questions and more, through its surveys of 15-year-olds in the principal industrialised countries. Every three years, it assesses how far students near the end of compulsory education have acquired some of the knowledge and skills essential for full participation in society.”

This statement serves to remind us that financial education is as important as the traditional subjects taught in school: As I have mentioned often, just as it was not possible to live in an industrialized society without print literacy—the ability to read and write, so it is not possible to live in today’s world without being financially literate. The financial crisis has put economic news on the front pages of newspapers almost daily, requiring individuals not just to be abreast of concepts such as deficit, national debt, and interest rate spread but also to evaluate the economic reforms that political leaders are proposing. Not only are young people required to make one of the most important decisions of their lifetime— whether to invest in higher education—during high school, but they are also confronted with numerous decisions of economic consequence: having a car, a cell phone contract, a bank account, and a debit or credit card. Financial literacy is an essential tool for anyone who wants to be able to succeed in today’s society, make sound financial decisions, and—ultimately—be a good citizen.

We, on the PISA committee, are only at the beginning of our journey. Our next meeting has been scheduled for Heidelberg, Germany, next September, so we fly to yet another country. I have collected little items from those trips to remind me of our meetings. From our trip in Australia, I brought home a little yellow road sign that hangs in my study. It says: “Kangaroos, next 15 km.”

To read the financial literacy framework, please see below:
http://www.pisa.oecd.org/dataoecd/8/43/46962580.pdf
My previous blog on PISA:
http://annalusardi.blogspot.com/2010/09/comparing-financial-literacy-of-young.html

We are All Blacks!

2011-10-24T17:42:00.006-04:00

This has been a busy fall so far with a lot of travelling (I am on my way to Sweden), starting a new financial literacy seminar series (more in future blogs), and keeping up with my newly acquired interests: football and rugby! It has been a season full of exciting games, including the Rugby World Cup, which was held in New Zealand. I am extremely happy to announce that the New Zealand All Blacks are the World Cup champions! I am ecstatic and wish I were in New Zealand to celebrate their victory. What could be sweeter than winning the World Cup when your country is the host and your fans are in the stadium? I can only imagine the explosion of joy in Eden Park in Auckland at the end of the match with France (and the sense of relief as well since the score was so close, I could hardly breath...).

I will celebrate this great victory by writing about New Zealand and the role they have played in the field of financial literacy. Under the leadership of feisty Diana Crossan, the Retirement Commission has done a lot of innovative work on financial literacy. I mentioned in a previous post that they have one of the best national web sites dedicated to improving the financial literacy of the population. They were also one of the first countries to conduct a second national financial literacy survey in order to measure financial knowledge over time and therefore assess their progress in improving financial literacy. They have many programs targeted to specific groups of the population, recognizing that different people have different needs and different economic circumstances. One group of great interest is the Maori, and specific programs have been designed for them as well. While small and without a big budget, the Commission is a mighty group. And to better communicate the focus of their work, they have recently changed their name from Retirement Commission to the Commission for Financial Literacy and Retirement Income. The main lesson here is not to underestimate the power and ingenuity of what one institution—however small—can do for financial literacy. And while New Zealand is a small country, it has been a model to look to for financial literacy.

I have one recommendation for Diana Crossan: go to that talented captain of the All Blacks, Richie McCaw, show him your muscles (figuratively, I mean), and ask the team to support financial literacy. I am sure a lot of New Zealanders would pay attention. In my view, sport and financial literacy go very well together (wink)!

But for now, congratulations to the All Blacks and to New Zealand for being World Champions and hosting the World Cup. Bravi!

Financial literacy, the Maori, and … rugby

2011-10-04T21:21:00.004-04:00

I am just back from Australia and New Zealand and will write first about my trip to New Zealand. I was invited to attend a meeting at the University of Otago with representatives of the Maori population, who have become interested in financial literacy. If you do not know the Maori, they are the indigenous people of New Zealand and represent about 15% of the population today. Their name is derived from “Ma-Uri,” which means “children of Heaven.” Maori comprise many “iwi” (tribes), “hapu” (subtribes), and “whānau” (extended family units). Having originated in Polynesia, they brought with them the rich culture of the region, where song, dance, art, and oratorical skills were significant, especially as there was no written language at that time. On my visit to New Zealand a couple of years ago, I went to Rotorua, a town settled by the Maori on the North Island. This time, I was in Dunedin, on the South Island of New Zealand, home of the Ngāi Tahu. See below a picture of the formal greeting among the Maori.

In one of the papers that is part of an international comparison of financial literacy across countries, which I have edited for a special volume of the Journal of Pension Economics and Finance, a research group in New Zealand headed by Pension Commissioner Diana Crossan documented differences in financial literacy among the new Zealanders of European descent and the Maori population; the Maori tend to know less. However, this is not the case for the Ngāi Tahu, and one explanation offered for this finding is the fact that Ngāi Tahu have promoted a series of programs aimed to increase financial literacy and saving. A description of Whai Rawa, their matched saving initiative, is provided on the web page noted at the end of this post. The meeting at the University of Otago was about trying to measure the effectiveness of the new initiatives and changes in the well-being of this population over time.

It felt special to sit among this group. The meeting opened with the traditional Maori greetings, and much of the discussion and questions were led by one of the Ngāi Tahu representatives. He was just as one would expect a chief to be: charismatic, wise, and pragmatic. His questions to me were remarkably similar to the ones I often hear when I travel around the world: What is the business case for financial education? What works? and How do we know that it works? But there were major differences, too. The Ngāi Tahu’s planning horizon is very long. Their vision is “For us and our children after us” (Mō tātou,ā, mō kā uri ā muri ake nei). They feel strongly about their community and about sustainability of resources over time. I came away with not only a deeply felt respect for such foresight but also admiration for this capacity to lead and look ahead.

You may know about the Maori from the “haka,” or war dance, that the New Zealand rugby team performs before each game (if you have not seen it, you have got to watch the video posted below). I like the haka for many reasons. First, it shows how much the Maori traditions have been embraced by the population in general. Maori or not, every player in the rugby team plays the haka very seriously. Second, one wants to build up energy at the beginning of an important event. Third, it scares the hell out of the opposing team. And this brings me to my next topic: rugby! New Zealand is currently hosting the Rugby World Cup. Their national team is the All Blacks, and I spent a good part of my time in New Zealand watching rugby. The All Blacks are amazing players and I was glued to the TV for hours. On Sunday, I went to the stadium in Dunedin to watch Italy against Ireland. We (Italy) did not win, but we put up a good fight against the Irish; it was a good game. On the first leg of my trip back to the U.S. on Air New Zealand from Dunedin to Auckland, the flight safety video was done by the captain and the coach of the All Blacks and everything on the plane was about the All Blacks, including pictures of the players on the coffee cups. Believe me, they are irresistible! One advertisement said: “we are crazy about rugby.” Well, for a week I was too.

Kia ora.

http://www.facebook.com/pages/Financial-Literacy-Center/119369231450239
http://www.ngaitahu.iwi.nz/News/2011/Whai-Rawa-Five-Years-of-Saving-Success.php
http://www.youtube.com/watch?v=6f3fvUvOiLQ&feature=related

Advice to rookies

2011-09-11T23:51:00.008-04:00

If you’re a regular reader of my blog, you’ll know that I have become a football fan. People change over the course of their life and pick up new hobbies and interests. For me, it’s football. So this Sunday, I watched the Ravens score a crushing victory against the Steelers. It was a beautiful game! I also watched the kickoff last Thursday. Two games in a week; that is pretty good for a rookie fan, no?

In this new season, with rookie players on their field for their first games, there is an abundance of discussions and articles about these newcomers. In the New York Times yesterday, there was an article about finance and financial advice to the rookies. The link to the article “Financial Lessons from Sports Stars’ Mistakes” is at the end of this post.

As I have mentioned in previous posts, the statistics about football players mismanaging their money are pretty staggering. The article mentioned several star athletes who have had brushes with bankruptcy: Michael Vick (recently acquired by the Philadelphia Eagles); Bernie Kosar, formerly of the Cleveland Browns; and Mark Brunell of the New York Jets.

Some have argued that the behavior of football players is similar to those who win the lottery. Flushed with large sums of money that come to them suddenly, players squander it and are left with little or nothing a few years out. I do not think that this is a good analogy. One difference between football players and lottery players is that we know the former are very talented people: Who else could do the things they do when they are out in the field? Moreover, these people know discipline; they show up to practice every day. They also know the correlation between efforts and outcome; if one works steadily at something, he will get better. These are great skills that can be applied not only to playing football but also to managing money.

So, why do we see players going bankrupt? One of the reasons why people (including football players) make mistakes is because they lack financial knowledge. This problem can be particularly acute for young, inexperienced people whose highest earnings are concentrated at the beginning of their career. But this is not an impossible problem to fix, and the New York Times article outlined a set of lessons that could be learned from some players’ mistakes.

I have three pieces of advice for rookies. (There is more advice to give, but let me start with this simple list; I will follow up in future posts.)

1) Do not spend it all. The career of football players is short and risky; you want and need to have provisions for the future and for uncertain events. An example? The recent lockout. What would have happened if the lockout had continued? Another example? Even superstars have injuries and/or cannot play for health reasons. Peyton Manning, for example, just had neck surgery.

2) Take it in your hands. Money management is too important and too personal to be delegated entirely to someone else. You are the one who knows your needs, your aversion to or love of risk, your objectives for the future. If you leave it to others to manage your money, chances are they will not make the decisions you had wished for. Even if you seek financial advice, rely on reputable experts and stay involved in the process. After all, it is your future that is at stake here.

3) Be humble about finance. My research repeatedly shows that the majority of people are overconfident about what they know of finance. Four out of five Americans gave themselves high financial knowledge ratings but, when asked questions about basic concepts, they answered incorrectly. And ignorance hurts. Study after study documents that it is those with low financial knowledge who pay more for financial services and who are more likely to end up in financial distress. Do not be afraid to speak up about what you do not know; it is not a weakness, it is a strength, and you will intimidate anyone around you when you admit it. Most people do not have that kind of courage. Do not jump into projects or investments you do not understand well. Tell people around you, “I want to be smart about my money.” Over time, you will be.

When I got my first job as an assistant professor at Dartmouth College about twenty years ago, I showed up in the Human Resources office and was given all of these forms to fill out, requiring me to indicate which of the three pension providers I wanted and how I would allocate my pension money. I remember feeling puzzled that such an important decision would be asked of me without inquiring about my knowledge and whether I needed any help. Throughout the years, I have worked to change that process and, with the collaboration of some great people at Dartmouth’s HR office, there are now programs in place to help new hires. I take a little pride in that.

The NYT article is posted here:
http://www.nytimes.com/2011/09/10/your-money/financial-lessons-from-sports-stars-mistakes-your-money.html?pagewanted=all

Think big, in a practical way

2011-09-06T14:15:00.002-04:00

I left for Italy in mid-August feeling pretty discouraged. Most of the recent discussions I had heard about financial literacy were focused on cost. This is clearly an important concern, but, in practice, when people talk mostly about costs, it often means they are not interested in “buying” it. And while the cost of improving financial literacy is a very legitimate concern, how about the cost of this financial mess we’re in. How about that?

The discussion around some financial education programs was also not a mood booster. Some of the papers I saw presented this summer covered programs in which individuals—often impoverished and with little education—were brought to a classroom and given a few hours of “financial education.” The expectation was that those few hours would transform people into savvy entrepreneurs or investors. And what was the main discussion around this? How much these programs cost!

This dominant concern about cost obscures the fact that we face a very important and challenging problem in need of a solution. But we need to think big; we need creative ideas that can help overcome big barriers. Lack of financial knowledge is not something that can be tackled by bringing the adult population back to a classroom for a lecture or two on financial education. We need to be practical, too, regarding what can be implemented. As my college friend—a successful entrepreneur I get together with every time I return to Italy—put it: "think big, in a practical way."

Being in Italy, with a break from my daily routine, allowed me to focus on big ideas, and I have some recommendations, that are also practical, to at least start the discussion, and I would like to hear from others.

Big Idea #1: TEACH THE YOUNG. Financial literacy needs to be implemented in schools. It is too difficult to reach the adult population and it is hard to do any teaching if there is little or no base to start from. Also, we need people to be financially literate before rather than after they engage in financial transactions. There will and should be costs of educating the young. It is meaningless to mandate financial education without, for example, training the teachers to teach those courses. Mandates do not make people any smarter, but having a well-developed curriculum that is followed by trained teachers might.

Big Idea #2: FOCUS ON WOMEN. Women have low levels of financial literacy (lower than men), but they also know that they lack knowledge. Moreover, they want to be “treated”; in most financial programs I have been involved with or read about, the majority of participants have been women. It is going to be much easier to reach and deliver to a population who is interested in financial literacy. This is a simple truth that has been mostly ignored. There are costs of only thinking about costs!

Big Idea #3: MAKE IT SIMPLE. Some financial decisions are truly complex, but there are universal concepts that are at the basis of most financial decisions and that can and should be explained in very simple ways. I am talking about the power of interest compounding, the effects of inflation, and the benefits of risk diversification. In fact, even this is economic jargon we can get away from. Let’s use plain English and explain these ideas in very simple ways. We can even come up with ways to tell stories to teach the concepts so that even a five-year-old could learn them.

Speaking of five-year-olds and of being practical, I was given the following test to see whether one can think practically. Here it is: How do you put a giraffe into a refrigerator? The answer is at the end of the post, but please do not look before you come up with your own solution. I thought about it for five minutes and came up with a method about as simple as putting a man on the moon. That evening, I saw my little niece Giorgia drawing a picture of the family dog, depicting him with 9 legs and 2 enormous eyes. I thought she would be an ideal person for the giraffe test, so I asked her very innocently: “Giorgia, how do you put a giraffe into a fridge?” She looked up, gave me a big smile, jumped from her chair, and ran to the fridge. Moral: you can never beat the creativity of a five-year old!

Question: How do you put a giraffe into a refrigerator? Answer: You open the door and put the giraffe in.

Ten questions and things to know about financial literacy

2011-08-27T06:00:00.002-04:00

While on vacation under the Italian sun, I was asked a lot of questions about financial literacy. Rather than writing a blog post about a single topic, I thought it might be useful to answer some of the questions I’ve been asked in order to hit on a lot of general information about financial literacy. So, here is my list of the top ten questions and things to know about financial literacy:

1) What is financial literacy?
Financial literacy is like reading and writing. It is the knowledge of basic but essential concepts that are needed to be able to operate in today’s society.

2) How do I know whether I am financially literate?
You can take a test here:
http://www.rand.org/labor/centers/financial-literacy/widgets/financial-knowledge-test.html

3) How do I compare with respect to others?
The above test will tell you how the average American responded to five financial literacy questions. If you live in the U.S. and you want to know how financially literate people in your state are, check here:
http://www.usfinancialcapability.org/

4) How does financial literacy in the United States (or Italy) compare with respect to other countries?
We have done a comparison of financial literacy across eight countries (the U.S., Italy, Germany, the Netherlands, Sweden, Russia, Japan, and New Zealand). In a nutshell, the world is flat in terms of financial literacy! You can read about this work here (warning: these are long papers but still fun to read)
http://www.financialliteracyfocus.org/academics/FLatW.html

5) Why should I become financially literate? Can’t I be happily ignorant?
There are costs of being financially illiterate. Studies show that those who have low financial literacy are less likely to take advantage of the opportunities offered by financial markets (for example, refinancing mortgages when interest rates go down or getting higher returns by investing in stocks and bonds), are less likely to invest in mutual funds with low fees, and are more likely to have problems with debt and to pay higher borrowing costs. Overall, ignorance is not bliss.
An overview of these studies is provided in this paper:
http://www.financialliteracyfocus.org/files/FLatDocs/Lusardi_Mitchell_Overview.pdf

6) Where do I go for information if I want to improve my financial literacy?
For readers in the United States, a reliable and independent source of information is www.mymoney.gov. One of the best web sites for financial literacy is New Zealand’s national site. Here is the link (after all, we are going global!):
http://www.sorted.org.nz/

7) What if I want to have fun while I’m learning?
Excellent idea! Doorways to Dreams has designed financial literacy games, so you can become financially literate while having fun. Here is their financial entertainment website:
http://financialentertainment.org/

8) What do I do to promote financial literacy and to become financially literate?
Ask for financial literacy programs in your school, your workplace, and your local library. Become an ambassador for financial literacy.
Three examples of initiatives or tools to use are here:

http://www.math.dartmouth.edu/~mqed/FinancialLiteracyProject/

http://nyse.nyx.com/financial-fitness-kit

http://www.finra.org/Newsroom/NewsReleases/2011/P122886

9) Who is promoting financial literacy? Just academic nerds like you?
Are you kidding me? Here is a list of people (and one puppet) who are promoting financial literacy.
(i) Elmo, puppet and TV celebrity (for you younger readers):
http://video.nytimes.com/video/2011/04/15/business/100000000776361/talking-money-with-elmo.html?hp

(ii) Ben Bernanke, Chairman of the Federal Reserve. You can read one of his recent speeches here:
http://www.federalreserve.gov/newsevents/testimony/bernanke20110420a.htm

(iii) Ray Lewis, football star. You can read about one of his talks here:
http://articles.nydailynews.com/2011-04-29/sports/29510296_1_ray-lewis-uaf-financial-literacy

(iv) Both President Bush and President Obama have been supporters of financial literacy, via, for example, the President’s Advisory Council on Financial Literacy
http://www.treasury.gov/resource-center/financial-education/Pages/Advisory.aspx

10) Are there any big initiatives happening on financial literacy?
Yes, there are many. One important initiative is that of the OECD (Organisation for Economic Cooperation and Development). Starting in 2012, the OECD’s Programme for International Student Assessment (PISA) will measure financial literacy among 15-year-olds in 19 countries. You can read more about this important initiative here:
http://www.pisa.oecd.org/dataoecd/8/43/46962580.pdf

No Roman Holidays

2011-08-15T15:55:00.000-04:00

I am in Italy where, it has been said, even the statues go on vacation in August. While this is the feeling one normally gets in the summer, the Italian government, under pressure from the European Central Bank, has just—in a short period of time—put together a series of decisive reforms. Little was left untouched, from cuts that reached into the pockets of politicians, from whom many privileges have been taken, to the abolition of small provinces to reduce the costs of local governments to tax increases —including a new “solidarity fund” which will require temporary tax increases for those whose income is above 90,000 Euros—to increases in the pension age for women (a gradual move from age 60 to age 65).

This was no Roman holiday (for those of you who have seen the wonderful movie with Audrey Hepburn and Gregory Peck) for the Italian politicians, who have used all of the tools at their disposal to rein in the deficit and tackle a public debt as high as 120% of GDP. And for those who think these are the reforms that Socialist Europe makes, I want to remind readers that Italy, in fact, has a right-wing government. For those who wonder why this was not done before, I would argue that this is a good way to use a severe crisis (no crisis should be wasted) to convince both citizens and politicians that changes are necessary.

The reason I have chosen this topic for this blog posting is that in many countries around the world the crisis has profound consequences, with or without changes in government policies. In the newspapers, the first pages are now dedicated to economic news. Long articles are written about the reactions of the financial markets, about the spreads in the government bonds of different countries, and about the economic measures that countries have taken in reaction to a severe crisis.

This is another reason why we need financial literacy. Every day we read and hear economic news. This news is not only affecting or reflecting the macro economy but has an effect on our lives. The behavior of financial markets is affecting our savings, our cost of traveling abroad, our capacity to retire or to donate to the initiatives we deem important. Similarly, the changes in economic policies are affecting the services that we get from the government, our income, our capacity to find a job or to get a good education. We need to be able to understand what this news means, we need to be able to take advantage of the opportunities offered by the financial markets, we need to be able to understand the causes and consequences of the economic reforms that governments are proposing to us. And it is perhaps in a time of economic crisis that we need financial knowledge the most.

So, while Italy pauses during this national holiday, I am writing a new blog post about financial literacy because it is a regular Monday in other countries, because many stock markets are closing with moderate gains today, and because economic crises may even bring good things, for example new and much-needed economic reforms.

If some of you are wondering what I will do with my non-Roman holiday, I will do three things: bask in the sun, go to the opera, and of course write more blogs.

Financial literacy for politicians

2011-08-09T20:44:00.002-04:00

I have argued in my blog postings that individuals need financial literacy because we are increasingly asked to make financial decisions that have important consequences. But there is a group for whom financial literacy is even more important, since their decisions are going to affect the whole population. These are our politicians.

As a case in point, the consequences of the standoff about the debt ceiling are severe. For the first time in history, the US debt has been downgraded from AAA to AA. This could mean higher interest rates, for example, on mortgages or car loans, and thus higher costs for many consumers. The stock market gyrated last week, dropping sharply, and it dropped more than 600 points on Monday, destroying in less than a week most of the gains that had been made slowly over many months. These are serious problems that affect real people!

When politicians make decisions with such consequential economic implications, they must be financially literate. Consumers learned about the costs of financial illiteracy during the financial crisis; politicians will likely get their lessons soon, if what they want to see is what happens to an economy in which basic economic principles are ignored.

There have been a number of statements by politicians that reveal their financial illiteracy. One example: the argument that it does not matter (or we should not care) if the world is watching or what the world thinks of how the US handles the debt ceiling. This is unfortunately wrong. A large portion of US debt is held by the Chinese, and so it does matter what other countries think of the discussion about the debt ceiling, and politicians should care—in fact, they should care a lot. Another example: the suggestion that we should let the government default to demonstrate how important it is to reign in the deficit. This is strange financial decision-making. It is the equivalent of a household wanting to burn down the house to discipline its members. I would recommend trying that strategy on a desert island but not in a country inhabited by 300 million people.

I doubt financial illiteracy is concentrated in one political party only. We have witnessed poor economic decisions a lot in the past few years. Having public debt on an unsustainable path is not only problematic, but it provides a bad example to citizens as well. Not just the federal government but also state and local governments have done a poor job in keeping their finances in order.

The decisions that politicians make have enormous implications for the economy and for all of us. We are the ones paying the cost of the decisions that are made. We should demand that the politicians we sent to represent us and who are bound to make these important decisions be financially literate and explain their decisions to us in economic terms. A fragile economy that has survived a very severe crisis and is trying to recover from a great recession needs politicians who understand basic economic principles, now more than ever.

The NFL is Back

2011-07-31T23:47:00.006-04:00

I was very happy to hear that the NFL lockout was over, and I have been avidly reading the sports section of the newspapers. I normally read the business section, but this week I could not bear to read the discussion about the debt ceiling any longer, and it was good to go straight to the sport pages. While attending the National Bureau for Economic Research (NBER) Summer Institute last week, I startled a few economists with my conversations about football; I enjoyed that!

There are four things I like about the agreement that was reached last week:

1) Players’ safety and health. The agreement limits on-field practice time and contact. Importantly, it limits full-contact practice in the preseason and regular season. Who needs concussions? I was appalled at the statistics about injuries among football players when I read them. These are serious issues and I frankly wonder why it took so long to worry about players’ safety. This discussion has already trickled down to college football, and I was very happy to see that the Ivy League colleges have also adopted a limit to football practices to reduce head injuries. Importantly, the new agreement provides enhanced injury-protection benefits and an opportunity for current players to remain in the player medical plan for life. It also set up a fund for medical research, health care programs, and NFL Charities. These are smart features; a big thumbs up.

2) Benefits for retired players. The agreement provides additional funding for retiree benefits and sets up a fund to increase the pensions of pre-1993 retirees. This is also a good and needed program. The career of players is often very short (and cut short by injuries as well) and it is hard to accumulate a good pension during a short career (let alone think about pensions when one is 22!). We have read too many stories of players running out of money after they stop playing, and it is important to find ways to provide for the players’ future. Another thumbs up.

3) Improvements to career transition and degree-completion programs. Because, as already mentioned above, the career of players is short, it is important to provide help in their career transitions. Players have very specific skills that can be used well in sports but also in other fields, but they need help in translating those skills or simply in being connected to other fields. Some players have not completed their college education and, given the returns to higher education, it is beneficial to facilitate and help players finish their degrees. A thumbs up here as well.

4) Sharing among players. To those who believe players are greedy and want absurdly high wages, I would like to point out there are absurdly high amounts of money on the table, and the projections are for high growth in that money in the future as well. In fact, players have agreed not only to a stricter salary cap but a new fund will also be created to redistribute savings from the new rookie pay system to current and retired-player benefits and a veteran-player performance pool. And we have now heard news about Peyton Manning staying with the Colts but passing up being the highest paid player in NFL history. This will allow the Colts more flexibility to sign other players. This is the statement Manning made: “Whether I deserve to be the highest-paid player over the next five years is irrelevant. I would rather them use the money and keep the players they want to keep and get other players.” One thumbs up to Peyton Manning. Another thing I want to remind readers is that players donate generously. Many have their own charities and are very sensitive to social issues related, for example, to poverty, education, and discrimination. Because of that spillover, I would have preferred to see more rather than less money going to the players.

But the best news is that we will be able to go see the games. I am getting ready to not only watch them on TV but to go to the stadium. As for the other lockout (about the debt ceiling), I think politicians could learn a thing or two from the NFL.

Hopes for the Consumer Financial Protection Bureau

2011-07-25T22:33:00.000-04:00

The Consumer Financial Protection Bureau (CFPB) officially opened its doors on July 21, 2011. Established by the Dodd-Frank Act, we finally have an institution that, as the name says, will be devoted to protecting consumers. This is an important milestone. It is not possible to live in a world of individual responsibility without at the same time having a structure in place to protect consumers. This is not just a political choice, it is an inevitable step to take when we put people in charge of their financial well-being. The shift in responsibility from governments and employers onto individuals has stemmed from changes in the age composition of the population (an increasingly elderly population) and in the increased mobility of the labor markets (which requires that pensions be portable), and I do not see a way of going back to a system dominated by, for example, defined benefit pensions. But consumers face a formidable task, particularly now that financial markets around the world have become very complex and the choice of financial products has dramatically expanded.

I have several hopes for the Consumer Financial Protection Bureau.

• First, I hope they will set the right expectations about what they can accomplish, in particular in the short run. Protecting consumers is a very complex task; it requires a combination of both regulation and financial education, and it will take time to get that combination right. Having the Bureau does not make people smarter overnight, and—given widespread financial illiteracy—the Bureau has a challenging task in front of it. I can already envision front-page news articles the next time we will experience financial troubles (and there is trouble to come; more on this below), which will argue that despite the existence of the CFPB, we have not prevented financial woes. Having the CFPB does not mean that consumers will not make financial mistakes or that the supply of financial products will have no flaws. While the Dodd-Frank Act provides guidelines on what the Bureau should do, it is very important to make clear what it can realistically aim to accomplish in the short run.

• Continuing on the previous point, I hope that the Bureau will devote ample attention to financial education. One of its mandates is to promote financial education but, as we know, education inevitably takes time—and no one has time; no one can wait. But, as Federal Reserve Chairman Ben Bernanke has said, “well-informed consumers, who can serve as their own advocates, are one of the best lines of defense against the proliferation of financial products and services that are unsuitable, unnecessarily costly, or abusive.” We need an institution that has the brains, the courage, and the vision to think beyond the short run. In this respect, the Bureau could set itself apart from other institutions intent on pleasing people, politicians, or voters, with no consideration for the future. Myopic policies are costly and these costs will eventually be paid (young people, be warned). Most of our financial decisions have to do with transferring resources to the future (for example to pay for expenses after retirement or for children’s college education), and we need institutions with a long planning horizon.

• Third, I hope that the Bureau will pay careful attention to what has happened during the recent financial crisis but it will also look ahead and be proactive in addressing potential future problems. There are early indications of serious problems brewing inside the Defined Contribution pension system. There are also problems regarding how people assume and manage debt. These are issues that emerge when looking at data, and is important to use that evidence for prevention.

• Finally, I hope the Bureau will focus its efforts on those who need protection the most. While everyone will benefit from the existence of the Bureau, it is clear that there are vulnerable groups in society that deserves particular attention. These groups include not only the young and the old, which have been shown to display alarmingly low levels of financial knowledge, but also women, those with low educational attainment, and African-Americans and Hispanics. Again, the data speak clearly about who the vulnerable groups are and also provide suggestions on how to protect those vulnerable groups.

The CFPB is an institution that can make a difference in people’s lives. I want to remind you that we are all consumers; we all make financial decisions; we all need fair treatment in the market and financial products that serve our needs well; we all have grandparents, children, and female and minorities friends who are part of those vulnerable groups. Personal finance is, well, “personal.” We should not forget about that, and we should take time to recognize that with the CFPB we have made one important step forward. It’s about time.

Teaching the STARs

2011-07-13T00:10:00.002-04:00

I recently taught a class on financial literacy in the new STAR EMBA program that the George Washington School of Business (GWSB) just launched. This is a new Executive Master in Business Administration (EMBA) for Special Talent, Access and Responsibility (STAR) students, targeted to athletes, celebrities, and others. For those who do not yet know, I have moved to GWSB, so you can say I went from teaching the little stars (Dartmouth undergraduates) to teaching the bigger stars (athletes and celebrities).

Programs like this one are much needed and fill an important gap. Irrespective of high salaries and lucrative contracts, an athlete’s career is normally very short and often riddled with injuries. Ken Ruettgers, a former NFL player and now the executive director of GamesOver, documented that 78% of NFL players are bankrupt, divorced, or unemployed two years after retiring. This is one of the ugliest statistics I have seen. As Doug Guthrie, the dean of GWSB, stated succinctly: “These individuals need help translating their special talents and access to resources at a very early stage in their lives into the business skills that will help them elevate their personal brands into business dreams that will change the world.” I particularly like the latter part of the statement. These are extraordinarily talented individuals who were recruited for the EMBA program because of their enormous potential to make an impact.

The program is customized to fit these students’ needs, including their playing seasons (several of the football players in class are still active). Thus, it started with two weeks of full immersion in many courses in Washington, DC, and will continue in the heart of the financial capital (New York) and on the West coast, in Los Angeles. Spouses were also accepted and very much welcomed into the program, and out of 23 students, we had four couples in class.

