“People underestimate their longevity and might not save enough”
- Interest rates, inflation and risk diversification are three essential components of financial literacy.
- Countries in northern Europe have higher levels of financial literacy than southern and eastern ones.
- Households that have a high level of debt do not save at all.
- In Germany, there will be a transition from the "baby boom" to the "baby bust" generation in the next 15 years, which will shift the balance in the public pensions system.
Tabea Bucher-Koenen is a senior researcher at the Max Planck Institute for Social Law and Social Policy in Munich. She is also head of research for the Old-age Provision and Social Policy unit. Her research fields include social policy and health economics. She specialises in public and private pension insurance, financial literacy, and saving behaviour.
What level of knowledge is required to be financially literate?
Annamaria Lusardi1 and Olivia Mitchell2 define three big measurement tools that are needed to carry out a financial literacy survey when making financial decisions.
The first is interest rates, how they work, and also how compound interest works over time.
The second is inflation. People should know what inflation does to their savings. Understanding the combination of interest and inflation is important, especially when making a long-term savings decision. This also affects credit decisions.
The third topic that is really crucial is risk diversification. How risky are certain investments? I think a lot of people have difficulty understanding risk diversification, but I believe this is also one of the core areas that people should be aware of.
How high are financial literacy levels in Europe today?
In general I think it is rather mixed. A paper on global financial literacy levels by Ms Lusardi and the World Bank provides information on Europe in particular. What you see is that the countries in northern Europe have relatively high levels of financial literacy compared with those in southern and eastern Europe. Norway, Sweden, Finland and Germany all fare rather well compared with levels even in France and Austria, which are a little lower. Switzerland ranks between Germany and France.
In most of the advanced economies you have a hump-shaped pattern of financial literacy in relation to age. Younger people tend to know less because they have not had the experience, and those aged over 65 tend to know less than those in the middle-age range category, but it is not clear why this is the case. Unfortunately, the research on financial literacy is not old enough to carry out cohort studies.
Given the current financial climate, do you think it is difficult to persuade young, working people to save and understand their personal finances?
It might be harder to convince people to put something aside because interest rates are really low but, in general, this has always been an issue. In a study on German households, we looked at their current wealth and savings behaviour and forecast how much they would have at retirement. We also estimated the pension gap that will arise as a consequence of the German pension reforms in 2001 and 2004. What we found is that, on average, people can more than close the pension gap given their current wealth and savings behaviour.
Where do the biggest differences occur?
When looking at wealth distribution, we found large differences between rich and poor households. There is a fraction of households that are really well equipped, but almost half of the population is not covering the gap. In particular, households that have a high level of debt have difficulties saving for their retirement, and around 40% of households do not save at all.
Do you think the majority of Europe’s current elderly population has adequate finances?
Some 90% of pensioners are covered by the public pension pillar in their respective countries, and with the other types of pensions (occupational and private) it depends very much on the institutional context of the countries.
Do you think this varies greatly by country or are there similar patterns across western Europe?
In general, many current pensioners have lived through a period of peace and prosperity since the post-war period, so they have had relatively uninterrupted earnings histories. They experienced a growth period that now affects their pension wealth. A study from a couple of years ago shows that pensioners are also profiting from inheritances. In Germany there is now quite a rich middle class that can leave an inheritance to the next generation. This is an interesting aspect to keep in mind.
How should older citizens feel about financial planning now compared with 20 years ago?
I do not think the situation has changed a lot for pensioners now compared with 20 years ago, because the current pension offerings are still generous. However, the situation will change for those pensioners getting their pensions in 20 years’ time, because private and occupational pensions will be more relevant, and also a decrease in the levels of income from public pensions will really kick in for them.
In Germany we will have a transition from the "baby boom" to the "baby bust" generation in the next 15 years, with the baby boomers reaching retirement age. This will shift the ratio of pension contributors to pension recipients in the public pensions system.
How does longevity matter for savings decisions?
People substantially underestimate their longevity by six to eight years on average, and as a consequence may not save enough for their retirement. Governments should inform their citizens about the most recent forecasts for longevity. They should give cohorts life tables so that people really know what the forecast for their longevity will be. This is one thing that is really closely related to financial literacy and it is very important that both are considered.
1Denit Trust Chair of Economics and Accountancy an der George Washington University School of Business.
2International Foundation of Employee Benefit Plans Professor an der University of Pennsylvania.