The effect of financial literacy on the adequacy of post-retirement income

Current literature finds that for households with the least amount of assets there still is an unexplained drop in non-durable consumption as they enter retirement. Other studies show that households with few assets usually have a low financially literacy and hardly plan for retirement. This leads to the hypothesis that the unexplained drop in non-durable consumption for some households is due to their inability to plan for retirement as they do not possess the required financial knowledge. This paper tests this hypothesis by utilizing the LISS Panel, a true panel which contains data on several consumption categories for Dutch households. Furthermore, in an additional module four financial questions were asked, which allows me to construct two financial literacy indices. After evaluating the evolution of non-durable consumption for several groups of households based on their financial literacy around retirement, I employ the predictions of the Life Cycle Hypothesis on the data. I use the unexplained part of the change in non-durable consumption as the households retire as a proxy for the unanticipated shock at retirement. After assessing the effect of financial literacy on the unanticipated shock I find that basic financial knowledge is an important determinant of the size of the unanticipated shock at retirement. Furthermore, I find that the amount of assets of the household has a mitigating effect on the relationship between basic financial literacy and the size of the unanticipated shock. The results imply that the lack of basic financial knowledge seriously hinders these households from planning adequately for their retirement and that this effect is largest for households with a low amount of assets. This implies that policymakers should try to increase the basic financial knowledge of its population as this seriously affects the social welfare. Furthermore, the paper advocates that the degree of financial knowledge should be seriously considered when policymakers try to devise reforms for the current financially stressed Dutch pension system.