Why Financial Literacy Is Most Important

Financial Literacy : As consumer habits and financial products change, financial literacy has taken a blow. In past generations, cash was used for most daily purchases; today, it’s rarely flashed—particularly not by younger shoppers.

Financial Literacy in Decline

The way we shop has changed as well. Online shopping has become the top choice for many, creating ample opportunities to use and overextend credit—an all-too-easy way to accumulate debt, and fast.

Also meanwhile, credit card companies, banks, and other financial institutions are inundating consumers with credit opportunities—the ability to apply for credit cards or pay off one card with another. Without the proper knowledge or checks and balances, it is easy to get into financial trouble.

Many consumers have very little understanding of finances, how credit works, and the potential impact on their financial well-being for many, many years. In fact, the lack of financial understanding has been signaled as one of the main reasons many Americans face problems with saving and investing.

Every few years, the Financial Industry Regulatory Authority (FINRA) issues a five-question test as part of its National Financial Capability Study, which measures consumers’ knowledge about interest, compounding, inflation, diversification, and bond prices.

On its most recent test, only 34% of those who took the test got four out of five questions correct, which suggests that the basic economic and financial principles that underpin these problems are widespread, touching every state in the country in different ways.

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Key Takeaways

  • Financial literacy is the education and understanding of various financial areas including topics related to managing personal finance, money, borrowing, and investing.
  • Trends in the United States show that financial literacy among individuals is declining, with only 34% of respondents correctly answering four out of five questions posed by FINRA on the topic.
  • At the same time, financial literacy is more important than ever as people manage their own retirement accounts, trade personal assets online, and carry student, medical, credit card, and mortgage debt.

What Is Financial Literacy?

Financial literacy is the confluence of financial, credit, and debt management knowledge that is necessary to make financially responsible decisions—decisions that are integral to our everyday lives.

Financial literacy includes understanding how a checking account works, what using a credit card really means, and how to avoid debt. In sum, financial literacy has an impact on families as they try to balance their budget, buy a home, fund their children’s education, and ensure an income at retirement.

A lack of financial literacy is a problem not only in emerging or developing economies. Consumers in developed or advanced economies also fail to demonstrate a strong grasp of financial principles in order to understand and negotiate the financial landscape, manage financial risks effectively, and avoid financial pitfalls.

Nations globally, from Korea to Australia to Germany, are faced with populations that do not understand financial basics.

The level of financial literacy may vary with education and income levels, but evidence shows that highly educated consumers with high incomes can be just as ignorant about financial issues as less-educated, lower-income consumers (though, in general, the latter do tend to be less financially literate). And it seems consumers are hesitant to learn.

The Organization for Economic Co-operation and Development (OECD) cited a survey conducted in Canada in which people reported that they found choosing the right investment for a retirement savings plan was more stressful than a visit to the dentist.

Trends Making Financial Literacy More Important

Compounding the problems associated with financial illiteracy, it appears financial decision-making is also getting more onerous for consumers. Five trends are converging that demonstrate the importance of making thoughtful and informed decisions about finances:

1) Consumers are shouldering more of the financial decisions

Retirement planning is one example of this shift. Past generations depended on company pension plans to fund the bulk of their retirement. Pension funds, managed by professionals, put the financial burden on the companies or governments that sponsored them.

Consumers were not involved with the decision-making, typically did not even contribute to their own funds, and they were rarely made aware of the funding status or investments held by the pension.

Today, pensions are more a rarity than the norm, especially for new workers. Instead, employees are being offered the ability to participate in 401(k) plans, in which they need to decide how much to contribute and what to invest in.

2) Savings and investment options are more complex

Consumers are also being asked to choose among various investment and savings products. These products are more sophisticated than in the past, requiring consumers to choose among different options that offer varying interest rates and maturities, decisions they are not adequately educated to make. The choices made from among complex financial instruments with a large range of options can impact a consumer’s ability to buy a home, finance an education, or save for retirement, adding to the decision-making pressure.

3) Government aid is lacking

A major source of retirement income for past generations was Social Security. But the amount paid by Social Security is not enough, and it may not be available at all in the future. The Social Security Board of Trustees reported that by 2034 the Social Security trust fund may be depleted, a scary prospect for many. So now, Social Security acts more like a safety net that barely provides enough for basic survival.

Longer lifespans mean we need more money for retirement than earlier generations did.

4) The financial environment is changing

The financial landscape is very dynamic. Now a global marketplace, there are many more participants in the market and many more factors that can influence it. The quickly changing environment created by technological advances such as electronic trading makes the financial markets even swifter and more volatile. Taken together, these factors can cause conflicting views and difficulty in creating, implementing, and following a financial roadmap.

5) We are inundated with choices

Banks, credit unions, brokerage firms, insurance firms, credit card companies, mortgage companies, financial planners, and other financial service companies are all vying for assets, creating confusion for the consumer.

Why Financial Literacy Matters

Financial literacy is crucial to help consumers manage these factors and save enough to provide adequate income in retirement while avoiding high levels of debt that might result in bankruptcy, defaults, and foreclosures.

Yet in its Report on the Economic Well-Being of U.S. Households in 2019, the Board of Governors of the Federal Reserve System found that many Americans are unprepared for retirement. One-fourth indicated that they have no retirement savings, and fewer than 4 in 10 non-retirees felt that their retirement savings are on track.

Among those who have self-directed retirement savings, nearly 60% admitted to feeling low levels of confidence in making retirement decisions.

Low financial literacy has left millennials—the largest share of the American workforce—unprepared for a severe financial crisis like the coronavirus pandemic, according to research by the TIAA Institute. Even among those who report having high knowledge about personal finance, only 19% answered questions about fundamental financial concepts correctly.

Forty-three percent report using expensive alternative financial services such as payday loans and pawnshops, more than half lack an emergency fund to cover three months’ expenses, and 37% are financially fragile (defined as unable or unlikely to be able to come up with $2,000 within a month in the event of an emergency).

Millennials also carry large amounts of student loan and mortgage debt—in fact, 44% say they have too much debt.

While these may seem like individual problems, they have a broader effect on the entire population than previously believed.

All one needs to do is look at the financial crisis of 2008 to see the financial impact on the entire economy that arose from a lack of understanding of mortgage products (and therefore a vulnerability to predatory lending) or the lack of financial preparedness that threatens a rise in mortgage foreclosures due to job loss during the COVID-19 crisis.

Financial literacy is an issue with broad implications for economic health and an improvement can help lead the way to a global economy that is competitive and strong.

The Bottom Line

Any improvement in financial literacy will have a profound impact on consumers and their ability to provide for their future.

Recent trends are making it all the more imperative that consumers understand basic finances because they are being asked to shoulder more of the burden of investment decisions in their retirement accounts—all while having to decipher more complex financial products and options.

Becoming financially literate is not easy, but once mastered, it can ease life’s burdens tremendously.

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