Financial Literacy

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Financial Literacy Planning Implications for
Retirement Wellbeing
Presentation to the 3rd ESRC Seminar
Series Personal Finance I Savings, Pensions
and Debt March 17, 2006

• Annamaria Lusardi
• Dartmouth College NBER
• Paper and related research at
• www.dartmouth.edu/alusardi/

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Significance

• Workers are increasingly responsible for saving
  investing their retirement assets.
• What influences these decisions?
• Are they well-equipped to make the decisions?

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Life cycle/permanent income model

• Posits that consumers
• Save and work given life-time budget constraints
• Look ahead plan for the future
• Understands basic economics (e.g. interest rates,
  inflation, risk diversification)

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A famous permanent income consumer

• When he won the Nobel prize in Economics, Milton
  Friedman was asked how he would spend the prize
  money.
• He replied I have already spent most of it

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Other work

• In previous work, I have shown that the majority
  of older workers do not plan for retirement.
• Lusardi (1999, 2002, 2003)
• Workers have little knowledge of crucial
  variables for planning Social Security and
  pensions.
• Mitchell (1988), Bernheim (1995, 1998), Gustman
  and Steinmeier (2004)

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Other related work

• Household finance
• Campbell (2006)
• Mistakes made by households and importance of
  defaults
• Choi, Madrian and Laibsons work
• The effects of financial education on saving
• Bernheim and Garrett (2003)

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To evaluate the working of such model

• We devised a module on Financial Literacy
  Planning for the 2004 Health and Retirement Study
  (HRS)
• Financial Literacy
• Do people understand the basic working of
  interest rates, inflation, and risk
  diversification?
• Planning
• Do people calculate how much to save for
  retirement? How well do they plan?

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Some qualifications

• People could consult others when making financial
  decisions.
• People could make good decisions even without
  knowledge (or precise knowledge).
• It is not clear how much people should know.
  Saving and investing involve using complex
  assets, such as indexed annuities, etc.

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3 questions on Financial Literacy (I)

• Compound Interest
• Suppose you had 100 in a savings account and
  the interest rate was 2 per year. After 5
  years, how much do you think you would have in
  the account if you left the money to grow?
• i) more than 102
• ii) exactly 102
• iii) less than 102
• iv) dont know (DK)
• v) refuse to answer.

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Financial Literacy (II)

• Inflation
• Imagine that the interest rate on your savings
  account was 1 per year and inflation was 2 per
  year. After 1 year, would you be able to buy
• i) more than today with the money in this
  account
• ii) exactly the same as
• iii) less than today
• iv) DK
• v) refuse.

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Financial Literacy (III)

• Stock Risk
• Do you think the following statement is true or
  false? Buying a single company stock usually
  provides a safer return than a stock mutual
  fund.
• i) True
• ii) False
• iii) DK
• iv) Refuse.

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Financial Literacy Results
See Table 1 NB only 34 correctly answer all 3
questions only 56 correctly answer Inflation
Compound Interest.
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Differences in Financial Literacy Across
Demographics Groups

• When accounting for demographics together, the
  variables that remain significant to explain
  correct responses are
• Compound Interest age (-), male (), Black
  Hispanic (-), education ()
• Inflation age (-), male (), Black Hispanic
  (-), education (), baby-boomers cohort (-)
• Stock Risk age (-), male (), Black (-),
  education ()

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Extensions

• I devised financial literacy questions for a
  household survey for the Dutch Central Bank.
• I devised financial literacy and planning
  questions for the Rand Internet Panel, which
  surveys younger respondents.

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Changing the wording of the question

• Each respondent is assigned randomly to one
• of the two versions
• Do you think that the following statement is true
  or false?
• Buying a single company stock usually provides a
  safer return than a stock mutual fund.
• Buying a stock mutual fund usually provides a
  safer return than a single company stock.

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Responses to different versions
Pearson chi2(3) 184.67 (p0.000)
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A simple question about bonds and stocks

• Each respondent is assigned randomly to one
• of the two versions
• Do you think that the following statement is true
  or false?
• Stocks are normally riskier than bonds.
• Bonds are normally riskier than stocks.

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Responses to different versions
Pearson chi2(3) 6.47 (p0.091)
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A question about bond prices

• Each respondent is assigned randomly to one
• of the two versions
• If interest rates fall, what should happen to
  bond prices? Rise fall stay the same DK,
  refusal.
• If interest rates rise, what should happen to
  bond prices? Rise fall stay the same DK,
  refusal.

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Devising questions about literacy
Pearson chi2(3) 23.22 (p0.000)
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3 questions on Retirement Planning

• Trying to plan
• Have you ever tried to figure out how much your
  household would need to save for retirement?
• Developing a plan
• Have you developed a plan for retirement
  saving?
• Sticking to the plan
• How often have you been able to stick to this
  plan? Would you say
• i) always ii) mostly iii) rarely or iv) never?

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What we find

• Tried
• Have you ever tried to figure out how much your
  household would need to save for retirement?

Developed a plan Have you developed a plan for
retirement saving?
Stuck to the plan How often have you been able
to stick to the plan?
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Prevalence of retirement planners
See Table 2 Panel B
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Which tools do people use for planning?
See Table 3
NB ¼ of planners have not used any of these
tools.
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The effects of financial literacy

• Are the more financially literate
• more likely to plan?
• more likely to save?
• more likely to invest in complex assets?

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Analysis of Simple, Serious, and Successful
Planners
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Analysis of Simple, Serious, and Successful
Planners Accounting for Differences in
Demographic Characteristics
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Analysis of Stock Ownership
a Race, Gender, Marital Status, Born in US,
Education, Age, Baby-Boomer Cohort
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Analysis of Checking Account Ownership
a Race, Gender, Marital Status, Born in US,
Education, Age, Baby-Boomer Cohort
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The Effects of Financial Literacy Wealth
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Extensions How to make people save

• Devise messages to alert households of the need
  to save.
• Devise programs to increase the effectiveness of
  financial education.

• Joint project with Punam Keller (Prof. of
  Marketing, Tuck School of Business)

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Summary of findings

• Only 1/3 of respondents have basic knowledge of
  key economic variables interest rates,
  inflation, and risk diversification.
• Fewer than 1/3 have attempted to calculate how
  much they need to save for retirement. Even fewer
  (19) follow through.
• People use a variety of tools to plan for
  retirement, including informal means such as
  talking to family and friends.
• Financial literacy is strongly correlated with
  planning, savings, and asset ownership.

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Implications

• Financial knowledge among workers cannot be taken
  for granted.
• A one-time/one-size-fits-all financial
  education program is likely to be ineffective in
  stimulating saving and retirement financial
  security.

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Concluding remarks

• Saving for retirement is a complex decision. We
  need to incorporate difficulties in making
  decisions into our saving models.
• Important to study not only the demand but also
  the supply side of the market (mutual funds,
  mortgage companies etc.)