PROspective Vol I No II February 2010

This month, PROspective features Dr. Annamaria Lusardi, one of the country’s leading authorities on financial literacy, on how financial literacy impacts 401(k) plans.

In a recent paper titled “Financial Literacy and Financial Sophistication Among Older Americans” published by the Pension Research Center at Wharton Business School (with co-authors Olivia Mitchell and Vilsa Curto), Lusardi writes:

“For this sample of older respondents over the age of 55, we find that people lack even a rudimentary understanding of stock and bond prices, risk diversification, portfolio choice, and investment fees. Furthermore, people that got one question correct were not particularly likely to get others correct, and “do not know” responses were quite widespread.”

“This analysis may be of use to policymakers working to enhance retirement security. It is clear that employees and retirees are increasingly being asked to take on tasks requiring financial sophistication, including making saving, investment, and dissaving decisions for retirement. Our research suggests that it may be particularly important to build retirement human capital via seminars, educational programs, and retirement planning products. Nevertheless, one-size-fits-all programs are unlikely to successfully address saving shortfalls particularly among the elderly, given the very different patterns we have discerned by sex, age, educational levels, and race/ethnicity. Instead, programs must be targeted so as to address fundamental differences in preferences, saving needs, and financial knowledge as well as sophistication.”

Lusardi expands on these themes with interviewer Chuck Miller.

Chuck Miller: From your research, what did 401(k) plans do right, and what did they do wrong?

Annamaria Lusardi: My research is mostly on financial literacy and I believe that what the 401(k) plans do wrong is to assume that people are well equipped to make decisions about how much to save for retirement and how to allocate their retirement savings. In fact, most workers lack knowledge of even basic financial concepts, such as the power of interest compounding, the effects of inflation, and risk diversification. In my view, the financial education that is provided is also insufficient to deal with the problem of widespread financial illiteracy. What they do right is to provide an effective way to save for retirement.

If you give me an hour of physics, I am not going to run home and fix my car. If plan sponsors want to affect behavior, they have to listen to employees’ needs and barriers to saving. They also have to move beyond focusing on retirement savings only; employees make many financial decisions and these decisions are interrelated.

For example, according to the findings from the National Financial Capability Survey released last December 2009, many people are in debt and often borrow at high costs. One of the ways to promote retirement security may be debt management and debt reduction strategies rather than asset building strategies (asset building would follow).

Employees might have retirement savings, but if they engage in a very expensive mortgage loan, they might end up in financial trouble, despite having retirement savings. Also, many workers, particularly young ones, may be concerned about saving for their children’s education. By addressing that problem and helping them plan for their children’s education expenses, one can then help them save and plan for their retirement.

CM: There’s a trend to make 401(k) plans more like defined benefit plans, with plans including provisions like auto enrollment and enhanced default options… what are your thoughts on this trend?

AL: It is a good trend; it is important to help employees in their saving decisions and to simplify decisions as much as possible. We know there is a lot of inertia in saving behavior and we want inertia to work in favor of and not against employees. Also, there is no reason why the default should be zero contribution; employees need to save for their retirement. On the other hand, we know that employees are very different from each other and that one size does not fit all. Also, if employees carry debt, it is not always a good idea to enroll them right away into a pension; they should decrease debt first. And success should be measured by whether employees achieve financial security, not by whether they stay enrolled in pension plans. Employees may be more likely to stay enrolled in pensions if the default is set at a low contribution rate, but this may be insufficient to guarantee a comfortable retirement. This is why I am such a strong advocate of automatic enrollment PLUS financial education. Automatic enrollment alone and financial education alone may not work well, but together they can work effectively.

CM: What other ideas are out there to help people save more for retirement?

AL: I would like to mention a program we implemented right here at Dartmouth College. This was a joint project with Punam Keller, a marketing professor from the Tuck School of Business, and Adam Keller, our VP for Finance and Administration. What we did was to provide new hires with a planning aid: a simple seven-step description of how to enroll in a Supplementary Retirement Account (SRA).

We also showed a video during employees’ orientation (posted on the Dartmouth HR web site) where employees describe in their own words why they save and plan for retirement.

Our ideas? First, listen to the employees. They told us they did not know where to start when making a decision about pension plan enrollment (hence the planning aid). They also told us they get information mostly from their peers (hence the video). Second, provide the information when it is relevant (hence the intervention for new hires). Third, target the groups that are most vulnerable: women and low-income workers (hence the types of workers speaking in the video). Participation rates in SRAs doubled at Dartmouth after our first intervention. This was not only an effective but also a cost-effective intervention. I covered this topic in my book. (“Overcoming the Saving Slump: How to Increase the Effectiveness of Financial Education and Saving Programs,” University of Chicago Press in 2008).

CM: President Obama has announced a plan to give savings plans to employees who don’t have one… can you explain this program? Do you like this plan and if so why?

AL: About half of working Americans do not have an employer-sponsored pension plan. The President wants employers who do not offer a retirement plan to enroll employees in a direct-deposit IRA, unless the employee opts out. Under the plan, workers would automatically have 3% of pretax earnings go into an IRA. The money would either be placed into a diversified portfolio or the worker would have the option to invest the money as he or she sees fit.

I like this plan a lot. Employees, particularly low-income ones, have been struggling in this economy and have been struggling to save. We need to find a way to encourage and help these workers too save. However, we need to make sure that workers invest wisely and are careful about fees because low-income workers display lower financial literacy than the average worker.

Moreover, what I said above regarding automatic enrollment is true in this case as well. Many low-income workers are in debt. In this circumstance, one has to find effective ways to help people build financial security beyond automatically enrolling workers into an automatic IRA. However, this is a very good start.

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