(This article appeared previously on MarketWatch.com.)
When it comes to investing for retirement in your 401(k) and the like, there are just five basic financial planning concepts you need to know. It’s that simple.
That’s it. Get a handle on compound interest, inflation, risk diversification, tax treatment of retirement savings vehicles, and employer matches of defined-contribution plans and you’ll be well on your way to better retirement planning and a larger nest egg.
To be fair, plenty of research has linked financial knowledge to better financial results. But few have figured out how to teach the concepts of compound interest, inflation, risk diversification and the like through better design and appropriate delivery methods. In essence, few have figured out how to make financial education work.
(MORE: Invest Like a Rich Person)
Five Steps to Financial Literacy
Enter Annamarie Lusardi, a professor at George Washington University, and fellow researchers, who created a financial education program called Five Steps.
Five Steps “was explicitly developed using psychological principles to increase appeal and motivate behavioral change,” according to a working paper just published on the National Bureau of Economic Research website. In other words, Five Steps was created to get people to plan for retirement, to save more, to invest wisely, and to build large nest eggs.
“When we envisioned this project some time ago, we were fully aware that most people lack the knowledge of the fundamental concepts at the basis of financial decision-making, such as interest compounding, inflation, and risk diversification,” said Lusardi, citing work she and Olivia Mitchell, a professor at The Wharton School at the University of Pennsylvania had done on the subject.
According to basic models of saving, Lusardi said people need to know these concepts to transfer resources over time and also to protect themselves from risk. Unfortunately many do not. In fact, Lusardi and Mitchell discovered in their most recent paper, Financial Literacy and Retirement Planning in the United States, that only 30% of the U.S. population can answer correctly three simple questions measuring these concepts.
Take the Test
Want to see how financially literate you are? Take a look at the basic quiz here. (There are 17 questions followed by an answer key.)
Most important, Lusardi noted in research conducted in 12 countries including the U.S., that knowing these concepts are important predictors of retirement planning and retirement savings, even after accounting for a lot of demographic characteristics, including income and education.
What’s more, Lusardi and Mitchell discovered that “those who know about risk diversification are 7.8 percentage points more likely to plan for retirement and in other work, they have shown that retirement planning is a strong predictor of retirement savings.”
Knowledge is Wealth
In the Five Steps research, survey participants learned about the five core concepts that underlie successful retirement planning in a mix of short videos and short stories. And without getting too deep into the footnotes and references, Lusardi and her colleagues were able to show beneficial effects in the short- and medium-run.
Knowledge, it would appear, is not just power, it’s wealth too. Those who know more, save more.
“One innovation of our work is to teach about these concepts in a simple way,” said Lusardi. “And interestingly, while we targeted the young, we find an effect among older adults as well.”
So given that, let’s take a closer look why those five concepts are so important. We’ve also included links to the videos used to help teach people about those concepts that are the basis for sound retirement planning. With hope, you’ll become all the richer and wiser after watching them. (FYI: The narratives can be found in the paper, Five Steps to Planning Success. Experimental Evidence from U.S. Households.)
1. Compound Interest
“Understanding the difference between simple and compound interest, and how quickly interest accumulates can help individuals both appreciate the importance of starting to save early and the dangers of borrowing at very high interest rates,” wrote Lusardi and her co-authors. “However, people seem to know little about interest compounding. Moreover, in what has been termed future value bias, people tend to underestimate how quickly compound interest grows.”
This, wrote the authors, is a case of the more general exponential growth bias, in which people underestimate the growth of functions with exponential terms. And this bias, they noted, is strongly correlated with savings, portfolio choices, net worth, and other measures of personal finances.
“Individuals need to understand the potential reduction in purchasing power over time due to inflation in order to assess saving and borrowing decisions in real rather than nominal terms,” the authors wrote, “This is particularly important given the long horizons typical in planning for retirement. There seems to be little knowledge of the workings of inflation.”
Behavioral research, the authors noted, also documents money illusion: people tend to think in terms of nominal rather than real monetary values, insufficiently taking into account the impact of inflation.
3. Risk Diversification
“Individuals should not put all of their eggs in one basket, but rather choose well- diversified portfolios and avoid investing in only one asset, particularly if that asset is their employer’s company stock,” the authors wrote. “There is very little knowledge about risk diversification.”
The understanding of risk diversification, the authors noted, seems also influenced by affect and heuristics. “For example, people often rate company stock, the stock of their employer, as a safer investment than a diversified fund,” the authors, citing the research of others, wrote. “Even when spreading assets among several investments, 401(k) investors often choose naive diversification, with equity exposure tracking the relative number of equity funds in the menu of available funds.”
4. Tax Treatment of Retirement Savings
“Retirement assets invested in tax-advantaged vehicles such as 401(k)s and IRAs benefit from tax exemptions on contributions, capital gains, or withdrawals, allowing for more rapid potential growth,” the authors wrote. “In fact, people possess limited attention and often do not deliberatively consider and appropriately weight all features of complex decisions. The impact of taxes on decision making therefore does not depend solely on their economic consequences, but also on the salience of these taxes.”
5. Employer Matches of Defined-Contribution Plans
“Many employers match (in different proportion, often one-to-one) the contributions employees make to retirement accounts, resulting in a much higher return on retirement savings,” the authors wrote. “Failure to contribute up to the employer’s matching threshold is often the equivalent of leaving money on the table. However, a large portion of individuals do not take advantage of their employer’s full 401(k) matching contributions; evidence suggests this cannot be fully attributed to rational strategies.”
In fact, the authors noted that it’s difficult to explain why 401(k) plan participants don’t contribute up to the employer’s matching threshold.
This article is reprinted with permission from MarketWatch.com. © 2013 Dow, Jones & Co., Inc. All Rights Reserved.