In spite of their special talents, the group, in many ways, behaved very much like regular students. After a few days, they were wearing GW T-shirts or caps, were complaining about homework, and had found the strategic places in the classroom where they thought they could surf the internet, respond to e-mails, or finish their assignments without being noticed (we saw them, of course). There were differences as well. After a few days they stopped eating the catered lunches (too many calories I guess); regular students would never pass up buffet lunches. They went regularly to the gym, many of them looking so super-fit that I could not avoid feeling very wimpy.

But beyond these differences, they were not, by any means, a regular class. Their insights were profound and they startled a few faculty members with their comments. They did not speak a lot in class, but when they did, they were succinct and nailed a point, as if there was no margin for error. Even though they were soft-spoken in class, I could sense their confidence and determination. I admired the female basketball players’ toughness—they had played in several countries, spoke many languages, and one of them, more than 6 feet tall, was wearing very high heels!

We knew we had great potential to work with. We knew we could push these students for more work, give them challenges, and expect the best. These students know endurance, the importance of hard work, the correlation between effort and results. As I looked at this class of football, basketball, and baseball players; Olympic gymnasts; and poker players, I knew I could expect a lot from them. I also knew they expected a lot from me.

My class on financial literacy was divided into three parts. In the first part, I discussed why financial literacy has become important for each of us, what the consequences of financial illiteracy are, and why—in a new world of individual responsibility—financial literacy is an essential tool for making financial decisions. In the second part, I discussed why financial literacy is especially important for athletes: given their short careers, good planning is particularly important, as is an understanding of how to grow and protect wealth to make sure that resources last a lifetime. While most people get rich later in life (apart from those pesky Harvard students who invent Facebook while in college), athletes are rich early in life, so they have to learn in their twenties about trusts, wills, and prenuptial agreements. In the third part of the class, I discussed how these students can make a difference in promoting financial literacy. My discussion here was focused on the divergence of wages between those with and without a college degree and the fact that high school students are asked to make one of the biggest investments of their lives—the investment in education—without having any notion of this basic concept or of the basics of economics and finance. I discussed what athletes can do to make a difference in the lives of the many young people who look up to them.

For those of you who think that we professors just show up in class and teach off-the-cuff, let me tell you that I prepared a lot for this class and was quite nervous at the idea of teaching this group of students. Several weeks ahead, I started reading about the different sports played by the athletes who would be in my class. For example, I read lots about football and football players: rate of injury, lengths of careers, what it means to be drafted. Because I did not know anything about the game, I read “Football for Dummies,” so at least I knew what a linebacker is and could understand the dossiers of the athletes in my class. I read the sport pages of the newspapers and read sports magazines (I understood half of what they were saying, but there were some good stories). At the end of the class, I went to talk to one of the students, who is a football player for the Baltimore Ravens. I had mentioned the Ravens a lot in class and talked about Ray Lewis (of the Ravens) as an example of an athlete who cares a lot about financial literacy, and I wanted to tell him that I think the world of Ray. He jokingly suggested I come teach the Ravens. When I told him I didn’t know whether I could really teach a whole team, his reply hit me like a ball in the head: “Yes, you can. Because you can relate to us.” I always prepare for my classes because I want to know who my students are, what they need, and to make the class relevant to them, but no student ever told me “you can relate to us.” I’ve been teaching for close to 20 years, and it was a linebacker from a football team in Baltimore who best articulated what teaching means for me and what I strive for every day in the classroom. I never felt so good. As I told you, these people are truly special, they are STARS!

The courage of women

2011-06-30T20:28:00.002-04:00

I want to cover a topic that is not discussed much in the world of finance: the courage of women. In an arena in which women have been scarce and where financial genius and wizardry are often synonymous with being male (and there are many excellent men out there), it’s interesting to note, by gender, some of the key players in financial events of recent years.

In a world where corporate interests have a big voice, it was a woman who stood up and advocated protecting the consumer, the “little guy.” It was a woman who promoted regulation of the derivatives market, an arcane market that few understood well but in which immense risk could be taken. It was a woman who blew the whistle on Enron and its overinflated evaluations. And the list goes on.

In the same time frame, we witnessed Bernie Madoff carry out an enormous Ponzi scheme that defrauded individuals of their retirement savings and institutions of their endowments. And it was a young derivatives broker who brought down Barings Bank, one of the oldest of the United Kingdom’s investment banks. This dude even had the audacity to write a book titled “How I Brought Down Barings Bank and Shook the Financial World.” Another male trader almost took down France’s second-largest bank. The former head of the International Monetary Fund, which had been dealing with the financial situation in Greece, which is threatening the very existence of the Euro, has been under house arrest. And the list goes on.

At the risk of making gross generalizations about gender and finance, the above outline makes me hope we will begin giving truly serious consideration to furthering the role of women in the financial world and start opening doors more widely to them. One useful role I could see for women is in curbing the excesses that we have witnessed in recent years and that have caused some venerable firms to go knocking at the doors of government for help. The risk-averse attitude of women (considered a fact but hardly documented in the data), often considered a weakness, may turn out to be a strength. As women rise to the top, I hope their voices will be heard.

Some progress has undoubtedly already been made. The top regulator of financial markets and head of the Security and Exchange Commission is Mary Schapiro. At the Department of Labor, Phyllis Borzi is the Assistant Secretary of Labor for the Employee Benefits Security Administration, whose mission is to protect the security of retirement, health, and other employee benefits for America’s workers and to support the growth of the private sector employee benefits system. We are talking about trillions of dollars here! The endowments of some of the wealthiest universities, such as Harvard, are managed by women, and many Ivy League colleges and universities (which are some of the richest institutions in the United States) are headed by women. We have yet to see any woman go down in flames from their seats at those positions of power, but, of course, history will tell. The helm of the International Monetary Fund will be given to a woman. This is another milestone, though I wish women were not brought in only when crises occur and when everyone—man or woman—will face very difficult situations and is more doomed to fail than to succeed.

I believe that one ideal job for women in finance is that of financial advisors. A critical quality in that job is the ability to care for clients and listen to their needs and concerns, and women can excel in that. And, important in wealth management is not only wise investing but also the right amount of protection, against disability, death, and other risks. Coming back to my posts of a few weeks ago, there was much wisdom in the football players’ bringing their mothers to the New York Stock Exchange to discuss financial literacy. That memory still warms my heart.

Women have used cleverness and ingenuity when caring for others, achieving important results. My favorite example is Ethel Percy Andrus. A school principal who retired in the late 1940s to take care of her ailing mother, she was shocked to discover how many retired teachers had no health insurance. As there was no national health care program for people over age 65 (Medicare wasn’t created until 1965), Ethel turned to insurance companies to offer group health insurance to retired educators. She was turned down by more than a dozen companies but she persisted until one company agreed to develop a health plan for retired teachers. The plan became so popular that non-educators also wanted to purchase it. In 1958, Ethel established AARP (then known as the American Association of Retired Persons). The rest is, well, history.

A (very special) College Fund

2011-06-03T14:57:00.001-04:00

If you watched the NBC Nightly News on Wednesday, June 1st, you heard the story of a boy, La’Shaun Armstrong, just 10 years old, who survived a very tragic accident in which his mother drove a van carrying him and his three siblings into the Hudson river. La’Shaun was able to escape via a car window and swim for help. Tragically, his mother and siblings were dead by the time help arrived. But if you watched that broadcast, you also heard that the Ray Lewis Foundation and United Athletes Foundation (UAF) recently organized a fund-raising event to provide La’Shaun with counseling and a college scholarship and how athletes involved with the foundation have rallied to support La’Shaun.

I am going to put on my economist’s hat to talk first about college funds. Over the past decade, tuition and fees at four-year public colleges and universities have increased more rapidly than they did during the 1980s or 1990s, rising by an average of nearly 5 percent each year (adjusted for inflation). With this trend unlikely to abate, an average American family with children can expect to dedicate a sizable share of their resources to paying college tuition. However, according to the FINRA Financial Capability Study, well below half—41 percent—of those who have financially dependent children have set money aside for college educations. And even those who have set money aside may not have done it in the most tax-savvy way. Only 33 percent of those who have set aside money for college educations have used a tax-advantaged savings account such as a 529 Plan or a Coverdell Education Savings Account.

But with the costs of college increasing so fast, planning for children’s education is critically important and may be the deciding factor in whether children will be able to go to the college of their choice or even to attend college at all. And with wages diverging so widely for workers with and without a college degree, not having that degree may mean a lifetime of low and stagnating wages. Building a college savings fund may be not only the best investment for the children’s future but also a way to inspire children to go to college. Of course, starting early is the key to build up savings: one dollar put aside today at an interest rate of 5 percent will more than double 15 years down the road. It is great that the foundations helping La’Shaun have thought about a college fund for him.

But let me now return to this story without my economist’s hat. As Albert Camus would say, life has its way of being tragic, and those frigid waters changed La’Shaun’s life instantly and dramatically. His is a story of incredible survival and resilience. Still, a kid of that age needs more than financial support. I had the opportunity to meet La’Shaun in New York at the recent event organized by the UAF. He is a shy kid with a tenderness in his eyes, and on meeting him, you can hardly resist giving him a hug. And a big hug he got from, well, a very big guy (you can see pictures of those strong hugs along with the full NBC story here: http://today.msnbc.msn.com/id/43236305/ns/today-today_people/t/boy-who-survived-hudson-crash-nfl-star-brother/ ). Ray Lewis and the UAF have committed not just to establishing a college fund but to being the mentors, the family, of this very special kid. In the words of La’Shaun, Ray Lewis is “like an older brother to me.” Reggie Howard, the president of UAF, has made La’Shaun part of the players’ families.

When asked what they aim to do for La’Shaun, Ray Lewis stated it succinctly. His hopes are “to achieve much more than what his situation offered.” There is early indication that what they are doing is working. When asked what he wants to do when he grows up, La’Shaun responded without hesitation: “I’m not sure yet.. First, I have to finish college.”

If you want to donate to this very special college fund, see the link below.
http://www.unitedathletesfoundation.org/

Ending Athletes' Bankruptcies

2011-05-30T17:22:00.003-04:00

I’d like to dedicate another blog post to the issue of athletes and financial literacy. Around the time of my previous post on the topic, NPR featured a story about professional athletes and their financial literacy (the link is provided at the end of this post). The article mentions Kenny Anderson, who earned more than $60 million during his 14 years in the NBA, yet declared bankruptcy the year his career ended. The story goes on to talk about what happens when athletes acquire great wealth without having a clue about money management. Even in the NFL, which has the most college graduates, players often do not have any experience managing money, including what they might learn from paying for a college education, as they generally attend college on a scholarship.

I sent the NPR story to Reggie Howard, who is the President of the United Athletes Foundation and cares deeply about this topic. His reply came back with even more sobering information. He was just informed that 15 athletes in one city alone have been victimized by a single financial advisor. Each athlete gave the advisor’s agency control over their bill payments and money management and all got a bad deal. No one ever talked about it, which allowed the advisor to continue to use the same method on each player. Reggie was outraged and ended his message with the passionate tone he uses when he talks about victimized players: “This subject really gets my blood boiling. We have to change this.”

Stories like this one illustrate yet again the dire consequences of financial illiteracy. Unfortunately, professional athletes—newly wealthy, young, and inexperienced—are ideal targets for scams or unscrupulous advisors when instead good financial planning is the thing they need the most. Even for those making very sizeable incomes, there is no guarantee that the money will last a lifetime; athletes’ career paths are very unique (for example, they can be quite brief) and risky (a serious injury can put a quick end to a high income), and this requires even more skillful money management than normal. Sound planning is needed to make sure that money will extend well beyond the careers of players, that it is invested to grow over time, and that it is not squandered in unsustainable lifestyles or in risky investments that players do not understand or have experience with. And athletes need to know how to protect their wealth, including how to avoid bad advisors and unscrupulous agents and how to make good decisions when presented with well-intended requests or investment suggestions from friends.

We cannot expect all professional athletes to be experts in dealing with money. They become wealthy very early in life, before they have had a chance to gain any experience in dealing with financial matters. Their colleagues are mostly other athletes or sports professionals, so it is not possible to get much help from their peers. In my view, some money management has to become part of the standard, ongoing services that are offered to athletes. In the same way that it is standard for athletes to have coaches, doctors, and managers to help take care of their physical fitness, so it should be standard to have help in taking care of their financial fitness. And this help has to be specialized, designed to fit the needs of the very specific career that athletes face. Finance and financial decisions are too important, with potentially profound consequences for athletes' lives, to just be left for the athletes to figure out on their own.

Like Reggie, I detest the idea of athletes going bankrupt. It is not just the fact that it is unjust, unnecessary, and ugly as hell. It is also that we look up to and admire these people. Unlike them, we cannot bound up two flights of stairs without gasping for breath, we have back pain from sitting long hours at a desk, and we have boring jobs and screaming children. But when we see these athletes play, they make us dream. We believe they are special and we admire their skills and talents. This is why we get very upset when we find out that an athlete has, say, a gambling problem or beats up his spouse. In our eyes, they are better than we are, and they should do better than we do. And to young people, athletes are practically superheroes. Telling kids about athletes’ financial troubles would be like breaking the news that the Bat mobile has been repossessed. If athletes are in financial trouble, then, well, they are just like the rest of us. I’d like to see them be better equipped to make good financial moves; maybe if they can do so, the rest of us will follow.

Here is the link to the NPR story.

http://www.npr.org/2011/05/19/136445218/for-some-athletes-a-short-lived-financial-success

Financial literacy and football

2011-05-11T10:35:00.003-04:00

I was recently invited to participate in a panel on financial literacy that was organized by the United Athletes Foundation (UAF) and the STAR EMBA program at the GW School of Business. It was held at the New York Stock Exchange, and it was good to go back to NYSE a second time. I had accepted the invitation without giving much thought to who would be in attendance at the event. A few days before the event (which was held April 29, 2011), I was given the list of the panel participants: Robert Marcham (moderator), Annamaria Lusardi, Ray Lewis, Rushia Brown, Chuck Lewis, Bill Imada, Sam and Char McNabb, and Gordon Brown. I had not heard of these financial literacy experts before and wondered whether they were academics as well (please, remember that I was born in Italy, so I do not know very much about American football or basketball). So, it was not until I arrived at NYSE that Friday that I discovered that Ray Lewis was THE Ray Lewis of the Baltimore Ravens, Sam and Char McNabb were the parents of THE Donovan McNabb, and Rushia Brown was THE Rushia Brown. There I was sitting on a podium to the right of superstar Ray Lewis, speaking to an audience of athletes and their families as well as the President of the UAL, Reggie Howard. Oh boy, I was in deep trouble!

I was the first on the panel to speak. I talked about the troubling state of financial literacy in the population, of the divide between those who know and those who do not know, of the sharp contrast between the complexity of financial markets and the very low level of financial knowledge that most people have. I spoke of the dire consequences of the lack of financial literacy; it is those who are less financially literate who pay more for financial services, who are more likely to engage in high cost mortgages and to default on them, and who are less likely to take advantage of the financial markets or to accumulate wealth. In the same way in which skills, practice, and experience help athletes to score and avoid faulty steps, financial literacy empowers people to take advantage of the opportunities offered by financial markets and to avoid scams or running into financial trouble. I also spoke of the difficulties that athletes may face in managing their finances and taking care of themselves, their families, and their communities both because of the peculiarity of their short careers, the increased complexity of financial markets that everybody is facing, and, of course, their fame.

Ray Lewis spoke next. He simply blew everyone away. He spoke of what financial literacy means to him, and the problems he has faced. He reflected on the grim statistics we had heard from the moderator that more than 70% of NFL players are bankrupt, unemployed, or divorced a few years after retiring. He talked about how many young athletes are ill informed about investing and managing their money and the problems that result. And he spoke of the need for athletes to be worry-free when on the field practicing or playing—absolutely nothing should distract from the focus on the game. He spoke with a passion and an intensity I have not seen in any person. I have a Ph.D. in economics and am myself passionate about financial literacy, but I could not have articulated the case for financial literacy the way Ray Lewis did.

Sam and Char McNabb spoke of the continuous worries that parents of athletes have about their children. From the anticipation of who will be drafted to the journey through the games, injuries, victories, and losses, they spoke of the desire to protect their son from making bad financial decisions, but the difficulty they face in knowing where to turn for advice. It was when Char McNabb spoke that I realized that about half of the audience were mothers of athletes. She asked them to raise their hands, and so many hands went up! I cannot begin to tell you how appealing it was to see that it is their mothers who the athletes brought to this event; it is them they turn to, whom they trust. I developed an instant affinity for these football players! And when the speaking was finished and I watched the mothers posing for a group photo, I could clearly see where the determination of these athletes comes from!

Sitting among these extraordinary people, I started to dream. What if these athletes became the champions for financial literacy? What if they spoke to students and told them how important it is to become financially literate. Students would listen to them; they look up to athletes. Imagine if we could organize a competition among schools, and the students who got a perfect score on a financial literacy test would get to spend an hour with, say, Ray Lewis or Reggie Howard, to listen to the stories of how they trained to win a game and why they care about financial literacy. Imagine if one of these players decided to become a spokesperson for financial literacy. Imagine…

As I hope I have conveyed, this was not my usual financial literacy conference, and not my typical audience. But it was a special day, and it illustrated how profound and widespread financial illiteracy is and how severe the problems associated with it are. And everybody can be affected by it, even the superstars we watch on TV. At the close of the panel, I got a warm handshake from Ray Lewis; he said he enjoyed my talk. It was . . . priceless!

You can look at some of the photoes of the event on our Facebook. Here is the link: http://www.facebook.com/media/set/?set=a.174503175936844.49893.119369231450239&saved

The Workplace Financial Fitness Toolkit

2011-04-21T22:33:00.001-04:00

On April 12, 2011, we launched the Workplace Financial Fitness Toolkit. With the support of the New York Stock Exchange (NYSE) Foundation, Punam Keller, from the Tuck School of Business, and I have designed a customized workplace financial fitness program using an innovative and practical approach based on well-established financial literacy and marketing principles. Every employer interested in starting a financial education program can use this toolkit.

Lack of financial literacy in the United States is well documented—the research tells us that most people lack basic financial knowledge and are not well equipped to deal with complex financial decisions. As a result, many individuals have difficulty making sound financial decisions. Remedying this problem is terribly complicated, one reason being that individuals have different needs, different preferences, and face different economic circumstances.

The workplace is an ideal venue to provide tools to facilitate financial decision-making. The goal in developing the toolkit is to provide a checklist of recommended financial fitness action items along with marketing materials to encourage employees to improve their financial fitness.

In essence we have developed two toolkits: an Employer Customization Toolkit and an Employee Customization Toolkit. The Employer Customization Toolkit contains (1) the Employer Checklist, (2) motivational information about the importance of every employer providing or facilitating 10 key steps to financial fitness, and (3) additional materials to help employers with implementation of the financial fitness recommendations. The recommendations are divided into three stages: basic, intermediate, and advanced. Employers who currently offer financial fitness assistance can use the Employee Customization Kit to motivate employees to participate in the financial fitness programs offered.

The Employee Customization Toolkit is designed to empower employees to improve their own financial fitness. The Employee Customization Toolkit contains (1) the Employee Checklist, (2) motivational information on the importance of every employee improving aspects of their financial fitness, and (3) implementation guidelines for each recommendation. Like the Employer Customization Toolkit, the employee toolkit allows individuals to customize or select the fitness recommendations that suit their needs.

Developing the program was a challenging task. But we very much benefitted from the guidance of Michelle Greene, the VP, Head of Corporate Responsibility, executive director of the NYSE Foundation and a champion of financial literacy. We also assembled a team of experts to help us in this work. We benefitted from the insights of academics like Robert Clark (North Carolina State University College of Management) and Eric Johnson (Columbia Business School), financial literacy leaders like Carrie Schwab-Pomeratz and Michael Townsend from the Schwab Foundation and Ted Beck from the National Endowment from Financial Education (Carrie and Ted also serve on President Obama’s Council on Financial Capability), Janet Parker from the Society for Human Resource Management (a former member of President Bush’s Council on Financial Literacy), and Jennifer Wayman from Olgivy PR Worldwide (one of the creators of the The Heart Truth, an award-winning national awareness campaign about women and heart disease with its signature Red Dress symbol).

On April 12, not only did we launch the program but we also rang the opening bell at NYSE, an experience I will never forget. And yes, we took a lot of pictures which are now posted on the FLC’s Facebook page. You can also watch a video of the opening bell ceremony (did I say it was memorable?).

http://www.facebook.com/pages/Financial-Literacy-Center/119369231450239
http://www.nyse.com/events/1302515608944.html

We hope many companies will embrace the Workplace Financial Fitness Toolkit and customize it to meet their goals of assisting employees in the attainment of financial independence and security. The program can be found here:

http://nyse.nyx.com/financial-fitness-kit

Celebrating Financial Literacy Month

2011-04-01T22:53:00.004-04:00

April has been declared Financial Literacy Month and we, at the Financial Literacy Center, celebrate it by meeting with our team members to present preliminary results from the 19 projects the teams are doing in year 2. The research teams are tailoring educational materials for people at various stages of their lives: young workers, mid-career workers, those approaching retirement, and retirees. They are also targeting underserved populations such as low-income, young, and disabled workers, all of whom are particularly vulnerable during periods of financial turbulence.

The second year activities cover a range of topics, including:
• How automatic enrollment in pension plans can improve savings
• How to increase the use of the government’s key tax-time savings policies, particularly the Saver’s Credit targeted to lower-income households
• How financial advisors help their clients decide when to claim Social Security benefits and whether this advice is based on client attributes
• How to develop an effective curricula to teach financial literacy to pre-service K-8 teachers and adult learners
• How to improve access to financial services for legal immigrants
• Whether additional disclosure would be valuable in helping people anticipate and plan for health care expenses in retirement
• Whether an intensive online “financial bootcamp” for women is effective in modifying behavior.

We held our meeting at Harvard Law School and I am grateful to Howell Jackson for hosting the workshop in the elegant rooms of HLS. But the New England weather did its April fool’s trick: rather than warm spring weather, we got several inches of snow today. (Note to self: move closer to the equator!)

You can read more about our projects at: http://www.rand.org/labor/centers/financial-literacy/projects.html
And you can see a picture of all of us on Facebook!

Financial fragility

2011-03-14T14:02:00.001-05:00

I mentioned in my previous blog post the importance of having a buffer stock of savings. I would like to continue to discuss what individuals actually have or can rely on in case they are hit by a shock. This is part of a new research project, which is joint work with Peter Tufano of Harvard Business School and Daniel Schneider, a sociologist who is finishing his Ph.D. at Princeton University.

We engaged the market research firm TNS Global and collaborated with them to design a new survey that was fielded in June–September 2009. Specifically, we ask respondents: “How confident are you that you could come up with $2,000 if an unexpected need arose within the next month?” Respondents could reply:

• 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

Because we are dealing with an unexpected event in the future, it is important to ask about confidence rather than ask a yes or no question. The $2,000 figure reflects the order of magnitude of the cost of a major car repair, a large co-payment on a medical expense, legal expenses, or a home repair.

The news is not good: The capacity to cope with financial emergencies is very limited. Half of Americans report that they would probably or certainly be unable to cope with such an emergency. More specifically: 24.9% of respondents reported being certainly able to cope; 25.1% probably able to cope; 22.2% probably unable to cope; and 27.9% certainly unable to cope.

The capacity to cope with a financial emergency is not only generally limited but also varies significantly with the economic and demographic characteristics of individuals and their households. While those with higher income and greater educational attainment report greater capacity to cope, a large proportion of individuals with middle-class incomes report they are certainly not or probably not able to cope. Moreover, even among those with some higher education, more than half reply that they would be certainly or probably not able to cope. In other words, while inability to cope is severe among the less educated and low-income groups, it is not limited to the poor or to a small group of the population. Similarly, while financial fragility is more pronounced among the young, many older respondents, who are presumably close to retirement and at a point in life when their wealth accumulation should be at its peak, report anticipating difficulty in coping with a financial a shock. And women and families with children are less likely to be able to cope with shocks.

The financial crisis is a clear contributor to financial fragility, although not the only one. Those who suffered wealth losses, particularly large losses in excess of 30%, report greater inability to cope. This may explain why even some wealthy people anticipate potential inability to cope with a shock—likely due to lowered wealth in conjunction with high fixed costs and inflexible commitments The unemployed are also much more financially fragile, with just about one-third reporting they would certainly or probably be able to cope and 41.2% reporting they would certainly be unable to cope.

This is a worrisome finding as it shows that individuals and the economy are fragile to shocks. Many policies have so far focused on promoting asset building for the long run. It may be useful to start considering the short run as well.

I am presenting this work at the Brookings Institution this week, and I will keep discussing more findings and the potential implications of this work. Please send me your comments, too.

The Huffington Post featured this paper on their web and asked to share your story. Here is the link:
http://www.huffingtonpost.com/2011/03/17/could-you-come-up-with-20_n_837225.html

Saving for a rainy day

2011-02-24T14:16:00.002-05:00

This week, February 20-26, 2011, is America Saves Week and I would like to write about the importance of precautionary saving.

One of the most worrisome statistics from the 2009 FINRA Financial Capability Study is that, when asked whether they had said aside sufficient funds to cover expenses for three months in case of sickness, job loss, economic downturn or other emergency, 51% of respondents (in a sample representative of America) said they do not have such precautionary funds. The crisis may have depleted some of these funds, but not having a buffer stock of savings exposes both the individual and the economy not only to a large shock but also to a small shock, such as the car breaking down, the house needing a small repair, or a sudden out of pocket health cost. And with unemployment rates as high as 10%, the lack of precautionary saving makes people not just vulnerable but also hit hard by the loss of their job.

The expansion of the opportunities to borrow may give the idea that, if an emergency arises, one can turn to credit cards or find other ways to borrow. The problem is that, in a moment of need, borrowing at high interest rates is not only problematic, but can turn quickly into higher costs and fees if one were to miss a payment, go over the limit, or use the card as a cash advance. Turning to payday lenders or similar types of loans would only further increase the cost of borrowing. The problem with these methods is that they do not provide insurance at all. One wants an instrument, like saving, that can help in time of needs, not turn to an instrument that becomes pricey when most in need.

Because it deals with emergencies that happen unexpectedly, these funds are better be liquid. One does not want to sell possessions: a car, the home, or other such items when faced with a shock. Even selling stocks may come with a stiff cost if one has to sell when the market is down. As we have experienced in the past few years, having high unemployment when the stock market plunged only accentuates the pain of job loss.

This principle is perhaps so important that even Aesop illustrates it in a fable known as The Ant and the Grasshopper. The fable concerns a grasshopper that has spent the warm months singing while the ant worked to store up food for winter. Sure enough when the winter came, the grasshopper found himself in great difficulty. I would say there are not many cases when economics crosses path with literature, but it is great when it happens. As the story says perhaps better than any equation I would write, it is a good idea to store up a little bit for those winter rainy days.

If you want to look at the statistics about who has saving for a rainy day, here is the link to the state-by-state Financial Capability Study data: http://www.usfinancialcapability.org/

Some questions about financial literacy

2011-02-18T23:02:00.005-05:00

A reporter from Germany contacted me recently to discuss financial literacy. Because we were not able to speak on the phone, she sent me her questions and asked that I write back to her. Since these are very general and important question, I thought I would also post them on my blog. Here they are:

1. How much do Americans know about finance? Do you have actual research results that show that there is a lot that needs to be improved?

For several years and in many published papers I have documented the lack of financial literacy among Americans. I would like to describe the most recent results, which I presented to the Financial Crisis Inquiry Commission last year and which are part of a new survey, the Financial Capability Study, by FINRA Investor Education Foundation in collaboration with the U.S. Treasury. According to that survey, less than half of Americans can correctly answer two simple questions about interest rates and inflation, and only 30% of Americans can correctly answer these two questions and a question about risk diversification. As I mentioned when I testified to the Commission (a link to my presentation and the full report on the findings of the Financial Capability Study are below), these levels of financial illiteracy are very worrisome.

Link to report prepared for the Financial Crisis Inquiry Commission:
http://c0182412.cdn1.cloudfiles.rackspacecloud.com/2010-0226-Lusardi.pdf
link to the video presentation:
http://www.fcic.gov/videos/view/11

2. What do you regard as the main causes for a lack of financial literacy in America?

In America, as in other countries, changes in demographics (aging of the population and reduced fertility), increased mobility in labor markets (by the time workers turn 35, they have already held many jobs and they need to have portable pensions), and changes in financial markets have shifted the responsibility of financial well-being from the government and employers onto individuals. However, this has not been accompanied by changes in school curricula or workplace programs to equip people to deal with increased personal financial responsibility. In other words, it is not the case that financial knowledge is getting worse, simply that the world has changed and is still changing rapidly. The financial knowledge people are equipped with is inadequate to deal with the complexities of the current financial system and market structure.

3. What is it that makes financial literacy so important?

What makes financially literacy so important are the many changes we are experiencing in the following areas:
1) The pension system. Pensions have been shifting from defined benefit to defined contribution programs. As a result of this shift, workers are now in charge of deciding how much to save and how to allocate their pension wealth. Moreover, when they retire, they are in charge of decumulation of their pension wealth, and have to make decisions such as whether to annuitize or to take their pension as a lump sum: a very difficult decision with important consequences for financial well-being after retirement.
2) Financial markets. Consumers are confronted with much more complex financial instruments than ever before; consider, for example, adjustable rate mortgages or mutual funds that invest in foreign markets.
3) Opportunities to borrow. Opportunities to borrow have increased dramatically in recent years. One of the features of credit cards and sub-prime mortgages is that decisions about how much to borrow are entirely in the hands of borrowers. One can borrow a very large amount on credit cards simply by using more and more cards. Similarly, with sub-prime mortgages banks were leaving the decision of how much to borrow in the hands of the borrowers. In these situations, it is important that the borrower is financially literate and can understand key concepts such as interest compounding.

4. What are the difficulties when you want to improve the financial literacy of the American citizens?

Improving financial literacy requires a consistent set of programs aimed at different groups of the population. We cannot necessarily bring adults into the classroom, but we can and should provide financial literacy in schools to prepare young people for the new world they are facing. Most adults would fare better with programs at work (this is where workers are and where they often have to make financial decisions). It is difficult to coordinate all of these efforts and engage the various institutions that should be part of a consistent strategy to improve financial literacy, from the Department of Education to the U.S. Treasury to the regulators to the business community. Moreover, education and programs require resources. Education is going to deliver results in the long run, yet very few politicians or institutions have a long-run horizon.

