Sunday, December 9, 2007

The case for improving financial literacy

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.

Thursday, November 15, 2007

Baby Boomer Retirement Security: The Importance of Financial Literacy

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.

Saturday, November 3, 2007

International Evidence on Financial Literacy

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.

Sunday, October 28, 2007

The Importance of Being Financially Literate

Workers and retirees have increasingly been asked to take unprecedented responsibility for their retirement and other saving, as defined benefit pensions decline and government programs face insolvency in one country after another. As a result, consumers now confront a bewildering array of financial decisions and a wide range of financial products ranging from 401(k) plans and Roth and regular Individual Retirement Accounts to phased withdrawal plans, annuities, and many more. This process implies that it is becoming ever more important for households to acquire and manage economic know-how. But in practice, there is widespread financial illiteracy. Many households are unfamiliar with even the most basic economic concepts needed to make sensible saving and investment decisions. This has serious implications for saving, retirement planning, retirement, mortgage, and other financial decisions, and it highlights a role for policymakers working to boost financial literacy and education in the population.

U.S. Evidence on Financial Literacy

Researchers have undertaken several studies of financial literacy in the United States. For instance, a survey conducted for the National Council on Economic Education (NCEE) in 2005 indicated that nearly all U.S. adults believe that it is “important to have a good understanding of economics.” But despite this goal, the evidence shows that actual financial knowledge is sorely deficient for both high school students and working-age adults. The survey consisted of a 24-item questionnaire on topics grouped into categories including “Economics and the Consumer;” “Money, Interest Rates and Inflation;” and “Personal Finance.” When results were tallied using standard grading criterion, adults had an average score of C while the high school population fared even worse, with most earning an F.

Low levels of financial literacy are confirmed by related research by the Jump$tart Coalition for Personal Financial Literacy focusing on U.S. high school students. In both recent surveys (2004 and 2006) on basic personal financial management skills and how to improve them, students fared poorly on credit management and personal finance questions and knew little about stocks, bonds, and other investments.

Americans’ lack of financial knowledge has been confirmed in the larger population by Hilgert and Hogarth (Board of Governors), who used data from the University of Michigan’s Survey of Consumers. Some 1,000 respondents between the ages of 18 and 97 were given a 28-question True/False Financial Literacy quiz, with questions examining knowledge about credit; saving patterns; mortgages, and general financial management. Overall, that study found that respondents could answer only two-thirds of the questions correctly. They were best informed regarding mortgages (81% correct responses), followed by saving patterns (67% correct), credit cards (65% correct), and general financial management (60% correct). Respondents were less knowledgeable about mutual funds and the stock market: Only half knew that mutual funds do not pay a guaranteed rate of return, and 56% knew that “over the long-term, stocks have the highest rate of return on money invested”. All of these studies found substantial differences among demographic groups: Those with low education, women, and Blacks and Hispanics display very low financial literacy, a common finding in other studies reported below.

To explore financial literacy in more depth, Olivia Mitchell and I have devised and fielded a purpose-built module on planning and financial literacy for the 2004 Health and Retirement Study (HRS), a survey that covers respondents over the age of 50. This module includes questions measuring how workers made saving decisions, how they collected the information for making these decisions, and, most important, whether they possessed the financial literacy needed to make informed decisions. Our research shows that only half of the HRS respondents surveyed could answer two simple questions regarding interest compounding and inflation correctly. Furthermore, only one in three could correctly answer those two questions plus an additional one on risk diversification. We also found that financial illiteracy was particularly acute for Blacks and Hispanics, women, and those with low educational attainment. In related work, we employed data from the 2004 HRS to evaluate whether Baby Boomers are relatively well informed about financial matters. Specifically we focused on Early Boomers (age: 51-56) in 2004. The following financial literacy questions were posed to these respondents:

1) “If the chance of getting a disease is 10 percent, how many people out of 1,000 would be expected to get the disease?”

2) “If 5 people all have the winning number in the lottery and the prize is 2 million dollars, how much will each of them get?”

For respondents who answered either the first or the second question correctly, the following question was asked:

3) “Let’s say you have 200 dollars in a savings account. The account earns 10 percent interest per year. How much would you have in the account at the end of two years?”

The good news is that over 80% got the percentage calculation question correct. But only about half could divide $2 million by 5, and only 18% correctly computed the compound interest question. Of those who got that interest question wrong, 43% undertook a simple interest calculation, thereby ignoring the interest accruing on both principal and interest. These are uncomforting findings, especially considering that these respondents are only a dozen years from retirement and, one surmises, have handled numerous financial decisions during their lives.

These figures hide wide differences among demographic groups. For example, financial literacy rises steeply with education: the more educated are much more likely to answer the questions correctly. Moreover, Blacks and Hispanics are much less likely to answer correctly than Whites. These findings confirm those provided by other researchers, such as Douglas Bernheim from Princeton University, who was among the first to warn of the lack of financial literacy among savers and investors. It also confirms the findings of studies on smaller samples. For example, the State of Washington sponsored a survey to assess financial literacy among its residents and concluded that people are particularly uninformed about financial instruments. More than one third did not know that stocks had higher returns than bonds over the last forty years, and many did not know about risk diversification. Respondents were also uninformed about mutual funds: Many did not know what a no-load mutual fund was, or that mutual funds do not pay a guaranteed rate of return. Finally, a large fraction of these respondents did not understand interest rates, which was especially troublesome since a subset of the respondents had applied for loans. This study confirmed conclusions from surveys conducted by the Employee Benefit Research Institute. For example, their survey in 1996 showed that only 55 percent of workers knew that U.S. government bonds provided lower returns than the U.S. stock market over the past 20 years.

Concluding Remarks

Financial literacy surveys show that consumers are poorly informed about financial products and practices. This is troubling because financial illiteracy may stunt peoples’ ability to save and invest for retirement, undermining their wellbeing in old age. It is also a matter of significant concern that these deficiencies are concentrated among particular population subgroups—those with low income and low education, minorities, and women—where being financially illiterate may render them most vulnerable to economic hardship in retirement.

Consumers require additional support for old-age retirement planning and saving. Also, education programs will be most effective if they are targeted to particular population subgroups, in order to address differences in saving needs and in preferences. As old-age dependency ratios rise across the developed world, and as government-managed pay-as-you-go social security programs increasingly confront insolvency, these issues will become increasingly important. As a result, the crucial challenge is to better equip a wide range of households with the financial literacy toolbox they require, so they can better build retirement plans and execute them.

This is a summary of my work with Olivia Mitchell (Wharton School), published in the January 2007 issue of Business Economics. You can read the entire paper on my web page.