By Martha M. Hamilton
Sunday, March 4, 2007
Let's say you have $200 in a savings account. The account earns 10 percent interest per year. How much would you have in the account at the end of two years?
If you get the answer wrong, you have plenty of company.
Annamaria Lusardi, professor of economics at Dartmouth, and Olivia S. Mitchell, executive director of the Pension Research Council at the Wharton School of the University of Pennsylvania, have spent time trying to measure financial literacy -- how many of us have it and what that portends for our retirement.
In a paper published last month, they took a look at how a group of 1,700 people in their early 50s scored on three questions contained in the University of Michigan's Health and Retirement survey in 2004.
The first questions were:
1. If the chance of getting a disease is 10 percent, how many people out of 1,000 would be expected to get the disease?
2. If five people all have the winning number in the lottery, and the prize is $2 million, how much will each of them get?
More than 80 percent correctly answered question No. 1. But only half had the correct answer to question No. 2. "And more distressingly, only 18 percent correctly computed the compound interest question," Lusardi and Mitchell wrote. That's the question we started with, which was posed to only participants who got one of the first two questions right.
The nature of things is that many of you who are reading this column already have an interest in financial issues and probably aced all three. But many more people who don't have a natural interest in financial issues are being required to make smart decisions about saving and investing for retirement -- or face the dismal consequences in old age.
That's the result of the ongoing shift away from traditional pensions -- the old-fashioned kind that sends you a monthly payment for life -- to defined-contribution plans such as 401(k)s. The burden is on the individual to get it right, and many of us don't have the training or even the basic financial literacy to be confident we can.
When a company sets up a traditional pension plan, it does so with some high-priced help.
The company hires legal help to make sure the plan complies with Internal Revenue Service and Labor Department rules. It will probably hire an actuary and benefits consultant to help design a plan that helps make it competitive in attracting workers. The actuary will analyze the workforce to help project how long workers will live, how many will retire early, and how many will take a lump sum instead of a monthly pension. The company also will have someone to manage the plan's investments and someone to administer the plan and communicate with employees, said Christine Mahoney, a principle in Mercer Human Resource Consulting.
Setting up a defined-contribution plans requires a company to hire help too, but some of the burden is shifted to employees. For instance, most participants pick their own investments from an array offered by the employer. Making sure there's enough at the end also becomes the task of the individual, not the actuary.
And it's tough. Predicting how many out of a large group of workers will live to 80 or older in order to have enough money to pay their claims is doable, but predicting how long an individual will live -- and how much he or she will need -- is more difficult.
Will I get hit by a bus tonight when I cross the street to the garage? Who knows? But if I don't and live to be 100, will my savings be enough?
That brings us back to financial literacy. Those who answered the financial questions correctly were more likely to have planned and saved for retirement, Lusardi and Mitchell said. Small wonder there. For many people, saving is hard because keeping up with day-to-day expenses is hard. The better you understand how saving early is likely to pay off, the more likely you'll make the extra effort to do so.
And Lusardi and Mitchell pointed to other surveys that reinforced that many of us have a long way to go. For instance, they noted that a survey by the state of Washington found that "most respondents did not know the inverse relationship between bond prices and interest rates." The study said: "They were also uninformed about mutual funds: Many did not know what a no-load mutual fund was, or that mutual funds do not pay a guaranteed rate of return. More than one-third did not know that stocks had returned more than bonds over the last forty years, and many did not know about risk diversification."
In introducing their paper, Lusardi and Mitchell described how "workers and retirees have increasingly been asked to take on an unprecedented degree of responsibility for their retirement and other saving, as defined-benefit pensions decline and government programs face insolvency in one country after another."
If that responsibility is not combined with economic know-how, the outcome could be ugly. That's one reason for the growing interest in automatically enrolling workers in retirement plans and in providing them with more help in their investment choices.
And it's why it is important to understand how compound interest works.
The answer to the question at the beginning of the column is $242. The first year, the account earns $20 in interest. The second year, the account earns $22 in interest, because now it holds $220. The other answers are 1) 100, and 2) $400,000.
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The Treasury Department is trying to do some financial education, including a campaign to persuade Social Security recipients to elect direct deposit of their benefits, through a program called Go Direct. Direct deposit is both more convenient and safer than dealing in paper checks, the Treasury says. Last year, 57,000 paper checks for a total of $54 million were fraudulently signed by someone other than the beneficiary, Treasury officials said.