April is Financial Literacy Month

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

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!

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?

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

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

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?

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.