Why are there so many Americans who are woefully unprepared financially for retirement? A recent study by Wharton business economics and public policy professor Olivia S. Mitchell, Executive Director of the Pension Research Council, and Annamaria Lusardi, Professor at the George Washington School of Business and Academic Director of the Global Financial Literacy Excellence Center, offers important insights.
A study that was begun a decade ago posed just three essential questions about compounding, inflation and risk and yielded some surprising results. While Mitchell expected respondents to answer all three questions correctly, most of the people queried — in the United States and around the world — were stumped by at least one question.
More specifically, in the U.S., only 44.3% of those with college degrees answered all three questions correctly, compared with 12.6% for those with less than a high school degree, 19.2% of those with only a high school degree and 31.3% for those with some college. Among those with post-graduate degrees, just 63.8% got all answers right.
How would you do?
Question 1: “Suppose you had $100 in a savings account and the interest rate was 2% per year. After five 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.
Question 2: “Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After one year, how much would you be able to buy with the money in this account?
A) More than today.
B) Exactly the same.
C) Less than today.
Question 3: True or false: Buying a single company’s stock usually provides a safer return than a stock mutual fund.”
The answers? 1) More than $102. 2) Less than today. 3) False.
In “Financial Literacy and Economic Outcomes: Evidence and Policy Implications,” Mitchell and Lusardi posit that people who get any of the three questions wrong are unlikely to be successful with the larger challenge of choosing appropriate investments for retirement. That makes sense because incorrect answers reflect a lack of understanding and appreciation for the power of compounding and of a properly diversified portfolio held for the long-term — two major drivers of investment returns.
In today’s complex financial market, a financial education is more important than ever. It is further evidence that our homes and educational institutions need to do a better job of teaching financial literacy at an early age.