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25 terms every retirement saver should know

A lot of people tell me how annoyed they are by the jargon they come across while planning for retirement. At best, these financial terms can put you to sleep; at worst, they are confusing enough to cause bad financial decisions. So I thought it might be a great idea to run through some key terms that every retirement saver should know:

 

401(k) – The most common type of workplace retirement plan, a 401(k) allows employees to defer up to $18,000 of their annual salary on a pretax basis. Employers will typically match your contributions, up to a certain percentage point. Savings are typically pooled into mutual funds, where, due to compound interest, they can grow considerably. Distributions are made during retirement and taxed as ordinary income.

 

403(b) – Like a 401(k) but for employees of tax-exempt, nonprofit institutions such as schools and hospitals. The contribution limit and other rules are the same as with a 401(k), but there is rarely an employer match.

 

Asset allocation The strategy of dividing your investments among different assets, such as stocks and bonds. The aim is to put your money in the right place to balance risk and reward. A typical portfolio for a younger saver apportions 90% to stocks and 10% to bonds. Asset allocation adjusts itself automatically in many popular funds, such as target-date funds, based on the risk tolerance and age of the participant.

 

Brokerage account – If you would like access to a wide range of investments you can open a brokerage account and have a financial firm buy and sell stocks on your behalf.

 

Catch-up contributionsRetirement savers aged 50 or over, get the opportunity to “catch up” on their retirement saving: They can contribute an extra $1,000 to an IRA (on top of the $5,500 limit) and an additional $6,000 towards a 401(k) or 403(b) (above the $18,000 limit).

 

Compounding The investments in your retirement account earn interest—and that interest itself earns interest. The longer your money compounds, the faster it grows. Letʼs suppose you own stocks growing at 6% per year; the value of that investment will double in about 12 years but will be worth four times as much in 24 years. The earlier you start saving, the more you benefit from the “magic” of compounding. If saving is delayed, the power of compounding is lost and savers need to defer a greater percentage of their salary to catch up.

 

Defined contribution planDefined contribution (DC) plans, such as the 401(k), have largely replaced old-fashioned defined benefit (DB) plans (where employees were promised a specific benefit in retirement). DC plans shifted responsibility from employer to employee; so now you decide how much to contribute and how that money is invested.

 

Diversification – Spreading your investments across various asset types in order to reduce your exposure to risk. Also known as hedging your bets…or not putting all your eggs into one basket.

 

ERISA – The Employee Retirement Income Security Act was enacted in 1974 to provide protection for an employeeʼs retirement assets (from both creditors and employers). Qualified retirement plans must follow ERISA rules, for example participants must be provided with important information about plan features and funding.


Equities – These are basically pieces of companies, or stocks. A large portion of your portfolio is likely invested in equities because they offer excellent growth potential.

 

FiduciaryWhen planning your retirement, you may come across registered investment advisors and ERISA-appointed fiduciaries. “Fiduciary” is a legal term derived from the Latin word for “trust.” As a fiduciary, your advisor is legally required to put your interests above all others (for instance, the commission they may receive for selling you a product) and act with “care, skill, prudence and diligence.” Fiduciaries have a duty to continually monitor your investments and financial situation.

 

Financial planner – When choosing a financial advisor, make sure he or she is a

Certified Financial Planner (CFP), a title bestowed on professionals who have completed extensive training and experience requirements, and are held to rigorous ethical standards.

 

Fixed annuities – In exchange for a lump-sum cash payment, an insurance company can provide you with a steady stream of income for life (or whichever period of time you choose). The money invested in your annuity is guaranteed to earn a fixed rate of return. Typically you need to wait for a set period of time before your payments kick in.

 

Fixed-income funds - These funds are less risky than equity funds but generally provide less growth. As you near retirement, your portfolio will typically become more weighted towards fixed-income funds, such as bonds.

 

Glidepath – In a target-date (or lifecycle) fund, the glidepath is the formula that determines your asset allocation mix; the closer you get to your target date, the more conservative your portfolio becomes.

 

IRAAn Individual Retirement Account is often used to supplement workplace plans. It has the same tax advantages (contributions are deductible from your gross income) for most people, but the annual contribution limit is much lower ($5,500). If you leave your job you can transfer (or “roll over”) the balance from your workplace retirement plan into an IRA; that way you get to continue enjoying tax-deferred growth on your assets.

 

Lifecycle funds – This a “one-stop” no-hassle fund that many plans use as their default because they require minimum effort from participants. Lifecycle funds are also known as target-date funds; they use your estimated retirement date as a target, and follow a glide path to automatically adjust your asset mix as you near retirement.

 

Load and no-load fundsWhen brokers pick out a mutual fund for you, they often charge you for the recommendation. This sales charge is also known as a “load.” In other words, no-load funds cost you nothing to purchase; load funds do.

 

Mutual fund – Professionally managed funds that pool money from many investors to invest in stocks, bonds and other securities. Typically, the cash you put into your retirement plan will be invested in mutual funds.

 

Risk tolerance – Determines how conservatively or aggressively your investment strategy should be. Your risk tolerance profile comprises many factors, including your age, financial circumstances and personality. Often, younger people have more tolerance for risk since they are decades from retirement, and typically apportion 90% or even 100% of their assets to stocks.


Roth IRA – With a Roth IRA, you make contributions on an after-tax basis, which means itʼs a great way to set aside some tax-free retirement income. There are income limits for contributing to a Roth IRA, so they arenʼt an option for higher earners.

 

S&P/Dow – Although people talk about “the market,” there are several indexes that investors can use to try and make sense of movements in the stock market. The two main indexes are the S&P 500 and the Dow Jones Industrial Average. The Dow includes 30 of the biggest U.S. companies, representing about a quarter of the entire U.S stock market. The S&P 500 represents about 70% of the total value of U.S. markets, so captures a wider, more diverse segment of the economy. The average retirement saver will not benefit from tracking the market on a daily basis, since retirement investing is a long-term game; investors who are many years away from retirement are generally advised to leave their stocks alone, and avoid panic when the stock market plunges. By gradually allocating assets away from stocks as they near retirement, long-term savers are well-positioned to weather the ups and downs.

 

Self-directed IRAs – If you prefer a more hands-on approach to investing, you can call the shots and enjoy complete control over your investment choices. Most retirement plans offer varying degrees of self-directed investing.

 

SRI funds – Socially Responsible Investing seeks not only financial return but also considers the environmental and social impacts of companies whose stock may be invested in.

 

Variable annuities – Like a fixed annuity, you are handing over a lump sum in exchange for a steady income in retirement. The difference is, you get to choose from a mix of investments. The size of your payments will vary according to how those investments are performing.

 

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