Academic journal article Generations

Financial Literacy and Financial Decision-Making in Older Adults

Academic journal article Generations

Financial Literacy and Financial Decision-Making in Older Adults

Article excerpt

An economist's look at the level of financial knowledge among elders, and the quality of their financial decision-making.

In the United States and other industrialized countries around the world, individuals and their families are increasingly responsible for securing their own financial well-being. Prior to the 1980s, many U.S. workers relied for their retirement income mainly on Social Security and on employersponsored defined benefit (DB) pension plans.

Today, in contrast, baby boomers are increasingly relying on defined contribution (DC) plans and Individual Retirement Accounts (IRA) to finance their golden years. Indeed, in 1980, about 40 percent of private sector pension contributions went to DC plans; by the year 2000, almost 90 percent of such contributions went to personal accounts-mostly 401(k) plans (Poterba, Venti, and Wise, 2008).

The transition to the DC retirement saving model has the advantage of permitting more worker flexibility and labor mobility than in the past, yet it also imposes a greater responsibility on individuals to save, invest, and later decumulate their retirement wealth sensibly. Furthermore, the spread of DC plans means that workers today are directly and immediately exposed to financial market risks, a reality that was less evident in the old DB system.

Many DB plans have been frozen or terminated, and individually managed accounts will increasingly become the mainstay of retirement. For these reasons, individuals are increasingly called to "roll their own" retirement saving and decumulation plans, and their financial security in retirement will depend upon their own financial decisions and behavior.

At the same time, the financial landscape has become more challenging for the individual investor. Financial markets have become more complex, offering products that are often difficult to understand. Moreover, new products and financial services have become increasingly accessible to the small investor, and the expansion of consumer credit has increased opportunities to borrow.

Whether individuals-in particular, older individuals- are equipped to deal with this new financial landscape is an important question that has implications for both policy and for care providers. This article provides some evidence on what we know about both the level of financial knowledge among the elderly, and the quality of their financial decision-making.

What Is Financial Literacy?

Together with Olivia Mitchell, I designed a survey module to measure financial literacy, defined as the knowledge of basic financial investment concepts such as inflation and risk diversification and the capacity to do calculations related to interest rates (Lusardi and Mitchell, 2011a). The questions asked in this survey module, which first appeared in the 2004 Health and Retirement Study (HRS)- a survey covering respondents who are ages 50 and older- are as follows:

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 leftthe money to grow: more than $102, exactly $102, less than $102? Do not know; refuse to answer.

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? Do not know; refuse to answer.

Do you think that the following statement is true or false? "Buying a single company stock usually provides a safer return than a stock mutual fund." Do not know; refuse to answer.

Assessing financial literacy and financial knowledge

Responses to these three questions revealed a very low level of financial literacy among the older U.S. population: only about one-half of the HRS respondents could do a simple 2 percent calculation and demonstrate an understanding of inflation; only one-third of respondents could correctly answer all three questions (Lusardi and Mitchell, 2011a). …

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