Over the last 40 years, we as individuals have been given increasing responsibility for ensuring our own financial well-being in retirement. But it’s gotten quite complex, with an alphabet soup of retirement saving vehicles – from 401(k) to 403(b) plans to IRA and Roth IRAs – and our responsibilities loom large. Not only must we figure out how much to save and how to invest our retirement assets, but we also must take advantage of a variety of tax-favored assets, employer matches, payout options, and much more.
In my research, I investigate how well-equipped we are to make such complex financial decisions. For instance, how much do we know about the power of compound interest, so we can appreciate how critical it is to save early and grow our money tax free? Do we know how to diversify risk? Such knowledge provides a firm foundation for good financial decision-making over the entire lifetime.
To gain an understanding of the level of financial literacy in the population, Olivia S. Mitchell and I designed and fielded three key questions which have now been used in a large number of national and international surveys. We have also administered the survey to a variety of employees at large companies, to see exactly what they know – and don’t know.
Try the quiz yourself (right answers are in bold):
1. The Interest Rate question (Numeracy)
Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow?
2. The Inflation question
Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, how much would you be able to buy with the money in this account?
3. The Risk Diversification question
Please tell me whether this statement is true or false. “Buying a single company’s stock usually provides a safer return than a stock mutual fund.”
Our findings in the US and around the world proved to be shocking! Only one-third of Americans can answer all three questions correctly. And while one might expect that the more experienced would be substantially more financial literate, this is not the case. In fact, older adults are not much savvier than the young, despite their having had to make many financial decisions including about retirement savings. We also find that financial illiteracy is particularly severe among certain demographic groups, such as the low paid, women, and young adults.
Moreover, when we take our financial literacy survey abroad, the results are not much better! Respondents in Australia and Germany do perform better, while thus far we see respondents in Eastern Europe and Russia are the least financially savvy. But all of us have a long way to go.
I worry a great deal about such low levels of financial literacy, because retirement planning requires a modicum of financial sophistication – and planning is a strong predictor of retirement wealth. According to our research, those who plan accumulate up to three times the amount of wealth of non-planners. The data shows the link to financial literacy is very strong; it is those who are financially literate that plan for retirement. And without basic financial skills, people get into trouble young, taking out payday loans and overdrawing their credit cards, and they stay in trouble later, by failing to pay down their mortgages and borrowing against their retirement accounts.
Granted, raising our nation’s financial savvy will require costs and effort. Nevertheless, there are costs of ignorance, including not saving, not being able to retire, and being poor during one’s later years.