Chapters 9/10 Flashcards
Investment Company Act of 1940
Governs investment companies. Identifies 3 types of investment companies:
1. Face-amount certificate companies
2. Management companies (open-end funds and closed-end funds)
3. Unit investment trusts (UITs)
Open-End Investment Funds/Mutual Funds
An investment company that provides investors w/ similar goals (growth, preservation, etc.) a means to invest. Mutual funds have a BOD that hire an expert, an IA, to perform security selection and trading functions.
Mutual fund managers must be registered IAs under the IA Act of 1940
- Most mutual funds are organized as a corporation but some are organized as trusts.
Advantages of mutual funds
- Diversification
- Professional management
- Liquidity
- Exchanges at NAV: No sales charge will be assessed if shareholders of a mutual fund exchange shares in one fund for shares of another fund within the fund family.
- Convenience
- Recordkeeping: Mutual funds take care of recordkeeping requirements
- Mutual funds are highly liquid, but unlike stocks, these are not traded throughout the day. Only after the close.
- Mutual funds MUST send detailed reports to their shareholders at least twice per year.
What qualifies a mutual fund to be classified as diversified:
- At least 75% of assets must be invested
- No more than 5% of the invested assets may be invested in any one company.
- No more than 10% of the voting stock of any one company may be owned.
- A diversified company must meet these standards at the time of initial investment; however, subsequent market fluctuations or consolidations will not nullify its diversified status.
Mutual fund SEC registration requirements
The IA Act of 1940 requires every investment company w/ more than 100 shareholders to register w/ the SEC UNLESS all shareholders are qualified investors. Also, mutual funds MUST have a min. net worth of $100k in order to offer shares to the public.
Mutual fund prospectuses
A fund’s prospectus is the primary disclosure document for potential investors. Fund’s MUST provide a prospectus to investors before or during a sale AND prospective investors. An RR CANNOT alter the prospectus in any way (even highlighting or underlining important parts).
What does a mutual fund prospectus contain:
- Investment objectives
- Investment policies and registrations
- Principal risks of investing in the fund
- Performance info
- The fund’s managers
- Operating expenses
- Sales charge (referred to as the sales load)
- Classes of shares the fund offers
- How the fund’s NAV is calculated
- How investors redeem/purchase shares
- Exchange privilages
NAV is also referred to as the redemption or bid price
True or false: A mutual fund’s public offering price is the NAV + any sales charges?
True. The public offering price is referred to as forward pricing because if an investor buys a share at 11am, the NAV won’t be calculated until after the close. Mutual funds are redeemed at their intrinsic value.
POP = NAV + sales charge or POP = NAV ÷ (1 - sales charge)
The statement of additional info (SAI)
A document that provides more detail than the propsectus about a fund’s investment objectives and risks. The fund IS required to give an SAI to buyers but IS NOT required to give it to prospective investors.
The mutual fund must give an SAI to anyone who requests it
Responsibilities of a mutual fund’s BOD
- Establish the fund’s investment policy (any fundamental change to this policy must be approved by the BOD)
- Determining when the fund will pay dividends and capital gains distributions to shareholders
- Appointing the fund manager
- Selecting the fund’s transfer agent, custodian, and principal underwriter.
Custodian bank of a mutual fund
Responsible for protecting the fund’s cash and securities and collecting dividends and int. payments from these securities.
- A custodian bank DOES NOT guarentee the mutual fund’s shareholders against investment losses, nor can it sell shares to the public.
- A custodian bank may also serve as the transer agent.
Transfer agent of a mutual fund
Performs recordkeeping functions for a mutual fund (issuing new shares, cancelling shares for redeemed investors, etc.) Transfer agents distribute capital gains/dividends and make sure that investors receive required disclosures.
Principal underwriter/sponsor/wholesaler/distributor of a mutual fund
Sells shares directly to the public or it may employ intermediaries such as a discount or full-service brokerage firm.
- A FINRA member firm may not sell fund shares at a discount to a nonmember firm since
only member firms may receive sales charges. - A mutual fund IS NOT required to have a principal underwriter.
