Financial Literacy JEP 2014

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<ul><li><p>8/10/2019 Financial Literacy JEP 2014</p><p> 1/40</p><p>Journal of Economic Literature 2014, 52(1), 544</p><p>5</p><p>1. Introduction</p><p>Financial markets around the world havebecome increasingly accessible to thesmall investor, as new products and finan-cial services grow widespread. At the onsetof the recent financial crisis, consumer creditand mortgage borrowing had burgeoned.People who had credit cards or subprimemortgages were in the historically unusualposition of being able to decide how muchthey wanted to borrow. Alternative financial</p><p>*Lusardi: George Washington University. Mitchell:University of Pennsylvania. The research reported herein</p><p>was performed pursuant to a grant from the TIAACREF</p><p>Institute; additional research support was provided bythe Pension Research Council and Boettner Center atthe Wharton School of the University of Pennsylvania.The authors thank Janet Currie, Tabea Bucher-Koenen,Pierre-Carl Michaud, Maarten van Rooij, and StephenUtkus for suggestions and comments, and Carlo de BassaScheresberg, Hugh Kim, Donna St. Louis, and Yong Yu forresearch assistance. Opinions and conclusions expressedherein are solely those of the authors and do not representthe opinions or policy of the funders or any other institu-tions with which the authors are affiliated.</p><p> Go to to visit thearticle page and view author disclosure statement(s).</p><p>The Economic Importanceof Financial Literacy:Theory and Evidence</p><p>A L O S. M*</p><p>This paper undertakes an assessment of a rapidly growing body of economic researchon financial literacy. We start with an overview of theoretical research, which casts</p><p>financial knowledge as a form of investment in human capital. Endogenizing financialknowledge has important implications for welfare, as well as policies intended toenhance levels of financial knowledge in the larger population. Next, we draw onrecent surveys to establish how much (or how little) people know and identify theleast financially savvy population subgroups. This is followed by an examination of</p><p>the impact of financial literacy on economic decision making in the United States andelsewhere. While the literature is still young, conclusions may be drawn about theeffects and consequences of financial illiteracy and what works to remedy these gaps.</p><p>A final section offers thoughts on what remains to be learned if researchers are to</p><p>better inform theoretical and empirical models as well as public policy. (JEL A20,D14, G11, I20, J26)</p></li><li><p>8/10/2019 Financial Literacy JEP 2014</p><p> 2/40</p><p>Journal of Economic Literature, Vol. LII (March 2014)6</p><p>services including payday loans, pawn shops,auto title loans, tax refund loans, and rent-to-own shops have also become widespread.1Atthe same time, changes in the pension land-scape are increasingly thrusting responsibil-ity for saving, investing, and decumulatingwealth onto workers and retirees, whereasin the past, older workers relied mainly onSocial Security and employer-sponsoreddefined benefit (DB) pension plans in retire-ment. Today, by contrast, Baby Boomersmainly have defined contribution (DC) plansand Individual Retirement Accounts (IRAs)during their working years. This trendtoward disintermediation is increasingly</p><p>requiring people to decide how much to saveand where to invest and, during retirement,to take on responsibility for careful decumu-lation so as not to outlive their assets whilemeeting their needs.2</p><p>Despite the rapid spread of such finan-cially complex products to the retail market-place, including student loans, mortgages,credit cards, pension accounts, and annuities,many of these have proven to be difficult forfinancially unsophisticated investors to mas-ter.3 Therefore, while these developmentshave their advantages, they also impose onhouseholds a much greater responsibility toborrow, save, invest, and decumulate theirassets sensibly by permitting tailored finan-cial contracts and more people to accesscredit. Accordingly, one goal of this paper isto offer an assessment of how well-equippedtodays households are to make these com-plex financial decisions. Specifically we focus</p><p>onfinancial literacy, by which we mean peo-</p><p>1 See Lusardi (2011) and FINRA Investor EducationFoundation (2009, 2013).</p><p>2 In the early 1980s, around 40 percent of U.S.private-sector pension contributions went to DC plans;two decades later, almost 90 percent of such contributions</p><p>went to retirement accounts (mostly 401(k) plans; Poterba,Venti, and Wise 2008).