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Financial literacy
and the life cycle
The understanding of financial needs leads to an understanding that there
exists a structure of reasoning and explanations, which is both necessary
and sufficient to understand the crux of the issues regarding financial
literacy at various stages of life.


to apply the philosophy exposed through
Dr. Somnath Basu
the dissection of these examples to other
Director, California Institute of Finance (USA)
financial decisions and conclude whether

he US Financial Literacy and health, it is infeasible to educate all the knowledge can be generalized for all
Education Commission defines consumers about how to take care of all financial decisions.
financial literacy as “the ability their medical needs. Rather, the general Consider first the example of saving
to make informed judgments and to take education regarding health is mostly in for retirement. Here, the consideration
effective actions regarding the current and the lines of educating about activities and begins by observing that the primary
future use and management of money.” behavior, such as good diet and exercise, objective in this decision is to save so
Financial literacy should include the which generally promote good health that the standard of living established by
ability to understand financial choices, and well-being. Further, people seek the individual prior to retirement can be
plan for the future, spend wisely and expert medical help when they observe maintained through the retirement years.
manage and be ready for life events such symptoms of problems in themselves. The pinpoint accuracy of the explanation
as job loss or saving for retirement. At Similarly, the intent of financial education is important because it serves as a way to
the heart of the definition of financial should concentrate on financial activities avoid complications with other potentially
literacy is the term “informed,” as and behavior that promote general related decisions, leading to less-informed
emphasized previously. It is the effective financial well-being and health. Along the decisions.
use of information in the decision making same lines, the general education should While most consumers understand
that retirement implies the cessation of
IN CONSIDERING THE ENTIRE PROCESS OF work-related income, they may often fail
EDUCATION, a very useful analogy can be to appreciate that the retirement years
made between the financial health and well-being coincide with the gradual loss of an ability
of a person and their medical health and well- to make up for shortfalls in retirement
being. Regarding medical health, it is infeasible to funds with advancing age. It is this
knowledge that can truly spur the decision
educate all consumers about how to take care of
to save. In an equivalent sense, the
all their medical needs. consumer needs to understand that the
process that separates the more literate also provide consumers with the ability to cost of not having sufficient funds during
from the less literate decision. This paper detect symptoms of poor financial health retirement when the funds are most needed
will focus on what constitutes information so that they can seek a financial expert. can result in reductions in living standards
as defined, what are the benefits of Thus, financial literacy must begin by that are more painful at an advanced age.
being informed, the costs of not being explaining the need and importance of The clarity is also important to separate
adequately informed, and the dynamics of good financial decisions. other decisions that are often included in
information over time. Individuals make a wide array of this decision.
As with any other decision, a financial financial decisions through their lifetime. For example, consumers budgeting
decision arises from some need. The study Examples of such decisions include saving for retirement savings may include the
of the nature and characteristics of various for retirement, managing credit wisely, contributions made in funding children’s
financial needs serves as the starting point budgeting, tax and estate planning, college education. Consumers need to
in financial education. As will be seen in insurance etc. Each of these decisions is understand that this is a separate
the rest of the paper, the understanding of prompted by the emergence of a need. To investment and savings decision and
financial needs leads to an understanding help consumers make informed decisions, should be approached separately.
that there exists a structure of reasoning the process of education should begin by Otherwise, the simultaneous solution of
and explanations, which is both necessary a very clear explanation of the need and attempting to meet two different financial
and sufficient to understand the crux of why the decision to correctly satisfy the objectives will typically lead to sub-
the issues regarding financial literacy at need is so important. This explanation optimal decisions and transactions in
various stages of life. should also be accompanied by the costs unsuitable products. This latter example
In considering the entire process of of an ill-informed decision. exposes the role of clarity in defining
education, a very useful analogy can be In the rest of the paper, three examples financial objectives. In turn, it is this
made between the financial health and of financial decisions will be continually clarity that leads to the proper “informed”
well-being of a person and their medical used to elaborate on the content and decisions.
health and well-being. Regarding medical process of literacy. The reader is urged As a second example, consider the


