Financial Savvy Means More 401k Returns
Financial knowledge is critical to one’s retirement security, finds a new study showing that 401(k) plan participants who scored higher on a test of their financial knowledge earned an additional 1.3 percentage points of investment returns annually on their retirement accounts.
Over a 30-year working life, that higher rate of return would add 25 percent to total savings at retirement.
Readers can take the quiz by clicking here; answers appear at the end of this blog post.
Americans now live in a 401(k) world: 90 percent of all contributions flowing into employer retirement plans today go into 401(k)s or other defined-contribution plans. That compares with just 40 percent in the 1980s, when defined-benefit pensions were still prevalent.
Previous studies demonstrated that financially literate people have more wealth or that they gravitate to investments with lower fees, which can boost the share of returns going directly into investors’ portfolios.
This new study – by Robert Clark at North Carolina State University, Annamaria Lusardi at George Washington University, and Olivia Mitchell at the Wharton School – adds to the literature by connecting financial knowledge to actual investment returns. (The researchers used risk-adjusted returns for 10 years, a period of market highs and lows ending in September 2013.)
They analyzed returns for 2,763 employees from a major financial institution and then subjected them to a quiz on their financial knowledge. Each employee was scored on a Financial Knowledge Index, based on his answers to five basic questions about the following topics: interest rates, inflation, risk, tax offsets, and the employer match.
The Financial Knowledge Index ranged from 0 to 5, and the average score was 3.7. Just one-third of those tested got all five questions right.
Since the employees work at a financial company, they are likely to be more knowledgeable than the general population. But the impact of this over-educated sample would only tend to “underestimate the results that would be obtained” if all U.S. employees had been sampled, the researchers said.
The higher returns earned by people who are more financially sophisticated, they conclude, support the contention that financial literacy can be “a driver of wealth inequality.”
Answers: 1. More than $110; 2. Less than today; 3. False; 4. Decline by $75; 5. Increase by $200.
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Question 4 is not a financially literate question in at least two different ways!! The 25% tax bracket refers to the incremental rate one pays at a certain income level. For example, I am normally in the 26% bracket but pay at an overall rate of 12% of total income. Secondly, the change in your paycheck due to a pretax deduction has no relation to your tax bracket. Your paycheck tax deduction rate depends on the deductions claimed on the W-4 form submitted to your employer.
The questions were written by an illiterate -- not a financial illiterate -- just a plain illiterate. Example: Question 4 -- The answer is incorrect: Your paycheck goes down by $100, not by $75, because you normally don't get the tax deduction for your 401K contribution in your paycheck; you get it when you file your income taxes the next year, and pay $25 less in taxes than you would otherwise have paid. Yes, you could decrease your withholding by $25, but that is not what the question is supposed to be about, and most people don't do that. They will have $100 less in their paycheck.