Retirement planning and its role in wealth inequality

 
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In the old days, according to popular allegory, you worked for a company most of your life. At retirement, that firm rewarded you with a pension, a guaranteed income for your golden years. These days, retirement planning is a bit more complicated. Fewer employers offer defined-benefit pension plans. Instead they require employees to parse byzantine literature and make life-altering choices for themselves. And more options are available than ever before.

One frequent choice nowadays is whether to make a direct contribution into a retirement account (such as a 401(k)) from each paycheck, which is sometimes matched by the employer. This amounts to transferring a current resource (cash that could be enjoyed today) into a hazy and distant figure (numbers on a piece of paper, for now). Between 1980 and 2000, the share of retirement savings that Americans contributed to such self-directed funds more than doubled, according to research published in the Proceedings of the National Academy of Sciences.

All this demands some financial knowledge. Yet large shares of the population are not financially literate, researchers have shown. Knowledge is expensive and paying for it – just like investing in human capital – can be a gamble. In short, Americans are increasingly responsible for planning their own finances in retirement, but they are not necessarily better prepared.

A 2017 study in the Journal of Political Economy, “Optimal Financial Knowledge and Wealth Inequality,” addresses how financial illiteracy impacts the amount of money on which retirees live.

The researchers, led by Annamaria Lusardi of George Washington University, simulate how people acquire financial knowledge and how they make decisions affecting their future economic security. By looking at these factors rather than external stimuli – such as one’s salary – they estimate that 30 to 40 percent of wealth inequality among retirees is a result of differences in financial knowledge.

Lusardi and her colleagues also argue that not everyone benefits from investing time or money on, say, retirement-planning courses. In some cases, people expecting traditional pension benefits have little need to invest in educating themselves. At other times, the opportunity cost is too high; late in life, there is too little time remaining to benefit from the knowledge.

Because Social Security benefits help many Americans without financial knowledge, Lusardi and her colleagues expect that any curtailing of this public pension benefit would lead more people to invest in financial literacy. In fact, for the time being, Social Security may “discourage the accumulation of financial knowledge.” That is true also in other countries that offer safety nets for retirees.

Helpful resources:

People are living longer than ever before. We’ve covered how that’s affecting government budgets. We have also covered research on income inequality and college debt. The National Bureau for Economic Research (NBER) has published papers on financial literacy and decision making, the importance of financial literacy, and on tapping into one’s Social Security benefits before age 62.

Researchers have also discussed the push in high schools to improve financial literacy because of the ballooning cost of college.

Social Security benefit data is available from the Social Security Administration here.

 

    Writer: | Last updated: March 22, 2017

    Citation: Lusardi, Annamaria; Michaud, Pierre-Carl; Mitchell, Olivia S. “Optimal Financial Knowledge and Wealth Inequality," Journal of Political Economy, 2017. DOI: 10.1086/690950.
     

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