MONEY Kids and Money

The Best and Worst Ways to Give Your Teen Credit

When your kid needs access to serious money, what kind of plastic is best for the job?

When your children’s concept of pocket change involves actual change, helping them keep track of their money is pretty easy. But when they start needing serious coin to gas up a sports utility vehicle, or travel abroad, you need more sophisticated financing alternatives like a credit card.

Keith Singer saw the light when his teenage son’s backpack was stolen at school, and he realized there had been $300 in his wallet. “He lost all his money,” says Singer, a wealth manager from Hollywood, Florida.

Here are some options, along with what you need to know before you give your teen access to credit:

Your Credit Card

Pros: Adding your child as an authorized user should take a simple phone call, and the child will have her own card to use. You can usually get a separate accounting of their charges.

Cons: The card will have your credit limits. Plus, no restrictions will be imposed on spending. Also, U.S. cards do not always work in foreign countries. They often have high transaction fees abroad, especially for cash advances.

Parents say: It’s hard to trust a teen with your own credit. Curtis Arnold, editor-in-chief of cardratings.com, added his two oldest children as authorized users on his accounts, but never gave them the cards. “We’ve never felt comfortable handing them a card other than for one-time use,” he says. His top fear: they would lose it.

Bank Account with ATM Card

Pros: It may take an in-person visit to a bank to open up an account for a minor, but then you can link it to a parent’s account to easily transfer funds. The ATM card makes it easy to get cash while traveling and can be used as a credit card. If you do not sign up for overdraft protection, transactions will be denied when funds are not available.

Cons: Beware that fees can rack up if the account does go negative or below a required minimum. Debit cards do not offer all the same consumer fraud protections as credit cards. They may incur overseas transaction or ATM service fees, and they require parental attention to keep adding funds.

Parents say: When one of Elizabeth Powell’s 16-year-old triplets went to England last summer, he opened up an account at his dad’s credit union. Then she transferred in several hundred dollars a month. The teen was able to use the debit card for his needs in British pounds, with minimal fees. “The system worked perfectly,” Powell says.

Keith Singer says one additional benefit for the bank account he opened for his son, who is now 17, is that it encouraged the teen to deposit his summer earnings.

Prepaid Debit Card

Pros: Getting one is easy, and most have slick mobile interfaces. As they are not linked to any bank account or credit line, there are fewer worries about overspending, loss or identity theft. Some cards, like Oink, allow parents to restrict spending in certain categories, like alcohol.

Cons: Some prepaid cards come with lots of hidden fees just to access your own money. They do not help build a credit history.

Parents say: Arnold likes the Bluebird card offered by Wal-Mart and American Express because, he says, “it’s like a credit card on training wheels.”

Most of all, he likes the relative safety of it. His oldest son had a credit card that was compromised while he was a senior in college. “With a prepaid, you don’t run that risk because they could wipe out the account, but not the whole checking account,” Arnold says.

Personal Credit Card

Pros: Building a credit score at 18 is smart. A typical newcomer does not start at zero, but rather at around 600, says Greg Lull, head of consumer insights at Credit Karma. That is in the middle range between the top of 850 and the bottom of 300.

Cons: If your young adult is not ready to handle the responsibility, his credit score will drop, and he will build up debt. Most young adults bottom out at age 21 before turning things around, says Lull.

Parents say: When our kids are ready, we’ll go for it. Arnold says of his third child, who is now 17: “Once he gets through freshman year of college, maybe we’ll do regular debit card, and then as an upper classmen, get a student credit card for him.”

MONEY investing strategy

Most Americans Fail This Simple 3-Question Financial Quiz. Can You Pass It?

piggy bank with question marks on it
Peter Dazeley—Getty Images

These questions stump most Americans with college degrees.

Following are three questions. If you’ve been around the financial block a few times, you’ll probably find all of them easy to answer. Most Americans didn’t get them right, though, reflecting poor financial literacy. That’s a shame — because, unsurprisingly, the more you know about financial matters and money management, the better you can do at saving and investing, and the more comfortable your retirement will probably be.

Here are the questions — see if you know the answers.

  1. 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 $102. (B) Exactly $102. (C) Less than $102.
  2. 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. Please tell me whether this statement is true or false: Buying a single company’s stock usually provides a safer return than a stock mutual fund.

Did you get them all right? In case you’re not sure, the answers are, respectively, A, C, and False.

