Overview
• State pension in the UK has been decreasing over time
• The heavier burden on individuals to plan and save for their retirement
• Lack of financial literacy leads to individuals not planning for retirement
• Certain groups are more vulnerable such as people with low income and education, young and women
• Financial literacy training leads to wealth accumulation, retirement planning and debt reduction
• Training should give at an early age when an individual has to make important decisions such as house mortgage and spillovers are positive thus better use of scarce resources
• The cost of planning, implementing and reviewing a policy should be considered
Background
Demographic changes arising due to lower birth rates and higher life expectancy put increasing pressure on established pension systems. As a result, there has been a major change in pension schemes from defined benefit (employer has responsibility and risk) to defined contribution (individual has responsibility for investing and risk). These changes have resulted in more risk and more choice for individuals (Samwick and Skinner, 2004), and present the possibility that individuals might not save enough to support themselves in old age (Poterba, 2014). Moreover, state pension in the UK cannot by itself provide for sustainable retirement because it is around 40% below the absolute poverty threshold. As a result, policymakers impose a much heavier burden on workers to become financially literate and make decisions in their own best interest.
According to Office for National Statistics (2022), almost a third of people didn’t expect to have any pension source apart from the State Pension when they will retire. Moreover, the financial literacy levels across all countries including the UK, indicated by combining scores for behaviour, attitudes and knowledge, are relatively low (OECD, 2016). There is well-documented research that financial literacy increases pension planning activities and individuals who do more retirement planning tend to accumulate more wealth. Moreover, financial literacy also has a positive impact on other forms of household behaviour such as portfolio diversification thus increasing retirement resources. In the next section, I will present a more nuanced and detailed examination of empirical evidence, along with an analysis of demographic factors that bear relevance to our policy recommendation in the final section.
Empirical Findings
Sekita (2011) measures the level of financial literacy in Japan by analysing the response to 3 basic questions on the interest rate, inflation and risk diversification.
She finds that women, young, less educated and low-income individuals have the lowest levels of financial literacy and savings plans for retirement increase with the increase in financial literacy. She exploits the fact that in Japan students are allowed to deposit and withdraw money through schools which can be seen as the development of saving habits and find that when they become adults, they are more likely to save more. To solve the causality problem between financial literacy and retirement planning, she uses Japanese language proficiency as an instrument for financial literacy as there are rare chances that language ability is correlated with developing a retirement plan. These results are convincing and suggest that training should be targeted to the groups most affected such as women and individuals with less education and low income.
Van Rooij et al. (2012) estimate the relationship between financial literacy, retirement planning and wealth accumulation in the Netherlands. The final sample consists of 1091 households. They find a strong positive association between financial literacy and net worth. Moreover, financial literacy is positively related to wealth accumulation through two channels. Firstly, highly financially literate individuals are more likely to invest in the stock market (Van Rooij et al, 2011a). Secondly, financial literacy has a positive relationship with retirement planning which has been shown to boost wealth. Moreover, they find a strong correlation with age, as the individual gets closer to retirement, they start thinking about their retirement needs. Moreover, the educated group who think about retirement plans is almost double compared to those with less knowledge. They use economics education as an instrument for advanced financial literacy to assess the causal relationship between financial literacy and wealth accumulation. However, a potential concern is an unobserved factor, ability, which can affect literacy education and wealth. For this reason, they used cognitive ability as a proxy for ability. Finally, to account for drivers of wealth heterogeneity such as households having a different propensity to save (Venti and Wise, 1998) and self-control which is an important factor in saving outcomes (Thaler, 1994), authors use direct proxies which are measured by relevant responses to different questions they asked. They did find both these variables are major determinants, but the inclusion of these variables didn’t change the magnitude of financial literacy or the relationship between financial literacy and wealth accumulation. The results suggest that the ability to handle complex saving decisions prevents individuals to work out retirement saving needs and plans.Finally, the results indicate that individuals with low income and less education should be targeted while giving financial literacy training.
Fornero et al. (2011) measure the effect of financial literacy on house mortgage choice, the most common type of family debt (Campbell and Cocco, 2003). They use Italian data on 8000 households and information on demographic characteristics, income and wealth. To determine financial literacy, they asked 5 questions that have been developed in the literature and the effect of financial literacy on three outcomes: mortgage provider choice, fixed and adjustable interest rate mortgage choice and delays in mortgage payments. They find financially literate household chooses a better option, evaluate risk exposure correctly and reduce the probability of delays in payment. According to a report by Halifax (2021), the average age of first-time homebuyers in the UK is 32, in light of this fact it can be convincingly argued that financial literacy training should be given to individuals before that sothey can avoid costly mortgages decisions to ensure adequate retirement funds in old age.
