Financial Competence and Expectations Formation: Evidence from Australia

Abstract

This research studies the propensity of individuals to violate implications of expected utility maximization in allocating retirement savings within a compulsory defined contribution retirement plan. The paper develops the implications and describes the construction and administration of a discrete choice experiment to almost 1200 members of Australia's mandatory retirement savings scheme. The experiment finds overall rates of violation of roughly 25%, and substantial variation in rates, depending on the presentation of investment risk and the characteristics of the participants.

Presentations based on frequency of returns below or above a threshold generate more violations than do presentations based on the probability of returns below or above thresholds. Individuals with low numeracy skills, assessed as part of the experiment, are several times more likely to violate implications of the conventional expected utility model than those with high numeracy skills. Older individuals are substantially less likely to violate these restrictions, when risk is presented in terms of event frequency, than are younger individuals. The results pose significant questions for public policy, in particular compulsory defined contribution retirement schemes, where the future welfare of participants in these schemes depends on quantitative decision-making skills that a significant number of them do not possess.

Keywords: discrete choice, retirement savings, investment risk, household finance, financial literacy

JEL Classification: G23, G28, D14