Hearing on "The State of Financial Literacy and Education in America."
Second Hearing in a Series.

I am Stephen Brobeck, executive director of the Consumer Federation of America. For three decades, our organization and I personally have sought to promote effective financial education. In our opinion, there has never been a greater need to advance this education. So, we commend you, Mr. Chairman, and your Committee for organizing these hearings. Hopefully, they will focus national attention on consumer financial literacy and the most effective educational strategies for improving this literacy.

This testimony begins by arguing that the financial education needs of the least affluent and well-educated Americans deserve special attention, in part because recent changes in the financial services marketplace have increased the financial vulnerability of these households. The testimony then outlines five important principles for effective financial education. The last of these principles stresses the importance of a comprehensive plan for increasing financial literacy, which probably cannot be developed and implemented without effective federal leadership. The testimony concludes by suggesting that appropriate regulation provides a necessary complement to financial education.

We cannot think of a large population with greater financial education needs than the tens of millions of the least affluent and well-educated Americans. Because these individuals lack financial resources and often are charged high prices, they cannot afford to make poor financial choices. But because of low general and financial literacy levels, they often have difficulty making smart financial decisions, in part because they are especially vulnerable to abusive seller practices.

In 1998, 37% of all households had incomes under $25,000. With the exception of older persons who had paid off home mortgages, these households had accumulated few assets. In 1998, according to the Federal Reserve Board’s Survey of Consumer Finances, most of these least affluent households had net financial assets (excluding home equity) of less than $1,000. Moreover, between 1995 and 1998, a time of rising household incomes, the net worth of lower-income households actually declined.

Households with low incomes and assets cannot afford to make unwise financial decisions simply because they have few discretionary financial resources. Failing to adequately budget expenditures may pressure these consumers into taking out expensive credit card or payday loans. Mistakenly purchasing a predatory mortgage loan could cost them most of their economic assets.

These households also need to make smart buying decisions because they tend to be charged higher prices than more affluent families: higher homeowner and auto insurance rates because they live in riskier neighborhoods; higher loan rates because of their low and often unstable incomes; higher furniture and appliance prices from neighborhood merchants that lack economies of scale and face relatively high costs of doing business; and higher food prices in their many neighborhoods without stores from major supermarket chains.

Lower-income families are also faced with higher prices for basic banking services. Partly because of high minimum balance requirements to open accounts and avoid fees, these households tend to pay high prices for checking services, or they do their banking at check-cashing outlets where check-cashing fees typically are at least 2% of the face value of checks. These families also lack access to basic savings options.

Lower-income households also are charged higher prices because their low general and financial literacy levels make effective product searches difficult and expose them to seller abuse. Low incomes are highly, and increasingly, correlated with low education levels, and these low levels are closely associated with low general and financial literacy levels. In our comprehensive 249-question test of the nation's consumer knowledge, conducted by the Educational Testing Service in 1989, lower-income households answered fewer than one-half of questions correctly. If the functionally illiterate and marginally literate members of our sample population had not had the option of having questions read to them, this percentage of correct answers would have been much lower.

Consumers who have difficulty reading are unlikely to understand the fine legal print in ads and contracts. Those with limited mathematical skills often do not understand percentages that express the key cost and yield indicators, respectively, for credit and savings products. For example, research shows that only about three-fifths of consumers understand and use the most important index of credit costs, the annual percentage rate or APR, and that non-users tend to have low incomes and education levels.

Lower-income households with low literacy levels are especially vulnerable to seller abuse. Consumers who do not understand percentages may well find it impossible to understand the costs of mortgage, home equity, installment, credit card, payday, and other high-cost loans. Individuals who do not read well may find it difficult to check whether the oral promises of salespersons were written into contracts. And, those who do not write fluently are limited in their ability to resolve problems by writing to merchants or complaint agencies. Consumers who

do not speak, read, or write English well face special challenges obtaining good value in their purchases.

Over the past decade, the financial vulnerability of low- and moderate-income households has increased simply because of the dramatic expansion of the availability of credit. Throughout the last century, consumers were exposed to widespread and persistent marketing of goods and services. Yet, they were insulated to an extent from the potentially adverse effects of this marketing by the financial constraints of their incomes and savings. Most of the credit extended to households took the form of first mortgage loans and installment loans, both of which were secured by the property purchased and amortized in fixed, regular payments.

During the 1990s, lenders greatly eased these financial constraints by significantly expanding credit available to consumers and by marketing this credit aggressively. Since this credit tended to be open-end and carry a high price, it exposed consumers to greater financial risks than did the closed-end loans that had earlier dominated consumer credit markets.

The loans that subjected the greatest number of Americans to financial risk were made with credit cards. From 1990 to 2000, fueled by billions of mail solicitations annually and low minimum monthly payments of 2-3%, credit card debt outstanding more than tripled from about $200 billion to more than $600 billion. Just as significantly, the credit lines made available just to bank card holders rose to well over $2 trillion. By the middle of the decade, having saturated upper- and middle-class markets, issuers began marketing to lower-income households. By the end of the decade, an estimated 80% of all households carried at least one credit card.

