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Laura Rowley Money & Happiness

Laura Rowley, Money & Happiness

What You Don’t Know Can Hurt You Financially

by Laura Rowley

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Posted on Wednesday, March 5, 2008, 12:00AM

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."

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59 Comments

Showing comments 6-35 of 59<< PreviousNext >>
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  • ryan j - Sunday, March 9, 2008, 6:56PM ET  Report Abuse

    • Overall: 1/5

    Saving cash is aways good, but not in a bank. You are loosing cash with the dollar dropping.The fedis stealing money from you everytime they lower the rate

  • Howard - Sunday, March 9, 2008, 3:57PM ET  Report Abuse

    • Overall: 3/5

    At what point are financial experts going to stop using annual income percentages for retirement savings and planned nest eggs etc.. Today's world represents a radical shift in the way people are employed. Executives one year are pulling down $200K for a few yr's, and then find themselves out work for 1,2 years or simply holding down the fort with consulting gigs with $100k annual income. These old school formula's worked back in the 50's, maybe 70's when your dad worked for IBM for 30 years and pulled down the same, roughly, salary for a lifetime....

  • willsin713 - Saturday, March 8, 2008, 12:01PM ET  Report Abuse

    • Overall: 1/5

    "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." Actually, you are very much wrong. We are experiencing almost the exact same inflation rate the your parents experienced in 1980. Right now, we are experiencing about 12.8% inflation as it was defined in 1980. The fact is that the Fed has changed the definition 2 or 3 times since then to minimize the perception of inflation while the US dollar has devalued significantly.

  • Yahoo! Finance User - Saturday, March 8, 2008, 9:10AM ET  Report Abuse

    • Overall: 4/5

    saving is an attitude forming same with borrowing, its a matter of choice.

  • Loyd - Friday, March 7, 2008, 8:59PM ET  Report Abuse

    • Overall: 1/5

    ASTOUNDING !!!!

  • JimO - Friday, March 7, 2008, 1:46PM ET  Report Abuse

    • Overall: 4/5

    The dysfunctional primary and secondary education establishment is the primary cause of financial illiteracy. But the answer is always through more moeny at the schools even though they get failing grades.

  • Qniform - Friday, March 7, 2008, 12:25PM ET  Report Abuse

    • Overall: 4/5

    A fair assessment of the state of the population at any given time. Most will never take the advice to improve their understanding of finance. The troubling trend is that our society will demand and/or allow government bail out rather than personal responsibility, leading to worse problems than we can imagine now.

  • Yahoo! Finance User - Friday, March 7, 2008, 12:16PM ET  Report Abuse

    • Overall: 1/5

    "If you ask people about Shakespeare or the capital of India, a lot of them may not know, but it doesn't matter," --- Lusardi is a fool...If you don't know the capital of one of fastest emerging economies, you are indeed illiterate...

  • Yahoo! Finance User - Friday, March 7, 2008, 11:55AM ET  Report Abuse

    • Overall: 3/5

    I agree with the person who wrote about we folks who live in the ordinary world. We have little left to save and our federal government rewards those who do not live on their income. Just watch for the subprime bailout while I lived in a house that I could afford!

  • gudg - Friday, March 7, 2008, 10:16AM ET  Report Abuse

    • Overall: 3/5

    What most would want to know is how to protect savings against current mad inflation. a real and practical solution, not just recommendation for gold, silver (speculation) or inflation-protected bonds (low yielding). Jump to foreign currency is the best one I can think of.

  • Yahoo! Finance User - Friday, March 7, 2008, 9:53AM ET  Report Abuse

    • Overall: 3/5

    The one thing that I learned most from this article is that mitchjim is an absolute moron..LOL..

  • Suteebu - Friday, March 7, 2008, 9:47AM ET  Report Abuse

    • Overall: 4/5

    This article is good. Informative. I often think that the reason why people can't save is government spending. It is hard to save when 30-40% of your income is taxes. Just my thoughts

  • Yahoo! Finance User - Friday, March 7, 2008, 6:49AM ET  Report Abuse

    • Overall: 4/5

    Pablo, Pablo, Pablo... This and the other financial articles are written to educate people who want to make something of themsleves -- not 40 years old losers working a minimum wage job. Where have you been all your life? Here's the key. If a job doesn't pay enough for you to live, pass it by and make yourself fit for a job that does. When enough people pass that job up, then the owner will be forced to pay more for the worker. As long as someone can & will do it for cheap, cheap is what you'll get.

