Field Work

Financial Education Strategies Need Work

Brigitte Madrian

In a September paper distributed by the National Bureau of Economic Research, Professor Brigitte Madrian and her co-authors reviewed the current state of U.S. financial education.  In an interview, Madrian, a professor in Harvard University’s John F. Kennedy School of Government, provided some fresh insights into education, regulation, and the role of the financial industry.

Q:  Besides low financial literacy, why do people make bad financial decisions?

A:  Procrastination.  Inattention – one reason people accrue credit card late fees is that they forget to pay their bills on time.  Advertising – people are swayed by the marketing of financial services and products.  Not all products pushed by financial advisers or financial-services companies are appropriate for everyone, and sometimes people are swayed into purchasing products that may be right for someone else but aren’t right for them.

Q:  Does financial education even work?

A:  I believe the jury is out.  We do not have a lot of compelling evidence on the impact of financial literacy programs.  There have been lots of studies on programs, but many of them are of dubious scientific validity.  Of the ones that are more credible in terms of methodology, some find very little impact on financial education and a handful find financially positive effects.

One co-author on this paper, Bill Skimmyhorn, is on the faculty at West Point.  He wrote a paper analyzing a mandatory personal finance course that everyone in the Army has to take.  He finds that the course increases participation in the military’s Thrift Savings Plan and also leads to less debt like car loans.  The nice thing about his study is that it has lots of people, and he finds beneficial effects of financial literacy in multiple domains.  But the reason his study is so interesting is because it’s so unusual.  We need more research on what works and why it works.

Q:  Is it important to recognize that financial decisions today seem very complex?

A:  Yes. Many of the financial decisions individuals are making are more complicated than they were in the past, and that’s in part because financial products have become more complicated.  It’s also in part because there are more financial products and decisions that need to be made, so making tradeoffs across different domains is more complicated.  A good example would be saving: there are at least a dozen different tax-favored ways to save.  How do you decide if you should be saving with a 401(k) or an IRA or a 529 college savings plan?  Thirty years ago, these savings vehicles didn’t exist.

Q:  Your paper includes myriad examples of financial mistakes.  Can you name one that’s particularly egregious?

If I had to pick one area where large numbers of people are making mistakes that can have sizable financial consequences, it would have to be investment allocation.  There is a lot of evidence that many people do not understand the properties of different investment products.  They don’t know what kind of assets underlie these investments.  They don’t know what the risks are.  They don’t know what a typical rate of return might be.  They don‘t know the fees.  As a result, people are making investment choices that they don’t understand very well.

Sometimes they’re investing in inappropriate products like employer stock, because they don’t understand the risks.  If you’re investing in your company, the fortunes of your paycheck are tied to the fortunes of your investment.  That’s really undiversified.  People don’t understand diversification so they will invest in two different investment products that are fairly similar and think they’re diversified simply because they’ve got more than one.  They don’t understand that fees are something you should pay attention to, and they don’t understand what a reasonable or unreasonable fee is.  We have been asking people to take more control, but they don’t necessarily have the skills to manage well.

Q:  Do we know how to measure financial literacy?

A:  There hasn’t been a lot of effort devoted to the best way to assess financial literacy.  The Big 3 and the Big 5 questions have gotten a lot of attention in the literature.  They have the advantage that they are parsimonious and have been linked to various financial outcomes but there aren’t a lot of benchmarks against which to compare them.  The JumpStart Coalition has been giving financial literacy surveys to high school and college students that have many more questions.  There hasn’t been a lot of rigorous research examining what types of financial literacy questions are most predictive of financial outcomes.

Q: You say that measuring outcomes is an alternative to quizzes and surveys.  What do you mean?

A:  One alternative approach to measuring financial capability would be to look at the actual financial outcomes that individuals experience to see whether certain people are making common mistakes across a variety of domains.  For example, let’s suppose you had data on all the financial decisions everyone was making, and you notice that the people with credit card late payment fees are the same people who are likely to invest too much in employer stock and are the same people who are behind on their mortgage.  You might paint a picture of people who are consistently experiencing outcomes that would appear to be suboptimal.  Does that behavior better characterize limited financial capabilities than a survey?  The data requirements are huge, but there is more data and computational ability to do it than ever before.  We’re still a long way from being able to do that, but it’s an interesting possibility.

Q:  Do tests measure information rather than behavior, and is behavior more important?

A:  Some tests measure computational skills, and to some extent they measure understanding of basic financial concepts.  One thing that an outcomes-based measure would provide is how much people can compensate for deficiencies in their financial literacy.  For example, I have no idea how to change the oil in my car, and I would fail an automobile literacy test.  But we might not worry about me, because I can get an expert to do it for me.  So if we were to look at a test measure, I would not look very good, but if we look at an outcomes measure, I would look great.  If someone says I’m not very financially literate but my spouse is, then that may not be such a huge problem.  To be clear, however, the great thing about these quizzes is they’re quick and cheap and easy to measure.

