Consumer Financial Protection in the Current Economy
by Paula Hogan
Here’s some good news for your finances. Just as the public health community has historically developed and advocated for effective public health policies, such as immunizations and clean water, the academic and policy-maker community in the financial industry is currently engaged with similar research and advocacy efforts.
The following are some highlights from an interdisciplinary policy conference held last year at the Boston University School of Management. At the conference, a diverse group of finance professionals shared research and insights about supporting the health of the modern financial consumer. Their work is encouraging and informative, and can also be protective for your own financial planning. (For further details on the conference, visit smg.bu.edu/exec/elc/lifecycle/2011/index.shtml.)
Core Ideas for Conference Discussions
These are some of the core ideas that formed the backdrop for conference discussions.
Complexity Is a Key Feature of the Modern Era
In the modern era, significant personal responsibility has been imposed on the individual investor for achieving and managing lifetime financial security. The era of pensions is gone. The societal safety net for health care is strained and punctured. Longevity is increasing. Personal portfolios are primarily self-directed. Consumers also face the daunting challenge of shifting from the accumulation to the decumulation stage of personal financial management at about the same time that cognitive abilities peak. There is also a change in the definition of ‘a full life.’ For those still in the work force, work hours are up 20% from 1968. Plus, parents now do homework with kids, are urged to exercise regularly and volunteer in their communities—and manage their finances. Similarly, retirees are exhorted to engage in encore careers, travel the world, take university-level courses, have vibrant relationships with their grandchildren, follow ultra-healthy diet and exercise programs—and manage their finances, despite the likely changes in cognitive ability associated with aging.
The financial choices available to consumers in the modern era are also more difficult to understand even if you are at the top of your game, have a college degree and possess a working knowledge of the markets. The swift development of the derivatives markets has created great opportunity but also complexity in the market for consumer financial products. Unfortunately, business models for consumer financial products and services often have roots in the theoretical past and, in addition, are not always well aligned with the consumer’s best interest.
In sum, it’s a nasty world out there for individual consumers, and especially for older consumers and lower-income consumers who live with tighter budgets and fewer financial choices. The fundamental question for conference participants was what could be done about consumers having great responsibility but poor preparation for making fundamentally important personal finance decisions.
As a consumer, you can begin to protect yourself simply by becoming aware of some key public policy ideas addressed at this conference as you forge ahead with your own personal planning.
Frame Personal Finance Considerations in Terms of Income, Not Wealth
Just as Jane Austen describes Darcy in “Pride and Prejudice” not as having a particular portfolio wealth but as having a particular income per year, it’s appropriate to identify the goal of financial planning as a secure and inflation-adjusted lifetime standard of living, not as beating the market, having better portfolio performance than your neighbor, or achieving some fixed percentage investment gain each year.
Once you do frame the financial planning goal as having sufficient inflation-protected lifetime income, the key variables to consider when evaluating various planning strategies become the expected minimum income in retirement, the chance of successfully securing this income, the necessary savings rate to create that lifetime income, and the expected retirement date.
Once you correctly specify the goal of financial planning in this manner, you have three ways to influence your retirement security: work longer, save more, or take on more investment risk.
Conference speaker Robert C. Merton, a Nobel Laureate economist, pointed out that making good personal finance decisions requires the ability to see how various combinations of these three trade-offs are expected to impact real (after-inflation) lifetime income. Given this information, it’s easier to make decisions that are right for you. Ideally, financial product and advice companies would frame planning consideration in terms of the appropriate goal, such as a lifetime standard of living, not wealth. And they would do so in terms of actionable trade-offs, the only financial factors you can control: how long to work, how much to save, and how much risk to take. There are some initial shifts in this direction, including the prescription for 401(k) providers to show individual participants the lifetime income they might expect given various levels of employee contributions.
Regulations Are Not a Substitute for Consumer Education
In a perfect world, you would also be able to purchase very effective, but necessarily complex, lifetime-income financial products that are marketed fairly, using terms that reveal meaningful and actionable choices for your individual finances. An encouraging feature in the modern economy is the emergence of competitive distribution channels for inflation-protective immediate annuities. However, as Merton further elaborated, there is an awkward production paradox for these consumer products: The easier a product is to use, the more complex it is to produce. This raises a second policy question: Are intelligent product design and regulatory oversight effective substitutes for consumer education? Can we simply get the right products in place, along with appropriate regulation, fair distribution channels, and effective education for the product providers and advisers, and then let the consumer focus on actionable trade-offs?
