Three Questions That Indicate Your Financial Literacy

To successfully accumulate retirement savings and then make that money last throughout retirement, a person needs to have some basic financial knowledge. The Wharton School Pension Research Council at the University of Pennsylvania developed a three question financial literacy test to determine the level of financial literacy in various populations.

A short financial literacy test

Here are the three financial literacy questions that comprise the test:

1. Suppose you had $100 in a savings account and the interest rate was 2 percent per year. After 5 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 percent per year and inflation was 2 percent per year. After 1 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.”

a. True
b. False

Information to answer test questions is basic and readily available

How did you do? (The correct answers are at the end of this post.) I suspect you probably scored 100%. Why? Because if you found this blog, you must have an interest in personal financial matters; that interest motivates you expand your knowledge of the subject. The information necessary to correctly answer the three questions, the affect of compound interest on savings, the impact of inflation on purchasing power, and the need to diversify investments, is readily available to anyone with the slightest interest in personal finance. You, no doubt, encountered this basic information early in your education on personal finance matters.

Test results in United States

With so much information available on personal finance, specifically retirement saving and investing, it is surprising that Americans over 50, who should have an interest in this subject, scored so poorly when given the test:  only 50% answered the first two questions correctly and only 33% answered all three questions correctly. When the test was give to a more comprehensive sample representing all Americans, the results were essentially the same. Participants with more education fared better on the test, but still the scores were disappointing: 64% of those with a post-graduate degree answered all of the questions correctly, followed by 44% of college graduates, 31% of those with some college, and 19% of high school graduates.

Lack of financial literacy is symptom of deeper problem

The results prove the need for some kind of universal basic financial education, but the problem runs deeper than a lack of financial literacy: most Americans simply aren’t interested in managing their finances. Oh, they would like to have the fruits of effective money management; they just aren’t interested in the details. Most would much rather consume. And we Americans are expert consumers. We’re so good at it that we spend more than we earn. When it comes down to a choice between consumption or saving, immediate vs deferred gratification, most Americans want it now. Until that changes, a majority of Americans will continue to be financially illiterate—all the way to the poorhouse.

Answers: 1. a, 2. c, 3. b

K. C. Knouse is the author of True Prosperity: Your Guide to a Cash-Based LifestyleDouble-Dome Publications, 224 pages

Increases in Income During the First 20 Years of Work Life Key to High Rate of Saving

A painless way to dramatically increase your rate of saving is to save a percentage of all increases in income.  It’s painless because you have not had that income to spend, so increasing your rate of saving this way does not adversely affect your standard of living.  There is no need to sacrifice.  In fact, if you save only a percentage of your increases in income, you can still use the remainder to advance your standard of living.  You enjoy the best of both worlds: an increased rate of saving and a boost to your standard of living.

Most increases in income occur in your 20’s and 30’s

Recent studies show that the most advantageous time to employ this strategy is in your 20’s and 30’s.  It is during these two decades that the highest increases in inflation adjusted income occur.  In a labor department study that followed 10,000 workers’ earnings from 1979 to 2012, those that had college degrees averaged 9% per year increases in inflation adjusted income from ages 18-24, 6% average per year increases from 24-29, just under 5% average per year increases from 30-34, just under 4% average increases from 35-39.  By your 40’s you can expect increases in income to taper off dramatically.  The study showed a drop in the average annual increase in inflation adjusted income to just over 1% from ages 40-48.  Inflation adjusted income plateaus in your 50’s and may even decrease as you approach retirement age in your 60’s.

By capturing a portion of these average annual increases in income during your 20’s and 30’s to realize a progressively higher rate of saving, you accomplish two complementary objectives: 1. you save more relative to your income which makes it easier to achieve financial independence, and 2. you keep a lid on your standard of living relative to your income which also makes it easier to achieve financial independence.  By increasing your rate of saving substantially in your 20’s and 30’s, you also take advantage of time to compound the earnings on your savings.

