Banks and other institutions are inundating consumers with credit opportunities—the ability to apply for credit cards or use credit checks to pay other credit balances—and without the proper knowledge or checks and balances, it is easy to get into financial trouble. In past generations, cash was used for virtually every purchase. Today, cash is rarely used. The way we shop has changed as well. Online shopping has become the top choice for many younger shoppers, creating ample opportunities to use and overextend credit, an all too easy way to accumulate debt, fast. Many of these consumers have very little understanding of finances, how credit works and the potential impact on their financial well-being for many, many years. In fact, the lack of financial understanding has been signaled as one of the main reasons behind savings and investing problems faced by many Americans.
What Is Financial Literacy?
Financial literacy is the confluence of financial, credit and debt management and the knowledge that is necessary to make financially responsible decisions—decisions that are integral to our everyday lives. Financial literacy includes understanding how a checking account works, what using a credit card really means, and how to avoid debt. In sum, financial literacy impacts the daily decisions an average family makes when trying to balance a budget, buy a home, fund their children’s education and ensure an income at retirement. (For more, see series: Teaching Financial Literacy.)
A lack of financial literacy is not a problem only in emerging or developing economies. Consumers in developed or advanced economies also fail to demonstrate a strong grasp of financial principles in order to understand and negotiate the financial landscape, manage financial risks effectively and avoid financial pitfalls. Nations globally, from Korea to Australia, or from Germany to the U.S., are faced with populations who do not understand financial basics.
The level of financial literacy varies according to education and income levels, but evidence shows that highly educated consumers with high incomes can be just as ignorant about financial issues as less educated, lower income consumers. Although in general, lower income individuals tend to be less financially literate. And it seems consumers are hesitant to learn. The Organization for Economic Co-operation and Development (OECD) cited a survey conducted in Canada which found choosing the right investment for a retirement savings plan was more stressful than a visit to the dentist.
Five Trends Forcing Financial Literacy
Compounding the problems associated with poor financial literacy, it appears financial decision making is also getting more onerous for consumers. Five trends are converging that demonstrate the importance for making thoughtful and informed decisions about finances:
- Consumers are shouldering more of the financial decisions: Retirement planning is one example of this shift. Past generations depended on pension funds to provide the bulk of their retirement funding. Pension funds are managed by professionals and put the financial burden on the companies or governments that sponsored them. Consumers were not involved with the decision making, typically did not even contribute their own funds, and they were rarely made aware of the funding status or investments held by the pension. Today, pensions are more a rarity than the norm, especially for new workers. Instead, employees are being offered the ability to participate in 401K savings plans, in which they need to make investment decisions and contribute to the plans.
- Complex options: Consumers are also being asked to choose among various investment and savings products. These products are more sophisticated than in the past, asking consumers to choose among different products options offering varying interest rates and maturities, decisions they are not adequately educated to make. Deciding on complex financial instruments with a large range of options can impact the consumer’s ability to buy a home, finance an education or save for retirement, further complicating financial decision making.
- Lack of government aid: The major source of retirement income in past generations was Social Security. But the amount paid by Social Security is not enough, and it may not be available at all in the future. The Social Security Board of Trustees reported that by 2033 the Social Security trust fund may be depleted, a scary prospect for many. So now, Social Security acts more like a potential safety net that may provide enough for basic survival. (For more, see: A Social Security Reality Check.)
- Longer life spans: We are living longer. This means we need more retirement savings than prior generations.
- Changing environment: The financial landscape is very dynamic. Now a global marketplace, there are many more participants in the market and many more factors that can influence it. The quickly changing environment created by technological advances such as electronic trading make the financial markets even swifter and more volatile. Taken together these factors can cause conflicting views and difficultly in creating, implementing and following a financial roadmap.
- Too many choices: Banks, credit unions, brokerage firms, insurance firms, credit card companies, mortgage companies, financial planners, and other financial service companies are all vying for assets creating confusion for the consumer.
Why It Matters
Financial literacy is crucial to help ensure consumers save enough to provide adequate income in retirement while avoiding high levels of debt that might result in bankruptcy and foreclosures. A few years ago, a study from financial services company TIAA-CREF showed that those with high financial literacy plan for retirement and in essence have double the wealth of people who do not plan for retirement. Conversely, those with low financial literacy borrow more, have less wealth and end up paying unnecessary fees for financial products. In other words, those with lower financial literacy tend to buy on credit, and are unable to pay their full balance each month and end up spending more on interest fees. This group also does not invest, has trouble with debt and a poor understanding of the terms of their mortgages or loans. Even more worrisome, many consumers believe that they are far more financially literate than they really are.
And while this may seem like an individual problem, it is broader in nature and more influential on the entire population than previously believed. All one needs to do is look at the financial crisis of 2008 to see the financial impact on the entire economy from a lack of understanding of mortgage products and the subsequent defaults. Financial literacy is an issue with broad implications for economic health and an improvement can lead the way to a global economy that is competitive and strong. (For more, see: The 2007-08 Financial Crisis in Review.)
The Bottom Line
Any improvement in financial literacy will have a profound impact on consumers and their ability to provide for their future while avoiding the pitfalls of debt. Recent trends are making it all the more imperative that consumers understand basic finances because they are being asked to shoulder more of the burden of investment decisions in their retirement accounts while having to decipher more complex financial products and options. The tasks are not easy but a better understanding and more knowledge can ease the burden tremendously.