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Over the past thirty years, individuals have had to become increasingly responsible for their own financial security following retirement. The shift from defined benefit (DB) to defined contribution (DC) plans has meant that workers today have to decide both how much they need to save for retirement and how to allocate pension wealth.

However, there is evidence that many individuals are not well-equipped to make sound saving decisions. This paper demonstrates widespread financial illiteracy among the U.S. population, particularly among specific demographic groups. Those with low education, many women, African-Americans, and Hispanics display particularly low levels of literacy.

The author describes how specific questions in household surveys can be used to determine levels of financial literacy.  She argues that it is possible to gauge financial knowledge from a small set of questions that cover fundamental concepts.

The paper shows that most individuals cannot perform simple economic calculations and lack knowledge of basic financial concepts, such as the working of interest compounding, the difference between nominal and real values, and the basics of risk diversification. Knowledge of more complex concepts, such as the difference between bonds and stocks, the working of mutual funds, and basic asset pricing is even scarcer.
Financial literacy impacts financial decision-making. Failure to plan for retirement, lack of participation in the stock market, and poor borrowing behaviour can all be linked to ignorance of basic financial concepts.

The author argues that while it may not be feasible to transform financially illiterate people into sophisticated investors, it may be possible to teach them a few principles about the basics of saving and investing. Moreover, as illiteracy was not eradicated with a handful of lessons or in a matter of months, so financially illiteracy cannot be eradicated with small interventions, such as a few seminars or one benefit fair.  Set in this framework, it is clear that some standards for financial literacy are needed.

What do people need to know? What should the pillars of financial literacy programs be? Setting these standards will be the backbone of devising financial education programs. There are obvious benefits to having one institution that presides over or establishes those standards, and the U.S. Department of Treasury seems an obvious candidate for this role. Given the current low levels of financial literacy, employers and the government should devise and encourage programs that simplify financial decision-making as well as provide sources of reliable financial advice.

[Please note: this article is accessible online, free of charge to residents of nearly any developing country or transition economy, whose internet-access address can be automatically recognised by the NBER website. If you are in a developing country/transition and still have access problems, email wwp@nber.org for support]

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