Robert Powell / USA Today
If ever you needed an incentive to learn more about money, this might be it. A new study shows that the more financially savvy you are, the more you'll earn on your 401(k) plan. And not just a little bit more, a whole lot more.
Using what they described as a "unique new data set" that links administrative data on investment performance and financial knowledge, researchers discovered that investors who are more financially knowledgeable earned – on a risk-adjusted basis – 1.3 percentage points more per year on their retirement plan investments than their less sophisticated counterparts.
In fact, being financially literate could help you build over the course of a 30-year working career a retirement fund some 25% larger than that of less-knowledgeable peers, according to the study, "Financial Knowledge and 401(k) Investment Performance," which was recently published as a working paper on the National Bureau of Economic Research website.
For example: If you're financially smart you might accumulate $625,000 in your 401(k) plan while those less smart about money might accumulate just $500,000, or $125,000 less.
One reason why the financially knowledgeable earn higher rates of return has to do with the makeup of their portfolios, according to the study's co-author Olivia Mitchell, a professor at the University of Pennsylvania's Wharton School and director of the Pension Research Council.
They own more stocks and can expect higher risk-adjusted returns, according to the study. In fact, the most financially knowledgeable in the study owned 11.5% more stock than their less smart peers, and that accounts for about 1 percentage point of their better returns. Money-smart 401(k) plan participants invested on average 61.4% of their retirement plan in stocks.
To be sure, all that might make sense to some investors: Stocks, though volatile, have returned on average a tad more than 9% since 1993, while low-risk money market funds, which aren't nearly as volatile as stocks, returned just 3% per year.
In other words, financial savvy 401(k) participants are merely taking advantage of the potential for greater returns that comes with investing a greater percentage of their retirement plan in risky assets.
The second finding from the study, however, suggests that being financially smart doesn't necessarily make you a prudent investor. According to Mitchell, the financially sophisticated select more volatile portfolios and their investments are more concentrated, as compared to their counterparts. Why is that? "Perhaps because they think they are better at predicting market outcomes," says Mitchell. "Interestingly, having 'some' knowledge is not strongly associated with most performance measures; rather it's the best-informed who are different."
Take the quiz (see below) from the study to measure your financial knowledge. Consider yourself financially knowledgeable if you answer four or five of the questions correctly.
To be fair, this isn't the first study to show that more money-smart people accumulate larger nest eggs. But it is the first to show that financially smart 401(k) plan participants earn higher risk-adjusted expected returns compared to their less sophisticated counterparts.
Another finding from the study has to do with financial education. We need more of it, and perhaps sooner rather than later in life. "It can still be socially optimal to raise financial knowledge for everyone early in life, for instance by mandating financial education in high school," says Mitchell. "This is because even if the least educated never invest again and let their knowledge endowment depreciate, they will still earn higher returns on their saving which generates a substantial welfare boost."
There's also evidence that workplace financial education can also help. For instance, Mitchell noted that people attending an employer-sponsored retirement saving seminar are more likely to contribute to their pension accounts. "There remains some concern about reverse causality – maybe those motivated to save went to the seminars," she says. "Yet randomized controlled trials do confirm that people receiving information about the additional benefits they could get from extra pension contributions did save more."
In the absence of financial education, Mitchells says investors would be wise to follow some age-old rules of thumb, such as don't buy a house unless you have 25% of the purchase price for a down payment. And your payments for the principal and interest on mortgage plus real estate taxes shouldn't exceed 25% of your income. "All these rules of thumb went by the wayside during the run-up to the financial crisis," she says. "I think we could do well to go back to some of those (rules of thumb) quite honestly."
Mitchell also says that new 401(k) plan features, often referred to as nudges, such as auto-enrollment and auto-escalation, have helped in the absence of financial education. But it's not enough in and of itself.
"We are not hitting the targets we need to hit," she says, noting that participants in the U.S. aren't contributing on average much more than 6% of their salary to their retirement plans. "I think we ought to be contributing 25% of income to retirement plans. If you think about how much longer people are going to be living in the future and couple that with relatively low expected rates of return on the market, we're just going to have to save a lot more and work a lot longer to be able to get there."
And so what needed is more nudging as well as more financial education, especially in schools. "Maybe we should be focusing more on financial literacy than calculus two," says Mitchell.
Financial Knowledge Quiz
How many of the below questions can you answer correctly? The more you get right, the more likely your 401(k) will outperform those who are less financially savvy. (Answers are below.)
1 - Interest Rate: Suppose you had $100 in a savings account and the interest rate was 2% per year. After five years, how much do you think you would have in the account if you left the money to grow?
a. More than $110
b. Exactly $110
c. Less than $110
2 - Inflation: Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After one year, how much would you be able to buy with the money in this account?
a. More than today
b. Exactly the same
c. Less than today
3 - Risk: Is this statement True or False? Buying a single company's stock usually provides a safer return than a stock mutual fund.
4 - Tax Offset: Assume you were in the 25% tax bracket (you pay $0.25 in tax for each dollar earned) and you contributed $100 pretax to an employer's 401(k) plan. Your take-home pay (what's in your paycheck after all taxes and other payments are taken out) will then:
a. Decline by $100
b. Decline by $75
c. Decline by $50
5 - Match: Assume that an employer matched employee contributions dollar for dollar. If the employee contributed $100 to the 401(k) plan, the account balance in the plan including that contribution would:
a. Increase by $50
b. Increase by $100
c. Increase by $200
d. Remain the same
Editor's note: The first question measures peoples' ability to do a simple interest rate calculation; the second tests peoples' understanding of inflation; and the third is a joint test of knowledge about "stocks" and "stock mutual funds" as well as risk diversification, since the correct response requires the respondent to know both what a stock is and that a mutual fund is comprised of many stocks. Source: Financial Knowledge and 401(k) Investment Performance
Answers: 1,a; 2, c; 3, b; 4, b; 5, c.