The 5 Retirement Concepts Everyone Should Know: Do You?

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It’s no secret that many Americans put retirement on the back burner. According to a recent Bankrate retirement poll, one-third of Americans say they’re not saving enough for retirement and only 28 percent say they’re meeting their retirement saving goals. Another one-third aren’t saying anything at all.

To find out some of the driving forces behind why some people have better financial behavior and understand financial concepts better than others, the National Bureau of Economic Research (NBER) studied how well certain demographic groups understand and retain information about retirement. The study included a sample of around 3,000 households. Within the sample, 30 percent of the participants were below the age of 40; the largest group, 55 percent, were between 41 and 64; and 15 percent of the participants within the sample were over the age of 65. The study also included a focus group made up of young adult “savers,” who had already begun saving for retirement and “non-savers,” who had not yet begun saving. NBER then delivered information to the participants either through a video, through a narrative, or both. At the end, NBER wanted to see how much the participants knew.

The NBER theorizes that retirement can be broken down into five core sub-concepts — compound interest, inflation, risk diversification, tax treatment of retirement savings accounts, and employer matching. If you notice, most discussions pertaining to retirement involve some, or all, of these ideals. How much do you know about each? Let’s see how you stack up against the NBER participants.

1. Compound Interest

Most retirement funds earn compound interest. Although people generally understand that interest accumulates on these funds, some don’t understand the difference between simple interest, which is interest on the principal balance only versus compound interest, which is interest on the principal and interest on the principal accumulates. Sound a bit confusing? Think of it this way: mathematically, time, as a variable, is multiplied by your rate with simple interest. With compound interest, you increase your rate by time exponentially. So, using simple interest, an account with a starting balance of $100,000 and a 5 percent rate will earn $100,000 in interest in 20 years ($100,000 x .05 x 20.)

Let’s say instead of using simple interest, we use compound interest. That same $100,000 would grow to $265,329 in 20 years {$100,000 x [(1+.05)^20]}. Compound interest is a major reason why starting retirement savings while you’re young is so important. It gives your money more time to grow.

The majority of the participants in the survey had an understanding of compound interest. More than half of the respondents across all income ranges, genders, and education levels were able to answer questions correctly. However, these factors did impact the results. Those who earn more than $75,000 per year had a higher rate of understanding than those who earn under $35,000 annually, the 65 and older group also scored better than the 18 to 40 age group, and those with college education scored higher than those with only a high school education.

Source: Trading Economics http://www.tradingeconomics.com/united-states/inflation-cpi

2. Inflation

When it comes to a retirement fund, it’s essential to account for inflation. This simply means your money, when you retire in 10, 20, or 30 years from now, is not going to have the same purchasing power it does today. You may hear stories from your grandparents about how when they were younger, a loaf of bread was only 10 cents, or a soda pop was a nickel. This is because as the economy expands with time, prices rise. In the short-term, when there’s a higher demand than supply for the goods and services we produce, this causes a rise in prices. The inflation rate generally averages in the range of between 1 and 3.5 percent. The most recent inflation rate was 2 percent, for the 12 months ending April of 2014.

Participants in the NBER study seem to know less about inflation than compound interest. The groups with the highest rates of knowledge were college graduates (of all ages and income groups) and those who earn over $75,000.

3. Risk Diversification

Diversification is based on the ideal that you can win more often by betting on more than one pony, with a bit of strategy. NBER brings up how people sometimes invest in only one asset, particularly their company’s stock. If their company’s stock doesn’t perform well, they have an unsuccessful strategy.

To reduce the risk of losing your money, you can find two or more assets that are negatively correlated. Since they move in opposite directions, when one security’s value goes up in a certain situation, the other goes down, and vice versa.

Just as with inflation and compound interest, as income increased, the rate of knowledge increased in this area as well. Those in the above $75,000 category responded correctly over 80 percent of the time, compared to around 60 percent for those in the under $35,000 category. College graduates also score high (over 80 percent) in their knowledge of risk diversification, as did those over the age of 65.

Source: http://www.flickr.com/photos/68751915@N05

4. Tax Treatment of Retirement Accounts

This was one of the categories where participants in the NBER study scored the lowest. Scores ranged between 43 percent and 66 percent (rounded) for the group as a whole. Again, the college graduates, 65 and overs, and those who earn over $75,000 scored highest in this area.

This concept of retirement simply says taxes are an important factor to consider when making retirement decisions. You have to pay taxes on your retirement account at some point and when you decide to pay can make a large financial impact. With an IRA (or Roth IRA), you have the option to pay taxes now or later. Depending on your individual situation, this decision can save (or cost) you thousands of dollars. You have similar options with a 401(k), where you can make pretax or after-tax contributions.

5. Employer Matching

Many employers offer matching at one-to-one ratio. This means, if you contribute what your employer is willing to contribute, your contribution doubles, and then continues to grow. If you contribute less than your employer is offering to match, you are wasting free money.

The NBER study results indicated that like taxes on retirement account, this was also one of the areas people understood the least. Perhaps it sounds too good to be true. Overall, scores were as low as 46 percent (rounded) on some aspects of employer matching.

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