Teaching Three Fundamentals of Financial Literacy

Wealth carries a hidden risk for affluent families. When money flows as freely as tap water and high ticket prices are no obstacle to luxury, money becomes "invisible." In this setting, a child assumes that family wealth is permanent, bottomless, and impervious to erosion. They don't think about money until it's not there anymore. This mindset jeopardizes a family's long-term financial security.

By contrast, parents who teach children about money from an early age take out an educational insurance policy. They gift the next generation skills that help kids weather life's storms and prevent self-inflicted financial casualties. The idea is to start immediately.

True financial literacy starts young, begins at home, and ideally includes money that kids have earned from their own efforts. You want to give your children information little by little, in age-appropriate amounts they can handle. Following are three important fundamentals of financial literacy.

Lesson 1: Live Within Your Means

It's human nature to spend more when we can afford more. But over time, spending creeps up and can overtake income. We want to help kids understand that someone who earns $50,000 a year and lives on $40,000 is more financially secure than the person who earns three times that amount but constantly borrows to live on four times that amount.

One popular way to teach children about living within their means is through allowance. Some parents hand kids an allowance of a fixed number of dollars each week, no strings attached. The child can use this money to practice budgeting, perhaps with three piggy banks: one for savings, one for spending, and one for charitable giving.

Other parents prefer to provide spending money in exchange for a child completing a chore that is above and beyond ordinary family responsibilities. For example, the child is expected to make their bed, clean their room, and take out the trash without compensation since those responsibilities are part of being a member of the family. But the parent could offer a specific amount of money to cut the grass or wash the car because those are things that may not be expected. In this way, the child learns the profound lesson of the value of earning a dollar versus being given a dollar. As I mentioned in part one of this series, kids who practice earning their own money gain more confidence and feel less dependent as adults.

Lesson 2: Understand the Meaning and Purpose of Money

Philanthropy is a wonderful tool for teaching children how to handle money and do good. One approach is to establish a donor-advised fund in partnership with a local community foundation. Another option is to establish your own private family foundation.[1] In both cases, you'll want to involve children in on-going, age-appropriate discussions about how to spend and invest money. For example, a 16-year-old daughter who loves puppies might say, "I think we should make a donation from our foundation to the local Humane Society." And mom and dad might say, "Great, we're going to create a five-for-one match. For every dollar you put in, we're going to match it with five dollars from the foundation."

A foundation provides real-world examples and spurs meaningful decision making. As the kids get older, they can be brought into the fold and participate in important discussions. In the process, they learn the answers to questions such as:

• What is asset allocation?
• How do I measure risk?
• What is the difference between a stock and a bond?
• How do I choose an advisor?

Getting the family together to make charitable spending decisions is an excellent way for kids to learn core concepts. Not only will they learn important family values and how to effect positive change through organizations they care about, they'll also get an education in how to manage money.

Lesson 3: Think Long-Term and Leverage the Miracle of Compound Interest

With children of clients, I'll sit down and say, "You're 24 years old, and you've been in the workforce for two years. Your job pays $40,000 a year. Your rent is $800 a month, and you can't save any money. But you're getting a distribution from your trust of X dollars which allows you to maximize contributions to your company's retirement plan and take advantage of the employer match."

This young person also has enough work income to qualify to open an individual retirement account. So I walk them through the Rule of 72, a simple way to determine how long an investment will take to double. By dividing 72 by the annual rate of return[2], they can estimate how many years it will take for the initial investment to duplicate itself. For example, they see that at 7% annual return, the money's going to double in about 10 years.

I tell that young person, "If you take $5,000 of your trust distribution, establish a Roth IRA and earn 7% over time, when you're 34 it will be worth $10,000. When you are your grandparents' age at 84, that investment will be worth $320,000. What if you did that next year and the next year and the next year?" Then their eyes get really big. They see the earlier they start, the more money they're going to have. They begin to understand saving and investing.

Start Talking About Money Now

Today, many young people don't even understand the difference between a credit card and a debit card. They graduate college steeped in student debt and credit card debt. Without blinking, they pay 18% interest on a revolving credit card balance when they have $10,000 in a savings account that's only earning 2% interest. They were never taught to consider the true cost of borrowed money or that by using their savings to pay down the credit card debt, they can effectively save 16%. Few schools offer courses in financial health.

Unfortunately, entrepreneurs often wait until they've sold a valuable business to start teaching their children how to handle money. By then, the damage is already done. In short order, the capital the parents worked so hard to amass slips through the next generation's fingers.

Now is the time to introduce children and young adults to important financial concepts and practices. Philanthropy and trust planning are ideal real-life scenarios that can be used as learning tools. By involving kids from an early age and teaching them, step by step, about managing money, you can help promulgate family values and protect a financial legacy. 

[1] Be aware that with a family foundation, there are no secrets about how much money it contains. Every not-for-profit is legally obligated to file a Form 990 each year, which is publicly disclosed, and to pay out 5% of the assets’ value.
[2] Rate of return is the net gain or loss on an investment over a specified period of time, expressed as a percentage of the investment’s initial cost.