Can Your Clients Answer the ‘Big 3’ Financial Literacy Questions?

What You Need to Know

If they can’t, a new analysis warns, it’s more likely they will make costly mistakes in the effort to prepare for retirement.
Researchers say distressingly low levels of financial literacy mean it’s likely many Americans are making suboptimal financial choices.
They advocate for targeted financial literacy education both in schools and in the workplace.

The broad shift from defined benefit pensions to defined contribution retirement plans implies that most U.S. workers must now shoulder the burden of saving, investing and drawing down their own retirement assets.

This shift, in turn, means it has become increasingly important for consumers to improve their knowledge of fundamental financial concepts. It also elevates the importance of the work of financial advisors, especially those who serve clients in the middle-income and mass affluent markets.

Unfortunately, according to a new analysis published by the National Bureau of Economic Research, there is little evidence to show Americans’ financial literacy is rapidly improving, especially with respect to challenging concepts that underlie retirement income planning.

As the NBER analysis shows, the fact that so many people lack such knowledge not only makes their economic lives more difficult, it also contributes to wealth inequality and other serious problems in the economy at large.

The new NBER analysis was put together by contributing researchers Annamaria Lusardi and Olivia Mitchell. Their latest paper offers an eye-opening assessment of decades of prior research on financial literacy, which has collectively shown that the effort to improve individuals’ financial knowledge represents an important investment in human capital.

According to Lusardi and Mitchell, a significant number of convincing financial literacy studies are now available, from which the advisor industry can draw telling conclusions about the effects and consequences of financial illiteracy.

Ultimately, the researchers conclude the financial literacy gap is a clear and pressing challenge for the U.S. workforce and economy, and they propose a new framework for assessing literacy and helping individuals improve their decision-making.

The ‘Big Three’

Lusardi and Mitchell point out in their paper that they have been collaborating on this topic for nearly 20 years, having first teamed up in 2004 to create and field an experimental module on financial literacy for the landmark longitudinal Health and Retirement Study.

Their efforts eventually produced what is now known as the “big three,” a short set of questions that has allowed the research community in the U.S. and other countries to track people’s understanding of basic financial concepts.

Lusardi and Mitchell report the wording of their questions as follows:

Suppose you had $100 in a savings account and the interest rate was 2% per year. After five years, how much do you think you would have in the account if you left the money to grow? More than $102? Exactly $102? Or less than $102?
Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After one year, how much would you be able to buy with the money in this account? More than today? Exactly the same? Or less than today?
True or false? Buying a single company’s stock usually provides a safer return than a stock mutual fund.

Strikingly Low Literacy

According to Lusardi and Mitchell, testing data leveraging these questions shows financial literacy is “strikingly low” in the United States. For instance, while 81% of Americans understand simple interest rates, about three-quarters get the inflation question correct, and only 61% of the population knows that a single stock is riskier than a stock mutual fund.

Most notably, Lusardi and Mitchell warn, only 43% of the respondents are able to answer all of the questions correctly. Thus, knowledge of basic financial concepts cannot be taken for granted, they suggest, even in a country with well-developed financial markets and where the transition to defined contribution plans has been underway for decades.

“Knowledge is particularly low about risk diversification, an important and fundamental concept, but where the percentage not just of incorrect answers but also of ‘do not know’ answers is strikingly high,” the pair explain.

A Framework for Improvement

Lusardi and Mitchell say their research offers useful insights about what financial literacy courses should teach if the goal is to improve people’s lifecycle decision-making.

“For example, the ‘big three’ tell us that most people do not grasp key fundamental financial concepts, particularly financial risk and risk management,” the pair write. “We advocate covering these topics extensively and rigorously in literacy courses, building first on simpler concepts.”

According to the analysis, people must make many consequential decisions that require them to know about specific financial instruments and contracts, such as student loans, mortgages, credit cards, investments and annuities. Consumers must also be aware of their rights and obligations in the financial marketplace, Lusardi and Mitchell write.

“Moreover, planning for the future often requires complex calculations,” the pair explain. “Our research shows that much can be done to help people make savvier financial decisions.”

According to the NBER researchers, acquiring financial knowledge is a lifelong process, and for that reason, financial education will ideally also be provided after people leave high school or college. They say one approach that’s finding increasing favor is via the workplace, with such education offered in coordination with DC-style retirement plans.

Given that the costs of financial education programs need not be high, employers may find it beneficial to provide financial education for their employees, the researchers conclude. Moreover, as there are large differences in financial knowledge across demographic groups, one size will not necessarily fit all.

“For this reason, providing tailored programs will better address the needs of specific groups,” the researchers suggest. “For example, some of the observed gender differences in financial literacy may be due not only to knowledge, but also to self-confidence. Programs targeting women could therefore try to promote both.”