In examining the origins of the recent economic crisis, much of the finger pointing has been directed at the government. Many have criticized the absence of sound regulations on high-risk derivatives such as credit default swaps, which cost investors and taxpayers trillions of dollars.
But another factor was at work behind the scenes. As the financial system grew increasingly complex over the past decade, spurred by globalization, technology and innovation, consumers lacked the acumen to understand the underlying risks and interconnections among various financial instruments. A lesson learned from the mortgage meltdown in the U.S., for example, is that numerous homebuyers—especially low-income families with limited access to financial advice—were unaware of the inherent risks of their sub-prime mortgages.
To rebuild a stable international financial system and prevent future crises, leaders of the G20 countries recently called for coordinated efforts to strengthen existing regulatory and institutional practices. However, the long-term stability of the financial sector also depends on the general public’s ability to make financial decisions based on solid fundamental knowledge.
Financial literacy has profound implications for an individual’s long-term economic prosperity. In particular, many studies have found a strong correlation between financial literacy and effective retirement planning.
The majority of Canadians do not have any form of employer-sponsored pension, and many employers that do provide pensions have now shifted from defined benefit (DB) plans to defined contribution (DC) plans. A May 2009 study by Statistics Canada shows a substantial decline in DB coverage among Canadian employees, from 41% in 1991 to 30% in 2006. As investment risks are transferred from employers to employees, workers are becoming increasingly responsible for saving for their retirement and maintaining their financial well-being after they retire. This calls for a greater degree of financial competence.
Those who fail to rise to the challenge can expect to pay a price. For example, target date funds and guaranteed products are geared to investors who do not understand how to invest by removing the need for decision-making. But ultimately, these products might not serve investors well from both a risk and a cost perspective.
The Case for Education
Financial illiteracy among the U.S. population has been well documented in many studies. For example, in a 2006 working paper, A. Lusardi and O.S. Mitchell note that only one-third of Americans age 50 or older can answer three simple questions on interest rates, inflation and risk diversification. According to a study by the Organisation for Economic Co-operation and Development (OECD) conducted in 2005, many other countries, including Australia and the U.K., have also conducted surveys to assess financial literacy at a national level. The OECD reports that all literacy surveys suggest a low level of financial understanding. For example, less than 40% of U.K. respondents are confident about making financial decisions. In Australia, the majority of respondents indicate that they understand the concept of compound interest—yet most of them failed to solve a math problem using that concept.
Canada has yet to conduct a national survey. However, anecdotal evidence indicates that average Canadians lack financial knowledge and competence. Workers who are fortunate enough to participate in an employer-sponsored pension plan often aren’t able to articulate whether it is a DB or a DC plan. Those in DC plans have a difficult time making investment choices that reflect their own financial situation and risk tolerance. In fact, a number of these plan members make no investment choice at all and end up with all of their assets in the default fund, which often bears no relation to their personal investment profile.
According to the 2009 Watson Wyatt Survey of Pension Risk, members’ lack of interest in their pension arrangements ranks as one of the top challenges to the long-term sustainability of DC plans. While a significant amount of time and money has been deployed in attempting to educate DC members, actual plan activity indicates that members are not engaged in these investment decisions, do not fully understand their risks and fail to take advantage of the educational tools at their disposal.
National Strategies
A number of countries have launched a national strategy to raise public interest in financial literacy. The U.K. Financial Services Authority (FSA), a pioneer in strategy development and implementation, started its national effort in 2003. The Financial Literacy and Education Commission developed the U.S. strategy in 2006. More recently, New Zealand published its national strategy in 2008.
The Financial Consumer Agency of Canada (FCAC) was established by the federal government in 2001 as a regulatory agency to ensure compliance with the consumer protection laws and to expand consumer education. In 2007, $3 million over two years was allocated to FCAC for launching the Financial Literacy Program, targeting Canadian youth. Many organizations in the private and public sectors have also set up initiatives to promote financial literacy, such as the Ontario Securities Commission’s Investor Education Fund, the British Columbia Securities Commission (BCSC) and the Canadian Securities Administrators.
The 2009 federal budget provided for an independent task force to be commissioned this fiscal year. On June 26, 2009, Finance Minister Jim Flaherty announced the launch of this financial literacy task force, which includes representatives from private companies, community organizations, education departments and academia. While the original stated intentions of the task force were to avoid duplicating efforts and to better coordinate the various initiatives currently underway, it appears that the mandate will also include, as a first step, an assessment of the state of financial literacy in Canada and a review of best practices in other countries. The task force is scheduled to report back to the Ministry of Finance in late 2010.
Creative Curricula
A key element of a national strategy is to incorporate financial literacy into school programs. The U.K. and Australian strategies are two successful examples that allow students to develop basic knowledge and life skills on financial matters during their compulsory years of schooling. The FSA has made considerable efforts to place financial education in the national curriculum. In September 2008, personal finance was introduced as part of Personal, Social, Health and Economic (PSHE) education in secondary schools, and the U.K. government has recently announced its commitment to make PSHE education statutory in both primary and secondary phases. Australia now has a unified framework for all students from kindergarten to year 10. An integrated cross-curriculum approach was developed based on consolidated financial courses previously included in different state curricula. Instead of creating a separate program specifically for personal finance, consumer and financial literacy is integrated into existing curricula across different subjects: English, mathematics, science, business, civics and citizenship, and information technology.
In Canada, many classroom materials have been developed for teaching young people the basic skills to manage money. The Ontario program, Taking Stock in Your Future, was created by the Investor Education Fund in collaboration with the University of Toronto and The University of Western Ontario, and Financial Life Skills for Planning 10 was designed by the BCSC. The success of Planning 10 has led to a partnership between the BCSC and the FCAC to launch an online resource, The City: A Financial Life, which was unveiled to teachers and students in September 2008.
Most of the teaching programs are available for free, but on a voluntary basis. British Columbia is the only province that requires the teaching of basic financial skills in high school, with Planning 10 as a mandatory credit for Grade 10 students. According to the Youth Financial Literacy Study conducted by the FCAC in 2008, less than 25% of young Canadians between 18 and 29 years of age have ever taken a course or training session in personal finance. To promote financial literacy among the nation’s youth, other provinces need to incorporate mandatory financial skills programs in their school curricula.
Continuing Education
When a large percentage of the public lacks the basic skills to make sound financial decisions, society as a whole can pay a heavy price. At the same time, financially literate individuals are better able to provide for their personal financial success and security over a lifetime.
Research on Canadian saving patterns shows the majority of people under age 30 do not own a house and have little in the way of investments. Although financial planning does not seem to be a priority for young people at an early stage in their careers, it is important to help them develop good habits in managing their money before they enter the workforce. A growing number of countries are laying the foundation for adult financial literacy with national strategies that incorporate personal financial skills in the classroom.
For Canadians in the workforce, saving for retirement is becoming more important, as most are not covered by employer-sponsored pensions. Adult programs that build on training in schools would help people to make good financial decisions at different life stages and, ultimately, could reduce their need for social welfare later in life.
Lori Satov is an actuary and Terence Yuen is a senior research economist with Watson Wyatt Worldwide.
lori.satov@watsonwyatt.com
terence.yuen@watsonwyatt.com
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© Copyright 2009 Rogers Publishing Ltd. This article first appeared in the September 2009 edition of BENEFITS CANADA magazine.