Friday, May 12, 2017

How Much Financial Knowledge Do People Acquire as They Age? Not Much.

This blog post was also posted on The Wall Street Journal and can be found here.

People often argue that financial knowledge can be acquired with experience. But if the evidence from a new survey index is any indication, that way of learning may, in fact, be very slow or not work well at all.

The TIAA Institute-GFLEC Personal Finance Index, or P-Fin Index for short, provides a snapshot of Americans’ understanding of basic financial concepts. And the results don’t look too promising.

U.S. adults surveyed only answered about half the questions in the index correctly. Just 16% demonstrated a relatively high level of personal-finance understanding; they answered more than three-quarters of the questions correctly. But what was surprising is that Americans’ knowledge of personal finance is low even among people who have already made many important and fundamental financial decisions. This includes older Americans who own investment assets.

Specifically, by age 45 only 10% of respondents could answer more than three quarters of the survey questions correctly.

More unsurprisingly, younger adults fared the worst. Just 30% of people aged 18 to 30 were able to correctly answer only a quarter—or fewer—of the questions in the P-Fin Index.

This is worrisome as young people today have to deal with important and consequential decisions, from whether to invest in education and how to finance that education, to saving and investing in retirement accounts that are much more dependent today than in the past on an individual’s savvy. It is also worrisome because, if we can infer how learning progresses with age by looking at the experience of  the older survey cohorts, we see from the index that learning, overall, is slow.

We can get further insights on that learning from the concepts the index covers. While previous surveys gauged financial knowledge by using only a handful of questions, the P-Fin Index encompasses 28 questions covering eight functional areas: earning, consuming, saving, investing, borrowing, insuring, risk and reliable sources of information and advice.

For most topics, American adults can barely answer half of the questions correctly, even when the topics affect decisions that are made regularly. Take risk and risk management. It is a feature of most, if not all, financial decisions since financial decisions relate to the future, which is by definition uncertain. On average, U.S. adults answered only 39% of the risk-related questions correctly. Risk is a very complex concept, and perhaps this is what limits learning by experience.

One example of a question measuring risk:

There’s a 50/50 chance that Malik’s car will need engine repairs within the next six months which would cost $1,000. At the same time, there is a 10% chance that he will need to replace the air conditioning unit in his house, which would cost $4,000. Which poses the greater financial risk for Malik?

-  The car repair (correct answer; chosen by 41% of respondents)
- The air-conditioning replacement (chosen by 19% of respondents)
- There is no way to tell in advance (chosen by 19% of respondents)
- Don’t know (chosen by 20% of respondents)

Interestingly, most U.S. adults understand borrowing. But knowledge about debt seems the exception rather than the rule. On average, 61% of the questions about borrowing were answered correctly. Debt is now a standard component of American life, and it may be that knowledge and understanding is generated from confronting accumulated debt, often while young.

Many of the index’s findings, while troubling, point to avenues for putting consumers on a safer financial track, which was one of the objectives of collecting these new data. We know people are making financial decisions that are important to their future and to society, yet their choices rely on a base of very limited personal-finance knowledge. We also know from P-Fin Index data that only 40% of U.S. adults have been exposed to financial-education programs. Clearly, access to financial education should be embraced and expanded.

School is one logical place to start. As I have written previously, a mandatory personal-finance course in college would provide a powerful boost. But we could—and should—start even earlier. Financial literacy in primary and high schools would prepare the young, including informing the decision to go to college.

Financial education in the workplace is another important avenue, particularly now that individuals carry greater responsibility for managing their pensions and health coverage. Workplace education also may be a way to reach older individuals.

Young people do not have the financial understanding they need to make informed decisions about their future. And now we see that U.S. adults, even late in life, have still not acquired that knowledge. Just relying on experience for enlightenment may offer too little and deliver it too late.

Thursday, May 11, 2017

Access to Financial Services But Without the Skills to Use Them: The Importance of Financial Literacy

This article was originally posted on the "Think20" blog, published by the German Development Institute and the Kiel Institute for World Economy. You can view the original post by clicking here.

Only half of the adults in major advanced economies who use a credit card or borrow from a financial institution are financially literate. In emerging economies, financial literacy levels are even lower. And around the world, population subgroups—women, the poor, people with low formal education—trail in their financial knowledge, regardless of the strength of their countries’ economies.

According to the new Standard & Poor’s Global Financial Literacy survey—the world’s largest and most comprehensive study of financial knowledge—we have reached a crisis stage. Financial literacy is not only very low in emerging countries, such as the BRICS, but it is also shockingly low in countries with well-developed financial markets and countries with high per-capita income. That includes the major advanced economies—among them the G7—where the use of financial products is widespread.

