Financial experts constantly report that people aren’t saving enough for retirement. And everyone knows that too many consumers mismanage their budgets, invest unwisely, spend too lavishly and defeat themselves by buying high and selling low.
But, of course, some are doing much better, accounting for the soaring assets in mutual funds, 401(k) accounts and tax-free college savings programs.
So, on balance, how bad are things, really?
The picture, overall, is in fact pretty bleak, according to studies by Wharton business economics and public policy professor Olivia S. Mitchell, executive director of the Pension Research Council, and Annamaria Lusardi, professor at the George Washington School of Business and academic director of the Global Financial Literacy Excellence Center. One of their projects began about 10 years ago, posing three simple questions about compounding, inflation and risk. Most of the people queried — not just in the United States, but around the world — were stymied by at least one question.
“When we first started this line of research back in 2004, we thought this was so simple, everyone would know [these things].”–Olivia S. Mitchell
“When we first started this line of research back in 2004, we thought this was so simple, everyone would know [these things],” Mitchell says. “But that’s not the case.”
The issue is especially timely as politicians, academics and the public turn their attention to economic inequality. While that involves controversial matters like taxation, government incentives, trade policy and collective bargaining rights, Mitchell and her coauthors have found that fully one-third of wealth inequality can be explained more simply: by the financial-knowledge gap separating the well-to-do and the less so.
In a new paper, “Financial Literacy and Economic Outcomes: Evidence and Policy Implications,” Mitchell and Lusardi survey a range of research findings by themselves and others, to test participants’ command of financial principles and planning. The work includes a review of results from Mitchell’s and Lusardi’s three-question poll. People who get any of the three questions wrong are unlikely to master trickier challenges like choosing the right investments for retirement, the researchers note.
The three questions were:
Question 1: “Suppose you had $100 in a savings account and the interest rate was 2% per year. After five years, how much do you think you would have in the account if you left the money to grow? A) More than $102. B) Exactly $102. C) Less than $102. D) Do not know/Refuse to answer.” (Answer: more than $102.)
Question 2: “Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After one year, how much would you be able to buy with the money in this account? A) More than today. B) Exactly the same. C) Less than today. D) Do not know/Refuse to answer.” (Answer: less than today.)
Question 3: “Please tell me whether this statement is true or false: Buying a single company’s stock usually provides a safer return than a stock mutual fund.” (Answer: false.)
The initial survey — of Americans 50 and older — found that only half could get both of the first two questions right, while only one-third answered all three correctly. The results were similar when the survey was given to a broader sample representing all Americans.
“Wondering whether Americans might be unusual in their financial knowledge, next we launched several comparable surveys around the world,” Mitchell and Lusardi write. “Again to our dismay, however, we found widespread financial illiteracy even in relatively rich countries with well-developed financial markets such as Germany, the Netherlands, Switzerland, Sweden, Japan, Italy, France, Australia and New Zealand. Performance was markedly worse in Russia and Romania.”
While people with more education did better, their results were still less than impressive. In the U.S., for example, only 44.3% of those with college degrees answered all three questions correctly, compared with 12.6% for those with less than a high school degree, 19.2% of those with only a high school degree and 31.3% for those with some college. Among those with post-graduate degrees, just 63.8% got all answers right. Other countries showed similar results.
According to the researchers, people who do not understand the principles of interest tested in the first question are unlikely to profit by keeping money in savings and investments for long periods. And they might well underestimate the snowballing effects of even slight changes in investment returns, or of reinvesting rather than spending interest and dividends from bank accounts, stocks or mutual funds.
“We are still trying to tease out how much of it is an age effect and how much is a cohort effect.”–Olivia S. Mitchell
Those who get the inflation question wrong may think they can live in retirement on less than they will actually require, getting a false sense of security from accounts that are growing but not as fast as prices. And those who don’t understand that a single stock is riskier than a diversified mutual fund could be devastated by mistakes like putting too much money into their employer’s stock.
