Knowing is Half the Battle: Unpacking Financial Literacy

The opening of the new Affordable Care Act health insurance marketplaces presents millions of Americans with a complicated financial decision. How do they value insurance? The marketplaces will primarily serve people who are not employed full time or are in low-wage jobs—and are therefore likely to be juggling tight finances already. What is the cost of paying down debt more slowly to buy insurance? The obvious intervention to help people make better financial decisions when faced with complex options is financial literacy.

Unfortunately, the evidence on financial literacy is pretty dismal. David McKenzie’s study of a voluntary financial literacy program in Mexico that finds no effect is pretty representative. Earlier this year, author Helaine Olen wrote that financial literacy is “a bunch of hooey,” Jason Zweig at The Wall Street Journal cited educational programs that actually make people worse off financially, and FINRA released a study showing that financial literacy among Americans has weakened since 2009.

While financial literacy levels are linked to better financial decisions, study after study shows that financial literacy courses are ineffective. So we know financial literacy matters, but how do we deliver it effectively? Then there is the definition itself. What does financial literacy mean and how do we know when someone has achieved it? If we use the Jump$tart coalition’s definition that “financial literacy refers to an evolving state of competency that enables each individual to respond effectively to ever-changing personal and economic circumstances,” how can individuals obtain and maintain that state?

In addressing these questions, let’s first take a step back. In any market, consumers need information in order to make appropriate purchasing decisions. Financial services can be harder to understand and compare than other types of services: there are many different pricing models as well as complicating factors like inflation and interest rates. However, millions of Americans lack basic literacy and numeracy skills, the building blocks of financial literacy. In a study of financial knowledge among baby boomers by Annamaria Lusardi and Olivia Mitchell, only 56% of respondents could correctly answer the question “If five people all have the winning number in the lottery and the prize is $2 million, how much will each of them get?” Younger generations don’t do any better. When Lusardi, et al. studied literacy levels among youth populations, they found “only 27% knew about inflation and risk diversification and could do simple interest rate calculations.”

So is the answer simply to teach more math courses? Indeed, research from Kenya and the US show evidence that increased math skills may be a better path to better decisions than traditional financial literacy programs. Another approach is radically simplifying financial literacy curriculums. A 2011 RCT conducted by Drexler, Fischer, and Schoar found that a simple “rules of thumb” approach to financial literacy (i.e. keep business and personal accounts separate) produced more meaningful improvements to business practices among Dominican entrepreneurs than standard accounting training. Of course there’s a reason that financial literacy curriculums tend toward the complex. Law professor Lauren Willis reminds us that “a rule of thumb to spend no more than 28 percent of monthly income on a mortgage was applicable when mortgages had level payments. But today consumers face mortgages with variable and uncertain future monthly payments.” Calculating mortgage terms or loan repayment plans requires forecasting expected income, which can be difficult for the poor whose income flows are often variable and unpredictable.

There is clearly a need for further research about the appropriate financial literacy approach for a variety of contexts. Willis argues that in the complexity of the American financial market, it may be time to rely on financial advisors just as we rely on doctors to diagnose our illnesses instead of increasing medical literacy. FAI’s Jonathan Morduch and Barbara Kiviat highlight additional strategies to effective financial literacy such as changing norms and improving structures in the market that induce good behavior. The quick bottom line: “maximizing the effectiveness of financial training is not just a matter of better use of classrooms and better development of training materials, but also of re-envisioning what financial literacy education can be.”