In order to make sound financial decisions, people must understand at least basic financial concepts. Yet the data shows that too much of the world’s population lacks the ability to make informed financial choices when it comes to saving, investing, borrowing, and more.

Financial knowledge is especially important during times when increasingly complex financial products are easily available to a wide range of the population. We are living in those times. As governments in many countries push to boost access to financial services, the number of people with bank accounts and credit products is rising rapidly. Changes in the pension landscape are transferring decision-making responsibility to workers who previously relied on their employers or governments to ensure their financial security after retirement. In the United States, where lawmakers are promising to revise an already complicated health insurance system, most Americans do not understand the precepts of insurance. In China, where credit card ownership has doubled since 2011, only half of credit card owners can perform simple calculations related to interest.

Financial ignorance carries a hefty price tag. Consumers who do not understand interest compounding, for example, spend more on transaction fees, run up bigger debts, and incur higher interest rates on loans. They also end up borrowing more and saving less.

The potential benefits of financial literacy, meanwhile, are manifold. People with strong financial skills do a better job planning and saving for retirement. Financially savvy investors are more likely to diversify risk by spreading funds across several ventures. They also earn more on their investments.

Until recently, a comparison of financial literacy across many countries was not possible. The Standard & Poor’s Ratings Services Global Financial Literacy Survey has opened the way to a comparable measure of financial literacy in more than 140 countries. The S&P Global FinLit Survey, for short, also links financial literacy to measures of financial inclusion provided by the Global Findex Database. These new data make it possible to examine financial knowledge worldwide and to assess the potential impact of what consumers do—or do not—know.

Financial literacy is measured through questions that assess basic knowledge of four fundamental concepts in financial decision-making: interest rates, interest compounding, inflation, and risk diversification. The S&P Global FinLit Survey findings are sobering. Worldwide, only 1-in-3 adults are financially literate. Or put in another way, some 3.5 billion adults globally fail to understand basic financial concepts.

Worldwide, there are striking similarities among the groups that are less likely to be financially literate. Irrespective of the level of income or the sophistication of the financial markets, women’s financial literacy levels are low—and that is true in almost all countries. This finding is important since roughly half the people on the planet are female. Worldwide, 30 percent of women are financially literate. That compares with 35 percent of men.

Income is another indicator. The rich have better financial skills than the poor. Some 31 percent of adults in the richest 60 percent of households in the major emerging economies are financially literate. In the poorest 40 percent of households, 23 percent of adults are financially literate. The size of the income gap is similar in the major advanced economies, although some suffer from even deeper inequality.

Access to Financial Services Carries Benefits; Poor Financial Literacy Dilutes Them

Financial literacy skills are important for people who use payment, savings, credit, and risk-management products. For many, opening an account at a bank or other financial institution—or using a mobile money-service provider—is an important first step to participation in the financial system. When people have financial accounts and use digital payments, they are better able to provide for their families, save money for the future, and survive economic shocks. According to the S&P Global FinLit Survey, financial account holders tend to be more financially savvy (although plenty of them still lack financial skills). Globally, 38 percent of account-owning adults are financially literate, as are 57 percent of account owners in major advanced economies and 30 percent in major emerging economies.

But there is a drawback. Account owners without financial knowledge may not fully benefit from what their accounts have to offer. Even more, this access to financial products can propel them into financial disaster, such as high debt or bankruptcy.

Take savings as an example. Globally, 57 percent of adults save money, but just 27 percent use a formal financial institution, such as a bank, to do so. Others rely on more precarious and less lucrative alternatives, such as informal savings groups or stuffing cash under a mattress. Only 42 percent of account owners worldwide use their accounts to save, and 45 percent of these adult savers are financially literate. Given the benefits derived from using financial services, it is important to ensure that people are capable of managing those services to their advantage.

Financial literacy challenges are universal, confronting developing economies and advanced economies alike. Policymakers should build strong consumer protection regimes to safeguard citizens from financial abuse and provide a smooth market environment. They should also take steps to ensure access to financial education.

School seems a great place to start, both for its capacity to reach large segments of the population (including women) and because individuals lacking financial knowledge are less likely to learn it from families or peers. Low-income groups can be targeted by embedding financial education programs in some of the programs already offered to them.

The message of the G20 Summit is “shaping an interconnected world.” As these influential leaders convene to empower people around the globe, addressing the challenges of financial literacy promises a high-impact multiplier effect.

Map 1: Global Variations in Financial Skills

Friday, May 5, 2017

New insight into Americans' financial capability

This blog was originally published in the May 15, 2017 print issue of Pensions & Investments. The online version can be found here.

