The amount of financial jargon used by financial advisors, especially in the retirement plan space, can become overwhelming and intimidating very quickly. If you can relate to this, you are not alone. The general public, according to a recent Empower Retirement survey, often misunderstands words that are commonly used by financial providers, employers and others in the retirement planning industry. Below are a few examples defined in plain English.
Traditional: A traditional tax-advantaged account is a way to save for retirement that gives you tax advantages. Contributions you make to a traditional tax-advantaged accounts may be fully or partially deductible, depending on your circumstances. Generally, amounts in these accounts (including earnings and gains) are not taxed until distributed. Therefore, the taxes are deferred. Examples of Traditional tax-advantaged accounts include but are not limited to Traditional IRA’s, SEP IRAs, Traditional 401ks.
ROTH: A ROTH account holds your retirement investments and encourages you to save by offering you a tax benefit. Although these contributions are not tax deductible, the investment earnings grow tax free, which allows for tax-free distributions in retirement. Examples of ROTH accounts include ROTH IRAs and ROTH 401ks.
IRA: An Individual Retirement Account (IRA) is a tax-advantaged account that is designed to help you save for retirement. There are two different types of IRAs: Traditional and Roth IRAs.
Deferral: This is simply the percentage of your paycheck that you contribute into a 401(k) plan or the amount of funds contributed to a Traditional tax-advantaged account on which taxes will be deferred.
Defined Contribution: This term sounds a bit odd, but easy to understand when broken down. When an individual decides to contribute a percentage of their paycheck into their 401(k), you may hear the plan called a ‘defined contribution’ plan, which simply means a workplace savings plan.
Basis Points: This one takes a while to understand, especially if you don’t hear it all the time. In finance, individuals use this term to avoid ambiguity in discussions about rates. Basis points are used to understand percentages under 1%. One basis point is equal to one one-hundredth of one percentage point (.01%). Therefore, 100 basis points = 1%. You may see the expenses you pay for your workplace plan referred to as a certain basis point (or percent) of assets.
Asset Classes: Asset Class refers to a type of asset an investment (fund) may invest in. For example, five friends walk into a bakery and buy a treat. There are 5 total asset classes and each of them represent a dessert. So, let's say stocks are donuts, bonds are muffins, real estate is cookies, commodities are cupcakes and cash is pie. Now because each friend buys a different dessert, which has a different taste and satisfies each person differently, we cannot truly compare them without taking the differences into account. Same is true about comparing how a fund performs. If I am comparing my fund to another fund, it is important that the comparisons are equal. Participants often compare how a fund performs without regard to the asset class the fund is intended to invest in or the objectives of the fund. So, it is important to understand the asset class the fund invests in in order to understand how well that fund is doing versus other funds in the same asset class.
Dollar-cost averaging: When you invest in your 401k plan, you have the option to invest a fixed amount of money at regular intervals over a long period. So, when you receive a paycheck, a fixed amount will be invested on a weekly or monthly basis in your 401(k) This investing technique means you invest when the market is up and when the market is down allowing you to take advantage of different prices over time and hopefully avoid “chasing” returns or trying to time when to invest. Over a period of time, studies have shown that dollar-cost averaging can have a positive impact in the overall return of a portfolio.
Risk: This is a term that some are comfortable with, while others maybe not so much. Risk is often expressed as “volatility.” Volatility is the movement of an asset moving quickly down or up in price in a short period of time. At its core, risk measures the probability of loss or exposure to loss of investment. Risk will vary based on a multitude of factors.
Glide Path: You may hear this term when someone speaks about a certain investment option available in your retirement plan called a Target Date Fund, or TDF. The “Glide Path” refers to how the TDF reduces risk over a period of time, moving the fund from high risk (stocks) to lower risk (bonds) assets. The “target” for the fund is typically age 65, which will correlate to the date in the fund –e.g. Target Date 2050 (a participant is expected to turn 65 in, or around the year 2050). The younger, or further away, the participant is from the year 2050 the more risk (conceptually) the participant can take on. As the participant nears age 65 (the year 2050) the fund reduces the risk. Kind-of like gliding down a slide, the higher the slide, the more perceived risk, as you slide toward the bottom of the slide, there is less perceived risk.
Vesting: You may hear this term when you learn about the money your employer is putting into your retirement account to help you save for your future. Vesting just refers to an employees’ entitlement (or ownership) to the money their employer has deposited into their retirement account. When an employer’s match contribution becomes “fully vested” it means an employee will receive 100% of the employer money after a stated period of time. A match contribution refers to a matching dollar amount contributed by an employer to the retirement savings account of an employee who makes a similar contribution, usually to a 401k plan.
Portfolio: Think of a portfolio like an account that holds the various investments in your retirement plan.