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The high price of financial illiteracy

Here is a test. Suppose you had $100 in a savings account that paid an interest rate of 2 percent a year. If you leave the money in the account, how much would you have accumulated after five years: more than $102, exactly $102, or less than $102?

And would an investor who received 1 percent interest when inflation was 2 percent see his spending power rise, fall or stay the same?

This test might seem a little simple. But a survey found that only half of Americans older than 50 gave the correct answers. If so many people are mathematically challenged, it is hardly surprising that they struggle to deal with the small print of mortgage and insurance contracts.

The solution seems obvious: Provide more financial education. But is it possible to teach people to be more financially savvy? A survey by the Federal Reserve Bank of Cleveland reported that: "Unfortunately, we do not find conclusive evidence that, in general, financial education programs do lead to greater financial knowledge and ultimately to better financial behavior."

This is especially the case when children are taught the subject at school, often well before they have to deal with the issues personally. Surveys by the Jump$tart Coalition for Personal Financial Literacy, a campaign group, found that American students who had taken courses in personal finance or money management were no more financially literate than those who had not.

A detailed survey of students from a Midwestern state found that those who had not taken a financial course were more likely to pay their credit card in full every month (avoiding fees and charges) than those who had actually studied the subject.

Perhaps the answer is to teach people when the issues are more relevant. That was the conclusion of the Cleveland Fed researchers, who recommended that programs be targeted at specific individuals, such as those making a house purchase or struggling with credit-card debts. There is evidence that employees who receive training about the benefits of pension plans are more likely to join schemes and to save more when they do.

But even this approach has its problems. Consumer enthusiasm for learning about finance is limited. When a free online financial-literacy course was offered to struggling credit card borrowers, only 0.4 percent logged on to the website and just 0.03 percent completed the course. Those who choose to be educated about finance may be those who are already interested and relatively well-informed about it.

Making such education mandatory for consumers would be expensive. And who would pay for it? Governments have many claims on their cash. Financial firms might sponsor such courses but would the resulting advice be entirely objective?

Furthermore, many consumers do not want to make their own financial decisions, either because they find the issues too complex or because they fear the consequences of choosing the wrong option.

They would rather leave the decisions in the hands of an adviser or rely on the experience of family and friends. When firms offer a range of pension funds to choose from, the default option is by far the most popular. Governments should focus on making that option as safe and inexpensive as possible.

So should we give up on financial education altogether? Not necessarily. The purpose of education is to prepare children for the challenges they face in life. Coping with finance is one of those challenges.

It may be that better-designed courses can be more successful: replacing yakking lecturers with financially themed video games is one way that people are trying to make education more appealing. None of this, alas, will help if students cannot understand basic math. As the saying goes, there are 10 types of people: those who understand binary numbers and those who don't.

© 2013 The Economist

The high price of financial illiteracy 03/04/13 [Last modified: Monday, March 4, 2013 3:57pm]
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