High risk mutual fund categories
- Aggressive growth funds: Often invest in small companies or IPOs
- Specialized/sector funds
- International and global funds
- International funds invest in specific countries outside the U.S. Global funds invest in the U.S. and/or international countries.
- Emerging markets funds are a popular type of high risk international fund.
Moderate risk mutual fund categories
- Growth funds: Focused on capital appreciation.
- Equity income funds: Focused on dividends.
- Growth and income funds: Capital appreciation and dividends are key investment objectives.
- Bond funds: Focused on current income and capital appreciation.
- Index funds
- Balanced funds: Allocate funds to equities, bonds, and money-market instruments.
- Asset allocation funds: Similar to balanced funds but the allocation to any one of the 3 may drop to zero for a period of time depending on projections.
Low risk mutual fund categories
- Money market funds
Net asset value
The intrinsic value of a mutual fund. NAV must be computed daily- normally as of the close of the NYSE.
Total net assets ÷ # of outstanding shares
Settlement of mutual fund transactions
Mutual funds transactions usually settle on the same day as purchase/redemption. The ex-dividend date is determined by the fund/principal underwriter, however usually is the business day following the record date.
Sales charges/Front-end loads
Maximum sales charge permitted under FINRA is 8.5%. Reduced sales charges are permitted and usually given to investors who purchase a large # of class A shares.
(POP - NAV) ÷ POP
Back-end loads and contingent deferred sales charges
Sometimes mutual funds don’t assess a sales charge at the time of purchase, but rather wait until the shares are redeemed in order to assess a charge. Back-end loans MUST be disclosed, according to FINRA.
- Usually, the longer the investor owns the shares the less of a back-end load they assume.
- A confirmation for a fund that assesses a contingent deferred sales charge must disclose that a charge may be assessed upon redemption, even if the same disclosure is made in the prospectus.
No-load funds
Mutual funds that don’t assess sales charges. No-load funds cannot assess front-end loads, back-end loads, or 12b-1 fees that exceed 0.25% of the fund’s avg. annual net assets.
Class B shares may not be sold as no-load.
12b-1 fees
When mutual funds pay for distribution expenses (the cost of distributing the fund’s shares to the public. (Ex: advertising, sales commissions, etc.)) by having them deducted from the portfolio’s assets. 12b-1 fees typically range between 0.25%-1% of the fund’s assets.
Service fees
Charges deducted under a 12b-1 plan and used to pay for personal services or the maintenance of shareholders accounts.
Administrative charges
Charges deducted from the net assets of a mutual fund that are used to pay for various costs associated w/ operating the fund. (ex: payments to custodian banks and/or transfer agents).
True or false: A mutual fund is not required to disclose all of its fees?
False, a mutual fund MUST disclose all of its fees at the front of its propsectus.
Expense ratio
The % of fund assets used to pay operating costs
The % of fund assets ÷ avg. net assets
Class A mutual fund shares
Usually have front-end loans but small or no 12b-1 fees. Investors who purchase large amounts of shares within the same fund family may be given reduced sales charges. This class of mutual fund shares is most suited for LT investors.
- The disadvantage to Class-A shares is that not all of the initial investment gets invested. Ex: If there’s a 1% front-end load, and an investor invests $100, then only $99 gets invested.
Class B mutual fund shares
No front-load charges but higher 12b-1 fees. Investors are also subject to back-end loads. This class of shares is most suitable for investors who have a 5-7 year timeframe, especially if the back-end load decreases over time.
- W/ Class B shares, once enough time has passed to where there is no back-end load, most Class B shares will convert to Class A.
Class C mutual fund shares
Shares that have a level load , which is an ongoing fee (typically 1%) for as long as the investor holds the shares. There’s no front-end or back-end load, but a back-end load may be applied if the shares are sold within a year. This class has higher 12b-1 fees than Class A. This class of shares is most suitable for ST investors.
True or false: In a mutual fund’s prospectus, it must disclose all classes of shares and the applicable sales charges and fees?
True
True or false: FINRA prohibits an advisor to make recommendations to their clients about which class of mutual fund shares are suitable?
False
Breakpoints
$ levels at which the sales charge is reduced. Mutual fund shares MUST be quoted at the maximum sales charge, but most mutual funds offer breakpoints on shares purchased w/ a front-end load.
