FINANCIAL LITERACY AND PENSION INVESTMENT DECISIONS

Financial Accountability & Management, 27(3), August 2011, 0267-4424 FINANCIAL LITERACY AND PENSION INVESTMENT DECISIONS NATALIE GALLERY, GERRY GALLERY, KERRY BROWN, CRAIG FURNEAUX AND CHRISANN PALM INTRODUCTION Following worldwide trends, there has been a significant shift from defined benefit plans (DBPs) to defined contribution (DC) superannuation funds in Australia. 1,2 Most DBPs in both the public and private sectors are closed to new members (Australian Prudential Regulation Authority (APRA) 2007), with total assets held in DBPs comprising only about 20% of the total held in all superannuation funds with more than four members (APRA, 2009). Closure of DBPs to new members and the introduction of compulsory superannuation have resulted in rapid growth of assets and membership in DC funds. Given that most members in those funds have a choice of how their superannuation savings are invested, the adequacy of the retirement benefits that individuals will ultimately receive is, in part, contingent on the decisions undertaken by fund members throughout their working lives. Most working Australians are faced with the decision of choosing their superannuation fund, and once they have selected a fund, they need to decide among the various investment options offered by the fund to determine where their superannuation savings should be invested. 3 These decisions are ongoing, requiring members to periodically monitor and evaluate the performance of their chosen fund and investment option, and decide whether to switch to another fund and/or investment option. To achieve optimal outcomes in this complex decision-making environment requires decision-makers to have adequate levels of financial knowledge and skills. As financial literacy is key to informed Natalie Gallery, Gerry Gallery and Chrisann Palm are in the School of Accountancy, and Craig Furneaux is in the School of Management at the Queensland University of Technology; Kerry Brown is in the School of Tourism and Hospitality Management at Southern Cross University. The authors gratefully acknowledge funding provided by QSuper and input to this research project by Nicole Peterman, QSuper Financial Literacy Manager. They also thank Cameron Newton in the QUT School of Accountancy for his assistance with the development of the survey questionnaire, Frederic Fery and Kathryn Heiser for their IT support in developing and managing the survey website, Jake Shorter and Sukie Sawang for their research assistance on this project, and two anonymous referees, Irvine Lapsley (editor), and Kym Irving for helpful comments and suggestions on earlier drafts of this paper. Address for correspondence: Natalie Gallery, School of Accountancy, Queensland University of Technology, GPO Box 2434, Brisbane, Queensland 4001, Australia. e-mail: n.gallery@qut.edu.au, 9600 Garsington Road, Oxford OX4 2DQ, UK and 350 Main Street, Malden, MA, MA 02148, USA. 286

FINANCIAL LITERACY AND PENSION INVESTMENT DECISIONS 287 retirement saving decisions, better financial education is necessary if individuals are to achieve their retirement income objectives (Arnone, 2005). However, emerging evidence suggests financial illiteracy is widespread and the ability of individuals to plan adequately for their retirement is limited. In a review of financial literacy surveys in twelve member countries, the OECD (2005) noted that financial literacy levels among general populations are low; particularly for certain groups of individuals, such as those who are less-educated, have lower incomes, and belong to minority groups. In Australia, poor financial literacy, combined with the shifting of responsibility for choosing a fund and investments from employers and trustees to individual members, has created a high risk environment for those members (PJCCFS, 2007). Poor financial literacy has negative consequences for both individuals and society, in that bad decisions detrimentally affect individuals long-term financial well-being, which, in turn, could mean a greater burden on taxpayers to support those individuals in retirement (FSA, 2006). While recognising the general need for education programs to address poor levels of financial literacy, the OECD identifies that to properly design and appropriately target those education programs, more research is needed to assess the education needs of particular groups (OECD, 2005). Empirical evidence of financial literacy levels is limited with most studies conducted in the US and UK. In Australia, the research is confined to broad-based consumer surveys, such as the 2005 ANZ Survey of Adult Financial Literacy in Australia, that examines consumers knowledge and understanding of basic financial matters. No known prior research has examined financial literacy in the context of more complex superannuation or pension investment decision-making. Motivated by this absence of empirical research on the adequacy of financial literacy levels in the context of superannuation decision-making, and the significant adverse economic and social consequences of poor financial decisionmaking in superannuation matters, this study explores the financial literacy of members of a large Australian public sector-based superannuation fund. Associations between explanatory factors relating to demographics, wealth, benefit type and sources of information, and three dimensions of financial literacy general financial matters, general investment matters, and specific investment matters are examined. The next section provides an overview of the Australian superannuation system and how investment decision-making has shifted to superannuation fund members, followed by a review of prior research on financial literacy, leading to the research questions addressed in this study. The research design is then described, the research findings are presented, and conclusions are presented in the final section. OVERVIEW OF SUPERANNUATION IN AUSTRALIA Australia is one of only a few countries that has legislated mandatory superannuation as part of its retirement incomes policy. Since 1992, employers

