Monday, March 5, 2012

Why isn't Finance Understandable? Here are some Ideas on Fixes

When I talk to my non-finance friends about safe and fair finance, their first response is that, as a first priority, finance should be understandable. One can only wonder why consumer finance is not easy to understand.

From a conceptual perspective, consumer finance is super simple. Financial products sold to households consist of just a few variations of a theme. Loans are provided for a short period of time (such as for credit card borrowing or payday lending) or a long period (to finance a residential mortgage, for example). The interest rates are either fixed or floating, or fixed for a while and then floating for a while, or vice versa. Fees are due when you set up the loan or you pay it back early or you don’t pay on time. It gets more complicated if you provide your house or apartment as collateral, or if your lender insists on life insurance (in case you die before the loan is repaid). It is the same in reverse when you make deposit money in the bank--except that you can't ask for life insurance for the bank. That is why deposit insurance was put in place.

Investing in securities may seem to be same as betting in the casino but there are lots of rules (although maybe not enough rules) on how companies treat retail investors. In general, if Apple sells lots of iPhones and iPads, you (the investor) see the value of your shares rise. But if your company declares bankruptcy, your stock certificates have value only as framed collectors’ items. Buying into a mutual fund (or collective investment fund in Europe) means that you hire a professional to choose stocks for you. You just have to decide on your risk profile and the manager does the rest (for a fee).

Even insurance is not so difficult to understand. If you have a car accident or a house fire, the insurance company pays for most of the damage. The complicated part is if you buy a variable annuity (or investment-linked annuity in Europe), which is really a securities investment camouflaged as insurance. A variable annuity is indistinguishable from a mutual fund but supervised under the insurance regulation rather than securities regulation. But most consumer financial products are not that convoluted.

The hard part in all of this is figuring out how much money you need to save to cover you if you don't work again for the rest of your life, i.e. when you retire. But that's another issue.

In itself, figuring out how to use financial products is simple stuff—or should be. Why is it that people with advanced college degrees have difficulty understanding what they are buying? Why is it more fun to buy a sweater at Nordstrom’s than open a certificate of deposit with Bank of America? Clearly financial service providers have not clued into the idea that consumers like retail therapy—and that for most people, dealing with personal finance is a painful experience. Indeed a 2005 survey by the Royal Bank of Canada found that for most people, selecting the right investment for their retirements was more stressful than going to the dentist.

So what is the solution?

Safe and Fair Finance Blog suggests that as a starting point, financial institutions should be obliged to make consumer information easy to understand. The standard for consumer health information is that it should be understandable for people with just a ninth grade education. Given that 90 percent of Americans have graduated from high school or have equivalency diplomas, this would seem to be a reasonable standard. Why is the same not also required for consumer financial information?

Some people are trying. In a video from Tristan Cooke and Tom Nelson of the Australian firm, Humans in Design, they lay out how residential mortgage statements (in this case from Westpac Bank) could be redesigned. Their view is that customers want to receive clear and concise information about their mortgages. The proposed layout provides clear information that is useful for consumers in making decisions, such as whether to increase their repayments of their mortgages. The graphs also show the impact of changes in interest rates. The idea is that by giving customers clear and concise information about their monthly statements, consumers will feel empowered to make informed decisions about managing their mortgages.

Some of the government regulators are also working on it. The U.S. Federal Reserve Board conducted extensive surveys of shoppers to work out the government-mandated format for credit card statements. What used to be complicated and hidden in fine print is now easy to read—and even easier to understand. What is most striking is the estimate of how many months (or years) it will take to pay off your credit card debt if you only make the minimum monthly payment. Thank you, Federal Reserve.

Safe and Fair Finance Blog hopes that other regulators, consumer groups and just marketing folks also try their hand at making consumer finance understandable for us all.
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