Independent experts agree that expanding credit card debt has been the principal reason for rising consumer bankruptcies. These insolvencies were still precipitated by unexpected major expenditures or income losses. However, many of those experiencing these new financial burdens or losses would have been able to manage if they had not been carrying large credit card debts. Contrary to the perception of many, the annual incomes of typical Chapter 7 bankrupts average well under $30,000.

Also worrisome has been the expansion of high-priced mortgage loans and stratospherically-priced smaller consumer loans. In the 1990s, creditors began to aggressively market subprime mortgage loans carrying interest rates greater than 10% and higher fees than those charged on conventional mortgage loans. By 1999, the volume of subprime mortgage loans peaked at $160 billion. Mortgage borrowers in low-income neighborhoods were three times more likely to have subprime loans than mortgage borrowers in high-income neighborhoods. A significant minority of these subprime borrowers would have qualified for much less expensive conventional mortgage loans. And, a minority of these borrowers were victimized by exorbitantly priced and frequently refinanced predatory loans that "stripped equity" from the homes of many lower-income households.

The 1990s also saw explosive growth in predatory small loans -- payday loans, car title pawn, rent-to-own, and refund anticipation loans -- typically carrying effective interest rates in triple digits. The Fannie Mae Foundation estimates that these "loans" annually involve 280 million transactions worth $78 billion and carrying $5.5 billion in fees. The typical purchaser of these financial products has income in the $20,000 to $30,000 range with a disproportionate number being women.

There is no clear consensus about how to effectively provide financial education, especially to those who have completed their secondary education and to those with low literacy levels. However, our own research and programs, as well as those of others, suggest five principles on which successful financial education programs should be built.

Seek behavioral change, not just improved knowledge. An important threshold question is how one defines the purpose of financial education. Is the goal simply to increase financial literacy -- to expand consumer knowledge about the financial services marketplace and how consumers can best utilize this knowledge? Or, is the goal, more fundamentally, to improve the quality of consumer financial decisions -- to help ensure that consumers not only have adequate knowledge but also successfully apply this knowledge in decisions about spending, saving, and the use of credit?

We strongly believe that behavioral change should be our most important financial education goal. After all, the principal reason for the growing focus of attention on financial literacy is the fact that the financial decisions of many consumers are viewed as unwise. These decisions may relate to poor spending decisions, in particular, spending beyond one's means. They may pertain to poor savings decisions, such as not accumulating sufficient savings or concentrating these savings either in cash or in highly speculative investments. Or, they may relate to poor credit decisions such as unsustainable borrowing at very high prices. Perhaps nothing has increased our interest in financial education more than the growth, over the past decade, of consumer purchases of predatory mortgage and consumer loans.

Deciding to focus on the quality of consumer financial decisions means that evaluation of financial education programs should examine their behavioral effects, not just increased knowledge levels. The most sophisticated efforts to measure these impacts, such as recent research on financial education mandates and savings accumulation published in the Journal of Public Economics, do just this.

Make certain to include "attractive" useful knowledge that can be easily applied by consumers making financial decisions. It is sometimes assumed that the only effective financial education includes explanations of how the economy and markets function. That knowledge, in our opinion, is extremely important for Americans to have -- we would support mandatory economic education for young people -- but chiefly because it is essential to an informed citizenry. Consumers also need practical information about household budgeting, consumption, use of credit, and saving. Particularly for adults, knowledge about these subjects should be the focus of financial education.

What this knowledge includes will depend somewhat on the time and interest of targeted consumers. But we feel strongly that this knowledge should always include relatively short, simple messages containing built-in motivators about how to meet financial needs and attain financial wants. Many consumers will never take a financial education course or workshop, or even read a lengthy pamphlet. Concise, powerful messages can be communicated most easily to millions of Americans, particularly if the same messages are disseminated by government, nonprofit, and business "financial educators."

In the early 1990s, after forming the Consumer Literacy Consortium, 25 government agencies, business groups, and consumer organizations spent two years researching and developing 66 messages, related to 28 products, on how shoppers could save money. The typical motivators in these messages are potential dollar savings that result from applying the tip, for example: "You can save more than $100 a year in fees by selecting a checking account with a low (or no) minimum balance requirement that you can, and do, meet." Or: "You can reduce credit card fees, which may add up to more than $100 a year, by getting rid of all but one or two cards, and by avoiding late payment and over-the-credit limit fees." For several years, this publication has been by far the most popular pamphlet distributed for a fee by the federal government's Consumer Information Center. To date, 1.4 million copies of the publication have been requested from the CIC and the Consortium.

Address values as well as knowledge. Financial literacy is a necessary but insufficient condition for sensible financial decisions. Consumers must also desire and make the effort to apply this knowledge in this decision-making. Many consumers are greatly influenced by product marketing that may create wants which they try to satisfy by purchasing all the products that their incomes and credit lines permit. For these individuals, financial planning is usually not a high priority. Interestingly, "spenders" and "savers" can be found in every income group. Our research shows that, despite modest discretionary incomes, a significant number of lower-income households manage, during their lifetimes, to accumulate six-figure wealth. Our research also reveals that a number of high-income families build little wealth.

