Why Financial Literacy Will Not Save America's Finances

The problem with Americans’ household budgets isn’t that people are too dumb to save, but that the system asks too much of them.

Americans trying to understand financial products (Susana Vera / Reuters)

From taking out loans to pay for higher education to investing for retirement, Americans are shouldering enormous levels of personal financial responsibility—more so than ever before. At the same time, financial products have both proliferated and become much more complex. Americans now face an Alphabet (and Numbers) soup of saving and investment options (401(k)s, 529s) and a head spinning array of credit options (credit cards, mortgages, home-equity loans).

While Americans are not expected to manage their own legal cases or medical conditions, they are expected to manage their own finances. To be sure, the rise of the independent and empowered consumer rests on the belief that they have the requisite knowledge to be up to the task. But is it reasonable in such a system to expect people to succeed? Economists examining financial literacy would say no.

According to their research, the vast majority of Americans lack basic levels of financial literacy. For example, a survey of Americans over the age of 50 that asked three basic questions about compound interest, inflation, and risk diversification found that only a third answered all three questions correctly. And a more extensive survey of financial literacy among high-school students found that young people aren’t any more informed. Forty-four percent of U.S. students surveyed had scores that placed them at the lowest levels of financial literacy.

Worse still is that levels of financial literacy are lower among the less educated, minorities, and women. Almost 65 percent of Americans with graduate degrees possess basic financial knowledge and skills, compared to just 19 percent of high-school grads. African Americans and Hispanics score lower than do whites on surveys measuring knowledge about financial concepts like debt. And analysis done in the U.S. and Europe has consistently found that women are significantly less likely to answer financial-literacy questions correctly than men.

The costs of financial illiteracy are high. For example, research on credit-card debt found that those with lower levels of debt literacy were more likely to do things that resulted in higher fees and charges like going over the credit limit or only making the minimum payment. One study estimates that up to one-third of the fees and charges paid by those with lower debt literacy is due to a lack of knowledge. Overall, financial mistakes tend to be more common among those with less education and income. Financial institutions often target such unsophisticated consumers  with their less-than-straightforward—and often very expensive—financial products. A recent study found that misconduct by financial advisers is concentrated in firms located in counties with low levels of education and elderly populations.

By contrast, being financially savvy has clear payoffs. Those with higher levels of financial literacy are more likely to plan for retirement, make better investment decisions, refinance mortgages at the optimal time, and manage credit-card debt better. They are also more likely to sidestep common pitfalls like borrowing against 401(k) accounts.

So who is financially literate? Disproportionately, they are white males from college-educated families whose parents had stocks and retirement savings. Phillip Cartwright, the CEO of a biotech start up, underscores the high levels of financial literacy among white men at the top. Talking to me about how he manages his finances he said, “I talked to different financial advisors. But I went to business school, I worked in finance for five years. So I went to meet with some [advisors] and I thought ‘Maybe these people know something?’ I couldn’t find anybody who knew a lot more than I did.”

The George Washington University economics professor Annamaria Lusardi has done pioneering research on financial literacy. Her studies have documented the gaps in financial knowledge among different demographic groups. “What the data on financial literacy shows is that financial knowledge is unequally distributed,” says Lusardi. “Those with the least knowledge are also the most vulnerable groups in economic terms. As a result, the lack of financial literacy exacerbates economic inequality.” Lusardi’s own analysis has estimated that more than one-third of wealth inequality could be accounted for by disparities in financial knowledge.

Lusardi directs the Global Finance Literacy Excellence Center that focuses on raising the level of financial knowledge through financial-literacy education. “Finance has entered the lives of every family in a much more significant way than in the past. We now have a lot more responsibility for managing our money. Everyone needs to know the ABCs of finance,” notes Lusardi.

But how much can financial education do to even out the playing field and enable all Americans to better navigate a complex and fast changing global economy?

Finance expert and author Helaine Olen is skeptical. “Which is easier?” Olen asked, “Educating and changing the financial practices of 300 million Americans or changing the financial frameworks surrounding them? The vast majority of Americans think that their financial advisor has a fiduciary responsibility to act in their best interest. As of right now, that's not true. Instead of educating people about this, why not just make it a legal duty that financial professionals act on the behalf of consumers.”

Lusardi agrees that increasing financial literacy alone is not enough. “Some things are better addressed through regulation,” says Lusardi. “If there are things that are clearly negative for consumers, then they don’t need to exist. But changing the financial framework is also not enough,” she says. “Financial literacy is an essential skill for thriving in today’s economy.”