Financial Literacy, Retirement Planning, and Household Portfolio Behavior: Four Empirical Contributions

Abstract

This thesis provides empirical evidence on financial skills and the relation with household financial decision-making based upon specially designed questions for the DNB Household Survey (DHS). The majority of the respondents has some grasp of concepts such as interest compounding, inflation, and the time value of money. However, very few go beyond these basic concepts; many households do not know the difference between bonds and stocks, the relationship between bond prices and interest rates, and the basics of risk diversification. The empirical estimates reveal that financial sophistication has a statistically and economically significant impact on private wealth holdings. This is important for public policy, especially in view of the widespread fear that many households do not save enough for retirement. Indeed, we also show that financial sophistication fosters planning for retirement. At the same time, we find that financial knowledge increases the likelihood of entering the stock market, thereby improving opportunities to diversify and taking advantage of the equity premium, which might contribute to better portfolio management and higher wealth as well. This finding contributes to the literature which tries to understand the puzzle of limited stock market participation by focusing on participation costs, as higher levels of financial sophistication lower the costs of collecting and processing information and reduce the relevance of barriers to participation. The same mechanism lowers thresholds to engage in retirement planning activities. Given the important role of financial literacy in decision-making, we can ask ourselves whether we can make decision tasks simpler, e.g. by offering helpful default options (i.e. the choice that follows when no specific action is taken). We investigate the impact of financial literacy and other personal traits on the attractiveness of default options in many situations including e.g. voting participation, having a will, and organ donation, but with a special focus on retirement savings decisions in the Netherlands as well as in the US (based upon data from the RAND American Life Panel). Our results show that default options indeed matter for individual decision-making and that procrastination and financial illiteracy are important determinants of default choices. As financial literacy is limited, one could wonder how households assess the international trend towards more individual responsibility for e.g. retirement. We find that the majority of Dutch employees opposes to changes that provide them with more individual responsibility for their pension provisions. The unwillingness to take investor autonomy might partly be related to a resistance towards changing the status quo, which is that employees in the Netherlands have no direct say in the investment policy of pension funds. Nevertheless, the willingness of employees to take control over their own pension savings correlates in an intuitive way to their risk tolerance, which is especially low in the pension domain, and their self-assessed level of financial literacy. Indeed, Dutch employees recognize their limitations as regards financial decision-making, and an experiment on choices in a hypothetical defined contribution retirement plan corroborates this self-assessed lack of financial skills.