How Much Do People Know About Economics and Finance ? Financial Illiteracy and the Importance of Financial Education

Th e American pension environment is undergoing a dramatic shift from defi ned benefi t, in which the amount of retirement benefi ts are determined largely by years of service, to defi ned contribution, in which retirement wealth depends on how much workers save and how they allocate their pension wealth. A wide range of fi nancial products are now available for retirement saving, and workers are called upon to make investment decisions. Th us it is more important than ever for households to have a high degree of fi nancial savvy. However, as this brief will demonstrate, there is widespread fi nancial illiteracy. Many households are unfamiliar with even the most basic economic concepts needed to make sensible saving and investment decisions. Th is has serious implications for saving, retirement planning, retirement, mortgage, and other fi nancial decisions, and it highlights a role for policymakers to improve fi nancial literacy in the population. Several surveys exist that report information on fi nancial knowledge in subgroups or among the whole U.S. population. However, these surveys rarely provide information on variables related to economic outcomes such as saving, borrowing, or retirement planning. In an eff ort to combine data on fi nancial literacy with data on fi nancial behavior, Lusardi and Mitchell (2006) have pioneered inserting questions measuring fi nancial literacy into major U.S. surveys. Th ey fi rst designed a special module on fi nancial literacy for the 2004 Health and Retirement Study (HRS); this module has now been added to the National Longitudinal Survey of Youth (NLSY). Th ese and other questions measuring fi nancial knowledge have also been added to the Rand American Life Panel (ALP) and to other surveys covering specifi c subgroups of the population both in the US and in other countries. Th e three questions Lusardi and Mitchell (2006) devised for the HRS measure basic but fundamental concepts relating to fi nancial literacy, such as the working of interest rates, the eff ects of infl ation, and the concept of risk diversifi cation. Results from this survey module reveal an alarmingly low level of fi nancial literacy among older individuals in the United States. Only 50 percent of older respondents (i.e., 50 and older) in the sample were able to correctly answer the fi rst two questions, and only one-third of respondents were able to answer all three questions correctly. Th e question that …