As an aside, when presenting my research and work on financial literacy and financial education, I used to receive objections from people who insisted that financial education is too expensive. I think that the financial crisis has shown us that it is too expensive NOT to do financial education.

5. Do you think that politicians give enough attention and efforts to this issue?

Some politicians do, and they need to be praised for that. I travel a lot and give talks in many countries, and I think that several countries have become aware that they need to address the problem of financial illiteracy, as they will end up paying for it one way or another. For example, lack of financial literacy can mean costlier welfare benefits for some groups, and some countries understand that prevention is cheaper than the massive costs incurred when crises erupt.

6. With great interest I have read your current blog entry about two new videogames called "Bite Club" and "Farm Blitz", which were developed by Doorways to Dreams Fund. How do you promote these videogames in order to make sure that many people play these games and gain knowledge? Do you know anything about the success of the former games Groove Nation and Celebrity Calamity?

These games were targeted to a specific subgroup of the U.S. population. As a result, they will be distributed at places such as Walmart stores. Of course, we can’t force anyone to play, so the game creators have used social marketing techniques to encourage play and have made sure the game is as fun and engaging as other popular online games. We have submitted proposals to formally and rigorously evaluate the effectiveness of these games, and we will know soon how effective they are. So far, we have done a qualitative evaluation via focus groups and in-depth interviews. It is very important to know what works and what does not work in financial education. This why the projects we do at the Financial Literacy Center always have an evaluation component built into them. Please look at the projects we have completed in year one and the new projects we are doing in year two:
http://www.financialliteracyfocus.org/academics/projects.html

Annie Sullivan of personal finance

2011-02-15T12:49:00.001-05:00

Beth Kobliner wrote in her most recent blog post that I am the Annie Sullivan of personal finance. I have received praise for my work, but this is the best I’ve ever gotten. I must say that the association with Anne Sullivan almost made me cry (yes, you students who took my classes, I do have a heart). It is very humbling and is also giving me energy to do more.

I am deeply honored and gratified by Beth Kobliner’s praise, but I want to point out that she is doing some truly excellent work to benefit young people. While I write a blog—not as often as I would like—and do research work on financial literacy, Beth Kobliner has written a best-selling book geared to helping young adults make good financial decisions and has been very active in youth financial education. In recognition of her important work, President Obama nominated her to the President’s Advisory Council on Financial Capability. The Council has held their first meeting this year, and Beth is already very active in its Youth Education Subcommittee.

Every day we have a chance to make a small difference in improving financial literacy. Someone said, “People seldom see the halting and painful steps by which the most insignificant success is achieved.” That someone was Anne Sullivan.

Here is a link to Beth Kobliner’s blog:
http://www.bethkobliner.com/beths-blog/tag/financial-capability

A Smiling Horse

2011-01-10T13:24:00.000-05:00

I have mentioned some of the activities of the Financial Literacy Center (FLC) in previous posts and I want to discuss them further here. We place a high value on creativity and ingenuity in the design of financial literacy programs and have found that this is particularly important when trying to reach certain segments of the population such as the young and those not in school and not in the workplace.

One needs to think outside the box to find effective solutions to financial illiteracy. One of our teams has certainly gone in that direction. Doorways to Dreams Fund (D2D) has been developing video games targeted to low-income individuals to provide training in critical financial literacy areas, including household budgeting, consumer decision making, and cost-effective use of financial service providers.

The team has already launched Celebrity Calamity (http://www.d2dfund.org/first_game), a game targeted to lower-income women aged 18-30, especially single mothers. Players become the financial manager for up-and-coming celebrities who spend beyond their means. To be successful, players must effectively use a bank account, debit card, and credit card, so the game teaches the importance of paying off credit card balances, minimizing credit card finance charges, avoiding fees (including bank overdrafts, late payments, and over-the-limit fees), and making informed annual percentage rate choices. The game also includes a number of implicit learning objectives, such as raising awareness of spending behavior and the value and utility of saving money.

The game that the FLC supported and that D2D is now completing is called Bite Club. Designed for lower-income adults, this game is inspired by the very popular casual video game Diner Dash. Bite Club offers players a simulated experience in which they face the real-world tension between managing debt payments and current spending needs on the one hand and saving for the long-term goal of retirement on the other. For low-income and minority adults, building retirement savings may seem completely out of reach, given pressing needs to pay down debt and manage daily expenses. Bite Club players experience the natural tension that exists among debt service, spending, and long-term saving as the game unfolds.

I want to explain the workings of the game to show you what I mean when I say we need to think outside the box! To win, players must successfully manage a “day club” for vampires. By featuring vampires, who live forever, the game is able to highlight the impact of long-term savings. Bite Club is a 15-round game with three years’ time passing between each round, allowing the game play experience to span 45 years. In effect, the players enter a financial simulation running from age 22 to age 67.

The core challenges of the game include the following:

• Running a club for vampires that offers patrons seating areas with tables and couches, a bar (type A, B, or O blood!), a DJ booth with interactive song selections, and a dance floor.
• Servicing the four stations of the club in order to satisfy a variety of vampire customers and earn revenue.
• Making financial management decisions related to paying off debt, managing current consumption, and saving for retirement.
• Reacting to a variety of savings offers, which include retirement “open enrollment” and additional long-term savings promotions.

The core instructional design content includes

• Saving for Retirement. Players’ characters long to move to the “No Sun-belt” for retirement, but because vampires are immortal, they must save a substantial amount of money to finance their retirement dream, and they must reach this retirement savings goal before they can close down their “day club” and retire.
• Paying Down Debt. Players start with credit card debt (from purchases of items needed to open the club) from the Werewolf Bank. And in order to retire, players must pay off low annual percentage rate student loans from their university business classes.
• Managing Current Consumption. The club must be managed effectively to continue to satisfy customers. Players are offered the option to purchase various upgrades, some of which are valuable (needs) and some of which are merely aesthetic (wants).

Why this approach to improving financial literacy? As many as 72% of Americans play video games, with rates of play highest among those under age 35. Moreover, video games are the fastest growing form of entertainment in the United States. We need to find ways to engage individuals in financial education. Learning through traditional venues like classrooms and the workplace are not feasible or desirable for all populations.

Thinking outside the box requires creativity and ingenuity. Nick (Maynard), Tim (Flacke), Peter Tufano, and others at D2D have been willing to experiment with new ways to improve financial literacy. They have been willing to think differently and consider unique approaches. Often it seems this kind of thinking requires the creative mind of a child not yet locked into traditional ways of thinking. I was in Boston Common last summer and saw a group of people around a guard riding a tall, beautiful horse. I joined them to admire the horse. Everyone in the group had comments on the horse, very similar to what I was thinking too, until a little girl looked up and asked, “Does this horse smile?” Now, who would have thought of that?

Post mega conference

2010-11-23T10:22:00.003-05:00

The first conference of the Financial Literacy Research Consortium was held last Thursday and Friday, November 18 and 19, in Washington, DC. The Financial Literacy Center was in charge of organizing it, and I just want to say how happy I am about the outcome. There are as many as five things I want to highlight about the conference.

David Rust, the Deputy Commissioner for the Office of Retirement and Disability Policy at the Social Security Administration (SSA), opened the conference. As he described the work that SSA is doing to promote financial literacy, the image of a family doctor came to my mind. In the same way that a family doctor attends to his patients over time, caring for them at each stage of the life cycle, treating illness when necessary and preserving health when possible, so Social Security has been taking care of individuals, supporting them when they face problems such as disability. And with the financial literacy initiative, SSA is aiming to preserve and promote future financial stability by making sure that people are accumulating enough for retirement and are well equipped to make savvy financial decisions. SSA is ideally situated to promote financial literacy: it is an institution that is focused on the long term and that has the patience to wait for results in the long run. And investments in financial literacy will bear fruit in the long term, in line with the horizon of SSA.

Michael Barr, the Assistant Secretary for Financial Institutions at the U.S. Department of Treasury, delivered the keynote address at lunch. Michael is also a top law scholar and a faculty member at the University of Michigan Law School. He gave one of the most articulate descriptions of the role of financial literacy and financial regulation that I have heard. He generously interacted with the audience after his talk, and the many questions that were asked are a testament to the importance of the work he is doing. The Treasury Department is playing a significant leadership role in the field of financial literacy, and I am proud that Michael Barr is at the helm of many initiatives, including the important work of building the new Consumer Financial Protection Bureau.

Punam Keller, the Charles Henry Jones Professor of Management at the Tuck School of Business, delivered the closing talk. Punam is an expert on marketing strategy and social marketing and she is also the Marketing Director for the Financial Literacy Center. She described why financial literacy needs a marketing strategy and gave many tips on how social marketing can be of help in designing programs that are effective in influencing behavior. Punam is one of the most engaging, energetic, and brilliant speakers I have heard, and I am very happy to have been able to collaborate with her on so many projects.

The conference was large, with over 500 people registered. We designed the conference for interaction, and I believe we succeeded in engaging the audience. There were a lot of questions at the end of each session, and in the sessions I was able to attend, I learned as much from the questions that were asked as from the presentations. The agenda included an hour dedicated to visiting exhibit booths at which our team members displayed the products and projects they have been working on in the past year and interacted with conference attendees. I walked through the conference foyer during breaks and took stock of the many conversations generated by the topics presented at the conference sessions. A number of people approached me to say how much they enjoyed being involved in the conference. A sense of involvement and engagement is not a given at all conferences and one lesson I took away from this event is the value of creating a dialogue between the presenters and attendees. There is much to be gained from a conference at which everyone feels part of the conversation and everyone feels they have a chance for their voice to be heard.

Some of the programs that were presented speak of the creativity and ingenuity that is being used in designing financial literacy programs. One of the most popular presentations and exhibit booths was that of Doorways to Dreams (D2D). D2D has developed a casual video game, called Bite Club, to teach financial literacy. Bite Club, which is inspired by one of the most popular casual games of all time, Diner Dash, offers players a simulated experience in which they face the real-world tension between managing debt payments and current spending needs on the one hand, and saving for the long-term goal of retirement on the other. Players must manage a “day club” for vampires which demands they successfully pay off debt, meet current consumption needs, and save effectively for retirement. The core instructional design teaches the value of three important real world behaviors: (1) saving for retirement, (2) paying down debt, and (3) managing current consumption. In case you did not think there is a relationship between vampires and financial literacy, think again!

Let me turn now to the topic of food. As I have mentioned in previous posts, I believe food contributes to the success of any event. The food at the Ronald Reagan Center was as expected: breakfast was hearty, with plenty of bagels, muffins, juices, and strong coffee (much needed!). For lunch, we had to go for popular choices: salad as the appetizer and chicken as entrée. But the chocolate dessert was delicious, a tart with fresh raspberries on top of a good layer of melted chocolate. I gulped mine down and, since Michael Barr had to rush off at the end of his presentation, I ate part of his, too!

Presentations, keynote speeches, and photos of conference participants will be posted soon on our new web site http://www.financialliteracyfocus.org/

Mega conference

2010-11-02T20:02:00.007-05:00

I am writing this blog to make sure all my readers are aware of the First Annual Conference of the Financial Literacy Research Consortium. The conference, titled “New Insights and Advances in Financial Literacy: Translation, Dissemination, Change,” will be held on November 18 and 19, 2010, in Washington, D.C., at the Ronald Reagan Building and International Trade Center.

For those of you who do not know it, the Financial Literacy Research Consortium (FLRC) consists of three centers: (1) the Financial Literacy Center, which is a consortium of three institutions under the coordination of the RAND Corporation, (2) the Center for Financial Literacy at Boston College, and (3) the Center for Financial Security at the University of Wisconsin-Madison. The FLRC was established in October 2009 and is supported by the Social Security Administration.

We (the Financial Literacy Center) are hosting this conference and have been very busy preparing for this day-and-a-half event, which will bring together scholars from the Consortium to present their research and discuss how programs, educational products, and policies can best promote financial planning and financial security.

The conference is designed for interaction. For example, it include a series of workshops on innovative products, small seminars that focus on different stages of the life cycle, and a product fair at which participants can try out new educational products and interact with the developers. We are expecting as many as 400 attendees and the agenda features topics that span from video games that teach the perils of debt to building an effective web site for financial literacy to discussions of effective financial education programs. You can find the program and the link to the conference registration at http://www.rand.org/events/2010/11/18/.

A short description of the projects that our center has done in our first year and that will be presented at the conference is posted at http://www.rand.org/labor/centers/financial-literacy/projects/ .

I was attending the Pension Research Council’s Board meeting two weeks ago at the Wharton School, and one of the Board members asked Olivia and me: “So, what are the dates of your mega conference?” I was caught by surprise, but “mega conference” is a pretty good description of our upcoming event, and that’s how we’ve been referring to it ever since!

You are invited to attend the conference, or better, the mega conference! We hope to see you there.

Asset building or debt management?

2010-10-11T20:57:00.000-04:00

At the risk of making my blog look dangerously like a travel diary, I write this having returned from Oxford University where I spoke about financial capability at a conference composed of academics, the insurance industry (mostly Allianz), and policy makers. Oxford has a magnificent campus, and I could devote many paragraphs describing the beautiful Corpus Christi college, where the conference was held, but I will instead write about financial capability.

As you may know from previous posts, FINRA Investor Education Foundation supported the National Financial Capability Study, a project done in collaboration with the U.S. Treasury. The National Financial Capability Study consists of three linked surveys: (1) the National Survey, a nationally projectable telephone survey of 1,488 American adults; (2) the State-by-State Survey, a state-by-state online survey of approximately 25,000 American adults (roughly 500 per state, plus the District of Columbia; and (3) the Military Survey, an online survey of 800 military service members and spouses. At my visit to Oxford, I presented the data from the National Survey, administered to respondents between May and July 2009.

The National Survey shows that financial capability is low in the United States, and this lack of financial capability has important implications not only for policy but for the economic system in general. As I discussed at the conference, when people talk about financial security, they tend to focus on asset building. With the shift that occurred in the past twenty years from Defined Benefit (DB) to Defined Contribution (DC) pension plans, individuals have been put in charge of deciding how much to save for retirement and how to allocate their pension wealth. They have to make those choices in the face of financial markets and financial products that are increasingly more complex. As documented in the National Survey, people do not seem well equipped to make the necessary financial decisions. Only 30% of Americans can correctly answer three basic questions related to calculating interest payments and to inflation or risk diversification, concepts that are at the basis of most financial decisions. Several studies have argued that many workers are poorly managing their retirement accounts and pensions funds. We had a glimpse of this with the failure of Enron, which revealed that many Enron employees were heavily invested in company stock; not an ideal way to diversify risk. But DC pensions have not matured yet, and it will be another twenty years before we see how individuals have fared in mostly independent management of retirement savings and investments. Current pensions are mostly paid out by DB schemes, and even the baby boomers who are starting to retire will rely mostly on savings that were part of a DB plan or a mix of DB and DC plans.

If we want to talk about financial security and witness the impact of lack of financial literacy on financial behavior, we have to turn to debt. One other important recent change in the economy has been an increase in opportunities to borrow. Consumer credit, like DC pensions, was rare in the past but has now become available to a large share of individuals, and decisions about how much to borrow have shifted onto individuals. Consider credit cards. Credit card offers arrive in the mail and one can borrow a large amount of money by simply using more and more cards. No one is checking to see whether individuals are borrowing an amount that they can realistically repay. With sub-prime mortgages, almost anyone who wanted a mortgage could get one; banks were not checking to see whether borrowers could afford the loan contract they were getting into. I have used before the analogy of a water faucet: with plentiful and readily available credit, the faucet was fully open and one could draw as much water as was desired; it was up to the consumer alone to decide when to turn off the tap.

What are the consequences of these changes to the economy, and how well are consumers doing on debt behavior? Unlike poor asset building and asset management, the consequences of poor debt behavior can be seen in the short run. Personal bankruptcy rates have skyrocketed, tripling in a matter of ten years. Most sub-prime mortgages went bust, sinking both the banks and the consumers who engaged in them. I hardly think I have to tell you the statistics that have resulted from the National Survey (although being an academic, I will, so bear with me), because American’s problems with debt have been so widely apparent in the last few years. But the findings from the National Survey clearly document just how widespread debt is in the U.S. population. For example, 23% of Americans have engaged in high-cost methods of borrowing in the past five years (payday loans, pawn shops, and the like). In other words, more than one in five Americans has borrowed at interest rates that can be as high as 1000%. Fewer than half of those who have credit cards pay their bill in full each month, and a sizable share of those who borrow on credit cards engage in behavior that generates not only interest payments but also fees. One disturbing result is that many of those who use credit cards in ways that generate interest payments and fees are close to retirement—the people who should be at the peak of their wealth accumulation are instead borrowing at rates that are much higher than those earned on their assets. Another equally disturbing feature is that many of those who carry credit card balances do not know the interest they are paying on their balance. Similarly, many mortgage borrowers do not know some crucial terms of their mortgages. And while about half of the population have retirement accounts, many have been borrowing on those accounts, in effect borrowing on themselves.

These finding bring me to three thoughts. First, it is very limiting to assess financial security by looking at asset building only. One of the ways to help people achieve financial security may be to help them manage their debt. In any case, one cannot look at one side of a household balance sheet (assets), without focusing on the liability (debt) side. Second, we have clearly seen how poorly individuals manage debt when they are put in charge of it without any consideration of what they know and how they make financial decisions. Third, there may be another crisis brewing around DC pensions. In twenty years, when workers with DC-only pensions start retiring and are confronted with the decision of whether to take their pension payments (however small or large) in a lump sum or to annuitize, we will fully understand the consequences of the shift in pension plans. We can act now and prevent a potential crisis by empowering workers with both financial knowledge and help.

Walking through the beautiful gardens of Corpus Christi and the New College in Oxford it was difficult to think of financial crises and their devastating consequences. But mistakes can build up silently and explode without much warning. We all need to be better prepared to live in today’s world of individual financial responsibility.

Advice to Parents

2010-10-04T16:45:00.001-04:00

Having offered advice to students in a recent blog post, I want to turn now to parents to talk about how they can be advocates for their children’s financial education. As I have mentioned in previous posts, financial literacy is a necessary skill in the modern world, akin to the skills of reading and writing. Just as, with modernization, written literacy became a critical skill, the realities of today’s economies have made financial literacy a critical skill.

What changes have made this a reality? Today’s young people are very aware of and widely exposed to money, and there are many transactions that require an understanding of basic financial concepts, from deciding what to do with allowance or gift money to managing a mobile phone account to allocating earnings from an after-school or a summer job. As they finish high school, young people confront one of their most important financial decisions: whether and how much to invest in education. The wage difference between college- and non-college-educated workers has been increasing, with individuals without a college degree seeing their wages stagnate or even decrease. Lack of a college degree may mean a lifetime of low wages. On the other hand, the cost of education has been increasing rapidly, requiring astute decisions about which college to attend, in which state, and at what cost.

And when they enter the world of work and young adulthood, today’s young people will have to make many other important financial decisions. With the shift in retirement-planning responsibility from employers and government to individual workers, young people will be in charge of deciding not only how much to save but also how to allocate their retirement wealth, and they will have to do so confronting financial markets that are increasingly complex in terms of products offered and management and understanding of those products. Not only asset building but also debt and debt management will be increasingly important. Opportunities to borrow have expanded and, in addition to financing education, young people will have to learn how to manage credit cards and other, often more expensive, methods of borrowing. In such an environment, mistakes are easy to make and, as the financial crisis has indicated, can be very expensive, and costly mistakes may ultimately mean that you—the parent—are supporting your child far beyond the time you had expected to (I know, a scary thought).

There are several reasons why financial education should be offered in school. First, the level of financial literacy is very low; in my view, too low for young adults to be able to make savvy decisions. Moreover, current studies show that financial literacy is unequally distributed in the young population. According to studies from the Jump$tart Coalition for Personal Financial Literacy, only about 9 percent of high school students can be deemed financially literate. And this small proportion of students is disproportionately comprised of white males who have financially sophisticated parents. Thus, students are going to start out on very unequal footing, and differences can only grow larger over time. And even for those belonging to the more financially literate group, it is not clear that reliance on parental know-how and guidance is an effective way of learning; parents’ experience may not apply in a rapidly changing economic environment, in particular one in which young people will be competing in global financial markets filled with people from other nations, who have been exposed to formal financial education in school.

So, what can be done to promote financial education in school? One good start is to request that your child’s high school participate in the Financial Capability Challenge. The Challenge is a voluntary online exam and classroom toolkit that helps educators teach high school students about saving, budgeting, investing, use of credit, and other important skills critical to developing strong financial knowledge and capability. The next online exam will take place between March 7 and April 8, 2011. Educators and students who score in the top 20 percent nationally and who are among the top scorers in their school will receive official award certificates.

The Financial Capability Challenge is an excellent initiative, and it provides a good incentive to both students and teachers for gaining financial education. More than 76,000 students and 2,500 educators in all 50 states participated in the 2009–2010 school year Challenge. I participated in one of the award ceremonies last spring and saw what a rewarding experience it was for the students, teachers, and parents, and I was proud to be able to be part of it.

Become an ambassador for financial literacy by asking your school to participate in this program. Make sure your children will be prepared for the new world they will be facing: for the decisions they’ll need to make about their own education and for the financial markets they’ll have to participate in if they are to provide themselves with a financially sound adulthood.

Educators can begin registering for the Challenge today at http://www.challenge.treas.gov/.

Help spread the word!

Advice to freshmen

2010-09-16T18:55:00.000-04:00

As I walk through college campuses this fall, I can easily spot the freshmen. They are identifiable not so much by age (although they look younger every year) but by the look on their faces: that unique mixture of surprise, excitement, and fear that accompanies the start of the first year of college. There is so much to do and to learn and there’s no shortage of advice being directed at college freshmen, but I am going to add my piece anyway, and it is not only a suggestion about what students should do but who most needs to do it.

My recommendation is simple: if your school offers a financial education course, take it. If it does not, take a basic economics course (Economics 101 or Principles of Economics). Financial knowledge has become an essential life skill; just as it is necessary to be able to read and write (and use Twitter and Facebook), it is essential to have basic financial knowledge. Financial decisions are made every day, from how much to borrow on a credit card to how to manage a checking account to whether to pay for dinner on a disappointing date. And the responsibility of making good decisions has been shifted onto individuals. Both government and employers are increasingly asking citizens and workers to take care of their own financial security. Like it or not, the benefits and risks associated with financial decisions are now yours. And you have just embarked on one of the biggest investments of your life: the investment in education (in case you are not aware of just how big an investment it is, ask your parents, but only after they recover from the shock of paying the first round of bills for tuition, room, and board). In my view, education is one of your best investments, with returns in higher lifetime wages and likely entry into more stable sectors of the job market. (There tends to be lower unemployment among jobs requiring a college education.) And there are many intangibles, too, that command a value, from gaining a network of smart and educated friends to having the opportunity to experiment and gain knowledge in many fields, under the guidance of experts.

In the same way that low educational attainment may mean a lifetime of low and erratic wages, so low financial knowledge has been found to be associated with poor financial decisions, from excessive borrowing to lack of participation in financial markets to inadequate wealth accumulation for retirement. The costs of poor decisions can be high, particularly when dealing with debt: choosing the wrong mortgage can push people into poverty or bankruptcy, and according to the research I did with Peter Tufano from Harvard Business School, those who display low levels of financial literacy are likely to pay 50% more in credit card interest and fees than those with higher levels of financial literacy.

While a course in financial literacy or in basic economics can benefit all students, based on my years of research, I recommend it most strongly to the following students:

Women: According to my research, women are much less financially literate than men. I do not know why this is the case, but one worrisome finding is that there is a gap in financial knowledge between women and men not only among young people but also later in life. This likely means that women face fewer opportunities to become financially knowledgeable than men do, for example by interacting with groups (perhaps other women) who are less likely to talk about finance. Enrolling in a college-level economics or financial literacy offers a chance to counteract that tendency.

African Americans and Hispanics: There is a wide gap in financial knowledge between whites and African-Americans and Hispanics, even after accounting for the many demographic differences in these groups, including income and wealth. Again, this may be the result of fewer learning opportunities over the lifetime. A college course in economics or finance can start to make up for this gap.

Students whose parents are not financially sophisticated: According to my research, as well as research from the Jump$tart Coalition for Personal Financial Literacy, the (small) percentage of students who are financially knowledgeable are disproportionately white males with college-educated parents (in particular, college educated mothers) who had stocks and retirement savings when their children were teenagers. This means that a lot of financial knowledge is learned at home. If you are among the first generation in your family to go to college and your parents have never invested in stocks, you start at a disadvantage in terms of financial knowledge with respect to your peers. Take the opportunity now to make up for that gap.

Students who hate economics and finance: If you think that the study of economics and finance is for uncreative people, and is evil and will only teach you to work on Wall Street and exploit poor people and poor countries, then you, too, should sign up for a basic economics or financial literacy course. In my experience, people who express disdain for economics tend to make poor and costly financial decisions. Take advantage of a chance to offset that tendency.

Let me finish by adding that there is a risk in taking a course on financial literacy and economics: You may actually find that you like it!

Comparing financial literacy of young people across countries

2010-09-09T17:41:00.003-04:00

One of the new tasks I have taken on is to chair the Financial Literacy Experts Group at the OECD, which has been put in charge of designing a module on financial literacy for the Programme for International Student Assessment (PISA). The Programme is a worldwide evaluation of 15-year-old students’ scholastic performance, evaluated first in 2000 and repeated every three years. A new module will be proposed for the 2012 survey to measure financial literacy among 15-year-olds in 19 countries (the countries which so far have agreed to participate are Albania, Australia, Belgium, Brazil, China, Colombia, Croatia, Czech Republic, Estonia, France, Hungary, Israel, Italy, Latvia, New Zealand, Slovack Republic, Slovenia, Spain, and the United States).

This is an important initiative that shows the leadership role that the OECD has undertaken in the field of financial literacy at the international level and that will provide much needed data to improve educational policies across countries. There is a lot to be learned from these data. First, we will be able to assess the level of financial knowledge of young students, before they take on related decisions such as choosing whether to pursue a college education, in my view one of the most important decisions in a person’s lifetime. Second, we will be able to assess which students know the most and which know the least, not only across economic strata and demographic groups but also across countries. Third, we will be able to assess the link between financial literacy and mathematical ability as well as the link between financial knowledge and knowledge in other fields, such as the sciences.

The comparison across countries is particularly valuable. Not only are financial markets becoming increasingly integrated but many countries are shifting to pension systems that require increased individual responsibility. Moreover, the availability of consumer credit and the instruments associated with that credit (credit cards, short-term loans, payday loans, and so on) require that consumers have the ability to understand the terms of the contracts and their consequences. Countries in which consumer credit has expanded rapidly have also witnessed an increase in personal bankruptcy. How do countries handle the increase in individual responsibility, how much are young people prepared for the new financial systems which are becoming more global and more complex, and who are the leaders in terms of financial literacy? These are very important questions and the objective of the data is to provide countries with evidence that can guide policies toward improving financial education.

PISA data has been used in many policy assessments. Just last Sunday the New York Times had an article about the strength of Brazil’s economic expansion. While Brazil has been growing fast, the low level of education of the population (as measured by the math scores in PISA studies) is seen as a potential stumbling block both in terms of ability to produce a qualified labor force and to promote innovation. And interestingly, it is the Nordic countries (Norway, Finland, Sweden) whose students do very well in terms of mathematical ability, and perhaps it is not by accident that these countries host some of the most innovative firms, products, and ideas—Nokia, Ikea, Santa Klaus (if you believe, as I firmly do, that he lives in the North Pole).

This is clearly no small task and the Financial Literacy Experts Group is hard at work to design questions that are comparable across countries. We have representatives who come from different countries and who also bring a variety of experiences. We have not only educators but also representatives from government institutions (Treasury and Finance departments), central banks, and retirement commissions. Moreover, we have representatives from countries in which financial education in high school has been or is in the process of being implemented and countries in which financial education in school has yet to be adopted. This will allow us to examine whether the countries whose young people are exposed to financial education programs in school do better than countries in which young people learn on their own.

One other thing I’ve learned is that among Italians, one has to be careful in discussing PISA. I had hastily mentioned my new role to my father during our weekly calls, telling him that one of the benefits of the project would be a lot of travel close to my family’s home in Italy. I realized the discussion had gone astray when my sister sent me an e-mail congratulating me for joining the expert group on the Leaning Tower of Pisa and asking what, exactly, I had to do in there. We had a good laugh; this added new meaning to my father’s conviction that his daughters can do anything!

Blogging

2010-08-12T11:47:00.000-04:00

I was informed recently that my blog has been listed as one of the must-read blogs in the field of economics. While I don’t know much about how this ranking was done, it did boost my ego quite a bit and I thought I would post the link:

http://master-degree-online.com/top-100-graduate-blogs-by-university-personnel/

When I started blogging some time ago, I did not know how much I would enjoy it. While my schedule has become quite busy, particularly since taking on the role of director of the Financial Literacy Center, I am trying to keep up and write as much and as often as I can. Both the financial crisis and the financial reforms have offered a lot of material to reflect upon and to write about, so I am not short on topics, even though I write exclusively on subjects related to financial literacy.

But I am posting this short blog to thank my readers for their support and also to encourage them to continue reading. Have a good rest of the summer to all. I am getting ready to go to Italy, one of my favorite vacation places, and I will write more from there.

Financial education: What works?

2010-08-09T13:54:00.001-04:00

I am just back from Denver, where I attended a conference titled “Implications of a Quarter Century of Research in Personal Finance,” organized by the National Endowment for Financial Education and Tahira Hira from Iowa State University. A group of researchers met over three days to discuss what we have learned so far on this important topic. I headed a team that addressed the question, “What learning strategies, interventions, and delivery methods hold the most promise for effective financial education outcomes?”

As we reviewed the many papers that have been written on this topic, we faced the difficulties commonly encountered when looking at the existing work. Navigating the bulk of existing literature and figuring out the common findings is a challenge, but our analysis of that extensive literature led us to what we called a “cautious optimism” about the effects of financial education. Along with this optimism, we are mindful of several difficulties inherent in evaluating financial education interventions. First is the issue of self-selection: i.e., are the people who attend financial education programs those with an existing interest in the subject, and is it their interest or the content of a program that motivates them to make certain financial decisions? Second is the dearth of details regarding program content, frequency, delivery method, and goals (to improve knowledge or change behavior or to satisfy a legal requirement) of the programs that are reviewed in the literature. This lack of information makes it hard to evaluate what makes a program effective (or ineffective). Third, one has to be mindful of the size of the intervention. Small interventions, for example, providing information on a particular issue cannot transform naïve investors into Warren Buffetts.

