Laura Rowley Money & Happiness

Answer the following questions:

1. Suppose you had $100 in a savings account and the interest rate was 2 percent per year. After five years, how much do you think you would have in the account if you left the money to grow: More than $102, exactly $102, or less than $102?

2. Imagine that the interest rate on your savings account was 1 percent per year and inflation was 2 percent per year. After one year, would you be able to buy more than, exactly the same as, or less than today with the money in the account?

3. Do you think that the following statement is true or false?: "Buying a single-company stock usually provides a safer return than a stock mutual fund."

Save or Splurge?

I was thinking about these questions, which are part of a financial literacy survey developed by economists at Dartmouth and Wharton, after the discussion in the comments section of last week's column on savings and inflation. One reader suggested that saving is basically for suckers; that we should blow every dime we have now, since a coming era of high inflation will demolish the value of our nest eggs.

I disagree (as did a number of other readers). Am I annoyed that a gallon of milk costs $4.50? Yes. But does inflation approach the rate of 13.5 percent that my parents had to contend with in 1980? Not so much.

Clearly, inflation does erode a dollar's buying power. That's why, if you're worried about hyperinflation and don't want to eat cat food in retirement, you should save more, not less, and invest in assets that offer a hedge against inflation. (See my blog for some suggestions.)

You, the Actuary

The problem is, a great number of people don't even know how inflation works. Or compounding. Or risk diversification. In fact, researchers found that just 34 percent of adults in their 50s answered all three questions above correctly. (The answers are "more than $102," "less than today," and "false.")

"There is nothing easy about finance," says Annamaria Lusardi, a Dartmouth economist and visiting scholar at Harvard, who studies financial literacy. "These are often difficult decisions for people who don't have a lot of financial sophistication. My research shows over and over that financial illiteracy is widespread, not only among the poor or uneducated, but even people with college degrees."

That's not surprising when you consider that companies used to hire legions of actuaries and investment planners to manage their pensions -- and now you and I get to do it. First, you have to anticipate how long you'll live, the kind of lifestyle you expect to lead, and its cost. You also need to predict your annual household income between now and when you retire, so you know how much you can save.

Future Tense

In addition, you must have a handle on risk diversification, available asset choices (stocks, bonds, and so on), data on their performance, and the cost of owning them -- so you allocate your money in investments that grow into the appropriately sized nest egg without crazy amounts of risk. You also need to know how to rebalance each year to stick with that allocation.

Next, it's handy to know what percentage of your savings to draw down each year so you won't run out of money before you die. It's important to understand how taxes affect your investments, and make educated guesses about your future tax bracket so you choose the right investment vehicle (for example, a Roth IRA is a good choice if you expect to be in a higher tax bracket).

Finally, you have to look into your crystal ball and predict how the shenanigans of the U.S. government today will impact the economy (and you) when you're ready to retire -- little things like, say, a national debt of $9 trillion, future tax rates, or the fact that Social Security, on its current trajectory, will be bankrupt the year I turn 65.

Missed Connections

Lusardi and other economists have been examining the links between financial literacy and wealth for the last decade. In a separate literacy survey containing slightly more sophisticated questions than the ones above, Lusardi and Wharton professor Olivia Mitchell found that less than half of those surveyed answered all the questions correctly. (You can take the test here.) And in a survey released last month, Dartmouth and Harvard researchers created a hypothetical example of credit card debt. Only 36 percent could calculate how many years it would take for the debt to double.

"This is critically important, because if you don't fully grasp interest compounding, how do you appreciate the importance of starting to save early?" asks Lusardi. "People who heavily underestimate the power of interest rate compounding were the people who had too much debt." Those who did understand compounding were more likely to be saving for retirement.

Research also shows that financially unsophisticated households are less likely to invest in stocks; less likely to refinance their mortgages in a beneficial environment; and select less advantageous mortgages. Moreover, people who can't correctly calculate interest rates borrow more and accumulate less wealth.

A Financial Literacy Cheat-Sheet

The good news is that people who took the time to think about retirement and tried to plan for it ended up with more wealth than those who didn't, Lusardi found. So no matter what your level of financial literacy, here are a few suggestions that will help keep your options open in retirement:

• Keep track of your spending for a month or two. Then aim to keep fixed expenses at 50 to 60 percent of your budget, and savings at least 10 to 20 percent. The other 30 to 40 percent is lifestyle, which can be switched to savings, or fixed expenses if your income declines. Always save for retirement before you save for college.

• Sign up for your 401(k) plan at work and set aside at least enough to get any match given by your employer. If you have no employer retirement plan, set up an automatic deposit to an individual retirement account. (See my blog for a guide to IRAs, and take action before April 15.)

• Put a number on your ultimate goal. I like this elegant formula proposed by Colorado financial planner Charles Farrell: By age 65, he suggests you have 12 times your then-current pay stashed away. (So if you earn $100,000 in your last year of work, you want to save $1.2 million.) You would then withdraw 5 percent a year from your nest egg.

To get there, put away least 10 percent of your annual pre-tax income if you start saving in your 20s or 30s; at least 15 percent if you start in your 40s; and at least 20 percent of your pre-tax income if you start in your 50s. If the recommended percentage is beyond your budget, start saving 1 percent today, and add a percent each year -- 2 percent in year two, 3 percent in year three, and so on, until you reach your goal.

• If you don't know anything about investing, put the money in a "life cycle," "target date," or "age based" mutual fund. You choose the fund based on the year you plan to retire, and the fund gradually shifts the investment strategy from aggressive to more conservative as you near retirement. Some examples include T. Rowe Price Retirement Funds, Vanguard Group's LifeStrategy funds, or the Freedom funds from Fidelity Investments.

• Plan to have your mortgage and other major debts paid off when you retire. This will give you more flexibility to weather different economic cycles.

Hit the Books

Finally, if you want to end up rich, commit to getting financially literate. "If you ask people about Shakespeare or the capital of India, a lot of them may not know, but it doesn't matter," says Lusardi.

"Financial literacy matters because it influences decision-making, and there is a very strong link between financial literacy and your debt behavior, wealth accumulation behavior, and retirement planning."