Social Security and Pension Reform: International Perspectives

14 - Financial Literacy, Education, and Advice, John A. Turner and Dana M. Muir

299 14 Financial Literacy, Education, and Advice John A. Turner Pension Policy Center Dana M. Muir Stephen M. Ross School of Business, University of Michigan Social security privatization with individual accounts and employerprovided defined contribution systems shift responsibility for investment decisions to individual workers. With social security privatization, workers usually have some choice as to how the money in their individual accounts is invested. The choices workers make can have an important effect on their levels of retirement income. By comparison, in traditional social security and pension systems, fewer burdens for decision-making responsibility are placed on individual workers. Instead , decisions regarding financial management of investments are made by financial professionals. A further distinction is that in traditional defined benefit plans workers do not bear financial market risk, while in privatized defined contribution plans workers do bear this risk. This raises the issue of how to communicate to workers who are financially unsophisticated to the possible consequences of financial market risk. Proponents of social security privatization and defined contribution systems argue that workers are capable of learning about financial markets and investments and making good financial decisions. Traditional economics, which assumes well-informed, rational decision makers, supports that position. Behavioral economics, however, focuses on the difficulties that many workers have making financial decisions. Many workers are not interested in, and some are not capable of, learning the financial information needed to adequately manage an individual acIn order to view this proof accurately, the Overprint Preview Option must be checked in Acrobat Professional or Adobe Reader. Please contact your Customer Service Representative if you have questions about finding the option. Job Name: -- /356308t 300 Turner and Muir count. In addition, the market for financial services is more complex and less transparent than most other markets for goods and services (Rajnes 2003). In part because of problems clients have encountered when they seek financial advice, trust in financial services is at a low level. A recent survey in the EU finds that many people mistrust pension and investment services, ranking 50th among the services surveyed and ranking lower in trust than the market for used cars or for gambling (KPMG 2011). In this chapter, we discuss financial literacy and financial advice as weak links in social security privatization and employer-provided defined contribution systems. They cause programs to take on added expenses to try to reduce the effects of worker investment errors and bad advice. Widespread financial education has become a necessary part of social security privatization. We begin by discussing the lack of financial literacy and some of the types of errors that workers make in managing individual account pensions. We document that lack of financial literacy is widespread in a number of countries. We then discuss in turn financial education and financial advice as possible responses. Financial education is often seen to have limited success, in part because of a lack of interest by workers . This discussion is followed by commentary on problems that have arisen with financial advice, including legal issues that arise when advisers do not have a fiduciary duty to act in the best interest of their clients. We explain how the structure and level of advisory fees may result in conflicts of interest that may affect the quality of advice provided to individuals. Then we explain how laws and regulations are evolving in different countries in response to the conflicts of interest. We offer conclusions in a final section. ERRORS INVESTORS MAKE Making investment decisions is a complex process that requires an understanding of risk diversification as well as knowledge about different types of investments. A recent U.S. survey finds that 34 percent of investors were “overwhelmed” by the options facing them (Cornfield In order to view this proof accurately, the Overprint Preview Option must be checked in Acrobat Professional or Adobe Reader. Please contact your Customer Service Representative if you have questions about finding the option. Job Name: -- /356308t Financial Literacy, Education, and Advice 301 2012). Another study finds that only 31 percent of U.S. workers are confident in their ability to manage their investments during retirement (Yakoboski 2005). A Canadian study finds that workers rated choosing the right investment for their individual account pension plan (RRSP plan in Canada) as more stressful than seeing the dentist (Canadian Press 2005). While traditional economic theory assumes that investors do not make systematic errors, increasingly economic theory, using insights from behavioral economics, suggests...