NATIONAL BUREAU OF ECONOMIC RESEARCH
NATIONAL BUREAU OF ECONOMIC RESEARCH

Financial Literacy, Planning, and Retirement Saving

Individuals are increasingly responsible for making decisions that determine their financial security in retirement. With the shift in private pensions from defined benefit to defined contribution (401(k)-style) plans, most workers must now decide whether and how much to contribute to their pension plan, how to invest fund balances, and how to draw down funds after retirement. Moreover, the array and complexity of financial products offered to individuals for their investments both inside and outside of retirement accounts is increasing.

These trends raise important questions. Do individuals know enough about financial concepts and the specifics of their pen-sion plan and Social Security benefits to make informed retirement savings decisions? Do individuals even plan for retirement? What are the most effective approaches to promote better financial decision-making and enhance retirement security? These questions are the subject of a new working paper by researcher Annamaria Lusardi, "Household Saving Behavior: The Role of Financial Literacy, Information, and Financial Education Programs". (NBER Working Paper 13824). The paper summarizes previous work with researcher Olivia Mitchell and presents new evidence on financial literacy, planning, and saving.

In her earlier work, Lusardi used data from the Health and Retirement Study (HRS) to examine whether people plan for retirement. She found that nearly one-third of workers age 50 and older have not thought at all about retirement, a finding that is confirmed in her work with Olivia Mitchell using more recent waves of the HRS. Lack of planning is concentrated among groups that are at higher risk for financial insecurity in retirement, including those with low education, African-Americans and Hispanics, and women. Even among those who have tried to plan for retirement, relatively few are able to develop a plan and stick to it - fewer than one in five respondents fall into this category.

A second factor that affects individuals' ability to save adequately for retirement - and indeed, that may be related to their planning behavior - is their level of information about financial concepts and retirement benefits. Social Security and private pension benefits make up half of retirement wealth for a typical family and an even larger share for low-income families, so understanding these benefits is essential for retirement planning. Previous studies have found that many individuals are poorly informed about these benefits. For example, many workers do not know whether their pension is a defined benefit or defined contribution-style plan or the age at which they are entitled to full Social Security benefits. This lack of information is concentrated among the same groups that fail to plan.

To assess knowledge of financial concepts, Lusardi and Mitchell devised a special module on financial literacy for the 2004 HRS. Findings from this module reveal an "alarmingly low" level of financial literacy among older individuals. Only half of respon-dents were able to correctly answer two simple questions about interest rates and inflation; this figure falls to one-third when a third question about the relative risk of investing in a single company stock vs. a stock mutual fund is added. In a related study of literacy among early baby boomers, only half of respondents could do a simple math calculation (divide $2 million by five) and fewer than one in five could correctly calculate compound interest over two years. Again, the lack of literacy is concentrated among the groups that fail to plan.

Does lack of financial literacy matter? As the author notes, lack of literacy may be inconsequential if individuals get help in making financial decisions or if financial literacy is unrelated to financial decision-making. To address the latter point, Lusardi and Mitchell examine whether literacy is an important determinant of retirement planning . Even after accounting for demographic characteristics such as education, race, and gender, they find that financial literacy affects retirement planning. To show that this represents a causal effect of literacy on planning and not the reverse (as might be the case if those who want to plan invest in acquiring financial knowledge), they use data on financial literacy early in life that was obtained from a module they designed for the Rand American Life Panel. They find that those who are financially literate when young are more likely to plan for retirement many years later.

The author also notes that many people are reluctant to rely on advice from financial experts - one study found that only half of workers would take advantage of investment advice offered by companies managing their employer-sponsored pension plan, and many of these would follow the advice only if it was in line with their own ideas. Most individuals rely on family and friends for financial advice. This is particularly true for the less educated, which is a particular concern since their peer group is likely to consist of others with low levels of financial literacy.

Finally, Lusardi examines options for improving financial decision-making and retirement security. One option is financial education, such as retirement seminars offered through the workplace. It is notoriously difficult to assess the value of such semi-nars, since those who choose to attend may be systematically different from other workers (for example, more interested in plan-ning) and workers at firms that offer seminars may be different from workers at other firms (for example, seminars are often offered at firms where workers do little or no saving). Most of the evidence suggests financial education has, at best, a modest effect on saving.

A second option is automatic enrollment in employer-provided pension plans. This feature has been shown to increase pension participation. Since workers tend to stay with the default participation level and asset allocation, it is important that these be chosen carefully to help workers achieve financial security in retirement. For example, a low contribution rate or very conservative asset allocation may leave workers with insufficient retirement assets.

A third option is to find new tools to simplify saving decisions. One tool that has been proposed and successfully tested by the author is a planning aid that is distributed to new hires during employee orientation. The aid breaks down the enrollment process into seven easy steps and provides useful information such as the minimum and maximum allowable employee contri-bution to the pension plan. The author finds that contribution rates to the pension plan tripled after the introduction of the planning aid.

In conclusion, the author notes that financial literacy cannot be taken for granted, particularly among specific groups, such as women and the less educated, and that it may be important to devise programs tailored to the needs of these groups. More broadly, poor financial literacy and a lack of planning may lead individuals to make financial mistakes, such as not saving enough for retirement or investing in assets that are too risky or too conservative. She concludes: "If taxpayers will be asked to support those who have made mistakes, there is a role for regulation and for implementing 'mandatory' programs," such as requiring people to acquire some basic financial knowledge.

 
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