Ex: W/ $100k of purchases, sales charge reduced from 1% to 0.5%.
The breakpoint is set by the fund, NOT anyone selling it.
- Breakpoints must be clearly stated in the prospectus.
When are variations in sales charges allowed
- If the variations apply to all investors
- Adequate info is given to shareholders and potential investors
- The prospectus is revised if variation schedules are changed
- The company advises its existing shareholders of any new variations within a year.
Letter of intent (LOI)
Allows an investor to qualify for a breakpoint w/o initially depositing the entire amount required. Since an LOI is nonbinding, if the investor fails to make the additional payment to meet the required amount, they will not be penalized but they will be charged an amount that equals the higher sales charge applied to the purchase.
- A letter of intent (LOI) allows an investor to reach a breakpoint without initially investing the entire amount and it covers a period of 13 months. The letter may be backdated 90 days.
Rights of accumulation (ROAs)
Rights that allow a mutual fund shareholder to receive reduced sales commission charges when the amount of mutual funds purchased plus the amount already held equals the ROA breakpoint.
Who is eligable for a breakpoint, LOI, or ROA?
- An individual
- A buyer’s immediate family member
- A fiduciary
- A trustee
- Certain pension and profit-sharing plans
- Other groups that were not formed solely for the purpose of paying reduced sales charges.
Only purchasers of Class A shares are eligable for breakpoints.
True or false: For a mutual fund to assess the maxium allowable sales charge of 8.5%, it must offer investors both breakpoints and rights of accumulation?
True
True or false: If dividends from a mutual fund are reinvested at the NAV, they are non-taxable?
False, dividends that are reinvested from a mutual fund are reinvested at NAV and are taxable and add to the client’s cost basis.
Dollar Cost Averageing (DCA)
When investors reinvest dividends at fixed $ amounts of regular intervals, regardless of the market price of the shares. This leads to the investor buying more shares when the price is low and less shares when the price is high.
Necessary disclosures for DCA
- No assurance of LT growth
- Prices will vary
- Contributions must continue when prices decline, otherwise losses could occur.
True or false: The IA Act of 1940 requires mutual funds to pay the redemption proceeds to investors who redeemed their shares within 10 business days?
False, SEVEN CALENDAR days
Systematic Withdrawal Plans
When investors receive regular payments from their accounts, typically on a monthly or quarterly basis. Investors have 3 options: fixed $, fixed %, or fixed-time (liquidating their holdings over a period of time). Payments are first made from dividends and then on capital gains. However, if these are not sufficient then it will begin to redeem their shares.
Systematic withdrawal plans from mutual funds do not work like annuities. A systematic withdrawal plan could eventually result in the exhaustion of the account, whereas a life annuity payout will continue as long as the annuitant lives.
Redemption fees
Some mutual funds assess a small redemption fee of 0.5% to 2%. Some funds waive these fees if the shares have been held for a certain amount of time.
Prohibited practices related to breakpoint sales of mutual fund shares
RRs are not allowed to induce clients to purchase shares at a level that’s just below the value where a breapoint is available. Clients should be advised to use LOIs, if available.
Prohibited practices related to selling dividends of mutual fund shares
RRs are prohibited from pressuring clients to immediately purchase mtuaul fund shares in order to capture an impending dividend. There’s no economic benefit to the customer since once the dividend is paid, the fund’s NAV will fall, and by receiving the dividend the customer will have to pay taxes on them.
Prohibited practices related to swtiching of mutual fund shares
RRs are prohibited from advising clients to sell existing mutual fund shares and buy into another fund within the same family so that a new sales charge will be levied. This CAN be done if it’s in the client’s best interest but RRs cannot abuse this just to make money.
True or false: RRs should recommend that clients looking to place a large order in mutual funds purchase Class B Shares?
False, Class B shares do NOT get a breakpoint.
Regulated investment company (RIC)
An investment company that passes through at least 90% of its net investment income (dividends plus interest minus expenses) to shareholders. RICs benefit from tax benefits.
Average cost basis of a mutual fund example
Investor A makes an initial investment of $20k into a mutual fund and acquires 702 shares. Over the next 5 years, investor A deposits another $25k and reinvests $14k and acquires another 1,240 shares.