Our experience with saving increases in income

I experienced these benefits firsthand.  In my case, I didn’t save anything until very late in my 20’s.  I spent the early years digging a hole of debt.  Fortunately, credit was not as plentiful then, and I didn’t earn that much, so my debt in dollars and cents wasn’t that much by today’s standards, but relative to my income, it was huge.  Then at age 28, my income more than doubled overnight.  All of that extra money frightened me into creating a budget so I didn’t blow it all.  And with the budget came savings.  I don’t recall how much of the increase I saved, but it was somewhere in the vicinity of 20% to 30%.  The rest went to pay off debt.  Thereafter, I saved most of my pay increases and bonuses.  In fact, Rosa and I saved a high percentage of both of our salaries by of socking away pay increases in our late 20’s and throughout our 30’s; we basically lived on the equivalent of one income, even though both of us worked full time at professional jobs.

Rather than increase our standard of living based on increases in income, Rosa and I have increased our standard of living based on our accumulated savings:  Can our accumulated savings sustain an increase in our standard of living?  That has always been the test.

Pain awaits those who put off serious saving until age 40 or later

Unfortunately, most in their 20’s and 30’s employ increases in income exclusively to boost their standard of living, thinking they have time to plow money into savings beginning in their 40’s.  Not only have they lost 15 to 20 years of compounding, their increased standard of living makes it nearly impossible to save enough money to attain financial independence, even at retirement age.  To make matters worse, by their early 40’s the era of large percentage increases in inflation adjusted income have probably passed them by.  This leaves them with the unhappy and difficult task of downsizing their standard of living in order to save at a high enough rate to achieve financial independence.  Because it is painful to cut back on spending once one has become accustomed to a certain standard of living, most will be in denial of the need to downsize until reality hits in their mid-50’s, making the likelihood of setting aside sufficient savings to achieve financial independence a near impossibility.

The situation is made worse for those who choose to use increases in income during their 20’s and 30’s exclusively to improve their standard of living if they postpone starting a family until their late 30’s or early 40’s   They haven’t had the expense of child rearing early in adulthood to temper their spending.  With their standard of living firmly established, the cost of raising children only adds to their spending at a time when those who had children early in their working years are shedding that expense and adding to savings.  It is improbable that those who begin families in their late 30’s or early 40’s will reduce their standard of living during this time as they will want to give their children every advantage possible.  Downsizing for them won’t begin until their late 50’s or early 60’s, far too late to set aside sufficient savings with which to enjoy financial independence.

Studies of historical data may not reflect your reality

According to the recent historical data, the time to take advantage of pay raises to boost your rate of saving is in your 20’s and 30’s.  The steady stream of high percentage increases in income during that time establishes, by age 40, your level of income for the rest of your working life.  If you wait until your 40’s to get serious about saving, you will have missed the bus.  But there is another reason to take advantage of pay increases early to boost your rate of saving:  you may not experience that steady upswing in income during your 20’s and 30’s; your income may go up and down throughout your working life.

That has been our experience.  Rosa and I each had career changes that set our joint income back, once in our 30’s and once in our 40’s.  Our joint income declined again in our late 40’s when Rosa took a year off and then worked part time as a substitute teacher for several years afterward in order to be a caregiver for her mother.  She then worked full time for several years as a paraprofessional, making a fourth of what she would have earned as a teacher.  The last three years of her working career, Rosa returned to full-time teaching which sent her income skyrocketing.  However, at that time, income from my business had declined.  When we had those declines in joint income, we saved less; when our joint income recovered, we saved the increase.

Despite the studies, you don’t really know how your income will grow throughout your working life, so it is only prudent to take advantage of any and all pay increases, whenever they occur, to boost your rate of saving.

K. C. Knouse is the author of True Prosperity: Your Guide to a Cash-Based LifestyleDouble-Dome Publications, 224 pages

Freedom from Responsibility: Dependence Disguised as Liberty

Freedom from responsibility is becoming the new mantra for those who believe that the societies of the advanced economies are unfair.  They believe that certain classes of people have been victimized by society and therefore are entitled to compensation.  The welfare state is and has been an expression of this idea.  People are not held responsible for their choices in life, instead society is made to assume that responsibility.