The team identified places where financial education seems most effective and methods to make financial education more effective. The most effective place for financial education was concluded to be the workplace; important methodology was judged to be that relating to adult education and to informal learning.

There are many (some obvious) reasons why the workplace is an ideal venue in which to provide financial education. First, this is where many adults are and also where many important financial decisions are made, e.g., how much to contribute to a retirement account, how to invest retirement wealth, whether to annuitize retirement wealth, and the list goes on. There are also benefits to employers in making sure that workers save for retirement and avoid financial problems, as financial problems and/or worries can affect worker productivity and morale. One benefit to both employers and employees, which in my view is not discussed enough, is that financial education can make people aware of and able to take advantages of benefits an employer offers (for example, employer matches of retirement contributions) or better understand and take advantage of tax-favored assets.

Financial education has normally been conceived of as being delivered in a classroom, but one has to think more broadly and creatively about adult education. In contrast to young students, adults have a rich set of experiences that shape how they view their financial situation. Additionally, financial education can be made more effective with reference to theories of learning that offer important suggestions and insights. One such theory is Mezirow’s transformative learning theory. This theory has been around for over 30 years and has been used as a framework to help make sense of learning and teaching in numerous disciplines—health and medical education, intercultural relations, psychology, environmental sciences, higher education, instructional technology, archaeology, human resource development, just to mention a few. I mention the importance of theory here because, in my view, one of the reasons why financial education has not been as effective as it could be or has not been given the attention it deserves is because it is not considered within a rigorous and theoretical framework.

Even within such a framework, it is possible to incorporate different ways of learning, including informal learning. Informal learning is increasingly becoming recognized as significant to workplace education. Instead of having employees participate in traditional workshops or training sessions, employers are creating conditions in which workers can learn from each others. Financial educators, policy makers, and program planners will do well to recognize that financial education efforts can be successful outside of the formal settings that are the traditional venue for financial education.

As I have mentioned in previous blogs, to run a successful conference you need to have good people, good papers, and good food. Having provided, I hope, a little glimpse of the energetic discussion that went on throughout the meetings in Denver (as well as the informal learning that occurred outside of the meeting rooms!), let me turn to the topic of food. Our meals were a blend of French and Italian cuisine. We went to a wonderful French bistro one night where we tried pâté, saucissons, onion soup, and a wonderful pistachio-crusted trout. The Brown Palace hotel, where we stayed, provided us with succulent breakfasts. At a lunch one day we had gourmet pizza. Some were surprised by this lunch choice. Not me. Give me pizza, and I am happy!

Some comments about "Greater Foools"

2010-07-19T23:35:00.003-04:00

I am happy to post on my blog a comment by Nan Morrison, President and CEO of the Council for Economic Education, on the article "Greater Fools" published in the New Yorker.

James Surowieki’s financial page piece “Greater Fools” unfortunately quite accurately diagnoses the depths of America’s struggle with financial literacy and its costs to society. And without significant changes, our children may face an even worse fate than their parents. Nellie Mae reports that on average, incoming freshmen now bring an average of $1,585 in credit card debt to college.
Yet despite the extent of this problem, according to a CEE / State Farm survey, only 21 states require an economics course to be taken in K-12, and only 13 states require a course in personal finance. Even fewer require testing of these concepts. But requirements need trained teachers, and to make matters worse, as a society, we are not preparing teachers to deliver this vital content with confidence. In a recent survey by the National Endowment for Financial Education (NEFE), less than 20 percent of teachers reported feeling competent to teach basic personal finance topics. Furthermore, even many teachers of high school economics have taken two or fewer semesters of economics in college.

In our eyes, the real question is “How, as a society, can we improve our economic and financial literacy and what benefits might we see in future generations as a result?” Our answer at the Council for Economic Education (CEE) – equip and enable teachers to educate our children in basic personal finance and economic concepts in school from kindergarten through 12th grade. Why? Good habits are built early, just like brushing your teeth.

America is about economic opportunity – our kids need to be financially fit and economically literate to grasp that opportunity. As consumers, investors, entrepreneurs, and voters we all make decisions that involve finance and economics every day. If every parent, school and state, made economic and financial education a priority in schools from K-12, perhaps more Americans would be able to ensure their financial well being in a changing and complex world. Improving our collective economic and financial literacy is vital to our economic growth, job creation, and prosperity. Many in government, education, and financial services, across our nation support those goals, as they are good business and good citizenship well as essential ingredients in a stable financial system.

Nan J. Morrison
President & CEO, Council for Economic Education

Greater Fools

2010-07-16T19:13:00.003-04:00

James Surowiecki’s recent column in The New Yorker magazine discussed the dangers of financial illiteracy in America. It is great that such a prominent and widely read magazine has featured a piece on the issue of financial illiteracy. I do not know about you, but I love The New Yorker: not only is it great reading, but it makes me dream of all the things I could do if I were living in New York! In this blog, I want to write in more detail about something that I discussed with James Surowiecki and which he reported in his column.

Of the changes that we have witnessed in the financial markets in recent decades, we have seen not only an increased complexity in financial products but also an increased reliance on the expertise (or lack thereof) of consumers. For example, individuals have been bombarded with credit card offers. One could easily sign up for a sizeable collection of credit cards and, in so doing, borrow a large amount of money. While some consumers have been targeted more than others, many are receiving printed checks in the mail. These types of offers make it very easy to borrow; and it is the individual who has to be savvy about how to use the credit cards and checks that come in the mail; the offers will keep coming, and the amount one can borrow will keep increasing, irrespective of how much one can afford.

Subprime mortgages have worked in much the same way. While banks and mortgage lenders would normally do background work in order to assess how much to lend their potential borrowers, subprime mortgages were available to almost anyone who wanted a mortgage, regardless of their ability to afford the loan they were taking on and without much or any look to proper documentation. For some, the offer came in the mail together with the credit card offer!

In other words, we have opened the doors and made credit available to a much larger number of individuals than was the case several decades ago. Moreover, while not infinite, the amount people can borrow is very large. And perhaps most importantly, it is often up to the consumers to decide what and when it is enough.

This is why financial literacy is so important and why, in my view, developments in financial markets should be accompanied with initiatives to provide the knowledge required to make good use of any such developments. One cannot trumpet how great it is to be able to buy a house at age 25 if young workers do not even know what interest compounding means. Similarly, dispensing credit cards to people who have little understanding of how fees work can be counterproductive at best and catastrophic at worst.

I have a similar view toward assets. Some have been lamenting the high proportion of unbanked individuals, in particular among certain segments of the population. I believe financial access is incredibly important, but we cannot simply give everyone a checking account and think we have improved people’s lives! Not knowing how to use a checking account to prevent overdraft fees and returned checks can quickly turn the benefits of this simple asset into a nightmare.

As we pass new legislation about financial reforms, we should keep in mind the many advantages that advanced financial markets can bring to the economy but also be mindful that without financial knowledge, people now have a much greater opportunity not only to increase wealth, but also to destroy it. As I have argued in many previous blogs, it is not enough to regulate supply, we also have to think about demand and how to empower consumers with the knowledge necessary to make proper financial decisions. We should not be talking only about banks, we should also be talking about the borrowers!

On a side note, James Surowiecki’s column was published on July 5, which also happens to be my birthday. Without knowing it, Surowiecki provided me with a very nice birthday gift by writing so proficiently about a topic I care so much about. Only a trip to New York would have made it better!

Read James Surowiecki’s column here: http://www.newyorker.com/talk/financial/2010/07/05/100705ta_talk_surowiecki

Financial Literacy Among the Young

2010-07-07T09:56:00.000-04:00

I want to write this time about financial literacy among young people. Olivia Mitchell, from the Wharton School; Vilsa Curto, from the Education Innovation Laboratory at Harvard; and I have just published a paper in the Journal of Consumer Affairs that describes the results from the responses to three questions that we added to the National Longitudinal Survey of Youth in 2007-2008. Respondents to this survey are 23-28 years old.

These young consumers must confront complicated financial decisions in today’s demanding financial environment, and financial mistakes made early in life can be costly. Young people often find themselves carrying large amounts of student loan or credit card debt, and such early entanglements can hinder their ability to accumulate wealth or to choose their desired job. To examine how well equipped young people are to make financial decisions, we assessed knowledge of basic concepts: the ability to do a 2% calculation and the understanding of how inflation and risk diversification work.

We have three major findings:

1. Financial literacy is low among young adults. Only 27% of people age 23-28 can answer three basic questions about interest rates, inflation, and risk diversification.
2. There are large gender differences in financial literacy. Young women know much less than do young men about basic financial concepts. In another survey, we found large gender gaps in financial literacy among older respondents (51 and older), and this recent work tells us that these differences hold when we look at young people.
3. Financial literacy is influenced by parents. Those who are financially literate are more likely to have college-educated parents (in particular, college-educated mothers) and to have parents who had stocks and retirement savings when these young adults were growing up (when they were 12 to 17 years old).

I want to stress the third finding: family background is found to have a strong impact on financial literacy. A college-educated male whose parents had stocks and retirement savings when he was a teenager was about 45 percentage points more likely to know about risk diversification than a female with less than a high school education whose parents did not own retirement or risky assets. In other words, financial knowledge appears to be much higher for those who grow up with parents who are financially sophisticated.

This research is consistent with the findings from the Financial Capability Survey, the results of which were released last December by Secretary Geithner together with Secretary Duncan. http://www.ustreas.gov/press/releases/tg446.htm. That survey also documents very low levels of financial knowledge, particularly among the young.

These are unpleasant findings. We have put people in charge of many important financial decisions. People must decide how much to save for retirement and how to invest that savings, yet people do not appear to understand how to diversify risk; individuals are bombarded with credit card offers, yet we are learning that many people do not know how compound interest works, so cannot calculate how their debt will grow. Research has shown that financial illiteracy can be linked to problems with debt, lack of participation in the stock market, lack of retirement planning, and lower wealth accumulation. If we do not address financial illiteracy among young people and if we do not equip young people with the tools they need to make sound financial decisions, we may pay the cost down the road.

I am worried about the implications of these findings. If financial literacy is learned at home, many young people will begin their lives at a disadvantage, as not everybody comes from a college educated family or from a family that has stocks and retirement savings. In other words, inequality may start at the very beginning of the economic life if we do not offer everybody an opportunity to learn financial literacy outside of their homes. This is one reason why it is important that our schools incorporate financial literacy into their curricula.

In my work as a college professor, I am surrounded by young people. Last month, as we bid farewell to the Dartmouth class of 2010, I could not help but wonder whether we have provided all that is needed for these students to start on their journey into adulthood. Most of them will start a job, open a new bank account, rent an apartment, get more credit cards, pay down their student loans, donate to their college (ahem . . .), and pay taxes. Are they ready?

Proposals, Pizza Boxes, and Prilosec

2010-07-01T11:41:00.001-04:00

I have not written for a while, but now—after a month and a half of grueling work—am able to turn attention to my blog, having just finalized the submission of a multi-project proposal for the second year of funding for the Financial Literacy Center.

Every year at around this time, we have to collect our best projects and ideas and submit them to our funder, Social Security. There are many valuable aspects of this process. First, it forces us to think hard about the many ongoing projects and the new ideas we have been compiling with input from our teams and then evaluate the most promising ones to submit for funding. It makes us think about the future and about the type of work we’d like to engage in over the next year.

Second, it forces us to be specific about what we want to pursue. This is the time when we need to transform ideas, conjectures, even dreams, into concrete plans that have to be described in detail, thinking not just about the outcomes we want but the manner in which we plan to achieve them.

Third, it gives us the opportunity to form new partnerships. Several of our proposed projects have become multi-disciplinary, with psychologists, linguists, and law scholars collaborating with economists. And co-authors from existing projects are brought in to add their experience and insight to newly proposed projects.

But for those of you who have never dealt or submitted a grant, let me tell you that despite all of the good that comes of it, the process is grueling and the work is massive. There are strict procedures to be followed, a vast amount of documentation to be provided, deadlines to be met, and, if more than one team is involved, a lot of people to coordinate. On a scale from 1 to 10 of the unpleasant things one might do, this is probably an 8, right up there with a root canal or training for the Tour de France after major surgery.

As the submission deadline approached last week, I looked dangerously like my students on the day of a final exam: my hair uncombed, coffee cups and empty pizza boxes piling up on my desk, mail unopened, and email clogging up my inbox. Staying late at my desk, I startled more than one security guard patrolling the building to shut off the lights late at night. And, of course, the sure indicator of a grueling grant submittal period: regular doses of Prilosec after week two of the process.

Truth be told, I have gotten much better at writing grants. My first grant submissions, which I wrote with no understanding that I was competing with the giants in my field, I have to say were not received with great enthusiasm. In some cases, my submission did not even merit consideration among the proposals to be funded; in others I received rejections complemented by letters from referees who had a lot of not very friendly things to say about my research ideas. The ones I have the fondest memories of are those in which I was told I was not quite there, and was invited to re-submit. I did that, adding another two or three weeks of work (and medication), and—bingo!—I was rejected after the resubmission!

Grants have became a part of my academic life, as I need support for big projects—to hire assistants, to pay for data, and to do empirical research. Not many institutions had the stomach to fund research on financial literacy when I started working on it many years ago, and I am very happy that Social Security has been a funder and a supporter of my work from the very beginning. I will probably be collecting Social Security benefits by the time I publish this work, so I can say that Social Security has been and will be a constant in my life.

But now the submission is over; I can go back to a healthy diet and to a normal intake of coffee. I will again think positively about the future. And I am very busy catching up on sleep.

Improving Our Financial IQs: Why Managing Money Should Be a Lifetime Skill

2010-05-28T18:17:00.000-04:00

At the Wharton conference that I described in my previous blog, I sat down with Michelle Greene for an interview with Knowledge@Wharton. The link to the interview is provided below, but in this blog I wanted to discuss a few topics that have come up many times in this and other discussions.
http://knowledge.wharton.upenn.edu/article.cfm?articleid=2496

In case you do not know Michelle, she is the Deputy Assistant Secretary for Financial Education and Financial Access at the U.S. Treasury Department. The title may look long, and it is for a good reason: she heads the office at Treasury which is in charge of financial literacy and financial education. One of the issues that office has to deal with is that many Americans are unbanked or underbanked and do not participate in traditional financial markets, hence the attention to financial access in addition to financial literacy.

Many people have asked me why financial literacy is so low and why we appear to be getting worse in terms of financial knowledge. In my view, it is not the case that financial knowledge has worsened, rather that the world has changed. Individuals have been put in charge of decisions that were—in the past—the responsibility of employers or the government (such as determining how much to put aside for retirement and how to manage pension wealth). Individuals have to make these decisions while facing much more complex financial markets. For example, ETFs, REITS, and 403(b)s were not in vogue twenty years ago and yet, while the acronyms are not exactly appealing, they have become part of what an average worker has to deal with in their financial planning. In the past, a CFO with an MBA in finance was making decisions about how to allocate investments in order that the company be able to pay a pension to the firms' employees; now workers John and Jane Doe are in charge of making these decisions. This means that every single worker now has to spend time and effort in collecting information and searching for the best conditions.

Given these changes, it may be obvious why the office that Michelle Greene heads is so important: we need to equip people with the tools to make financial decisions and increase financial knowledge if we are asking them to be in charge of their financial well-being after retirement. But, it is not enough to put them in charge. These are difficult decisions—even for a CFO with adequate training—and we cannot expect the average worker to navigate the financial markets if he/she does not know the difference between a bond and a stock or what an annuity is.

As Michelle stated in the interview, if there is a silver lining to the financial crisis, it is that there is a renewed sense among people that they need to understand their own finances. They need to engage in better behaviors and think more about the future. The financial crisis has also taught us the cost of financial mistakes. While we have not yet witnessed what may happen if workers with defined contribution pensions accumulate too little for retirement or make bad decisions on how to draw down the money from their retirement accounts, we have seen that choosing the wrong mortgage can end with the sheriff at the door and the furniture for sale on the lawn.

Michelle also spoke of the importance of starting to learn and to save when young and the need for inserting financial education into our schools. In my view, this is critically important as people need to have a basis on which to build their financial knowledge. Schools cannot teach every concept that will be of importance for making financial decisions in the future. But they can make people appreciate the importance of financial knowledge and the need to build on it over time. I am often asked what we should teach in high school to improve financial knowledge and my short answer is that we should teach people to be curious and to be interested in financial literacy. We do not teach literature expecting students to write the next War and Peace but rather to appreciate a good book. Similarly, we should teach financial literacy so that students appreciate the need to be informed before making financial decisions.

I want to end by saying that I am extremely proud of the work that Michelle is doing. Her work can and is having an impact on the lives of people, on the decisions that John and Jane Doe have to face—decisions that are part of a very different system than the one encountered by previous generations. There is a lot at stake here, and I hope that people will realize that inside the gray and imposing Treasury building alongside the White House, there is an office devoted to improving financial literacy and financial access.

Financial Literacy: Implications for Retirement Security and the Financial Marketplace

2010-05-03T16:39:00.002-04:00

Olivia Mitchell and I organized a conference at Wharton last Thursday and Friday, April 29–30, titled “Financial Literacy: Implications for Retirement Security and the Financial Marketplace.” This seems a good way to end Financial Literacy Month and reflect on the importance and role of financial literacy.

There are 3 ingredients to a successful conference: (1) good people, (2) good papers, and (3) good food. We provided a good lunch and we had dinner, surrounded by Chinese art, in a large hall in the University of Pennsylvania museum. But the people and papers were more than good, and I left Philadelphia with a lot of ideas and projects I want to pursue.

Our keynote speaker, who opened the conference, was Michelle Greene, the Deputy Assistant Secretary for Financial Education and Financial Access at the U.S. Treasury. She told the audience about the initiatives and the approach of the office she heads at the U.S. Treasury. Several things resonated with me. She stressed the importance of evidence-based policies and cited several studies, from the FINRA Financial Capability Survey to the FDIC Survey of Unbanked and Underbanked Households. She also stressed that the U.S. Treasury wants to put financial education where it works and where it is most needed. In my view, these criteria are not only critically important but also offer a way for research to make a real difference and to impact policy. She discussed the work that the Treasury is doing with state and local governments and with the private and nonprofit sectors. This is a reminder that while we need a national financial literacy policy, a lot of work is done at the local level, thus a grassroots approach when dealing with financial literacy is important. The U.S. Treasury is also coordinating the many federal agencies that are doing financial education programs. I was particularly pleased to know that the White House has joined the Financial Literacy and Education Commission and, in particular, that the White House Council on Women and Girls has become involved in financial literacy. As I have mentioned in many of my blogs, there is a real need to focus attention on women and girls and to address the existing gender gap in financial literacy. Michelle also mentioned that the website www.mymoney.gov has been revamped. This is the website to go to obtain financial information, and, again, I cannot stress enough the importance of having a trusted and independent source of information to rely on.

The papers that were presented at the conference spanned many topics. Some documented individuals’ financial mistakes. While the experience with subprime mortgages has made us acutely aware of the problem of financial errors, evidence about the use of credit cards and payday loans adds reasons to worry about the behavior of households who use high-cost methods of borrowing. Families have also started to borrow from their 401(k) plans, i.e., they are now borrowing from themselves and the money they have put away for retirement. And financial literacy seems to be a contributing factor: those with low levels of financial literacy are found to be more likely to borrow from themselves. Low literacy is also found to keep people from investing in the stock market. While one has to understand and be aware of the risks of investing in stocks, it is problematic to shy away from the stock market, particularly when investing for the long run. Moreover, when selecting a pension fund from a menu of possible offerings, those with low financial literacy are shown to rely more on the advice of employers, friends, and coworkers than on cost fundamentals. Those with low financial literacy are also more sensitive to how information is framed when interpreting the relative benefits of different investment choices. Given the choices that people have to make on their DC (defined contribution) pensions, these are worrisome findings.

Other papers documented other aspects of financial literacy. For example, when surveyed individuals are asked to rank their own financial knowledge, many give themselves high rankings, yet responses to a set of financial literacy quiz questions result in relatively low scores for many individuals. This type of overconfidence can negatively influence financial behavior.

Still other papers looked at the effectiveness of financial education initiatives provided by employers or by counseling agencies. Paraphrasing Michelle Greene’s message, we need these studies and rigorous evaluations of financial education programs to be able to allocate our resources to where they are needed, to where programs are proven to work!

The conference did not focus on the U.S. experience only. The retirement commissioner from New Zealand described some of the successful strategies that have been used to promote financial literacy among Kiwis (I mean the citizens of New Zealand, not those delicious fruits). The OECD has been a pioneer in promoting financial literacy and financial education programs and has worked on this topic since 2003. They have been not only a major force behind many important initiatives but are also working on promoting financial literacy in many emerging nations, from India to China to Latin America. Most importantly, they are serving as the coordinator of the activities that many countries are engaging in and serve as a clearinghouse for data and information. The World Bank has recently joined that effort and is devoting resources and expertise to promoting financial literacy among developing countries; in my view, an important and necessary effort.

In the closing panel, one representative of the Social Security Administration remarked that “he had not heard yet that financial literacy hurts.” I would very much agree that there are no obvious downsides to financial literacy.

We ended the conference with a quote that Michelle Greene had included in her presentation slides. She cited President Obama, who said, “If you work hard your whole life, you ought to have every opportunity to retire with dignity and financial security.” We hope that the government, academics, the financial community, and not-for-profit institutions will all work to make that opportunity possible.

Fixes for the Financial System

2010-04-25T23:20:00.002-04:00

Today's New York Times described the proposal of six academics for changing the financial system. Mine is one of them.

http://www.nytimes.com/2010/04/25/weekinreview/25chan.html?pagewanted=1&sq=They%20have%20got%20it:%20fixes%20for%20the%20financial%20system&st=cse&scp=1

Compound Interest 101
ANNAMARIA LUSARDI

A person borrows $100 at an annual interest rate of 20 percent. How long does it take that debt to double? About four years. What share of American adults can figure that out? About one in three, says Annamaria Lusardi, an economist at Dartmouth College.

Ms. Lusardi wants to add financial literacy to high school curriculums. A crisis sparked in part by the decisions of millions of Americans to take mortgage loans they could not afford has underscored her conviction that “lack of financial knowledge is alarmingly widespread.”

Only three states — Missouri, Tennessee and Utah — now require a course devoted to personal finance, according to the JumpStart Coalition for Personal Financial Literacy, a nonprofit group. Another 18 states incorporate some lessons into other courses.

“Financial literacy is an essential piece of knowledge that every student should have,” Ms. Lusardi wrote recently on her blog. “Just as reading and writing became skills that enabled people to succeed in modern economies, today it is impossible to succeed without being able to ‘read and write’ financially.”

Let's hope that in this time of reforms some attention will be given to consumers and to financial literacy.

April showers bring future flowers

2010-04-23T18:51:00.000-04:00

I like very much the fact that April has been declared Financial Literacy Month. As a result there has been a flurry of events and activities devoted to discussing, promoting, and improving financial literacy. I cannot stress enough how important it is to have financial literacy at the center of attention, including the extensive coverage it’s been receiving in the media.

It is also at this time that one realizes the need for information. How many institutions are doing financial education programs and how do they do them? I do not know the answer to this question nor would I know where to find this information. I also fear that anybody who is entering this field could end up reinventing the wheel: devising yet another set of curricula, materials, and programs rather than making use of what already exists or backing their program with proven best practices.

Via the creation of the Financial Literacy and Education Commission (FLEC) under the coordination of the Office of Financial Education at the U.S. Treasury, the federal government had admirably coordinated the efforts of its agencies and bureaus that are doing financial education programs. But what about the not-for-profits and other organizations that have become engaged in financial literacy?

In my view, there are many advantages to sharing information and in some degree of coordination among agencies, organizations, and businesses. First, it is very important to know what others are doing so as to minimize wasteful overlap. These days everybody seems eager to set up yet another Web page adding to the ten-thousand existing Web pages! While I appreciate the differences that may distinguish these offerings, I am afraid that their proliferation may simply add to the search costs of individuals who have to navigate an ocean of information on the Web. For those developing financial literacy programs, coordination with others who are doing the same thing can save valuable time and resources. For multiple organizations to spend weeks and months in designing programs that others have already thought about and perhaps even implemented and tested is certainly a waste of time and brain power.

Understanding what is effective in improving and promoting financial literacy is another critical piece of information. It would be very valuable to have this information reported somewhere. We need to devote resources to that which is effective and which has an impact. Funders should be able to determine which programs are effective and worthy of support and institutions interested in promoting financial literacy should be able to look for success cases and use them as models for their own programs.

Because I direct a center that is devoted to promoting financial literacy, I have to subject myself and the center’s research teams to these criteria: evaluate what we do, share information, coordinate activities, and not waste a cent of our valuable resources.

Tax day

2010-04-15T19:02:00.002-04:00

Today is April 15: the deadline for filing income taxes. Money is on everyone’s minds these days. Even before the recession, Americans were confronted with an increasingly complex financial landscape that requires difficult financial decisions. Yet, studies show that most are not well-prepared to handle their personal finances. I discussed this topic on Vermont Public Radio last Tuesday, and how we can improve our financial literacy. If you would like to listen to the interview, the link is below:

http://www.vpr.net/episode/48366/

April 2010: Financial Literacy Month!

2010-04-01T20:41:00.002-04:00

April is Financial Literacy Month. You know financial literacy is in troubles when they dedicate a month to it! Because today is April 1, I thought we could start off with a list of the reasons to be financially literate, following the example of other famous top ten lists.

Top ten reasons to be financially literate:

1. Because being financially literate is smart and sexy!
2. Because it is useful to know that ARM has to do with mortgages and is not a rock band;
3. Because 401(k) is the worse name that could be given to pensions and you still cannot figure out how anyone came up with it;
4. Because you are tired of having to get endless stock market tips from your brother-in-law;
5. Because you would love to criticize banks but do not know what to say;
6. Because you need topics to share with your barber/hair-dresser, taxi drivers, and bar tenders that make you look rich and cool;
7. Because everybody talks about the financial crisis and you have no clues what is going on and whom to blame other than banks;
8. Because you have time to spare now that unemployment is really high and nobody seems to be able to find a job;
9. Because you want to protect granny from scams;
10. Because you want to mathematically prove that the Lexus your neighbor drives with such pride was a bad financial decision.

Regional Feds and Financial Literacy

2010-03-26T18:17:00.004-04:00

I recently visited the Federal Bank of Richmond to give a presentation at their Community Development Advisory Council’s spring meeting. Under the leadership of President Jeffrey Lacker, the Community Affairs Office of the Bank is making the promotion of financial literacy one of their strategic goals.

Regional Feds are ideal vehicles for the promotion of financial literacy. They have an intimate knowledge of the local economy and of the problems and most pressing needs in the community. They are in contact not only with local banks but with business owners and employers, community development agencies and not-for-profits. Much of the conversation that took place during my short visit to Richmond—including during coffee breaks and on a shared cab ride to the airport—was about using business principles to help development in the local community. This is ideal grounding for financial literacy; we need to develop and implement effective programs and avoid feel-good initiatives that may go nowhere.

So, I welcomed the hard questions that I was asked during the presentation, the insistent focus on what works and what the evidence shows about the effects of financial literacy. I prepared a lot for this audience because I knew I would be facing researchers who understand the nuances of research work and also economists and businesspeople who are interested in the relevance of the subject to their work.

Regional Feds have active research departments and some of the best research originates from these banks. Not only do these researchers not have teaching commitments (which—believe it or not—take a lot of time!) but they often have access to great data. They are confronted all the time by tough and important questions and this directs them toward research that is of economic and policy relevance. Economists from the Richmond Fed’s research department have written about entrepreneurship and financial education, among other topics. They had produced a review of the effectiveness of financial education that I have used in my research and that I discussed with them at the meeting.

During the lunch discussion in an elegant room in the high floor of the building, we talked about financial literacy in schools. Two main ideas emerged that I want to credit to the economists from the research department.

First, the advancement of learning normally builds over the years: one first learns beginning Spanish, then masters intermediate Spanish, and then can take advanced Spanish courses in the later years of high school. Similarly, one starts by reading short chapter books, then simple essays, short stories, then novels . . . it takes a while to build up to War and Peace. But financial education is often a stand-alone course offered in the final year of high school without much, if any, preparation in previous years. It is hard to imagine, even from a simple pedagogical perspective, that this method could be effective either in teaching financial literacy or in making financial knowledge stick. (In my case, I remember little from my one Spanish course but I could challenge Schwarzenegger to a Hasta la vista, baby! contest.)

The second idea is that one of the objectives of financial literacy education should simply be to make people interested in learning more; laying the groundwork so that people will seek out information and education over the course of their life. In the same way that good English literature instruction makes us appreciate a good book and fosters a taste for reading, so good financial literacy instruction may give people a taste, early in life, for future learning: reading the business section of the newspaper and making an effort to incorporate good financial practices into everyday life.

President Lacker took me around the building that houses the Richmond Fed, with its stunning views of the James River. He pointed out the bridges from the Civil War era that are still standing across the river. He spoke of the history of Richmond, and how much he enjoys living there. And he spoke with pride about the work that the Bank is doing. I returned home content and very much convinced that, in the Richmond district, financial literacy is in good hands.

Take the National Financial Capability Challenge

2010-03-06T23:20:00.002-05:00

In previous posts, I have described the importance of teaching financial literacy in school, the difficulties in teaching financial literacy, and the need for teachers’ training. In this post I would like to inform readers about the National Financial Capability Challenge and encourage students and teachers to participate in the challenge.

The National Financial Capability Challenge is an awards program designed to increase the financial knowledge and capability of high school students across the United States. It challenges high school teachers and other educators to teach the basics of personal finance to their students, and rewards students, educators, schools, and states for their participation and their success.

All high school teachers and other educators working with U.S. high-school aged students (ages 13-19) are encouraged to register for the Challenge, download the Educator Toolkit, prepare their students, and administer the online exam. Educators who have been teaching students about personal finance for years as well as those who never have before are urged to join this national initiative.

