Advantages of Mutual Funds and 401ks

The Benefits of Mutual Funds and Employers Matching Employees’ Pension Contributions 
Question 1

Investing in a mutual fund has major advantages compared with investing in the company stock. The first benefit is diversification of risk. Mutual funds invest in many different companies, often across different industries (Bogle, 2015). This means if the value on one share in the portfolio falls, or evens collapses, it will not result in a significant decline in portfolio value (Bogle, 2015). This reduces the risk when compared to any investment in a single stock, where a change in the share price will impact directly on the value of the investment (Bogle, 2015). The purchase price of the investment units in the mutual fund will also reflect market condition, as they are determines by the underlying asset prices (Howells & Bain, 2007). This is an advantage compared to the company stock, as the firm is currently private, with the prices set not by market condition, but by the directors which may result in biased valuation and increased risk of potentially over paying for shares. In addition, the mutual fund is more liquid, as the underlying assets are more easily tradable compared to private shares (Howells & Bain, 2007), and there is no guarantee that the company will go public. 

Question 2
    
The EAR is the annual equivalent rate, returning to the rate of return that is received calculated as an annual return (Investopedia, 2016). In this scheme it is stated that a 5% contribution of salary will be matched by the firm. If the new employee is on a salary of $50,000, the following will be the contributions for the year.   

Table 1; Total pension contribution
Salary    50,000
Employee contribution    2,500
Employer contribution     2,500
Total contribution     5,000

The calculation of an EAR is undertaken to assess a return when there are payments received on an investment over a period of time, with the calculation often needed due to the compounding effect; where interest is paid on the total value of an investment, which can include the interest from previous periods (Investopedia, 2016). However, in this case, looking only at the EAR that is gained from the matching process, and not any additional gains made by the underlying investment, there is no mismatch between the timing of the employees investment and the return created by the employers matching contribution; they take place at the same time. While figures given above are annual, the contributions and the matching payments will be monthly. 

As there is no need for the adjustments which are made when interest is paid periodically on a lump sum, the calculation is simple; calculate the percentage return that is provided by the matching sum, this is (amount gained/investment amount) x 100
(2,500/2,500) x 100 = 100%. 

Therefore, the EAR from the matching scheme is a 100% return. This means that the investment appears to be very advantageous for the employee, as they make an initial 100% gain before the money is even invested and has chance to EAR from the underlying assets. The benefit is greater than just this initial gain, as the additional investment may also make gains in the investments, and these gains will help to support increased compound growth, as interest (gains) are earned on the total value of the investment, which will include the interest earned in the previous periods. 

This matching scheme may be seen as providing a good incentive for the employee to invest in a pension scheme, which is also supported by the advantageous tax treatment of any funds one invested. This means that the pension plan is likely to offer the greatest potential for growth, making it the most suitable investment vehicle when saving for retirement.