Total $ amount deposited: ($20k + $25k + $14k) = $59k
Total amount of shares acquired= (702 + 1,240) = 1,942
Average cost basis = ($59k ÷ 1,942) = $30.38
Taxable events related to a mutual fund
- Receiving dividends
- Reinvesting dividends
- Exchanging shares (wthin a fund family)
- Switching shares (outside a fund family)
Any dividend is taxed as ordinary income.
- Dividends can be qualified or non-qualified. For a dividend to be qualified, the mutual fund fund must have held the shares on which the dividend is paid for more than 60 days and the investor must have held the shares for more than 60 days.
True or false: Capital gains/losses are determined by subtracting the cost basis from the sales proceeds?
True
Face-Amount Certificate Company
Another type of open-end fund. A very rare type of investment company that issues debt certificates that pay a pretermined rate of interest.
Investors can purchase these shares by making periodic payments or a lump sum and then receive a fixed amount if they hold these certificates until maturity. Investors who cash in these securities will receive a lesser amount- the surrender value.
Unit Investment Trust (UIT)
Invest in a fixed portfolio of income-producing securities (bonds or preferred stock). UITs are formed under a legal document called an indenture. UITs issue units (a.k.a. shares of beneficial interest (SBI)). Each SBI entitles the holder to a proportionate amount of the UITs portfolio that the investor invested.
Since the portfolio remains static, there is no fund manager and thus no mgmt. fees. UITs are supervised, not managed.
Closed-end investment funds
Unlike mutual funds that continuously issue shares, closed-end funds issue shares like a company- on a one-time basis. Similar to a corporation, secondary offerings can be issued later. Closed-end funds trade in secondary markets and they’re traded on exchanges. There’s no prospectus delivery requirement for these secondary market trades.
The price of closed-end funds is determined by market forces, not NAV, and when closed-end fund shares are bought or sold the investors are subject to commissions rather than sales charges.
Closed-end funds may be sold short and bought on margin, unlike open-end
- Closed-end funds can issue common stock or senior securities- pref. stock/ bonds
Exchange-traded funds (ETFs)
The most common type of closed-end fund. ETFs issue shares which track an underlying index. An ETF may be appropriate for customers who are investing a lump-sum and seeking diversification and low costs. ETFs also may be suitable for investors looking to implement an asset allocation plan. ETF portfolios are generally fixed.
Inverse ETF
Attempts to perform the opposite of the index it’s tracking. Essentially, the goal is to yield performance equal to shorting the index.
- When selling short, an investor is exposed to a potential unlimited loss; however, with an inverse ETF, the investor is only exposed to a potential loss of the instrument’s purchase price (i.e., ETFs offer limited liability).
Leveraged ETFs
Leveraged ETFs are products that use debt instruments or financial derivatives such as swaps, futures, and options to amplify the returns of a specific index. For example, a leveraged ETF may be designed to deliver 2x the performance as the Nasdaq.
- Since most leveraged ETFs reset their portfolios and leverage daily, investors should typically sell their holdings before the market closes at the end of the day. For example, if an investor invests $1k into a 2x leveraged ETF, and on day 1 the index rises 20%, the investor’s ETF shares increase by 40% to ($1k * 1.40)= $1.4k. But, if on the second day the index falls by 20%, the investor’s shares are now only worth ($1.4k * (1-0.4)) = $840.
- The same logic as the bullet above applies to inverese ETFs as well.
True or false: Leveraged ETFs and inverse ETFs are best used for LT buy and hold strategies?
False, leveraged ETFs and inverse ETFs are best used for short-term trading strategies such as attempting to take advantage of intraday price swings on a given index.
Annuity
A contract between an owner and an insurance company where the owner gives the other party and amount of money and the insurance party agrees to pay the owner income at a later date. Annuities are inherently LT investments. Annuity grows tax-deferred. Annuities have a long-life and if the owner wants their money back there is a signficant surrender value.
The majority of annuities are non-qualified, so the owner must invest on an after-tax basis. However, the money grows tax-deferred. If the owner withdraws from the annuity account before 59 and 1/2, there is a penalty on top of it being taxed. If the withdrawal is subject to taxation, it’s taxed as ordinary income.