Q:  Have financial firms become our biggest financial educators?

A:  Financial education is an interesting challenge.  It’s not feasible to teach a lot of the financial skills you want people to eventually have when they are captive in a classroom.  You’ve got a captive audience until people graduate high school, but you can’t teach a 17 year old whether to get a fixed- or adjustable-rate mortgage or what investment allocation they should use in their 401k plans.  Those decisions have no relevance to them, so teaching high school students to make those decisions isn’t likely to stick.  The problem is when people are out of school and have financial decisions to make, they are no longer a captive audience.

Financial services firms are providing on-demand financial education, but there’s definitely some question of how much of it is financial education and how much is advertising.  If you went on to the website of the firm that charges high fees, they may give you give good advice about how much to save and whether to invest in stocks and bonds, but they’re probably not going to tell you, “By the way, we charge really high fees, and you should invest with a competitor that charges lower fees.”  I don’t want to suggest the financial education they’re providing is useless, because I don’t believe that, but I do not think it’s always complete and unbiased.

Q:  Can financial educators compete with financial advertisers?

A:  So far, I don’t think financial educators have done a very good job competing.  Part of the problem is that for so long the paradigm of financial education has been exactly that – education.  But classroom-based education has to compete with Madison Avenue advertising budgets, and it needs to be more appealing.  Financial education is as much a marketing challenge as anything, but I don’t think most people think of it that way.  They see we have a financial literacy crisis, and if we build it they will come.  That’s just not the case.

Q:  What kinds of financial education policies do we need?

A:  The thing we need most now is research to evaluate different approaches to education in a serious and credible way so we can make policy decisions.  Lacking better research there really isn’t a lot of guidance about what’s going to work better on the policy front.

Q:  What about financial regulation?

A:  Better research will also inform more sensible regulation.  But I think we can say more on the regulation side.  Certainly, we have pretty good evidence of financial mistakes happening in a number of domains that are of material consequence.  This suggests there is a role for better regulation.  Historically, regulation in the financial sector has been focused on disclosure.  Disclosure equals fine print that nobody ever reads.  The consequence is disclosure hasn’t been very effective.  This is one area where things are changing in Washington.  There are efforts to make disclosure easier to read and more relevant.  There are other movements to help consumers assess how appropriate a financial product might be, based on how they might actually use it.   A simple example is a cell phone contract.  The contract that is best for me is going to depend on how I use my cell phone but it’s hard to assess that without trying all the cell phone contracts out there.  But I have to lock into a two-year program.  Can you take my calling data and plug it into a program that tells me which contract is suitable?

Q:  Tailoring financial products – that’s very futuristic.

A:  It’s on the horizon.  One interesting idea that might merit consideration is whether certain types of financial products should be limited to individuals who have demonstrated some ability to understand the risks associated with the products.  We have this to some extent: if you want to trade in complicated securities instruments, you have to pass a test.  With some financial products, such as a savings account or a fixed-rate mortgage, we can say this product is good for anyone.  But other products have more potential for causing harm, and you might like people to first demonstrate that they are aware of what they are getting into.

2 Responses to Financial Education Strategies Need Work

  1. Nancy Mitiguy says:

    I think financial literacy education that occurs during life’s “teachable moments” will end up producing the most favorable outcomes. Those teachable moments occur when people are motivated to buy a house, or have a child, or reduce their debt, or get divorced. It’s the perfect storm of compelling “life events,” motivation, and knowledge relevant to the situation that I believe will produce the best results. So much of people’s relationship with financial issues is based on a lifetime of behaviors and emotion that make it difficult for financial literacy to produce lasting outcomes–unless people are motivated to try new strategies over a period of time.

  2. As Ms Mitiguy explains, personal motivation is an essential element in adult education and financial behavior change.

    But without effective education – what professor Madrian says we need much more of – it’s likely that most adults will not acquire the personal motivation to get serious about retirement savings until they are in their 40s or 50s…when they naturally begin to think about retirement.

    According to studies, if people wait to 45 to begin saving, they’ll need to contribute around 30% of their pay to fund a 401k plan for an ample retirement. What are the chances of that happening? If they start saving in their 20s, it’s closer to 15%.

    Behavioral economists have a well-intended theory of nudging employees through automatic escalating contributions so employees will accumulate several hundred thousand dollars for retirement. That’s fine as long as it’s done along with education so employees know the realistic cost of the retirement they want.

    To believe automatic provisions will work without effective education, you must also believe that employees will never take the money when they change jobs, buy a house or encounter a hardship — and they will never reduce the contribution rate — even though they have no idea how much the retirement they’ll want will cost. What are the chances of that happening?

    For voluntary 401k plans to succeed, so must retirement education.

    Yet retirement education is the largest failure ever of adult education. Our country cannot afford to allow the failure to continue.