Okay, folks -- it's time for a Personal Finance 101 quiz. Please answer the following three 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, less or the same)?
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, how much would you be able to buy with the money in this account (more, or less)?
3. Is this statement true or false: "Buying a single company's stock usually provides a safer return than a stock mutual fund."
Most of you probably think you can provide the correct answers -- 70 percent of Americans think they have above the median level of financial knowledge, according to a recent national survey on financial literacy.
But if that's true, why is it that just 65 percent of the survey respondents were able to give a correct answer to the first interest rate question -- which doesn't even ask for an actual calculation of return? (You would have more money, of course -- $110.51, assuming compound interest paid monthly and a constant interest rate.)
Just 64 percent had the right answer on inflation (you'd be able to buy less); 20 percent got it wrong; and 14 percent couldn't provide any answer.
Only 50 percent got the answer right on diversification (the mutual fund is safer), while one-third couldn't answer at all.
The questions and responses are among the highlights of new research by two of the nation's top experts on financial literacy: Olivia Mitchell, a professor at the Wharton School of the University of Pennsylvania and Annamaria Lusardi of Dartmouth College.
Their research began in the wake of the 2008 financial crisis. "We started thinking about how people make financial decisions, especially young people in college," says Mitchell. "We realized that we're putting young people out into the wide world without enough understanding of what compound interest means and not paying your bill every month. The subprime mortgage problem wasn't much different -- people didn't understand the consequences of taking out a mortgage where you never really paid down principal."
The researchers wanted to understand what is stopping Americans from saving enough for retirement. "Part of the explanation is that the lower-wage segment of workers simply doesn't make enough to set aside," Mitchell says. "But even in that group we found a great deal of variation in how much is being saved, so it's not only wages."
The initial research focused on people over age 50 but not yet retired. "The results were shocking," Mitchell says. "We have profound levels of financial illiteracy, which helps explain how we have people winding up with no saving for retirement and high levels of debt."
Experts often point to poor financial decision-making as a cause of the retirement security crisis. The problem has become more critical as we've moved away from professionally managed pensions and toward do-it-yourself defined contribution plans. Studies show workers do poorly managing their 401(k)s, including too-low contribution rates, infrequent rebalancing and maintaining too much exposure to equities in the last few years before retirement.
In addition, more than half of retirees file for Social Security benefits before their full retirement age, suffering penalties for early filing that reduce annual benefits by about 8 percent. President Barack Obama's deficit commission pointed to that issue when it recommended that the Social Security Administration be directed "to provide better information to the public on the full implications of various retirement decisions, with an eye toward encouraging delayed retirement and enhanced levels of retirement savings."
But proposals like that only can work if consumers have basic levels of financial literacy. Mitchell advocates adding much more financial education at the high school level. Just as important, she adds, is to get parents to do a better job talking with their kids about money. "Parents need to talk with kids to talk about deferred gratification -- the idea that you don't have to have everything today. If they want a new bike or video game, talk with them about how to save for that."
What about grown-ups? "Do a budget, and keep track of what you spend," she says. "It isn't fun, but it's important. Will you have enough to retire? Do you need to work longer? What will be the impact of taking Social Security or a pension later?"
Has there been any progress in closing the knowledge gap? Not surprisingly, Mitchell says, men and women with higher levels of education know more about personal finance than those with less education. The research also shows gaps between whites and minority groups, with blacks and hispanics less likely to know than whites. And while men are more knowledgeable than women, men think they know more than they really do.
"Women are more likely to say they don't know, but men who are incorrect still think they do know," she says. "They are confidently incorrect."
(Editing by Beth Pinsker Gladstone and Andrea Evans)