Read Published Article

How prepared are you for retirement? Take this quiz.

1. 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:

a. More than $102

b. Exactly $102

c. Less than $102?

d. Don’t know.

2. Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. With the money in this account, after a year, would you be able to buy…

a. More than you can today?

b. Exactly the same?

c. Less than you can today?

d. Don’t know.

3. Do you think that the following statement is true or false, or you don’t know? “Buying a single company stock usually provides a safer return than a stock mutual fund.”

Answers: A, C, False

Easy pickings, right? Bet you aced it. Congrats. But the disturbing thing is the fact that only one-third of the 1,269 American adults surveyed could correctly answer all three questions, according to the findings in a new working paper, Financial Literacy and Planning: Implications for Retirement Wellbeing, published this month by theNational Bureau of Economic Research.

The study is authored by two of the most well-respected researchers in the field–Professor Annamaria Lusardi of the George Washington School of Business and Olivia Mitchell, Ph.D., a professor at the Wharton School at the University of Pennsylvania and the executive director of the Pension Research Council.

The three questions aren’t strictly scientific, of course, but they can predict if you are likely to be prepared for retirement, according to Lusardi and Mitchell.

The first two questions the authors refer to as the “Compound Interest” and “Inflation” items “indicate whether respondents command the key economic concepts fundamental to saving”. The third question, which they dub “Stock Risk,” evaluates knowledge of risk diversification, “crucial to informed investment decisions,” they explain.

To further investigate the links between the sources of information on which households rely, financial literacy, and planning,  the researchers designed a special module on retirement planning to assess levels of financial literacy along with consumers’ efforts to budget, calculate, and develop retirement saving plans.  Then they, implemented this in the context of the Health and Retirement Study (HRS), a nationally representative longitudinal dataset of Americans over the age of 50.

The findings on financial literacy among this sample of older Americans showed that only two- thirds of the respondents understand compound interest. “This is a discouraging finding inasmuch as this generation in its 50’s and 60’s has made many important financial decisions over its lifetime,” Lusardi and Mitchell write.

More of the respondents, three-quarters, can answer the inflation question correctly and understand they would be able to buy less after a year if the interest rate was 1 percent and inflation 2 percent. Yet only half of the respondents know that holding a single company stock implies a riskier return than a stock mutual fund. This suggests widespread financial illiteracy among older Americans, according to the authors.

The researchers also asked respondents how they calculate retirement saving needs:

1. Have you ever tried to figure out how much your household would need to save for retirement?

2. Did you develop a plan for retirement saving?

3. How often were you able to stick to this plan: Would you say always, mostly, rarely, or never?

Last, they asked what tools people use to devise and carry out their retirement saving plans.

• Did you talk to family and relatives?
• Did you talk to co-workers or friends?
• Did you use calculators or worksheets that are computer or Internet-based?
• Did you consult a financial planner or advisor or an accountant?
• How often do you keep track of your actual spending: would you say always, mostly, rarely, or never?
• How often do you set budget targets for your spending: would you say always, mostly, rarely, or never?

“Fewer than one-third of this cohort on the verge of retirement had ever tried to come up with a retirement plan, and only two-thirds of these succeeded,” they found. Moreover, the duo’s analysis shows that financial knowledge and planning “are clearly interrelated, and keeping track of spending and budgeting appears conducive to retirement saving.”

Finally, they evaluate the planning tools people use. “It is interesting that the respondents who did plan were less likely to talk to family/relatives or co-workers/friends, and more likely to use formal means such as retirement calculators, retirement seminars, or financial experts,” they report. Those who were correct regarding compound interest and inflation, for example, were more likely to have attended a retirement seminar.

For me, it’s simple. Financial literacy is the root of all things good. In other words, the more you know, the more you save, the greater your chances of having enough socked away for a retirement without money worries.

If you’re feeling insecure about your financial smarts, regardless of your age, do something about it. You’re never too old to learn–take a class, tap into free planning centers on web sites like Vanguard.com. Fidelity.com andTroweprice.com. And head over to the web site of the US Treasury: www.mymoney.gov, a must-stop independent educational resource. You might even ask your employer to sponsor a retirement planning seminar.

Knowledge is money.

For more on this study, go to: http://www.nber.org/papers/w17078