Sunday, April 19, 2015

Financial Savvy Key to a Secure Retirement

I have started to write a blog for Forbes, and I hope you will follow my blogs there. I provide the link below. However, I will keep posting the blogs here as well as I sometimes write a longer text than what is published online.

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?
More than $102
Exactly $102
Less than $102
Do not know
Refuse to answer

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?
More than today
Exactly the same
Less than today
Do not know
Refuse to answer

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.”
Do not know
Refuse to answer

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.

Saturday, April 18, 2015

Three Key Concepts Every Personal-Finance Class Should Teach

I have started to write a blog for the Wall Street Journal, and I hope you will follow my blogs there. I provide the link below. However, I will keep posting the blogs here as well as I write a longer text than it is published because there is a hard word limit at the WSJ.

More than ever before, we must make financial decisions that are important and consequential. How much should we contribute to retirement accounts and how should we invest our retirement savings? Should we enroll in a health insurance plan with a low or high deductible? What do we need for our children’s education? Household finances have become sufficiently complex that simple intuition or the advice of family and friends is not enough to guarantee good choices.
There are courses in corporate finance and specialized curricula for managing firms’ finances, but what is available when we serve as our own Chief Financial Officer (CFO)? Fortunately, personal finance is a subject making its way into schools, from high schools to colleges to graduate programs. Online courses are also springing up, and some employers have started to offer financial education programs to their employees.
What should the content of such courses be? As member of the Board of Directors of the Council for Economic Education, I served as an adviser on the National Standards for Financial Literacy. From these standards, we can identify some of the crucial concepts that everybody needs to make informed financial decisions. I am going to focus on just three, the Big Three as I tell my students.

One fundamental principle of personal finance is the power of interest compounding. This knowledge is key for saving, borrowing, and investing decisions. It enables us to understand, for example, why it is important to start to save early. And we need to do calculations to see results. If I borrow at 20 percent on my credit card, how long does it takes before my initial debt doubles? If expenses and fees reduce my rate of return by one percentage point, how is my wealth affected over a 30-year horizon?
Because financial decisions are inherently about the future, we must consider how money’s purchasing power changes over time. We must also acknowledge that the future is uncertain. That brings into play two more building blocks: knowledge of inflation and risk. Distinguishing between real and nominal values is essential to keeping a stable standard of living over a lifetime. Indeed, personal finance is where we can fully appreciate the critical role the Fed and its monetary policy play, especially when it comes to low and stable inflation and its implications for financial planning.

Knowledge of risk and risk diversification is at the basis of portfolio choice. We can formally prove that the old adage “do not put all of your eggs in one basket” is, indeed, good advice. Even more, we can learn how to implement it well. Moreover, we can protect ourselves and our wealth from the many sources of risks: interest rate risk, health risk, and the risk of living too long!
The Big Three are the stanchions of a personal finance course we launched three years ago at the George Washington University School of Business. While I cannot say whether this course will lead to smarter financial decisions, students’ eagerness to enroll, performance on the tests, and comments when they complete it give me much hope.