</p><p>3 See, for instance, Brown, Kapteyn, and Mitchell(forthcoming)</p><p>ples ability to process economic informationand make informed decisions about financialplanning, wealth accumulation, debt, andpensions. In what follows, we outline recenttheoretical research modeling how financialknowledge can be cast as a type of investmentin human capital. In this framework, thosewho build financial savvy can earn above-average expected returns on their invest-ments, yet there will still be some optimallevel of financial ignorance. Endogenizingfinancial knowledge has important implica-tions for welfare, and this perspective alsooffers insights into programs intended toenhance levels of financial knowledge in the</p><p>larger population.Another of our goals is to assess the effects</p><p>of financial literacy on important economicbehaviors. We do so by drawing on evidenceabout what people know and which groupsare the least financially literate. Moreover,the literature allows us to tease out theimpact of financial literacy on economicdecision making in the United States andabroad, along with the costs of financial igno-rance. Because this is a new area of economicresearch, we conclude with thoughts on poli-cies to help fill these gaps; we focus on whatremains to be learned to better inform theo-retical/empirical models and public policy.</p><p>2. A Theoretical Frameworkfor Financial Literacy</p><p>The conventional microeconomicapproach to saving and consumption</p><p>decisions posits that a fully rational andwell-informed individual will consume lessthan his income in times of high earnings,thus saving to support consumption whenincome falls (e.g., after retirement). Startingwith Modigliani and Brumberg (1954) andFriedman (1957), the consumer is positedto arrange his optimal saving and decumula-tion patterns to smooth marginal utility overhis lifetime. Many studies have shown how</p></li><li><p>8/10/2019 Financial Literacy JEP 2014</p><p> 3/40</p><p>7Lusardi and Mitchell: The Economic Importance of Financial Literacy</p><p>such a life cycle optimization process can beshaped by consumer preferences (e.g., riskaversion and discount rates), the economicenvironment (e.g., risky returns on invest-ments and liquidity constraints), and socialsafety net benefits (e.g., the availability andgenerosity of welfare schemes and SocialSecurity benefits), among other features.4</p><p>These microeconomic models gener-ally assume that individuals can formulateand execute saving and spend-down plans,which requires them to have the capacity toundertake complex economic calculationsand to have expertise in dealing with finan-cial markets. As we show in detail below,</p><p>however, few people seem to have muchfinancial knowledge. Moreover, acquiringsuch knowledge is likely to come at a cost.In the past, when retirement pensions weredesigned and implemented by governments,individual workers devoted very little atten-tion to their plan details. Today, by contrast,since saving, investment, and decumulationfor retirement are occurring in an increas-ingly personalized pension environment, thegaps between modeling and reality are worthexploring, so as to better evaluate wherethe theory can be enriched, and how policyefforts can be better targeted.</p><p>Though there is a substantial theoreticaland empirical body of work on the econom-ics of education,5far less attention has beendevoted to the question of how people acquireand deploy financial literacy. In the last fewyears, however, a few papers have begun to</p><p>4 For an older review of the saving literature seeBrowning and Lusardi (1996); recent surveys are providedby Skinner (2007) and Attanasio and Weber (2010). A</p><p>very partial list of the literature discussing new theoreticaladvances includes Cagetti (2003); Chai et al. (2011); DeNardi, French, and Jones (2010); French (2005); French(2008); Gourinchas and Parker (2002); Aguiar and Hurst(2005, 2007); and Scholz, Seshadri, and Khitatrakun(2006).</p><p>5 Glewwe (2002) and Hanushek and Woessmann (2008)review the economic impacts of schooling and cognitivedevelopment.</p><p>examine the decision to acquire financialliteracy and to study the links betweenfinancial knowledge, saving, and investmentbehavior (Delavande, Rohwedder, and Willis2008; Jappelli and Padula 2013; Hsu 2011;and Lusardi, Michaud, and Mitchell 2013).6For instance, Delavande, Rohwedder, andWillis (2008) present a simple two-periodmodel of saving and portfolio allocationacross safe bonds and risky stocks, allow-ing for the acquisition of human capital inthe form of financial knowledge ( la Ben-Porath 1967, and Becker 1975). That workposits that individuals will optimally elect toinvest in financial knowledge to gain access</p><p>to higher-return assets: this training helpsthem identify better-performing assets and/or hire financial advisers who can reduceinvestment expenses. Hsu (2011) uses asimilar approach in an intrahousehold set-ting where husbands specialize in the acqui-sition of financial knowledge, while wivesincrease their acquisition of financial knowl-edge mostly when it becomes relevant (suchas just prior to the death of their spouses).Jappelli and Padula (2013) also consider atwo-period model but additionally sketch amultiperiod life cycle model with financialliteracy endogenously determined. Theypredict that financial literacy and wealth willbe strongly correlated over the life cycle,with both rising until retirement and fallingthereafter. They also suggest that, in coun-tries with generous Social Security benefits,there will be fewer incentives to save andaccumulate wealth and, in turn, less reason</p><p>to invest in financial literacy.