Flunking Your Retirement

Pop quiz! Test your number skills with these two questions:

1. "If the chance of getting a disease is 10%, how many people out of 1,000 would be expected to get the disease?"
2. "If five people all have the winning number in the lottery and the prize is $2 million, how much will each of them get?"

Duh! You knew the first answer (100) before you reached the question mark. The second one ($400,000) took a tad longer. Maybe two seconds? Five max?

These questions were asked during a Health and Retirement Study (HRS) to measure the financial literacy of Baby Boomers. While 84% nailed the disease question, only 56% could divide the lottery correctly. People who got at least one of the answers right were asked a bonus question:

"Let's say you have $200 in a savings account. The account earns 10% interest per year. How much would you have in the account at the end of two years?"

Only 18% got the right answer, $242, to this simple problem in compound interest.

A prize-winning article in The Journal of Monetary Economics cited these stats to make a connection between financial literacy and retirement security. However, the article also shows that the former does not guarantee the latter. The critical link is a four-letter word: P-L-A-N. Savers with a financial plan retire with about twice the wealth of non-planners.

Don't most people plan for retirement?
Nope, not even one in five. The biannual HRS survey targets people 50 and older, an age when you'd expect some serious efforts at retirement planning. Astonishingly, the article reports that less than a third of the respondents have tried to calculate their savings needs, and only 18% reported success in developing a savings plan.

The failure to plan is probably a carry-over from previous generations. When today's Boomers were children, pensions were common, life expectancies were shorter, and families often supported elderly parents. Today the pension is fast becoming a relic, people are living longer, and less than half as many elderly live with their children. The problem is worsened by a shaky of Social Security system and health care costs growing at twice the rate of inflation.

Foolish dollars and sense
The fact that you read Fool articles is evidence of your financial literacy. But are you still among the vast majority with no retirement plans? You may understand compound interest, but that won't transport you to retirement bliss. For that, you need a plan.

"But I'm good with money!" you exclaim. "I have a 401(k), and last year I opened a brokerage account and invested in some of my favorite stocks."

Great! Perhaps you follow the markets on Yahoo! (NASDAQ:YHOO) Finance and earned some money selling stuff on eBay (NASDAQ:EBAY). You shop at Amazon.com (NASDAQ:AMZN) using your Dell laptop (NASDAQ:DELL) and use Google (NASDAQ:GOOG) to surf the Internet. But your first computer, an IBM (NYSE:IBM) running Microsoft (NASDAQ:MSFT) Windows, has a special place in your heart. So, at the beginning of 2006 you invested some money equally among these stocks.

Your portfolio has increased by 14.4%, which trailed the S&P 500 (after dividends) by a whopping 2.7 percentage points. And how much time do you spend daily checking your stocks, fretting on market downturns, and wondering if you should sell this or buy that?

Have you spent any time in actual retirement planning? Sorry, tracking your portfolio doesn't count.

What's the difference?
Assembling and monitoring a market-beating portfolio is a great start, but even that's not enough. It still leaves some important questions unanswered:

• How much retirement income will you need each year?
• How much do you need to save now to generate that income?
• How will you protect your savings from the ravages of inflation?
• How much can you safely withdraw to ensure your money lasts as long as you do?

You can start to answer those questions by being among the prudent minority who calculate their retirement savings needs, which can be done using a retirement calculator.

For the more detailed planning you need -- as well as a more sophisticated number cruncher -- join The Motley Fool's Rule Your Retirement service free for 30 days.

You'll have access to all the past issues, special reports, and the DirectAdvice Financial Planning Tool, which steps you through a personalized planning interview and handles all the calculations for you. Get started building your plan with Rule Your Retirement today.

Fool contributor Doug Short (TMFDoug) is a happily retired Fool whose major hobby is retirement planning. He's an accredited asset management specialist and is available to answer questions on the discussion boards at Rule Your Retirement. Doug owns shared of Microsoft, which is also an Inside Value pick. Dell is a Stock Advisor and Inside Value pick. Amazon, eBay, and Yahoo! are Stock Advisor picks. The Fool has a disclosure policy.