common need for life insurance. In this credit, and again, in this case, a secondary 20s. Consider the typical needs of such a
case, the primary information is that this need. Consequences of mismanaging this person. The new found economic identity
need allows the insured person the ability and the primary decision can and does most often leads to greater consumption,
to protect her/his dependents and loved lead to similar undesirable outcomes. especially those purchasing preferences
ones from a sudden loss of income due to The above three examples of common that were postponed due to a lack of
a premature and unexpected death. Thus, financial decisions illustrate first and resources. Further, it is often during these
life insurance is said to cover “pure” foremost the importance of crystallizing years when such people begin thinking
risk. This explanation is easy for most the basic needs in the minds of consumers. about raising a family.
consumers to comprehend. This clarity This in turn should lead to a set of One of the first financial decisions that
is a necessary piece of information since information that consumers will need to many individuals make at this stage is
life insurance products are commonly make informed decisions. Thus, it can to begin saving towards the objective of
bundled with instruments that satisfy other be said that the first step in financial purchasing a house. This decision is also
financial needs such as investment, tax literacy is the clarification, in all details, made easy by the fact that the outcome
deferral, small business succession, or as of the financial objectives for the decision of this decision is of a shorter term and
a source of credit. being made. It is also important to educate young professionals are more comfortable
Without the definitional clarity, the consumers to determine when to make with that perspective. To many people at
decision becomes complex since the a financial decision on their own, and this life stage, the need to insure her/his
various bundled instruments may indeed to understand symptomatic conditions
be the most suitable and optimal of deeper rooted problems that may GENERALLY, the need
instrument for some consumers. require financial expertise from an to make financial
Generally, understanding this suitability independent, qualified adviser. In other decisions begins with
issue is beyond the grasp of most words, consumers should be educated an individual’s work life
consumers. In a sense, educating in the need for financial literacy and and career. In other
consumers about the basic need in this case education. Such educated consumers
may just prove to provide a preventive benefit most from education, counseling
words, the need to
rather than a curative set of knowledge. and guidance, public and/or private.
decide on cash
A third and final example is now The next step in the literacy process is outflows begins when
considered. When a consumer saves to to help consumers learn about the need to cash inflows begin.
buy a house, it is because she/he wishes prioritize the objectives and the methods
to provide a secure and comforting of doing so. To begin with, consumers life is not of a high enough priority, since
environment for her/his family. This have a wide array of financial needs and a this person typically does not have any
reason is generally well understood by limited amount of resources. Hence, there dependents as of yet. Similarly, the need
consumers. Unfortunately, what is not exists a need to allocate these resources in to save for retirement, an event more than
understood is that the satisfaction of the most efficient and optimal manner. 40 years away, is generally an even more
this primary need may be jeopardized if A comprehension of the need for remote objective.
the decision includes elements that solve efficient allocation should then be Educating this person on the need to
other financial needs. followed by an education process of the allocate some of the income for insurance
For example, most consumers order and magnitude in which various and retirement savings is not only about
understand that an owned house is also an financial needs should be addressed. To financial education but it is also about life
investment vehicle and for this purpose do so, the first step is for the consumer to counseling and planning. The individual
is more desirable than the alternative of understand the time horizon of each of the must be counseled strongly about why
renting a home. However, as in many decisions. Using the three examples in the savings for retirement is so vital for
other decisions, the decision to invest in previous section, the need to understand individuals in their early 20s, especially
real estate is also speculative. It is quite the implications of time horizons can now when mortality and old age may not
clear that a part of the education process be duly explored. seem immediately relevant as a financial
should include that making a decision Generally, the need to make financial objective. However, the difficulty here is
based on satisfying more than one need decisions begins with an individual’s work alleviated through financial literacy, i.e.,
at a time for some consumers may be a life and career. In other words, the need an appreciation that this individual can
symptom of potential financial loss and/or to decide on cash outflows begins when actually set aside a very small sum and
the loss of peace of mind. Similarly, cash inflows begin. For most individuals, that the power of compounding and a
equity in real estate is also a source of this generally happens during their early lengthy investment time horizon will


