Question

In order to vest in the pension plan, Sarah must work at her job for 10 years and contribute 2% of her salary to the pension fund. If she does works at least 10 years, she will receive a percentage of the last year before she retires salary. Assume the amount she receives each year in retirement is 40% of her final salary and is guaranteed to be paid out each year until death. If she does not stay the full 10 years, she will be refunded the amount she has contributed, plus 1% interest. Alternatively, she can contribute 5% of her salary into a 401 (k) plan and UConn will match it with 5% of her salary (i.e. she puts in $1, UConn also puts in $1). There is no vesting period in order to receive this matching and she can walk away with the full amount if she ever decides to leave. There are three different investment options – a safe investment that cannot go down in value and generates a 3% return annually, a passive market index that moves up and down with the S&P500, and actively managed mutual fund that holds a mix of stocks and bonds.

What information would you need from Sarah in order to give her sound advice?

Answer 1

Sarah has to decide if she is risk friendly or risk averse; the three investment options given in the question have different risk characteristics as follows:

a. A safe investment that cannot go down in value and generates 3% return annually - If Sarah is risk averse then this option would be safe for her as it gives guaranteed principal value and additionally it also give 3% return annually.

  b. A Passive Market Index that moves up and down with S&P 500 - If sarah is risk friendly then she can choose this option of investment; she would benefit from this investment option if she is of the opinion that the market index will go up in the coming years.

c. Actively managed mutual funds that holds a mix of stock and bonds - If sarah is risk friendly then she can choose this options as this options falls in between Option a and Option b because the mutual fund comprises of both stock and bonds; the value of the stocks are generally market driven and bonds generally come with a defined principal repayment.