  • Pablo Mannino - Friday, March 7, 2008, 1:53AM ET  Report Abuse

    • Overall: 1/5

    Laura is saying that most people are finacially illiterate because they cannot do simple financial math. Can you or any of your collegues write articles that can show the math for the average individual? For example, with min wage in NY at $7.15, a full time employee earns less than a $1,000 a month. rent is at least $700 Food $ 200 Transportation and every other expense $100. Is there any room for 401K, savings, etc. I want to see this type of math from the Pros like you

  • Yahoo! Finance User - Friday, March 7, 2008, 1:36AM ET  Report Abuse

    • Overall: 5/5

    You are back on a good roll of good essays Laura -- keep it up!! This essay helps me understand a little better the weaknesses of individuals in their financial life, and thus some ways they can overcome those weaknesses.

  • __A_YAHOO_USER__ - Thursday, March 6, 2008, 9:44PM ET  Report Abuse

    • Overall: 1/5

    michjim10 you can tell all that from a few words? At least Bob based it on her articles. It sounds like you are the real idiot here. Must be embarassing....to be exposed as a moron in front of everyone....

  • JamesP - Thursday, March 6, 2008, 9:18PM ET  Report Abuse

    • Overall: 5/5

    And I can tell you're a real prize Bob.

  • DavidO - Thursday, March 6, 2008, 9:16PM ET  Report Abuse

    • Overall: 3/5

    Her parents double digit in the 80's how young is this wizened sage? Laura you can lead a horse to water but... you know the rest. Most Americans can't balance their check book. When they buy something the question is not how much but what is the payment. As far as savings either you get it or you don't. Boomers and up don't

  • __A_YAHOO_USER__ - Thursday, March 6, 2008, 8:44PM ET  Report Abuse

    • Overall: 1/5

    I bet it's an absolute living hell to be married to this woman

  • Yahoo! Finance User - Thursday, March 6, 2008, 8:35PM ET  Report Abuse

    • Overall: 3/5

    the future is always uncertain-and that includes the area of finance.after rampant inflation of 1970's,many were afraid to invest.then what happened?the longest bull market in it's history.almost anyone can become financially independent by following just a few relatively simple actions-save all that you can,live within your means,and stay out of debt as much as possible.we don't know what the future holds,but neither did anyone 50 years ago.

  • Yahoo! Finance User - Thursday, March 6, 2008, 8:09PM ET  Report Abuse

    • Overall: 4/5

    Most members of the public are woefully unread in matters of finance, especially in those areas that have a quantitative component. The practical hints ("thou shouldst do this...") are valuable. A worthy compensation on Yahoo! for drivel from the likes of the unlamented P. Trunk, and R. Kiyosaki.

  • Yahoo! Finance User - Thursday, March 6, 2008, 8:09PM ET  Report Abuse

    • Overall: 5/5

    This information isn't new to me, but I'm pretty active in managing my money, and already do most of what's recommended. But I look at friends and family and - I don't even know if they're reading these sorts of articles - this is information they NEED to have. Laura, I'd love to see more focus on what self-made millionaires are doing. I don't know many self-made millionaires, but, boy, do I feel like I'm living in left field, saving, watching consumption, and focusing on building and keeping my nest egg (~1.2 million right now). My young relatives think that millionaires live in million-dollar homes and drive Ferraris (no, honey, that's billionaires with a B). I couldn't BE a millionaire if I lived like that - we have a middle-class home, and rarely buy new cars (Prius last year, a truck 10 years ago). We eat out a few times a year, but eat like royalty at home. We travel inexpensively with our dogs, and we pay cash when we splurge. We have a budget and stick to it. We could spend down our net worth in 10 years quite easily without even living extravagantly - but we could live off our nest egg for the rest of our lives if we make frugal choices. A few more years of saving and investing, and we expect to be truly financially independent - and, yes, that includes buying into a falling market, dollar-cost-averaging our way into a low-cost, high-return portfolio. Family members expect lavish gifts and use us as their emergency savings, but they define "rich" as someone with a crummy job, a big house, a flashy car, and a credit card that isn't maxed out (yet). If they understood that self-made rich comes from modest consumption patterns, they'd have a better chance of actually becoming self-made rich. How do we develop financial literacy among the illiterate, and ensure financial literacy for future generations? And to Erik, I'd like to say: Save what you can. If all you can save is $10 a paycheck, then it will make a world of difference to you when you reach $60 in savings; if all you can afford to save is $50 a month, the $600 you save in a year will be a small fortune. Just get started saving. Open a savings account and start feeding it - it will grow and you will be better off.

