Editor’s note: This excerpt is from an in-depth study of financial literacy around the world (access the entire study here), and its determination of retirement preparedness. InFRE has long held this to be the case, and therefore created the RetirAwareness Quiz (RAQ) for use with employees and clients as part of the Retirement Readiness Index and Profile InFRE created for the Office of Personnel Management (OPM) and federal workers during the years 2003-2007.
In other work, we have shown that financial literacy is closely tied to retirement planning and retirement wealth accumulation (Lusardi et al. 2010; Behrman et al. 2010). In this special issue of the Journal of Pension Economics and Finance, we report on an international project on financial literacy patterns in seven other countries which, like the United States, have added the financial literacy questions originally designed for the U.S. Health and Retirement Study (HRS) to national surveys. In what follows, we discuss how to measure financial literacy, as well as the links between financial literacy and financial behavior. We also draw out key lessons and research questions that emerge from this international project on financial literacy around the world.
Measuring financial literacy
While it is important to assess how financially literate people are, in practice it is difficult to explore how people process economic information and make informed decisions about household finances. Perhaps because of this, relatively few researchers prior to 2000 incorporated financial literacy into theoretical models of saving and financial decision-making. Our effort, in the context of designing financial literacy measures for the US HRS, was to measure financial literacy keeping in mind four key principles:
1) Simplicity. We aimed to measure basic financial concepts, akin to the notions of the rudimentary ABC’s for reading literacy.
2) Relevance. Questions had to relate to concepts pertinent to peoples’ day-to-day financial decisions over the life cycle; moreover, they had to capture general rather than context-specific ideas.1
3) Brevity. Few representative surveys can devote much time to financial literacy topics, so the number of questions had to be kept to a minimum in order to secure widespread adoption.
4) Capacity to differentiate. We needed questions that can differentiate between financial knowledge levels, so as to compare people in terms of their scores on a common set of questions.
Our questions were designed to be included in an experimental financial literacy module for the 2004 Health and Retirement Study. In doing so, we relied on economic models of saving and portfolio choice to identify three economic concepts that individuals should have some understanding of, if they are to use them when making financial decisions:
i) interest compounding;
ii) inflation; and
iii) risk diversification.
To keep these concepts simple in the context of telephone or face-to-face interviews, we did not require respondents to engage in complicated calculations; rather, we simply evaluated whether people could carry out elementary calculations related to these concepts. To this end, we designed three questions which have now become the benchmark by which a wide variety of analysts measure financial literacy:
1) 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
Less than $102
Do not know
Refuse to answer
2) Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, how much would you be able to buy with the money in this account?
More than today
Exactly the same
Less than today
Do not know
Refuse to answer
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.”
Do not know
Refuse to answer
The first question measures numeracy or the capacity to do a simple calculation related to compounding of interest rates. Of course complex interest compounding is also important, but we elected to focus instead on whether individuals could get the general idea of calculations relating to interest rates. Our second question measures the understanding of inflation, again in the context of a simple financial decision. The third question gauges knowledge of risk diversification; it is a joint test of knowledge about “stocks” and “stock mutual funds,” and of risk diversification, since the answer to this question depends on knowing what a stock is and that a mutual fund is composed of many stocks. In view of the fact that employees are increasingly asked to select their retirement investment portfolios, it is important to ask questions related to risk diversification.2
It will also be noted that, when structuring these questions, we also specified the list of possible answers, to make it easier for people to simply select a preferred response. Moreover, respondents could indicate they did not know the answer or chose to refuse to answer, if they wished. This procedure prevented respondents from being forced to pick a numeric answer, and it also enables us to differentiate across different levels of financial knowledge.
Does financial literacy matter?
Several prior studies have shown that people who plan for retirement do, in fact, accumulate more retirement savings. For instance, Lusardi (1999) showed that a 1992 HRS question asking people how much they thought about retirement (a lot, some, a little or hardly at all) was a strong predictor of retirement wealth. In addition, the impact was quantitatively important for the HRS respondents in their mid-50s: those who thought about retirement had double the wealth of those who had not thought about retirement.
Similar findings were measured in the 2004 HRS (Lusardi and Beeler, 2007). A different question in the 2004 HRS experimental module asked whether people had even tried to calculate how much they needed to save for their retirement to measure planning (Lusardi and Mitchell, 2011). This question has also been used in the Retirement Confidence Survey (Yakoboski and Dickemper 1997) as a means of assessing whether individuals are forward-looking and attempt to calculate how much they need to save as the life cycle model implies. Results showed that those who planned for retirement accumulated three times as much wealth as those who did not (Lusardi and Mitchell, 2011).