When the National Financial Capability Study launched in 2009, it promised valuable new information about the financial situations of U.S. households following the Great Recession. The ongoing national surveys — every three years — have lived up to that expectation, revealing not only how people manage their finances but also whether they are capable of handling those responsibilities.

But the FINRA Investor Education Foundation sought an even deeper dive into what we know about consumer finances. In 2012, it provided funding to add the NFCS' questions to a representative sample of 2,000 individuals selected from the RAND American Life Panel, which includes more in-depth information about Americans' finances. That new data is examined in “Financial Capability of the American Adults: Insights from the American Life Panel,” a report I wrote in collaboration with Marco Angrisani and Arie Kapteyn from the Center for Economic and Social Research at the University of Southern California. It includes a number of findings of interest for the pension and financial industry.

Out-of-pocket medical expenses are a significant source of financial strain.

The likelihood of incurring large out-of-pocket expenses — for preventive care or treatment after a medical crisis — is, perhaps not surprisingly, linked to how healthy an individual is and whether they have insurance. But the weight of those factors is impressive when looking at short-term shocks and their affect on families' security. At the same time, since low education and low income often go hand-in-hand with poor health and lack of insurance, households with low socioeconomic status are both more likely to face economic shocks and less prepared to deal with them.

Using respondents' self-assessment, our study divides individuals into those with good health and those with poor health. As expected, we find the risk of health shocks to be high for individuals who smoke, have a body mass index greater than 30 or have been diagnosed with high blood pressure. We also break respondents into groups depending on whether they have health insurance. Respondents with poor health, a higher risk of health shocks and no health insurance — those who are most likely to face a health shock — are 15 to 30 percentage points less likely to have money to cover an emergency than respondents on the opposite end of the scale.

When it comes to planning for the long term, most Americans fall short.

An important aspect of planning is to set medium- and long-term financial goals, taking into consideration future events such as retirement. But the NFCS-ALP reveals a widespread lack of planning. Only 40% of respondents have ever thought about their retirement savings. Looking more closely, only 47% of workers aged 40 to 59 have planned at all. Among younger (workers aged 18 to 39) the figure is much lower: it is only 31%.

People nearing retirement age are not thinking ahead.

Even when it comes to individuals aged 60 and older, less than 50% have thought about planning for their post-work years. To look at this unsettling finding in more detail, we take working individuals in the NFCS-ALP who are at least 60 years old and separate them into two groups, according to whether their expected likelihood of working past age 65 is below or above 50%. We would assume that workers more likely to leave the labor force by 65 will have put more thought into their retirement savings. Indeed, 66% of them have (as have 56% of those more likely to work past 65). Still, it is striking that more than half of older workers on the verge of retirement have not done any retirement planning.

Financial planning is critical for economic well-being, but a large proportion of Americans live from paycheck to paycheck.

The NFCS-ALP questionnaire asks respondents whether they have set aside a “rainy day” fund to cover expenses for three months in the event of sickness, job loss or other adverse circumstances. Only 41% of respondents answer affirmatively. As further evidence of the financial fragility of American families, only 44% are certain they could come up with $2,000 if an unexpected need arose within the next month.

Planning for retirement pays off in powerful ways.

There are striking differences between non-planners and planners when it comes to the wealth they have available beyond employer-sponsored pension plans. Among workers over the age of 60, the median financial wealth is only $1,500 for those who have not planned. At $160,000, it is many times that amount for planners. Viewed another way, the mean financial wealth for non-planners is $65,000 while that of those who plan is $310,000 — still a dramatic difference.

Financial literacy levels are an obstacle.

Research has found that higher financial literacy correlates strongly with whether individuals plan for retirement and have rainy day funds. The NFCS measures financial literacy through questions addressing key concepts of economics and finance, notably compounding interest, inflation and risk diversification. Two additional questions test individuals' understanding of the effect of the length of a mortgage and the relationship between interest rates and bond prices. These questions have been asked in the broader ALP panel as well. Only 18% of the respondents in the NFCS-ALP sample answer all five questions correctly. Less than a third — 31% — answer four questions correctly. Consistent with previous research, data from the NFCS-ALP show those who are more financially literate are more likely to plan for retirement and more likely to hold precautionary savings.

What do all these findings mean? By exposing the behaviors and barriers that contribute to financial vulnerability, the new data open a pathway for exploring policies and programs that will make American families more secure. It will be important to fortify financial health not only in the long term but also in the short term. And it will be critical to ensure Americans have the basic knowledge needed for sound financial decisions, including to plan for retirement and to save for unexpected shocks.