How Ordinary Consumers Make Complex Economic Decisions: Financial Literacy and Retirement Readiness Annamaria Lusardi (Dartmouth College and NBER) and Olivia S. Mitchell (University of Pennsylvania and NBER) RRC Conference, August 2009 This work was supported by SSA via MRRC

Relevance: Transitioning to a new system Workers must manage own financial security pre/post retirement:  Demographic changes  Labor market changes: more mobility  Pension changes: From DB to DC Financial markets more complex: Proliferation of mutual funds Globalization of financial markets

Individual responsibility Individuals must decide:  How much to save for retirement  How to invest retirement wealth  How to draw down wealth Our questions: Are people well-equipped to take responsibility for their retirement financial well-being? Are they financially literate? Does financial knowledge matter and how much?

We address these questions using ALP Rand American Life Panel (ALP): we devised a financial literacy and retirement planning module. ALP an Internet survey: Can assess quality of financial literacy data; Efforts to include those not using the internet Advantages of using ALP :  All ages  Measures both basic and sophisticated literacy  Measures self-assessed literacy  “Instruments” for financial literacy  Several measures of retirement planning to assess whether knowledge matters.

1) Numeracy (HRS 2004) 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: more than $102, exactly $102, less than $102? 2) Interest compounding Suppose you had $100 in a savings account and the interest rate is 20% per year and you never withdraw money or interest payments. After 5 years, how much would you have on this account in total: more than $200, exactly $200, less than $200? Five basic financial literacy questions

3) Inflation (HRS 2004) 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 more than, exactly the same as, or less than today with the money in this account? 4) Time value of money Assume a friend inherits $10,000 today and his sibling inherits $10,000 three years from now. Who is richer because of the inheritance: my friend, his sibling, or are they equally rich? 5) Money illusion Suppose that in the year 2010, your income has doubled and prices of all goods have doubled too. In 2010, will you be able to buy more, the same, or less than today with your income? Basic financial literacy questions (cont.)

Financial literacy: Correct answers Number of correct financial literacy questions ___________________________________________________ N correct responses% of respondents ________________________ None All43.8 ___________________________________________________ N= 989

1) Main Function of Stock Market Which of the following statements describes the main function of the stock market? (i)The stock market helps predicts stock earnings; (ii)The stock market results in an increase in the price of stocks; (iii)The stock market brings people who want to buy stocks together with those who want to sell stocks; (iv)None of the above. 2) Knowledge of Mutual Funds: Which of the following statements is correct? (i) Once one invests in a mutual fund, one cannot withdraw money in the first year; (ii) Mutual funds can invest in several assets, for example invest in both bonds and stocks, (iii) Mutual funds pay a guaranteed rate of return that depends on their past performance; (iv) None of the above. Sophisticated financial literacy questions

Sophisticated financial literacy questions (cont.) 3) Bond prices If the interest rates fall, what should happen to bond prices: rise, fall, or stay the same? 4) Company Stock (HRS 2004) Buying a company stock usually provides a safer return than a stock mutual fund. True or False? 5) Stock Risk Stocks are normally riskier than bonds. True or False?

Sophisticated financial literacy questions (cont.) 6) Return Considering a long time period (for example 10 or 20 years), which asset normally gives the highest return: Savings accounts, Bonds or Stocks? 7) Volatility Normally, which asset displays the highest fluctuations over time: Savings accounts, Bonds or Stocks? 8) Diversification When an investor spreads his money among different assets, does the risk of losing money increase, decrease or stay the same?

Answers to Advanced Financial Literacy Questions CorrectIncorrectDKRefusal Q1. Main function of the stock market 71.5%20.2%8.3%0.0% Q2. Knowledge of mutual fund. 63.0%13.6%23.3%0.0% Q3. Relation between interest rate and bond prices 31.6%43.8%24.5%0.1% Q4. What is safer: company stock vs stock mutual fund 71.4%4.0%24.5%0.0% Q5. Which is riskier: stocks vs bonds 80.2%5.4%14.4%0.1% Q6. Highest return over long period: savings accounts, bonds or stocks 62.3%27.5%10.1%0.1% Q7. Highest fluctuations: savings accounts, bonds, stocks 88.3%4.5%7.1%0.0% Q8. Risk diversification 74.9%18.4%6.7%0.1%

Financial literacy indices Use factor analysis to summarize information on basic and sophisticated literacy questions. Construct 2 indices: basic and sophisticated literacy. Assess self-reported financial literacy and its relationship with literacy indices. On a scale from 1 to 7, how would you assess your understanding of economics?

Financial literacy index & self-assessed literacy Advanced Literacy Index quartiles Self-assessed literacy 1234N __________________________________________________________________________________ 1 (very low) (very high) __________________________________________________________________________________

Does financial literacy matter? Outcome: Retirement planning Empirical model: Planning = α + β Fin Literacy + θ X + u Literacy a choice variable: To assess causality, perform IV estimation using two sets of instruments for financial literacy: Exposure to fin education in school Exposure to fin education at work

Retirement planning Our prior work shows that retirement planning is a strong predictor of wealth Lusardi 1999, 2002, 2005, 2008; Lusardi and Mitchell 2006, 2007 Use a simple question piloted in two waves of the HRS: “How much have you thought about retirement.”

Retirement planning Question% of sample How much have you thought about retirement? A lot26.5 Somewhat43.0 A little16.6 Hardly at all14.0

Instruments for financial literacy index Planning = α + β Fin Literacy + θ X + u Use information on whether individuals lived in a state that mandated financial literacy in high school Bernheim, Garrett, and Maki 2001 Also interact that with age, sex, and state education expenditures per pupil when respondent age 17 Card and Krueger 1992; Burtless 1996

Multivariate analysis of retirement planning OLSIV Adv. Literacy Index0.163*** (0.062) 0.493*** (0.116) Demographicsyes F value 1 st stage4.12 Hansen J test (p val)0.04 N obs989936

Second instrument for literacy Planning = α + β Fin Literacy + θ X + u Use information on exposure to financial education in the workplace. “Did any of the firms you worked for offer financial education programs, for example, retirement seminars?”

Using an alternative instrument OLSIV Adv. Literacy Index0.163*** (0.062) 0.993** (0.443) Demographicsyes F value 1 st stage10.14 N = 989

Contributions of this paper New financial literacy measures: Basic and sophisticated knowledge Self-assessed knowledge Show financial literacy affects behavior. Those who are more literate are more likely to plan for retirement Extend analysis of state mandates and employer-provided financial education. Derive implications for financial education

Summary and Policy Implications Our questions: Are people well-equipped to take responsibility for their retirement financial well-being? Are they financially literate? NO Does financial knowledge matter? YES When is time for financial education? NOW

If you want to read more I have edited a book published by the University of Chicago Press on how to improve the effectiveness of financial education programs