Financial literacy is a hot topic around the world because there are major concerns that individuals have too much debt and don't have sufficient skills or knowledge to cope with an increasing array of financial instruments.
A survey in Australia found that 37 per cent of investors don't understand that
their investments can fluctuate in value. A study in the United States showed that four out of 10 American workers were not saving for their retirement.
In Japan, it was found that more than two-thirds of individuals had little awareness of the concept of risk and return or the importance of a diversified investment portfolio.
The huge level of personal debt, the over-exposure to residential housing and the large inflow of funds to finance companies suggests that financial literacy is also a problem in this country.
Are New Zealanders aware that house prices could fall as well as rise?
Do individuals understand that it is prudent to have a diversified investment portfolio and not be over-exposed to residential property?
Are investors aware of the potential risks associated with putting all their money in one finance company? How many individuals understand the term "secured first ranking debenture stock" in the finance company ads?
The financial literacy issue has been highlighted by a recent 178-page report by the Organisation for Economic Development and the controversy regarding the under-funding of company pension plans in North America and Europe.
The OECD report concludes that financial literacy has become increasingly important in recent years for several reasons:
* Baby boomers will live longer and will have to provide for their own retirement.
* Financial markets are becoming more sophisticated with a vast number of new and complex products.
* Consumer debt is escalating as financial institutions encourage individuals to borrow more and more, particularly through mortgage and credit-card facilities.
* A large number of highly dubious investment products are being offered through the internet.
Surveys in 12 countries, not including New Zealand, demonstrated that financial literacy is low. Individuals claimed that they had a higher level of financial literacy than was actually the case.
In Australia, 67 per cent of respondents indicated they understood the concept of compound interest, but when asked to solve a problem using this concept, only 28 per cent demonstrated a good level of understanding.
A survey in the United States found that 65 per cent of respondents were sure or very sure that they could manage their own finances, but when tested, their performance was similar to individuals with limited financial skills.
The OECD concludes that this overconfidence is unfortunate because it discourages individuals from trying to improve their financial literacy.
The problem with company pension plans has also raised the issue of financial literacy. Most major companies in North America have had defined benefit pension plans for employees. These are schemes whereby the employee is guaranteed a specific payment per week when they retire.
If the performance of the pension fund is not sufficient to meet these payments, then the deficit has to be funded out of normal company activities. Most major companies have a serious underfunding problem because of the recent poor performance of US sharemarkets.
In recent months, a large number of companies have said they are moving to a defined contribution scheme or cancelling their pension plan, particularly for new employees.
A defined contribution scheme is where an individual makes a specific payment each week but the amount they receive on retirement is determined by the investment performance of the fund.
Defined contribution schemes are less attractive to employees because the pension payments may be far less than anticipated and individuals may have to establish their own investment plans to ensure that they have sufficient retirement income.
There is widespread concern in the Northern Hemisphere that individuals do not have enough financial literacy to establish their own investment plans. There seems to be a limited understanding of the concept of risk and return and the importance of diversification.
There is also a concern that under a do-it-yourself system individual investors will have a strong orientation towards residential housing, as it is easier to understand, and will shun the sharemarket because it is more complex and difficult to value.
These concerns are fully justified when one looks at New Zealand.
We have the ultimate DIY investment system for two reasons:
* In the late 1980s, Finance Minister Roger Douglas abolished the tax incentives for pension superannuation funds after advice from the Treasury. This encouraged many companies to close their pension funds. (The Treasury said the tax concessions gave individuals, particularly on high income, too much incentive to save.)
* When individuals adopt the DIY approach, they must go through either a pooled fund (unit trust) or make their own investment decisions. There is a strong incentive for individuals to make their own investment decisions because pooled funds are subject to a capital gains tax but individual accounts are not.
Not surprisingly, given the limited number of company pension plans and the capital gains tax on pooled funds, New Zealanders have an extremely low level of pension fund assets.
New Zealand's pension fund and life insurance investment assets represent 15.5 per cent of GDP compared with 108.7 per cent for the OECD as a whole. Only Hungary, Poland, Czech Republic and Turkey rank below us.
Bank lending and NZX statistics also indicate that under New Zealand's dominant DIY system there is a strong bias towards residential property vis-a-vis shares.
This is consistent with the concerns being expressed in the Northern Hemisphere and anecdotal evidence in this country.
This column received an unusually large number of email responses to the December 17 commentary on the small size of the NZX.
Most respondents said that they preferred residential property because they had more control over these assets and housing was easier to understand than the sharemarket.
The introduction of concepts such as ebitda, ebit, EV, wacc, risk-free rate, equity risk premium and other terms is making the NZX more difficult for individuals with limited financial literacy.
This week's dividend policy announcement by Sky City Entertainment doesn't help matters. Sky City is going to issue bonus shares, which can be converted into cash, because it "allows more efficient management of the company's capital and its imputation credit position".
Does this mean that the group's previous dividend policy, which involved a cash payment, was inefficient? Does it also mean that the cash dividends paid by other companies are inefficient?
New Zealanders' bias towards housing begs the question: Why are we almost totally relying on Reserve Bank Governor Alan Bollard to curb the overheated residential housing market - while crushing the export sector - when there are other instruments, including tax policies and financial literacy education, that could help achieve this aim?
Disclosure of interest: Brian Gaynor is an investment strategist and analyst at Milford Asset Management.
Financial literacy is a hot topic around the world because there are major concerns that individuals have too much debt and don't have sufficient skills or knowledge to cope with an increasing array of financial instruments.
A survey in Australia found that 37 per cent of investors don't understand that
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