Surprising numbers

The questions originated about a decade ago, with Wharton business school professor and executive director of the Pension Research Council Olivia Mitchell, and George Washington School of Business professor and academic director of the Global Financial Literacy Excellence Center Annamaria Lusardi. In a quest to learn more about wealth inequality, they’ve been asking Americans and others these questions for years, while studying how the results correlate with factors such as retirement savings. The questions are designed to shed light on whether various populations “have the fundamental knowledge of finance needed to function as effective economic decision makers.”

They first surveyed Americans aged 50 and older and found that only half of them answered the first two questions correctly. Only a third got all three right. As they asked the same questions of the broader American population and people outside the U.S., too, the results were generally similar: “[W]e found widespread financial illiteracy even in relatively rich countries with well-developed financial markets such as Germany, the Netherlands, Switzerland, Sweden, Japan, Italy, France, Australia and New Zealand. Performance was markedly worse in Russia and Romania.”

If you think that better-educated folks would do well on the quiz, you’d be wrong. They do better, but even among Americans with college degrees, the majority (55.7%) didn’t get all three questions right (versus 81% for those with high school degrees). What Mitchell and Lusardi found was that those most likely to do well on the quiz were those who are affluent. They attribute a full third of America’s wealth inequality to “the financial-knowledge gap separating the well-to-do and the less so.”

This is consistent with other research, such as that of University of Massachusetts graduate student Joosuk Sebastian Chae, whose research has found that those with higher-than-average wealth accumulation exhibit advanced financial literacy levels.

The importance of financial literacy

This is all important stuff, because those who don’t understand basic financial concepts, such as how money grows, how inflation affects us, and how diversification can reduce risk, are likely to make suboptimal financial decisions throughout their lives, ending up with poorer results as they approach and enter retirement. Consider the inflation issue, for example: If you don’t appreciate how inflation shrinks the value of money over time, you might be thinking that your expected income stream in retirement, from Social Security and/or a pension, will be enough to live on. Factoring in inflation, though, you might understand that your expected $30,000 per year could have the purchasing power of only $14,000 in 25 years.

Mitchell and Lusardi note that financial knowledge is correlated with better results: “Our analysis of financial knowledge and investor performance showed that more knowledgeable individuals invest in more sophisticated assets, suggesting that they can expect to earn higher returns on their retirement savings accounts.” Thus, better financial literacy can help people avoid credit card debt, take advantage of refinancing opportunities, optimize Social Security benefits, avoid predatory lenders, avoid financial scams and those pushing poor investments, and plan and save for retirement.

Even if you got all three questions correct, you can probably improve your financial condition and ultimate performance by continuing to learn. Many of the most successful investors are known to be voracious readers, eager to keep learning even more.

MONEY retirement planning

The Proven Way to Retire Richer

Looking for more money for your retirement? Who isn't? This study reveals that there is one sure-fire way to get it.

Last June, the National Bureau of Economic Research with professors from the University of Pennsylvania, George Washington University, and North Carolina State University, released a study entitled “Financial Knowledge and 401(k) Investment Performance”.

In it the authors found that individuals who had the most financial knowledge — as measured through five questions about personal finance principles — had investment returns that were on average 1.3% higher annually — 9.5% versus 8.2% — than those who had the least financial knowledge.

While this difference may not sound consequential, the authors noted that it “is a substantial difference, enhancing the retirement nest egg of the most knowledgeable by 25% over a 30-year work life.”

Yes, knowing the answers to five questions had a direct correlation to having 25% more money when you retire.

So what are those questions? For example, and for the sake of brevity, here are the first three:

Interest Rate: Suppose you had $100 in a savings account and the interest rate was 2% per year. After 5 years, how much do you think you would have in the account if you left the money to grow?

Answers: More than $110, Exactly $110, Less than $110.

Inflation: Imagine that the interest rate on your savings account was 1% per year and inflation was 2% per year. After 1 year, how much would you be able to buy with the money in this account?

Answers: More than today, Exactly the same, Less than today.

Risk: Is this statement True or False? Buying a single company’s stock usually provides a safer return than a stock mutual fund.

While the questions aren’t complex, they’re tough. And few people can answer all three correctly (with the answers being: More than $110, Less Than Today, and False).

So what did those people who were able to answer those questions most accurately actually do to generate the highest returns? The authors found one of the biggest reasons was that the most financially literate had the greatest propensity to hold stocks (66% of their portfolio was in equity versus 49% for those who scored lowest). And while their portfolios were more volatile, over time, they had the best results.