288 GALLERY, GALLERY, BROWN, FURNEAUX AND PALM have been required to pay superannuation contributions on behalf of employees earning $450 or more per month under the Superannuation Guarantee (SG) legislation; the contribution rate started at 4% and increased to 9% by 2002. With the introduction of the mandatory system the superannuation industry grew rapidly and assets held in superannuation funds now total more than $1 trillion (APRA, 2009). In addition to expanding coverage of superannuation to almost all Australian workers, mandatory superannuation also gave rise to an increase in the number of defined contribution (DC) funds, and a decline in defined benefit (DB) funds. 4 Following the worldwide trend of employers closing their DB funds (Ashcroft, 2009), almost all Australian DB funds (including public sector funds) are closed to new members. With superannuation assets in DC funds rapidly growing after the introduction of the SG system, there was increased pressure to offer members investment choice. As at June 2007, 80% of funds with over $100 million in assets offer their members investment choice (APRA, 2007). Thus, the majority of fund members are now responsible for deciding how their superannuation savings are to be invested. As part of broader reforms to the regulation of financial services and products, the Financial Services Reform (FSR) Act 2001 sought to increase consumer protection through an enhanced disclosure regime to make the understanding of financial products easier for investors, and to promote consumer confidence. Additional disclosures are a key part of those reforms. Accordingly, the Corporations Act 2001 imposes a requirement on superannuation funds to provide a Product Disclosure Statement (PDS) when members first join the fund. The objective of a PDS is to help members compare and make informed choices about superannuation products (ASIC, 2007, RG168.7). While those legislated disclosure requirements are primarily aimed at new members, the PDS also serves the purpose of providing all DC members with information about the fund s investment options on an ongoing basis that enables them to periodically review the investment options and decide whether to switch their superannuation to an alternative investment strategy. Adequate disclosure is just one of the prerequisites for informed decisionmaking. Making informed investment choices also requires individuals to have adequate financial literacy in terms of knowledge and understanding of various investment products and associated risks. This study explores the extent to which members of one large superannuation fund possess such financial capabilities. FINANCIAL LITERACY AND PRIOR RESEARCH Although there is no universally agreed definition of financial literacy, a definition commonly used is: the ability to make informed judgements and take effective decisions regarding the use and management of money (Schagen and Lines, 2006, p. ii). Improving financial literacy of individuals to facilitate informed financial decision-making has become a global issue over recent years.

FINANCIAL LITERACY AND PENSION INVESTMENT DECISIONS 289 The OECD guidelines for member countries on core rights and protection of members in occupation pension plans include the right for members to be provided with: sufficient opportunity to acquire the financial skills or education and other assistance that they need in order to make appropriate investment decisions in their pension plans (OECD, 2003, p. 13). Recently, the OECD (2008) also set forth recommendations on financial education of pension fund members. A range of government-initiated and other programs addressing financial literacy issues have emerged in various countries. For example, the National Strategy for Financial Capability developed by the Financial Services Authority in the UK, programs of the Financial Literacy Education Commission in the US, and the Understanding Money program developed by the Financial Literacy Foundation in Australia. These programs are generally very broad in that they are targeted at improving basic financial knowledge and skills necessary for day-to-day financial decision-making such as managing household budgets and savings, and finances related to personal loans and home mortgages. Empirical research on financial literacy is largely confined to broad population surveys which assess individuals attitudes and behaviours in relation to general financial matters, 5 and are generally based on the self-assessed responses of participants to questions aimed at measuring very basic financial literacy. Two recent studies in the Netherlands and the US test more advanced financial knowledge and skills. van Rooij et al. (2007) designed two modules included in the 2005 and 2006 DNB Household Surveys in the Netherlands to measure basic financial literacy, such as the effect of inflation and compounding interest, and more advanced financial knowledge, including understanding differences between stocks and bonds, how risk diversification works, and the relationship between bond prices and interest rates. Lusardi and Mitchell (2007) draw on the van Rooij et al. (2007) model to test basic financial literacy and what they term as sophisticated financial literacy. In both the van Rooij et al. (2007) and Lusardi and Mitchell (2007) studies, the advanced and sophisticated measures of financial literacy focus exclusively on knowledge and understanding of investment products and markets. As neither of those studies focuses on decision making in a pension context, it is difficult to generalise their findings to the setting of our study. In focusing on financial literacy relevant to investment decision-making in the context of superannuation funds, this study addresses the following two research questions: 1. How does the level of financial literacy of superannuation fund members vary across general financial and specific investment matters? 2. What demographic and other factors are associated with different financial literacy levels among superannuation fund members?

