A National Bureau of Economic Research working paper has found that investors who are the most “financially knowledgeable” earn 130 basis points more in risk-adjusted annual returns in their DC retirement plans than “their less sophisticated” peers. In a key takeaway for advisors, the authors find that professional advice can't replace financial literacy, only complement it.
The study’s authors — Robert Clark of North Carolina State, Annamaria Lusardi of George Washington University and Olivia Mitchell of the Wharton School at the University of Pennsylvania — argue in NBER Working Paper No. 20137 that those retirement plan participants who scored highest on a test of their financial knowledge might have “more volatile” portfolios, but their portfolios are not more diversified than their less knowledgeable peers.
Their conclusion? “Overall, financial knowledge does appear to help people invest more profitably; this may provide a rationale for efforts to enhance financial knowledge in the population at large.”
The researchers begin their paper (the NBER provides its research free of charge to journalists, government employees and others, but offers free subscriptions to its Bulletin on Aging and Health for the public) by citing other research that showed some correlation between investor knowledge and better returns.
"Numerous studies show that more financially knowledgeable people accumulate more retirement wealth," they point out, including that they are more likely to plan and save and that they are "more aware of, and manage better, the fees and charges associated with financial products." However, "little is known about whether more financially knowledgeable people also earn higher returns" on their retirement savings.
The NBER paper, however, looked at the actual performance of DC plan participants from an unnamed “large financial institution” with 22,000 employees across the U.S. to explore whether financial knowledge and performance in DC plans was correlated. Maintaining individual plan participants’ confidentiality, the HR department at that financial institution shared the investment choices of each participant from the plan’s wide menu of mutual funds, and the researchers looked at 10 years of performance data from those choices. Those participants were then invited to take a five-question online quiz measuring their financial knowledge; 16% of the total participants took the quiz, which asked them questions of varying difficulty on interest rates and saving, on investment risk, on taxes and investing and on employers’ DC plan matches.
For example, the tax question was this:
Tax Offset: Assume you were in the 25 percent 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: Decline by $100, Decline by $75, Decline by $50, Remain the same, Don’t Know
The questions have been used in many similar surveys, and the researchers pointed out that “very few Americans can answer all of the first three questions correctly …and not many more know the correct answers to a majority of them.” However, the respondents overall correctly answered more of the questions than would the general population, not surprising since these were financial services company employees who were “substantially more financially knowledgeable … than the general population.” The results allowed the researchers to build a “Financial Knowledge Index” for the respondents measuring their knowledge.
With the caveat that this is a working paper by academics, not yet peer reviewed, and thus not easily condensed, here are the major findings:
1) “More financially knowledgeable people hold more equity in their portfolios, and hence they can expect higher risk-adjusted returns… the most knowledgeable hold 11.5% more stock than their least knowledgeable counterparts and they can anticipate earning around 1% or 100 basis points more. In other words, the most financially sophisticated earn higher risk-adjusted excess returns. Since we control on respondents’ 401(k) balances, it is remarkable that there remains a positive and statistically significant association between excess returns and the financial index after netting out past investment success."
2) “…the portfolios of the more financially knowledgeable are more volatile, particularly for the most knowledgeable … Thus the portfolio of the highest scoring group has a 1.8 percentage-point higher standard deviation in risk-adjusted returns."
3) These most knowledgeable participants “can also anticipate significantly higher expected excess returns, which over a 30-year working career could build a retirement fund 25% larger than that of their less-knowledgeable peers."
4) Finally, the researchers write that “Our estimates of the positive association between financial knowledge and investment returns may be understated. As noted above, survey respondents at this institution were likely to be better informed than non-respondents, implying that a stronger and more positive relationship between knowledge and returns is likely to hold in the work force as a whole. Additionally, this institution provided relatively few pension investment choices, many of which were index funds.Where more complex investment menus are available, it can be surmised that the measured effect of financial knowledge would be even larger.”
While the researchers point out that “it would be premature to offer policy recommendations” and that further research into the topic is warranted, they conclude that “Nevertheless the significantly higher risk-adjusted annual expected returns of 130 basis points for the best versus the least knowledgeable confirm that financial literacy can contribute to better earnings in 401(k) retirement plans.”
Check out Top 10 Dumbest States for Financial Literacy: 2014 on ThinkAdvisor.