Financial literacy training could have important spillover effects which help them to reach a larger audience (Lusardi, 2013), meaning trained individuals actively pass new knowledge to their friends and family. Kallenos et al. (2022) assess the impact of a semester-long, university course on financial education to evaluate its effect on financial knowledge in Cyprus. The success of the course is measured by measuring the financial knowledge scores of individuals using the OCED (2018) methodology before and after the course in the treatment and control group while controlling for students’ initial financial knowledge scores and demographics that can affect the outcome. They find a statistically significant increase in the financial knowledge score of the individual in the treatment group relative to the control group, implying the new course was effective. Moreover, to capture the main differences they find lower financial knowledge in people with lower education and income and younger people, consistent with the previous studies above.
To evaluate the spillover effect, they assess the effect of the course on participants’ parents before and after the course and compared these with parents whose children did not take the course. They find that parents of individuals who participated in the course experience an increase in their financial knowledge and this increase is higher if interacting frequently with their child. These results suggest us financial literacy training should be given to not only disadvantaged groups (low-income, less educated and young) but also to individuals where the multiplier effect is higher and can help reach a wider community ensuring efficient use of government scarce resources.
Policy Implications and Recommendations
From the above evidence we can conclude that an increase in financial literacy training will increase financial outcomes during retirement through multiple channels such as retirement planning, portfolio diversification, wealth accumulation, and reduced debt. However, it is recommended that the government selectively target potentially vulnerable groups identified such as people with lower education, people with lower income, younger people and women.
It is important to make financial literacy compulsory from an early age as pension depends on levels of contribution throughout working age (Foster, 2012). This will also allow policymakers to take appropriate action on time to prevent the consequences of under-saving. Secondly, we have seen lower mortgage prices with a level of literacy which means once they will retire, they will have lower debt levels. Thirdly, as seen the development of saving habits at an early age will encourage individuals to save towards their retirement when they become adults. As shown above, financial literacy interventions tend to have positive spillover effects. Promoting such spillovers would be a cost-effective and smart way and help reach a wider community who otherwise don’t have access to financial literacy education.
Financial literary programs tend to be more effective if they target specific needs(Varcoe et al., 2005) e.g., we find evidence that a large population don’t know the basic concepts of interest rates and inflation and it is highly unlikely they willunderstand these in a single seminar. To address this, policymakers should provide a more comprehensive and sustained approach such as multiple training sessions to have a significant impact on the decision-making process. Similarly, training for women should be concerned with different issues they have to face such as the gender pay gap that may affect their ability to save for retirement. Training for retirees from low-income and less-educated households should focus on areas such as managing retirement income, healthcare costs and avoiding financial scams.
Policymakers should consider the costs associated with developing, implementing and evaluating these programs. Moreover, policymakers should do complementary interventions such as improving financial access or basic awareness to normalise thinking about retirement as it is relatively a new social phenomenon. Overall, financial literacy training has the potential to improve household financial behaviours and policymakers should target vulnerable groups and consider the unique needs and circumstances of each group such as the timing and content of financial training.
By Momin Rizwan
Blogger
By Samuel Golder
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References
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Fornero, E. and Monticone, C. (2011) ‘Financial literacy and pension plan participation in Italy’, Journal of pension economics & finance, 10(4), pp. 547–564. doi: 10.1017/S1474747211000473.
Foster, L. (2012) ‘'I Might not Live That Long!' A Study of Young Women's Pension Planning in the UK’, Social policy & administration, 46(7), pp. 769–787. doi: 10.1111/j.1467-9515.2012.00854.x.
Halifax, 2021, First-Time Buyer Review 2021
Kallenos, T.L., Milidonis, A., Nishiotis, G. and Zenios, S.A., 2022. Financial Education and Spillover Effects. Available at SSRN 4094763.
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Van Rooij, M. C. J., Lusardi, A. and Alessie, R. J. M. (2012) ‘Financial Literacy, Retirement Planning and Household Wealth’, The Economic journal (London), 122(560), pp. 449–478. doi: 10.1111/j.1468-0297.2012.02501.x.
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