Do clients understand what advisers are saying?

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Financial literacy levels in Australia and around the world are low, but it may be eye-opening to learn just how low they are. It’s an important issue for financial advice. There’s no point providing a 70 page Statement of Advice if the client does not understand the basic concepts in there.

How is financial literacy measured? Annamaria Lusardi and Olivia Mitchell (from Dartmouth College and Wharton School, University of Pennsylvania) have led the development of financial literacy survey designs. There are two assessments most commonly used – a basic and an advanced literacy test. Here are the ‘Australianised’ versions of these tests (created by Bateman and research partners*). Answers can be found at the end of this article.

Test 1 – basic financial numeracy

  1. Numeracy/interest rate: Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow?
    (Answers: a. More than $102; b. Exactly $102; c. Less than $102; d. Do not know; e. Refuse to answer.)
  2. Compound interest: Suppose you had $100 in a savings account and the interest rate is 20% per year and you never withdraw money or interest payments. After 5 years, how much would you have on this account in total?
    (Answers: a. More than $200; b. Exactly $200; c. Less than $200; d. Do not know; e. Refuse to answer.)
  3. Inflation: Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, how much would you be able to buy with the money in this account?
    (Answers: a. More than today; b. Exactly the same; c. Less than today; d. Do not know; e. Refuse to answer.)
  4. Time value of money: Assume a friend inherits $10,000 today and his sibling inherits $10,000 three years from now. In three years, who is richer because of the inheritance?
    (Answers: a. My friend; b. His sibling; c. They are equally rich; d. Do not know; e. Refuse to answer.)
  5. Money illusion: Suppose that in the year 2020, your income has doubled and prices of all goods have doubled too. In 2020, how much will you be able to buy with your income?
    (Answers: a. More than today; b. Exactly the same; c. Less than today; d. Do not know; e. Refuse to answer.)

Test 2 – advanced financial numeracy

  1. Individual shares: Buying shares in a single company usually provides a safer return than buying units in a managed share fund
    (Answers: a. True, b. False, c. Do not know, d. Refuse to answer)
  2. Shares versus bonds: Shares are normally riskier than bonds
    (Answers: a. True, b. False, c. Do not know, d. Refuse to answer)
  3. Diversification: When an investor spreads his money across different assets the risk of losing money…
    (Answers: a. Increases, b. Decreases, c. Stays the same, d. Do not know, e. Refuse to answer)

Lusardi and Mitchell subsequently identified the three underlined questions as most significant for a shorter test which is known as the ‘financial literacy instrument’. It is used in academic studies around the world and in government body surveys in the US.

Table 1 shows the survey results for basic financial literacy for Australia and the US.

1. Numeracy / interest rate 2. Compound interest 3. Inflation 4. Time value of money 5. Money illusion All Five Correct
Australia

88.4%

71.8%

78.4%

54.9%

86.7%

36.5%

US

91.8%

69.0%

87.1%

73.8%

78.4%

43.8%

Table 1: Basic financial literacy results: Australia: Bateman et al (2011)*, US: Lusardi & Mitchell (2009)

In addition, Julie Agnew and research partners (2013)** performed the shorter financial literacy instrument test across a survey group of over 1,000 Australians. They found that only 43% achieved three correct answers.

Most industry participants should find the basic financial literacy questions quite simple, so the numbers in the final column of Table 1 should be alarming. Only 36.5% of Australian participants answered all five questions correctly, especially since the academic literature indicates that people with higher levels of financial literacy are more likely to plan for retirement.

There are many areas where the industry could make use of financial literacy tests, such as:

  • At a financial planning level: When assessing risk tolerance do financial planners also assess financial literacy? Financial literacy levels may distort risk tolerance assessments used across industry. Should risk tolerance be independent of financial literacy (ie a true measure of our tolerance for risk)? Does the way that advice is delivered take into account financial people’s level of financial literacy?
  •  For SMSF’s: Are people capable of being effective trustees of their own SMSF if they do not have basic levels of financial literacy? Is there a way that basic financial literacy assessment can be included in a checklist on whether it is appropriate for someone to establish an SMSF?
  •  For institutional super funds: Should there be a basic financial literacy requirement for trustees of super funds? While the diversity of skill arguments across trustees are well made, surely a minimum level of financial knowledge should be a pre-requisite.

The results of this research are worrying. As an industry we have to be careful to understand that financial literacy levels of non-industry participants may fail to even reach basic levels. The way that we communicate complex information is very important and an ongoing challenge for regulators, product manufacturers and financial planners.

Answers:
Basic financial literacy: 1 – a, 2 – a, 3 – c, 4 – a, 5 – b
Sophisticated financial literacy: 1 – b, 2 – a, 3 – b

* Hazel Bateman, Christine Eckert, John Geweke, Jordan Louviere, Susan Thorp and Stephen Satchell

** Julie Agnew, Hazel Bateman and Susan Thorp

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9 Responses to Do clients understand what advisers are saying?

  1. Chris Barrett November 29, 2013 at 11:51 AM #

    The real challenge is not for those seeking advice to come up to speed on these concepts, although that would be good, it is for advisers to provide advice in language and context that ensures clients understand what and why something is being advised.