Consumer finance policy advocates are concerned: In a world of complex products presented simply to consumers, what happens to transparency? How does the individual consumer stay informed? To use an analogy that was frequently referenced during the conference: Just as the roads are safer because none of us changes the brake pads on our own cars, the markets are safer when none of us are designing our own retirement products. But the dilemma remains: Do we need to know how to change the oil in our car? Or is it sufficient just to know that you need to take the car in for service when the warning light goes on? The production paradox described above is a central policy consideration.
Financial Illiteracy Is Pervasive and Expensive for Individuals and Society
Despite voluminous research, we still don’t have good data about how to effectively increase financial literacy, but we do know that financial illiteracy is pervasive.
Financial illiteracy is a central policy concern. To extend the car analogy, people who don’t know the basics of safe driving and routine car maintenance have more accidents, trigger larger medical and other costs to society, and also hurt others, including drivers who follow meticulous car maintenance and safe driving habits. But we don’t yet understand how to foster good financial habits.
Data on the success of financial literacy programs is not definitive or encouraging, although efforts to promote financial literacy continue. For example, finance professor Peter Tufano suggested using the SAT exam to promote financial literacy by adding a consumer finance spin to the math questions. Elizabeth Duke from the Federal Reserve described a whole new genre of video games promoting financial literacy (financialentertainment.org).
With these core ideas as context, conference participants engaged in deep discussion about such policy questions as: In the modern era, what do financial consumers need to know? How do we protect their ability to make meaningful personal choices? How do we increasingly incorporate a scientific point of view when managing personal finances? As a society, how do we shift from an asset accumulation point of view to a more comprehensive lifetime financial security point of view? How do we teach our children about personal finance? How do we make sure that low- and middle-income families are not left behind? How do we stamp out financial illiteracy? How in fact do people learn about money and therefore what, when, and how do we teach them? Is it better to focus our attention on financial literacy or on public policy and regulation for product design and distribution? What constitutes effective disclosure for financial products and services? What can we learn from our colleagues around the globe?
A Sampling of Policy Ideas
Here is a sampling of policy ideas from the conference.
The Ideal Retirement Product
Banking and finance law professor Henry Hu, the inaugural director of Risk, Strategy, and Financial Innovation at the Securities and Exchange Commission, proposed a federally issued inflation-adjusted lifetime annuity as our best strategy for offering ordinary people protection from the risks of longevity and inflation. He sees this product as a logical extension of inflation-indexed government savings bonds and Social Security benefits.
Think how different your personal planning would be if you were assured some base level of this product and if you could direct savings during your working years toward purchasing larger amounts. This suggestion is timely and appealing once you frame financial security as securing lifetime inflation-protected income sufficient to cover your minimum base standard of living.
Professor David Weil pointed out that disclosure is essential when there is asymmetry in information between the user and the discloser and, further, that disclosure is effective when users have the will and capacity to improve choices and when disclosers can improve performance.
He described a successful example: restaurant hygiene reports posted in the windows of Los Angeles County restaurants. In this case, the policy of publicly posting hygiene reports clearly addressed uneven knowledge between users and disclosers. Plus, users could act on the information (by choosing a different restaurant), and disclosers could act (by improving their restaurant’s hygiene). The result is a win/win/win: Consumers were empowered to make effective choices, restaurants were motivated to improve business by improving hygiene, and restaurants become cleaner—all from actionable information posted in a timely and visible manner for the users to see. Weil contrasted this with the Homeland Security airport security disclosure system, where there is no clear guidance as to what the public is supposed to do when the threat level is elevated to indicate a “significant risk of terrorist attacks.”
In the housing market, economist Paul Willen reported that mortgage delinquencies don’t turn into foreclosures unless home prices fall. He proposed that mortgage disclosures would optimally show what change in home price would lead to various odds of foreclosure. He also added to the education versus regulation question by asking the following question: Should the Titanic have disclosed the number of lifeboats on board or have been required to have an adequate number of lifeboats?
As a consumer, you would be prudent to consider the quality of the disclosure you are offered when considering a financial product.
