The Case for Financial Literacy: Recognizing Financial Education as a Key Element of Future Retirement Income Policy

The Case for Financial Literacy: Recognizing Finan…
01 Apr 2013

The last few decades have seen a dramatic transformation in the arena of retirement security. This transformation is marked by two significant changes: individuals have become progressively more responsible for making their own pension and retirement decisions, and financial markets around the world have become increasingly accessible to the small investor. This empowerment has been accompanied by greater individual exposure to market risk and increasingly complex financial products and services, many of which are difficult for financially unsophisticated investors to grasp. For people around the world, a secure retirement will depend on how well they make the transition to this new landscape.

The United States presents a powerful example of how these changes have played out. Prior to the 1980s, many Americans relied on Social Security and defined-benefit plans under which employers promised to provide specific pension payments upon retirement, usually based on a salary and tenure formula. Today, members of the so-called Baby Boom generation are seeing their retirement years financed through defined-contribution (DC) plans and Individual Retirement Accounts (IRAs), the values of which fluctuate depending upon contribution rates and investment gains and losses. Indeed, in 1980, about 40 percent of private-sector pension contributions went to defined-contribution plans; 20 years later, almost 90 percent of such contributions went to personal accounts, predominantly 401(k) plans (Poterba, Venti, and Wise, 2008). As more defined-benefit plans are frozen or terminated, individually managed accounts will be institutionalized as the mainstay of retirement. 

There are advantages to the DC retirement savings model. It permits more worker flexibility and labor mobility. Since workers change jobs more often than in the past, their pensions need to be portable, which the DC model allows. However, the flexibility that permits workers to take the funds with them when they change jobs also can be exploited to tap the funds for non-retirement purposes. Defined-contribution plans also expose workers more immediately to financial market risks.

The living standards of aging citizens around the world will hinge on how well workers plan for retirement. Research shows that successful retirement planning depends strongly on an individual’s level of financial literacy, defined as the ability to process economic information and make informed decisions about household finances, wealth accumulation, pension contributions, and decumulation after retirement (Lusardi and Mitchell, 2013). Government policies to promote financial education may, therefore, play a critical supporting role in enhancing retirement security.

This report provides a review of international scholarship in the area of financial knowledge and its relationship to retirement planning and security, drawing on recent studies to establish how much (or how little) people know and who falls into the high-risk groups. This report also reviews broad strategies for effective financial education programs, explaining why they must begin early in an individual’s life cycle and why they must be institutionalized as lifelong learning.

Page last modified: 15 Mar 2018