There has been plenty of talk about the need to improve financial literacy in Canada. But without convincing evidence that greater literacy changes consumer behaviour and improves household finances, the concept may only get lip service rather than genuine attention from policy-makers.

However, some new research suggests that there is a tangible payoff to improving financial literacy — a finding that governments and the financial services industry should not ignore.

In mid-October, the standing Senate committee on banking, trade and commerce issued a report that makes several recommendations to the federal government that are designed to enhance financial literacy. The report notes that there is “a need for greater financial literacy and education” among Canadians.

In addition, a federal task force has been studying the issue for more than a year and will deliver its recommendations on the creation of a national financial literacy strategy to the federal minister of finance by yearend.

It remains to be seen what, if anything, comes of the Senate banking committee’s report and the task force’s forthcoming recommendations. However, a new working paper from the University of Pennsylvania’s Population Aging Research Center concludes that there is a measurable payoff to boosting financial know-how.

That paper notes that previous research has found a positive link between household wealth and both financial literacy and academic achievement. But, the paper says, those studies may have been biased due to “noisy measures” of financial literacy and schooling, as well as the influence of underlying factors such as intelligence and motivation, which cloud the question of whether there is indeed a relationship between literacy and wealth.

In other words, are people richer because they understand finance better? Or are they richer because they are smart and driven, which also means they do better in school and are savvier about money?

This is an important distinction from a public-policy point of view because governments that are contemplating investing in financial literacy need to know if the investment is worth it. If financial education is largely irrelevant and it is other fundamental factors, such as academic ability or socioeconomic status, that dictate whether households struggle or thrive, then money spent on educational initiatives may be wasted and could be better directed at alleviating poverty or reducing income inequality.

ALTERING BEHAVIOUR

But if there is a distinct benefit to financial literacy itself, then such education should become a real priority for governments that want a cost-effective way to alter individual behaviour without being overly paternalistic.

The PARC study aimed to isolate the effects of financial literacy itself by using new data from the Chilean Social Protection Survey, which includes extensive information on household wealth as well as individual and household characteristics that allow the PARC researchers “to evaluate the effects of financial literacy using a richer range of ages and schooling than [before].”

The PARC study found that “financial literacy is a powerful determinant of wealth and pension contributions.” In particular, regression analysis finds that a 0.2 standard deviation increase in the financial literacy score (using a weighted scoring mechanism) on average raises net wealth by US$13,800 in a population in which total net wealth averages US$71,500.







@page_break@This estimated wealth gain is composed of a US$5,200 increase in pension wealth, US$1,600 in net housing wealth and US$6,900 in other wealth (which includes business wealth, agricultural assets, other real estate assets and financial investments, minus household debt). Notes the paper: “Increased financial literacy can have relatively large payoffs in wealth, particularly pension and other wealth, and less so in terms of housing wealth.”

This same increase in financial literacy score also boosts the density of pension contributions (how often workers contribute to their pensions) by about 3% on average, the PARC paper reports.

The PARC study also found that the data suggest “that it is financial literacy that actually counts” in boosting household wealth, rather than a general increase in education. In addition, improving scores on “core” financial literacy questions — on basic concepts such as understanding risk and the concept of interest — has a particularly strong effect on wealth.

In other words, there’s a bigger payoff to learning the basics — and that benefit diminishes for additional, increasingly sophisticated financial concepts.

The paper offers a number of conclusions: that financial literacy is at least as important, if not more important, than schooling in explaining variations in household wealth; and these estimates of the significance of financial literacy “are substantial enough to imply that investments in financial literacy could well have high payoffs.”

SOME ARE SKEPTICAL

These conclusions also have meaningful policy implications. “Our results are relevant for financial educational policy, in that we find that improved financial literacy can make a significant difference for financial behaviour, even after controlling for schooling,” the paper concludes. “This rigorous analysis of the impact of financial literacy on wealth accumulation should be useful in informing governments and their policy advisors around the world as they consider new initiatives for financial education.”

However, the movement to improve financial literacy has its skeptics. For example, Lauren Willis, professor of law at Loyola Law School in Los Angeles, has argued that efforts to improve financial literacy are misguided. She says consumers cannot be expected to attain a level of proficiency that enables them to manage their own financial affairs competently in a market of ever-increasing complexity, saddled with well-known behavioural biases that undermine sound financial decisions, amid the vast disparity in resources between educators and the financial services industry.

Willis also has argued in a 2008 paper that efforts to improve financial literacy can be harmful: “The pursuit of financial literacy poses costs that almost certainly swamp any benefits. For some consumers, financial education appears to increase confidence without improving ability, leading to worse decisions. When consumers find themselves in dire financial straits, the regulation through education model blames them for their plight, shaming them and deflecting calls for effective market regulation.”

Willis stresses that people don’t act as their own doctors and lawyers, and shouldn’t have to be their own financial advisors. She notes: “The search for effective financial literacy education should be replaced by a search for policies more conducive to good consumer financial outcomes.”

However, improving financial literacy doesn’t have to be an either/or proposition. Policy-makers and regulators can work on issues beneficial to consumers — such as boosting disclosure and eradicating distorting market incentives.

And they also can take measures to improve financial education based on the evidence that this would result in greater household wealth accumulation. IE