The next question is why people fail to plan, and we argue that a key reason is because they are financially unsophisticated. Obviously planning requires making calculations, many of which are facilitated by financial literacy. For example, less sophisticated individuals who do not have a good grasp of interest compounding may engage in high-cost credit-card borrowing, or they may be more likely to pay high fees when using financial services. Lusardi and Tufano (2009) found that low literacy individuals are more likely to carry high-cost debt and to have problems with debt. More financially literate individuals tend to include stocks in their portfolios, as they better understand the principle of risk diversification (Van Rooij et al. 2011; Christelis et al. 2010).
There are also other channels via which financial literacy operates. For example higher literacy individuals may be more likely to choose funds with lower fees or be more savvy about fund expenses; for instance there is a strong correlation between financial literacy and investment in lower cost funds (Hastings and Tejeda-Ashton, 2008; Hastings et al. 2010; Hastings and Mitchell 2011).
All in all, what this review suggests is that there is a potentially important role of financial literacy in shaping retirement planning. How strong this relationship is an empirical question and the evidence across eight countries can teach us about this important relationship.
Financial literacy around the world
In collaboration with several other teams from a wide range of countries, we have started to explore how the 2004 module HRS financial literacy questions work in the international context, as well as how they relate to patterns of retirement planning. We outline several key lessons here.
First, financial illiteracy is widespread even when financial markets are well developed as in Germany, the Netherlands, Sweden, Italy, Japan, and New Zealand. Thus observed low levels of financial literacy in the U.S. are prevalent elsewhere, rather than specific to any given country or stage of economic development. Second, there are notable differences across countries. For example, where people score high on math and science tests, they also tend to score high also on questions measuring numeracy. As examples, respondents in Sweden and the Netherlands do well on math tests (e.g. the Programme for International Student Assessment; OECD, 2005) and they also score high on numeracy. Third, people are more knowledgeable about inflation if their country has experienced it recently. For example, Italians are more likely to answer the question on inflation correctly. Conversely, in a country like Japan that experienced deflation, many fewer people answer the inflation question correctly. Fourth, people are more knowledgeable about risk diversification if the country recently experience pension privatization, as in Sweden. By contrast, Russians and people born in East Germany know less about risk diversification. It is notable, however, that even in countries with very developed financial markets, many respondents state they do not know about risk diversification; for example in the U.S, as many as one-third of respondents say they do not know how to answer the risk diversification question.
Another remarkable finding has to do with persistent international sex differences in financial literacy: in most cases, women are less financially knowledgable than are men.3 Moreover, women are not only less likely to answer the questions correctly, but they are more likely to state they do not know the answers, compared to men. This is a systematic and persistent difference between men and women in financial literacy. In Russia and for residents of East Germany, there are no sex differences in financial knowledge – and both women and men are equally financial illiterate. But when comparing East versus West Germans, those living in the West are most financially knowledgeable, and financial knowledge in the West is sharply worse for women than for men. Thus it seems that women have more difficulty catching up with economic and financial market development, than do men.
The international studies of financial literacy also explore how financial literacy relates to retirement planning. In the majority of the countries studied, those who are more financially literate are more likely to plan for retirement, even after accounting for a large set of economic characteristics and economic circumstances. Given the many differences in pension schemes, privatization of pensions, and generosity of the pension system across countries, this is a remarkably consistent result. While some may argue that financial literacy is itself a choice variable so that the association between financial literacy and retirement planning may not be causal, the studies reported herein find little evidence that people invest much in financial knowledge. Indeed, it is unclear how people could improve their financial knowledge even if they wished to, given the paucity of adult education programs in several of the countries reviewed here such as Russia and Italy.
Thus, around the world, we uncover the same finding, financial literacy makes people plan more, enabling them to be more financially secure in their retirement. In sum, around the world, financial literacy is critical to retirement security.
1Relatedly, we sought a small number of questions that would be relevant across ethnic/cultural groups rather than focus on any specific market. For example questions focusing on the US mortgage market (Moore 2003) would be difficult to translate to an international context.
2 When the Enron Corporation filed for bankruptcy in 2004, it turned out that a large number of now-jobless employees had also invested their entire pension assets into their company’s now-worthless stock. It is therefore of interest to assess whether employees have learned from that event.
3This confirms US findings in Lusardi and Mitchell (2008a).
Excerpts from Financial literacy around the world: an overview; ANNAMARIA LUSARDI and OLIVIA S. MITCHELL, Journal of Pension Economics and Finance, Volume 10, Issue 04 , (October 2011), pp 497-508.
Copyright © 2011 Cambridge University Press. Reprinted with permission.