Fixed annuities
An annuity where the money being contributed is invested by the insurance company in its general account. W/ fixed annuities, the insurance company assumes the investment risk, and for this reason these are NOT considered securities. W/ fixed annuities, the insurance company will guarantee a min. rate of return or a fixed $ amount to be provided (the insurance company has to pay regardless of the general account’s performance).
Fixed annuities are good for conservative investors seeking tax-deferred growth. RRs MUST disclose that these are LT investments. The disadvantage to fixed annuities is that the fixed $ amount will not keep pace w/ inflation and the fixed rate of return might not.
- The assets from the fixed annuity in the general account are mixed w/ the assets from other insurance plans (life insurance, health insurance, etc.)
Variable annuties
Rather than choosing from a fixed rate of return or a fixed $ amount, investors choose from several options (growth, income, LT bonds, aggressive growth, etc.). Contributions are invested in the insurance company’s separate account. Nothing about a variable annuity is guarenteed. The assets in the separate account are not mixed w/ assets from the general account. The separate account must be registered w/ the SEC.
Variable annuities provide investors w/ variable payments at regular intervals for the contract term. All the risk is assumed by the annuitant, NOT the insurance company. Variable annuities can provide a hedge against inflation. A prospectus MUST be delivered to prospective annuitants.
These types of annuities are generally NOT suitable for senior investors, but moreso for people w/ LT investment goals who will not need access to their money for at least 5-7 years.
- Investors may choose to transfer assets from one subaccount within the separate account (ex: aggressive growth to income) w/o incurring taxes or sales charges.
Immediate annuities vs deferred annuities
Immediate annuities = When payments to the annuitant begin immediately after the lump sum is paid. If the contract is for monthly payments, payments will begin one month after the lump sum is paid. If annual payments, one year after the lump sum is paid.
Deferred annuities= When payments to the annuitant are delayed for a period of time after the lump sum is paid. In these cases, sometimes the lump sum is paid as a series of payments rather than a single premium.
- For Series 7 Examination purposes, if not specified, it should be assumed that the questions are referring to non-qualified deferred contracts which are funded with after-tax dollars.
Two phases of variable annuities
- The accumulation period
- The annuity period
Accumulation period
When the owner/annuitant makes payments to the insurance company and the value of the annuity begins to grow. While mutual fund investors buy shares, variable annuity investors buy accumulation units.
Investors buy accumulation units at NAV and are normally assessed a deferred sales charge. The NAV of every subaccount is calculated daily. Annuities use the same forward pricing method as mutual funds. If the annuitant dies during the accumulation period, a designated beneficiary will receive the greater of the sum of total payments made or the value of the accumulation units owned.
Charges and expenses during the accumulation period
- Sales charges: Most of the time in the form of a contingent deferred sales charge that’s assessed if the annuity isn’t held for a certain period of time (similar to Class B shares of a mutual fund).
- Mgmt. fee
- Expense risk charges: When a firm issues a variable annuity, it guarentees it will not raise costs for administering the contract beyond a certain level. This expense compensates the firm if the costs to the firm for adminstering the annuity turn out to be more than estimated.
- Admin. expenses
- Mortality risk: The risk that the individual lives for a very long time and the firm has to make payments for the entirety of it.
Annuity period
When the annuitant begins to receive payments. During this period, accumulation units are converted into a FIXED # of annuity units. The number of annuity units on which each payment is based is fixed, but the value will fluctuate.
Factors to determine the number of annuity units
- Age and gender
- Life expectancy
- Selected payout option
- Projected growth rate (a.k.a. the assumed interest rate (AIR))
Settlement/payout options an annuitant can choose from:
- Straight-life annuity
- Life annuity w/ period certain
- Unit refund life annuity
- Joint and last survivor life annuity
Straight-life annuity
A payout option where the annuitant will get a payment at a certain interval (monthly, yearly, etc.) for the rest of their life but after they die it’s over- their is no beneficiary. So even if only one payment is made and then they die, it’s over.
