A common refrain that one hears in the context of financial services for low-income households is the importance of “keeping it simple”. A simple product, combined with “financial literacy”, is the most common prescription for financial inclusion. But this is a dangerous approach and one that is not rooted in a good understanding of the nature of finance.
Let’s first see how simplicity can affect financial design in the case of a farmer. Before the sowing season, the farmer needs to finance his sowing operations. This can be done in two ways: first, a crop loan payable in equal monthly instalments and second, a crop loan where principal and interest payments are linked to the amount of rainfall obtained in the region.
The first option is clearly a simple product to design and communicate for a provider, since it shifts to the farmer the responsibility of insuring against rainfall risk. The damaging effect of this “simple” loan product is evident, as fixed payments are attached to volatile cash-flows.
The second option, however, requires the provider to develop an integrated solution by hedging the risk at his level. While the resulting product is complex, it addresses the farmer’s needs more efficiently.
Re-examining this notion of simplicity in the context of retirement planning, we find a household with earning members today wants to invest in assets that will give them stable income post-retirement and protect them from longevity and health risk. An optimal choice here is a contract combining an annuity scheme with health insurance. But, in the market, these are two stand-alone products, priced with very different assumptions.
A health insurance contract assumes that the people who purchase it will be those who expect to fall ill more often; the logic that goes into pricing an annuity, on the other hand, is just the reverse. In this disaggregated method of delivery, purchasing these products individually would not only impose a high cost on the consumer, but will also assume that the average consumer has the capability to understand this contract.
Policy-makers see financial literacy as a solution to empower consumers and enable them to take decisions that will benefit them. But in the case highlighted above, the expertise needed to choose the optimal bundle of products goes beyond financial training. The financial marketplace is dynamic and it is almost impossible, even for the sophisticated consumer, to keep pace with financial innovation. Even for a well-informed consumer, translation of such knowledge into a purchase decision calls for his getting past an array of cognitive biases, such as procrastination, regret and loss-aversion, mental accounting and information overload. Financial literacy makes the very troubling assumption that if customers had all the necessary information, they would make perfect, welfare-enhancing decisions. Unfortunately, there is very little evidence to back this assumption.
A study conducted by professors at the London School of Economics, and published by Financial Services Authority, shows that behavioural biases often result in sub-optimal decisions for consumers. For instance, lower rates of annuitisation among retirees are attributed to a greater weight being assigned to the risk of early death over a longer-than-expected retirement period.
The inherent difficulty in navigating the growing assortment of choices results in customers placing higher levels of trust in their financial service providers and advisors. However, how much liability does the provider have today for this ‘advice’ that he gives?
Benefits for agents
The model of delivery is largely commission-based, with mutual funds and insurance schemes being pushed on to clients in a way that maximises the agent’s commission and not always the clients’ welfare. Disclosure is usually in the form of a bulky document that the client has to sign on, often a poor substitute for informed consent. Outcomes from an investment are not always possible to predict ex-ante and, in many cases, will depend on the provider’s decisions.
Speculation by a fund manager can, for example, lead to losses for the investor, without the company taking responsibility for it. Risks and losses may not be appropriately conveyed, or conveyed late, leaving the investor to deal with them. Alternatively, the right combination may be technically too complex for the investor to choose by himself. Financial literacy has a very limited role to play here. Is it fair, then, to say that the preoccupation with simplification gives the provider an unfair advantage? Households and individuals are looking to fulfil certain basic functions over their lifetime, such as reducing risks and accumulating assets. These functions may vary at different stages of the life-cycle, as does their capability to achieve them.
An inclusive financial system should be able to equip a household with the right set of tools to enable informed decision-making. While this requires basic knowledge on the part of the consumer, the optimal choice can result only with changes in the current system of product design and delivery. The provider will have to cut across traditional institutional barriers to develop integrated products and services that lead to more efficient financial outcomes. In order to facilitate this process of financial re-engineering regulators and policy-makers will need to work in a coordinated manner. The way forward will be a shift in responsibility from the user to the provider, through a more prescriptive approach to financial service delivery.
This article first appeared in The Hindu Business Line.