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.