Knowns and Unknowns

While reading about the results of a recent investor survey from the American College of Financial Services, I couldn't help thinking about former Secretary of Defense Donald Rumsfeld's incredible riff on "Known Knowns" from back in 2002. The display came during a press conference and was in response to a question about a growing lack of evidence linking Iraq to WMD (a link to the short video is below if you'd like a reminder).

What could this possibly have to do with financial planning? Well, Americans continue to be surprised by how wrong they can be about what they think they know about finance. In its survey, the American College showed that about 75% of around 1,200 respondents failed a 38-question quiz on a range of retirement income topics. The quiz was not complicated, but covered a variety of topics that investors approaching retirement should be aware of.

Americans aged 60 to 75 and with at least $100,000 of investible assets were surveyed, so the high failure rate is troubling. This is the age-range when people really need to know this important, fundamental information, but most don't.

There are many "known knowns" represented in this quiz that are instead "unknown unknowns" for a large swath of the investing public. It appears that most people gearing up for retirement simply don't know what they don't know. And this, of course, is a huge risk for their financial future.

Even among the 61% of self-reported "highly knowledgeable" respondents, only 33% passed the quiz. And only 6% of all respondents earned an A or B, so most who passed barely did so. Demographics played a role in this, as you might imagine. Men scored higher than women, which is unfortunate considering women have a longer life expectancy and will disproportionately bear the brunt of poor planning later in life. Also, high school grads underperformed their college-educated brethren substantially. But again, most respondents failed the quiz.

Here are four questions (and answers) I pulled from the quiz results. As you can see from the answers, these are questions respondents had a harder time with. Take a look to get a feel for the quiz and consider taking it yourself.

You don't need to be an expert in these topics since you have me in your corner and that's my job. But you should familiarize yourself with the topics. Feel free to ask questions and maybe we can incorporate them into your next review.

9. The lifetime income payout rate (the annual annuity payment as a percentage of the purchase price) for an immediate income annuity for a 65-year-old male today is roughly...

A: 3-4%
B: 6-7%
C: 10-12%
D: 14-15%

The correct answer is B. Only 17% of survey respondents answered this question correctly. This is a hard question, but if a retiree is considering purchasing a life annuity as part of a retirement plan, it is helpful to know how much it will cost. If the safe withdrawal rate from a portfolio is 4% and the payout rate for an annuity for a 65-year-old male is 6-7%, the annuity begins to look attractive considering it is low risk and requires no ongoing consideration while investing the portfolio is full of complexity.

12. What is the proportion of the population that is going to need assistance with activities of daily living (need long-term care) at some point?

A: 10%
B: 25%
C: 50%
D: 70%

The correct answer is D. Only 18% of survey respondents answered this question correctly. This fact points out that the majority of Americans will need long-term care at some point in their lives. The odds are so high—everyone needs to consider that this is an issue that is likely to affect them.

29. If 100% of a mutual fund's assets are invested in long-term bonds and the investment climate changes so that interest rates rise significantly, then the value of the mutual fund shares...

A: Decrease significantly
B: Increase significantly
C: Will not change at all
D: May rise of fall depending on the type of bond

The correct answer is A. Only 34% of survey respondents answered this question correctly. Investors often think of bonds as low-risk investments. They forget that the value of bonds varies depending upon the relationship between the interest rate paid by the bonds and the interest rates available in the market. When interest rates are rising, the market is offering higher interest rates on new bonds than the existing bond holdings, reducing the value of the existing bonds. In retirement income planning, sometimes individual bonds are purchased to provide income needs. If the interest and principal of the bond is going to be spent to meet income needs, the price variation of the bond is less important. In this case, what is more important is that bonds can provide specific income with certainty for a predictable cost.

30. Historically, which one of the following generates the highest returns over a long time period?

A: Dividend paying stock funds
B: Large company stock funds
C: Small company stock funds
D: High yield bond funds

The correct answer is C. Only 10% of survey respondents answered this question correctly. Small company stock funds carry more risk, which means that performance varies a lot from year to year. But on average, to compensate for that risk, returns are generally higher. From 1926 through 2012, small-cap stocks averaged an annual return of 12.28% compared to 10.08% for large cap, according to Morningstar Ibbotson data.

Here's a link to the quiz: http://retirement.theamericancollege.edu/retirement-101/2017-retirement-income-literacy-quiz

Or, you can jump ahead to the answers: http://retirement.theamericancollege.edu/node/1416/quiz-results/398541/view

Rumsfeld's stand-up act: https://www.youtube.com/watch?v=GiPe1OiKQuk

Have questions? Ask me. I can help.