Why Does Financial Knowledge Matter in Retirement Planning?

Financial literacy is beneficial for achieving financial well-being, yet acquiring these skills can be challenging for investors. In a recent paper, The Production of Financial Literacy¹, we explore the accumulation process of financial knowledge, finding support for a learning-by-doing process: Investors learn about finances as they invest—either by understanding products beforehand or by discovering new financial insights through outcomes. Plan sponsors are well-positioned to help facilitate this approach.

We identify two main factors that influence knowledge accumulation—the first one being resources. As expected, those with higher incomes and greater savings tend to invest more and, in turn, gain more financial knowledge. Employers can support this process by promoting retirement plans, which nudge employees to increase their savings and investments. Therefore, increasing employees' resources helps prepare them for retirement and helps enhance their well-being by creating diversified portfolios, reducing borrowing costs, and establishing emergency funds—among many other benefits linked to greater financial literacy. Morningstar Retirement Manager can help put employees on the path to their retirement goals with personalized advice on how much to save, which investments to choose, when to retire, and more.

The second factor is risk tolerance. We find that high risk aversion can hinder the gain of financial abilities. Individuals who keep their savings solely in checking or savings accounts not only miss exposure to other financial assets, but also skip the chance to learn more about finance and build financial knowledge.

This is not a call to invest in riskier assets or to change the inherent risk tolerance of investors. Instead, this second factor emphasizes another way employers and plan sponsors can help employees in gaining financial competence. By participating in plans that include assets and funds beyond basic bank accounts, employees are more likely to encounter advanced financial products, increasing the chances of learning about them. While risk tolerance is a personal characteristic that is not likely to be altered, exposing employees to investment options typically favored by those with lower risk aversion can enhance their financial understanding.

One of the main benefits of this accumulation process is the positive feedback between financial resources and financial knowledge. By promoting resource accumulation through employer-sponsored plans, employees are more likely to build financial knowledge and make better investment decisions outside the sponsored plan, further increasing their wealth. This cycle starts a virtuous pattern that enhances employees' financial well-being throughout their lives.

This is one reason why supporting employees earlier in life can lead to even greater benefits. Our research shows that small differences in financial knowledge at a young age can compound into substantial wealth disparities by retirement. The finding reinforces a growing body of literature indicating that financial education interventions can have enduring impacts on financial well-being.

Encouraging employees to save more can also “crystallize” their financial knowledge. Financial knowledge tends to persist, especially in older investors, so what is learned today aids future accumulation. For instance, understanding basic concepts, like compounding and net present value, provides a foundation for grasping more complex ideas related to financial markets and assets.

Additionally, employees who are encouraged to gain financial knowledge may also benefit from professional financial advice. While many view financial advice as a substitute for financial literacy, ample evidence suggests that financially savvy individuals seek higher-quality advice, often from professional advisers. Improving financial literacy helps investors recognize when to seek advice and understand the guidance they receive. Rather than empowering investors to make decisions independently, financial literacy helps them know when and how to use professional advice, benefiting both advisers and investors by making financial planning more effective and investors’ personal finances more solid.

The benefits extend beyond plan sponsors, financial advisers, and employees—they also carry significant macroeconomic implications. Our research shows that improving financial literacy not only enhances individual well-being but also reduces inequality. According to our estimates, around one-fifth of wealth inequality at retirement can be attributed to disparities in financial literacy. Early differences in financial knowledge exacerbate wealth gaps over time, leading to greater inequality by retirement. Thus, programs that level financial literacy could also help decrease wealth inequality.