  • michaelE - Thursday, March 6, 2008, 6:00PM ET  Report Abuse

    • Overall: 3/5

    Saving's is for sucker?? Those that say inflation will eat your check are correct in terms of oil and food. Housing and stocks are crashing and if interest rates rise due to oil and food inflation they will fall even more. If there is rampant inflation and oil doubles, there will be a lot of used cars for sale especially SUV's and they won't cost much. Small cars and hybrids will get more expensive. Due to the collapse of construction you can certainly find good deals on used construction equipment. With the death of the US consumer other economies around the world will collapse and all that demand for oil and food will collapse with it. Then the future really gets muddy. Previous poster suggested Dems were to blame, really take a look at what our national debt did on the current republican president and the republican congress 2000-2005. Take a look at how lac of regulation championed by republicans has contributed to the current subprime meltdown. Bushco fought individual states that tried to roll back preditory lending, they initially cut funding for the SEC, and have gutted regulation in general.

  • Yahoo! Finance User - Thursday, March 6, 2008, 5:38PM ET  Report Abuse

    • Overall: 5/5

    www.mintedsilver.com

  • madmad08 - Thursday, March 6, 2008, 4:52PM ET  Report Abuse

    • Overall: 1/5

    lame questions!!

  • Mark - Thursday, March 6, 2008, 4:17PM ET  Report Abuse

    • Overall: 2/5

    I agree with the part about every one has to be their own financial analyst. You never know who to trust and when the market tanks in years like 2000 and you had just jumped in at the top per "professional advise" - you loose and it takes a long time to recover. Prior to 2000 a lot of analysts used to say assume a 12% annual return - now they say 6%-8%. Many pundits looked like idiots but didn't have to worry about the repercussions.

  • Andy - Thursday, March 6, 2008, 3:53PM ET  Report Abuse

    • Overall: 2/5

    Most of this is general conventional wisdom, most people visiting this site already have basic knowlegdge of investing, etc. Much more critical article article will be how to invest considering this bear market will last another 2-4 years and a lot of people will be seeing their 401K, IRA, etc shrink significantly. Propose better funds, etc to invest money in to reduce this exposure.

  • Erik M - Thursday, March 6, 2008, 3:36PM ET  Report Abuse

    • Overall: 2/5

    I think an eighth grader could have written this stuff. It's not only funny, but it's also way too general overall. Everyone knows that they should save and invest. The problem lies in how can someone when the paycheck is being stretched too thin? There is no money left over to do any of the things stated above. It works in theory, but in reality, you live in a house that you paid too much for, your raises are not keeping up with inflation and the stock market is going down, so there is little incentive to invest in anything right now. Lol, put 15% in the 401k? Yeah, ok, and $4 gas, $4 milk? What will we have left to spend? Not much!! Plus, why put that much in the 401k just to see it shrink when the market tanks (which is happening a lot lately, but you never hear any articles about that). I guess it's an easy life when you get paid for what you 'know' and tell others what to do. Twin deficits will bury this nation. Social Security will be broke by 2016. Life is getting tougher, not better, in America.

  • TT - Thursday, March 6, 2008, 2:31PM ET  Report Abuse

    • Overall: 4/5

    Hi Laura, very good article. A big improvement over your typical "he said, she said" articles where you just quote a bunch of "experts" who may or may not know what they're talking about. This article offers concrete advice for creating a financial plan and following through. Most people would benefit from implemented what you suggest.

  • Yahoo! Finance User - Thursday, March 6, 2008, 2:26PM ET  Report Abuse

    • Overall: 5/5

    I give Laura best regards in writing an-other excellent article. I still remember the previous article which she had commented especially on the sucker comment which one reader have written about and also replied back to Laura. I am glad Laura and the readers are in unison (united) . God bless Laura. Peace to the world. May your day be a happy day. That show if you read the comments of the readers, you will see and notice, I too have written on Yahoo Finance in the reply to the experts under Yahoo Finance User.

Showing comments 6-35 of 59<< PreviousNext >>
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