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 Personal Finance Terms

401(k) plan A defined-contribution retirement plan that allows an employee to contribute pretax dollars to a company pool that is invested in stocks, bonds, or money market instruments. Named after the section of the Internal Revenue Code that created it.

403(b) plan A defined-contribution retirement plan available to employees of public schools, certain tax-exempt entities (including churches), and educational institutions. Allows an employee to contribute pretax dollars to a company pool that is invested in stocks, bonds, or money market instruments. Named after the section of the Internal Revenue Code that created it.

annuity A series of fixed-amount payments paid at regular intervals over the period of the annuity.

asset allocation Dividing your investment portfolio among the major asset categories such as stocks, bonds, and cash. Determines the risk and return of your portfolio.

cash value In a life insurance policy, cash value is the build-up in the owner's cash savings. At any point in time, it represents the amount of money (before adjustments) that would be returned to the policy owner upon cancellation of a policy.

compound sum of an annuity Constant payments are made at equally spaced time periods and grow to a future value.

defined-benefit plan Pension plan that pays a specified amount to employees who retire after a set number of years of service. Plans do not pay taxes on investments; usually all contributions are made by the employer.

defined-contribution plan A type of retirement plan where the ultimate benefits that are paid out depend on the level of contributions made to the plan and the investment performance of those contributions.

diversification The process of accumulating securities in different investments, types of industries, risk categories, and companies in order to reduce the potential harm of loss from any one investment.

expected return The average of a probability distribution of possible returns.

financial planner An investment professional generalist who helps individuals delineate financial plans with specific objectives and helps coordinate various financial concerns.

guaranteed investment (interest) contract (GIC) Debt instrument sold in large denominations often bought for retirement plans. The word guaranteed refers to the interest rate paid on the GIC; the principal is at risk.

holding period return/yield Income plus price appreciation during a specified time period divided by the cost of the investment.

individual retirement account (IRA) Personal retirement account that an employed person can set up with a deposit that is tax deductible up to a set maximum per year. Such deposits qualify as a deduction against income earned in that year and interest accumulates tax-deferred until the funds are withdrawn at age 59 1/2 or later. Early withdrawals are subject to a penalty. (See also Roth IRA.)

inflation risk Uncertainty over the future real (after-inflation) value of your investment.

Keogh A tax-deferred retirement account designated for employees of unincorporated businesses or for persons who are self-employed (either full-time or part-time).

lump-sum distribution A single payment to a beneficiary covering the entire amount of an agreement. Participants in individual retirement accounts (IRAs), pension plans, profit-sharing, and executive stock option plans generally can opt for a lump-sum distribution if the taxes are not too burdensome when they become eligible.

Medicare A U.S. Social Security Administration program that reimburses hospitals and physicians for certain medical care to qualifying persons over the age of 65.

modern portfolio theory (MPT) Overall investment strategy that seeks to construct an optimal portfolio by considering the relationship between risk and return, especially as measured by alpha, beta, and R-squared. This theory recommends that the risk of a particular stock should not be looked at on a stand-alone basis, but rather in relation to how that particular stock's price varies in relation to the variation in price of the market portfolio. The theory goes on to state that given an investor's preferred level of risk, a particular portfolio can be constructed that maximizes expected return for that level of risk.

pension Fund set up by a corporation, labor union, governmental entity, or other organization to pay the pension benefits of retired workers.

present value The value today of a future payment, or stream of payments, discounted at some appropriate interest rate.

real rate of return The annual percentage return realized on an investment, adjusted for changes in the price level due to inflation or deflation.

risk Possibility that an investment's actual return will be different than expected; includes the possibility of losing some or all of the original investment. Measured by variability of historical returns or dispersion of historical returns around their average return.

risk/return trade-off The balance an investor must decide on between the desire for low risk and high returns, since low levels of uncertainty (low risk) are associated with low potential returns and high levels of uncertainty (high risk) are associated with high potential returns.

RiskGrade A measure that standardizes risk by taking the average standard deviation of all the world's equities and assigning it a standard deviation value of 100. All other standard deviations are expressed as a percentage of that figure. Developed by RiskMetrics Group (www.riskgrades.com).

Roth IRA Individual retirement plan. Contributions are not deductible, but qualified distributions are tax free.

R-squared A measurement of how closely a portfolio's performance correlates with the performance of a benchmark index, such as the S&P 500, and thus a measurement of what portion of its performance can be explained by the performance of the overall market or index.

standard deviation A measure of the degree to which returns of an asset vary around the mean.

term life insurance A type of life insurance where the insured only pays for the cost of protection of death. No cash value is built up, so term insurance is cheaper; however, as the insured gets older, the cost of premiums increases.

unit investment trust A company that purchases securities (usually fixed income) and sells shares representing proportional interest in the portfolio of those securities. The trust is liquidated when the securities mature.

universal life insurance A form of whole life insurance in which premium payments and coverage is more flexible, allowing increases and decreases without additional sales charges.

variable annuity A life insurance company investment product that combines a savings plan with a small life insurance component to provide certain tax benefits. The savings portion can be invested in a choice of pooled vehicles, including stock funds.

variable life insurance A form of whole life insurance that allows the cash value portion to be invested in stock, bond or money market portfolios.

whole life insurance Insurance that provides protection if the insured dies while also building up cash value. Premiums are high but level, and include the cost of term insurance plus a savings component.