An analysis of employee retirement plans found evidence supporting a link between greater financial literacy and greater retirement wealth. Employees who are more literate about financial and investment concepts allocate more to stock funds, own portfolios with higher expected returns and diversify better. They also have portfolios that are less likely to encounter volatility caused by factors related directly to one type of fund.

The results are similar to those of prior studies. People who are financially savvy have been shown to have more retirement savings, have higher equity allocations and do a better job of diversifying their investments. What made this study unique was that the researchers had access to data on actual defined-contribution [e.g., 401(k)] savings accounts.

The researchers looked at administrative records on accounts of Federal Reserve System employees. They were able to see what the employees held and the returns realized by each employee. Additionally, an Internet survey was conducted to test the financial knowledge of individual employees. The survey asked five questions covering compounded returns, the impact of inflation on purchasing power, diversification, the tax savings of pretax contributions and employer matching contributions.

The surveyed employees proved to be more financially literate than the American population as a whole, which was not surprising given their employer. On average, survey respondents got 3.8 out of all five questions correct.

The least-knowledgeable employees were less likely to hold domestic, international and small-cap stock funds. They had an average equity allocation of 44.3%, whereas the most financially sophisticated employees had a 62.3% equity allocation. As such, the most knowledgeable employees averaged eight basis points (0.08%) per month more in expected excess return.

Not surprisingly, the higher allocation to stock funds meant higher portfolio volatility for the most literate. Idiosyncratic risk was much lower, however. In other words, while increased literacy was associated with greater risk, the more knowledgeable an employee was about personal finance, the more likely he or she was to diversify against the risks posed by a specific fund.

Source: “Financial Knowledge and 401(k) Investment Performance: A Case Study,” Robert Clark, Annamaria Lusardi and Olivia Mitchell, Pension Research Council, June 2015.