Some Suggestions to Address the Retirement Saving Crisis

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

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

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?

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

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

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

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?