Advocates for a guaranteed basic income want to take this idea a step farther; they want society, by means of a government stipend, to pay every member a guaranteed basic income to cover the basic necessities of life: food, shelter, utilities, and so on.  Just what constitutes basic necessities is never made quite clear but proponents use the government’s poverty threshold as a guide to how much the stipend should be.

According to proponents, a guaranteed basic income would wipe out poverty as every member of society would be given the means to support themselves.  They would be free of worry about meeting their basic life needs, free from the need to work jobs that they didn’t find fulfilling, free from the need to work at all, free to devote their time to pursuits that may not produce income such as artistic endeavors, community service, caregiving, education, and such.

A guaranteed basic income has found support across the political spectrum in the United States, including Libertarians who see it as a more efficient and effective replacement for a complex and expensive welfare system.

The paradox of freedom from responsibility

If freedom from responsibility didn’t undermine personal liberty, it would hold as great a promise for the elimination of material suffering as its supporters claim.  The paradox is that freedom from responsibility isn’t freedom at all but dependency fueled by entitlement.  A person who never takes responsibility for himself never learns the life lessons that come with it.  Without that experience, he is never able to assume responsibility for himself and remains forever dependent and convinced that his basic living expenses are someone else’s responsibility.  This is hardly the description of a free person, but rather that of a perpetual teenager who continues to look to parents for food, shelter, and other basics of living while he goes on his merry way, oblivious to the real world, certain that he knows everything, because he has learned nothing of life.  True freedom requires a maturity that can only come through the experience of being responsible for one’s self.

The need to support one’s self motivates like nothing else:  it focuses the mind and drives the effort needed to overcome obstacles and accomplish tasks; it instills discipline; it clarifies the relationship between productivity and pay; it forces a person to examine her values and prioritize the allocation of time and money.  Through trial and error, a person learns life’s lessons, acquires survival skills, and matures into a responsible adult.

Entitlement mentality precludes growth

It is reasonable to ask:  Wouldn’t a person who receives a guaranteed basic income have to learn these same life lessons if he is to succeed in covering his basic living expenses, in living within his means?  Wouldn’t he go through the same trial and error process, acquire survival skills, and mature into a responsible adult?  He could but he won’t because he doesn’t accept that responsibility.  A feeling of entitlement will hold him back:  he wasn’t responsible for earning that money, so he won’t be responsible in spending it.  If he can’t make it on the guaranteed basic income, he will blame the responsible party: society by way of the government.  He will perceive the problem to be an inadequate stipend: it is simply not enough to live on.  It won’t be his fault; he is not responsible.  It will be society’s fault; they are responsible: the definition of poverty needs to be updated and the stipend increased to fix the problem.  This cycle will repeat itself perpetually, because there will never be enough of a stipend until the person accepts responsibility for himself.  When that happens, no stipend will be necessary.

Entitlement vs Accomplishment

What about the other benefits attributed to a guaranteed basic income:  the freedom from the need to work jobs that aren’t fulfilling, freedom from the need to work at all, freedom to devote time to pursuits that may not produce income, such as artistic endeavors, community service, caregiving, education, and such?  These benefits can be and are enjoyed by people who do not receive a guaranteed basic income:  they obtain new job skills that lead to more fulfilling work while holding down full-time jobs; they make financial independence a priority and accumulate the resources necessary to make work optional; they work full time while pursuing interests in their spare time that do not produce income.  The difference between these folks and those who would enjoy these benefits as a result of a guaranteed basic income is that they earned them, and because they are earned they are valued.  There is a big difference between entitlement and accomplishment:  the former is the assertion of a right, the latter is achieved through an investment of one’s time and energy.

Children are good at asserting their rights, they feel entitled to everything.  They don’t mature into independent, productive adults until they take the responsibility to earn that which they need to survive and prosper.  Taking responsibility for themselves sets them free.

K. C. Knouse is the author of True Prosperity: Your Guide to a Cash-Based LifestyleDouble-Dome Publications, 224 pages