The role of financial literacy and knowledge in determining retirement plans

Robert L. Clark, North Carolina State University
Melinda Sandler Morrill, North Carolina State University
Steve Allen, North Carolina State University

Older workers develop retirement plans using their basic understanding of financial markets and financial mathematics along with their knowledge of their employer retirement plans, Social Security, and Medicare. To the extent that their knowledge base is correct, employees can develop optimal plans for the transition from full-time work to full-time retirement. Older workers who have limited or incorrect knowledge will make suboptimal retirement choices. As a result, they will not be able to achieve the highest possible lifetime utility given their available assets. Thus, it is important to examine the relationship between the lack of specific types of information regarding public and company-provided retirement benefits and an individual’s stated retirement plans and goals. More specifically, the impact of being wrong in one’s assessment of financial issues and retirement plans depends on the type of errors. In other words, under- versus over-estimates of true values, such as ages of eligibility for retirement programs, will impact retirement decisions differently. Our analysis shows that both the level of knowledge and the types of informational errors influence retirement decisions. To examine the relationship between knowledge and lifetime planning, we partnered with three large employers who allowed us to survey all of their employees nearing retirement, ages 49 to 65, in 2008 and 2009. The surveys obtained detailed socio-economic information on the respondents and their households, their retirement plans, their knowledge about retirement programs, and their confidence in their knowledge. We estimate how the retirement plans of the respondents are related to their understanding of retirement plans and their basic financial literacy. Survey responses indicate that the retirement-eligible employees in these companies had a rather low level of knowledge, a lack of confidence in their ability to make optimal retirement choices, and a strong desire for their employers to provide more formal pre-retirement planning programs.