Understanding the terminology surrounding 401(k) plans can be difficult for those who are new and unfamiliar with the industry, yet is necessary in order to make informed and effective decisions.
In an effort to improve financial literacy surrounding retirement plans, we’ve compiled a list of commonly associated terms and their definitions.
401(k) – A 401(k) is an employer-sponsored retirement plan that is funded directly from an employee’s paycheck. Traditional 401(k) plans allow individuals to make pre-tax contributions, while a Roth 401(k) allows them to make after-tax contributions.
Asset allocation – Simply put, how assets are allocated in a portfolio. Assets are usually divided into different investment categories, such as stocks, bonds, ETFs, and mutual funds.
Assets Under Management (AUM) – Also known as funds under management, AUM is the total number of financial assets that a financial institution manages on behalf of its clients. All 401(k) plans have an AUM fee, however, some providers charge higher rates than others.
Auto-Rebalancing – Auto-rebalancing is when an investment account is “rebalanced” to the original asset allocation that was set based on an individual’s risk tolerance and retirement timeline. This feature is common amongst robo-advisors (such as SaveDay).
Deferral – A deferral is the amount of money that is taken from each paycheck to be invested in a retirement account. Deferrals can either be a percentage (contribution rate) of a paycheck or a specified dollar amount. Businesses that use auto-enrollment will automatically set the contribution rate, but participants can adjust it if they wish.
Bond – A bond is a type of investment that is commonly used in retirement accounts. When an individual invests in a bond, they are essentially loaning money to a borrower, such as the government or a company. As compensation for the “loan”, the borrower pays interest on the bond to the investor.
Exchange-Traded Fund (ETF) – Another common type of investment seen in retirement accounts, ETFs are funds that are passively managed and traded throughout the day on stock exchanges, tracking specific assets. There are several types of ETFs, including – index, commodity, bonds, industry, and many more. The most common type is an index ETF, which is designed to track specific indexes, such as the S&P 500.
Mutual Funds – Mutual funds are similar to ETFs in many ways, such as having a mix of different assets, however, they differ in many ways as well. Unlike ETFs, mutual funds are actively managed, and can only be purchased at the end of the day. Since mutual funds are actively managed, they tend to have higher fees and higher expense ratios than ETFs.
Net asset value (NAV) – NAV is commonly used when discussing mutual funds and ETFs. Simply put, it is the cost (or value) of shares/units in the fund. The NAV of a share/unit is calculated at the end of each trading day.
Plan Administrator – A plan administrator is responsible for all administrative tasks associated with owning a 401(k) plan, including (but not limited to) recordkeeping, compliance, and participant loans and distributions. Some 401(k) providers, such as SaveDay, will act as the plan administrator and take care of these duties. If not, then someone within an organization must take on the responsibility of a plan administrator.
Plan Provider – A plan provider is an entity or individual who provides a business or organization with their 401(k) plan. As mentioned above, some providers will also act as the plan’s administrator, but not all do. Each provider will have different fees, investment options, and services, so it’s important to find a provider that will meet your needs.
Plan Sponsor – Plan sponsors are responsible for setting up the plan for their business or organization and its employees, and ensuring the plan is in compliance with the IRS. They ultimately oversee the plan and are responsible for ensuring that all information is correct and up-to-date to avoid issues that may arise with the plan administrator or provider.
Rate of Return – Rate of return is used to measure the performance of a 401(k) portfolio. How a portfolio performs, and therefore its rate of return, is calculated based on different factors, such as asset allocation, market conditions, and more. While rates of return are different for everyone, the industry average is 3% to 8%.
Rollover – Transferring a 401(k) plan from one provider to another (or from one employer to another), is known as a rollover. Lower plan costs, better investment options, or switching employers are all common reasons why an individual or a company may rollover a plan.
Stocks – Stocks are shares of a company. When an individual purchases stock in a company, they are essentially taking a divided share of ownership in that company. Individuals who invest in stocks do so in hopes of receiving a return on their investment, whether that is through dividends or selling shares at a higher price than what they were purchased at.
Target-Date Fund – These funds consist of either ETFs or mutual funds, and are designed to rebalance asset allocations in an effort to minimize risk as an individual approaches their “target-date”, which may be retirement or another important life moment that they are saving for.
Vesting – In terms of 401(k) plans, to be vested in a 401(k) means that an individual owns the money that is in it. Participants will always be 100% vested in their contributions, but may not be fully vested in their employer’s contributions. In this case, participants will follow a “vesting schedule”, or in other words a timeline of how much ownership they have in their employer contributions dependent on years of service. Vesting schedules are determined by the plan document.
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