  2. Eelsha Dixon November 30, 2013 at 3:21 PM #

    What would also be interesting to know is what proportion of the financial literate 36.5% used financial planners.

    Did they know enough to understand that financial planners (should) know more than them and help them meet their goals.

    The scarier question is what percentage of the less financial literate (63.5%) don’t use financial planners and have a SMFS.

  3. Michael Rees-Evans December 1, 2013 at 10:20 AM #

    Relieved my wife got 100% and 12 year old daughter did well……but sobering reading in general…thanks for sharing.

  4. Sam Naidu December 1, 2013 at 9:59 PM #

    Do we accountants and financial planners have a responsibility to help train our clients in financial literacy?

  5. Michael McAlary December 2, 2013 at 4:39 PM #

    Great work, I totally agree David! However, I think there is a typo. A full Statement of Advice (SoA) is 170 pages, not 70 pages. Plus you are meant to attach the relevant Product Disclosure Statements (PDSs) and other source materials which can make the SOA including attachments 300-500 pages. Prior to preparing a SOA you must get the client to do a Risk Assessment and Client Needs Analysis.

    We have both an AFS and Australian Credit Licence (ACL), so you can image the compliance requirements.

  6. Brian Wallace December 3, 2013 at 2:57 PM #

    I’d be marked down on Q5, as I would have said c because of rising personal tax rates. Of course if the question specified after tax income, b would be correct.

  7. Warren Bird December 3, 2013 at 7:43 PM #

    Brilliant pick up Brian!

    Of course in the US they have indexation of personal income tax scales, so an American study would produce different answers to an Australian one.

    • David Bell December 4, 2013 at 9:04 PM #

      Yes – good pick up Brian. I will make sure to pass that back to Hazel Bateman and co.

      Thanks,
      David

  8. Harry Chemay December 5, 2013 at 12:25 AM #

    A high level of financial literacy is a key requirement in any economy where government retirement policy has abrogated collective risk-sharing in favour of personal choice and individual risk management. Australia is one such economy.

    Empowering the individual with choice-of-fund and member investment choice without a commensurate lift in investment knowledge and financial literacy is akin to giving a learner driver the keys to a Ferrari and saying “Best of luck, drive safe”. The neo-classical notion of ‘homo-economicus’ , the average person as a utility-maximising agent able to make financial decisions on the basis of probability weighted outcomes, and as informed and capable as seasoned market professionals, is laughable. Yet much of Australia’s retirement policy framework assumes exactly that. SMSFs are a case-in-point.

    ASIC is the government agency charged with lifting Australia’s woeful financial literacy standards. It has had a National Financial Literacy Strategy in place since 2011, and the next is due to run from 2014 to 2017. ASIC has the help of a Financial Literacy Board, 13 eminent individuals appointed by the (previous) Assistant Treasurer and Minister for Financial Services and Superannuation. ASIC also works with a range of stakeholders in delivering the national strategy including the OECD, COAG, The Australian Curriculum, Assessment & Reporting Authority, government and non-government schools and the business community. All these interactions results in a bewildering array of programmes, trials, pilot schemes and other initiatives aimed at lifting financial literacy standards across the age and socio-economic spectrum.

    Compare the above with our Trans-Tasman cousins. New Zealand created a Commission for Financial Literacy and Retirement Income with an act of Parliament in 2001. It is headed by a Retirement Commissioner appointed by the Minister for Commerce. The Commissioner is an ‘autonomous Crown entity’ and has a legal mandate to lead and co-ordinate their National Strategy for Financial Literacy (reporting to the Minister every 6 months), review the government’s retirement income policy (reporting to the Minister every 3 years) and broadly monitor the retirement village industry.

    The Commission measures financial literacy using a Financial Literacy Competency Framework for Adults, and regularly conducts a Financial Knowledge and Behavioural Survey to determine progress against highly specific goals. One of the assessment criteria for secondary schools is the performance in the Programme for International Assessment (PISA) tests, against which Australian students appear to be regressing in measures of general, let alone financial numeracy.

    In short, it’s not that Australia lacks the wherewithal or desire to improve financial literacy. What is lacking is the laser-like focus that NZ has in lifting financial literacy for the good of all its citizens, headed by an autonomous Commissioner with the legal power (and obligation) to get the job done. ASIC does a might job of financial education, but it simply does not have the luxury of focusing wholly and solely on financial literacy and retirement income education. After all it is the corporate regulator, with responsibility to ensure the integrity of our financial markets and to prosecute corporate malfeasance.

    Perhaps its time we took a leaf (or should that be fern) out of the textbook provided by our cousins across the ditch.

  9. Robert Skinner December 9, 2013 at 9:20 AM #

    Good question. I think many of the financial concepts, clients would struggle to understand. A literacy test might be a good idea, however might also be a little embarressing for those that get a low score.

    If it is too cumbersome or confronting to test literacy for each client, maybe giving the clients safe and reliable resources to learn would at least help. Many people don’t want to ask what they think are ‘silly’ questions, for the fear of looking silly. However, this is where the internet has given businesses such a good way to provide information – 24/7 (whilst no-one is watching).

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