Your Money Matters


March 2011 Issue


The Importance of Financial Literacy

Financial literacy is defined as “having the knowledge, skills and confidence to make responsible financial decisions”. The term “financial literacy” is often confused with “financial education” or “financial capability”. Financial education is the method used to develop financial literacy. Financial capability comes from:

• financial knowledge and understanding, making sense of everyday, self-interested financial matters
   

• financial skills and knowledge, applying financial knowledge and understanding to predictable and unpredictable situations
   

• financial responsibility, appreciating the impact of financial decisions on both personal and wider circumstances, understanding rights and responsibilities, and knowing sources of advice and guidance.

Financial literacy will mean different things at different ages that roughly fall in three phases: youth, accumulation (working years) and post accumulation (retirement). The degree of responsibility and/or knowledge will vary at these stages. For example, during the youth phase, up to about age 25, society and family are mainly responsible for financial literacy development. The focus is on financial education in earlier years, with real financial capacity emerging in later years (university, part/full time work force).

During the accumulation (working years) phase, which covers years from 25 to 65, developments shift from the social fabric to financial industry campaigns and/or employer pension and savings programs. The challenge during this time, is to reach an optimum level of financial literacy many years prior to the next phase so that individuals understand that the wealth accumulated during this phase will fund their retirement.

During the post accumulation (retirement) phase, lasting approximately 20 years or more, the need for financial literacy is absolute. Individuals need adequate assets to cover cost of living and other retirement expenses. They need to protect principal, account for inflation, and understand how to mitigate the risks of longevity and capital draw downs.

The pension and savings industry – both of which are heavily involved with the working and retirement components of the life cycle appear to be against financial literacy. You have no doubt heard the arguments: Plan members are not engaged in the process. They are not qualified to make investment decisions. Sponsors do not engage actively in the process. The industry has no incentive to empower members.
There is an abundance of programs that offer pre-programmed fund options – members input answers to questions and presto! Out pops the target date funds to go into. Add some auto-on features such as automatic savings plan, default funds, etc and members are not required to do much at all. The members really do not have much choice.

At the other end of the spectrum of choice is the program with a fully member-directed choice of assets, auto features turned off, multiple asset classes, and multiple fund managers. This results in the need for greater empowerment of members and an understanding of the wider range of potential risk-return outcomes. Some members will do much better or worse than others. At this end of the spectrum of choice, much greater financial literacy is needed to navigate the complexity of investment options and tools required to make investment decisions.

If greater choice is provided, then members have greater responsibility for outcomes. This means that the sponsor has greater responsibility for financial education and communications to support investment choices.

Choice also means that members must decide if they have the capability, time and interest to do it on their own or if the use of a financial is best for them. Even with the use of a financial advisor, it is the member’s responsibility to voice their concerns if and when they don’t fully understand what has been explained to them.

Regardless of more or less choice, ultimately, a plan member or an individual have a reasonable expectation in terms of the level of retirement assets they are likely to achieve, and have a reasonable chance of fulfilling these expectations. Only an adequate level of financial literacy can optimize this process over a life cycle..


Theresa Wever and the Money Concepts Team.

Commissions, trailing commissions, management fee and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated.