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RRC Conference, 10-11 August 2009 This work was supported by SSA via MRRC

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, 10-11 August 2009 This work was supported by SSA via MRRC.

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RRC Conference, 10-11 August 2009 This work was supported by SSA via MRRC

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  1. How Ordinary Consumers Make Complex Economic Decisions: Financial Literacy and Retirement Readiness Annamaria Lusardi (Dartmouth College and NBER)andOlivia S. Mitchell (University of Pennsylvania and NBER) RRC Conference, 10-11 August 2009 This work was supported by SSA via MRRC

  2. 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

  3. 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?

  4. 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.

  5. Five basic financial literacy questions 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 compoundingSuppose 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?

  6. Basic financial literacy questions (cont.) 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 moneyAssume 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?

  7. Financial literacy: Correct answers

  8. Sophisticated financial literacy questions • 1) Main Function of Stock MarketWhich of the following statements describes the main function of the stock market? • The stock market helps predicts stock earnings; • The stock market results in an increase in the price of stocks; • The stock market brings people who want to buy stocks together with those who want to sell stocks; • 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.

  9. Sophisticated financial literacy questions (cont.) 3)Bond pricesIf 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 RiskStocks are normally riskier than bonds. True or False?

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

  11. Answers to Advanced Financial Literacy Questions

  12. 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?

  13. Financial literacy index & self-assessed literacy

  14. Does financial literacy matter? • Outcome: Retirement planning • Empirical model: • Planning = α + βFin 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

  15. 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.”

  16. Retirement planning

  17. Instruments for financial literacy index • Planning = α + βFin 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

  18. Multivariate analysis of retirement planning

  19. Second instrument for literacy • Planning = α + βFin 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?”

  20. Using an alternative instrument • N = 989

  21. 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

  22. 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

  23. 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

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