Series 65 wk 3 Flashcards
What are the advantages and risks associated with ETFs that track alternatively weighted indices?
Equally weighted, alternatively weighted, fundamentally weighted and volatility weighted ETFs offer exposure to other investment styles and may provide enhanced performance.
These ETFs present additional risk factors such as being more complex, thinly traded and hard to understand for both advisers and retail investors.
Lack of liquidity can lead to wider spreads causing the product to be expensive to buy and sell for invsetors. The portfolio often have high turnover, which can lead to increased transaction costs for ETF.
What is a front-end load? What are shares with front-end load called?
Sales charge that the investor pays when they purchase shares. The sales charge is added to the NAV of the fund and the investor purchases the shares at the POP. Shares that charge a front-end load are known as “A” shares
What are back end loads? What is this also called? (2)
Back-end load is known as contingent differed sales charge (CDSC)
Investors that pay back-end loads will pay sales charge at the time of redemption of fund shares. (This sales charge declines as holding period increases). Mutual fund shares that charge a back-end load are known as “B” shares.
What are the 2 other types of sales charge?
“C” shares - level load shares - based on NAV.
“D” shares - charge asset-based fee and back-end load.
What does a 12B-1 fee (asset-based distribution fee) cover? How is this fee determined?
Covers expenses related to promotion and distribution of fund’s shares.
Fee is determined annually as a percentage of the NAV or as a flat fee
How is 12B-1 fee charged to shares? What votes must be collected annually to approve of the 12B-1 fee?
12B-1 fee charged to shares quarterly. 3 votes required to approve and reapprove annually: 1. Majority of BOD 2. Majority vote of non-interested BOD 3. Majority vote of outstanding shares
What votes are required to terminate a 12B-1 fee?
- Majority of noninterested BOD
2. Majority vote of outstanding shares
What are the limits of a 12B-1 fee?
Mutual fund (no-load fund) may charge a 12B-1 fee no more than 0.25% Mutual funds that are not no-load funds are limited to 0.75% of assets - and must be reasonably related to anticipated level of expenses incurred for promotion and distribution.
How often are 12B-1 fees reviewed?
Quarterly
What must be done to evaluate and recommend mutual fund?
Mutual funds do not typically time the market, so it is important to:
1. Make sure investment objective of mutual fund matches investor’s objectives
2. Must compare costs, fees, and expenses among the funds
Priority should be to any fund company with whom the investor maintains an investment
Why should priority be given for mutual fund company with existing investment? (Existing investment vs. new capital)
If client’s objective has changed, then fund most likely offers conversion privileges that will allow the investor to move into another portfolio without paying any sales charge.
If investor is committing new capital then fund company most likely offers combination privileges and rights of accumulation, which will help the investor reach a sale charge reduction
What is a red flag for breakpoint sales violations and abusive sales practices? (3)
Switching fund companies and/or spreading out investment dollars among different fund companies. Making a large investment in class B shares as large dollar amount would have most likely resulted in a reduced sales charge for the investors
When should investor invest in A shares vs. B or C shares?
A shares - Shorter time horizons
B shares - longer holding periods because expenses associated with B shares are higher, but sales charge upon redemption is better later
C shares - for investors who want to actively move money between funds to try to time the market (charge level load each year)
Sales charge percentage calculation
SC% = (POP-NAV)/POP
What is POP calculation?
POP = NAV/(100-SC%)
If open-end mutual fund charges maximum 8.5% Sales charge, what 3 privileges must they also offer? If mutual fund does not offer all 3 of these benefits, what does sales charge drop to?
- Breakpoint sales charge reductions that reduce the amount of the sales charge based on dollar amount invested.
- Rights of accumulation that will reduce the sales charge on subsequent investments based on the value of the investor’s account
- Automatic reinvestment of dividends and capital gains at the NAV.
If fund does not offer these, sales charge drops to 6.25%
What is incentive for investment of larger sums into mutual funds?
Breakpoint sale - Sale of a mutual fund at a set dollar amount that allows the fundholder to move into a lower sales charge bracket. As an incentive to invest larger sums of money, mutual fund will reduce sales charge based upon the dollar amount of the purchase.