</p><p>6 Another related study is by Benitez-Silva, Demiralp,and Liu (2009) who use a dynamic life cycle model of opti-mal Social Security benefit claiming against which theycompare outcomes to those generated under a sub-optimalinformation structure where people simply copy thosearound them when deciding when to claim benefits. Theauthors do not, however, allow for endogenous acquisitionof information.</p></li><li><p>8/10/2019 Financial Literacy JEP 2014</p><p> 4/40</p><p>Journal of Economic Literature, Vol. LII (March 2014)8</p><p>Each of these studies represents a usefultheoretical advance, yet none incorporateskey features now standard in theoreticalmodels of savingnamely borrowing con-straints, mortality risk, demographic fac-tors, stock market returns, and earnings andhealth shocks. These shortcomings are recti-fied in recent work by Lusardi, Michaud, andMitchell (2011, 2013), which calibrates andsimulates a multiperiod dynamic life cyclemodel where individuals not only selectcapital market investments, but also under-take investments in financial knowledge.This extension is important in that it permitsthe researchers to examine model implica-</p><p>tions for wealth inequality and welfare. Twodistinct investment technologies are con-sidered: the first is a simple technology thatpays a fixed low rate of return each period(_</p><p>R = 1 +_</p><p>r ), similar to a bank account,while the second is a more sophisticatedtechnology providing the consumer accessto a higher stochastic expected return, R(ft),which depends on his accumulated level offinancial knowledge. Each period, the stockof knowledge is related to what the individualhad in the previous period minus a depre-ciation factor: thus f</p><p>t+1=ft+it, where </p><p>represents knowledge depreciation (due toobsolescence or decay) and gross investmentin knowledge is indicated with it. The sto-chastic return from the sophisticated tech-nology follows the process R(ft+1) =</p><p>_</p><p>R +r(ft+1) +t+1 (where t is a N(0, 1) iidshock and refers to the standard devia-tion of returns on the sophisticated technol-</p><p>ogy). To access this higher expected return,the consumer must pay both a direct cost (c)and a time and money cost () to build upknowledge.7</p><p>7 This cost function is assumed to be convex, thoughthe authors also experiment with alternative formulations,</p><p>which do not materially alter results. Kzdi and Willis(2011) also model heterogeneity in beliefs about the stockmarket, where people can learn about the statistical pro-cess governing stock market returns, reducing transactions</p><p>Prior to retirement, the individual earnsrisky labor income (y) from which he canconsume or invest so as to raise his return (R)on saving (s) by investing in the sophisticatedtechnology. After retirement, the individualreceives Social Security benefits, which area percentage of preretirement income.8Additional sources of uncertainty includestock returns, medical costs, and longevity.</p><p>Each period, therefore, the consumers deci-sion variables are how much to invest in thecapital market, how much to consume (),and whether to invest in financial knowledge.</p><p>Assuming a discount rate of and o, y,and , which refer, respectively, to shocks in</p><p>medical expenditures, labor earnings, andrate of return, the problem takes the formof a series of Bellman equations with the fol-lowing value function Vd(st) at each age aslong as the individual is alive (pe,t &gt;0):</p><p> Vd(st) = maxct,it,t</p><p>ne,tu (ct/ne,t)</p><p> + pe,t</p><p>y</p><p>oV (st+1) dFe</p><p>(o) dF</p><p>e(</p><p>y) dF ().</p><p>The utility function is assumed to be strictlyconcave in consumption and scaled using thefunctionu(ct/nt), wherentis an equivalencescale capturing family size which changespredictably over the life cycle; and by educa-tion, subscripted by e. End-of-period assets(a</p><p>t+1) are equal to labor earnings plus the</p><p>returns on the previous periods saving plustransfer income (tr), minus consumption</p><p>and costs of investment in knowledge (aslong as investments are positive; i.e., &gt;0).</p><p>costs for investments. Here, however, the investment costwas cast as a simplified flat fixed fee per person, whereasLusardi, Michaud, and Mitchell (2013) evaluate morecomplex functions of time and money costs for investmentsin knowledge.</p><p>8 There is also a minimum consumption floor; seeLusardi, Michaud, and Mitchell (2011, 2013).</p></li><li><p>8/10/2019 Financial Literacy JEP 2014</p><p> 5/40</p><p>9Lusardi and Mitchell: The Economic Importance of Financial Literacy</p><p>Accordingly,</p><p> at+1</p><p>=R(ft+1)(at+ye,t+trtct</p><p>(it) cdI (t&gt;0)).9</p><p>After calibrating the model using plausibleparameter values, the authors then solvethe value functions for consumers with low/medium/ high educational levels by back-ward recursion.10 Given paths of optimalconsumption, knowledge investment, andparticipation in the stock market, they thensimulate 5,000 life cycles allowing for return,income, and me...</p></li></ul>