Compounding Kiwis and interest rates

Thousands of miles from the financial world’s hectic hubs, New Zealanders understand compound interest and inflation better than many others. But levels of financial literacy are still dangerously low according to a study

Christian Gressner

London, New York and Hong Kong may huddle closely at the top of financial center rankings, but the common man’s financial expertise is best at the greatest possible distance from either city.

When asked for their understanding of compound interest rate and inflation, 86% and 81% of New Zealanders – Kiwis, as they call themselves – answered correctly. “Among the countries we surveyed, New Zealand shows the highest level of financial literacy, ahead of Germany with 82% correct answers on inflation,” says Olivia S. Mitchell, co-author of the study Financial literacy around the world (Journal of Pension Economics and Finance, 10 (4): 497-508, October).

Overall, however, the study reveals discouragingly low numbers, given the questions’ simplicity and the fact that respondents were not asked to make a calculation but had to select from a list of answers. “That surprised me,” says Mitchell. “I had expected better results in countries with highly developed educational systems.”

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Conducted by professors Olivia S. Mitchell (University of Pennsylvania) and Annamaria Lusardi (George Washington University), the survey assessed participants’ understanding of compound interest, inflation and risk diversification in the Netherlands, Germany, Sweden, Italy, Japan, New Zealand, the US and Russia. While the results are low irrespective of the country’s financial market or its pensions system, New Zealand and Germany are best in class. This is alarming as savers have to accept more responsibility.

Financial education programs need to be implemented now Olivia S. Mitchell

“Perhaps one explanation is that the New Zealand government has taken very seriously the need to help the workforce plan and prepare for retirement. It has a widely-used website called “Get Sorted”, which a huge number of citizens has consulted in drawing up plans,” states Mitchell.

Italy and Russia are among the weaker performers. In Russia, only 36% gave the right answer for compound interest while a mere 13% showed an understanding of diversification. 40% and 60% of Italians responded correctly to the questions about compound interest and inflation respectively.

The results are all the more discouraging as pension plan sponsors are shifting from defined benefit (DB) to defined contribution (DC) systems. “Individuals have to accept an increasing responsibility to save, invest and spend wisely over their lifetime. A basic understanding of finance is crucial,” Mitchell notes. However, not all is bad in the DC world. “DC plans offer greater flexibility.”

The survey’s methodology

The study asked the following questions:

Interest compounding: Suppose you had $100 in your savings account and the interest rate was 2% per year. After five years, how much do you think you would have in the account if you left the money to grow? More than $102. Exactly $102. Less than $102.
Inflation: Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After one year, how much would you be able to buy with the money in this account? More than today. Exactly the same. Less than today.
Risk diversification: Please tell me whether this statement is true or false. “Buying a single company’s stock usually provides a safer return than a stock mutual fund”. True. False.

Lusardi and Mitchell have also collaborated with in-depth studies of financial literacy in each of the 50 US states, and they look forward to collaborating with emerging economies seeking to inform their citizens.

The survey asked three similar multiple choice questions to make results comparable across countries (see Methodology). The question on diversification was rephrased in Italy and New Zealand.

“For Germany, a good understanding of compound interest is not surprising as it is a mandatory element of German school curricula,” says Dr.Tabea Bucher-Koenen (Munich Center for the Economics of Aging) who contributed to the survey in Germany. More than 78% of German participants demonstrated a basic grasp of inflation while the question regarding risk diversification was correctly answered by 62% of respondents. The survey also unearthed striking regional and gender differences. “Understanding of basic financial concepts is lacking among women, the less educated and among East Germans,” Bucher-Koenen reports. “Interestingly, though, there is no gender disparity among people in East Germany.”

There are also important sex and age differences in financial knowledge that are common across countries, Mitchell and Lusardi found. Women generally know less and are aware of that, while older age groups and particularly men believe they know more than they actually do.

Such an obvious lack of financial literacy is not only deplorable in itself; it also has long-term consequences. “Retirement planning can be traced back to financial literacy. Workers who can undertake simple calculations, who have an understanding of inflation and who grasp the concept of risk diversification are more likely to plan for their retirements,” says Mitchell.

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Compounding Kiwis and interest rates

Thousands of miles from the financial world’s hectic hubs, New Zealanders understand compound interest and inflation better than many others. But levels of financial literacy are still dangerously low according to a study

Christian Gressner

Compounding Kiwis and interest rates

Thousands of miles from the financial world’s hectic hubs, New Zealanders understand compound interest and inflation better than many others. But levels of financial literacy are still dangerously low according to a study

Christian Gressner

The survey’s methodology

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