June 2007

Financial Literacy and Planning: Implications for Retirement Wellbeing

Why do so few Americans feel they have saved adequately for their retirement? Little is known about why people fail to plan for retirement and whether wide variations in Americans' financial knowledge may affect their decisions about how much to save and which investments to hold.

At this event, Dartmouth College economist Annamaria Lusardi presented the results of her research on the impact of financial literacy on retirement planning. Christopher D. Carroll, professor of economics at Johns Hopkins University, and AEI's Steven J. Davis commented on her findings. AEI's Kevin A. Hassett moderated. This event took place on June 14, 2007 at AEI.

Annamaria Lusardi
Dartmouth College

People should plan for the future and have knowledge of basic economic principles in order to retire with enough of a financial cushion to last the rest of their lives. To assess the level of elementary economic knowledge in older people, we asked three basic questions. Only 34 percent answered all three questions correctly. Upon further examination of the respondents, it is evident that education and race play a large role in financial literacy. Caucasians answered better than African-Americans and Hispanics, and college graduates responded correctly much more often than those with less education. Financial literacy was also found to be low among respondents over the age of seventy.

Of those polled, 31.1 percent said they had tried to figure how much their household would need for retirement. People who do plan generally have higher wealth and better portfolio choices. Incorrect answers on the first three questions correlate strongly with poor planning.

This study suggests that financial literacy cannot be taken for granted, and that there is a widespread lack of retirement planning in the older population. Financial education programs are a good way to educate workers closing in on retirement. They can help people plan much better and, when simple, can do much more than conceptually difficult economic programs. Even simple procedures can inspire people to enroll in supplementary pensions and look ahead to retirement before it is too late.

Christopher D. Carroll
Johns Hopkins University

Financial knowledge leads to smart investment and better planning for the future. The consequences of incorrect financial knowledge are much larger than the consequences of error with other categories of knowledge. Once a mistake is made, there is little opportunity for correction. This illiteracy is not confined to the poor and "stupid"; it is widespread across wealthy taxpayers and lower-class citizens alike.

Financial options like subprime loans can be hazardous because of their higher-than-normal interest rates, and they often pit virtuous, reliable borrowers against those that will be slow to pay back their loans. A Social Security pension policy is a good option that could allow markets to help the financially illiterate populace. Annuitization can be made the default upon retirement to allow retirees to know how their money translates on a year-to-year basis. Additionally, annual reporting of Equivalent Retirement Income could be required.

Steven J. Davis
AEI

Do the people polled in Lusardi's study misinterpret the concepts in the questions or the questions themselves in how they are worded? Maybe they know about diversification, but are not familiar with mutual funds. Do people understand the term "plan" like an economist? How much weight can we put on the figures from the study? Better-structured questions would generate much different results.

The setup of Lusardi's argument suggests that financial literacy and planning will result in wealth, but wealth also leads to higher financial literacy and better planning. The progression runs both ways. More wealth leads to larger payoffs on investments and makes advice on financial planning much more affordable.

The inability of financially illiterate individuals to predict the future and use economic tools to their advantage can lead to cognitive limitations and poor planning for the future. Financial education programs would generate more literacy, more investment and wealth, and superior financial planning for the immediate future as well as retirement.

AEI intern Douglas Wigley prepared this summary.