This is critical because it underscores the utter importance of understanding asset allocation. This measures how much of your retirement savings should be put in stocks relative to bonds. A general guideline is the “Rule of 100,” which suggests your allocation of stocks to bonds should be 100 minus your age. So, a 25-year-old should have 75% of their retirement savings in stocks.

Some have suggested that rule should be revised to the rule of 110 or 120 — and my gut reaction is 110 sounds about right — but you get the general idea.

This vital distinction is important because over the long-term stocks outlandishly outperform bonds. If you’d invested $100 in both stocks and bonds in 1928, your $100 in bonds would be worth roughly $7,000 at the end of 2014. But that $100 investment in stocks would be worth more than 40 times more, at $290,000, as shown below:

Of course, between the end of 2007 and 2008, the stock investment fell from $178,000 to $113,000, whereas the bonds grew from $5,000 to $6,000, displaying why someone who needs the money sooner rather than later should stick to bonds. But a 40-year-old who won’t retire for another 20 (or more) years can weather that storm.

Whether it’s $100 or $1,000,000, watching an investment fall by nearly 40% in value is gut wrenching. But in investing, and in life, patience is key, and as Warren Buffett once said, “The stock market serves as a relocation center at which money is moved from the active to the patient.”

While everyone’s personal circumstances are different (my risk tolerance is vastly greater now than it will be in 30 years) knowing that you can be comfortable allocating a sizable amount of your retirement savings to stocks will yield dramatically better results over time.

MONEY Aging

Are You Mentally Fit Enough to Plan for Retirement?

Book with money in it
iStock

People's ability to make sound financial decisions declines with age—even as their confidence about it doesn't.

In this era of “self-directed” retirement (no pensions, you make all the investment choices) postponing making a real plan poses a particular risk to future security. Not only are the logistics of planning hard enough—when to collect Social Security, how to budget for expenses, what to do with savings—but the decline in cognition that accompanies normal aging has a measurable negative impact on the ability to make sound financial decisions.

In 2010, researchers at the Center for Retirement Research at Boston College tested the financial literacy of a group of older people in the Chicago area by asking them questions such as the relationship between bond prices and interest rates, the value of paying off credit card debt, and the historical differences between stock and bond returns. They then retested the group every year and found that, among some participants, even while their knowledge of personal finance and investing was eroding, they remained just as confident about managing “day to day financial matters.” And perhaps because they remained so confident, more than half of them retained primary responsibility for handling their finances as their ability to do so was becoming increasingly compromised. (Other studies have shown that financial literacy scores decline by about 1 percentage point a year after age 60. )

One particular area of concern, and one that is often overlooked when discussing the future income of retirees, is the level of debt that older Americans are taking on near or at retirement. Debt later in life is problematic for obvious reasons: Payments can strain your income at a point where active earning years are ending; debt offsets asset accumulation, which you may be forced to reduce in order to service the debt; and finally, leveraging large housing debt in particular may leave older Americans with less resources to finance an adequate retirement.

Recent data from the Employee Benefit Research Institute (EBRI) shows that the percentage of American families with heads ages 55 or older that had debt increased from 63.2% in 2010 to 65.4% in 2013, with housing debt as the major component. Moreover, the percentage of families with debt payments greater than 40% of their income also increased, from 8.5% in 2010 to 9.2% in 2013.

Just because you have debt does not in and of itself mean you’re in financial danger. Nor does growing older automatically throw you into the kind of cognitive decline that could seriously impair your financial decision-making. But now that individuals are fully responsible for their own retirement security, part of that responsibility must certainly include the possibility that time may leave you less rather than more equipped to make the right decisions. As the saying goes: hope for the best but plan for the worst.

Konigsberg is the author of The Truth About Grief, a contributor to the anthology Money Changes Everything, and a director at Arden Asset Management. The views expressed are solely her own.

MONEY Kids & Money

New Year’s Money Moves for Kids

kid sock coin purses
iStock

These steps will get your child’s finances off to a strong start in 2015.

It’s never too early to start teaching youngsters about personal finance. Here are three tips from financial planners to help your kids become more savvy about spending, saving, and understanding the value of a dollar.

1. Prepare to spend. Is a prom or class trip on the horizon? Have your kid take owner­ship of the budgeting process, says Marguerita Cheng, a financial adviser in Rockville, Md. Regularly depositing babysitting money or other earnings in the bank for a big-ticket purchase will help your child understand how much things cost and what it takes to reach savings targets.

