Why Understanding Financial Matters is so Important

In 2008 a pair of researchers at a US university sought to test a sample of people’s financial literacy. They presented the following three questions:

1. Suppose you had $100 in a savings account paying 2% per annum. After 5 years how much would you have in the account? a) more than $102 b) exactly $102 or c) less than $102.
2. If the interest rate on your savings account was 1% per annum and inflation was 2% per annum, after one year would you be able to buy a) more than, b) the same, or c) less than today with the money in the account?
3. Buying a single company stock usually provides a safer return than a stock mutual fund. a) True b) false

The questions were presented to statistically representative groups in a number of countries. Simple questions? Only in Germany and Switzerland did a majority (53% and 50.1%) of respondents get all three questions right. In the US the figure was 30%, Japan 27% and Italy 24%. It would be interesting to see how readers of this column would fare in a similar study.

Does lack of knowledge make a big difference?

It certainly can. Failure to understand the impact of interest rates can lead to people spending on credit cards to their limits and repaying minimum amounts monthly without fully realising what interest rate they are being charged. Raising cash from a credit card can be even more costly, resulting in paying an interest rate of up to 40% per annum.

Failure to understand the impact of inflation can also lead to poverty in later life. Annuities are an example. In the UK, members of private pension schemes are currently obliged to convert the value of their pensions to annuities upon retirement. That is going to change next April when members will be free to take as much of their pension as and when they wish. The idea of an annuity is that you are guaranteed a fixed income for life so why would anyone wish to change that? There are three principal reasons; firstly, annuity rates are linked to bond rates which are at all time lows so the pension is not as attractive as it would have been several years ago when interest rates were higher. Secondly, there is unlikely to be any protection against inflation so what might appear a liveable income today could be worth a pittance in years to come. Thirdly, an annuity normally dies with you and your spouse. No matter how big a pension pot you started with there is nothing left to pass on to your estate.

So on the surface the British government’s decision to allow pensions to be freed up sounds good. Maybe so, but there is a serious downside and it does not take into account people’s poor undersanding of finance or human nature. One of the downsides is that withdrawals above a certain limit will be subject to heavy taxation. The other is that few people will be sufficiently prepared to manage a large sum of money. Invariably many will spend their pension pots too quickly and will be faced with a bleak financial future forcing them to become dependent on government handouts which may not even be available in the future.

People will be faced with a difficult choice of going with the old annuities and having a steady but small income for life or trying to squeeze a better income for life out of a lump sum while facing all the pitfalls of the investment world.

In the UK people will no longer be able to turn to financial advisers for free advice as the latter are no longer allowed to receive commissions from life companies and product providers but have to charge fees. To be economic these fees will be beyond the budget of average families.

What are governments doing about it?

The UK government has promised to provide an advisory service to pensioners to help them with their financial planning. A similar scheme was offered to national lottery winners but still resulted in many cases of big winners ending up financially ruined. Human nature is a powerful force and not easily tamed. Only sustained education will instill a level of discipline in financial management and even then there is no guarantee of success.

Australia has taken a lead with an initiative launched earlier this year by the Australian Securities and Investments Commission (ASIC). It provides for a ‘national framework for action’ across the government, business, community and education sectors. The programme was the result of a year-long consultation which prioritised the areas in which people required financial education.

Clearly much more needs to be done globally to educate the next generation so they can face the complexities of the financial world with confidence.

What can we do to improve things right now?

Many people do not have the time or inclination to learn about financial matters such as interest rates and mortgages, annuities, stocks, bonds and other investment vehicles. Yet a modest amount of time devoted to the subject could make a big difference to one’s financial well being. It is important to understand the importance of maintaining adequate cash resources so you do not find yourself in the position of having to borrow money at exorbitant rates. Budget carefully and don’t live beyond your means. And calculate carefully how much you will need to accumulate to ensure a comfortable retirement.

Self education costs little. If you are keen to learn as much as you can about personal finance there are plenty of books on the market or you can just go online and read some of the hundred or so previous articles in this column on the BA website!

Colin Bloodworth of PPI Indonesia has spent over 20 years in Indonesia. He is based in Jakarta but visits Bali frequently. If you have any questions on this article or related topics you are welcome to contact him at colin.bloodworth@ppi-advisory.com or +62 21 2598 5087