Please note that this is a free program and it works as follows:

Registration: Educators are encouraged to go to http://challenge.treas.gov, view the video message from Education Secretary Arne Duncan, and sign up as soon as possible. Registration is open through March 14, 2010.

Educator Toolkit: Once registered, educators will have access to a free Educator Toolkit that includes ready-to-use lesson plans that cover all the core concepts students need to learn to take the Challenge. Educators are encouraged to use whichever modules they like, use other existing resources, or create their own innovative approaches to teaching these concepts in an effort to help students increase their financial capability.

Challenge Exam: The Challenge online exam, which is designed to illustrate the relevance of financial topics to students, as well as to assess their learning, will be offered from March 15 - April 9, 2010. It will take the average student less than 40 minutes to complete, and each student should take the exam only once. Educators can decide which day to administer the exam and are expected to treat it just like an official exam.

Awards Program: The top two scorers at each school, plus all students scoring in the top 20%, will receive National Financial Capability Challenge Award Certificates. All participating educators will receive an official certificate, and educators from schools and states with the highest proportion of participating students will be recognized as well.

Please spread the word about this important program.

Financial Education: A Look at Teachers

2010-02-27T17:13:00.001-05:00

In previous posts, I have highlighted the importance of teaching financial literacy in high schools. I have discussed student financial literacy and the difficulties associated with teaching. In this post, I want to turn the attention to teachers themselves. Teachers are pivotal to the success of financial education. What do teachers think of financial literacy and how prepared are they to teach financial literacy courses?

A study by Wendy Way and Karen Holden titled “Teachers’ Background and Capacity to Teach Personal Finance: Results of a National Study” published in the Journal of Financial Counseling and Planning in 2009 sheds light on this important issue. More than 1,200 K–12 teachers, prospective teachers, and teacher education faculty representing four census regions responded to questions about their personal and educational backgrounds in financial education. There are several important findings from this study that I would like to highlight:

First, almost all teachers recognize the importance of and need for financial education. As many as 89 percent of teachers agree that students—in order to graduate from high school—should either be required to take a financial education course or pass a financial literacy test.

Second, teachers do not feel prepared to teach personal finance. Fewer than 20 percent of teachers and prospective teachers reported feeling very competent to teach any of the six personal finance concepts normally included in educational standards, such as those identified by the Jump$tart Coalition and in the NEFE High School Financial Planning Program®. Teachers and prospective teachers felt least competent in the more technical
topics, such as risk management and insurance, saving and investing, and financial responsibility and decision making.

Third, state education mandates appear to have no effect on whether a teacher has taken a course in personal finance, has taught a course, or feels competent to teach a course. Several of the states in the study had mandated financial literacy in high school, so while we might expect teachers in those states to be different, that doesn’t appear to be the case. Currently 80 percent of states have adopted personal financial education standards or guidelines, yet the majority of teachers (about 65 percent) in those states admit not feeling qualified to teach to their state’s financial education standards.

These are worrisome findings; while teachers recognize the importance of financial education, they admit limitations in their preparedness and ability to teach personal finance topics. If you feel discouraged, let me turn now to some encouraging findings reported in this study.

A majority of teachers are open to further education in financial literacy. Interestingly, those who report an interest in additional training are those who have had a college course in personal finance or who have backgrounds in vocational education or social studies. While the majority of teachers engage in a number of financial behaviors that typically help ensure financial security, they express the same financial concerns of the general population. In other words, not only do teachers seem interested in engaging in training to teach financial literacy but that same training may offer personal benefits to the teachers themselves.

This is an important study and has several implications for the discussion surrounding financial education in high school. Clearly, it is not enough to simply mandate financial education. Mandates alone do not make people any smarter. Instead, resources should be devoted to training teachers so that they can implement the standards that are required in financial education. Teachers would welcome this education, may themselves benefit from it, and believe in the importance of financial education. Thus, there are good reasons to expect training to be effective.

And parents, community leaders, and all of you “ambassadors” of financial literacy (identified in my previous blog), please be active, too. If our schools are to adequately prepare students, then consistent, comprehensive, and sound instruction in financial literacy needs to be an important component in every school’s curriculum. But, to adequately prepare our students, we first must prepare our teachers.

A link to the paper mentioned in this article is provided below:
http://6aa7f5c4a9901a3e1a1682793cd11f5a6b732d29.gripelements.com/pdf/vol20_2way_holden.pdf

Strangers in the classroom

2010-02-03T14:22:00.002-05:00

I regularly receive e-mails from people who recognize the terrible need for improving financial literacy among young people. Most of the people who write say they want to volunteer their time and teach financial literacy in high school. I am very impressed by how strongly people feel about financial literacy and I have been thinking of ways of harnessing that willingness to help and the generosity of volunteers. Financial literacy is much in need of promoters and organizers. It is a very important issue and we need to work for it.

While I want to encourage everyone to get involved with the schools, I am reluctant to recommend that individual volunteers teach financial literacy in schools, for three main reasons.

1. Contrary to popular belief, it is very hard to teach. I have been at Dartmouth for eighteen years now and I can tell you that every year I have to do a lot of preparation to be able to stand in front of my students and engage them. The first day of class normally ends with a room full of students with baseball caps expertly placed so that I can’t tell whether they are listening or are sound asleep, and a few anxious faces who have been checking their watches for the last 61 minutes of the 65-minute class, and who exit the classroom faster than Speedy Gonzales. And these are the economics students who have elected to be in these classes! It takes a while to filter through the stone faces beyond the first row, and even after years of grueling practice, I barely manage to get through the first half of the term without witnessing a decimated class. It does help to have an Italian mamma instinct, to be armed with limitless patience and unbounded optimism, and to be able to resist the temptation to hang myself from the maple tree outside the window after explaining a concept five different ways and realizing that it is still unclear. If somebody thinks they can just show up in the classroom and teach, I can assure you, it hardly works this way. If you want to teach, you have to be prepared to be trained or the students will “train” you (meaning you will feel like a train has run over you by the end of the class).

2. Individuals seem to have many different ideas about how to approach the instruction of financial literacy. As I have mentioned in previous blogs, financial literacy is a topic grounded in economic and finance theory and it should be taught accordingly. But what I often hear suggested are topics like how to balance a checkbook or how to buy stocks. We need to stay away from these narrow “how to” lessons of financial literacy, as the objective here is to prepare people to understand and navigate a world of complex and changing financial markets. We can’t just tell students how to get from point A to point B; we need to teach them to use a compass. This is no small task and in my view we need a curriculum that teaches the fundamental principals that combine to make one financially literate. Such curriculum development is best done at the national level; inflation does not decrease the value of money differently in Vermont than it does in California or Texas. And while Vermont is much colder than the southern states, it does not freeze how prices work. Once we have developed such a curriculum, there might be a way to engage volunteers in the instruction of it.

3. It’s not always clear how well qualified individuals are to teach financial literacy. In several cases, I have found that college freshmen have set up web pages to teach financial literacy and are eager to go to high schools to offer some classes, even though they may have taken only one introductory course in economics. This is the curse of economics. I have found that many people feel very confident about their views of how the economy works even if they have never read an economics textbook. In other cases, I’ve gotten the impression that people are intent on delivering wisdom and strong values acquired over many years of experience. On the one hand, I am very attracted by the passion that this topic engenders, on the other hand, the dissemination of a sound and consistent knowledge base should be our first priority.

I do not want to discourage anyone who is interested in the pursuit of improving financial literacy in schools. Quite the opposite! Please be involved; do not let the school in your own district not pursue financial literacy, not teach these courses! But perhaps the best role is to be an “ambassador of financial literacy”; be an advocate for financial literacy without going directly to the blackboard. We normally do not let strangers into the classroom, in any course, not just financial literacy. In my view, teaching financial literacy requires a deep knowledge of economics, solid training, and a fair dose of humility. My students would also say that a thick Italian accent helps keeps you awake, but in this case, even that might not be enough!

Three Reasons to Teach Financial Literacy in Schools

2010-01-20T18:03:00.000-05:00

On December 15, 2009, U.S. Department of the Treasury Secretary Tim Geithner and U.S. Department of Education Secretary Arne Duncan met with students, educators, and community leaders to promote strengthened financial capability among the nation’s youth. They outlined programs to encourage financial education in schools across the country. The need for financial education cannot be overstated. There are at least three compelling reasons to require financial education in schools.

First, it is important to be financially literate before engaging in financial contracts and not after. Yet findings from the Jump$tart Coalition for Personal Financial Literacy, which surveys high school students, and from the National Longitudinal Survey of Youth, which surveys young adults, show that young Americans lack knowledge of basic concepts of economics and finance. This is worrisome as it means that young people are borrowing without understanding, for example, the power of interest compounding and are choosing their investments, including investment in their own education, without knowing rates of return. Young people face many financial decisions, from how to use credit cards to how to buy a car or start a business. Of course, one of the most important decisions that students face right out of school is how to finance their education—an important investment decision both personally and financially. Also, an early grounding in financial literacy sets the stage for engagement in financial education later in life.

The second reason it is important to teach financial education in schools is that financial knowledge is based on scientific concepts—for example, the law of interest compounding and the concepts of risk and risk diversification—and the groundwork for this sort of conceptual understanding is best laid in a formal educational setting. Financial concepts are not necessarily best learned through experience over time or on the advice of friends, family, and colleagues who are not, themselves, financial experts. Some of the most important financial decisions individuals make are not made repeatedly over time. We do not retire many times or buy many houses. Risk management or rates of return are rarely explained to us in easy-to-understand terms; more likely they are reported in long and complex statements printed in 6-point fonts! And financial experiences can be difficult to decipher without some basic knowledge: For example, what is one supposed to learn from the current economic crisis?

The third reason that financial literacy should be taught in schools is to give everyone the chance to learn it. The surveys from Jump$tart Coalition show that the small groups of students who are deemed to be financially literate are disproportionately white males from college educated families. Similarly, data from the most recent wave of the National Longitudinal Survey of Youth show that the young adults (23–28 years old) who are financially literate have college educated mothers and have parents who had stocks and retirement savings when these young adults were teenagers. While this is good news for this limited demographic group, everyone—even those without highly educated and financially sophisticated parents—is faced with financial decisions and we all need the skills to make sound decisions. Some have argued that financial literacy is relevant only if one has wealth. This is a very narrow view. Individuals must make decisions not only about assets but also about debt. And debt is present, even pervasive, across all income strata.

For those of us who believe so much in the value of financial education, seeing Secretary Geithner and Secretary Duncan together on December 15, 2009, was an historical moment. When I look back at 2009, that day—December 15—was one of the best days of a bleak year. For me, it marks the day where we started making progress on an important topic like financial education. I feel better and more optimistic for the new year!

Wishes for the New Year

2010-01-10T23:16:00.003-05:00

I am back in Hanover after a term where part of every week was spent working in Washington, D.C., and I am looking forward to the new year. The beginning of a new year raises hopes and expectations; we expect the upcoming year to be different from the previous one and for things to be better. Our wishes often do not materialize but I have, nevertheless, three wishes for 2010.

In December, the findings from the new Survey on Financial Capability were released. They paint a troubling picture of the U.S. population both in terms of financial knowledge and financial behavior. As has been documented in other surveys, knowledge of basic concepts of finance and economics is lacking in the population. The majority of people do not understand the workings of inflation, risk diversification, and basic asset pricing. Nevertheless, individuals have to decide how much to save to afford a comfortable retirement and how to allocate their pension wealth. Moreover, and disturbingly, half of the population does not have a buffer stock of savings to shield against unexpected events like job loss or emergencies. This makes both individuals and the economy as a whole more vulnerable to shocks. There are many other findings that I will discuss in more detail in future blogs. (The executive report is available at http://www.finrafoundation.org/resources/research/p120478).
My first wish for the New Year is that these findings will provide the stimulus for implementing policies to improve financial literacy and help American families in their financial decision-making.

My second wish for the year is that attention will turn to the groups that need financial literacy the most. One of these groups is women. The Survey on Financial Capability (as well as other surveys) documents that women are lagging behind men in terms of financial knowledge. This is not only the case for older women; it is also true for young women entering the labor market and for high school students. In all of these demographic groups, women are found to be less financially knowledgeable than men. Women are a large and important group. With one in two marriages ending in divorce or separation, women increasingly have to rely on both their earning capacity and their ability to manage resources well to take care of themselves and others. However, very few financial education programs are targeted to women and much more can and should be done to empower women with financial knowledge and financial capability.

My third wish is for financial literacy to be taught in schools. As I have mentioned in previous blogs, financial literacy is an essential piece of knowledge that every student should have. Just as reading and writing became skills that enabled people to succeed in modern economies, today it is impossible to succeed without being able to "read and write" financially—in other words, without financial literacy. Students face formidable financial challenges both during their school years (when they are bombarded with credit card offers) and in the years of young adulthood when they have to make important decisions, including how to finance a college education. My hope is that knowledge and understanding of financial concepts will impact their lives in one particularly important way: the understanding that one of the most important assets they can invest in is their own education.

On a personal level, I will try to stay away from New Year’s resolutions I know I cannot keep, such as shedding these extra pounds (I like eating!), traveling less (the weather and the new security measures are taking care of it), and writing a novel (I am too nerdy for it). But I will continue doing my research and writing my blog. This continues year after year and does not notice the passage of time. It does not even require a special resolution. Happy New Year to all of you!

The Silent Course of Financial Mistakes

2009-11-24T10:31:00.002-05:00

One of the problems with financial mistakes is that they can go unnoticed for a long time before a crisis erupts. For example, one could spend many years undersaving for retirement only to discover at age sixty or sixty-five that one has not accumulated enough to afford a comfortable retirement. But prior to such a discovery there are no signals, no warnings: no bells go off to warn about lack of savings, no statements caution “careful, this amount of savings seems low for your age.” In some of my work I have found that people start planning for retirement or make changes to their retirement savings accounts when they witness negative shocks to those around them (older siblings or parents) but, clearly, relying on such signals is insufficient.

This is the case not only for assets but also for debt. One could pay the minimum amount due on credit cards and have the debt pile up until it is too large to be paid off. Of course, borrowing at rates of 18% or higher makes the debt balloon, but the law of compound interest can cause debt to accumulate rapidly if one does not understand that interest accumulates on interest. The consequences of this can be devastating. People who have accumulated a significant amount of debt may have to postpone retirement or work a second job or sharply decrease their standard of living after retirement. They may even end up in bankruptcy. Throughout the current financial crisis, we’ve witnessed people losing their jobs and having little savings to fall back on, with many ultimately losing their homes. As a result of this crisis, saving has increased to an unprecedented level, but it is unfortunate that it took a negative shock to lead to appreciation for having a buffer stock of savings. Wouldn’t it be better if good saving habits were instead the result of routine assessment and maintenance of one’s financial “health”?

If we consider how we take care of our finances in light of how we take care of our physical health, we might come to some interesting conclusions. Everyone knows that regular health screenings are important. Underlying health conditions are not always obvious: nothing hurts, no obvious symptoms are experienced, everything seems fine until one finds a lump while taking a shower. In matters of health, we know that it is best to catch a health condition before it is at an advanced stage. Doctors have long recommended regular physical checkups, and we subject ourselves to routine tests and visits to the doctor even when we feel healthy and in good shape. We also take the usual health precautions, getting flu shots in the winter, washing our hands carefully, taking vitamin and mineral supplements (at least for those of us over…ahem, 40). Recommendations like these abound in doctors’ offices, in the media, and in everyday personal interactions. Everyone knows what precautions they should be taking on a daily, monthly, and yearly basis to maintain their physical health.

But how about financial health? What are we doing to make sure we are doing well in our financial planning? What precautions are we taking to make sure our finances stay healthy? Are we setting aside a buffer stock of savings that can shield us against negative shocks such as loss of income or an unexpected expense? Are we managing our debt wisely and making good investments?

Health maintenance is not exactly fun. I do not particularly enjoy having needles stuck in my arms, spending time reading old magazines in doctors’ waiting rooms, or the fearful anticipation in opening a letter that contains test results. Yet, most of us do exactly this and we advise our friends and loved ones to do it too. Maintenance of financial health won’t be any more fun than getting regular checkups, but it can be just as important. Financial markets are more complicated today than they’ve ever been and we are more responsible for our own financial well-being than ever before. Regular financial checkups can help to prevent a poor investment decision from causing long-term damage to a retirement plan or keep an accumulation of debt from growing to a point that it’s impossible to recover from. Just as regular medical checkups can keep us healthy and provide a better quality of life, so regular financial checkups can keep our accounts in good shape and ensure financial well-being for years to come.

Our new Financial Literacy Center

2009-10-17T19:12:00.005-04:00

In my previous post, I have announced the creation of a new Financial Literacy Center, a collaborative effort among Dartmouth, the Wharton School, and RAND. I would like to explain in more detail its mission and its purpose.

MOTIVATION TO BUILD A FINANCIAL LITERACY CENTER
Individuals and families are increasingly being asked to take command of their own financial well-being. They must determine not only where and how long to work, but also how much to save and how to allocate their pension assets, when to claim Social Security and pension benefits, and how to manage their assets throughout a potentially long retirement period. These decisions were always difficult, but they have become even more so today since increasingly intricate and hard-to-understand financial products are now accessible to many people who are actually quite ill-equipped to take on the task. As a result, widespread saving shortfalls and difficulties with debt are emerging as serious challenges to households already at risk. And without a doubt, the current financial crisis has underscored the reality that, as a nation, we are subject to deep systemic risk attributable in part to financial illiteracy. These facts threaten to undermine many Americans’ hopes for a rewarding retirement.

Our goal with the creation of the Financial Literacy Center is to harness creativity and ingenuity to generate rigorous quantitative analysis and build innovative and exciting products that will work effectively in real-world settings to better identify and resolve the challenge of financial illiteracy. A multidisciplinary approach is integral to understanding the problem, so as to formulate concrete steps that can be structured to conquer inertia and to test products to determine what works best. The Center includes several strong cross-disciplinary teams that draw from diverse but relevant fields, including traditional economics and finance, behavioral economics, social marketing, psychology, marketing science, and sociology. Working across disciplines and theoretical backgrounds encourages the creativity needed to foster unconventional but potentially effective designs, to test programs and products for effectiveness, and to articulate best practice in a variety of different settings under this common unifying theme. All these steps will be invaluable in helping Americans of all working ages better understand the role of Social Security benefits and the need to save and dissave sensibly over their lifetimes.

Our review of the existing literature leads to the following general observations relevant to the goals of the Center:
1. Financial illiteracy is widespread. Financial literacy cannot be taken for granted among the population, particularly among specific groups (including those with low education, women, and minorities). This raises the issue of how to communicate information effectively, particularly to those who need it most.
2. Financial education can work. The provision of financial literacy can be invaluable in enhancing saving and investment decisions, retirement planning, and retirement outcomes.
3. “One size fits all” does not work. Different segments of the workforce require appropriate tailoring in terms of message and delivery system for financial literacy.
4. The financially illiterate require both information and help with implementation. Building literacy requires products and programs that (a) inform workers of retirement goals; (b) give them concrete ways to begin to think about how to attain these; (c) offer simple approaches to attain their goals and overcome obstacles; (d) provide timely reminders and encouragement about how to meet the goals; (e) offer additional information if the client so desires.
5. A step-by-step approach is needed. Enhancing financial literacy requires a sequence of steps: (a) a baseline assessment of literacy shortfalls; (b) the development of material and tools, including implementation steps, appropriate to specific subpopulations; (c) the development of modes of communication and delivery systems attractive to the relevant subpopulation; (d) evaluation of outcomes.
6. It is essential to integrate a thorough and careful project evaluation to fill in the knowledge gap about what works in the financial literacy.

Our New Financial Literacy Center

2009-10-08T22:28:00.005-04:00

I am very happy to announce the creation of a new Financial Literacy Center, a joint collaboration among Dartmouth College, the Wharton School, and the RAND Corporation. The press release is reported below:

http://www.rand.org/news/press/2009/10/07/financial_literacy.html

A new center dedicated to improving the financial literacy of the American public has been launched by the RAND Corporation, Dartmouth College and the Wharton School of the University of Pennsylvania.

The Financial Literacy Center will receive more than $3 million during its first year from the U. S. Social Security Administration to develop educational materials and programs that help foster saving and retirement strategies over the life cycle.

The new center will be hosted by RAND and led by Director Annamaria Lusardi of Dartmouth College and RAND, Associate Director Olivia S. Mitchell of the Wharton School and Associate Director Arie Kapteyn of RAND. Each of the leaders has an international reputation for their work on financial literacy.

"Americans are assuming increasing responsibility for decisions that will determine whether they have enough money to support themselves in old age," Lusardi said. "Unfortunately, they often lack the information and skills to make good decisions."

The Financial Literacy Center will empower different population groups by developing and testing innovative financial educational products that address their needs.

Besides researchers from RAND, Dartmouth and the Wharton School, the Financial Literacy Center team includes experts in multiple disciplines from the American Enterprise Institute, Cornell University, Doorways to Dreams Fund, FINRA Investor Education Foundation, Greenwald and Associates, Harvard University, Harvard Business School, ideas42, the National Endowment for Financial Education, the National Bureau of Economic Research and North Carolina State University, along with a range of corporate and nonprofit collaborators.

As requested by the Social Security Administration, projects in the first year will tailor materials for Americans at various stages of their working lives—young workers, mid-career workers and those approaching retirement—as well as current retirees who must manage the resources they have accumulated. The center will also provide financial literacy products for underserved populations, such as low income, young, and disabled workers, who are particularly vulnerable during periods of financial turbulence.

Does Simplification Work?

2009-10-02T22:30:00.002-04:00

One assumption behind recent policy proposals, including the new proposed regulation to protect consumers is the importance of simplifying decisions. But does simplification work and does it help consumers? The answer from two academic projects is a resounding “yes.” I describe each of them below.

James Choi, David Laibson and Brigitte Madrian, researchers from both Harvard and Yale, study the effect of Quick Enrollment, a program that gives workers the option of enrolling in the employer-provided saving plan by opting into a preset default contribution rate and asset allocation. Unlike defaults, workers have the choice to enroll or not, but the decision is much simplified as they do not have to decide at which rate to contribute or how to allocate their assets.

When new hires were exposed to the Quick Enrollment program, participation rates in 401(k) plans tripled, going from 5% to 19% in the first month of enrollment. When the program was offered to previously hired non-participants, participation increased by 10 to 20 percentage points. These are large increases, particularly if one considers that the default rate is not particularly advantageous: the contribution rate in the most successful program is set at only 2%, with 50% of assets allocated to money market mutual funds and 50% allocated to a balanced fund. Moreover, Quick Enrollment is particularly popular among African-Americans and lower income workers (those earning less than $25,000) who, as the research mentioned before shows, are less likely to be financially literate. Thus, changes in pension design can have a significant impact on participation. Most importantly, this is a low-cost program.

Another approach designed to simplify the decision to save and, in addition, motivate employees to make an active choice is the one we did at Dartmouth College (this was a joint collaboration with a professor of marketing at the Tuck School of Business, the Executive Vice President of Finance and Administration at Dartmouth, and myself). We designed a planning aid to help employees contribute to supplementary pensions. The planning aid displays several critical features. First, it breaks down the process of enrolling in supplementary pensions into several small easy steps, describing to participants what they need to do to be able to enroll online. Moreover, it provides several pieces of information, such as describing the low minimum amount of income employees can contribute (in addition to the maximum) and the pension carriers employees can choose from. Such a simple and low cost intervention lead to a large increase in contribution rates to supplementary pensions; contribution rates doubled after the introduction of the planning aid. This program was targeted to women and low income employees; in the survey we distributed among employees, many respondents told us “they did not know where to start.”

This program shares several features with other programs. First, while economic incentives, such as employers’ matches or tax advantages may be useful, they do not exhaust the list of available options. Given the massive lack of information and financial knowledge, there may exist other and more cost-effective programs that can induce people to save; in fact, simplification is a rather unexploited way to affect decision-making. Second, employees are more prone to decision-making at specific times. For example, the start of a new job makes people think about saving (often because they have to make decisions about their pension). Both the papers by Choi, Laibson and Madrian and our paper find that new hires are particularly open to making changes. Third, to be effective, programs have to recognize the many differences that exist among individuals, not only in terms of preferences and economic circumstances, but also in levels of knowledge and financial sophistication.

So, here is a recommendation: make it simple!

A copy of the paper is available at: http://www.dartmouth.edu/~alusardi/Papers/Lusardi_Keller_Keller.pdf

The New Initiative for Retirement Savings

2009-09-15T18:11:00.000-04:00

President Obama recently announced a new initiative that will make it easier for Americans to save for retirement. This is an important step. The stock of personal U.S. savings took a big hit in the midst of the financial crisis, and many families have been left scrambling to make ends meet. Before the crisis, the saving rate had been hovering around zero. Depending on which definition is used, anywhere from a quarter to just over a third of Americans are asset poor. The importance of having savings cannot be overplayed. Having savings guarantees security after retirement and can provide a buffer against shocks. A recent survey, conducted by the market research firm TNS, revealed that almost half of Americans doubt that they could come up with $2,000 in 30 days—whether from savings, borrowing, friends, or family—to meet an unexpected financial need. But the good news is that American families seem to have recovered an appreciation for saving and this new initiative will help people continue to save.

There are four new and important components of this initiative. The first component uses the “make it simple” approach to retirement saving, using automatic enrollment to default workers into retirement saving plans, with the ability to opt out if an individual so chooses. Large companies have successfully used automatic enrollments for years, but this initiative will make it easier for small companies to offer the same benefit. An effort to simplify saving may seem to be common sense but, in fact, is a radical departure from what models of saving have traditionally focused on. Both academic research and policies to stimulate saving have overlooked and underplayed the difficulties that people face in making saving decisions, in devising a saving plan, and in implementing such a plan. The new initiative will make it possible for more people to easily enroll in pensions. By defaulting workers into a pension, saving becomes the rule rather than the exception. And when saving is made simple with automatic enrollment, research indicates that workers make the choice to stay enrolled in a pension plan.

The second new component of this initiative is to facilitate the saving of federal tax refunds, which 100 million American families receive. If tax filers have a retirement account, they can have their refund deposited directly into that account. Notably, filers will be able to check a box on their tax return to receive their refund as a savings bond. This is not just simple, it is brilliant! This idea was originated and tested by Peter Tufano of Harvard Business School and Doorways to Dreams (D2D), the not-for-profit he founded in 2000. In 2007, the Federal government distributed $250 billion in 2006 tax year refunds to Americans, of which nearly $115 billion went to families with incomes under $40,000. Households or individuals with adjusted gross incomes under $40,000 received refunds of approximately $1,679. Research has shown that families, including low income families, aspire to save at least a portion of their tax refund. Yet, until now, there has been no simple way for them to do so. Savings bonds offer many attractive features. They comes in small denominations, charge no fees, generally pay a competitive rate, guarantee no principal loss, and are exempt from state and local taxes. Moreover, many people seem to know about savings bonds. According to Tufano’s research, as many as 89% of individuals in low income families are familiar with savings bonds. Multi-year research work in this field and pilot studies offering savings bonds to tax filers have demonstrated that such an initiative makes it possible for low income families to save (for more information about this research, visit http://www.d2dfund.org/). Now, every family that receives a tax refund has a simple way to put that money away: as simple as the stroke of a pen.

The third new component of this initiative is to enable workers to convert their unused vacation or other similar leave into additional retirement savings. In other words, it will now be possible for employees to put payments for unused vacation and sick days into their retirement plan if they wish. Another simple way to help people save!

The fourth component of this initiative is the guide that the Treasury and the IRS will put together to help workers and their employers better understand the available options for tax-favored retirement saving. Again, this will be written in simple and clear language. This is an important innovation. People need to have a reputable source of information to rely on, and they need to know where to go to access that information. The importance of such a guide should not be underestimated. Automatically enrolling people in a pension plan is a great way to foster retirement savings, but workers could make the decision to withdraw or borrow from a retirement account, sometimes incurring tax penalties, or individuals might fail to roll over a pension into another tax-advantageous account when leaving a job. My hope is that the guide will not limit itself to offering information about retirement savings; people are dealing with a lot of financial decisions and all of these decisions are interrelated. For example, it may not be wise for a worker to contribute to a retirement account if he/she carries a lot of high-interest credit card debt. And, judging from some of the behavior that the recent financial crisis exposed, some debt management tips should be included in the guide, too.

Our society has made it easy to consume, now this policy makes it easy to save!

Where Do People Get Financial Information?

2009-07-26T14:36:00.005-04:00

The financial decisions people have to make today are quite complicated, and the financial markets we interact with have made finances even more complicated. So, in such a complex world, where do people turn to for advice when making financial decisions? Survey after survey show that one of the primary sources of information are family members. Colleagues and friends are another common source. This is an important finding. A lot of financial transactions happen within the family and family members naturally exchange information and advice. Moreover, we spend a lot of time at work and the workplace is a natural environment in which to get information and exchange ideas. However, is it a good idea to rely mainly on family and friends for financial advice? Because there is inherently asymmetric information in this type of exchange (those who ask know less than those who provide information), it may be hard to know whether the advice one is receiving is sound. We trust family members to do right by each other, and it might be possible to know whether someone has made good decisions and trust that it is safe to follow in their footsteps. I have an older sibling and I have learned a lot by simply following some of the decisions she has made. But financial acumen is not always verifiable. We cannot always know whether our friends have chosen the best mortgage, how they invest their retirement wealth, and what they do with their credit cards. People do not go around with financial statements around their necks and the fact that someone has a nice house and a nice car might be an indication of a lot of debt rather than a lot of savings. Trust is important when it comes to financial information, but should trust trump expertise? If people around us are not really more knowledgeable in finance than we are, do we improve our knowledge by seeking advice from them? Ask yourself: would you trust a family member who is not a health care professional for medical advice? Finance is no less complicated than health, and the consequences of bad financial decisions can be as dire as taking the wrong medicine or leaving an illness untreated.

I am always intrigued by how much people like to dispense financial information and financial advice. Because I have been traveling a lot in the past few months, I have gotten a good deal of financial information and financial advice from taxi drivers, strangers at the airport, and hairdressers. One participant at a conference told me that in his town, everybody gets financial advice from the butcher. I will keep this in mind when I buy my steaks. I like that people are paying so much attention to finance and financial matters these days, and it’s interesting to hear what people are talking about. Some of the suggestions and theories I have heard are brilliant, some are odd, but others are just plain wrong. Finance and financial principles are grounded in theory: they follow laws that do not change based on who is in power or which state you live in; the power of interest compounding is no different in Florida than in California, and it does not change depending on whether the president is a Republican or a Democrat.

