Retirement Planning at J&J Bagel;

You recently graduated from Suffolk University, and your job search led you to J&J Bagel, Inc.
As you are finishing your employment paperwork, Jerry Chen, one of the co-owners of J&J Bagel,
informs you about the company’s new 401(k) plan.
A 401(k) is a type of retirement plan, offered by many companies. A 401(k) is tax deferred,
which means that any deposits you make into the plan are deducted from your current income, so no
current taxes are paid on these deposits. For example, if your annual salary is $30,000 and you contribute
$1,500 to the 401(k) plan, you will pay taxes only on the $28,500 in income. No taxes will be due on any
capital gains or plan income while you are invested in the plan, but you will pay taxes when you withdraw
the money at retirement. You can contribute up to 15 percent of your salary to the plan. As is common,
J&J Bagel has a 5 percent match program. This means that the company will match your contribution
dollar-for-dollar up to 5 percent of your salary, but you must contribute to get the match. In other words,
if you contribute 5 percent of your $30,000 salary (which is $1,500) towards the 401(k) plan, J&J Bagel
will match your contribution by adding another $1,500 to your plan, so that $3,000 in total will be
contributed to your 401(k) plan.
The 401(k) plan has several options for investments, most of which are mutual funds. As you
know, a mutual fund is a portfolio of assets. When you purchase shares in a mutual fund, you are actually
purchasing partial ownership of the fund’s assets, similar to purchasing shares of stock in a company. The
return of the fund is the weighted average of the return of the assets owned by the fund, minus expenses.
The largest expense is typically the management fee paid to the fund managers, who make all of the
investment decisions for the fund. J&J Bagel uses Imperium Financial Services as its 401(k) plan
administrator.
Jerry Chen then explains the following retirement investment options available for employees:
1. Company Stock. One option is stock in J&J Bagel. The company is currently privately held. The price
you would pay for the stock is based on an annual appraisal, less a 20 percent discount. When you are
interviewed by the owners, John Benson and Jerry Chen, they informed you that the company stock
was expected to be publically sold in three to five years. If you needed to sell the stock before it
became publicly traded, the company would buy it back at the then-current appraised value.
2. Imperium S&P 500 Index Fund. This mutual fund tracks the S&P 500 Index. Stocks in the fund are
weighted exactly the same as they are in the S&P 500 Index. This means that the fund’s return is
approximately the return of the S&P 500 Index, minus expenses. With an index fund, the manager is
not required to research stocks and make investment decisions, so fund expenses are usually low. The
Imperium S&P 500 Index Fund charges expenses of 0.20 percent of assets per year.1
3. Imperium Small-Cap Fund. This fund primarily invests in small capitalization stocks. As such, the
returns of the fund are more volatile. The fund can also invest 10 percent of its assets in companies
based outside of the U.S. This fund charges 1.7 percent of assets in expenses per year.
4. Imperium Large-Cap Fund. This fund invests primarily in large capitalization stocks of companies
based in the U.S. The fund is managed by Jenna King and has outperformed the market in six out of
the last eight years. The fund charges 1.5 percent in expenses.
5. Imperium Bond Fund. This fund invests in long-term corporate bonds issued by U.S. companies. The
fund is restricted to investments in bonds with investment grade credit rating. This fund charges 1.4
percent in expenses.
6. Imperium Money Market Fund. This fund invests in short-term, high credit quality debt instruments,
which include Treasury Bills. As such, the return on money market funds is only slightly higher than
the return on Treasury Bills. Because of the credit quality and short-term nature of the investments,
there is only a very slight risk of negative return. The fund charges 0.60 percent in expenses.
1 The return on a mutual fund after accounting for management expenses is calculated as follows. If a fund charges 2
percent in expenses and it is expected to yield a 10 percent return before expenses, then the return on this fund after
expenses will be (1 + 0.10)×(1 – 0.02) – 1 = 0.078 or 7.8 percent.
QUESTIONS
1. What advantages/disadvantages do the mutual funds offer compared to company stock for your
retirement investing?
2. One can assess investment risk by looking forward to how assets are expected to react to a particular
set of circumstances or “states of economy”. Use the following set of assumptions for the coming
year to compute the expected rates of return (before expenses) and the standard deviations for the
mutual funds described above.
Expected Rate of Return (before expenses)
Scenario Probability S&P 500
Index Fund
Small-Cap
Fund
Large-Cap
Fund
Bond
Fund
Money
Market Fund
Recession 20% -12% -30% -10% 18% 2%
Near Recession 10% -8% -20% -6% 14% 3%
Normal 30% 12% 22% 12% 8% 4%
Near Boom 20% 22% 38% 15% -1% 5%
Boom 20% 36% 54% 20% -6% 6%
3. Given the expected returns calculated for each of the mutual funds above, estimate the betas of these
funds. Assume a risk-free rate of 4 percent and the expected market return equal to the expected
return on the S&P 500 Index.
4. If you decide to invest your money equally in the Small-Cap and Bond funds, what would your
portfolio’s expected return and risk level (standard deviation and beta) be? (Hint: Adjust mutual fund
returns for management expenses as explained in footnote 1.)
5. What would happen if you were to put 70 percent of your portfolio in the Small-Cap fund and 30
percent in the S&P 500 Index fund? Would this combination be better for you?
6. The returns of the Imperium Small-Cap Fund are the most volatile of all the mutual funds offered in
the 401(k) plan. Why would you ever want to invest in this fund? When you examine the expenses of
the mutual funds, you will notice that this fund also has the highest expenses. Will this affect your
decision to invest in this fund?