Who are breakpoint sales charge reductions available to? (4)
Corporations, trusts, couples, and accounts for minors
What is a breakpoint schedule?
A sales charge amount related to dollar amount invested
Ex: $1-$24,999 (8.5% SC), $25K-$74,999 (7%), 75K-$149,999 (5%), $150K-$499,999 (3%), $500K or greater (1%)
What is a letter of intent on breakpoint?
An investor unable to reach a breakpoint with a single purchase, can qualify for a breakpoint sales charge reduction by signing a letter of intent.
LOI will give investor up to 13 months to reach the dollar amount they subscribed.
LOI is binding only to fund company, not on investor.
Shares are held in escrow - if met - these are released; if not met - investor is charged adjustment to sales charge (investor can choose to send in a check or allow some of escrowed shares to be liquidated).
What are the rules for backdating a letter of intent?
Investor can backdate LOI up to 90 days to include prior purchase and 13-month window starts from the back date.
What is a breakpoint sale?
A breakpoint sale is a violation committed by a registered representative who is trying to earn larger commissions by recommending the purchase of mutual fund shares in a dollar amount that is just below the breakpoint that would allow investor to qualify for a reduced sales charge.
A breakpoint violation also may be considered to have been committed if a representative spreads out a large sum of money over different families of funds.
A registered representative must always notify an investor of the availability of a sales charge reduction, especially when investor is depositing a sum of money close to breakpoint.
What are rights of accumulation?
Allow investor to qualify for reduced sales charges on subsequent investments by taking into consideration the value of the investor’s account, including the growth. This allows sales charge reduction for future payments made in new breakpoint schedule bracket, not retroactive reduction of sales charge on prior purchases
What is automatic reinvestment of distributions?
Investors may elect to have their distributions automatically reinvested in fund and use the distributions to purchase more shares. Most mutual funds will allow investor to purchase the shares at NAV when they reinvest distributions.
This feature is required for mutual funds charging 8.5% sales charge
What are combination privileges?
A feature sometimes offered by mutual funds allowing investor to combine the simultaneous purchases of two different portfolios to reach a breakpoint sales charge reduction. (Different portfolios become known as a family of funds).
What are 3 other mutual fund features they can offer?
- Combination privileges
- Conversion or exchange privileges
- 30-Day Emergency withdrawal
What is conversion or exchange privileges?
Mutual funds feature that allows investor to move money from one portfolio to another offered by the same fund company without paying another sales charge.
Fund company allows investor to redeem shares of one portfolio at NAV and use proceeds to purchase shares of another portfolio at the NAV.
How is conversion or exchange purchase taxed? What are the other 4 exchange conditions?
IRS sees purchase and sale, so investor will have to pay taxes on any gain on the sale of portfolio shares.
Other exchange conditions:
1. Dollar value of purchase may not exceed sales proceeds
2. Purchase of new portfolio must occur within 30 days
3. Sale may not include a sales charge refund
4. No commission may be paid to a registered representative of broker dealer
How does date apply for back-end loads when there is a conversion of shares in mutual fund portfolio?
Original purchase date
What is a 30-day emergency withdrawal?
If investor needs to liquidate mutual fund shares for emergency purposes, the investor will be able to reinvest an equal sum of money at portfolio’s NAV if they reinvest money within 30 days. (usually one-time privilege)
If client redeems shares within 7 business days of purchase, what happens to sales charge?
Sales charge earned by broker dealer and representative is returned to the fund company
What is dollar cost averaging?
Purchasing mutual fund shares through regularly scheduled investments of a fixed dollar amount (popular method).
How do you calculate average cost/share and average price per share for investor of mutual fund?
Average cost = total dollars invested/total # of shares invested ($400/27)
Average price = Total of purchase prices/number of purchases ($67.5/4)
Example: 4 $100 investments made at various share prices - $400 total investment; $67.5 (added share prices), 27 (number of shares purchased
How are mutual fund voting rights won?
By a simple majority, 51% of outstanding shares will win the vote. This is shares vote, not shareholders.
What are the major issues to be voted on for a mutual fund (11)?