If we are so eager for financial information, there is a clear role for a provider of information—a reputable, independent, and expert source. For example, Social Security started to send around statements about Social Security benefits in 1995. This is a laudable initiative and studies have shown that these statements have changed people’s behavior. The Department of Labor is hard at work to find ways to improve and streamline the information provided by pension plan providers. The Securities and Exchange Commission is looking for ways to better inform investors.

I have my own recommendation to offer. If you need financial information, use www.mymoney.gov. It was built by experts to provide financial advice for citizens. It is from a reputable institution that cares about people making good decisions.

Let’s not mix roles. There is a joke in Italian that goes approximately like this: In heaven, the Italians are the cooks, the Germans build cars, and the Swiss are in charge of running the trains. In hell, the Germans are the cooks, the Swiss build cars, and the Italians are in charge of running the trains. As you can see, we Italians like to poke fun at ourselves. But the same principle applies here: ask taxi drivers for directions, hairdressers for a good shampoo, butchers for a good sausage, and your government for good financial advice! You would not ask a taxi driver for a haircut or send to the Treasury for sausage, would you?

How to Build a Successful Website for Financial Literacy

2009-07-03T13:38:00.000-04:00

At an international conference in Washington, D.C., on financial literacy last year, the Retirement Commissioner from New Zealand stood up and stated that New Zealand has the best website in the world to promote financial literacy and financial education. I liked her instantly; you need to have a lot of guts to make that statement in front of an international audience of academics and policymakers, and possibly a good website. I checked out that website and good it is! It is called “Sorted,” a term that New Zealanders use to mean figuring things out and getting ready (http://www.sorted.org.nz/). The website is very well organized and provides information for financial decisions at every stage of life. One can find information about managing debt, mortgages, investment, and planning for retirement. And there is a variety of calculators as well to help people figure out the interest payments on their credit cards, how wealth can grow with the power of interest compounding, how much to save for retirement, and much more. On the website one can also take a money personality test “to help you work out your financial strengths and possible blind-spots.” I went through the questions and was told (among several other things) that when it comes to money matters, I am cool and dispassionate! I like that, too.

As I have argued before, citizens in every country could use one reliable, accurate source of information for managing their financial decisions. However, what really puts New Zealand's website over the top is the fact that it is so engaging. The information is not provided in those sterile graphs and statistics that even people with advanced degrees understand only after a bit of head scratching. One can watch a movie about investment, saving, and retirement. The soundtrack is so good that it made me play the movies a couple of times to listen to it again. One can also listen to stories and follow the journeys of Liz, Carl and Jess, Rochelle and Junior, and Raeanna and learn how they used the tools available on the website to help organize their finances. It is not just about information and simplifying decisions, but also about implementation. The website describes the steps that one has to take, for example, to set goals and to do a budget. And there are tips on a variety of topics, including how to cope with today’s financial climate. The information provided online is also available in booklets that can be downloaded or ordered for free.

According to a survey that was just released in June 2009, one-third of New Zealanders had either visited the website of the Retirement Commission or read one of the booklets, and a quarter had done so within the past twelve months (http://www.financialliteracy.org.nz/.) This is an extraordinary result. In my view, there are several reasons for this success. First, the Retirement Commission is an autonomous entity with the mission to “educate and inform New Zealanders from age 5 to 105 about managing their personal finances to ensure adequate provision for retirement.” Thus, the citizens of New Zealand know where to go to get a reliable source of information. We do not need many web sites, we only need one! And both the website and the work of the Retirement Commission are well advertised in the media and New Zealanders know about it. Most importantly, as the Retirement Commissioner remarked, it is a good website!

I visited the Retirement Commission last week to speak at their Financial Literacy Summit. I discovered that they designed a survey of financial knowledge in 2005, well before other countries. The development of a national strategy to lift New Zealanders’ financial literacy was announced at the inaugural Financial Literacy Symposium in Wellington in December 2006 and launched in 2008. And if the new survey in 2009 is any indication, 43 percent of New Zealanders are now scoring high on financial knowledge, and women and low income households are among the groups with the biggest improvements since 2006, when data from the first survey was collected. At the conference last week, the Secretary for Education announced that financial education will become part of the curriculum in schools throughout New Zealand. Moreover, the advisory committee for the National Strategy for Financial Literacy (composed of the Governor of the Reserve Bank of New Zealand, the Chair of the Securities Commission, the Chair of the Investment, Savings and Insurance Association, the Secretary for Education, the Associate Dean for Mâori and Pacific Development at the University of Auckland Business School, and the Retirement Commissioner) will now report to the Minister of Finance twice a year on progress in implementing the strategy.

As you may know, New Zealanders are also called “Kiwis.” The Kiwi is a flightless bird. As the story goes, Tane Mahuta, the lord of the forest, was surveying his ferny domain and became concerned that his children, the trees, were ill from being eaten by bugs. He called the birds together to ask if any might be prepared to eat the bugs, which would entail living on the dark, damp forest floor. The Kiwi put himself forward. As a reward it became the best-known and most-loved bird of all.

It is good to have such a symbol in a country so hard at work to improve financial literacy. Can they improve financial literacy? The answer I heard at the conference was: Yes, we can!

Protecting Consumers: Regulation is not Enough

2009-06-19T09:03:00.001-04:00

This week, the Obama administration laid out a financial reform plan that included the creation of a Consumer Financial Protection Agency. This and the Credit CARD Act of 2009, which was passed in Congress last month, are important steps toward improving consumer protection in the marketplace—but without a renewed focus on promoting financial literacy and financial education programs, these initiatives will fall flat.

Financial literacy is an essential tool for consumers trying to navigate today’s world, where they engage in a myriad of financial transactions in an increasingly complex financial marketplace. Consumers require financial literacy to make decisions related to saving, retirement planning, managing credit card debt, and acquiring mortgage loans. The transition in recent decades from defined-benefit to defined-contribution pension plans has meant that the responsibility for securing late-life financial well-being is now placed on the shoulders of consumers. Just like the fundamental skills of reading and writing, financial literacy is a key ingredient for economic success.

Promoting “transparency, simplicity, fairness, accountability, and access,” as the White House report touts, is certainly an essential goal for any effective consumer regulatory regime. However, the mere provision of accurate and clear information is often inadequate to achieve good consumer decision-making. For instance, the Truth in Lending Act of 1968 was designed to protect borrowers by requiring the disclosure of critical loan terms, such as the annual percentage rate (APR); but in fact many consumers do not understand the workings of interest rates. Without knowledgeable consumers, transparency is not enough.

And lack of financial knowledge is alarmingly widespread. In a survey of Americans that Peter Tufano of Harvard Business School and I conducted with the market research firm TNS Global, we found strikingly low levels of financial knowledge across the U.S. population. Only one-third of respondents were able to apply concepts of interest compounding to everyday situations or understand the workings of credit cards. While many American families use credit cards and carry balances, only a minority of respondents knew that borrowing at an interest rate of 20 percent, compounded annually, will lead to a doubling of debt in fewer than five years. Lack of financial literacy is particularly severe in groups that are already financially vulnerable: women, the elderly, minorities, and those who are divorced or separated. And the less financially knowledgeable pay dearly for their ignorance: the credit card fees paid by a low-knowledge individual are 50 percent higher than those paid by an average cardholder.

The Credit CARD Act of 2009 makes important strides in that it requires credit card companies to include, in the billing statement, the number of months it will take a consumer to pay off the balance if he or she makes only the minimum monthly payment. Making it easier for consumers to process information is an effective way to aid in financial decision-making.

Simplification can be taken much further: an example is the auto-enrollment IRA, one of the initiatives that the White House pushes for in its report. Automatic enrollment in pensions has been a way to substantially increase workers’ participation in defined-contribution pensions. However, this can fall short of securing retirement needs. Workers who carry credit card balances should reduce their debt rather than enroll in a pension. And automatic enrollment in pensions and IRAs is not a substitute for retirement planning; workers need to ensure they are saving for a retirement that meets their needs and goals, an objective that a one-size-fits-all automatic enrollment program might not achieve.

Increasing regulation of consumer financial products and circumscribing the set of products available to consumers, either by requiring businesses to provide “plain vanilla” financial products or by outlawing products that are deemed manipulative or misleading, as the White House outlines in its report, can be effective in limiting the scope of financial mistakes that consumers can make. However, these measures are not enough to promote long-term financial well-being.

Consumers engage in such a varied and increasingly complex array of financial transactions that it is not feasible to circumscribe and regulate all possible actions in every possible financial area, nor is it desirable. Instead, policymakers need to equip consumers with enough financial knowledge to make them capable of effective financial decision-making.

To this end, the Obama administration’s plan deserves praise for recognizing the importance of promoting financial education: the White House report envisions the Consumer Financial Protection Agency taking a “leading role” in educating consumers about finance. Consumer protection is a two-way street: it requires not just regulation and oversight of businesses but also ensuring consumers are adequately equipped to confront the array of financial choices available to them. Navigating today’s financial markets is not unlike navigating busy roads: putting up more road signs, increasing patrolling, and restricting traffic can limit accidents but if people do not know how to drive, they are still going to crash. Promoting financial literacy needs to remain not just an afterthought, but a top priority.

Are You Debt Literate?

2009-06-11T21:05:00.003-04:00

Individuals need financial skills—perhaps more now than ever before. Financial competence has become more essential as financial markets offer more complex choices and as the responsibility for saving and investing for the future has shifted from government and employers to individuals. As the credit crisis shows, borrowing decisions are also critical. Rapid growth in household debt and its link to the current financial crisis raises the question of whether lack of financial knowledge led individuals to take out mortgages and incur credit card debt they could not afford.
To assess how much knowledge individuals have with respect to debt, Peter Tufano of Harvard Business School and I designed and fielded a survey focused specifically on debt literacy, which is an important component of overall financial literacy. (The survey was conducted in partnership with the commercial market research firm Taylor Nelson Sofres [TNS] Global. It was fielded in November 2007, with data collected via phone interviews with a representative sample of 1,000 U.S. residents.) “Debt literacy” refers to the ability to make simple decisions regarding debt contracts, applying basic knowledge about interest compounding to everyday financial choices.
Our approach to measuring debt literacy has two components. First, we asked participants to judge, or “self-report,” their financial knowledge. Second, we devised questions to assess key debt literacy concepts, such as the power of interest compounding. These questions, measuring actual financial knowledge, can be solved with simple reasoning and do not require a calculator. Take a moment to answer the questions below, then compare your results to those we obtained in the survey.

Self-reported financial knowledge:
On a scale from 1 to 7, where 1 means very low and 7 means very high, how would you assess your overall financial knowledge?

Actual financial knowledge:

A) Suppose you owe $1,000 on your credit card and the interest rate you are charged is 20% per year compounded annually. If you didn’t pay anything off, at this interest rate, how many years would it take for the amount you owe to double?
(i) 2 years;
(ii) Less than 5 years;
(iii) 5 to 10 years;
(iv) More than 10 years;
(v) Do not know.
(vi) Prefer not to answer.

B) You owe $3,000 on your credit card. You pay a minimum payment of $30 each month. At an annual percentage rate of 12% (or 1% per month), how many years would it take to eliminate your credit card debt if you made no additional new charges?
(i) Less than 5 years;
(ii) Between 5 and 10 years;
(iii) Between 10 and 15 years;
(iv) Never, you will continue to be in debt;
(v) Do not know;
(vi) Prefer not to answer.

C) You purchase an appliance which costs $1,000. To pay for this appliance, you are given the following two options: a) Pay 12 monthly installments of $100 each; b) Borrow at a 20% annual interest rate and pay back $1,200 a year from now. Which is the more advantageous offer?
(i) Option (a);
(ii) Option (b);
(iii) They are the same;
(iv) Do not know;
(v) Prefer not to answer.

Analysis of responses to these questions is not heartening. We learn that the large majority of Americans do not know about the power of interest compounding, do not realize that one can never eliminate credit card debt by making minimum payments equal to the interest payments on the debt, and do not understand the time value of money. On question A, only about 36% of respondents knew that it would take less than 5 years for debt to double if one were to borrow at an interest rate of 20%. Even though about 80% of individuals have credit cards (and usually more than one card!) and have to decide frequently whether to pay off the card or carry a balance, only 35% knew the correct answer to question B—that one can never eliminate credit card debt by making minimum payments equal to the interest payments on the debt. A meager 7% of respondents chose the most advantageous option of those presented in question C: to buy an appliance and pay $1,200 a year from now. Many preferred to give money early to the retailer. Moreover, as many as 40% of respondents indicated that paying in one lump sum or in 12 monthly payments is the same option, thus overlooking the time value of money.

Notwithstanding the poor scores on these questions, when assessing their own financial knowledge, most respondents picked values of 4 or above: in other words, most people thought they were above the mean in their financial knowledge!

This is only part of the research we have been able to do on these data, but the findings are worrisome. We are confronted every day with decisions about how to shop, how to pay for what we buy, how to manage debt. The results of this study show that Americans are not as debt literate as we think we are. Knowing what we do not know can be a first step in acquiring the knowledge we need in order to make better financial decisions.

Women and Finance

2009-05-09T23:48:00.007-04:00

Tomorrow is Mother’s Day and I want to celebrate it by writing about women. As I have documented in previous posts, there is a substantial gender difference between women and men when it comes to financial literacy: women know much less about economics and finance than men. This is true not only among older cohorts but also among younger generations. Moreover, it holds true in many of the countries in which I have studied financial literacy, including Italy, Germany, the Netherlands, and Ireland. This is not good news for anyone because women often have to fend for themselves in an increasingly complex financial world: the divorce rate is much higher than in the past, single motherhood is very high in certain demographic groups, and greater longevity for women calls for more retirement savings for women than for men. And women may be most concerned about children’s education and how to help aging parents. Being a financially savvy woman involves making difficult decisions that have important financial implications.

Despite grim statistics about financial literacy among women, in my view, the evidence about how women fare in financial decision making is far from unfavorable. Research shows that women who hold stocks trade them less frequently than men, thereby paying fewer fees and transaction costs and ending up with more wealth. Women tend to hold more conservative portfolios, and in the current environment this has worked out well. Women are also less likely to be victims of scams that seem to be disproportionately perpetrated against white men.

One reason that women might be better financial decision makers, despite displaying, in general, lower literacy than men, is that women know what they do not know. In studies of financial literacy in which participants were asked to rank their level of financial knowledge prior to being given a set of problems to measure their actual level of financial literacy, women’s low self-evaluations were fairly consistently correlated with fair to poor performance on the literacy problems. This demonstrated lack of overconfidence may prove helpful in financial decision making and in avoiding financial mistakes, and this awareness may help women to take action. As several studies about financial education show, seminars and education programs are disproportionately attended by female participants. Moreover, it is primarily women who report being affected by those programs.

A project I did here at Dartmouth College confirmed many of the findings of larger surveys and data sets. The women I interviewed consistently spoke of finance with humility and considered themselves unsophisticated investors. Yet I was struck by how articulate women were in describing their financial needs, how much they had thought about financial matters, and not only how much they cared about the financial security of their loved ones but also the provisions they made to that end.

In my view, finance is an ideal field for women. The fact that women make decisions with the well being of others in mind, that they steer clear of excessive risk, and that they do not consider themselves “financial geniuses” and “financial wizards” are characteristics that have not been fully exploited. Interestingly, women are often brought in when there is a financial crisis and confidence needs to be restored. For example, after a less than spotless record, the Securities and Exchange Commission is now headed by a woman, and its Office of Investor Education and Advocacy is also headed by a woman. Perhaps one of the ways to ensure the smooth functioning of financial institutions and contracts is to have more women in charge.

On a personal note, my mother taught me a lot about finance, and so in my family, the passion for this topic has been transmitted from mother to daughter. Happy Mother’s Day!

Some Suggestions to Address the Retirement Saving Crisis

2009-04-26T17:50:00.003-04:00

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?).

Overcoming the Saving Slump: How to Increase the Effectiveness of Financial Education and Saving Programs

2009-03-08T18:55:00.002-04:00

In the previous blog, I have described a specific program about how to help people save. I would like to describe now a set of ideas I have pursued in my newly published book: “Overcoming the saving slump: How to increase the effectiveness of financial education and saving programs.”

This book explores the many challenges that have arisen in the transition to a pension system that requires more individual responsibility, focusing on micro behavior as it relates to saving and pensions and illustrating the impediments and barriers to saving. The issues at hand have not gone unnoticed. The financial industry, employers, and the government have taken initiatives to promote saving and financial education programs. The financial industry has developed and provided products that can better suit the needs of investors. In addition, financial education programs have been offered in different forms and from different institutions. This book tries to evaluate whether and how these developments are helping to effectively bridge the way to a new system. The authors who have contributed to this book have analyzed programs that are in place, examined available investment products, and taken a close look at the experiences of countries that have privatized their pension systems or experienced changes in their Social Security systems. From these contributions emerge what is perhaps the most important objective of this book: to provide suggestions on how to improve the effectiveness of these programs and products, thereby enabling the United States to make the transition to this new system more smoothly.

The economic changes that are occurring in the pension landscape in the United States are well documented in the first chapter of this book, which traces the increase of individual retirement accounts that has occurred in recent decades. Workers retiring before the 1980s relied mostly on Social Security and employer-sponsored defined benefit pension plans for their retirement income. The situation is very different for current workers, who will reach retirement with a different mix of funds—not only Social Security and defined benefit plans, but also personal retirement accounts, including IRAs and defined contribution pension plans. One characteristic of these accounts is that individuals are in charge of deciding how much to contribute and how to allocate their retirement savings. Moreover, individuals must decide how to decumulate their wealth when they reach retirement. A comprehensive retirement planning strategy requires consideration not only of how to save but also how to spend down wealth. Individuals have to make sure that retirement wealth lasts a lifetime (chapter six). The risk of individuals making costly mistakes in their saving and retirement planning are real. Throughout the book, evidence is shown of widespread financial illiteracy in the United States (chapters nine and thirteen). In addition, workers are found to be sorely lacking knowledge about their pensions. Chapter two documents that only about half of older workers know about their pension plans.

Lack of information and lack of financial literacy provide fertile ground for financial errors. Left to their own devices, employees may choose to invest their pension wealth in either too-conservative or too-aggressive assets. An analysis of portfolio allocation from a large sample of Vanguard investors (2,000 defined contribution plans and nearly 2.9 million 401(k) participants) in chapter four offers compelling evidence that portfolio allocation can be improved upon. Economic theory also suggests that life annuities can substantially increase welfare by eliminating the risk associated with uncertain life expectancies and providing consumers with a higher level of lifetime consumption. Yet, as described in chapter six, most individuals do not annuitize as often as the theory predicts, if they annuitize at all. And there are problems in relying on financial advice, as explained in chapter three, as the incentives of financial intermediaries do not always line up with the incentives of investors.

One of the key objectives of this book is to provide suggestions on how to increase the effectiveness of financial education programs. Effectively designing education and saving programs needs to take into account a number of factors: identification of barriers to effective saving, differences among demographic groups, and flexible program design. A variety of barriers are described throughout the book, from lack of literacy to lack of information to behavioral biases. However, this hardly exhausts the list of things that can affect individual behavior. The research that deals with increasing the effectiveness of financial education and saving programs, discussed in chapters seven, eight, ten, and thirteen, points to a variety of factors that need to be considered. Because individuals differ widely in their barriers to saving, it is important to develop methods to uncover those barriers. In designing effective programs, approaches such as in-depth interviews, focus groups, and ethnographic studies may need to be employed. The many differences among individuals must also 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. Chapters throughout the book document the many differences that exist among these groups. Furthermore, chapter seven shows that, to both understand and exploit differences in individual behavior, it is important to incorporate concepts of marketing and psychology into economics.

Fundamentally, to overcome the saving slump, as is discussed in chapter ten, it is important to create an infrastructure that promotes saving and asset accumulation. Such infrastructure would include not only effectively designed financial education and saving programs but also a variety of policies and initiatives to stimulate saving. For example, access to saving opportunities can be fundamental. About half of private-sector workers have jobs that do not offer pensions, making it particularly difficult for those workers to accumulate retirement wealth, and it is important to find ways to facilitate saving among those individuals. Low income households also display little or no savings. However, specific programs targeted to the poor have been proven to be effective in stimulating saving among this group of the population. Another important policy demand, given the findings of widespread financial illiteracy among high school students reported in chapter nine, is to prepare young people for financial life. This is a challenging task and a lot more has to be done to find effective ways to teach financial education in schools. As discussed in more detail in chapter ten, such infrastructure should pay attention to program design. For example, centralized and efficient accounting, low-cost investment options, and outreach can play important roles in stimulating saving. Moreover, the experiences of other countries offer important lessons for the United States. While the increase in individual responsibility that is required in the system we’re transitioning to provides incentives for individuals to become knowledgeable and informed, one has to be cautious about relying simply on individual initiative as the experiences of Chile, Sweden, and OECD countries described in chapters eleven, twelve and thirteen can teach us.

My aim in editing this book is to illuminate the issues facing so many Americans in regards to saving and retirement planning and to evaluate the existing programs and products that have been designed to facilitate saving. My hope is that such a close look at the situation faced today by individuals, businesses, and policymakers will help to provide a foundation to continue to devise effective financial education and saving programs, which can contribute to overcoming America’s saving slump.

More information about the book is available at: http://www.dartmouth.edu/~alusardi/book.html

New Ways to Help People Save

2009-02-21T09:22:00.001-05:00

As I have pointed out in previous posts, it is not easy for people to save. There are many barriers that prevent us from saving. Some are really hard to overcome, such as the size of our income, having a large family, or being hit with unexpected expenses. But other barriers may be reduced or even eliminated. I learned a lot about saving decisions in an initiative I did (together with other co-authors) here at Dartmouth College. Our aim was to foster participation in the Supplementary Retirement Accounts (SRA) that Dartmouth offers but that many employees do not take advantage of. We conducted focus groups and in-depth interviews and distributed surveys to enable us to hear what employees had to say about their savings. It was a humbling experience. It is remarkable and exciting to see how smart people are about their objectives and how articulate they are about what is important to them. On the other hand, there was a gulf between what people aimed for and their perceived ability to get there. We heard over and over, “I am not a sophisticated investor,” and “I do not know where to start.” We thought we could do something about that: we have Ph.D.s in this place and we could put them to use.

We provided a group of employees with a planning aid—a one page document—to help with saving in several ways. First, the planning aid provided the information that employees needed to set up an SRA, such as maximum and minimum contribution amounts and the list of the College’s pension providers. Second, it broke the SRA enrollment process into simple steps with an estimate of how much time each step would take. It also provided information about whom to contact for help, where computers would be available (the enrollment had to be done online), and how to avoid problems with the online registration timing out. Finally, the aid included a reminder about why it is important to save. We adhered to what the employees had told us over and over: they save for their family (I could not agree more; this is why I save, too), and we included a picture on the back of the planning aid of a family exchanging gifts.

We distributed the planning aid to new employees during employee orientation. Our objective was to provide information and facilitate decision making at the time decisions needed to be made. We also set up a method for evaluating this initiative. What good is a program if you do not know whether it works?

This simple and rather inexpensive aid proved to be very effective. The new employees who received the planning aid were more than twice as likely to participate in SRAs as those who were not exposed to the planning aid. This initiative was undertaken well before the onset of the current financial crisis and we do not yet know how the crisis will affect individuals’ decision to participate in an SRA. But our data collection process is continuing and we will soon find out.

There are a few things about this project that really resonate with me. I remember one focus group participant who told us about his dreams for retirement and how important it was for him to plan for retirement. Another, echoing so many others we interviewed, explained to us how her saving was shaped by the experience of her family. We asked one young man we interviewed over the phone what he would have liked to see done to help him save. He hesitated a little and then said, “You know, this phone call is already helpful.”

I have worked on many projects, written many papers, and worked with many data sets, but only with this project could I finally see and hear the depth and richness of individual stories about the importance of saving. The faces behind the numbers, the distinct reasons for saving or not saving, and the struggles behind people’s decisions became so vivid and have enriched my research work in a unique way.

There is not a simple way to help people save. But what I learned from this project is that simplification should not be undervalued, and we should not assume that people have all the necessary, basic information at their fingertips. I have also learned that people are very different and that those differences should be taken into account when devising saving initiatives. And there are simple things that can be done to remind people about the importance of saving, things as uncomplicated as a phone call.

If you are interested in reading a copy of the paper that describes this project, it is available on my web page at: http://www.dartmouth.edu/~alusardi/Papers/Lusardi_Keller_Keller.pdf

The Return to Thrift?

2009-02-08T21:37:00.003-05:00

The saving rate in the United States has increased in the past year. From zero or even negative values, the saving rate has now moved into positive terrain. Some have argued that we are witnessing a return to thrift. This may well be the case, but there are several reasons, according to the theory, why we are witnessing an increase in personal saving. First, saving is a forward looking-variable. According to the theory, saving should be high when income is expected to decrease in the future. Thus, what the current figures about saving may be telling us is the gloomy picture that most households have about the future. Second, saving serves not only to offset decreases in income, but also to insure against shocks. In the current economy, people may feel more uncertain about their future income. Consequently, the amount of precautionary saving may have increased. This is particularly true if people cannot rely on borrowing when facing shocks to income. Both the decrease in home equity and the high amount of borrowing that families are already carrying on their credit cards may indeed make further borrowing difficult or not possible. Thus families may be simply making provisions for a more uncertain future.

Uncertainty is not good for the economy as it depresses not only investment but also consumption. Thus, one way to boost consumption is to restore confidence about the economy and about the future (admittedly a difficult task).

But as families go through the hardship of the recession, buy on discount, and try to keep within their budget, there may be some learning about how to consume and save. In the traditional theory of saving, we assume that people make rather complex calculations to determine how much to save. In practice, only a minority of families seems to make plans and even fewer do any calculations to determine how much money to put aside. The future may seem far away and bad events hard to conceive if people have never experienced one. For example, in some of my research work, I find that people are more likely to understand the effects of inflation if they have lived through several inflationary episodes. Moreover, individuals are more likely to plan for retirement if they have witnessed their parents suffering health problems at an advanced age. Thus, the current crisis may end up affecting saving beyond what we expect from the pure theory and these effects may persist into the future.

Some have argued that thrift is a value that should be instilled into children and adults as well. I am not sure we need to be that sanguine. In the area of saving, as in other parts of life, it pays to plan and consider contingencies. That is the recommendation coming from basic economy theory. We can leave it like that!

Finance and the Ski Trails

2009-01-23T08:18:00.006-05:00

I have spent the holidays in Italy and, as in much of the United States, the snow was plentiful. It was good to be on the slopes and to enjoy the amazing views from the top of a mountain.

The Italian Alps were crowded with skiers. As some of you know well, beginner skiers are the most dangerous people on the slopes. Many of them do not yet know how to navigate the lifts and the trails, they think they ski much better than they actually do, and they are often in the way of other skiers. But ski resorts are well-organized places. First of all, the trails have been ranked and clearly labeled according to their degrees of difficulty. This information is presented in a very simple way. A set of colors and shapes tells skiers everything they need to know: black diamond (experts only), blue square (intermediate), green circle (beginners). There are no complicated formulas that calculate steepness of the terrain or statistics on the probability of falling down and breaking a leg. It is a simple system, yet very effective; beginner skiers know to stay off of the black diamond trails and experts know that they will encounter unsteady beginner skiers on the green circle trails. Additionally, there are well-established rules that govern skiing. The rules are simple, they are clearly posted, and they are taught in any beginner course. These rules are enforced; there are numerous ski patrols on the slopes in the Alps. I saw them in operation, and I can say they have watchful eyes and are excellent skiers (yes, way better than I am).

Let’s move now from the Alps to the financial markets. There are a lot of beginners out there as well, people who have never bought stocks or even opened a checking account. Do these people know when they are venturing onto black diamond terrain? Even in the Alps, it can be difficult to tell whether a trail will be hard or easy by simply looking at it from the top of the mountain; skiers need the information that is posted at the start of a trail, especially the beginners. The same is true for finance. Financial operations are complex and people often venture into contracts without fully understanding what they are getting into. Just like beginner skiers who venture onto a black diamond slope, people entering into complex financial contracts can be at risk and can hurt themselves financially. In skiing, it is very clear that those who make mistakes on the slopes can hurt not only themselves but also other skiers. In finance this has not always been very clear, but the current crisis has made it evident that mistakes can be paid for not only by those who made them but also by taxpayers.

There is another important feature to highlight, something that I have experienced many times. Everyone wants to be an expert and many people think they are better skiers than they really are. In fact, if you want to keep your relationships intact, never tell your friends and family what you really think of their skiing abilities. This is, of course, problematic because it means they may not learn about their weaknesses and limitations until they hit a tree. Even then, some may think it was the tree’s fault that they crashed. In finance, it is often the same. In all of the surveys I have conducted to measure financial knowledge, I have found that the large majority of respondents display little financial knowledge. Yet, when asked to assess their own level of financial knowledge, most respondents think they have a high level of knowledge, well above the mean. The financial crisis should have sent a strong signal about lack of financial knowledge, but some may still think it is the tree’s fault.

Now that I am off the slopes and back in the office, I have a few recommendations to offer. In my view, we need beginner courses in finance, so that people can learn how to navigate the complex system before they venture out to engage in financial contracts. We need to provide information about contracts, and that information should be as easy to understand as a sign at the start of a ski trail. And we need to find ways to easily assess and to inform people about how much individuals know—and don’t know—about economics and finance.

As for me, I love the Alps, the smell of the fresh air and the snow and the views from the top of the mountains. The descent from the top of the mountain to the bottom is so difficult that it makes me appreciate skiing even more. And I appreciate the warnings as well. They should be repeated as often as possible: Please be careful and go slowly

Financial Advice for the Public

2008-12-19T21:55:00.003-05:00

In previous posts, I have argued in favor of professional financial advice. Do not get me wrong, I am not saying that using a financial advisor is the only rational choice. Rather, I want to argue that there need to be alternatives for people who have little financial knowledge and who may currently choose to “do nothing” or to rely on the advice of people who may know as little as they do. But choosing a financial advisor can be a difficult task, so we need to find alternative sources that can provide advice and guidance.

