A recent survey of over 1,300 Americans finds that almost 3 out of 4 people aged 60 to 75 failed to pass a quiz measuring financial literacy, and only 5% managed a grade of 80% or better. The poor performance suggests many Americans aren't making the most of their money in retirement.
What's at stake?
Retirement dreams rarely include worrying how to pay bills, yet millions of retirees are doing exactly that. Why? Because Social Security income often falls short, and retirement savings are too small to make up the difference.
According to the Social Security Administration, almost 1 in 4 couples and nearly half of all single retirees count on Social Security for 90% or more of their income. Given the average retired worker collects just $1,360 in Social Security benefits per month, and half of all baby boomers have $50,000 or less in retirement savings, it's little wonder seniors are struggling to make ends meet.
Few answered key questions correctly
The American College New York Life Center for Retirement Income asked respondents to answer 38 questions to determine their financial know-how. Though it was a multiple-choice quiz, the questions asked weren't easy for many to answer correctly.
For example, one question asked if a person with a $100,000 portfolio split equally between stocks and bonds could afford to withdraw 2%, 4%, 6%, or 8% annually and still have a 95% chance of their savings lasting 30 years. Only 38% of people answered correctly that historically, a maximum 4% can be withdrawn per year to achieve that goal.
Another question asked if a 25% drop in account value would have a bigger impact on retirement security if it happened 15 years before retirement, at retirement, or 15 years after retirement. Only 34% of people knew that a drop at the year of retirement puts long-term financial security in retirement most at jeopardy.
The survey results also show that many people don't know that it's best to roll traditional IRA assets into a Roth IRA when their tax rate is low, or that a person with a life expectancy of 90 years is generally better off waiting to claim their Social Security at age 70 rather than at their full retirement age.
Why those questions matter
While it's true that the stock market historically returns between 6% to 8%, those returns aren't guaranteed. Stocks often fall, and the older you get, the less likely it is you'll be able to make up any ground that's lost because of down years. Because of this risk, retirees usually lower their exposure to risky investments like stocks that tend to provide the highest returns. Taking into consideration a more diversified portfolio in retirement reduces historical returns to closer to 4%. Withdraw any more than that per year, and you increase the likelihood of outliving your money in retirement.
It's also important to understand how big drops in account value impact future financial security in retirement. Big declines long before entering retirement take a toll on investment accounts, but often those declines can be overcome by increasing contributions during bear markets. Suffer a surprise drop in the year you retire and you won't have the luxury of time to make up the difference. Instead, you may be forced to permanently reduce your retirement income from savings. Because of this budget-busting risk, most would-be retirees should start reducing risk in their portfolios at least five years prior to retirement.
Converting a traditional IRA into a Roth IRA at the wrong time can also dent your retirement budget. Traditional IRA contributions are made with pre-tax dollars, while Roth IRA contributions are made with after-tax dollars. This means that you pay ordinary income taxes on any money you convert to a Roth IRA in the year you do the conversion. Waiting to convert a traditional IRA to a Roth IRA when you have less income from other sources is best. If you don't, you could end up paying thousands of dollars more in taxes than you need to.
If you don't understand the benefits of Social Security's delayed retirement credits, you could end up leaving big money on the table in retirement -- especially if you live a long time. While arguments can be made for claiming Social Security benefits at other ages, Social Security increases the amount you receive in benefits by 8% annually for every year you delay beyond your full retirement age, up until age 70. Claim benefits early and you get more payments, but they'll be smaller. Delay claiming benefits and your payments could be up to 32% bigger than they'd otherwise be at full retirement age, assuming a full retirement age of 66.
Live until 90, and those bigger benefits can really add up. If your full retirement age is 66, the amount of money collected in Social Security income if you delay benefits until age 70 will outstrip the amount collected if you claim benefits at 66 by the time you're 81.
Doing your homework
Improving your financial literacy won't guarantee a worry-free retirement, but it can improve your chances. People who did better on the American College New York Life Center for Retirement Income quiz were generally more educated, and importantly, they took financial matters into their own hands. Therefore, educating yourself about personal finance and taking a more active role in your investments are two ways you can boost your financial IQ, and hopefully, reduce the risk of outliving your money.
The Motley Fool has a disclosure policy.