In 2012, Federal Reserve Chairman Ben Bernanke1 gave a speech on the importance of financial education. People commonly make financial mistakes such as saving too little, taking on too much debt, holding too little life insurance, making bad investment decisions and paying excessive fees that are unnecessary. The consequences of these mistakes can be enormous. They can be measured in terms of foregone opportunities, lesser net worth, or even personal bankruptcy and family impoverishment.
Reasons for mistakes
Why do people make these “mistakes”? Everyone faces complicated financial decisions such as how much education to obtain, how big a home to buy, how much to borrow and to save, how to invest, how to manage retirement. Financial products can be complex and multi-featured. Typically, financial products salespeople have an information advantage relative to the customer, and in many cases are incentivized to complete a transaction rather than augment the customer’s welfare.
Sometimes financial products are sold to people who do not fully understand all the relevant features. The positive features are accentuated while the negative features are downplayed or ignored. One example of this is the 2/28 hybrid subprime mortgage loan that was very popular in the mid 2000s. This mortgage had a relatively low start rate that was fixed for two years, and at the end of two years the rate would adjust to a floating rate at a large spread over a market index, typically LIBOR. The combination of a floating rate and large spread meant that this loan was highly risky for the borrower after the two year fixed rate period. The key selling point for the loan was that if the borrower could maintain a history of on-time payments during the fixed rate period, then the borrower would be eligible to refinance into a prime mortgage loan at a much lower rate. The unstated premise underlying the loan was that housing prices would trend higher. Of course, housing prices peaked in 2007 and began to fall. This eliminated the possibility of refinance for many 2/28 borrowers.
When you stop and think about the complexity of financial products, it is easy to see that ordinary people may not fully grasp the intricacies. This point was driven home to me by another Bernanke speech2; a presentation to his fellow professional economists at the American Economic Association in January 2009. In this speech Chairman Bernanke was describing what he felt to be the root cause of the financial crisis; namely, proliferation in mortgage loans with low initial payments. In particular, he focused on the “Pay Option ARM” in which borrowers were allowed to select their desired payment from a set of choices. The lowest payment generally was based on an initial start rate of 1%. The Chairman calculated the monthly payment on a hypothetical $180,000 loan to be just $150 ($180,000*.01/12=$150), as compared to $1,079 for the payment on a thirty year fixed rate fully amortizing loan at the then market rate of 6%. Obviously, $150 is a lot lower than $1,079 and this would have enabled many more people buy homes or to refinance. However, the typical Pay Option loan payment was not “interest only” as assumed by the Chairman, but rather was fully amortizing. The fully amortizing payment at a 1% annual rate is $579. In other words, if one of the smartest economists on the planet, in a speech assigning blame for a major financial calamity could be off on his estimate of the correct payment by 300%, how are the rest of us going to get it right?
One issue is a widespread lack of financial literacy. Perhaps financial decision-making would improve if more people became financially astute. Or, another possibility is people are fully aware of what they are doing. For example, perhaps savings rates are low simply because people discount future consumption heavily, strongly preferring consumption today. To choose between these alternative explanations, we need to assess the effect of financial literacy on financial decision making.
Academic experts aim to measure financial literacy using survey techniques. If people are unable to answer simple questions about percentages, or interest rates or even arithmetic, then they are deemed to be not financially literate. This problem is widespread. For example, more than 50% of the respondents on a survey were unable to correctly answer all of the following questions: 1. A disease has an incidence of 10%. Given 1,000 people, how many would you expect to have the disease? 2. If 5 people all have the winning number in a lottery and the prize is $2 million, how much will each of them get? 3. If you invest $200 at 10% annual interest, what sum will you have in two years? Based on questions like these, Professor Annamaria Lusardi has put together an index of financial Literacy (the FLI), and in one research paper3 she shows that people that score higher on the FLI tend to save more and spend more time engaged in retirement planning. People who score higher on the FLI also have higher savings rates, less debt, and in general appear to make more sensible financial decisions.
It seems to me that financial illiteracy is the failure to understand adequately how financial products work and, in particular, what are the downside risks. Rather than being a narrow problem, Professor Lusardi’s research and Chairman Bernanke’s 2009 speech suggest that it is widespread. In fact, maybe nearly all of us are afflicted with this disease. It is important and worthwhile to search for a cure, or at least a way to cope.
Behavioral researchers have found that there are psychological obstacles in the way of making coherent financial decisions, even if you have access to good information and advice. It is worthwhile to attempt to identify these obstacles and understand how they can impair good decision making.
Finally, some argue that the primary factors keeping most people from achieving financial independence are structural – falling real wages, low economic mobility and rising costs of necessities including education, housing and health care. Irrespective of what you think of the merits of this argument, people will be better off if they make better decisions. How can they do that?
What is the solution to this problem? One answer is consumer financial protection. The Dodd-Frank financial regulation bill mandated establishment of the Consumer Financial Protection Board (CFPB). The CFPB encourages financial services companies to offer simple products that are easily comparable across vendors, and has the authority to force providers to disclose information in an understandable format. This is intended to make it is a lot easier for customers to conduct comparison shopping. However, this does not address the reality that financial decision making is inherently complex. There are several sources of uncertainty including future wage income, investment returns and mortality. Simple products would be great; but which ones should we buy and how much?
Another approach is to develop educational programs in financial literacy for school children and adults, just as Chairman Bernanke discussed in his recent speech. The Fed has established a website that contains useful materials for students and teachers alike. Professor Lusardi has shown that people who participate in financial education programs score higher on her literacy index, and therefore are more likely to make sensible financial decisions.
Of course, you can always turn to firms that offer advice and guidance that is unbiased. But, how can you be sure that your advisor is unbiased and that her advice is worth her fee?