In other fields, such sources exist or have emerged. If you go to the National Cancer Institute’s web site, for example, you get basic information about what cancer is, available treatments, and a link to information about smoking that offers “free help to quit.” I like the smiles of the patients on that web page and the stern yet reassuring looks of the doctors. The U.S. Department of Agriculture has established the “food pyramid” to give guidelines about healthy eating. These are very general guidelines; nevertheless it is good to know that we should eat vegetables—lots of them. Moreover, some books have become “the bible” on certain topics. I am thinking of What to Expect When You’re Expecting, which almost every first-time mother I know read during her pregnancy.

Now, where do people go when they need financial advice? Which web site should they consider? Which book should they read when they want to start saving or investing or managing their debt? Believe me, there is a lot of information out there. The problem is that there is too much, and—in my view—a lot of confusion about what source to use. What is worse is that many people would like to dispense financial advice, irrespective of their qualifications.

There is an institution that is well-equipped to provide financial education and improve financial literacy. This institution meets three important requirements: (1) It possesses high qualifications, meaning a knowledge of economics and finance; (2) It is independent of the financial industry and any lobbies; (3) It cares about the well-being of consumers. As you may have guessed already, this institution is the central bank. Central banks in all countries, and the U.S. Federal Reserve in particular, have armies of bright Ph.D. economists who spend much of their time monitoring the state of financial markets. Central banks in most countries are independent institutions whose primary objective is to fight one of the big enemies of saving: inflation. Moreover, they are interested in the smooth functioning of financial markets and have incentives to care about citizens.

The U.S. Federal Reserve is already working on financial education (check their web site: http://www.federalreserve.gov/), but my recommendation is that they do more. First, they should take up that role officially and with more fanfare so that people know where to go for financial information. Second, they should provide a lot more resources on line. Their web site should be a “bank” of information. Third, they should offer some recommendations. As broccoli is good for you, so is risk diversification. Finally, on that web page we need a stern-looking Ben Bernanke, a few smiling, happy investors, and a link to a free guide on how to save.

Financial Advice

2008-12-07T18:26:00.001-05:00

In earlier posts, I have discussed financial advice and the fact that most people tend to consult family and friends when making financial decisions. In this post I would like to discuss consulting financial advisors. There is little research on this topic, but it seems to me it is an important area of interest. In a new financial world, where financial instruments are increasingly complicated, professional financial expertise can be very valuable. We may associate this sort of financial advice with setting up trusts, legal counseling, and complex investment strategies that preoccupy only the rich. In fact, financial decisions of the average family or individual have become sufficiently complex that such advice may be not only beneficial but also necessary. More so when, as I have argued repeatedly, there is very low financial literacy. Overall, it is not easy to choose the best mortgage (or even a good mortgage) among so many options. Similarly, it is not easy to know how much to contribute to a pension plan and how to allocate pension assets, not to mention how to best save for children’s education or simply how to deal with debt.

While many would admit that these decisions are difficult, few consider getting professional financial advice. Clearly, cost can be an issue, but it is not obvious that the cost, in most cases, is greater than the benefits. Consider, for example, retirement planning: setting up a plan for how much to save and how to invest retirement wealth may be very beneficial. According to the Retirement Confidence Survey and my own work using many waves of the Health and Retirement Study, many workers do not know how much they need to save for retirement. Even those who claim to have done some calculations are often not able to give the amount they will need at retirement or give figures that seem very rough estimates. This may reflect the fact that workers use rather crude tools to make retirement saving decisions. For example, a quarter of those who report being planners do not use any planning tools at all! However, planning does pay off. Those who report doing calculations of how much they need to save for retirement end up close to retirement with three times the amount of wealth of those who do not plan. And do not think that planning and financial counseling is simply for those who can afford it (i.e., those who have wealth). Counseling can be even more beneficial to those for whom every dollar counts. How families manage their balance sheets is very important, and making good financial decisions may have huge implications on our well-being, as the current crisis seems also to suggest.

Yet, people give little thought to these decisions and few consult financial advisors. Clearly, it may be challenging to find good financial experts who are motivated by incentives that do not work against consumers’ best interests, such as those whose compensation derives from high fees assets. But in my view, one reason we do not generally consult experts is that it is hard to know whether and when we are in financial trouble or can prevent financial trouble. For example, without going through the planning process, there is little to signal to people that they are not saving enough for retirement, particularly when they are many years away from it. We may only realize we have not saved enough when it is too late. It might be interesting to consider an analogy to guidelines regarding health maintenance issues. First, we do not normally self-medicate (or do surgery on ourselves) but we go seek (or should seek) medical advice when we have a problem. Second, even without being in pain, we tend to do check-ups to make sure we are in good shape and we will not have problems in the future. Third, we ask for a second opinion when in doubt. Wouldn’t it be a good idea to do the same for our finances?

Friends, Family and Finances

2008-11-17T11:03:00.001-05:00

In this post, I want to talk about how people become financially literate and from whom they learn about finances. In many of the surveys I have reviewed, including the ones I have designed, people report that they rely on family and friends for financial advice. In focus groups as well, people state that they learn from their family and friends. This is an important finding. I believe that people rely so much on friends and family because they want advice from people they trust and who have their best interests at heart. There are, however, limitations and drawbacks to relying solely on friends and family for financial advice.

One limitation of learning from our friends is that we tend to choose friends who are like us. So, if you are an artist, you are likely to be surrounded by people who know how to draw but do not necessarily know how to invest retirement savings. Furthermore, many financial matters are private. You may assume that your friend John is financially savvy, but you have probably not seen his 401(k) statement, and it is hard to tell from his house or car whether he is good at picking mutual funds. Nevertheless, he may be happy to offer you tons of financial advice.

Like friends, family members, parents in particular, are a popular source of financial advice, and many have argued that financial education does start at home. There are, nevertheless, drawbacks to advice from this source. First, not everybody has parents who are financially literate. Approximately half of the families in the United States do not invest in the stock market (at least when considering investment of private wealth). Thus, for many, it is not possible to learn about the stock market from parents. Second, parents—particularly older ones—lived in a very different economic environment than the one the current generation of working Americans are facing. Most parents of today’s young and middle aged adults had pensions that were defined benefit plans, experienced inflationary periods that decreased the burden of their debt, and hardly invested in the “global economy.” Financial markets have changed substantially from the time this generation of parents bought their homes, got their pensions, and invested their savings.

I do not mean to imply that we cannot learn from family and friends. One valuable lesson can be to avoid the mistakes that those around us have made, such as not preparing adequately for retirement, not having enough insurance, or having too much debt—mistakes that are proven to be all too common among many Americans today. But relying on such advice seems to me often too little and sometimes too late.

In my view, financial education belongs in schools. Finance and economics are sciences and should be taught as such. Moreover, people need to be financially literate before they engage in financial contracts and not after having learned how much financial mistakes can hurt. Finally, having financial education in schools offers a better chance that students whose parents do not work on Wall Street will be able to access financial knowledge.

There is an additional benefit: if everyone learns about finance in school, we can then talk to our friends about art, about history, about something other than our finances. One of the great benefits of obtaining financial savvy and know-how is that we are then able to devote ourselves to what really matters to us, without the distraction of financial worries.

The National Financial Literacy Challenge

2008-11-08T23:25:00.004-05:00

From November 3 until November 26, 2008, high school students can participate in the National Financial Literacy Challenge. This online 35-question test measures financial knowledge and serves to document the state of financial literacy among participating high school students. Please help me spread the word about this test and encourage the school in your district to register to participate.

It is important that we measure financial literacy among high school students. These young people soon will or already are confronting financial decisions, such as taking out student loans to pay for college, managing credit cards, and saving or spending income from summer employment and allowances. Are young people well equipped to make these decisions? We do not know, and we need to find out! Several states have mandated financial education in high schools and there is a lot of discussion about whether financial literacy should be integrated into high school curricula. I particularly encourage the schools where financial literacy has been mandated or where courses on financial literacy are offered to participate in this test. All tests are imperfect to some degree, but we need some measurement of how much our students know and how well we are doing at teaching financial literacy.

And there are rewards for participating in this test (can you tell that economists devised it?). Students scoring in the top 25th percentile nationwide will earn a certificate of recognition from the U.S. Department of the Treasury. Students scoring exceptionally high will win a National Financial Literacy Challenge Award medal (hey, this would look good on a resumé). And there are monetary rewards too. The Charles Schwab Foundation will award a scholarship of $1,000 to up to 100 students who get a perfect score of 100%. In addition, the Foundation will award $1,000 to each of those students’ schools.

For more information or to register, please follow the link below:
http://flc.treas.gov/index.htm

Just to make you smile, I am including here a test that is part of the newspaper advertising copy for this challenge.

A bond is:
(a) a British spy
(b) glue
(c) a type of loan that pays interest

Financial Literacy and the Current Crisis

2008-10-27T17:34:00.011-05:00

I was asked in a TV interview whether financial illiteracy has contributed to the current financial crisis. I do not have data yet on the current crisis, but the data I collected last year on debt literacy indicate that many people do not know about the power of interest compounding and tend to underestimate how quickly debt can grow if one borrows at high rates. Most importantly, those who had low debt literacy were more likely to report having difficulties paying off debt. So, my suspicion is that individual debt illiteracy has played a role in the current crisis. Exacerbating individual lack of financial literacy has been the role played by those lending institutions that did not do their part in checking borrowers’ backgrounds or calculating how much debt those borrowers could really afford to take up.

And in this current world of derivates, ARMs, subprimes, and preferred stocks, it is even harder to understand what is going on in both individual accounts and in global markets and what people need to know in order to successfully navigate the financial system. In my view, we need to stick to a few fundamental concepts: the power of interest compounding, the effects of inflation, the principles of risk diversification, the incentives offered by the tax system. Knowledge of these simple principles can go a long way in helping us make sound saving and investment decisions.

People have been crying out that financial education is expensive. Well, bailouts can be even more expensive; I think we understand that now. But I have not heard of plans for any money to be allocated to improving financial literacy as part of the rescue plan. This is a pity because, having seen the consequences of illiteracy not only at the micro level but also at the macro level, we need education now more than ever.

If you would like to watch the TV interview (Financial Literacy and You), it can be accessed at: http://www.tvo.org/TVO/WebObjects/TVO.woa?video?TAWSP_Int_20081021_779352_0

Learning From this Crisis: A Discussion About Risk

2008-10-16T20:27:00.000-04:00

As the financial crisis continues to unfold, it is important to reflect on the lessons we can learn from this experience and how those lessons can help us better manage household finances. In this blog, I want to focus on risk and risk management. Not only have prices in the stock and housing markets, in which many households invest, been gyrating, new financial instruments have made household balance sheets even more sensitive to the behavior of financial markets. For example, both the assets and the liabilities of households with adjustable rate mortgages, or ARMs, will be affected by a change in interest rates. Risk management is becoming more important than ever. Yet, according to several of the surveys on financial literacy I have conducted, the concept of risk diversification proves to be a difficult one for respondents, many of whom stated that they did not know how to answer to the survey question that dealt with this concept.

I want to discuss here the dangers posed by lack of diversification among the assets that are most common in household portfolios.

1. The danger of investing everything in a single stock.

One of the painful lessons that is right in front of us is the peril of investing in a single stock. Sure, all indexes are down and losses are large, but those who have invested solely in the stock of ailing banks now run the risk of losing everything. The importance of keeping a well-diversified portfolio should not be underestimated, particularly in the current situation. Clearly, in a crisis that is becoming global, most stock markets have been going down and portfolio diversification does not eliminate losses. However, it limits them and can provide a floor that prevents losses from being as extreme as they might otherwise be. While the experience of Enron stockholders may have been easy to forget, the magnitude of the current crisis should send a strong warning about the danger of putting all of one’s savings into a single stock.

2. The danger of investing everything in the house.

While we may not think of our house as an investment, in fact the house is often the most important asset we have. In some cases, it is the only asset people have. A large home, a nice backyard, plenty of room where our children can play are all features we want and cherish. However, when we buy, or when we plan to put an addition on the house, we have to consider what that will do to our portfolio. If we put everything we have into the house, we become very exposed to fluctuations in home prices. As the current experience shows, home prices can go down, and go down a lot! And we should not take comfort in the fact that we do not plan to sell our house any time soon. In the current labor market, mobility is important. Today’s workers change jobs many times in the course of a career, and one can hardly expect to be in one place throughout his/her lifetime. Moreover, and particularly in less populated areas, houses are not a good “hedge” against labor income risk. If a big firm in a small city goes under, local home prices are likely to drop. But this means that home values will decrease precisely when workers need their housing wealth the most: they may have to sell and move or they may need a home equity line of credit to offset the loss of employment income.

Risk is a part of our life, negative shocks happen, crises happen, and other shocks may lie ahead. More than ever before, we need to learn to deal with risk to insure the well-being of ourselves and our families.

Some Comments on the Current Crisis

2008-10-02T12:40:00.001-04:00

I have not been writing for a while, but have been reading about and watching the current economic crisis unfold. This is humbling, and there are many reasons to worry. One of the assumptions behind the sound functioning of markets is that the agents who stand behind demand and supply are well informed and rational. But, as I have argued in many previous blogs, there is reason to question that assumption in the face of widespread financial illiteracy. Of course, my studies of illiteracy focus on consumers, but the current events make me wonder about politicians. Perhaps there is need for a crash course in financial markets and money and banking down in Washington. I do not mean this in a sarcastic way, but rather express it with genuine concern; the lessons we should have learned from the past are seemingly being ignored. My views may be colored by the fact that I was a student of Ben Bernanke at Princeton, but his article on the collapse of the financial sector as a factor in transforming a recession into the Great Depression still resonates (for anyone interested in reading it, the article was published in the American Economic Review back in 1983). It teaches us that the financial sector is vital to the workings of the economy and that shutting it down may send the economy into a tailspin. The role of the financial system in the economy is critical: it channels the funds of savers to the firms and entrepreneurs who need them. Lack of credit prevents not only businesses from investing but also households from consuming and buffering against economic shocks. In other words, a financial system that is not working or that is limping can affect the macro economy and each of us individually. We do not want the economy to go that route.

There is an inherent instability in both the banking system, with its fractional reserve system (only a small fraction of deposits are kept in the banks, so if all depositors wanted to withdraw their deposits, there would not be enough funds to make it possible) and in financial markets, in which large sums of money can be moved very quickly. Several institutions and mechanisms are in place to counteract that instability, one example being the Federal Deposit Insurance Corporation, or FDIC. Some may argue that these institutions do not work very well; for example, what banks pay to be insured by the FDIC often does not reflect their actual risk. In reality, financial markets continually innovate. Moreover, financial instruments have become very complex in terms of risk. Derivates, such as options and futures, make it possible to take up large amounts of risk. Regulation has certainly not kept up with that.

When a financial crisis occurs, it is important to act quickly. Now more than ever we need to have economics and finance rule politics.

Are We a Nation of Financial Illiterates? Some Comments

2008-08-20T19:18:00.000-04:00

Stephen Dubner, one of the authors of Freakonomics, has posted an article on his blog (link is just below) that addresses this question: Are we are a nation of financial illiterates?

http://freakonomics.blogs.nytimes.com/2008/07/21/are-we-a-nation-of-financial-illiterates/

If you have read Freakonomics, you know he is a gifted writer. In his blog, he poses three critical questions. I modified these questions slightly (they are listed below), and added some discussion.

1. Are we a nation of financial illiterates?
2. How did we get that way?
3. How important is widespread financial literacy to the health of a modern society?

The answer to the first question is unfortunately a yes. In surveys after survey after survey, we find that the majority of the U.S. population lacks knowledge of some of the most fundamental financial concepts, such as the power of interest compounding, the workings of risk diversification, and basic asset pricing. In one of my most recent surveys, I measured “debt literacy,” or knowledge of the concepts related to debt and borrowing. Results are humbling: only one-third of the population has a good grasp of the workings of credit cards and understands how quickly credit card debt can grow when borrowing at the standard rates.

The answer to the second question is more complicated. While the quality of schooling education in general may be cause for concern (relevant statistics are not comforting), the financial landscape in the United States has changed dramatically in recent decades. One of the most notable changes has to do with retirement planning. In the past, the average worker did not have to make any decisions about his or her pension. Pensions were mostly defined benefit plans entirely overseen by the employer, so there was little incentive or rationale for individuals to learn about saving and investment. Today, the average worker needs to decide how much and how best to save for retirement—a decision that can be daunting and, if implemented poorly, that can result in inadequate preparation for retirement. Thus, the incentives and the reasons to learn how to save and invest were less pressing. Similarly, until quite recently, the financial instruments that people needed to deal with were fairly basic. When purchasing a new home, a typical household in the 1960s or 70s would likely get a 30-year fixed rate mortgage from a local bank. Today, the complexity of mortgages has increased dramatically and so has the number of lenders, making the process of financing a home a much more complicated endeavor. So, in answer to the question—how did we come to be a nation of financial illiterates?—perhaps it’s not that we have become less financially literate than in the past, but that the world around us, with it’s increasingly complex financial instruments and increasing demand for personal responsibility, is changing.

The answer to the third question—how important is financial literacy to the health of modern society?—is not an easy one either. It is difficult to assess the effects of financial literacy. Financial literacy is not distributed randomly among the population; it is often the result of personal choice, of parents’ education, and of an individual’s access and exposure to financial education. There are very few experiments we can rely on to assess whether or not financial illiteracy results in financial mistakes. Nevertheless, studies consistently show that those who display low levels of financial literacy are less likely to display healthy financial behavior. And in the modern economic system in which we all live, we have to make sure we are well equipped to make the financial decisions that confront us.

Coming back to Dubner’s blog, I am happy to see that it has generated a lot of comments (more than 200 as of today). One reader responded to Dubner’s posting with a fourth question (slightly modified here):

4. Which name doesn’t belong: Faulkner, Curie, Pasteur, Friedman?

My answer is Faulkner. The other authors have made important discoveries that have shaped science and public policy. One of the remarkable lessons we have learned from Milton Friedman is that “inflation is always and everywhere a monetary phenomenon.” This means that if the central bank does not change the money supply, prices will not keep increasing, even in the presence of an oil shock. Now, this is pretty useful to know, don’t you think?

Why Financial Literacy Matters

2008-08-05T11:10:00.001-04:00

In my previous blog, I posted three questions that can be used to measure financial literacy. In this posting, I want to discuss the answers to those questions and why getting them right matters.

The first question is:
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?

This question measures numeracy and knowledge of the power of interest compounding. The fact that interest grows on interest is an important concept to understand and explains how your investment can grow quickly over time.
There are two lessons to be learned from this concept:
1) To make the power of interest compounding work in your favor, it is important to start to save when you are young. Just a simple example: $1 invested at a 7% interest rate increases more than 7 fold in 30 years. This is pretty good, yes? (But see discussion of inflation below.)
2) It is important to borrow as little as possible with credit cards or through other high cost means. Borrowing at an interest rate of 20% means that it takes fewer than 5 years for your debt to double. To me, this seems to quickly hurt.

The second question is:
Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, would you be able to buy more than, exactly the same as, or less than today with the money in this account?

This question measures knowledge of inflation. Inflation is simply the change in prices overtime. If prices increase, it means you can buy less with your money.
There are two lessons to be learned from this concept:
1) You need to protect against the erosion of your purchasing power. Because of inflation, the money you have today will buy less in the future, so you need to invest your money at an interest rate that is higher than the inflation rate. If inflation is at 3% and you earn 1% on your savings account, believe me, you are not doing well!
2) It is important to take inflation into account when planning for the future. In other words, do not expect the prices tomorrow to be the same as the prices today.

The third question is:
Do you think that the following statement is true or false? “Buying a single company stock usually provides a safer return than a stock mutual fund.”

This question measures knowledge of risk diversification. This is a very important concept that relates to the old adage 'don’t put all of your eggs in one basket.' A simple fall and you have a "frittata," as we say in Italian.
Again, there are lessons to be learned from this concept:
1) Make sure that a single event does not put a big dent in your investment. For example, why invest in a single stock? Why give all of your money to your brother-in-law who wants to open a cigar shop? Firms can fail and people can stop smoking.
2) Investing in your company stock is very risky; if your company goes under, you will lose the money you invested when you need it most. Even if you like your company a lot, why take so much risk? Clearly, I am lucky; Dartmouth is not listed on the NASDAQ and I do not have to face this decision.

Are You Financially Literate? Do this Simple Test to Find Out

2008-07-12T22:47:00.002-04:00

One component of my “financial literacy initiative” is to provide (and share) ideas, suggestions, and tools to people interested in financial literacy. While I have discussed extensively financial literacy in previous blogs, I have not discussed how to measure financial literacy. However, this is a major part of the academic research I do. Together with Olivia Mitchell, I have devised three questions that are pretty successful into classifying respondents into levels of financial knowledge. I report the questions below. I urge all of the readers of this blog to go through these questions. In my view, it is important that we evaluate how much we know and simple tests like this one can serve this purpose (ok, I admit, it is the academic in me speaking…). Moreover, we could use these simple tests to classify respondents into different types and assign them to different groups. For example, new hires could be given a test to assess their financial knowledge; those who display little knowledge could be advised to consult with the HR office or a financial advisor before selecting their pension fund and the allocation of their pension assets. Why make important financial decisions ourselves if we know little or nothing about finance and economics? (And beware of asking your brother in law, chances are he knows much less than you were hoping for, but now there is a way to find out!).

Here are the questions:

1) 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?
a) More than $102
b) Exactly $102
c) Less than $102
d) Do not know

2) Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, would you be able to buy more than, exactly the same as, or less than today with the money in this account?
a) More than today
b) Exactly the same as today
c) Less than today
d) Do not know

3) Do you think that the following statement is true or false? “Buying a single company stock usually provides a safer return than a stock mutual fund.”
a) True
b) False
c) Do not know

The answers are reported at the very end. To be “financially literate” you need to answer correctly to all three questions. If you are able to answer correctly to two questions only, you are not in bad shape (in particular if you were able to answer correctly to the third question), but you need to improve your financial knowledge. If you answered correctly to one question, you are not in good shape and you need to improve your financial knowledge. If you got all questions wrong, you did not get a passing grade. If your answer was “do not know” to at least two of these questions, you are also not in good shape.

Now, let’s admit it, it is not fun to go through these types of tests and it is even less fun to find out that we do not know the answers to these questions. While this is true, it is also the case that how much we know influences how well we do in our financial choices. So, let’s leave these concerns aside and take the test. Financial literacy pays off! And next time your brother in law advances a suggestions on the stock you should buy in this turbulent market, smile and quickly shift the discussion to the weather (it works very well, at least in New Hampshire where the weather changes even more erratically than the stock market).

Answers

1. a) More than $102

2. c) Less than today

3. b) False

The Financial Literacy Initiative

2008-07-01T18:25:00.004-04:00

It is official: Today marks the start of my “Financial Literacy Initiative.” Thanks to the support of several institutions, including Dartmouth College and the Financial Industry Regulatory Authority, I can now launch this new initiative. For those of you who have not followed my work closely, I have devoted my research in the past six years to financial literacy and topics related to financial literacy (for example, financial education). My work will not only intensify but will also aim to a large public. In this blog, you will read not only how to measure your financial literacy but also how to improve your financial literacy. You will also read about the results of academic research (not only mine but also those of other authors) that provides useful suggestions and recommendations for our financial decisions, and much more!

Let me start this initiative by summarizing as briefly as possible what I have done so far. My work will continue from here.

In collaboration with Olivia Mitchell from the Wharton School, I have documented an alarmingly low level of financial literacy among older people in the United States. In our sample of older respondents from the Health and Retirement Study, we find that over half of respondents cannot undertake a simple calculation regarding interest rates over a 5-year period and do not know the difference between nominal and real interest rates. An even larger percentage of respondents do not know whether or not a single company stock is riskier than a stock mutual fund. We have also shown that financial illiteracy is related to the inability to devise and implement financial plans. That is, one reason people fail to plan is because they are financially unsophisticated. Our work demonstrates that planning behavior can explain the differences in savings and why some people arrive close to retirement with very little or no wealth. This is only one of the disturbing consequences of financial illiteracy. Consumers with low literacy are also less likely to participate in the stock market, and they are more likely to have problems paying off debt.

Our work has also evaluated the role and effects of financial education programs. Most large firms, particularly those offering Defined Contribution pensions, offer some form of education program. The evidence to date on the effectiveness of these programs is very mixed. In our work, we find that seminars do affect wealth holdings. Estimated effects are sizable, especially for the least wealthy. Moreover, we have argued that it is not surprising that one retirement seminar may change behavior only modestly. The few available studies of the topic indicate how many seminars were offered or how many participants attended; in general, participants appear to attend only once or a handful of times. It is unlikely that widespread financial illiteracy will be “cured” by a one-time benefit fair or a single seminar on financial economics. This is not because financial education is ineffective, but because these programs are too small with respect to the size of the problem they are trying to address.

Our efforts to examine the causes and consequences of financial illiteracy have also been extended to datasets beyond the Health and Retirement Study permitting us to assess financial literacy and financial sophistication for many different groups U.S. respondents. For instance, with our cooperation, our questions on financial literacy have been incorporated into the National Longitudinal Survey of Youth and the Rand American Life Panel. We have also been successful in getting several European institutions to add similar questions to household surveys in their own countries. For example, a recent Italian Survey on Household Income and Wealth included some of these questions, and I have worked with the Dutch Central Bank to design questions to measure both financial literacy and financial sophistication in the Netherlands.

I have organized and continue to design new conferences that explore ways to increase the effectiveness of financial education programs. One very influential conference was held at Dartmouth College in October 2005 (www.dartmouth.edu/~lusardiworkshop/ ) and a second at the NBER in Cambridge MA in May 2008 (www.dartmouth.edu/~conference2007/index.htm). These two conferences brought together practitioners, policymakers, and academics from economics, psychology, and marketing. By examining data from newly available surveys and combining knowledge and experience from different fields, the conferences sought to develop new methods and strategies to improve employer-provided financial education programs. Information and insights from these conferences are described in the book that I am publishing this year and that compiles contributions of some of the most highly regarded experts in the fields of financial education, savings, pensions, insurance, and portfolio choice. This book, entitled Overcoming the Saving Slump: How to Increase the Effectiveness of Financial Education and Saving Programs, examines not only the experience of the United States but also the experience of other countries, such as Sweden, Chile, and OECD nations. It is forthcoming from the University of Chicago Press.

Key Publications

The complete list of my publications and working papers appears in my CV posted on my web page. Some of publications that have been most influential include:
• My paper “Saving and the Effectiveness of Financial Education” was published in the book Pension Design and Structure: New Lessons from Behavioral Finance, eds Olivia Mitchell and Stephen Utkus (Oxford University Press, 2004). It was later reprinted in the Journal of Financial Transformation, vol. 15, December 2005.
• My study joint with Olivia Mitchell “Baby Boomer Retirement Security: The Role of Planning, Financial Literacy, and Housing Wealth,” appeared in the Journal of Monetary Economics in January 2007. This paper was awarded the Fidelity Pyramid Prize, a $50,000 award given to authors of research that best helps address the goal of improving lifelong financial well-being for Americans.
• The paper joint with Olivia Mitchell “Planning and Financial Literacy: How Do Women Fare?” appeared in the American Economic Review. It documents the very low level of financial literacy among older women in the United States.
• My paper joint with Peter Tufano “Debt Literacy, Financial Experience, and Overindebtness” has been widely cited in the press because it documents a strong relationship between financial illiteracy and debt problems.

And the effort will continue. More on the next blog!

In Favor of Financial Literacy Education

2008-06-20T23:29:00.002-04:00

Recent papers are arguing that it is futile to undertake financial literacy education. I do not share that view and let me make just a few simple comments in favor of financial literacy education.

One of the problems of scholars who review the literature on financial education without having done empirical work on this topic or touched the data is that they are likely to miss the large differences that exist in financial behavior. For example, in my work I found that financial education programs do not affect the 'average' household but they do affect those at the bottom of the wealth distribution and those with low educational attainment. These are the groups that financial education programs should reach, but the evidence would not have been found if one were to look simply at averages and to run simple regressions. Moreover, having spent the last six years measuring and looking at financial literacy data, I am concerned about how much we can expect the current financial education program to be effective given they often entail only one-hour of financial education. Small intervention of this magnitude cannot be expected to do much to combat widespread illiteracy. However, this does not mean we should not do any financial education at all.

The vast evidence from psychology that people suffer from biases in their decision-making is sobering and humbling. However, if taken at face value, it seems that people are truly inept and cannot make choice, in fact any choice, not just financial decisions. However, one of the features of the current environment is that people are confronted and required to make choices. People are confronted with a myriad of choices now. For example, they are increasingly asked to decide about the medical treatment to go through and have to be wary of doctors who tend to suggest expensive but unnecessary treatments. There is wide regional disparity on how hospitals treat the same medical condition and people would want to decide in which hospital they want to be treated. If people want to buy cereals, they have a full isle with more than 100 brands to choose from. If they want to buy a cell phone service, they have many features to consider. Should we regulate how people consume? They are likely to make lots of mistakes in that area too.

Continuing on the previous point, how do we deal with the increase in financial responsibility that people are required to take on? Financial literacy education is in my view one of the ways we can help people (and clearly not the only way we should limit to).

There is no obvious alternatives to financial literacy education. The idea is not to transform each person into a financial wizard, but to give him/her the tools to navigate the current financial system. The metaphor that I have used in my work is to have knowledge similar to having a "financial driving license": people drive car without being engineers and they do not need to know everything about cars and driving to be behind the wheels. Even with knowledge, accidents will occur, but this does not mean that it is much preferable to close down the roads that are more dangerous than to allow people to do their own driving.

Consumer Information: Is It Enough?

