Want 3x as Much Money in Retirement? Here’s the Key
I live with an interesting cognitive dissonance as a personal finance content creator: On one hand, I’ve always believed knowledge is power. I don’t buy that people are “bad with money” and actively choose to behave in a way that’s disadvantageous to them, and generally speaking, I believe when people know better, they do better. Clearly, on some level I believe more education makes a difference—otherwise, why would I write this blog or produce The Money with Katie Show?
“Financial literacy has a direct impact on financial outcomes.”
On the other hand, I can read graphs like these, documenting the rampant wealth inequality in our country that’s been steadily worsening since 1975. Today, the top 10% of earners take home 50% of the total income, leaving the remaining 90% to share the other 50%. It feels like an uphill battle.
Surely information alone is not enough to close this gap, right? I’d think to myself in varying degrees of despair: Does what I do even matter?
Maybe that’s why—when I stumbled upon the two academic papers we’ll be exploring today—my self-preserving confirmation bias sprang into action: Yes, it must matter!
To be sure, it’s certainly not enough to close the gap or solve the problem on its own. But we do have empirical data (from the National Bureau of Economic Research and the University of Pennsylvania) that prove financial literacy has a direct impact on financial outcomes.
Optimism!
My own experience with financial literacy
This is where I’ll regale you with my metaphoric before-and-after pictures, à la Jenny Craig infomercial.
But honestly, it’s not that deep. Financial literacy just played a pretty substantial role in my money (and life) glow-up. (Because it turns out having more money does, in fact, improve your life. “Money can’t buy happiness” merely means there are diminishing returns on happiness from accumulating excess wealth, not that having more money doesn’t make your life objectively easier.)
For the first year I worked, I had no plan. I didn’t understand investing. I saved haphazardly. I couldn’t have explained the logic behind a Roth IRA even if you had threatened to submerge me in hot queso (which I happened to eat a lot at the time, since I was going out to lunch every day).
After working for a year and earning a salary around $52,000, I had about $12,000 in savings—meaning I spent the other $33,240 of after-tax income on…well, I’m not sure, since my rent was only $800/month and I didn’t have a car payment.
“Without a doubt, learning the basics had a profound impact on my financial picture. My income hadn’t changed, but my approach did.”
But once I started learning about how to manage money (how to save it, how to invest it, how to track where it was going), I quickly amassed a net worth of around $100,000 in a little over two years. Without a doubt, learning the basics had a profound impact on my financial picture.
My income hadn’t changed, but my approach did—and as a result, I was able to plug all the holes in my monthly balance sheet and institute a more formulaic strategy that included:
Increasing my 401(k) contribution to 15%
Contributing $500/month to a Roth IRA
Contributing $200/month to a taxable brokerage account
Focusing more intently on increasing my income, though that took a few more years
I had a surprising realization after several months: “Wait, this isn’t that hard.”
Sure, it was challenging to cut back. It wasn’t always easy to prioritize and allocate my scarce resource to investing when what I really wanted to do was tie one on at the bar down the street and ride the mechanical bull 14 times in a row at five bucks a pop.
But it wasn’t (and isn’t) rocket science. It surprised me how quickly I grasped the basics (and how few “basics” there really were), and I was thrilled watching my net worth creep upward every month. It became addictive!
Yet this optimism is balanced with a healthy dose of reality: Some people really don’t have the extra income to invest (see also: the chart linked above that demonstrates the bottom 50% of our country has an average income of $20,000/year).
When you’re earning an average or above-average income (north of $50,000), you’re at an advantage—though with the unaffordability crisis in this country (the average rent is now $1,700 for a one-bedroom, which would’ve been more than half of my monthly income at the time I’m describing and a big reason why I’ve always had a roommate), it’s not hard to see why people often feel strapped.
So how much does financial literacy really matter?
Well, it turns out…quite a bit.
(Existential crisis avoided! Phew.)
Annamaria Lusardi and Olivia S. Mitchell found in their paper, Financial Literacy and Planning: Implications for Retirement Wellbeing, that “while several prior studies offer suggestions about why people fail to plan for retirement, few examine the roles that planning and information costs might play in affecting retirement saving decisions.” (emphasis mine)
Translation from academia: This is the first study that attempted to answer whether or not “planning” and “knowing what you’re doing” has a material difference on someone’s financial outcomes. When you know better, do you do better?
While other papers “have offered evidence on related topics; for instance Calvert, Campbell, and Sodini (2007) show that more sophisticated households are more likely to buy equities and invest more efficiently, and Hilgerth, Hogarth, and Beverly (2003) and Lusardi and Mitchell (2009) demonstrate strong links between financial knowledge and financial behavior,” this study attempted to answer the question directly—and their results were encouraging for financial content creators everywhere! collective sigh of relief
“When you have basic financial literacy, you’re more likely to invest in income-producing assets that will—you guessed it—continue to produce income for you later in life.”
Note the language here around “sophisticated households,” i.e., those with financial education: They’re more likely to invest in stocks. Put simply, when you have basic financial literacy, you’re more likely to invest in income-producing assets that will—you guessed it—continue to produce income for you later in life.
In the sample group studied, fewer than one-third had even attempted to plan for retirement, despite being only a few years away from leaving the workforce (!!). Though the majority of respondents hadn’t attempted to make a plan, Lusardi and Mitchell found that roughly 75% tracked their spending. This surprised me.
My assumption? They’re tracking their spending to ensure they don’t run out of money before the end of the month or, in other words, navigating the short term. It’s a little bit like what Gaby Dunn shared in their interview on the show: Those who are the best at budgeting are usually those with low incomes, because they have to budget to make ends meet.
