Sometimes financial terms can sound like a foreign language. Target-date funds. Asset allocation. Expense ratios. And when saving for retirement is already as challenging as it is, not fully understanding how your retirement fund works can make it all the more difficult.
If you have a 401(k) through your employer, you may be contributing a little bit of each paycheck. That's all well and good, but if you leave it at that without understanding how you could be maximizing your contributions, you may lose out on free money offered by your employer.
Image Source: Getty Images
The jargon surrounding 401(k) plans can deter people from taking advantage of them. In fact, language can have a major impact on how likely investors are to utilize their 401(k)s, according to a 2018 study from Invesco. Researchers found that the words employers use to describe the company's retirement fund affect how well participants understand the plans.
For example, if you had the option to invest in a target-date fund because it's a) "a customized strategy designed to help you balance growth potential and risk tolerance as you get closer to retirement," or b) "an all-inclusive asset allocation portfolio that is dynamically balanced with investments that have a low correlation," which would you choose?
If you picked option A, you're not alone -- according to the researchers, 48% of participants preferred that language, compared to just 19% who preferred the language in option B.
By simply understanding the jargon behind your 401(k) and how these funny terms impact your retirement, you will probably boost your savings over time. These are some of the most common terms you'll come across in your 401(k) plan that could ultimately impact how much you have saved when it's time to retire.
1. Employer matching contribution
An employer matching contribution is essentially free money from the company you work for. Not every 401(k) plan has an employer match, but if yours does, you certainly won't want to miss it, as the extra money regularly added to your fund can really turbocharge your savings when combined with compounding over time.
If you get a match, here's how it works: For every dollar you put into your 401(k), your employer will match a percentage of it, like 50% or 100%. There's a maximum so they'll match up to a certain limit, usually 3% to 6% of your salary. It's smart to contribute at least enough to earn the full match. Often times, that extra little bit can go a long way over time.
For example, say your employer will match 100% of your contributions up to 3% of your salary. If your salary is $50,000, that's $1,500 per year of free money. Now, if you're currently contributing $1,000 per year to your 401(k), which your employer matches, and your investments earn an annual rate of return of 7%, you'd have around $190,000 after 30 years. But, if you increased your investment to $1,500 per year to earn the full employer match, you'd have amassed roughly $283,000 over the same time period.
2. Target-date fund
When you're deciding how to invest your money in your 401(k), you're usually presented with a few different options -- one of which may be a target-date fund.
Typically, the name of the target date fund includes a year, such as Target-Date Fund 2020 or Target-Date Fund 2060. That date is your theoretical retirement year, when you would start making withdrawals from your 401(k) to fund your retirement.
In other words, if you invest in a Target-Date Fund 2040, your money in that fund will be invested in a way so that ideally, you'll have enough saved to retire by 2040. As you get closer to that target date, your money is shifted to more conservative investments to limit your risk, following a glide path, which is the gradual transition from an aggressive stock-based portfolio to a conservative one with more money allocated into stable bonds.
A target-date fund is essentially a one-stop-shop for investing, because your money is spread across a diverse set of investments. You don't need to decide exactly where to invest your money; rather, you can simply put all your retirement contributions into one target-date fund, and your money will be allocated to the right investments so that you reach your goal by the time your target date rolls around.
3. Expense ratio
There's no such thing as a "free" 401(k), and the fees associated with retirement funds are often misunderstood.
In fact, 37% of investors mistakenly believe they don't pay any 401(k) fees at all, according to a survey from TD Ameritrade, although the truth is that every retirement fund has some sort of fee attached to it -- after all, the financial experts behind the funds have to make money somehow.
The most common fee is the expense ratio, which is the percentage of the fund that goes toward management and administrative costs. The average 401(k) plan expense ratio is around 1% of assets managed, according to the Center for American Progress (CAP), so if you have $100,000 in your 401(k), $1,000 goes toward fees each year.
One percent may not sound like a lot, but because the expense ratio is a percentage of the total amount you have in your 401(k), the more you save, the more you pay in fees -- which can make a serious dent in your overall savings.
The average American will pay around $138,000 in fees over a lifetime if they start saving at 25 and are paying annual fees of 1%, according to CAP. High earners stand to pay even more -- to the tune of more than $340,000 in fees alone over a lifetime.
While you may not be able to control the amount you pay in fees, you can educate yourself on what you're paying so you know how it will affect your savings. If your 401(k) has an expense ratio that's higher than average, you might consider contributing enough to earn the full employer match, and putting the remainder of your retirement savings in an IRA with lower fees.
Pay attention to your 401(k)
The world of finance can be confusing. And let's face it: It's not the sexiest subject, and not everyone wants to understand the complex jargon behind their retirement fund. However, making an effort to understand some of the more fundamental terms can give you an advantage as you're planning for retirement. The more you know, the better decisions you can make -- and the more money you'll save and the happier you'll be in retirement.