Again, buyers of financial products need to become more knowledgeable and discerning. At the end of the day, each individual needs to choose the information sources that they find most amenable and trustworthy. The goal is to find advice that is unbiased and expert. You don’t necessarily have to become an expert yourself, but you do have to learn enough about the issues so that you are comfortable you are not being led astray.
Economists argue that financial planning rules of thumb (like a 4% withdrawal rate in retirement or a 10% savings rate while working) are not optimal and maybe even not sensible. The key economic idea is that consumption should be stabilized as much as possible. Since income is not stable, the implication is that the savings percentage of income will not be stable either. In periods of relatively high income, the optimal savings rate will be high and in periods of relatively low income, the optimal savings rate will be low.
Economists have developed sophisticated models to solve the financial planning problem. The objective is to find the maximum smoothed consumption path that is consistent with your resources and aspirations. The solution is take account of uncertainty about future wages, investment returns, mortality, and non-discretionary expenditures and solve for a decision rule that produces the appropriate spending and investment rules given your current situation.
The problem I see with the economist approach is twofold. First, the calculation is complex and not likely to be fully understood by very many people. It is more likely that people will follow a program that they understand. Second, the solution may be fragile in the sense that it is highly sensitive to the underlying assumptions. I think a better way to go is to build in a margin of safety through what I call a “sustainable” financial plan.
Sustainability – keeping it simple
To paraphrase Herb Stein, if a path is not sustainable then it will not continue forever. Conversely, a sustainable path is one that is likely to be able to withstand shocks without failure. Everyone is on a financial path of one sort or another, but many of them will eventually require drastic adjustment.
How do you come up with a viable plan?
You can go to a certified financial planner or to an economist that specializes in financial planning. Or you can produce a bare bones plan yourself. Here is a simple four-step process.
First, identify your financial resources including current financial net worth (the value of assets less debt), current and likely future income, the value of retirement plans including social security (if not already counted in financial net worth), and the amount of estimated future obligations, like your contribution to college expenses for your children.
Second, estimate (conservatively, since this is to be a sustainable plan) the after-tax real rate of return that you can expect to achieve on your investments. This will depend on your willingness to take risk and your degree of investment skill. For most people, the best investment strategy is to avoid relying on skill. Instead, invest in broad passively managed index funds.
Third, use the rate of return from step 2 to calculate the present value of your resources less obligations. This is your “wealth.” It consists of the sum of financial capital and human capital, less the value of future obligations.
Fourth, calculate the smoothed consumption path that is consistent with the available resources. This can be expressed as a fraction of current wealth where the fraction approximates the expected return from step 2. For many young people, it is likely that this optimal consumption level will be greater than current income. If this is the case then it is advisable to pare consumption to the lower of “optimal consumption” and current disposable income. For those people in or close to retirement, wealth will be dominated by financial capital and is subject to market volatility. It is possible that a major downdraft to equity prices will push wealth and therefore consumption sharply lower. To protect against this outcome, you can utilize several strategies. First, be mindful of excess concentration in equities. Second, build a cushion by not increasing consumption every time investment returns exceed your estimate. Third, consider a portfolio allocation to fixed annuities. And finally, if you must “retrench” do so in an optimal way as described by Gordon Pye in his book The Retrenchment Rule.4
There you have it, a sustainable path for consumption. Let’s take an example.
Consider the median income household with $50,000 after-tax income; head of household aged 45; intended retirement at 65, worst-case mortality at 100 and with $150,000 net worth. Assuming 3% real after-tax return on investment, total wealth is approximately $1.25 million, and the smoothed real consumption path is $37,500, or 75% of disposable income. This means saving 25% of income. Is the median household saving this much? No, the median savings rate is closer to 5% than 25%, so that actual consumption is $47,500 instead of $37,500. This is most likely not a sustainable plan. Something will have to change. It is possible that the portfolio return will be significantly greater than 3%. For example, if the realized after-tax real return is 5%, then the current level of consumption is sustainable. Alternatively, if the household head postpones retirement until age 75, then the actual consumption path is sustainable even at a 3% real return.
A dynamic optimization is likely to come up with a larger recommended consumption level. But along with greater consumption you will have a greater probability of a negative outcome down the road. The sustainable plan will probably wind up with greater wealth levels as you age. This wealth represents consumption that is foregone. But is that really so bad? Greater wealth provides valuable options like the ability to support family members or charities, the ability to spend more in retirement or leave a greater estate.
In general, people save too little. The primary cost of this is reduced flexibility in retirement. The solution is to make a long-term plan to smooth lifetime consumption using realistic expectations regarding wage income, investment returns and mortality. Of course, future income, investment returns and mortality are highly uncertain. The best way to protect against downside risk is to make conservative assumptions and err on the side of saving more not less.
Sustainable, but not all that simple
Upon reflection, this plan while surely sustainable is maybe not all that simple. It involves estimating future income and equity returns, making decisions about asset allocation to risky assets and annuities, and carefully calculating appropriate consumption spending. Most people will probably want to enlist the help of a trusted financial advisor to help develop their plan. Still, the fundamental ideas of taking into account your future income and making realistic estimates of after-tax returns can be understood by nearly everyone. Keep an eye on these basic ideas and don’t let yourself get lost in the details of complex financial products.
Of course, there are other elements of a complete financial plan, like the idea of “productive debt” and how to handle extreme events (“black swans”). More on this will be forthcoming in future blogs.
1Ben Bernanke, “Financial Education,” 2012.
2Ben Bernanke, “Monetary Policy and the Housing Bubble,” 2009.
3Annamaria Lusardi, “Planning for Retirement: The Importance of Financial Literacy,” Public Policy and Aging Report, 2009.
4Gordon Pye, The Retrenchment Rule, GBP Press, 2012.