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)
