People don't know much about financial decisions, but even if they did, research shows, their preference for immediate gratification at the expense of longer-term rewards would lead them away from sound retirement planning and investments.
"Two competing explanations for why consumers have trouble with financial decisions are gaining momentum," say researchers Justine S. Hastings of Yale University and Olivia S. Mitchell of the University of Pennsylvania in a paper for the National Bureau of Economic Research. "One is that people are financially illiterate since they lack understanding of simple economic concepts ... The second is that ... some people persistently choose immediate gratification instead of taking advantage of longer-term payoffs."
Of the two factors, instant gratification—what the researchers call "impatience"—"is a strong predictor of wealth and investment in health. Financial literacy is also correlated with wealth although it appears to be a weaker predictor," according to the paper.
"As individuals are being asked to exert more control over their own retirement accounts (e.g., 401(k)'s) and other household investments," the research "raises a concern about whether consumers are capable of making optimal investment and saving decisions. Further, the development of evermore complex financial products probably makes it difficult for consumers to use these sensibly," according to the research paper.
The findings were based on extensive research with consumers in Chile, not the United States. But the researchers said Chile is comparable to many developed countries. It also offered a useful environment because it has had a mandatory defined contribution retirement system since 1981 and regularly polls consumers on a range of issues relative to retirement. This information was supplemented with a pair of experiments to test for financial literacy and the way people made financial decisions.
In the first test, people were asked six literacy questions. Their answers were analyzed in terms of a person's education, income, sex, marital status, and other variables. In the second test, people were offered the chance to win money for filling out a shopping questionnaire, with the option of receiving the equivalent of about $8 if they filled out the questionnaire right away, or a larger amount of money if they took the questionnaire with them and mailed it back within four weeks. Their behavior on the second test was correlated with their financial literacy scores.
More than half the people (about 54 percent) chose the immediate payment, while 30 percent waited and got more money. Another 17 percent took the questionnaire with them and failed to return it, thus receiving no money. People wanting the money right away also were less likely to maximize contributions to their pension account. People with more income and education were more likely to wait for the higher payments.
"We find that the impatience measure strongly predicts respondents' self-reported retirement saving and health investments," the researchers said. "Financial literacy is also associated with more retirement saving, but it is less closely associated with sensitivity to framing of investment information."
Here are the six literacy questions. Nearly no one got all six right—68 out of nearly 14,250 tested, or fewer than 1 in 200. The fourth question was the most challenging. See how you do (the correct answers follow):
1. Chance of Disease: If the chance of catching an illness is 10 percent, how many people out of 1000 would get the illness?
2. Lottery Division: If five people share winning lottery tickets and the total prize is two million Chilean pesos, how much would each receive?
3. Numeracy in Investment Context: Assume that you have $100 in a savings account and the interest rate you earn on this money is 2 percent a year. If you keep this money in the account for five years, how much would you have after five years? Choose one: more than $102, exactly $102 or less than $102.
4. Compound Interest: Assume that you have $200 in a savings account, and the interest rate that you earn on these savings is 10 percent a year. How much would you have in the account after two years?
5. Inflation: Assume that you have $100 in a savings account and the interest rate that you earn on these savings is 1 percent a year. Inflation is 2 percent a year. After one year, if you withdraw the money from the savings account, you could buy more/less/the same?
6. Risk Diversification: Buying shares in one company is less risky than buying shares from many different companies with the same money. True/False
2. 400,000 pesos
3. More than $102