The Pension Research Council

MARKETWATCH: Financial illiteracy hinders savings

MARCH 2011

By Robert Powell
Sunday, March 20, 2011


Few would argue that we have a retirement crisis in America. What people might debate is how we solve the problem.

Slowly but surely, however, researchers are producing work that offers much-needed insight into how we can reduce the severity of the problem. Case in point: A working paper just published by the National Bureau of Economic Research, on two explanations for why consumers have trouble with financial decisions.

"One is that people are financially illiterate since they lack understanding of simple economic concepts and cannot carry out computations, such as computing compound interest, which could cause them to make suboptimal financial decisions," wrote Olivia Mitchell, the director of the Pension Research Council, and Justine Hastings, an economics professor at Yale University, in their paper, "How Financial Literacy and Impatience Shape Retirement Wealth and Investment Behaviors."

"A second is that impatience or present-bias might explain suboptimal financial decisions. That is, some people persistently choose immediate gratification instead of taking advantage of larger long-term payoffs."

In other words, people generally don't know much, if anything, about money. And two, consumers -- even when they are financially literate -- sometimes can't help themselves from making bad decisions. It's the way we are wired. The lizard part of our brain overrules the more rational part when it comes to things financial. The lizard part of the brain says that the joy of spending (or not saving) today is greater than the pleasure of having a nest egg later on.

"Impatience or present bias seems to be an inability to plan for long-term consequences," said Stephen P. Utkus, a principal with the Vanguard Center for Retirement Research. "It may be a learned trait from family and peers, or it may be inherited. There is some evidence from neuroeconomics that impatience may be related to certain brain structures.

"The argument is that the executive function of the brain, the prefrontal cortex, sometimes has difficulty executing long-term plans -- either perhaps because the prefrontal cortex might be deficient in some way, or because more automatic and visceral processes in the brain overrule it," he said.

Others agree. "We have a natural tendency to avoid things that make us feel uncomfortable, said Bill McClain, a principal with Mercer. "If you feel like your retirement situation is hopeless and you don't understand it, you will put it off."

So what lessons can be learned from the latest paper on the subject? What can consumers, lawmakers, plan sponsors, plan providers, and other interested parties do to solve the retirement crisis? The answer lies in part with more education and more automatic features in plans. Basically, more learning and more tricks that overcome our innate behavior.

In a world where a growing number of people are being asked to save on their own for retirement, where defined-benefit plans don't exist, and Social Security will pay out just 70 percent of the projected benefit, it's time to make financial education a mandatory part of the school curriculum, starting in kindergarten and straight through 12th grade.

To be fair, there is debate on this issue. "Financial literacy is correlated with wealth, though it appears to be a weaker predictor of sensitivity to framing in investment decisions," wrote Mitchell.

Other experts agree that more financial education is necessary but they say it's not the end-all be-all. "Financial literacy, while important and lacking, is necessary but not sufficient," said Michael Falcon, head of retirement at J.P. Morgan Asset Management. "We have some behavior biases that are so strong that they make us make bad decisions."

And for many people, or at least those who are not predisposed to saving, the only way to overcome those biases is to make sure we continue to add auto-everything to retirement plans, auto-enrollment, auto-escalation, and auto-rebalancing. "It is the most effective means that we have for driving retirement behavior," Falcon said.

With auto-enrollment, for instance, experts said participants can use inertia to their benefit. "Once you enroll in a workplace retirement plan, you're likely to stay enrolled," said Jamie Kalamarides, the senior vice president of retirement strategies and solutions at Prudential Retirement. "Participants should view the arrival of their monthly statement as a positive reminder of the investment they're making in their future."

Others, meanwhile, say Mitchell's paper reinforces the notion that behavior is both innate and learned. "Education and literacy on a particular issue is important," Utkus said. "The paper reminds us that the world isn't simply 'all behavioral' -- people also need better training and education to make good decisions. You can't solve every financial or health problem through defaults or framing."

Still, until the day comes when everyone is financially literate, auto-features will need to become more rather than less common. Yes, there are some people who for whatever reason don't yield to the impatience and can figure out, people who, as Falcon put it, are "dialed into" saving for retirement and doing the right thing.

Said Mitchell: "The forward-looking plan for and then implement a wide range of investments in themselves and their future."

But for the vast majority of Americans, Mitchell said, "Our results imply that it may be useful to facilitate decision making, particularly among the less-educated, as well as to facilitate people committing to and carrying out long-term financial decisions."

In other words, Mitchell said, plan sponsors and policymakers "seeking to enhance employee participation in, and contributions to, retirement saving programs would do well to invest in product simplification and better marketing, clearly describing to their workers the costs and benefits of different funds as well as the importance of fees in this decision.

"And to the extent that parents, teachers, doctors, and other leaders can teach the young to curb their impatience, this could have important and very positive long-term effects on a wide range of outcomes over the lifetime."