2. Sock money away. Putting money in a Roth IRA lets your child take advantage of both tax-free investing and many years of compound returns. She can contribute some of her earnings (the theoretical limit in 2015 is 100% of earned income up to $5,500); meanwhile, you can encourage her by agreeing to match her contributions, says Cheng.

3. Give a little bit. Plant the seed for charitable giving by showing your kid the positive impact firsthand. “If children are being honest, they don’t want to share,” says Shannon Ryan, who blogs about kids and money at theheavypurse .com. Seeing animals at a humane shelter or volunteering with you at a soup kitchen can help change that mindset.

Related:
How to Avoid Paying for Your Kids…Forever
What Smart Parents Teach Their Kids About Debt
Teach Your Kids Financial Values…Via Cellphone

 

MONEY retirement planning

Flunking Retirement Readiness, and What to Do About It

red pencil writing "F" failing grade
Thomas J. Peterson—Alamy

Americans don't get the basics of retirement planning. Automating 401(k)s and expanding benefits for lower-income workers may be the best solution.

Imagine boarding a jet and heading for your seat, only to be told you’re needed in the cockpit to fly the plane.

Investing expert William Bernstein argued in a recent interview that what has happened in our workplace retirement system over the past 30 years is analogous. We’ve shifted from defined benefit pension plans managed by professional financial pilots to 401(k) plans controlled by passengers.

Once, employers made the contributions, investment pros handled the investments and the income part was simple: You retired, the checks started arriving and continued until you died. Now, you decide how much to invest, where to invest it and how to draw it down. In other words, you fuel the plane, you pilot the plane and you land it.

It’s no surprise that many of us, especially middle- and lower-income households, crash. The Federal Reserve’s latest Survey of Consumer Finances, released in September, found that ownership of retirement plans has fallen sharply in recent years, and that low-income households have almost no savings.

But even wealthier households seem to be failing retirement flight school.

Eighty percent of Americans with nest eggs of at least $100,000 got an “F” on a test about managing retirement savings put together recently by the American College of Financial Services. The college, which trains financial planners, asked over 1,000 60- to 75-year-olds about topics like safe retirement withdrawal rates, investment and longevity risk.

Seven in 10 had never heard of the “4% rule,” which holds that you can safely withdraw that amount annually in retirement.

Very few understood the risk of investing in bonds. Only 39% knew that a bond’s value falls when interest rates rise—a key risk for bondholders in this ultra-low-rate environment.

“We thought the grades would have been better, because there’s been so much talk about these subjects in the media lately,” said David Littell, who directs a program focused on retirement income at the college. “We wanted to see if any of it is sinking in.”

Many 401(k) plans have added features in recent years that aim to put the plane back on autopilot: automatic enrollment, auto-escalation of contributions and target date funds that adjust your level of risk as retirement approaches.

But none of that seems to be moving the needle much. A survey of 401(k) plan sponsors released last month by Towers Watson, the employee benefit consulting firm, found rising levels of worry about employee retirement readiness. Just 12% of respondents say workers know how much they need for retirement; 20% said their employees are comfortable making investment decisions.

The study calls for redoubled efforts to educate workers, but there’s little evidence that that works. “I hate to be anti-education, but I just don’t think it’s the way to go,” says Alicia Munnell, director of Boston College’s Center for Retirement Research. “You have to get people at just the right time when they want to pay attention—just sending education out there doesn’t produce any change at all.”

What’s more, calls for greater financial literacy efforts carry a subtle blame-the-victim message that I consider dead wrong. People shouldn’t have to learn concepts like safe withdrawal rates or the interaction of interest rates and bond prices to retire with security.

Just as important, many middle- and lower-income households don’t earn enough to accumulate meaningful savings. “We’ve had stagnant wage growth for a long time—a lot of people can’t save and cover their living expenses,” says Munnell, co-author of “Falling Short: The Coming Retirement Crisis and What to Do About It” (Oxford University Press, December 2014).

Since the defined contribution system is here to stay, she says, we should focus on improving it. “We have to auto-enroll everyone, and auto-escalate their contributions. Otherwise, we’re doing more harm than good.”

Munnell acknowledges that a better 401(k) system mainly benefits upper-income households with the capacity to save. For everyone else, it’s important that no cuts be made to Social Security. And she says proposals to expand benefits at the lower end of the income distribution make sense.