Our America Saves campaign illustrates how financial education can seek to communicate values as well as knowledge. This campaign is directed at low- and moderate-income households who save little and are convinced that they lack the ability to save and build wealth. An important goal of our efforts is, through knowledge about who saves, how to save, and the power of interest compounding, to persuade consumers to consider saving more of their incomes. But through mass advertising and encouragement from those organizations with which potential savers are affiliated -- notably, employers, primary financial institutions, and churches -- we also try to persuade these individuals to value saving more highly. Then, when fellow employees, customers, and congregants begin saving, there is additional encouragement to shift priorities from spending to saving. For two decades, this social marketing approach has been used with much success in developed and developing countries to persuade individuals to change health and safety behaviors.

Provide opportunities to learn by doing as well as by studying. Traditional classroom/workshop pedagogy may be sufficient for increasing knowledge levels but not for changing behaviors. To improve the quality of financial decisions, educators may also need to teach students how to function in the marketplace through actual or simulated participation. This participation can take the form of budgeting of personal expenditures, maintaining checking

accounts, or making regular savings deposits. But it could also include using "monopoly money" to invest in the stock market or purchase services from a "classroom bank."

Focusing on the behavioral effects of financial education seems especially appropriate for low- and moderate-income consumers. We want assurance not just that these individuals "know" how to budget, open a checking account, and avoid high-priced loans, but that they actually succeed in doing so. Some of the most successful financial education programs serving lower-income households -- National Foundation of Credit Counselors’ member credit counseling, Individual Development Accounts, Cooperative Extension's Money 2000 program, and America Saves -- closely link education to successful budgeting, debt repayment, and savings deposits.

Develop a comprehensive plan for increasing the financial literacy of all Americans. While many worthwhile financial education programs exist, they are not well-coordinated, effectively reach only a small minority of the population, and do not reflect any broad, compelling vision. What is most needed is a comprehensive needs assessment and plan to guide and inspire financial educators and their supporters. At worst, such a plan would help ensure that the efforts of individual organizations were more cost-effective. However, a comprehensive plan could also convince a broad array of government, business, and nonprofit groups to work together to try to persuade the nation to implement that plan.

A comprehensive plan should include, at minimum, the following elements: First, a rigorous assessment of financial education needs. Second, selection of those populations with the most pressing needs that financial education would help meet. Third, evaluations of existing programs to develop the most promising, cost-effective strategies for meeting the needs of these targeted populations. Fourth, organizing broad-based societal support to implement these strategies. Fifth, at each stage of implementation, evaluating the success or failure of these strategies.

We believe that financial education can dramatically improve only through support from a broad array of public and private institutions. Yet, it is unlikely that any comprehensive plan could be developed and win broad support without leadership from the federal government. Accordingly, the hearings today represent a major step forward in making financial education an important national priority. Yet, this should only be the first step. Congress and the Administration should support the development of a plan, build support for this plan, and then help implement it.

A promising second step would be a major study of the nation's financial education needs, vulnerable populations, and the most effective financial education programs to meet the needs of these groups. This study should go well beyond typical GAO and CRS reports or those from existing financial agencies using current resources. We suggest that those federal entities with the greatest interest and knowledge of financial education select leading researchers to undertake this research, that the researchers be advised not only by federal agencies and Congress but also by a committee of leading financial educators, and that Congress appropriate at least $1 million to undertake this project. Frankly, if the federal government were not prepared to spend such a trivial amount on such evaluation and planning, we would question its commitment to financial education.

One topic that the researchers and their advisors should consider is whether it would be cost-effective to create a new federal Office of Financial Education to implement any recommendations of the study. If adequately funded, that office could go well beyond a review of existing research and programs to undertake new research and test new programs. It could also be given responsibility for communicating regularly with, and even help strengthen, the network of financial educators. This network not only could provide the office with useful advice, possibly through a formal advisory committee, but also could help mobilize support for the implementation of any comprehensive financial education plan.

For decades there has been a vigorous debate in Washington and around the country about the relative merits of education and regulation to solve societal problems. In our view, both approaches are necessary and complementary. In the financial area, regulation should proscribe socially destructive practices (including financially reckless practices as well as consumer deception and fraud), insist that markets be as transparent as feasible (chiefly through adequate reporting and disclosures), and enforce related rules. The recent collapse of Enron highlights the importance of effective regulation both for individuals and the whole economy.

Even in an effectively regulated financial marketplace, however, education is essential to ensure that consumers have the ability to make rational decisions in relatively dynamic markets filled with a broad array of complex products. After all, most regulation only sets minimum standards or requires effective disclosures. It is up to consumers to utilize the disclosures and other information to attain good value in their product purchases. Only education can help ensure that consumers undertake money management, consumption, use of credit, and saving in effective ways. If they do, they and the entire society will benefit because individual economic decisions, and the economy, will become more efficient and productive.

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