Tue, June 17, 2008
Are You Financially Literate?
The University Of Michigan Retirement Research Center recently published a brief summarizing the results of several surveys of financial knowledge. The studies suggest that many Americans need help understanding financial and economic fundamentals. How financially literate are you?
A profound shift in retirement trends has been underway in America in the last couple of generations. The landscape has shifted from retirements funded largely through pensions and Social Security to retirement years that will be heavily dependent on individual savings, with relatively less help from Social Security. Meanwhile, the leading edge of the Baby Boom has begun retiring. The financial industry, eager to cash in on a perceived demographic windfall, is busy creating new investment products that claim to meet every retirement need. Retirement savers have lots of options, but without a good understanding of personal finance, they’re likely to make their retirement saving choices in response to the winds of financial marketing.
Are Americans financially literate? It’s impossible to generalize, as socioeconomics, level of education, and other factors affect the answer to this question. However, the overall trends are not encouraging. Two researchers, Annamaria Lusardi (Dartmouth College) and Olivia S. Mitchell (University of Pennsylvania), posed a series of questions to Boomers born between 1948 and 1953. At the time of the survey, respondents were in their early-to-mid 50’s. The researchers reasoned that people in this age group would have already made multiple financial decisions, such as taking out mortgages and car loans. The group was also expected to be in the peak of its wealth accumulation years.
Two questions were asked, and respondents who got at least one of the first two questions right were asked a third question. I’ve paraphrased the questions here; I’ll provide the answers at the end of the post, so you can see how well you do.
(1) Suppose there is a 10% chance of getting a disease. Out of 10,000 people, how many people would be expected to get the disease?
(2) There is a lottery prize of $2 million. If there are five people who have the winning number, how much will each of them get?
(3) If you have $200 in a savings account today and the account earns 10% interest per year, how much would you have, assuming no withdrawals, at the end of two years?
Although the first question was a fairly simple percentage calculation problem, 16.5% of the group could not answer it correctly. The second question, a division problem, was answered correctly by only a little more than half of the group — 56%. The third question, given only to those who correctly answered at least one of the first two questions, produced very poor results. Only 18% of those who were given question #3 were able to answer it correctly. The third question involves compound interest, a concept that must be grasped in order to really understand long-term investment growth. As I noted in an earlier post, the impact of mutual fund fees on investment returns traces back to the compound interest effect.
These results are consistent with other studies summarized in the Michigan Retirement Research Center brief. They suggest that there is a considerable need for financial education among Americans in this age bracket. The results may indicate a more widespread problem if even “financially experienced” individuals had trouble giving correct answers to these questions.
More and more retirement outcomes will depend on individuals making wise saving and consumption decisions. One of my goals for this blog is to offer insights into how to make good financial decisions. Not everyone is fond of thinking about numbers, but most people have the capacity to improve their financial literacy. If they don’t, and if Baby Boomers have not adequately prepared their retirement finances, we’re likely to experience some real social and economic upheaval over the next generation.
ANSWERS:
(1) 1,000 people
(2) $400,000
(3) $242.00 (After the first year, you will have $220.00; the second year you will gain an additional $22.00 in interest. In the survey, many respondents failed to recognize that in the second year, interest would accrue on the interest received in the first year.)