“Given all the difficulty we’re having expanding coverage with employer-sponsored plans, that is the most efficient way to provide income to lower-paid workers.”

Read next: The Big Flaws in Your 401(k) and How to Fix Them

MONEY Kids and Money

Trouble Talking to Kids About Money? Try This Book Instead

parents trying to talk to teenage daughter
Getty Images/Altrendo

A new book hopes to impart important money lessons in just a few words and pictures

Talking to your kids about money is never easy. We have so many financial taboos and insecurities that many parents would rather skip it—just like their parents likely did with them. If that sounds like you, maybe a new easy-to-digest money guide written for teens can be part of your answer.

As a parent, you have to do something. Kids today will come of age and ultimately retire in a vastly less secure financial world. Their keys to long-term success will have little to do with the traditional pensions and Social Security benefits that may be a big part of your own retirement calculus. For them, saving early and building their own safety net is the only sure solution.

Most parents get that. After all, adults have seen first-hand the long-running switch from defined benefit to defined contribution plans that took flight in the 1980s. Yet only in the last 15 years have we really begun to grasp how much this change has undermined retirement security. Now, more parents are having the money talk with their kids. Still, many say they find it easier to talk about sex or drugs than finances.

The big challenge of our day, as it relates to the financial security of young people, is getting them thinking about their financial future now while they have 40 or 50 years to let their savings compound. But saving is only one piece of the puzzle. Young people need to protect their identity and their credit score—two relatively recent considerations. Many of them are also committed to making a difference through giving, which is an uplifting trait of younger generations. Yet they are prone to scams and don’t know how to vet a charity.

In OMG: The Official Money Guide for Teenagers, authors Susan and Michael Beacham tackle these and other basics in a breezy, colorful, cleverly illustrated booklet meant to hold a teen’s attention. The whole thing can be read in an hour. I’m not convinced the YouTube generation will latch on to any written material on this subject. And while the authors do a nice job of keeping things simple, they just can’t avoid eye-glazing terms like “liquidity” and “principal.”

But they make a solid effort to hold a teen’s interest through a handful of “awkward money moments,” which illustrate how poor money management can lead to embarrassing outcomes like their debit card being declined in front of friends or having to wear last year’s team uniform because they spent all their money at the mall. “Kids are very social and money is a big part of that social experience,” says Susan Beacham. “No teen wants to feel awkward, which is why we chose this word. If they read nothing else but these segments they will be ahead of the game.”

The Beachams are co-founders of Money Savvy Generation, a youth financial education website. They have a long history in personal finance and created the Money Savvy Pig, a bank with separate compartments for saving, spending, donating, and investing. In OMG, they tackle budgets, saving, investing, plastic, identity theft, giving, and insurance.

A new money guide for young people seems to pop up every few years. So it’s not like this hasn’t been tried before. Earlier titles include Money Sense for Kids from Barron’s and The Everything Kids Money Book by Brette McWhorter Sember. But most often this subject is geared at parents, offering ways to teach their kids about money. Dave Ramsey’s Smart Money Smart Kids came out last spring and due out early next year is The Opposite of Spoiled: Raising Kids Who are Grounded, Generous and Smart About Money from New York Times personal finance columnist Ron Lieber.

In a nod to how tough it can be to get teens to read a book about money, Beacham suggests a parent or grandparent ask them to read OMG, and offer them an incentive like a gift card after completing the chapter on “ways to pay” or a cash bonus after reading the chapter on budgets and setting one up. “Make reading the book a bit like a treasure hunt,” she says. That just might make having the money talk easier too.

 

 

 

MONEY

Surprising Lessons from the Latest Superstar Athlete to Go Broke

Columbus Blue Jackets defenseman Jack Johnson (7) during the NHL game between the Boston Bruins and the Columbus Blue Jackets at Nationwide Arena in Columbus, OH. The Boston Bruins defeated the Columbus Blue Jackets 4-3 in a shootout.
Aaron Doster—Cal Sport Media via AP Images

In Jonathan Rosen’s 1997 novel Eve’s Apple, a character describes her mother as someone who wanted to “have her kids and eat them, too.”