do the rest. Thus the educator should may receive the benefit of different types at the latter stages of their careers or life.
be able to demonstrate that the loss in of whole life insurance products that In other words, the risk-taking part of
consumption diverted to a savings plan is generate a cash buildup for retirement financial decisions should be made more at
very small. The case for purchasing life may well be true. the early stages and gradually decline over
insurance is similar but its illustration is Second, the consumer in his/her 20s the life cycle. For example, in the early
more powerful in the context that follows should be knowledgeable of the fact that years of savings for retirement, individuals
next. they will most likely buy a life insurance should focus on capital growth. With age,
Now consider the individual in our product when starting a family and that this focus should change to preservation
example 10 years later, or in her/his 30s. buying it today can actually save them of capital and generation of income. This
Typically, this individual is married and money due to much lower premiums over issue is discussed in greater detail in the
may have a child (or children), earning time. Similar to retirement planning, next section.
more and having accumulated a certain awareness that the individual will need Taken together, the financial objective
sum of money towards the purchase of a to insure at some time along with the of a decision and the life stage help
home. The most powerful need for this knowledge that lower premiums for determine the priorities of the decisions.
individual is to protect her/his dependents younger individuals will actually optimize This generally should lead to the more
in the event of a parent’s premature death their current consumption and not reduce efficient allocation of the limited resources
where the dependents lose their source it, is similarly necessary and beneficial. and eventually the successful satisfaction
of lifetime financial needs. There remains
THE FINANCIAL OBJECTIVE of a decision and one last, and in a sense, the most critical
the life stage help determine the priorities of the step in the education process.
decisions. This generally should lead to the more This critical step is educating
efficient allocation of the limited resources and individuals about themselves, especially
eventually the successful satisfaction of lifetime their perspective on risk. Central to this
step is to educate consumers about the very
financial needs. important fact that financial decisions are
of sustenance. Most individuals purchase Proceeding along the age line, the outcomes of reasoned processes; their
some form of life insurance at this point. individuals in their 40s generally earn decisions are not based on emotions. It
Two factors follow from this more than before and many at this point is often this misunderstanding that causes
observation. First, for many people in low have also purchased a house. The financial difficulties and pain to many consumers.
to moderate income categories, purchasing needs at this stage and their priorities Common examples of emotions that
a term life insurance policy is all that have now changed. Whereas retirement become entangled and may strongly
is needed. However, this is what they was a distant concept in their 20s, it is influence financial decisions are those
are frequently exposed to: products which not abstract today and its priority has of greed and fear. Decisions based on
protect in the event of untimely death but increased considerably. Hence, one at these emotions will in most cases have
which are bundled with other investment, this stage in life is more willing to accept unsuitable outcomes. To illustrate further
credit and tax deferral instruments, the need to save for retirement, if the on the problems of emotional decisions
instruments that serve different financial individual is educated properly. By this and the benefits of reasoned decisions, the
needs. time, such educated individuals should earlier financial examples can be utilized.
What such customers should also be able to have foreseen the rise of Consider the earlier discussion of
understand is that separating the two new needs such as saving for children’s saving for retirement. The mainstay of
decisions of risk management and other education or minimizing their tax liability, this decision lies in an understanding of
financial needs management can actually etc. Also, this individual is in his/her 50s the power of compounding. In the early
lead to greater consumption and costs. and at the career peak and wage earning career stage of an individual, the power
Unfortunately, the fear of premature death power, they should be comfortable in the of compounding along with the longer
often clouds consumer judgments, leading security of the financial decisions they time frame for saving allows the usage of
to the purchase of unsuitable products. have made so far. a very reasonable return expectation on
Hence, it is observed that the clarity An important observation regarding savings to achieve the necessary funds for
of the objective and the life stage are the changes in decisions during the retirement. The emphasis is on the term
intricately connected with making suitable aging process is that speculative financial “reasonable.” The natural question that
product choices. Note: The corollary that decisions, if made, are much easier to arises is what are examples of reasonable
individuals in higher income categories contend with at the early career stage than expectation is for a young individual


who is saving for retirement. In this education is for consumers to accept the
case, an expectation of a return between positive probability of such an event as
9%-12% can be thought of as reasonable. spurring the decision. Unfortunately, it is
A conservative youngster may seek a 9% more often the fear that the well-being
rate while the aggressive one may choose of loved ones may be jeopardized that
to earn a rate of 12%. prompts the purchase decision. Even more
Differences in risk tolerance, as unfortunate, this fear can often lead to
exhibited by return expectations, will exist the purchase of a product that attempts to
among people in similar career stages solve more than one need and which may
but the difference in expectation need not not be suitable for some consumers.
result in differences in expected returns Underlying such complex products
that span a very wide range. However, is the temptation of irrational return
when individuals are tempted by the expectations. For example, many
promise of, or are exposed to stories consumers in average income groups
about certain financial instruments that may not benefit from whole life products
can provide exceedingly high returns then where the accompanying tax deferral
the glitter of these promises do sway and investment products use growth (of
individuals to depart from their rationality capital) vehicles, such as stocks, which
and make mistakes due to irrational are implicitly (capital gains) tax deferred.
expectations. Finally consider the purchase of a
In some instances, such decisions house. Consumers need to understand
can lead to financial ruin. Reasonable that while the equity in a house is a
expectations, along with a clear, time- source of credit, borrowing against it for
bound objective is all that is required to consumption purposes may not be a wise
make informed decisions, much like a credit decision for some. Complexities
disciplined regimen of diet and exercise due to the speculative nature of real estate
are necessary for general good health. and issues regarding the relationships
Further, consumers also need to be between interest rates and value are
educated on the concept that these return often too complex for most consumers to
expectations will also change as they understand. Unfortunately, the attraction
progress through the life cycle. of easy money can lead to an emotional
This return dynamic can be observed decision, which may ultimately defeat the
through the example of the need for capital very purpose of the purchase.
growth in retirement savings in the earlier Thus, at the heart of financial education
years of a career changing to the need to lies the need for consumers to understand
preserve the funds at the latter stages. This that reason and rationality must be the only
change in need can simply be translated way in which financial decisions should be
as a decrease in return expectations over made. In fact, they should understand that
the life cycle. In other words, individuals such a disciplined approach to financial
become more risk averse with age and decisions generally lead to achieving
seek safer financial instruments that also the desired objectives. Thus, reasoned
necessarily provide lower returns. Thus, financial decisions lead to good financial
consumers need to understand that the health much like what good diet and
expectations of returns on savings should exercise does for physical health.
generally decrease with age. Alternatively, unreasonable expectations
Fear on the other hand is often - for any financial decision -- generally
portrayed as the primary consideration in lead to poor financial health.
purchasing life insurance, instead of the
need to protect dependents. Consumers
need not be afraid of premature death
in purchasing life insurance. Rather, the