By: Annamaria Lusardi
Annamaria Lusardi is an economist and professor at the George Washington University School of Business; her research focuses on financial decision-making, financial literacy, retirement, and entrepreneurship.
In my previous post, I discussed the pervasiveness of financial illiteracy. This post considers its disturbing consequences when it comes to retirement.
There are compelling reasons to be worried about retirement preparedness. My work with Olivia S. Mitchell of Wharton’s Pension Research Council has found that only a minority of individuals gives any thought to retirement, even when people are only 10 to 15 years away from it. Planning can make the difference between security versus fragility in retirement. Our research shows that those who plan end up with double or triple the wealth of those who do not.
Other factors complicate retirement preparedness. The responsibility for accumulating retirement wealth increasingly falls on employees’ shoulders. And since people are living longer, their retirement accumulations must now stretch over lengthier retirements.
Financial literacy is the critical tool. Indeed, financial literacy is strongly linked to both effective retirement planning and also to the amount of wealth accumulated for retirement. Among the ways in which financial illiteracy undermines retirement security, research has identified three critical areas: saving, investing, and drawing down wealth in retirement.
Saving for retirement is a notoriously complicated decision. A lot of information—and a great deal of calculation—goes into determining how much one should save. Complexities aside, the main principle at work is interest compounding. Indeed, a basic understanding of interest compounding points to the importance of saving early and often, to tap the advantage of time in building a retirement nest egg. And someone who understands this basic concept will recognize that current auto-enrollment rates for retirement accounts (for workers with pensions) are too low to provide a secure path for retirement.
To save effectively for retirement, retirement saving must be set to grow. A good rate of return is essential to building a nest egg. A difference of 100 basis points (for example, a return of 7 percent versus 6 percent) makes a huge difference over a long horizon. Again, there is a benefit from starting saving early. The sooner one starts to save, the more time the interest earned on that saving can feed retirement wealth.
There are many ways to achieve strong rates of return. Investment in riskier assets, such as stocks and mutual funds, is one avenue. While risky assets are, of course, no guarantee of high return, financial markets usually provide a reward for risk, and many retirement accounts offer investment options with these assets. The academic literature also underscores the importance of index versus actively managed mutual funds, since high fees can quickly erode the returns on managed investments. Moreover, employer matches can greatly increase the return on retirement savings, often above those one could attain on one’s own in financial markets. This is why it is so important to take advantage of them.
Earning high investment returns on assets is only part of the balance sheet, however. To grow wealth, one must also manage debt so that it does not jeopardize retirement wealth. We all need financial knowledge to invest and borrow wisely. Our recent study on a large employer’s pension plan participants showed that employees with higher financial literacy achieved higher investment returns on their portfolios. In another analysis, I found that people with higher financial knowledge were also least likely to borrow at high cost.
The work of many years can crumble as a result of poor decisions during the decumulation phase of the life cycle. For instance, one important decision in this area is whether to take a pension payout as a lump sum or to annuitize it. Even traditional defined benefit plans are increasingly offering participants the option of a lump sum.
Again, financial literacy is indispensable. One must dig deeply into the assumptions required for the lump sum calculation, the interest rate used to discount future benefits, and assumed mortality rates. Also taking the lump sum requires a very savvy investor to manage it, making sure the amount received can last a lifetime. In my testimony to the U.S. Department of Labor’s ERISA Advisory Council earlier this year, I discussed how ill-equipped people are to manage this delicate decision.
In his famous book, The Way to Wealth, published in 1758, Benjamin Franklin stated that an investment in knowledge pays the best interest. His advice remains salient today, especially when it comes to retirement wealth.
This piece was originally posted on July 15, 2015 on the Pension Research Council’s curated Forbes blog. To view the original posting, click here.
Views of our Guest Bloggers are theirs alone, and not of the Pension Research Council, the Wharton School, or the University of Pennsylvania.