- Changing capitalization (going from open end to closed-end fund)
- Changing sales load (going from a loaded fund to a no-load fund)
- Changing or terminating business
- Changing investment objectives
- Lending money
- Entering into real estate transactions
- Issuing or underwriting other securities
- Changing borrowing policies
- Electing BOD
- Electing investment adviser
- 12B-1 fees
How are mutual fund yields calculated?
Annual income (dividends)/POP = current yield
What is portfolio turnover rate? What is disadvantage of high portfolio turnover rate?
Says how long the fund holds its securities, turnover rate of 100% means that the fund replaces its portfolio annually (the higher the rate, the shorter the fund’s holding period).
Higher portfolio turnover cause fund to incur additional expenses in the form of execution charges.
The ex-dividend date on a closed-end mutual fund is set by who?
FINRA/NYSE
What is an annuity? What is an annuitant?
A contract between an individual and an insurance company. Once the contract is entered into, the individual becomes known as the annuitant.
What are the 3 types of annuities? What is generally similar and different?
- Fixed annuity
- Variable annuity
- Combination annuity
All 3 types allow investor’s money to grow tax deferred, but the type of investment made and how the money is invested varies according to the type of annuity.
What is a fixed annuity? What is risk?
Offers investors a guaranteed rate of return regardless of whether the investment portfolio can produce the guaranteed rate. If the performance of the portfolio falls below the rate that was guaranteed, the insurance company owes investors the difference.
Because purchaser of fixed annuity doesn’t have investment risk, a fixed annuity is considered to be an insurance product, not a security.
Investments are typically in conservative investments like mortgages and real estate.
Because rate that insurance company guarantees is not very high, annuitant may suffer a loss of purchasing power due to inflation risk.
What is a variable annuity?
Seek to obtain a higher rate of return by investing in stocks, bonds, or mutual fund shares, these securities traditionally offer higher rates of return than more conservative investments.
These do not offer guaranteed rate of return and the investor may lose all or part of their principal. Because of this risk, contract is considered to be both a security and an insurance product (representatives who sell variable annuities must have both their securities and insurance license)
Where are the money and securities contained in a variable annuity contract held? What must the insurance company to begin operating?
Held in insurance company’s separate account. (Must be kept separate from insurance company’s general funds).
The insurance company must have a net worth of $1M or the separate account must have net work of $1M in order for separate account to begin operating
How can the separate account in a variable annuity invest? (2 ways)
Direct investment - If money in separate account is invested directly into individual stocks and bonds, the separate account must have an investment adviser to actively manage the portfolio. This is then considered to be an open-end investment company under Investment Company Act of 1940 and must register as such.
Indirect investment - If separate account uses money in the portfolio to purchase mutual fund shares, it is investing in the equity and debt markets indirectly and no investment and no investment adviser is required to actively mange the portfolio. This is considered to be a unit investment trust under the Investment Company Act of 1940 and must register as such.
What is a combination annuity?
Combination annuity offers the annuitant features of both a fixed and variable contract. Has a fixed portion that offers a guaranteed rate and a variable portion that tries to achieve a higher rate of return.
Most combination annuities will allow the investor to move money between the fixed and variable portions of the contract.
Representatives who sell combination annuities must have both their securities license and their insurance license.
What is a bonus annuity? In order to offer bonus annuity, what must it do?
An insurance company that issues annuity contracts may offer incentives to investors who purchase their variable annuities (these are referred to as bonuses).
1. Premium enhancement
2. Ability to withdraw account’s earnings or up to 15% of total premiums paid without a penalty
Bonus annuities often have higher expense and longer surrender periods than other annuities.
In order to offer bonus annuities the bonus received must outweigh the increased costs and fees associated with the contract.
Fixed annuity contracts cannot offer bonuses to purchasers.
What is a premium enhancement?
A type of bonus annuity - under this option - the insurance company will make an additional contribution to the annuitant’s account based on the premium paid by the annuitant.
What is an equity-indexed annuity? How do equity-indexed annuities credit interest to the investor’s account? How are these rates shown (2)?
Offer investors a return that varies according to performance of a set index such as the S&P 500.
These annuities credit interest to investor’s account based on contract’s participation rate.
Participation rate of 70% and index return of 5% - investors return of 3.5% (70% of 5%) OR
Participation rate shown as spread rate. If contract has spread rate of 3% and index returned 10%, investor’s return is credited 7% (10-3)
What is floor rate and cap rate?
