Retirement Security of the Baby Boomers: the Role of Financial Literacy and Planning

The large "Baby Boom" generation (traditionally defined as those born between 1946 and 1964) is now on the cusp of retirement, with the first Boomers due to become eligible for Social Security next year. This generation has experienced a number of events that could affect its financial preparedness for retirement, including the 1983 Social Security amendments that raised the normal retirement age, the ongoing shift from defined benefit to defined contribution pensions, and recent boom and bust cycles in equity and housing markets.

To ensure adequate resources in retirement, Boomer households must save and plan for retirement during their working years. Yet in order to do so successfully, households must understand a number of key economic concepts including present values and the difference between real and nominal amounts, and they must also be able to make projections of future wages, pensions and social security benefits, retirement ages, and survival probabilities. Despite the fact that these are complex and demanding requirements, there has been little research on Boomer financial literacy.

In "Baby Boomer Retirement Security: the Roles of Planning, Financial Literacy, and Housing Wealth" (NBER Working Paper 12585), researchers Annamaria Lusardi and Olivia S. Mitchell explore the links between financial literacy, planning, and retirement saving adequacy. Specifically, the authors ask how financially prepared Baby Boomers are for retirement, whether more financially-literate individuals are more likely to plan for retirement, and whether planning affects wealth accumulation.

The authors use the Health and Retirement Study (HRS) for their analysis, a nationally representative survey of individuals over age 50. The survey interviewed participants every two years and has added new cohorts over time. The authors compare two cohorts in their analysis, the "Early Baby Boomers" in 2004 (born 1948 to 1953), and the younger half of the original HRS cohort in 1992 (born 1936 to 1941). Thus, they compare respondents of the same age (51-56) in different periods of time.

The authors begin by examining the level and composition of wealth holdings of these cohorts nearing retirement. The typical early Boomer household had a net worth of $152,000 in 2004, excluding Social Security and defined benefit pensions. Wealth proves to be highly skewed, with the household at the 75th percentile of the distribution having more than 10 times the wealth of the household at the 25th percentile, $400,000 vs. $36,000. There are also stark differences in wealth by socio-economic group, with less-educated, Black, Hispanic, and non-married households having sharply lower net worth.

The Boomer cohort is generally wealthier than was the earlier HRS cohort at the same age, although Boomer households in the lowest quartile are less well off. The primary reason the Boomer cohort is better off is that it has more housing equity: Mean housing wealth for Boomers is about 50% higher than for the earlier cohort. However, Boomers also appear to be relying more on their housing equity. The typical Boomer household holds nearly half of its wealth in the form of housing equity, and even the richest households hold one-third of their wealth in housing. This leaves Boomers vulnerable in the event of a housing bust: the authors estimate that a return to 2002 house prices would lower the typical Boomer household's net worth by 14 percent.

Next, the authors explore the extent of financial planning among these households. When Boomers were asked whether they had thought about retirement, over one-quarter responded "hardly at all." Interestingly, those who reported that they undertook any planning, even "a little," had wealth holdings over twice as large as that of nonplanners. The authors also find that less-educated and non-White households are much more likely to be nonplanners.

One reason people may fail to plan is because they are financially unsophisticated. In prior research, the authors showed that half of survey respondents could not make a simple interest rate calculation and did not know the difference between nominal and real interest rates; an even larger percentage did not realize that holding a single company stock is more risky than holding a stock mutual fund. In this paper, they again find that many Boomers are unable to make simple economic calculations, in particular when it relates to interest compounding.

The authors make use of the HRS data on planning and financial literacy to explore the link between the two. They find that financial literacy is important for planning. For example, being able to answer a question on compound interest correctly is associated with a 10 to 15 percentage point increase in the probability of being a planner.

Finally, the authors examine the effect of planning on wealth. They find that planning has a strongly positive effect on wealth, even after accounting for demographic factors like education and race. Their estimates suggest that those who plan accumulate nearly 20% more in net worth.

A possible alternative explanation for the findings is that wealthier households might plan more since they have more to gain from planning. To address this possibility, the authors look for an effect of wealth on planning, using regional differences in house price appreciation as a source of unexpected changes in wealth. They fail to find any effect, suggesting that the direction of causality likely runs from planning to wealth.

In summary, Lusardi and Mitchell find that Boomers are standing on the verge of retirement with higher levels of net worth than the earlier cohort, primarily because they have higher housing wealth. But the poorest Boomers are worse off than their earlier counterparts, and wealth remains very low for Black, Hispanic, and the least educated Boomers. Planning appears to be strongly linked to financial literacy and it is an important determinant of household net worth at retirement. The authors conclude that there may be a role for firms to offer their employees retirement seminars and pension plan advice, to jump-start the retirement saving process and help those at risk of not preparing adequately for retirement.

The authors acknowledge financial support from the U.S. Social Security Administration through a grant to the Michigan Retirement Research Center and from the Pension Research Council at the Wharton School.