Mutual Funds vs. Company Stock and Employer Pension Matching

Advantages of Mutual Funds Over Company Stock

Investing in a mutual fund has major advantages compared with investing in company stock. The first benefit is diversification of risk. Mutual funds invest in many different companies, often across different industries (Bogle, 2015). This means that if the value of one share in the portfolio falls, or even collapses, it will not result in a significant decline in the overall portfolio value (Bogle, 2015). This reduces risk when compared to any investment in a single stock, where a change in share price will directly impact the value of the investment (Bogle, 2015).

The purchase price of investment units in a mutual fund will also reflect market conditions, as they are determined by the underlying asset prices (Howells & Bain, 2007). This is an advantage compared to company stock, as the firm in question is currently private, with prices set not by market conditions but by the directors — a situation that may result in biased valuation and an increased risk of overpaying 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 ever go public.

Understanding the Effective Annual Return (EAR)

The EAR (Effective Annual Return) is the annual equivalent rate — the rate of return received, calculated as an annualized figure (Investopedia, 2016). In this scheme, a 5% contribution of salary is matched by the firm. For a new employee earning a salary of $50,000, the contributions for the year are as follows:

Table 1: Total Pension Contribution

Salary: $50,000
Employee contribution: $2,500
Employer contribution: $2,500
Total contribution: $5,000

The EAR calculation is typically undertaken to assess returns when payments are received on an investment over a period of time. This calculation is often necessary due to the compounding effect, where interest is paid on the total value of an investment — including interest accumulated from previous periods (Investopedia, 2016). However, when looking only at the EAR gained from the matching process itself, and not any additional gains made by the underlying investment, there is no timing mismatch between the employee's contribution and the return created by the employer's matching contribution; they occur simultaneously. While the figures given above are annual totals, both the contributions and the matching payments are made monthly.

Calculating the EAR from Employer Pension Matching

Because there is no need for the adjustments that apply when interest is paid periodically on a lump sum, the calculation is straightforward: compute the percentage return provided by the matching sum using the formula (amount gained ÷ investment amount) × 100.

(2,500 ÷ 2,500) × 100 = 100%

Therefore, the EAR from the matching scheme is a 100% return. This makes the investment highly advantageous for the employee, as they realize an immediate 100% gain before the money is even invested in the underlying assets. The benefit extends beyond this initial gain: the additional funds contributed by the employer can themselves generate returns, and those returns will support increased compound growth, since gains are earned on the full value of the investment — including gains accumulated in previous periods.