Financial literacy: How it affects planning for retirement

10-10-2024

The more you understand about money, the better equipped you are to prepare for retirement. That’s the conclusion from a number of studies that have been conducted to explore the link between financial literacy and retirement preparedness over the past decade, by academics and financial experts. While more than half of the respondents to the 2019 Consumer Financial Literacy Survey conducted by the National Foundation for Credit Counseling (NFCC) said they'd grade themselves an "A" or "B" for their knowledge of personal finance, retirement seems to be a sticking point that still worries many. While most of the survey respondents said they're saving something for retirement, more than one out of four are not at all confident they are saving enough.

If you can relate to those concerns, the solution may lie in giving your financial literacy a boost. Here's a closer look at why having a solid understanding of money can help you better plan for retirement.

1. You’ll be more likely to take advantage of tools that contribute to long-term wealth accumulation.

In one of the studies used to write “Optimal Financial Literacy and Saving for Retirement,” the authors found significant correlation between knowledge and the likelihood that a person would take advantage of sophisticated financial tools and technologies like online investment and retirement accounts, mutual funds, ETFs and other similar strategies to grow their wealth, versus keeping all their funds in a low-yield savings account or cash. The authors concluded that “knowledge allows individuals to invest in high return assets and results in much higher wealth accumulation at the time of retirement.”

2. You'll better determine the balance between risk and reward.

Your retirement strategy should be personal to your unique goals, financial reality, lifestyle, age, age at which you plan to retire and your risk tolerance.

It should account for those areas of your financial life that will change as you age, including your income and other debts like student loans or credit card balances, shorter-term goals like building an emergency saving fund or buying a home or car and your lifestyle.

Your retirement strategy should also account for how you feel about the prospect of losing money or missing out on the opportunity to grow your wealth (your risk tolerance), and how much “reward” you need to see from your investments to reach your retirement goals. Just as investing in a stock exposes you to the risk of potentially losing money, parking all your cash in low-yield investments or in a savings account that may not keep up with the pace of inflation can be risky. The more you understand about money, the more informed you’ll be in choosing the best strategy to reach the retirement you envision.

3. You can create a holistic financial plan that includes retirement and your other financial goals and obligations.

Saving for retirement is just one piece of your financial life. You also need to make choices around how you should pay down debt, balance saving for short-term goals and long-term goals like retirement, whether you should work toward both simultaneously or tackle them one at a time—and how to start taking action on whatever path you determine.

Financial literacy can help you make sense of important but sometimes abstract or confusing concepts, like the snowball or avalanche method for paying down debt, various budgeting techniques, compounding interest, inflation, variable and fixed interest and APR.

4. You'll control your financial fears.

A recent study showed that 59% of Americans fear running out of money more than death. When you understand how to set appropriate retirement goals and take actionable steps to eventually reach them, you can take control of those fears so you can feel less vulnerable.

5. You'll understand how NOT to derail your retirement plans.

Some retirement accounts like a Roth IRA may allow for access to funds without penalty—but there are specific rules around how the money can be used to avoid paying penalties. When you understand them you can make informed decisions.

Retirement contributions can help you manage how much tax you owe now, and in the future—but only if you understand how various types of retirement contributions and earnings on your investments are taxed and when. The more you know, the more you can ensure that the money you’ve put toward retirement works to your advantage.