It’s hard not think of such parental malevolence when considering the recent bankruptcy filing of Columbus Blue Jackets defenseman Jack Johnson, whose financial woes were caused almost entirely by the financial evildoings of his parents. But despite the extreme nature of this case—and because of the surprising frequency of money troubles for professional athletes—there are two valuable lessons in Johnson’s travails that are relevant to sports fans and the rest of finance-fogged America.

Lesson 1: We should start teaching personal finance in kindergarten.

Despite a tremendous increase over the past 30 years in the number of reliable sources offering solid financial advice instruction to anyone who cares to learn—from Money magazine to motleyfool.com to most reputable financial services companies—most Americans are woefully ignorant when it comes to basic principles of money management. As a country, we just don’t know enough about borrowing, saving, investing and insurance. And while some some states are being taken to address this problem, we’re only at the early stages of what will be a very long process.

Don’t believe me? Check out the four main recommendations of the President’s Advisory Council of Financial Capability—all of them smart—and tell me how close you think we are to solving the problem. Every school, in every state, needs to incorporate financial literacy into curriculums from the earliest stages, i.e., from the time kids learn their ABCs and numbers. The only way to overcome the inherent tedium of personal finance—a topic about as exciting as someone else’s golf score—is to make it less of a “subject” and more of a tool. I’ve been writing about personal finance, on and off, for nearly a quarter of a century and the only way to successfully educate all but the biggest money nerds is to make zucchini bread. That is, we have to hide the good-for-you-but-unappealing-stuff (apologies to zucchini farmers) in more exciting fare.

Lesson 2: Professional athletes are particular vulnerable to being ripped off.

When we look at professional athletes we see (or imagine) any number of positive qualities: talent, discipline, focus, commitment, bravery. But while most of those traits exist to greater and lesser extent in all sports stars, the one quality that must be present is what insiders call “coachability.” For every athlete MLB, NBA, NFL or NHL athlete there were dozens of others with similar skills who weren’t able to make it to the big leagues because they wouldn’t or couldn’t follow directions. I worked at ESPN for 14 years and I was struck by nothing so much as the willingness of otherwise supremely confident and self-directed men and women to listen to their coaches, trainers and managers. For good reason, too: These authority figures possess expertise that athletes respect and desire, a treasury of knowledge and experience from which they hope to achieve success and extend their careers.

Accurate, real-time salaries for thousands of careers.

The problem with this malleability is that it often applies to experts in fields outside their core sport—such as health, nutrition or fitness—but especially comes into play with complex or arcane subjects like finance. Once an athlete trusts a financial adviser, heaven help him or her if said adviser is up to no good or even simply incompetent. (Heaven help all of us if it’s a parent who’s doing the exploiting.) Most of the major sports leagues and players’ unions recognize this and try to provide guidance, protection and warning to their athetes, but they could and should do better. I write this knowing how difficult such a challenge is, not just because athletes work as hard and as long as they do to earn their rich salaries but also because they are, generally, young and cavalier about risks of all kinds. Such is youth.

If I were King of The Sports World—a development unlikely to occur any time in the near future—I would require that a majority of every pro athlete’s earnings be directed to some kind of TIAA-CREF type organization that would safeguard their fortunes until they are through with their careers. Such an arrangement might not be popular (or legal or practical) but it would ensure that far fewer pro stars are fleeced because they haven’t been taught well to handle their money and have been taught too well to follow orders.

Oh, yeah, one other rule in my hypothetical sports realm: Even after athletes retire, I wouldn’t give them control of their money until they’ve taken a few financial literacy courses.

MONEY 401(k)s

Are You Smart Enough to Boost Your 401(k)’s Return? Take This Simple Quiz

141119_RET_SmartEnough
Pete Ark/Getty Images

If you can answer these 5 basic questions, you'll likely earn bigger gains in your retirement plan.

Can knowing more about investing and finances boost your 401(k)’s returns? A recent study suggests that may be the case. But you don’t have to be a savant to improve performance. Even if you don’t know a qualified dividend from a capital gain, lessons from this research can help you fatten your investment accounts.

The more you know about finances and investing, the higher the returns you’re likely to earn in your 401(k). That, at least, is the conclusion researchers came to after giving thousands of participants of a large 401(k) plan a five-question test to gauge how much they know about basic financial concepts and then comparing the results with investment performance over 10 years.

You’ll get your turn to answer those questions in a minute. But first, let’s take a look at what the study found.

