Chapter 13 Part 9

Question 1

Indexing Methods

Answer 1

Different companies use different methods for calculating changes in the index to which the annuity is linked, which can also influence returns

Question 2

Annual Reset (Rachet)

Answer 2

This method calculates the contract’s return based on how much the relevant index has increased from the beginning of the year to the end. Decreases are ignored. The advantage of an annual reset is that the investor’s gains are locked in every year

Question 3

High-Water Mark

Answer 3

This method examines how the index has performed at various points during the life of the contract and uses the three highest values to calculate the annuity’s rate of return. This
formula may result in higher returns for investors while also giving them some protection against declines.

Question 4

Point-to-Point

Answer 4

This method compares the index’s value on two paiticular dates, such as the date the contract began and the date it ended. The advantage of this is that it may be combined with higher caps or participation rates to increase the contract’s returns. The disadvantage is that the returns depend on how the index is performing on a particular date, which can reduce
returns if the market dips

Question 5

Index Averaging

Answer 5

Some EIAs calculate the index’s average value on a daily or monthly basis rather than using its value on specific dates to calcttlate returns. This method may limit the contract’s returns

Question 6

The majority of EIAs do not include

Answer 6

dividends in their calculations. Instead, only increases in the market value of the securities comprising the index are counted. Investors, particularly long-term ones, may do better by investing in the market directly and receiving both dividends and capital gains

Question 7

As with variable annuities, equity-indexed annuities are not suitable for all investors, particularly

Answer 7

older investors, who may need access to their money for medical or living expenses. EIAs should never be sold to short-term investors. The surrender period for an equity-indexed
annuity may be as long as 15 years. Many contracts allow an investor to take out 10% per year without penalty, but an investor who takes out more may be required to pay significant charges

Question 8

In addition, an investor who surrenders an EIA early may receive only

Answer 8

a portion of the index-linked interest or none at aU. Some companies only credit the interest to investors who keep their contracts for the entire period. Investors who surrender prior to age 59 1/2 will be assessed a 10% tax penalty on the accumulated earnings as well.

Question 9

Currently, most equity-indexed annuities arc not classified as

Answer 9

securities. An agent who sells equity-indexed annuities that are not sponsored by his broker-dealer must inform his employer about his activities. the firm must approve the agent’s activities in writing and agree to supervise the sales.

Question 10

Section 1035 of the IRS Code allows

Answer 10

investors to exchange the following insurance products without incurring a tax liability: A nonqualified annuity for a nonqualificd annuity, A life insurance policy for a life insurance policy, A life insurance policy for a nonqualified annuity

Question 11

If the client executes a 1035 Exchange, the client may be subject to

Answer 11

surrender charges and higher fees

Question 12

An investor may not exchange a nonqualified annuity for a

Answer 12

life insurance policy under Section 1035 of the IRS Code

Question 13

An altemative investment is a product that does not fit into one of the three traditional asset classes

Answer 13

stocks, bonds, and cash. Examples of alternative investments include real estate, commodities such as precious metals, derivatives, hedge funds, and limited partnerships.

Question 14

Alternative investments are usually purchased by

Answer 14

institutional or high-net-worth investors. Many of these products are complex and illiquid, making them ill-suited for the average retail investor

Question 15

The advantage of alternative investments is that

Answer 15

their returns are not highly correlated (do not move in sync) with more traditional investments. For this reason, many pension funds and private endowments have placed a small portion (usually less than 10%) of their portfolios in hedge funds or other alternative investments

Question 16

A hedge fund is a

Answer 16

private investment pool that is not required to register with the SEC under the Investment Company Act of 1940. Since hedge funds arc typically open to a limited range of professional or wealthy investors, in many jurisdictions they qualify for an exemption from regulations governing short selling, derivatives, leverage, fee structures, and the liquidity of interests in the fund. Hedge funds may use strategies that more heavily regulated investment entities, such as mutual funds, may not. As a result, hedge funds are more complex and may expose investors to many different types of investment risk.

Question 17

Most hedge funds share a nurnber of characteristics. They are organized as

Answer 17

limited partnerships or limited liability companies (LLCs). The general partner or managing member manages the fund’s portfolio and makes all the investment decisions. The manager usually has a personal stake in the fund, and the manager’s compensation is heavily tied to the fund’s performance. Hedge funds typically seek absolute positive investment performance-ie., they set a definite performance goal (8%, for example) rather than measuring their performance against a benchmark (such as the S&P 500 Index or the Dow Jones Industrial Average

Question 18

Hedge funds generally rely on one of two exclusions contained in the Investment Company Act to avoid registration. Both exclusions require that interests in the fund be sold as

Answer 18

As a result, firms selling hedge funds generally may not solicit investors or advertise in the public media. These prohibitions include placing advertisements in print or on unprotected Web sites, using the broadcast media, or conducting investment seminars open to members of the public who have not been properly prequalified. When offering hedge funds, it is important to remember that solicitations must be limited to accredited investors. As we discussed previously, an accredited investor is either an institution or an individual who
meets minimum financial requirements–an annual income of$200,000 ($300,000 with a spouse) or a minimum net worth of $1 million

Question 19

An accredited investor who is an individual is prohibited from including his primary residence in his net worth. If the property’s value is less than the mortgage owed, the difference is

Answer 19

deducted from net worth

Question 20

Fund of Hedge Funds

Answer 20

these are a relalively new innovation with a larger number of potential investors than traditional hedge funds. In a fund of funds, the parent company may be registered with the SEC
as an investment company. The parent company then invests in one or more unregistered private hedge funds. Funds of funds often have much lower minimum investment
requirements than traditional hedge funds and may advertise publicly