Using the Right Yardstick: Assessing Financial Literacy Measures by Way of Financial Well-being

Abstract

With the shifting of responsibility for retirement planning and risk from employers to employees, the growth of 401(k) plans and the recent financial crisis, researchers, policy makers and practitioners have become increasingly concerned with the financial literacy of the U.S. population. Along with this interest has come a need to develop measures of financial literacy in order to evaluate interventions to improve financial literacy and examine the implications of financial literacy for financial well-being. However, the measurement of financial literacy is in its infancy. Questions to assess financial literacy have only recently been included in major secondary data sets, and the limited data on financial literacy and financial outcomes has largely led to simple cross-sectional analysis to validate these measures as predictors of financial wellbeing. Moreover, questions used to assess a respondent’s level of financial literacy that ask about knowledge of compound interest, inflation, and portfolio allocation/risk, may be salient in different ways across different segments of the population. Of particular concern is the relevance of these questions for measuring financial literacy among low-income populations who rely more heavily on Social Security benefits, and encounter very different forms of financial decisions and financial products than upper/middle income households. Using data from nine waves of the Health and Retirement Study (HRS) we examine whether existing measures of financial literacy are descriptive and/or predictive of successful household financial management and resilience to the recent financial crisis. Specifically, we assess whether correct responses to various financial literacy questions are significant predictors of successful asset accumulation, resilience to asset loss and changes in retirement expectations. We find that once individual characteristics are carefully controlled for correct responses to many of the financial literacy questions in widespread use are not significant predictors of asset accumulation or resilience to financial shocks