Savvier Investors Hold More Stocks

Basically, the 401(k) participants who answered more questions correctly earned substantially higher returns in their 401(k). And I mean substantially. Those who got four or five of the five questions right had annualized risk-adjusted returns of 9.5% on average compared with 8.2% for those who answered only one or none of the questions correctly. That 1.3-percent-a-year margin, the researchers note, would translate to a 25% larger nest egg over the course of a 25-year career. That could be the difference between scraping by in retirement versus living a secure and comfortable lifestyle.

But while the 401(k)s of participants with greater knowledge didn’t outperform the accounts of their less knowledgeable peers because of some arcane or sophisticated investing strategy. The secret of their success was actually pretty simple (and easily duplicated): They invested more of their savings in stock funds than their financially challenged counterparts. And even when less-informed participants did venture into stocks, they were less apt to invest in international stocks, small-cap funds and, most important to my mind, less likely to own index funds, the option that has the potential to lower investment costs and dramatically boost the value of your nest egg.

The better-informed investors’ results come with a caveat. Even though more financially savvy participants earned higher returns after accounting for risk, their portfolios tended to be somewhat somewhat more volatile (which isn’t surprising given the higher stock stake). So they had to be willing to endure a somewhat bumpier ride en route to their loftier returns.

I’d also add that while more exposure to stocks does generally equate to higher long-term returns, no one should take that as an invitation to just load up on equities. When investing your retirement savings, you’ve also got to take your risk tolerance into account as well as the effect larger stock holdings have when the market heads south. That’s especially true if you’re nearing retirement or already retired, as portfolio heavily invested in stocks could suffer a setback large enough to force you to seriously scale back or even abandon your retirement plans.

Mastering the Basics

Ready to see how you’ll fare on the study’s Financial Knowledge test? The five questions and correct answers are below, followed by my take on the lessons you should from this exercise, regardless of how you score.

Question #1. Suppose you had $100 in a savings account that paid 2% interest per year. After five years, how much would you have in the account if you left the money to grow?
a. More than $110
b. Exactly $110
c. Less than $110

Question #2. 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

Question #3. Is this statement true or false? Buying a single company’s stock usually provides a safer return than a stock mutual fund.
a. True
b. False

Question #4. 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
d. Remain the same

Question #5. Assume that an employer matched employee contributions dollar for dollar. If the employee contributed $100 to the 401(k) plan, his account balance in the plan including his contribution would:
a. Increase by $50
b. Increase by $100
c. Increase by $200
d. Remain the same

The answers:

1. a, More than $110. This question was designed to test people’s ability to do a simple interest calculation. To answer “more than” instead of “exactly” $100, you also had to understand the concept of compound interest. (Percentage of people who answered this question correctly: 76%.)

2. c, Less than today. This question gets at the relationship between investment returns and inflation and the concept of “real” return. To answer it correctly, you must understand that if your money grows at less than the inflation rate, its purchasing power declines. (92%)

3. b, False. Here, the idea was to test whether people understood that a stock mutual fund contains many stocks and that investing in a large group of stocks is generally less risky than putting all one’s money into a the stock of a single company. (88%)

4. b, Decline by $75. This question gauges people’s understanding of the tax benefit of a pretax contribution to a 401(k) and its effect on the paycheck of someone in the 25% tax bracket. (45%)

5. c, Increase by $200. This was simply a test of whether people understood the concept of matching funds and the effect of a dollar-for-dollar match. (78%)

Average score: 3.8 All 5 correct: 33% All 5 wrong: 2%

Okay, so now you know how you stack up compared with the 401(k) participants in the study. But whether you did well or not, remember that your performance on this or any other test isn’t necessarily a prediction of how your retirement portfolio will fare. Very financially astute people sometimes make dumb investment moves. Sometimes they try to get too fancy (think of the Nobel Laureates whose hedge fund lost billions in the late ’90s). Other times there may be a disconnect between what people know intellectually and how they react emotionally.

Nor does a lack of financial smarts inevitably doom you to subpar performance. You don’t need a PhD in finance to understand the few basic concepts that lead to financial success: spreading your money among a variety of investments instead of going all-in on one or two things, keeping costs down and paying attention to both risk and return when investing your savings.

So by all means take the time to educate yourself about investing. But don’t feel you have to go beyond a few simple but effective investing techniques to earn competitive returns and improve your chances of a secure retirement.

More from RealDealRetirement.com:

Can I Double My Nest Egg In the Final Years of My Career?