Men vs. Women
The international surveys found another consistent pattern: men tend to be more financially literate than women. In the U.S., 38.3% of men got all three questions right, compared to just 22.5% of women. In Germany, the figures were 59.6% for men and 47.3% for women. In the Netherlands it was 55.1% and 35%, and in Switzerland 62% and 39.3%.
Mitchell explains the reasons are what many would expect: In many societies, men control the finances and are more likely to work outside the home and thus be exposed to financial matters. But, Mitchell adds, studies also show that women are more likely to recognize their shortcomings in financial knowledge and be more open to learning. Men, the researchers write, “are more confident about their financial knowledge than they should be: even when they are wrong, they reported being ‘very confident’ about their answers.”
Another study looked at 15-year-olds across 18 countries. Again, performance was disappointing. Students in Shanghai did the best, followed by Belgium. Students in the U.S. were far back in the pack, just behind Latvia, France and the Russian Federation. Students from poorer backgrounds tended to do worse.
While it might be assumed that high school students have plenty of time to catch up before they make enough money to worry about financial issues, Mitchell and Lusardi note that a 15-year-old will soon have to decide whether to go to college and what to study, decisions that involve judging financial opportunities and costs. They add that “young people today are confronting ever-more sophisticated financial products and services than their parents did.” Young workers have to decide about taking on debt, what to spend their money on, how to save and invest, which health care options to choose and how to plan for retirement.
Older people, including those well along in retirement, tend to be weaker on financial knowledge than younger generations, though it has been difficult to rank the explanations for this. Reasons include loss of mental acuity, lack of experience with newer financial products, and growing up at a time the stock market was thought to be unrespectable, Mitchell says.
“We are still trying to tease out how much of it is an age effect and how much is a cohort effect,” she explains. “Cognitive functions definitely decline with age.”
A better understanding of this is needed to help older people manage their assets so they don’t outlive their money, she says. This wasn’t such a problem back when people died younger.
Savviness and Better Outcomes
Ample research, the writers say, shows that financial knowledge does indeed correlate with better outcomes. The financially savvy tend to take on less credit card debt and pay balances off each month. They’re more likely to refinance a mortgage when it is profitable to do so, are less likely to fall prey to high-cost debt like payday loans and are more likely to plan for retirement. Mitchell and Lusardi write: “Our analysis of financial knowledge and investor performance showed that more knowledgeable individuals invest in more sophisticated assets, suggesting that they can expect to earn higher returns on their retirement savings accounts….”
“It’s our belief that you really have to start financial education [at a] young [age].”–Olivia S. Mitchell
For academics, a key question is whether the correlation between greater financial knowledge and better outcomes actually demonstrates cause and effect. It could be the other way, with people learning more about finances because they have more money in the first place. But Mitchell and Lusardi say their review of studies from around the world concludes that the best studies show that “financial literacy proves to be even more powerful than can be detected from simple correlations.”
While many will agree that more financial education is desirable, what’s the best way to provide it? Schools and workplaces obviously offer convenient training grounds, and recent research shows that information delivered in these settings tends to stick, Mitchell and Lusardi note.
“It’s our belief that you really have to start financial education [at a] young [age],” Mitchell says, adding: “You can’t just hire the football coach and say, ‘Teach the kids to balance their checkbooks.’ That’s not enough.”
One study confirmed the value of three-minute videos that were easy to deliver to a large audience, but Mitchell and Lusardi note that evaluating educational strategies takes a lot of follow-up work that has been difficult to do. Often there is no control group — people to follow who did not get the lessons.
“Much remains to be done in this young field of financial literacy,” they write in their paper. “Curing and preventing financial illiteracy is not costless, but investing in financial literacy is likely to bring high payoffs. Twitter And our work demonstrates that financial literacy can benefit not only the economically vulnerable in society, but also the population at large.”