Context

The Money Advice Service leads the development of a Financial Capability Strategy for the UK. Financial capability encompasses the knowledge, attitudes and behaviours required to make good financial decisions. This study was undertaken to understand the degree to which improving consumers’ financial capability could affect not only their own outcomes but also the wider economy. This understanding would inform the delivery of the Strategy and could also influence stakeholders such as policy makers, regulators and the financial services industry to increase their support for improving financial capability.

The study

This study comprises a literature review and the creation of an economic model of how individuals would be affected if their financial capability improved.

The literature review included sources from both a standard economics and a behavioural economics perspective, and sought to understand the following:

• The factors that affect an individual’s financial capability, and the impact of improving that financial capability. These factors needed to be included in the model in some way.
• The factors other than financial capability that can affect financial decision making. These factors were seen as constraints on the model and its implications.

The model simulates consumer behaviour and how this interacts with variable financial capability factors, using data from the 2015 UK Financial Capability Survey (FCS) to represent a sample of over 3000 agents over their remaining lives. As such the model captures both static and lifecycle impacts of improved financial capability –those that happen at the time of the improvement and those that happen over the remaining economically active lifetime of the individual. The authors use the FCS to create a financial decision-making index (FDMI) (with scores ranging from 0 to 15) which feeds into the model together with demographics and data about life events and cash flow. The model also incorporates real-world pricing information gathered from a search of UK based literature and market data.

The study also considers how the financial services industry might react to improved financial capability in the population, but this is not included in the model.

Key findings

The literature review revealed the following behaviours relating to improved financial capability that the authors wished to capture in the model:

• Better budgeting capability
• Better shopping around for financial products
• Better choice of savings products and mix of risk and return
• Enhanced ability to identify opportunities to make better financial decisions, and of when to use a financial advisor
• Better ability to limit the effect of behavioural biases
• Greater accumulation of savings for life events and to cushion against income or expenditure shocks
• Greater likelihood of planning for retirement
• More rapid and effective management of financial difficulties, such as reducing consumption spend
• More effective actions to reduce indebtedness

Using the model to compare the effects of improved decision making across all of the agents in the FCS, the authors have shown how improved financial capability leads to monetary gains in terms of both wealth and increased consumption. These gains arise from changes in behaviour such as increasing savings and retirement provision, choosing better investments and financial products, and reducing over-indebtedness. The gains have been scaled up and weighted to represent the UK population as a whole. The model shows that over a 30-year period, overall wealth in the UK could increase by £79.6bn, and overall consumption by £28.8bn, leading to a combined effect of £108.4bn. The authors produced an adjusted combined effect of £105 – 127 billion which allows for sensitivity of the behavioural triggers, by increasing or decreasing the FDMI used (all figures are at present value).

The authors also consider the supply side response and suggest the following:

• The financial services industry may become more competitive; for a given volume, overall revenue may fall which may encourage more efficient or better value market entrants
• Firms may become more innovative and create new products to meet new demand, for example for savings products for low income earners
• Firms may be discouraged from using ‘exploitative’ strategies and ‘bad’ firms may leave the market
• In order to recover revenues lost as more sophisticated customers search and switch, firms may increase their fees for their less capable customers who are less likely to switch.

Points to consider

• Methodological limitations: The authors highlight a number of constraints:
• The model does not attempt to answer the question “How do people become financially capable?”
  • Factors other than financial capability, such as cultural factors, have an effect on financial decision making, and these are not included in the model.
  • People, being human, do not always behave rationally, nor are they always driven by the most financially beneficial choice; other factors, such as status, may be drivers and this will not be represented in the model.
  • Even with better financial capability, people with low incomes may still be likely to save less and be at risk of financial difficulties, so not realise the gains predicted by the model.
  • The model doesn’t take learning effects into account, such as the likelihood that someone who has experienced financial difficulties will improve their skills around budgeting and credit as a result.
  • The model doesn’t take structural context into account, such as the impact of the welfare state on decision making.
  • The response of the supply side to improved financial capability in the population is important but is also not included in the model, but discussed separately.
• Relevance: The study is highly relevant as it contributes directly to the ongoing development of the Financial Capability Strategy for the UK.
• Generalisability/transferability: The study is applicable to the UK only but researchers in other developed nations could adopt the methodology, using their own data to create a similar model and simulation.
• Applicability: This report is applicable to anyone with an interest in financial capability, such as financial services providers, government, support agencies, policy makers, regulators or educators.