Financial Literacy Matters – and Here Are 3 Reasons Why

Last month on Pi Day I wrote about how U.S. kids are falling behind other countries on math literacy. April is Financial Literacy Month, and unfortunately American children are falling behind in that area as well. In 2015, the Organization for Economic Cooperation and Development released results from an assessment of financial literacy among 29,000 15-year-olds in 18 countries. Perhaps not surprisingly, given American students’ math literacy scores, the United States finished in the middle of the pack, well behind China, which took first place.

While it’s not great news, some might still question if it really matters that we do not rank among the world’s leaders for our young people’s understanding of financial concepts. I would argue that financial literacy — which covers earning, saving, investing, spending and protecting wealth — is vitally important and essential to the wellbeing of individuals and families.

Here are three reasons why financially literate people are able to get ahead.

1.      They Are More Likely to Use Debt Wisely

While most people might not choose to become indebted to a financial institution, carrying debt isn’t necessarily a bad thing. Mortgages allow us to buy homes, which can be good investments as real estate tends to appreciate over time, and paying mortgage interest, which is deductible, offers some tax benefits. Student loans enable us or our children to attend college, and higher education can translate into greater earnings over an individual’s lifetime. People also borrow money to start or grow businesses. These examples represent the “better” kinds of debt. The “worse” kinds of debt tend to have higher interest rates, high fees, and no tax benefits. Into this category falls credit card debt and personal and auto loans.

Here’s where financial literacy comes in. According to a study from the National Bureau of Economic Research, people who are less knowledgeable about debt are more likely to use high-cost borrowing and incur greater fees. The study also estimated that up to a third of the charges and fees paid by less debt-savvy people could be attributed to a lack of knowledge about borrowing’s potential consequences.(1) The costs associated with “worse” debt can add up quickly and, over a long stretch, can spell financial ruin. A small amount of knowledge, however, can help lessen the impact of high-cost borrowing as people become more informed about the value of strategies such as shopping for cards with lower rates, and paying more than the minimum due each month on any credit card balances.

2.      They Save More for Retirement

Life expectancies are on the rise, and that increases the need for people to have significant savings when they retire. Traditional pensions – which employers paid out based on workers’ earnings and years of service without any contributions required from employees – still exist, but they have become a rarity. Most employer-sponsored retirement plans today are 401(k)s or other types of defined contribution plans. With these plans, the amount people have at retirement is largely dependent on how much they contributed to the plan while they were working. While the Social Security trust fund is still solvent, most young workers would be wise to not count on that government program to be around its current form when they are ready to retire.

The responsibility for supplying retirees with adequate income has largely shifted from institutions to individuals. Unfortunately, the knowledge of how to save and invest for retirement did not transfer over to the general public along with the responsibility. That is one of the reasons why retirement savings are in dire straits today. According to the Government Accounting Office (GAO), less than half of the American households led by someone aged 55 and older have retirement savings accounts such as 401(k)s and IRAs (Individual Retirement Accounts). Among those households that do have such savings, the median account balance is $104,000. While that may sound like a healthy sum, it is the equivalent of an inflation-protected annuity of between $310 and $649 each month.

This is another area where financial literacy scores a win. People who are financially literate are more likely to plan for retirement and to accumulate more in retirement-earmarked savings.(2)

3.      They Earn Better Investment Returns

The evidence also suggests that people with more financial knowledge earn better returns on their investments. A study of employees with 401(k) plans showed that financially knowledgeable participants are more likely to invest in stock funds over more conservative options.(3) While potentially more volatile, stocks have a better track record than most other investments for delivering the higher returns people need to fund long-term retirements.

How We Can Improve Financial Literacy

Fortunately, there is much that can be done to boost financial literacy among both children and adults. Even though some parents may find it difficult to discuss money with their kids, integrating lessons about money into everyday conversations can be a great way to set kids on the right path from an early age. It can start when they’re young by teaching them how to handle money and pay cashiers when you shop. As they get older, you can pay them for chores and help them open a savings account. Even explaining why you make certain decisions — waiting to buy things on sale versus paying full price — can help your kids develop the financial sense to make smart choices when they’re adults.

There are also resources available online and in person. The American Library Association and Federal Reserve Bank (Chicago) sponsor an annual Money Smart Week (April 22-29) that includes financial literacy events across the country. Many public libraries also offer programs on an ongoing basis.

Benjamin Franklin said that an investment in knowledge pays the best interest, and that’s especially true when it comes to financial literacy. There’s certainly no downside to becoming financially literate and it can be argued that it’s increasingly essential as individuals take on greater responsibility for securing their financial future.

1. Source: Annamaria Lusardi and Peter Tufano, “Debt Literacy, Financial Experiences, and Overindebtedness,” National Bureau of Economic Research, March 2009.
2. Annamaria Lusardi and Olivia S. Mitchell, “The Economic Importance of Financial Literacy: Theory and Evidence,” Journal of Economic Literature 2014.
3. Robert L. Clark, Annamaria Lusardi and Olivia S. Mitchell, “Financial Knowledge and 401(k) Investment Performance,” National Bureau of Economic Research, May 2014.