Consumer-Friendly Business Models
Business models in the financial industry are not always aligned with the consumer’s interest—but they could be, if behavioral economics were used to support healthy financial habits instead of short-term profits. Dutch economist Henriette Prast described how banks in her country make it much more difficult to cancel rather than to open a credit line.
Peter Tufano described a situation where 11% of bank customers never overdraft their account, 78% have an occasional overdraft, and 11% overdraft more than 50 times per year, incurring a $25–$27 fee per overdraft. Questions raised included: What information do consumers need to not get tripped up by such a fee schedule? At what point should regulatory policy intervene? How dependent is our banking system on such fee schedules?
Economist Zvi Bodie pointed out that, although “knowing how to invest” is not the fundamental aspect of financial literacy, focusing consumer attention tightly on that topic does fit the assets-under-management business model of many financial advisory and financial product firms. Discussion centered on what consumers should be demanding as they shop for firms offering financial products or advice.
Investor Fraud Awareness
According to former FINRA education head John Gannon, the most likely fraud victim is a 55- to 65-year-old college-educated high-income male who is a risk taker with a recent change in financial or health status, who owns or has owned high-risk investments, who relies on an informal network of friends and colleagues for investment information, who is open to new investments, who fails to do background checks on investment personnel, and who can’t spot the persuasion tactics of a con man. Gannon advised that one of the best fraud protection habits is to keep asking questions: “Questions throw fraudsters off their game.”
He further commented that senior citizens are also highly susceptible to fraud. On literacy tests, senior citizens display the lowest knowledge and the highest self-confidence—a bad combination for decision-making.
Just understanding who is a likely victim of fraud and being aware of some very basic fraud protections might help consumers develop more prudent financial habits.
Financial Struggles of Our Youth
Young people are struggling from the combination of high education debt and low initial salaries. College student bankruptcy is a growing issue not only for students and their families, but also potentially for the economy as a whole. Currently two-thirds of college seniors graduate with debt. Among the 37 million people in this country with outstanding student loans, the median balance is $12,800. Of these debtors, 72% have loan balances less than $25,000, according to data from the Federal Reserve Bank of New York. About 5% of borrowers owe more than $75,000, and the top 1% of borrowers has outstanding loan balances of $150,000 or more.
Pointing to the prevalence of financial illiteracy and the need for effective disclosure, a recent study by NERA Economic Consulting concluded that, of those with outstanding education loans of $75,000 or more, “about 65% misunderstood or were surprised by aspects of their student loans or the student loan process.”
These statistics highlight the need to discern the value of a particular education relative to its cost and for all of us to better understand the consequences of high student debt.
In sum, consumer financial protection is a matter of great concern to each of us as individuals and for our culture as a whole. It is also, fortunately, a topic of intense discussion, collaboration, and advocacy among concerned financial professionals in much the same way that concerned health care professionals have long advocated for improved public health policies.
In the meantime, an individual consumer should consider basic protective strategies such as the following.
- Be alert to the possibility of financial fraud. Ask lots of questions when presented with a new product or investment idea. Consider whether your demographics—or the demographics of someone close to you—increase personal vulnerability to a bad-faith sales pitch. Insert personal protections to the extent of that vulnerability: Don’t rush financial decisions; pause, reflect, and get more information. Check in on your older loved ones. Consider being more humble and less impulsive.
- Weigh the benefit of debt before incurring it. Find out the full cost of debt before incurring it, and weigh that cost against the actual benefits you expect to receive. Challenge yourself to develop a plan for how you would proceed without incurring the debt. Are you sure you need the debt? Is there a way to incur less debt? What is your outside limit of debt for each specific goal? What is your specific plan for paying back the contemplated debt? What does that debt repayment plan imply for other highly valued personal goals?
- Keep your focus on the true goal of retirement planning. Keep asking yourself to what extent you have covered your lifetime base standard of living with lifelong inflation-protected income. Ask your retirement plan provider to show you the lifetime income you could expect from your retirement account balance. Think more specifically about the difference between financial needs and wants.
- Demand meaningful disclosures. Whenever you see an ad or a public notice, pause and consider if you are getting timely disclosure of meaningful information or non-actionable gibberish. Make a family game of identifying good versus poor disclosure. Speak up. Help make poor disclosure policies unacceptable in our culture.