How To Save On Retirement Investing Fees

How To Build A $1 Million IRA

MONEY Kids and Money

4 Costly Money Mistakes You’re Making With Your Kids

parents cheering softball players
Yellow Dog Productions—Getty Images

Help your kids become financially literate.

When you’re a parent, it’s easy to get caught up in day-to-day money issues: Which brand of milk is a better value? Is Old Navy having a school uniform sale? How much lunch money is left in the kids’ accounts? But parenting is ultimately about the long view, with the goal of raising capable, self-sufficient adults. Dealing with daily details, we sometimes neglect important money issues that can have a huge impact on our kids — and on our finances — as they prepare for college and adult life.

The mistake: Not talking enough about money

Too many parents don’t talk about money with their kids at all. Others skirt topics they don’t know much about, like investing and debt. Parents are the main source of money information for children, but 74% of parents are reluctant to discuss family finances with their kids, according to the 2014 T. Rowe Price Parents, Kids, and Money Survey. That’s too bad, because ignorance about money can set your kids up to make bad decisions — and eventually pass those bad habits on to your grandkids.

The solution: Make financial literacy a family value

In her book, Do I Look Like an ATM?: A Parent’s Guide to Raising Financially Responsible African American Children, Sabrina Lamb details “the business of your family household.” Lamb, founder and CEO of WorldofMoney.org, says all families should work together on five financial topics: learning, earning, saving, investing, and donating time or funds to causes you value. She recommends a daily diet of business news, occasional meetings between the kids, your banker, and other financial advisors, and support of your older kids’ entrepreneurial goals.

The mistake: Believing in the “Scholarship Fairy”

A lot of parents pin their hopes on pixie dust when it comes to funding their kids’ college educations. Eight in 10 parents think their kids will get scholarships. In the real world, less than one in 10 U.S. students receive private-sector scholarship money — an average of $2,000 apiece, according to FinAid.org.

Even more unrealistic is the myth that great grades and high test scores will lead to a full scholarship. The truth, per scholarship portal ScholarshipExperts.com, is there are many more 4.0-GPA students than there are full-tuition awards, and only one-third of one percent (0.3%) of all U.S. college students earn a full-ride scholarship each year. The time to learn this hard truth is now, not when college acceptance letters start arriving.

The solution: Save something now (or accept that you can’t)

Accurate, real-time salaries for thousands of careers.

There’s a considerable body of literature out there on the merits of 529s, trusts, and other college savings options. Don’t let the details distract you from the real issue, which is that if you want to help finance your child’s higher education, you must save regularly, starting now.

If there’s no money to save, be honest with your kids about it. You can start educating them about ways to finance college through loans and cut costs with community college transfer credit and placement tests. It’s perfectly acceptable to expect your kids to take responsibility for their own higher learning as long as you prepare them properly to face that reality.

The mistake: “Investing” in extracurricular activities

Everyone’s heard about overscheduled kids with too many after-school activities. Not as much is said about the huge dent extracurriculars can put in your budget — hundreds or thousands of dollars each year for lessons, league fees, uniforms, and more. If you’re sacrificing because you think these activities will pay off when your child gets an athletic scholarship, remember that the Scholarship Fairy is rarely seen. The odds of any particular student getting even a small athletic scholarship at a Division 1 school aren’t significantly better than the odds of a student getting a full-ride academic scholarship.

The solution: Treat extracurricular activities as extras

If your child loves soccer, piano, or hip-hop and you have the time and money to spare, that’s ideal. But if it’s a choice between paying for extras and saving for college, save for college. Find cheaper after-school options for now, and don’t apologize for making that decision.

The mistake: Not teaching your kids to negotiate

There’s a big distinction between a child who’s been taught how to speak up when appropriate and one who’s been trained to be passive in the face of authority. The kids who know how to negotiate tend to earn more money as adults, even when they’re doing the same jobs as those who keep quiet. Salary.com found last year that workers who negotiated a raise every three years earned a million more dollars over the course of their careers than workers who simply accepted whatever they were offered.

The solution: Teach your kids how to deal

Show your kids the ins and outs of deal making through trading games, doing some haggling at garage sales, and expecting them to keep their word. You can find specific age-appropriate suggestions here.

By talking about money and business a little each day, being realistic about college planning, and giving your kids the skills to advocate for themselves, you’ll give them long-term advantages when it comes to understanding and earning money. That’s a valuable legacy to pass from one generation to the next.

Your browser is out of date. Please update your browser at http://update.microsoft.com