This payout option provides the highest possible payout of all options
Life annuity w/ certain period
A payout option where periodic payments are made for a certain period of time, but if the annuitant dies prior to the end of that period, a lump sum or series of payments is made from the insurance company to a beneficiary.
Unit refund life annuity
A payout option where periodic payments are made during the annuitant’s lifetime, and if the annuitant dies before an equal value to the amount they put in is paid out, the remainder is paid to a beneficiary w/ either a lump sum or series of payments from the insurance company.
Joint and last survivor life annuity
A payout options where payments are made to 2 or more people. If one person dies, the survivor continues to receive only his/her payments. Once the death of the last person, payments cease.
Assumed interest rate (AIR)
Once the payout option is selected, an AIR is selected to determine the first annuity payment. This is a projected return rate. Going forward, the AIR becomes the benchmark for determining subsequent payments. Annuitants can choose from various assumed interest rates when annuitizing their contracts. If the actual separate account return rate DOESN’T exceed the AIR, the annuity payment decreases.
- Each state has a maximum AIR.
- If the separate account performance is equal to the AIR, the annuitant’s payment will remain the same as the previous payment.
Taxation of variable annuities during the accumulation period
Annuities can be qualified or non-qualified. Only certain investors are eligable for qualified status. Non-qualified investors use after-tax money to contribute, and then the money grow tax-deferred. Any money withdrawn is not taxed, only the earnings.
If an investor makes withdrawals during the accumulation period, earnings are taxed on a LIFO basis. For example, if an investor has made contributions of $50k to a non-qualified variable annuity and the account currently has a $150k value, and the investor withdrawals $110k, the first $100k would be taxed as ordinary income becuase it was earned through dividends and capital gains. The next $10k is tax-free. The investor CANNOT claim $50k is tax-free.
Taxation of variable annuities during the annuity period
For a non-qualified annuity, at each periodic payment, the annuitant is only taxed on investment income (the part of the payment that represents dividends and capital gains). The annuitant is NOT taxed on the money they contirbuted.
For a qualified annuity, since the contributions were pre-tax, the entire periodic payment during the annuity period is taxable as ordinary income.
Death benefit taxation
If an annuitant dies during the accumulation period, the annuity’s value is included in their estate for the purpose of calculating federal estate taxes. The beneficiary will also be required to pay ordinary income taxes on anything they receive in excess of the cost basis. The death benefit skips the probate process.
Probate is how a dead person’s will is validated.
Variable annuity regulations
Anyone selling a variable annuity must hold a Series 6 or Series 7 license. Separate accounts for variable annuities must be registered as investment companies. FINRA member firms selling these policies must promptly transmit all applications and premiums for variable products to the insurance companies. RRs must obtain principal approval to sell a variable annuity. The principal can take up to 7 business days from the time they receive the application to decide if it’s suitable for the customer. The BD must keep a record of any payment from the customer and the date of payment, as well the date the BD forwards the funds to the insurance company.
- FINRA members that are principal underwriters of variable products may not sell them through another BD unless the other BD is also a FINRA member.
- As is the case w/ mutual funds, any selling agreement between an underwriter and a BD must state that if a client cancels the contract within 7 business days after the application is accepted, the BD will return the sales commission to the insurance company that issued the contract.
- A FINRA member firm is prohibited from selling variable contracts that are issued by an
insurance company that doesn’t promptly pay clients who surrender (cash in) all or part of their contracts
What must RRs have a reasonable basis to believe when selling variable products:
- The customer understands the various features of the contract (surrender periods and charges, fees, etc.)
- The customer will benefit from some features
- The contract has subaccount choices and features that make it suitable
1035 exchange
A tax-free exchange of a variable product to another similar fund. RRs must take into account that clients might inccur surrender charges or other fees, and must keep the client’s best interest in mind.
- An exchange is often viewed as inappropriate if the client has made another 1035 deferred variable annuity transfer within the previous 36 months.
- Clients should not be recommended the purchase of variable annuities within a tax-deferred account (ex: IRA) because those accounts already grow tax-deferred.
Variable annuity L shares/Short surrender securities
Variable annuities that have deferred sales charges that decline to 0 in 3-4 years and are designed for customers who may be considering a 1035 exchange in the future.
