Jane the Actuary General Interest

Forbes post, “Turns Out, It Appears We Can’t Agree On What An Emergency Fund Is For”

Originally published at Forbes.com on May 16, 2019.

 

How well do American save?

It seems the alarm bells are being incessantly sounded:  Americans are not saving enough, and not only do they not have enough saved for retirement, they’re up to their eyeballs in debt and they’re getting suckered into payday loans.

We heard plenty of alarm bells in May of last year, when the Federal Reserve released its latest report on the “Economic Well-Being of U.S. Households” (since this is an annual survey, we’re pretty much due for the next one).

At CNN, “40% of Americans can’t cover a $400 emergency expense.”

At MarketWatch, “Why 4 in 10 adults can’t cover a $400 emergency expense.”

At CNBC, “Fed survey shows 40 percent of adults still can’t cover a $400 emergency expense.”

Sure seems like the facts are clear, and the only thing in dispute is the extent to which the cause of this is irresponsibility, lack of financial literacy, or a sluggish and/or inequitable economy.

But at the time I first read this report, it didn’t quite sit right with me because that very same survey reports that half of all Americans do have three months’ worth of emergency savings , which is a much more positive statistic.  And last week a scholar at the Cato Institute, Alan Reynolds, has dug further into the raw numbers behind that headline figure, observing that the specific question did not ask whether Americans could pay an emergency expense from their savings,  but what they would do.  In fact, the Fed report authors treat “could” and “would” as identical.

Now, as it happens, Reynolds misinterprets the data as well.  Survey-takers had the ability, among multiple answer choices, to choose more than one response; one presumes that the 59% percent that the Fed reports says could/would cover a $400 emergency expense by cash or its equivalent (that is, paying off a credit card at the next statement) is based on all survey-takers who answered with one or more of these cash/cashlike answers, but Reynolds adds up the percentages from these individual responses and overstates the percentage of Americans who could cover the expense without borrowing.

Nonetheless, while 50% of Americans said they would/could pay off the cost with cash, and 36% said they’d charge it and pay it off right away, a further 18% said they’d charge it and pay it off over time — does that mean they don’t have cash, or that they do but want to hold onto it, and don’t understand how costly credit card interest charges are?  Reynolds also observes that, in a related question, 85% of Americans reported that the $400 expense would not affect their ability to pay their other bills in full.

Again, I don’t want to start shouting that the Fed is trying to pull a fast one on us, but the idea that 40% of adults don’t have even $400 for a car repair, while a full 50% (the report says “half” without a precise number) have a 3-month emergency fund sounds . . . off.

Then, today, what caught my eye was a new press release from NORC, the survey group at the University of Chicago, more known for their General Social Survey.  The headline:  “Most Working Americans Would Face Economic Hardship If They Missed More than One Paycheck.”

The actual question?

“How many paychecks in a row could you miss before you would be unable to pay for necessities (such as food, rent/mortgage, car loan) without using savings?”

Now, the actual responses people give to this question are almost besides the point because the entire objective of having savings is to be able to cover expenses such as these in a time of missed paychecks (for whatever cause:  job loss, government shutdown, disability, parental leave).  Yes, for two-earner couples where the survey-taker’s partner’s income is sufficient to pay household expenses, that person may respond that they could miss an infinite number of paychecks, but, well, to be honest, I’m a bit mystified as to how it was that only 8% of survey-takers responded with “other” (which included “unsure” or not answering the question).

This survey then asked:

“If your household missed paychecks and you had no additional savings, where would you get money to pay for essentials (such as food, rent/mortgage, car loans)?”

But, again, this asks what people would do once they’ve exhausted their savings.  It says nothing about how at-risk households are of having to go into debt due to missed paychecks, though, interestingly enough, there’s an element of “one of these things are not like the other” with answer choices generally being variations on ways to borrow, except for one: “seek a job in the ‘gig economy'” — yet one presumes that for people in the real-world situation of missing paychecks, job-hunting is something that they’re already doing, and the question of whether to take on a lower-paying or part-time job something that is ongoing.

So what is going on?

My initial title for this article was “Are Financial Literacy Advocates Jumping The Shark?” but that sounds a bit too accusatory, and as I mulled the puzzle over some more, I began to wonder:

Are we looking at a mismatch in understanding of what an “emergency fund” is?

Financial advice website The Balance told its readers, this past February, “What You Should Spend Your Emergency Fund on and When to Use It.”  Their answer:  don’t spend it on car repairs or home repairs.  Save it for catastrophic events such as the simultaneous job loss of both spouses, or a “major medical catastrophe.”  To be sure, they assume that, at the same time as readers build an emergency fund, they are simultaneously saving for these home repairs and similar expenses in a separate fund.  And Dave Ramsey on his website does give his readers permission to use their emergency fund for any “unexpected, immediate expense” with the instruction to replenish the fund as soon as possible.

If survey-takers or survey-writers think of their “savings” or “emergency fund” as reserved for the serious-est of emergencies rather than for minor unexpected expenses, then they might indeed hesitate to tap into it for repairs and prefer to borrow instead, and cause the financial state of Americans to appear to be worse off than is actually the case.

Or is it really just a poorly-designed survey?

 

December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.

Jane the Actuary Retirement

Forbes post, “What Is ‘Financial Literacy’ And Why Does It Matter?”

Originally published at Forbes.com on August 13, 2018.

