Sunday, February 12, 2012

Financial Literacy & Consumer Behavior: Can a Nudge work better than a School Book--or a Government Regulation?

Advocates for improved financial literacy suffer from a clear dilemma. Almost everyone supports that idea that all consumers need to be financially literate so that they can make informed decisions. Yet very few of financial education programs have proven effective in improving the levels of financial literacy.

A comprehensive review of the success of financial literacy education programs was conducted by Lauren Willis, Professor of Law at Loyola Law School and published in 2008. In study after study, Professor Willis came to the conclusion that financial education is not worth the investment. She found that education in financial literacy did not make individuals better able to make sound decisions in their use of financial services. Furthermore in some cases, the training provided a false level of confidence, encouraging investment in speculative stock market deals.

However the real problem is that even financially literate consumers can make “bad” economic decisions.

It may therefore be time to think about alternative approaches. In their 2009 book, Nudge: Improving Decisions About Health, Wealth, and Happiness, Richard Thaler and Cass Sunstein show how “choice architecture” can be established to nudge consumers in beneficial directions without restricting their freedom of choice.

Decisions about retirement planning provide a good case in point. Most people do not save enough money for retirement. In the U.S., data was collected of households with a 401(k) retirement account and where the primary earner was between 60 and 62. The study found that median households had saved less than one-quarter of what is needed to maintain income at the 85% pre-retirement level (according to data compiled by the Federal Reserve and analyzed by the Center for Retirement Research at Boston College for The Wall Street Journal.)

However a 2007 paper by the Vanguard Center for Retirement Research found that where new employees are automatically signed up in employer-supported pension plans (i.e. the 401(k) defined-contribution matching plans found in the U.S.), 86 percent stay in the plan, even when they have the option to opt out and withdraw from the plan. By contrast, when new employees are informed about the corporate pension plan and merely invited to join, only 45 percent do so. However the employees that were automatically enrolled were three times more likely to allocate all of their contributions to the default investment fund than were those investing in voluntary plans (67% versus 21%).

The implications are obvious. Since almost everyone will need a pension plan when they retire, the “default” option should be to register all new employees in the plans. But more still will be needed. The U.K. provides some intriguing ideas.

With Professor Thaler and a U.K.-based research team, the U.K. Government has established a Behavioural Unit Team (BIT a.k.a. the Nudge Team). They have not yet started working on consumer protection in financial services but their annual report for the first year provides some interesting ideas that might be applicable for financial consumer protection.

On public sector reform, BIT proposes two approaches. First, BIT suggests using transparency and feedback loops from users. Comments from other consumers can have a powerful impact on selection of choices as anyone who has used eBay, Amazon or Yelp can attest. Safe and Fair Finance Blog suggests that the difficulty is to ensure that feedback loops are not abused—by disgruntled former employees or the marketing staff of competitors. However well-designed consumer feedback sites can help consumers express their views of the quality of the customer experience in buying and using financial services and products.

Second, BIT suggests that whistle-blowers be encouraged. Regulators can be blind to the problems that can only be seen from the inside of a business or service. Providing rewards to whistle-blowers can help bring the issues to the surface. The amount of the rewards should be based on evidence that allows for the identification of significant harm to consumers. Safe and Fair Finance Blog suggests that encouraging whistle-blowers in the mortgage brokers to come forward might have helped save millions of consumers from toxic subprime borrowings.

Cutting red tape and reducing regulation is a goal for all governments. Such efforts are more likely to succeed when policy-makers (and industry and consumers) can identify an alternative process that delivers the same result—or better.  Safe and Fair Finance Blog suggests that both ideas from BIT might prove to be powerful not just for public sector reform but also for improvements in consumer protection related to financial services.

Safe and Fair Finance Blog would like to thank Tim Harford (a.k.a. the Undercover Economist) of the Financial Times for his opinion article about the Nudge Team and their valuable work.

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