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
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.
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 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?
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 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?
Financial literacy: Correct answers
Number of correct financial literacy questions
___________________________________________________
N correct responses
________________________
% of respondents
________________________
None
1.8
1
1.2
2
7.3
3
18.2
4
27.7
All
43.8
___________________________________________________
N= 989
Sophisticated financial literacy questions
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 (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
Q1. Main function of the stock
market
Q2. Knowledge of mutual fund.
Q3. Relation between interest
rate and bond prices
Q4. What is safer: company
stock vs stock mutual fund
Q5. Which is riskier: stocks
vs bonds
Q6. Highest return over long
period: savings accounts, bonds
or stocks
Q7. Highest fluctuations: savings
accounts, bonds, stocks
Q8. Risk diversification
Correct
Incorrect
DK
Refusal
71.5%
20.2%
8.3%
0.0%
63.0%
13.6%
23.3%
0.0%
31.6%
43.8%
24.5%
0.1%
71.4%
4.0%
24.5%
0.0%
80.2%
5.4%
14.4%
0.1%
62.3%
27.5%
10.1%
0.1%
88.3%
74.9%
4.5%
18.4%
7.1%
6.7%
0.0%
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
1
2
3
4
N
__________________________________________________________________________________
1 (very low)
75.6
19.1
5.3
0.0
10
2
56.2
29.7
12.5
1.6
43
3
53.4
24.6
19.8
3.1
115
4
50.4
21.0
22.7
6.0
269
5
27.1
22.4
29.0
21.6
343
6
18.2
20.3
35.8
25.7
165
7 (very high)
29.1
4.6
13.6
52.7
44
__________________________________________________________________________________
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 lot
26.5
Somewhat
43.0
A little
16.6
Hardly at all
14.0
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
Adv. Literacy Index
Demographics
OLS
IV
0.163***
(0.062)
yes
0.493***
(0.116)
yes
F value 1st stage
4.12
Hansen J test (p val)
0.04
N obs
989
936
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
N = 989
Adv. Literacy Index
Demographics
F value 1st stage
OLS
IV
0.163***
(0.062)
yes
0.993**
(0.443)
yes
10.14
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