FINANCIAL LITERACY AND PENSION INVESTMENT DECISIONS 305 advanced investment literacy, indicating there may be over-confidence of skills on more advanced investment matters. Overall, the findings show that respondents in this study generally have good basic financial literacy, but significant deficiencies are identified in relation to more advanced investment matters. The analysis highlights demographic groupings of members who are more likely to have lower levels of financial literacy and therefore at greatest risk of making sub-optimal superannuation investment decisions. These findings emphasise the need for development of education programs to address shortcomings in superannuation fund members investment knowledge and skills to ensure they are equipped with appropriate levels of financial literacy to make informed investment decisions. A limitation of this study is that it examines the financial literacy of only one of the large superannuation funds in Australia, and is also limited to public sector employees. Nevertheless, it identifies that, on average, this sample of members generally lack the financial understanding necessary for investment decisionmaking. Lack of financial skills and apparent over-confidence among some of those members in choosing investment options potentially leads to undesirable and unexpected financial outcomes for those individuals. The long-term financial well-being of those individuals critically hinges on the superannuation choices they make throughout their working lives. If individuals make wrong choices resulting in inadequate superannuation savings to fund their retirement, they are likely to fall back on the safety net of the government-provided age pension and thus increase the tax burden on future generations. Finally, the overarching question is: whose responsibility is it to educate superannuation fund members to facilitate informed investment decisionmaking? As part of the recent inquiry into superannuation, the Parliamentary Joint Committee on Corporations and Financial Services (PJCCFS) reported that while: Government initiatives can stimulate people s interest [in superannuation] and provide generic material on the system and interpretive information and advice,... funds and advisers usually have a more direct input into educating consumers on their own superannuation arrangements (PJCCFS, 2007, p.176). With the responsibility placed squarely with superannuation funds, it is critical that their member education programs are well-targeted and address specific shortcomings in members financial literacy. Further and ongoing empirical research into the financial literacy of superannuation fund members is clearly needed to inform education programs and, in turn, provide input to financial literacy and superannuation/pension policy-making in Australia and other jurisdictions. NOTES 1 The term superannuation is used in Australia to refer to employment-related retirement benefits, whereas the term pension is more commonly used in other countries.

306 GALLERY, GALLERY, BROWN, FURNEAUX AND PALM 2 In defined contribution superannuation plans (also referred to as accumulation plans), a member s benefit comprises contributions to the plan, plus earnings on those contributions, less tax and expenses. In defined benefit plans, a member s benefit is determined by a formula which is typically a multiple of the member s final average salary just prior to retirement, taking into account years of fund membership and the member s age. 3 Choice of fund legislation came into effect from 1 July, 2005, requiring many employers to offer their employees a choice of superannuation fund; this requirement does not apply where certain awards and workplace agreements are in place. Most superannuation funds that have an accumulation component offer members investment choice. 4 In 1983, 82% of superannuation fund members were in defined benefit funds, but by 2006, 97% of members were in funds providing either only accumulation benefits or a mix of accumulation and defined benefits (APRA, 2007). 5 See for example FSA (2006) in the UK, and ANZ (2005) and FLF (2007) in Australia. 6 The detailed set of questions used to test financial literacy in this study is available from the authors on request. 7 Details of factor loadings are available from the authors on request. 8 To avoid potential bias that might be caused by presenting the investment options by relative levels of risk/expected returns, the order of investment options presented in the questionnaire is the same as the order in which those options are presented in QSuper s Product Disclosure Statement. 9 To assess only those members with an accumulation account, members whose main account is defined benefit were removed from the sample; the results are virtually identical. 10 This result does not change when defined benefit members are removed from the sample. 11 Accumulation accounts held by those defined benefit members would generally comprise additional voluntary superannuation contributions made by the members. 12 Since their introduction, PDSs have been criticised for being too long, complex and difficult to understand (see for example PJCCFS, 2007), which may explain why so few respondents used them. 13 The personal income of members was included in tests as an alternative measure of income; the results are qualitatively the same. 14 The finding that members with share investments outside their superannuation are more financially literate is consistent with Banks and Oldfield s (2007, p.147) reverse causality argument. That is, rather than financial literacy leading to the propensity to invest, the act of investment increases financial literacy as individuals seek to increase their financial literacy in order to understand the investments they hold. REFERENCES Agnew, J. and L. Szykman (2005), Asset Allocation and Information Overload: The Influence of Information Display, Asset Choice, and Investor Experience, The Journal of Behavioral Finance, Vol. 6, No. 2, pp. 57 70. ANZ (2005), ANZ Survey of Adult Financial Literacy in Australia (Available at: http://www.anz.com/ aus/aboutanz/community/programs/pdf/anz_survey_2005.pdf). Arnone, W.J. (2005), Educating Pension Plan Participants, in R.L. Clark and O.S. Mitchell (eds.), Reinventing the Retirement Paradigm (Oxford University Press, Oxford), pp. 163 72. Ashcroft, J. (2009) Defined-Contribution (DC) Arrangements in Anglo-Saxon Countries, OECD Working Papers on Insurance and Private Pensions No. 35. Australian Prudential Regulation Authority (APRA) (2007), Insight: Celebrating 10 Years of Superannuation Data Collection 1996 2006 (Sydney). (2009), Annual Superannuation Bulletin June 2008 (Sydney). Australian Securities & Investments Commission (ASIC) (2007), Regulatory Guide 168 Disclosure: Product Disclosure Statements (and other disclosure obligations). Banks, J. and Z. Oldfield (2007), Understanding Pensions: Cognitive Function, Numerical Ability and Retirement Saving, Fiscal Studies, Vol. 28, No. 2, pp. 143 70. Financial Literacy Foundation (FLF) (2007), Financial Literacy: Australians Understanding Money (Barton). Financial Services Authority (FSA) (2006), Financial Capability in the UK: Establishing a Baseline (London).

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