2008-06-04T23:23:00.003-04:00

The Federal Trade Commission (FTC) hosted a conference on Consumer Information and the Mortgage Market on May 29, 2008. You can access the program at:

http://www.ftc.gov/be/workshops/mortgage/index.shtml

and also watch some it on CSPAN

http://www.c-spanarchives.org/library/cache/ASX_205746-2-0-0.asx

FTC certainly deserves credit for organizing such a conference. There was a lot of discussion about how to inform consumers and I came away from the conference pretty convinced that information alone is not enough. We need not only to find ways to communicate in an effective way, but also to simplify information. Some ideas proposed by the speakers were rather intriguing. If we look at other fields—and health is one recurrent example— we have put labels on many food items to make sure people make good decisions when they go shopping. More than this type of information, I like “rating” systems. For example, we use a star system to evaluate safety of cars. While this is not so easy when considering financial products (but Morningstar does it for mutual funds), I think it is important to think of ways not just to provide information but also to process that information and deliver it in a simple and intuitive manner. Two researchers from Vanguard, Gary Mottola and Steve Utkus, have done something similar for the classification of portfolios: they have used a stop-light system: red, yellow and green to classify portfolios. Red is a stop sign, it signals investors they need to stop and reconsider their portfolio; yellow indicates there are problems although not as severe as in the “red light” case. And green means that investors can continue cruising with the current portfolio allocation. In my view, that is a brilliant idea and it is worth a thousand statistics. We have to look for such easy ways to provide information. Note this is not simply information, there is some “mild” advice in it: Red means “stop.” I like that too as I believe this is what consumers are looking for.

The new findings from the 2008 Jump$tart Coalition? Not good!

2008-05-20T21:40:00.003-04:00

The results from the 2008 Jump$tart Coalition for Personal Financial Literacy have been released. This is the 6th survey and 6,856 high school seniors from 385 randomly-selected schools took the 31-question test in class. The findings are sobering: In 2008, high school seniors answered just 48.3 percent of the financial literacy questions correctly. This is the lowest score of the six surveys: In the 1997-98 academic year, students answered 57% of the questions correctly (not a passing grade by the way) and that fraction has been more or less declining over time.

One of the most significant findings of the study is that fewer than half of the students realized that credit card users who pay only the minimum amount each month run up the highest finance charges. This proportion was 70.6 percent in 2006 and had never fallen below 60 percent in all the years of the survey. Considering the record amount of household consumer debt, there should be significant cause for concern if people do not understand the terms of their credit cards (if the high school survey is any indication).

Other findings are similarly worrisome: Just 27.3 percent realized that interest on savings accounts could be taxed if incomes were high enough. Thus, by and large, students have a poor understanding of our tax system. Moreover, only 40.4 percent of students realized that they could lose their health insurance benefits if their parents became unemployed. And with the economy not doing well, students may end up learn about this fact the hard way.

Financial illiteracy is not only widespread but is particularly severe among some demographic group. Students in the highest family income category—over $80,000 per year—had average scores of 52.3 percent. This contrasts strongly with the scores of students from the lowest income families who averaged just 43.4 percent. Moreover, while White or Caucasian students averaged 52.5 percent on the financial literacy test, Black or African-American students averaged only 41.3 percent, Hispanic students 45.1 percent and Native-American students 37.7 percent. I have found these differences to be large among the older population as well, and this finding shows that differences are already present at a young age.

As I mentioned in my previous blog, April was Financial Literacy Month. These findings show there is a long road ahead to address the lack of financial literacy. We certainly need to keep working hard at it all year long!

April is Financial Literacy Month

2008-04-12T11:53:00.002-04:00

Recently, Google posted a new feature on its G-Mail account; users would be able to send e-mails with self-declared timestamps, thereby giving the impression to readers that the e-mail was sent earlier so that senders could meet missed deadlines. Sure enough, it was April 1st – April Fool’s Day. While the rest of the country thought about practical jokes to play on each other, April serves as an important milestone as the official Financial Literacy Month.

My research described in previous blogs has highlighted the relationship between low financial literacy and poor financial decision making; today, there are notably low levels of financial literacy within the U.S. population, making financial literacy education a significant societal concern. As a result, April’s status as the official Financial Literacy Month is important since it serves as a reminder of the need to promote financial education. Governmental agencies, not-for-profits, and industry leaders have focused on April as a unique opportunity to coordinate a comprehensive strategy to educate the public. The 2008 Financial Literacy and Education Summit is a prime example of this. Here, stakeholders have the unique opportunity to learn and share best practices to promote financial education. According to the Summit’s website (http://www.practicalmoneyskills.com/summit2008/), the purpose is to create a roundtable discussion with public policy, education, and private sector experts, to protect the long-term health of our economy.

With April as a focal point, as the official Financial Literacy Month, a more focused strategy can emerge that promotes the effectiveness of financial education efforts. Of course, financial literacy outreach shouldn’t stop at the end of April, but we should utilize this time to promote awareness regarding the pressing need to increase financial literacy.

My Advice to College Students

2008-03-23T18:21:00.003-04:00

I was recently interviewed by an undergraduate student from Boston University who writes for the Daily Free Press (the independent student newspaper at Boston University). She asked me about my work on financial literacy and debt and, at the end of the interview, she inquired whether I had any suggestions to give to college students to improve their financial literacy. This is an important question and I would like to use this blog to make my recommendation available to anybody who reads this blog or is interested in financial literacy. As I told the interviewer, college students have a great opportunity to improve their financial knowledge, and they should exploit it. My recommendation to students is to take economics courses while in college. Students do not have to major or minor in economics; one or two courses in economics can suffice to build some understanding of basic economic principles and how the financial system works. Several studies, including my own work, show that people who undertook economics courses while at school have much higher financial knowledge later in life. Most importantly, that financial knowledge does matter! For example, those who took economics courses while in school were more likely to invest in stocks later in life. And investing in stocks has become even more important now that individuals are increasingly put in charge of investing and saving for their own retirement (for those who want to read more about this topic, please see the paper posted on my web page: “Financial literacy and stock market participation").

This type of advice may look self-serving: Here is an economics professor advising students to take courses in economics! In this blog, I would like to describe not only my research but also my personal experience. I am happy today that as a young woman, I took courses in economics and finance. I have used that expertise not only to start saving very early in life but also to invest in portfolios that have given me steady returns. I have enjoyed the confidence in making financial decisions and the ability to ask for financial advice when it was necessary. I have stayed away from debt and from financial “opportunities” that were too good to be true. A few years ago, I bought a house I truly love. It is sitting on more than 3 acres of woods and every day I enjoy the view from my windows. The crisis in the real estate and the mortgage market has not and will not affect me. And if you ask me, it is good to be free of financial worries at this stage of my life.

Personally, I have always felt very proud in discussing financial matters with my father, who knew much more than I did. Recently, my parents have asked me to advice them on their financial decisions and this has made me even more proud of being a financially knowledgeable woman. I have also helped and advised several dear friends, who know little or nothing about economics. And that, to use one expression used often by my Dartmouth students, is really cool!

Here is a link to the article the student from Boston University wrote after the interview:

http://media.www.dailyfreepress.com/media/storage/paper87/news/2008/03/19/News/Survey.Americans.Financially.Illiterate-3274961.shtml

How to Improve the Effectiveness of Saving and Financial Education Programs? Simplify!

2008-03-08T23:39:00.001-05:00

If, as argued in my previous blogs, saving decisions are very complex and financial literacy is low, one way to help people save is to find ways to simplify those decisions. For example, what may be more effective is to find ways to ease people into action.

This is the strategy analyzed by James Choi, David Laibson and Brigitte Madrian in a NBER Working paper. They study the effect of Quick Enrollment, a program that gives workers the option of enrolling in the employer-provided saving plan by opting into a preset default contribution rate and asset allocation. Unlike defaults, workers have the choice to enroll or not, but the decision is much simplified as they do not have to decide at which rate to contribute or how to allocate their assets.

When new hires were exposed to the Quick Enrollment program, participation rates in 401(k) plans tripled, going from 5% to 19% in the first month of enrollment. When the program was offered to previously hired non-participants, participation increased by 10 to 20 percentage points. These are large increases, particularly if one considers that the default rate is not particularly advantageous: the contribution rate in the most successful program is set at only 2%, with 50% of assets allocated to money market mutual funds and 50% allocated to a balanced fund. Moreover, Quick Enrollment is particularly popular among African-Americans and lower income workers (those earning less than $25,000) who, as the research mentioned before shows, are less likely to be financially literate. Thus, changes in pension design can have a significant impact on participation. Most importantly, this is a low-cost program. Here is a new and powerful suggestion: simplify!

Where does illiteracy hurt?

2008-03-01T23:59:00.000-05:00

While the low levels of financial literacy discussed in my previous blogs are troubling in and of themselves, what is most important are the potential implications of financial illiteracy for economic behavior. One example is offered by an article Hogarth, Anguelov, and Lee published in 2005, that demonstrates that consumers with low levels of education are disproportionately represented amongst the “unbanked,” those lacking any kind of transaction account.

To examine how financial illiteracy is tied to economic behavior, Olivia Mitchell (Wharton School) and I used the questions we have devised for a special module for the 2004 Health and Retirement Study, and linked financial literacy to retirement planning. We found that those who are more financially knowledgeable are also much more likely to plan for retirement. Specifically, planners are most likely to know about interest compounding, which is clearly a critical variable to devise saving plans. Even after accounting for several demographic characteristics, such as education, marital status, number of children, retirement status, race, and sex, we still found that financial literacy plays an independent role: Those who understand compound interest and display basic numeracy are much more likely to have planned for retirement. This is important, since lack of planning is tantamount to lack of saving.

Other authors have also confirmed the positive association between knowledge and financial behavior. For example, in a paper jointly written with Maarten van Rooji and Rob and Alessie, we find that respondents who are more financially sophisticated are more likely to invest in stocks. John Campbell, from Harvard University, in his article published in the Journal of Finance in 2006 has highlighted how household mortgage decisions, particularly the refinancing of fixed-rate mortgages, should be understood in the larger context of ‘investment mistakes’ and their relation to consumers’ financial knowledge. This is a particularly important topic, given that most US families are homeowners and many have mortgages. In fact, many households are confused about the terms of their mortgages. Campbell also finds that younger, better-educated, better-off white consumers with more expensive houses were more likely to refinance their mortgages over the 2001-2003 period when interest rates were falling.

His findings are confirmed by Brian Bucks and Karen Pence, from the Board of Governors, who examine whether homeowners know the value of their home equity and the terms of their home mortgages. They show that many borrowers, especially those with adjustable rate mortgages, underestimate the amount by which their interest rates can change and that low-income, low-educated households are least knowledgeable about the details of their mortgages.

Further evidence of biases is provided by Victor Stango and Jonathan Zinman from Dartmouth College, who thoroughly document the systematic tendency of people to underestimate the interest rate associated with a stream of loan payments. The consequences of this bias are important: Those who underestimate the annual percentage rate (APR) on a loan are more likely to borrow and less likely to save.

Financial illiteracy and debt

2008-02-27T23:59:00.000-05:00

With the November elections rapidly approaching, millions of Americans are examining each candidate’s views on the country’s economic situation. Americans with unmanageable levels of debt, which, according to TNS’ survey, include over one in four Americans, will be particularly interested in candidates’ plans to help alleviate that burden. While strengthening family finances is a complex problem, one key element is financial literacy. The TNS survey, which includes questions that Peter Tufano (Harvard Business School) and I devised, found disturbing patterns of financial illiteracy and indebtedness:

Only 35 percent of respondents were able to correctly estimate how interest compounds over time

More than half of respondents did not understand how minimum payments are calculated and applied to a principal balance

Almost none of the respondents understood the financial difference between paying in monthly installments versus one lump sum at the end of a certain time period

The survey also explored Americans’ comfort with their personal debts. Respondents were asked if they felt they had too little debt, just the right amount, or too much debt. A sizable fraction of respondents (26 percent) report having too much debt and another 11 percent didn’t know if they did. While firms bombard Americans with credit card solicitations, only two percent of American wished they could borrow more. People who felt they had “too much debt” tended to be younger, with lower incomes and larger families. Beyond this, the over indebted did not understand the basic working of interest rates (this line did not read well). There is a strong link between financial illiteracy and excessive debt. Those who severely underestimate the power of interest compounding don’t understand how quickly debts can grow. They end up with more debt than they can handle.

What these findings show us is that financial illiteracy is pervasive. There is a widespread lack of financial know-how in America. This epidemic is not only prevalent in the low-income demographic. Excessive amounts of debt and personal financial worries may make consumers hold back on their spending.

About the Research
The study is based on a representative national sample of 1000 people aged 18+ in the TNS 6th Dimension Access Panel. The internet-based survey was conducted during the week of November 5, 2007.

Financial education: Learning from other countries

2008-02-16T23:22:00.004-05:00

The experiences of other countries offer important lessons for the United States. While the increase in individual responsibility that is required in the pension system we’re transitioning to (moving from Defined Benefit to Defined Contribution pensions) provides incentives for individuals to become knowledgeable and informed, one has to be cautious about relying simply on individual initiative. For example, lack of understanding of critical components of pensions is a persistent feature, even in economies where personal retirement accounts have been in place for many years.

In Chile, which adopted personal retirement accounts more than 25 years ago, there is a remarkably low level of knowledge about pensions. Only 69 percent of participants in the Chilean system indicate that they receive an annual statement summarizing past contributions and projecting future benefit amounts while, in fact, every participant is sent a statement. Less than half of the 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. Understanding of what workers have accumulated and how their assets are invested is also scanty. For example, just one-third of respondents stated knowing how their own money is invested, and only 16 percent can correctly identify which funds they hold (compared to administrative records).

In Sweden, which implemented comprehensive pension reform during the 1990s, transforming the old public defined benefit plan into a defined contribution plan and implementing a broad public information campaign, the level of knowledge is also not high. The cornerstone of communication of information to plan participants in Sweden is the Orange Envelope. The envelope is sent out annually and contains account information as well as a projection of benefits. Overall, three-fourths of all participants say they have opened the envelope, though only half report reading at least some of its content. Relying on self-reports of participants, chapter twelve documents that half of participants rate their knowledge of pensions as poor. Moreover, the share of respondents who report having a good understanding of the pension system has decreased over time. Measuring actual knowledge of the pension system from surveys that ask respondents about components of the system confirms the evidence provided by self-reports. Many participants are still unaware of the key principles regarding how benefits are determined and many overstate the importance of individual accounts.

Another problematic area for U.S. investors, which is validated in looking at the experiences of other countries, is knowledge of commissions and fees. High fees can prevent investors from accumulating adequately for retirement. However, fees can be easily overlooked. The experience of Chile provides compelling evidence that this is the case; only a minuscule fraction of pension participants (around 2 percent) seem to know the fees that are charged on their accounts.

The experience of Sweden further shows that when individuals are confronted with a very broad range of funds in which to invest—as many as 800—there can be a substantial increase in information and search costs. In fact, fewer than 10 percent of new participants in Sweden make an “active choice” and choose their portfolios. The large majority invest in a default fund. Thus, it is critically important to design defaults in a way that promotes wise portfolio allocation.

Moreover, widespread evidence of illiteracy is not unique to the United States, but is present throughout OECD (Organisation for Economic Co-operation and Development) countries. Importantly, illiteracy in all countries is particularly severe among certain groups, such as women, those with low income and education, and the elderly. This suggests that these groups are particularly vulnerable to many of the changes that are occurring in modern economies. It also suggests that it is possible to share programs across countries and develop international cooperation in efforts to develop effective financial education programs.

These topics are covered in more detail in my forthcoming book: Overcoming the saving slump: How to increase the effectiveness of financial education and saving programs, to be published by the University of Chicago Press.

Financial education: Does it work?

2008-02-10T22:45:00.000-05:00

As additional evidence that financial illiteracy is considered a severe impediment to saving, both the government and employers have promoted financial education programs. Most large firms, particularly those with DC pensions, offer some form of education program. The evidence on the effectiveness of these programs is so far very mixed. Only a few studies find that those who attend a retirement seminar are much more likely to save and contribute to pensions. Clearly, those who attend seminars are not necessarily a random group of workers. Because attendance is voluntary, it is likely that those who attend have a proclivity to save and it is hard to disentangle whether it is seminars, per se, or simply the characteristics of seminar attendees that explain the higher savings of attendees shown in the empirical estimates. However, a study by Bernheim and Garrett published in 2003 argue that seminars are often remedial, i.e., offered in firms where workers do little or no saving. Thus, the effects of seminars may have been underestimated.

My own work uses data from the Health and Retirement Study and confirms the findings of Bernheim and Garrett. Consistent with the fact that seminars are remedial, she finds that the effect of seminars is particularly strong for those at the bottom of the wealth distribution and those with low education. Retirement seminars are found to have a positive effect mainly in the lower half of the wealth distribution and particularly for those with low education. Estimated effects are sizable, particularly for the least wealthy, for whom attending seminars appears to increase financial wealth (a measure of retirement savings that excludes housing and business equity) by approximately 18 percent. Note also that seminars affect not only private wealth but also measures of wealth that include pensions and Social Security wealth, perhaps because seminars provide information about pensions and encourage workers to participate and contribute. This can be important because workers are often uninformed about their pensions.

In a series of papers, Robert Clark and Madeleine D’Ambrosio have examined the effects of seminars offered by TIAA-CREF to a variety of institutions. The objective of the seminars is to provide financial information that would assist individuals in the retirement planning process. Their empirical analysis is based on information obtained in three surveys: participants completed a first survey prior to the start of the seminar, a second survey at the end of the seminar, and a third survey several months later. Respondents were asked whether they had changed their retirement age goals or revised their desired level of retirement income after the seminar. After attending the seminar, several participants stated they intended to change their retirement goals and many revised their desired level of retirement income. Thus, the information provided in the seminars does have some effect on behavior. However, it was only a minority of participants who were affected by the seminars. Just 12% of seminar attendees reported changes in retirement age goals, and close to 30% reported changes in retirement income goals. Moreover, intentions did not translate into actions. When interviewed several months later, many of those who had intended to make changes had not implemented them yet.

Other papers find more modest effects of education programs. Duflo and Saez, in a paper published in 2003, investigate the effects of exposing employees of a large not-for-profit institution to a benefit fair. This study is notable for its rigorous methodology; a randomly chosen group of employees were given incentives to participate in a benefit fair, and their behavior was compared with that of a similar group in which individuals were not offered any incentives to attend the fair. This methodology overcomes the problem mentioned before that those who attend education programs may already be inclined to save. This is clearly important, and findings from this study show that benefit fair attendance induced participants to increase participation in pensions, but the effect on saving was almost negligible. Perhaps the most notable result of this study is how pervasive peer effects are: not only benefit fair attendees but also their colleagues who did not attend were affected by it, providing further evidence that individuals rely on the behaviors of those around them to make financial decisions.

Given the extent of financial illiteracy, it is not surprising that exposing individuals to a benefit fair or offering workers one hour of financial education does little to improve saving. To be effective, programs have to be tailored to the size of the problem they are trying to solve. While it is not possible to transform low literacy individuals into financial wizards, it is feasible to emphasize simple rules and good financial behavior, such as diversification, exploitation of the power of interest compounding, and taking advantage of tax incentives and employers’ pension matches. Another potential role of financial education is to help individuals assess their abilities to make saving and investment decisions and perhaps make them appreciate the value of financial advice or equip them with tools to deal effectively with advisors and financial intermediaries.

So, my answer is : yes, financial education works, but we can make it more effective.

The Newly Created Advisory Council on Financial Literacy

2008-01-29T23:06:00.000-05:00

President Bush announced last week the creation of the Advisory Council on Financial Literacy

More information is available on the White House web page:
http://www.whitehouse.gov/news/releases/2008/01/20080122-7.html

Operating under the guidance of the U.S. Treasury Department with the specific charge of keeping America competitive and assisting citizens in understanding and addressing financial matters, the 19-member council will focus exclusively on economic empowerment issues. Their duties will include advising the president and Treasury Secretary on such goals as improving financial education efforts for students and adults in the workplace, and establishing effective measures of
national financial literacy, and promoting effective access to financial
services, especially for those without access to such services.

This is a very important step. Financial literacy is sorely lacking in this country and it is urgent to address this issue. The hope is that the council will get to work right away!

Finance Literacy and Women

2008-01-19T22:45:00.000-05:00

The decision of how much to save for retirement is a complex one, as it requires collecting and processing information on a large set of variables including Social Security and pensions, inflation, and interest rates, to name a few, and also making predictions about future values of these variables. It is also necessary for the consumer to understand compound interest, inflation, financial markets, mortality tables, and more. Nevertheless, little research has asked exactly how households make saving decisions, how they overcome the difficulty of making those decisions, and whether they are financially literate enough to make well-informed choices. These topics are of paramount importance, particularly when older households are increasingly required to take responsibility for investing and allocating their pension wealth. This is a particular concern for women, who tend to live longer than men and have shorter work experiences and lower earnings.

To gain insight into how households make saving decisions, Olivia Mitchell and I devised a module on planning and financial literacy for the 2004 Health and Retirement Study. The module includes three questions on financial literacy, as follows:

1. 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?
2. Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, would you be able to buy more than, exactly the same as, or less than today with the money in this account?
3. Do you think that the following statement is true or false? Buying a single company stock usually provides a safer return than a stock mutual fund.

The first two questions, which we refer to as “Interest Rate” and “Inflation,” help evaluate whether respondents display knowledge of fundamental economic concepts and basic numeracy. The third question, which we refer to as “Risk Diversification,” evaluates respondents’ knowledge of risk diversification, a crucial element of an informed investment decision

The responses to these three questions among a sample of 785 women age 50+ in the 2004 HRS module on planning and literacy indicate widespread illiteracy. Only 61.9 percent of women correctly answered the interest rate calculation question. This is a relatively easy question, so it is surprising that so many were unable to respond correctly, particularly because these older women have most likely made numerous decisions involving interest rates over their lifetimes (e.g. credit card rates, mortgage financing rates, etc). Respondents were more accurate about the inflation question, with 70.6 percent answering correctly. By contrast, only 47.6 percent of the women respondents knew that holding a single company stock implies a riskier investment than a stock mutual fund.

Note also that only less than half of all respondents could answer correctly both the interest rate and inflation questions. This is a remarkably low ratio, taking into account the complex financial calculations that households on the verge of retirement have almost surely engaged in over their lifetimes. Also disturbing is the fact that only 29 percent of respondents could answer all three questions correctly.

These findings raise concerns about the ability of women to make sound saving and investment decisions over a long retirement period. In an environment where individuals rather than employers and governments are charged with handing retirement finances, it is essential that consumers become more financially literate in order to be more successful at retirement.

Where do presidential candidates stand in terms of policies for financial literacy?

2008-01-08T22:47:00.000-05:00

As people in New Hampshire cast their votes today, it is important to know where presidential candidates stand in terms of financial literacy policies. To that aim, together with the Networks Financial Institute we have sent the following letter to all presidential candidates:

Dear Presidential Candidate:

In recent days, the state of the economy has surpassed the war in the Iraq as the number-one concern of American voters. Networks Financial Institute at Indiana State University, in collaboration with Dartmouth College professor Annamaria Lusardi, is writing to ask how you, as President, would take steps to help more Americans make sound financial decisions.

The need to improve our citizens' financial literacy has gained recognition as Americans save less, spend the majority of their disposable income, and incur rising levels of debt. Data at both the national and state levels indicate that consumer financial knowledge is at an all-time low, which suggests our nation is now facing a financial literacy crisis. Consider the following:

i) the U.S. savings rate has been extremely low for several years;
ii) home foreclosures nationwide are rising very rapidly and are expected to continue to do so for the next year;
iii) the average American with at least one credit card owes nearly $9,000.

Aggravating the situation are a host of business and social factors including vigorous growth in the sub-prime lending industry, a proliferation of “pay day lending” companies and even an increasing array of credit products marketed to the “tween” demographic market. Our educational system has assumed that students will learn the necessary financial skills from their parents, while statistics show that the majority of our nation's adults lack sound financial skills themselves. Given these circumstances we would like to pose the following questions for your response.

First, the economic well-being of Americans increasingly depends upon making good decisions about complex subjects such as student loans, retirement saving, home ownership, and many others. Do you believe that the federal government has a role in improving the financial literacy of our citizens?

Second, educational research has shown that the foundation for learning core subjects like reading and math occurs during the early grades. Our research revealed that only 38% of elementary school teachers and only 52% of teachers in all grades across the nation address financial literacy in their classrooms, citing a lack of time and educational standards as their main obstacles. Do you support the development of national financial literacy standards to help educators prepare the next generation of consumers?

Thank you for addressing these questions.

Sincerely,

Elizabeth Coit
Networks Financial Institute

Annamaria Lusardi
Dartmouth College

I will post the replies as soon as we receive them.

The case for improving financial literacy

2007-12-09T23:02:00.000-05:00

The mixed evidence on the effectiveness of financial education programs has led some to question whether it is worth trying to improve financial literacy. In fact, it is not clear there is even a choice. As it was impossible to live and operate efficiently in the past without being literate, i.e., knowing how to read and write, so it is very hard to live and operate efficiently today without being financially literate. Given the complexity of current financial instruments and the financial decisions required in everyday life, from comparing credit card offerings, to choosing methods of payments, to deciding how much to save, where to invest, and how to get the best loan, individuals need to know how to read and write financially.

Note that, as with reading and writing, the objective of a policy for financial literacy should be basic knowledge. While it may not be feasible to transform financially illiterate people into sophisticated investors, it may be possible to teach them a few principles about the basics of saving and investing. Moreover, as illiteracy was not eradicated with a handful of lessons or in a matter of months, so financially illiteracy cannot be eradicated with a few seminars or one benefit fair.

Set in this framework, it is clear that some standards for financial literacy are needed. What do people need to know? What should be the pillars of financial literacy programs? Setting these standards will be the backbone of devising financial education programs. There are obvious benefits of having one institution that presides over or establishes those standards, and the Treasury Department seems an obvious candidate for this role.

Technology makes it possible to use interactive methods to teach. Thus, “students of financial literacy” do not necessarily have to attend classes at school, but can learn from courses on-line (or from CDs or DVDs) from their home. Courses can also be customized and tailored to the different needs and levels of financial knowledge. Moreover, as the evidence on the effectiveness of the stock market game in high schools seems to suggest, it may be important to find ways to make courses engaging and to stimulate interest in acquiring financial literacy.

Baby Boomer Retirement Security: The Importance of Financial Literacy

2007-11-15T14:33:00.000-05:00

They say that pyramids are a bad thing, but I like this one. Today, it was announced that my paper with Olivia Mitchell, "Baby Boomer retirement security: The roles of planning, financial literacy, and housing wealth," was awarded the Fidelity Research Institute Pyramid Prize for academic work on improving lifelong financial well-being.

Here's an overview of the paper:

With the first wave of 76 million Baby Boomers on the cusp of retirement, the authors sought to understand how financially prepared this large and influential cohort is for the next phase of their lives. Using the Health and Retirement Study for their analysis1, Lusardi and Mitchell explore the links between financial literacy, planning and retirement savings adequacy. They conclude that individuals who plan for retirement (planners) arrive close to retirement with much higher wealth levels and display higher financial literacy than non-planners. Their analysis shows that planning can actually jump-start the retirement savings process and that even a small amount of planning can go a long way towards boosting wealth holdings. Their estimates suggest that those who plan accumulate nearly 20% more in net worth versus those who don't plan for retirement.

Lusardi and Mitchell further conclude that from a policy standpoint, for financial literacy initiatives to be effective in complimenting legislation like the Pension Protection Act of 2006 which was intended to enhance overall retirement savings, that a one-size-fits-all approach is unlikely to do much to build retirement wealth. They contend that instead, targeted efforts will be needed and will be most useful if focused to particular subgroups in the economy that are most at risk of not preparing adequately for their retirement.

For the great majority of working Americans, their biggest and most complex financial goal will be preparing for retirement and this comprehensive research helps to advance our understanding of the connection from financial literacy to planning activity and from planning activity to wealth accumulation. These findings highlight the need to develop and integrate creative approaches to improving financial literacy for Americans to complement the development of other innovative initiatives such as auto enrollment, auto increases, and appropriate default investment options to improve the financial security of current and future retirees.

And here's a link to the paper.

International Evidence on Financial Literacy

2007-11-03T21:31:00.000-05:00

In my previous blog, I showed that financial illiteracy is widespread in the United States. Evidence from outside the United States on financial literacy is no more comforting. In 2005, the ANZ Banking Group conducted an extensive survey on the financial practices of consumers in Australia and New Zealand. The Australian survey of some 3,500 randomly chosen respondents age 18+ evaluated understanding of topics ranging from investment fundamentals, retirement planning and financial records, to basic arithmetic. In the Financial Terms section of the survey, 67% of respondents said they understood compound interest, but a mere 28% were rated as having a “good level” of comprehension when faced with an actual problem to solve. As in the United States case, those with low levels of financial literacy also had low education and income. This survey also confirmed the gender gap, with women concentrated in the lowest 20% of the literacy distribution. In the New Zealand survey of respondents age 18+, similar results obtained. Some 54% of respondents believed that fixed income investments would provide higher returns than stocks over an 18-year period, and again financial literacy was strongly positively correlated with socio-economic status.

The results extend to Europe. For example, a report commissioned by the UK Treasury showed that UK borrowers display a weak understanding of mortgages and interest rates. The UK Financial Services Authority also concluded that younger people, those in low social classes, and those with low incomes were the least sophisticated financial consumers. Other researchers, using data similar to the US Health and Retirement Study, documented that respondents in several European nations scored low on financial numeracy and literacy scales.

Meanwhile, on the other side of the Pacific, a Japanese consumer finance survey showed that 71% of adult respondents knew little about equity and bond investments, and more than 50% lacked any knowledge of financial products. A Korean youth survey conducted by the Jump$tart coalition in 2000 showed that young Koreans fared no better than their American counterparts when tested on economics and finance knowledge, with most receiving a failing grade. Again, a positive correlation was detected between family income and education, and the students’ performance on the financial literacy test.

While financial knowledge is weak, it is also the case that people tend to be more confident in their abilities than should be warranted. For instance, a German survey conducted by Commerzbank AG in 2003 found that 80% of respondents were confident about their understanding of financial issues, but only 42% could answer half of the survey questions correctly. Similar patterns are consistent in the United States, the United Kingdom, and Australia. Indeed, consumers’ overconfidence regarding their financial knowledge may be a deterrent to seeking out professional advice, thus widening the ‘knowledge gap’.

If you like to read more on this topic, please consult my article “Financial Literacy and Retirement Preparedness. Evidence and Implications for Financial Education,” published in Business Economics in January 2007 and posted on my web page. Also read “Improving Financial Literacy: Analysis of Issues and Policies,” published by the OECD in 2005.