Paradoxically, the very rich rarely track their spending closely (because they…you know…don’t need to).
Here’s the golden takeaway, though: “Prior work has established that planning has important implications for wealth accumulation…to this end, we report the distribution of total net worth across different planning types…and emphasize that, at the median, planners accumulate three times the amount of wealth than non-planners.”
Translation? Those with a plan accumulated roughly 3x as much as those without one.
My earlier anecdotal, microcosmic example—one year working with no plan followed by two years working with a financial plan I devised myself—illustrates this point well.
“If financial illiteracy leads to poor or no planning, it may also affect wealth accumulation. Lusardi (2003) finds that those who plan accumulate more wealth before retirement and are more likely to invest in stocks. Moreover, planners are more likely to experience a satisfying retirement, perhaps because they have higher financial resources to rely on after they stop working.”
And what do you need to make a plan? Say it with me: financial knowledge
Their findings kept circling back to one key similarity between the planners. The planners invested.
It sounds simple, but it’s worth explicitly stating: It’s not enough just to save your money, you need your money to go make more money for you.
Why would a plan be correlated to stock investing? Well, I think it comes down to knowledge: “When asked how much risk respondents are willing to take, a large majority (more than 60 percent) state they are unwilling to take any financial risk. This may be due not only to strong risk aversion, but also to the fact that many respondents feel they simply do not understand risk diversification.”
If you had asked me five years ago how “risky” I was with my money, I would’ve told you not at all. I am completely risk-averse. As a result, I wasn’t interested in stocks. They felt like gambling, because I didn’t know any better! (Because remember: Nobody pops out the womb with a deep understanding of proper risk diversification and equity risk premiums.)
“Not investing in stocks is riskier than investing in stocks in the long term.”
But the more I learned, the more I understood: Not investing in stocks is riskier than investing in stocks in the long term.
As Nick Maggiulli writes in his piece “Risking, Fast and Slow”—between 1926 and 2021, the S&P 500 had a near 0% chance of being down 5% over any given 20-year period. Holding cash, on the other hand, meant you’d face a 31% chance of being down by 5% or more in real terms (that is, 31% of the time, your cash’s purchasing power would’ve been down 5% or more in real terms).
In the short-term, holding cash feels safe. In the long run, nothing could be riskier.
But in order to know that and internalize it, one must first be exposed to the information (then you’ve gotta act on it—which is a different beast—but it starts with knowledge).
Youth is wasted on the young—so are good returns
In a 2017 paper for the University of Pennsylvania, Lusardi, Mitchell, and Michaud found something else: “The trend toward more individual responsibility means that people’s financial decisions made early in life can have long-term consequences.”
Unlike a bad tattoo that can be removed or the juvenile arrest outside a Lady A concert (guilty) that can be expunged, bad financial behavior early in life is harder to undo. It compounds.
And it’s not so much what you do that you’ll be punished for, it’s what you don’t do: Because time is your most valuable asset, in more ways than one.
It is precisely because you can’t get the time back that the decisions are so important—when you invest as a young person, you’re locking in a long time horizon. Your money has decades upon decades to compound. You can take more risk.
Exponential growth requires time and—importantly—defies logic, which makes it hard for us mere mortals to intuitively grasp.
Consider those brain twisters that demonstrate compounding by doubling a grain of rice every day for a month: On Day 1, you start with 1 grain. Day 2? You’ve got 2. Day 3? You’ve got 4.
…and so on and so forth. By Day 30, you’ve got 536 million grains of rice.
By Day 31, you have more than a billion.
By Day 20, you only have 524,288. You'll more than 1,000x your rice grains in the last 10 days of compounding alone. While this is an extreme example, it illustrates nicely why even small returns on large amounts of money (e.g., a billionaire’s wealth) begins compounding out of control rather quickly.
“The time that passes in the first 10 days and the time that passes in the last 10 days are not created equal. This is why starting early matters—because time matters.”
The time that passes in the first 10 days and the time that passes in the last 10 days are not created equal.
This is why starting early matters—because time matters.
Of course, young people also usually happen to make less money than their older counterparts, which makes it tempting to throw reason and data to the wind and say, “Fuck it, I’d rather enjoy my life now and worry about this retirement racket later when I’ve got more money. I don’t have enough income now for it to matter anyway.”
Ironically, “Venti and Wise (2001) show that permanent income differences and chance alone can explain only 30–40 percent of observed differences in retirement wealth.”
In other words, differences in income between people and “chance” explain less than half of the difference between those studied.
Here’s a doozy of a dissertation-level sentence for you: “By introducing endogenous variation in the returns that people can obtain on their savings, particularly on information-intensive assets, we can attribute another 30–40 percent of wealth inequality to financial knowledge.”
I’m not even going to pretend to know what “endogenous variation” means, but what I do know is that the researchers’ conclusion after 49 pages of…that…is that 30–40% of wealth inequality can be chalked up to a lack of knowledge.
When you know better, you do better.
The time you spend learning more will 3x your returns later in life
In a funny way, this post is a little full-circle for me: When I first started writing about personal finance in 2018, I believed knowledge alone could solve everyone’s problems, and I saw firsthand how merely mastering the basics propelled me to a six-figure net worth relatively quickly.
But eventually I learned there are factors at play that make the equation far more complicated than I had initially expected, and a sense of cynicism and hopelessness set in. I began to doubt that knowledge was the answer.
Now, I’m finding myself somewhere in the middle: Is knowledge enough to solve everything? No, of course not—but if we’re to believe the researchers behind these papers, it’s enough to make sure you’ve got roughly 3x as much later. I’ll take those odds any day.
