by Annamaria Lusardi, Pierre-Carl Michaud and Olivia S. Mitchell; CeRP WP 133/13
While financial knowledge is strongly positively related to household wealth, there is also considerable cross-sectional variation in both financial knowledge and net asset levels. To explore these patterns, we develop a calibrated stochastic life cycle model featuring endogenous financial knowledge accumulation. The model generates substantial wealth inequality, over and above that of standard life cycle models; this is because higher earners typically have more hump-shaped labor income profiles and lower retirement benefits which, when interacted with precautionary saving motives, boost their need for private wealth accumulation and thus financial knowledge. Our simulations show that endogenous financial knowledge accumulation has the potential to account for a large proportion of wealth inequality. The fraction of the population which is rationally financially “ignorant” depends on the generosity of the retirement system and the level of means-tested benefits. Educational efforts to enhance financial savvy early in the life cycle so as to produce one percentage point excess return per year would be valued highly by people in all educational groups.
published: March 2013