Financial literacy refers to the ability to make informed decisions about the use and management of financial resources (U.S. General Accounting Office [GAO], 2006). This includes managing risk, using credit responsibly, saving for desired goals, and avoiding transactions that can undermine financial stability. Every household has to make decisions about its finances; yet overwhelmingly, U.S. households have been shown to make poor financial choices and show a lack of financial literacy and financial planning. Although low financial literacy spans all demographic groups, it is more prominent among older adults, women of all ages, minorities of all ages, individuals with little education, and those who have had little exposure to economics while in school (Lusardi & Mitchell, 2009). The Financial Industry Regulatory Authority (FINRA) National Financial Capability Study found that measured financial capability is lowest among adults with no postsecondary education, households with incomes of $25,000 per year or less, and Hispanics and African Americans (Applied Research & Consulting, 2009).
Financial literacy is associated with an individuals financial outcomes. Those who have relatively high levels of financial literacy tend to have better financial outcomes, and correspondingly, those who have lower levels of financial literacy tend to have worse financial outcomes. Hilgert, Hogarth, and Beverly (2003) find that households with low scores on a cash management index (indicating that they had poor financial behaviors) also had lower financial knowledge scores than individuals with higher scores on the cash management index. They found the same effect for a credit management index, a savings index, and an investment index. In a review of the literature, Lusardi (2008) suggests that financial literacy has an impact on financial outcomes by affecting individuals ability to make decisions. Lusardi cites studies that show those who are more financially literate are more likely to invest in the stock market; those who are unable to calculate interest rates borrow more and accumulate lower amounts of wealth; those who underestimate compound interest are likely to experience difficulties repaying debt; financial literacy declines with age, with a commensurate increase in the need to make financial decisions; and women make more mistakes, particularly in relation to risk diversification. Results from the FINRA National Financial Capability Study, a survey of 1,488 individuals, reported an association between greater financial literacy and having an emergency fund and fewer incidents of credit card behavior that will lead to high-interest payments and fees (Applied Research & Consulting, 2009). However, these data were based on self-reports and may have response bias because of social desirability.
Many consumers experience financial strain. In the same FINRA study described above, almost half the respondents reported having trouble keeping up with monthly expenses and bills (Applied Research & Consulting, 2009), and low-income respondents faced even more financial challenges. While 33% of all respondents experienced a decline in income in the year preceding the summer of 2009, 41% of those earning less than $25,000 a year experienced a decrease. Hispanic respondents were also disproportionately affected, with 43% experiencing a decline in income. Not surprisingly, individuals reporting a decline in their income were more likely to report trouble making ends meet than were those who did not report such a decrease (Applied Research & Consulting, 2009).
While most consumers interact regularly with financial institutions, a significant minority of the population, particularly those with low incomes, does not. Overall, 12% of the population appears to lack both a checking and a savings account, while 15% lack a checking account and 28% do not have a savings account. In low-income communities, 31% of individuals were unbanked (i.e. had no bank account at the time of the survey) (Applied Research & Consulting, 2009; Seidman, Hababou, & Kramer, 2005). For both the low-income group and the general population, those without bank accounts were more likely to have lower incomes, lower education levels, and to be minorities than those with bank accounts (Seidman, et al., 2005; Applied Research & Consulting, 2009). The reasons the unbanked respondents gave for why they did not have accounts included not having enough income, not being able to afford the high cost of minimum balances, and living in communities with little need for checks (Seidman, et al., 2005; Applied Research & Consulting, 2009). Other reasons included not wanting to share personal information and having an aversion towards banks (Applied Research & Consulting, 2009).
However, interacting with financial institutions is not necessarily an indicator of financial literacy. Many individuals who hold rather complex financial instruments (such as mortgages, credit cards, or individual retirement accounts [IRA]) end up with problems when they overextend themselves or default on their obligations. Similarly, many individuals overdraw their bank accounts or incur penalty fees while using debit or credit cards. Low financial literacy, particularly related to the financial products and services being used, may be a factor in such circumstances.
Research suggests that financial literacy is a significant predictor of retirement behavior (Gonyea, 2007). Although 70% of American workers are saving for retirement, only 42% have calculated how much they will need for retirement (Helman, Greenwald, Copeland, & VanDerhei, 2006). Fifty-one percent of individuals have retirement accounts from their employers, 72% of which are defined contribution plans. Twenty-eight percent of those individuals who have employer plans also have additional retirement accounts (Applied Research & Consulting, 2009). Only 51% of those between 45 and 59 years of age have thought about what they need for retirement (Applied Research & Consulting, 2009).
Fifty-five percent of low-wage workers reported maintaining some retirement savings. Within this group, approximately 25% had set aside less than $2,500, and another 25% had set aside only $2,500 to $10,000 (Gonyea, 2007). Those with a greater understanding of investment and savings options were 30% more likely to have started to build up their retirement funds; also, workers who understood their employers defined contribution plans were twice as likely to report having retirement funds as those who did not.
Studies demonstrate that lower levels of financial literacy can lead to poorer outcomes related to preparation for retirement. Lusardi and Mitchell (2006) suggest that financial literacy is strongly associated with financial planning, and those with less financial knowledge are far less likely to plan for retirement or succeed in their planning. These authors suggest that one reason people may fail to plan for their retirements is that they have low financial literacy. The authors also find that those who were more financially literate made more sophisticated investment choices and therefore were likely to accrue more money in the long run. Results from the FINRA National Financial Capability Study also demonstrated that individuals with greater financial literacy were more likely to plan for their retirement and less willing to take financial risks than less financially literate people (Applied Research & Consulting, 2009).