Addressing Financial Illiteracy Through Financial Innovation: The Case for Goal-Specific Bonds the Embed Inflation and Compounding

Abstract

Financial illiteracy is widespread and leads to bad financial decisions (high debt, insufficient savings). Individuals cannot answer basic questions about inflation, compounding, and diversification. While financial literacy can be enhanced, are individuals teachable, and if so, what should they be taught and how lasting is the training? Prof. Merton suggests that some individuals can only be helped with innovation; Prof. Richard Thaler has argued for making the financial system more “user-friendly”. This paper argues that given the challenges posed by finance theory and financial instruments (in turn for financial literacy programs), a complementary approach along the lines of Profs. Merton’s and Thaler’s recommendations would introduce new financial instruments that embed goal-specific compounding and inflation protection. These interest-only real bonds (with goal-specific indexation), with a forward start date, would pay coupons for the period required for the respective goal. Further, there is ample potential supply from natural issuers. This innovation trivializes the investment problem to just simple multiplication or division thereby addressing the challenge of financial illiteracy with financial innovation across a range of saving/investment goals!