True or false: Individuals who are saving for retirement should normally exhaust all of their options to contribute to employer-sponsored retirement plans before investing in a variable annuity?
True
Variable life insurance
A form of permanent insurance which require fixed premiums, but have death benefits and cash values that may vary based on performance of the investment options. Anything w/ the term variable is considered a security, and thus variable life insurance policies are securities. Any offers to sell life insurance policies must have a prospectus attached.
Only a life insurance company that’s licensed and regulated by the state may ISSUE a variable policy. The company that SELLS the policy must be a BD registered w/ the SEC and a FINRA member firm. The RR must have a Series 6 or 7 license.
W/ variable life insurance, the policy owner decided how the premium payments will be invested. A feature of these policies is that there is a guarenteed minimum death benefit. Variable life insurance policies are not suitable for super conservative investors because the policy’s value may vary.
Characteristics of a variable life insurance policy
Policyholders make premium payments to the insurance companies, and those proceeds are deposited into the separate account net of any sales charges or fees. Policyholders choose their desired subaccount. Policyholders accumulate cash value where they can borrow (to pay premiums) later in life. They may also pass this down to heirs. Policyholders can use the cash value as a tax-sheltered investment.
The death benefit on a life insurance policy has a guarenteed minimum but may rise above this min. if the subaccounts perform well.
- Owners of variable life insurance policies get voting rights on certain issues with subaccount decisions.
- Each subaccount has a Board of Managers (essentially a BOD).
Life insurance rider
An additional feature/benefit addded to a life insurance policy. Each rider adds to the cost of the policy. Riders are often selected at the time of policy issuance but can be added later on as well.
Taxation of life insurance policies
The death benefit of a life insurance policy passes tax-free to the beneficiary, however, if the dead person owned the policy, the death benefit is included in the calculation of estate taxes. In order to avoid this, many advisors recommend the policy be placed in the name of a beneficiary or irrevocable life insurance trust.
Equity-Indexed Annuities/Indexed-Annuities
Hybrid products that contain aspects of fixed and variable annuities. These are NOT securities. The return on an EIA is linked to an underlying stock index performance. In order for there to be some guarenteed minimum payout, investors must accept the equity-indexed annuities return will be less than the underlying index.
Participation rate
What’s used to calculate an equity-indexed annuity’s return. Example, a participation rate of 80% suggests that if a equity-indexed annuity is tied to the S&P which rises 10%, then the annuity will return 8%.
Another way to determine returns for an equity-indexed annuity is to use a spread. For example, an equity-indexed anuity uses a 3% fixed spread to calculate returns, if the S&P rises 10%, the return will be 7%.
Cap Rates
Some equity-indexed annuities have rate of returns that are capped at some set %.
Indexing methods for Equity-Indexed Annuities
- Annual reset (Ratchet): Calculates the contract’s return based on the amount the underlying index has increased of BOY to EOY. The advantage to this is the gains are locked in every year and decreases ignored.
- High-Water Mark: Issues the 3 highest values of the index at points during the life of the contract to calculate the rate of return. May provide higher returns than #1.
- Point-to-Point: Compares the index’s value on the date the contract began and the date it ended. The advantage w/ this is it may be combined w/ higher caps or participation rates. The disadvantage is the returns are based on very specific dates.
- Index Averaging: Rather than using the index’s value on specific dates, uses average values on a daily or monthly basis.
Suitability of equity-indexed annuities
Not suitable for older investors who need income. Not good for ST investors.
True or false: When a mutual fund makes a capital gain distribution to a shareholder, the shareholder’s holding period is determined by the investment company’s holding period. The length of time the shares were held by the shareholder is not relevant for tax purposes?
True
True or false: To change the investment objective of a fund or subaccount in a variable annuity, a majority vote of the shareholders or annuitants is required?
True
- The IA is given authority over distributions.
True or false: Expenses and fees tend to be lower for variable annuities than for most mutual funds?
False, both fixed and variable annuities have higher sales charges and ongoing fees than mutual funds.
FINRA Rule 2330
Suitability requirements for recommendations concerning the purchase of variable annuities apply to the following three scenarios:
1. New purchases
2. Exchanges of variable annuities
3. Initial subaccount allocations.
