Question

Many employers provide 401K matching That is, once an employee has been with the firm for a sufficient period (often one year), the firm will match the employee’s contributions to the firm’s available 401K plan up to a certain percentage. Assume that an employee has just become eligible for the firm’s matching plan. In this case, the firm will match the employee’s investments up to 6% of the employee’s salary. (If the employee contributes 1%, the company puts in 1%, likewise up through 6%. If the employee puts in more than 6%, the company’s contribution remains at 6% of the salary.) If the 401K investment plan currently has earned an average of 5% per year for the past 5 years, consider the following:

What percentage of their salary should this employee invest in the 401K if they believe that they can earn 8% per year in an ETF (exchange-traded fund)? How does the current investment environment affect this employee’s decision? What might be circumstances you can envision that might change the employee’s investment decisions? Use the time value of money concepts that you have learned in this class to help you consider this problem. Be sure to consider the benefits and risks of investments in general and those for this example in particular. If you decide to use numeric examples, be sure to state your assumptions.

Note: 401K and similar plans allow employees to invest pre-tax funds as savings for their retirement. Taxes are paid when the funds are withdrawn during retirement, with steep penalties for early withdrawal of funds. “Regular” investments are made with after-tax funds.

Answer 1

1. Employee can invest upto 6% in the 401K as he/she is earning in ETF of about 8% , so if they invest 6% in the 401K , there will not be a loss to the employee and it can save 2% i.e (8%- 6%).

2. As currently 401k plan earned an average of 5% which is very low because of this employee decision can be changed.

3. Time Value of money is a concept by which we are able to calculate future value of money by using P.V or Present value

In this question they have clearly mentioned about the 401K investment and it's future value after 5 years by which we are able to know that how much employee can earn after 5 years.