 

Americans aren’t saving enough for retirement.

That’s a trite statement.

Precisely how great the shortfall is, is in dispute, of course, as is the question of what remedies, if any, should be undertaken.

But what’s the reason for this savings shortfall?  Discarding specifics like “no more traditional pension plans,” there are three potential reasons, each taking some portion of the blame, and each interconnected with the other:

Americans don’t have the knowledge needed to save for retirement.

Americans don’t have the self-discipline to save for retirement.

Americans don’t have the excess funds to save for retirement.

“Financial literacy” is the catch-all name for initiatives around education that, it’s hoped, will remedy the first of these problems — education that, it’s hoped, will occur in schools, through high school graduation requirements which exist or are slated to come into effect in 21 states, according to Pew, but also through employer-sponsored programs, which are in place at 63% of employers according to the publication Plan Sponsor.

And just how financially illiterate are Americans?

The standard measurement, as developed at the Global Financial Literacy Excellence Center (GFLEC), is a set of three questions.  In May I wrote about a recent study comparing Americans’ ability to answer these questions, relative to the rest of the developed world.  74% of Americans answered a survey question about compound interest correctly (about average globally); 53%, one on inflation (the global average was 63%); and 46%, one on risk diversification (again, right about at the average).

Are these valid questions, and valid measures of financial knowledge?  The experts in the field certainly believe so.  But here’s the actual text of the questions:

  • Suppose you had $100 in a savings account and the interest rate was 2 percent per year. After 5 years, how much do you think you would have in the account if you left the money to grow?  Answer choices:  more, less, or exactly $102.
  • Imagine that the interest rate on your savings account was 1 percent per year and inflation was 2 percent per year. After 1 year, how much would you be able to buy with the money in this account?  Answer choices:  more, less, or the same as today.
  • Do you think that the following statement is true or false? “Buying a single company stock usually provides a safer return than a stock mutual fund.”

The first of these seems obvious.  Surely everyone ought to understand about how interest works, right?  An older version of this type of survey, from 2015, has an available download that breaks down the answers given; there, 75% gave the correct answer of “more than $102,” 8% said “exactly $102,” 5% “less than $102” and 12% said “don’t know.”  One might attribute the “exactly $102” answers to a careless reading of the survey question, but what of the other wrong answers?  Or are these answers simply in line with general innumeracy among a certain segment of the population?

It does strike me, though, that we have lost the very basic means of learning about interest, the humble savings account.  Yes, it still exists.  Yes, Americans are encouraged to have a savings account.  But the interest earned in the year 2018 is so low that it might as well not exist; parents who want to teach their children about the concept of interest sometimes resort instead to creating the Bank of Mom and Dad to credit interest to money their children “save.”  And if you don’t have any understanding of interest, how can you likewise understand that high interest rates on money that you borrow can add up substantially?

What of the inflation/interest rate question?  In the 2015 survey, 59% answered correctly, 20% said “don’t know,” and 10% each answered more or less than today.  [Edit: this was a goof, of course.  The correct answer is “less than today” and the two incorrect answers which each had 10% of the replies, were “more than today” and “exactly the same.”]  To be honest, I can’t get all that worked up over this result given its abstractness.  If I could, I’d prefer to ask something like “if you get a 3% raise, and inflation is 3% for the year, are you better/worse off, or neither?”

And the final question, about mutual funds, it seems to me, showed a general lack of understanding of the term “mutual fund” with 46% answering “false,” 10% “true” and 44% replied “don’t know” — which seems believable enough.  After all, if you’re offered a 401(k) at work, you might invest there.  If you watch TV, you’ll see ads for E-trade and other brokers.  But it’s not obvious that people would know what a mutual fund is without directly being told about them.

But when we look at issues of financial literacy and financial education, we’re really talking about two distinct topics.  First, do Americans have a good understanding of how to wisely budget their money to stay out of debt and build up reserves, and, second, do Americans understand what to do with their money, that is, how to invest rather than merely save?

The reality is that Americans continue to report living paycheck-to-paycheck.  In the 2015 report, only 40% of Americans reported spending less than they earned, so as to build up a cushion.  Even among the college educated, only 48% reported building up savings, and among those earning $75,000 or more annually, only 53% reported this.  How much of this is because they don’t understand the long-term effect of debt, and the cost of interest?

One assumes that college-educated, $75,000+ earning households are not living in the sort of financial distress that means that unavoidable everyday expenses absorb their entire income.  But there are other families which are locked into a given level of spending due to American middle-class culture and a longstanding “financial miseducation”:  the encouragement by experts for years and years that the “financially responsible thing to do” is to is to attend the most prestigious college to which you can gain admittance, regardless of the loans required, and to buy the most expensive home in the highest-rated school district for which the bank will give you a mortgage, for instance, as well as the need, to preserve one’s social standing, to spend on travel sports and lessons for the kids.  A recent report at Bloomberg lamented that “Homeowners are sitting on a record amount of equity, but this time they’re stubbornly reluctant to borrow against it.”

So I’m all for financial education to build a core of knowledge around financial topics — not just at school, not just at the workplace, but also in the community, say, at one’s church or the local library.  But that’s just a start.

 

December 2024 Author’s note: the terms of my affiliation with Forbes enable me to republish materials on other sites, so I am updating my personal website by duplicating a selected portion of my Forbes writing here.