Want to know if you're getting the most out of your 401(k)? Time for a pop quiz:
How you fared may be a sign of how well you can expect your retirement investments will do. In a working paper released earlier this year by the NBER, North Carolina State's Robert Clark, George Washington University's Annamaria Lusardi, and the University of Pennsylvania's Olivia Mitchell found a correlation between people's scores on this test and how well their 401(k)s perform.
They examined data on employees of a large financial institution with more than 20,000 employees. The researchers sent them a survey asking five questions about finance and got nearly 2,800 responses:
Respondents' abilities to answer those five questions turned out to be significantly linked to how well their 401(k)s performed. The most knowledgeable participants also tended to have 401(k) returns that were 1.3 percentage points higher than their least knowledgeable peers, a statistically significant difference.
People who got 4 or 5 questions right — around two-thirds of respondents — had average returns of 9.5 percent. People who got 0 or 1 questions correct had returns of 8.2 percent.
While 1.3 percent might sound like a small margin, it's a huge difference when you calculate it out over a few decades. The authors figure that after 30 years of working, the most knowledgeable respondents will end up with retirement nest eggs that are 25 percent larger than the least knowledgeable respondents. That can be a huge difference, considering how much money most analysts recommend people save for retirement. These results suggest that if a lower-return person ends up with $600,000, a higher-return person will have $150,000 more by retirement.
One of the biggest things that put the more knowledgeable people ahead was stock ownership. The highest-return people were more likely to pick stock index funds, while lower scorers chose more conservative (and therefore lower-return) funds.
Of course, the share of people at the bottom of the spectrum was relatively small — just around 5 percent. However, the people who answered the survey tended to be older, save more, and earn higher returns than those who didn't participate. For this reason, the researchers think respondents are likely more sophisticated than the non-respondents, meaning the study still might underestimate the difference between the most- and least-sophisticated investors. In addition, the respondents work at a large financial institution, which may imply that they have more financial knowledge than your average person.
The basic gist is pretty unsurprising: better financial knowledge seems to make for better investments, the authors write. But the study highlights one of the biggest weaknesses of the American retirement system. As pensions disappear, people are encouraged to rely on tax-subsidized 401(k) accounts. They work great for the most knowledgeable investors, but for people who don't have some sort of financial know-how, they can encourage bad decision-making that rewards fund managers.
But there's also good news here: the concepts in that quiz are fairly simple. Understanding the basics about risk and rates of return would allow a person to ace the quiz — and, presumably, make smarter investment choices. Lusardi and Mitchell in a 2007 study found that teaching people economics in school and giving them work-based financial education can also meaningfully improve their financial literacy.
And there's room to do a better job of teaching these concepts. On the OECD's 2012 financial literacy test, American students were middle-of-the-pack when compared to other developed nations. Better education could easily make a nation of people who will be more secure in retirement.