Equity-indexed annuities may have floor rate (minimum interest rate that will be credited to investor’s account - could be 0% or higher number)
Cap rate - maximum rate that will be credited to the contract; If index exceeds cap rate, investor’s account will only be credited up to cap rate.
Who should you recommend variable annuities to?
More appropriate for investor who is looking to create an income stream, not trying to save for a large purchase or expense such as college tuition. Variable annuities are meant to be used as supplements to other retirement accounts such as IRAs and corporate retirement plans.
What are the 3 ways an investor may purchase an annuity contract?
- Single payment deferred annuity
- Single payment immediate annuity
- Periodic payment deferred annuity
What is a single payment deferred annuity? What does money invested in this buy?
The investor funds the contract completely with one payment and defers receiving payments from the contract until some point in the future, usually after retirement.
Money being invested in a single payment deferred annuity is used to purchase accumulation units.
The number and value of the accumulation units varies as the distributions are reinvested and the value of the separate account’s portfolio changes.
What is single payment immediate annuity? What does money invested in this buy?
With a single payment immediate annuity, investor funds contract completely with one payment and begins receiving payments from the contract immediately, normally within 60 days.
The money that is invested in a single payment immediate annuity is used to purchase annuity units.
The number of annuity units remains fixed and the value changes as the value of the securities in the separate accounts portfolio fluctuates.
What is periodic payment deferred annuity? What does money invested in this buy?
Investor purchases the annuity by making regularly scheduled payments into the contract. (This is known as the accumulation stage). During this stage - terms are flexible and there is no penalty if investor misses a payment).
Money invested in periodic payment deferred annuity is used to purchase accumulation units.
The number and value of the accumulation units fluctuate with the securities in the separate account’s portfolio.
What is an accumulation unit? How does the value of the accumulation unit change? When does an investor own accumulation units?
This represents the investor’s proportionate ownership in the separate account’s portfolio during the accumulation or differed stage of the contract.
Value of accumulation unit fluctuates as the value of the securities in the separate account’s portfolio changes. (As investor makes contributions to the account or as distributions are reinvested, the number of accumulation units will vary)
An investor will only own accumulation units during hte accumulation stage where money is being paid into the contract or when receipt of payments is being deferred by the investor, such as with a single payment deferred annuity.
What is an annuity unit?
When an investor changes from the pay-in or deferred stage of the contract to the payout phase, the investor is said to have annuitized the contract.
At this point, the investor trades in their accumulation units for annuity units.
The number of annuity units is fixed and represents the investor’s proportional ownership of the separate accounts portfolio during the payout phase.
What can affect the number of annuity units an investor receives?
- Payout option selected
2. Annuitant’s age, sex, value of the account, and the assumed interest rate
What are the annuity payout options?
Can take lump sum distribution or receive scheduled payments from the contract. If the investor to decides to annuitize the contract and receive scheduled payments, once the payout option is selected, it can’t be changed.
The 3 options (from largest to smallest monthly payment):
1. Life only/straight life
2. Life with period certain
3. Joint with last survivor
What is “life only/straight life” annuity payout option?
This payout option gives annuitant the largest periodic payment from the contract and the investor will receive payments from the contract for their entire life.
However if investor dies, there are no additional benefits to their estate.
If an investor dies unexpectedly shortly after annuitizing the contract, the insurance company keeps the money in their account
What is “life with period certain” annuity payout option?
This will pay out from the contract to the investor or to their estate for the life of the annuitant or for the period certain, whichever is longer.
If investor selects 10-year period and lives 20 years, payments will cease upon the death of the annuitant, however if same investor dies only 2 years after annuitizing the contract, payments would go to their estate for another 8 years.
What is “joint with last survivor” annuity payment option? How are the monthly payments determined?
This annuity is jointly owned by more than one party and payments will continue until the last owner of the contract dies. If wife/husband have account and husband dies, wife continues to receive payments the rest of her life. These payments could be at the same rate or at a reduced rate, depending on the contract.
The monthly payments will initially be based on the life expectancy of the youngest annuitant.
What factors affect the size of the annuity payment? (5)
- Account value
- Payout option selected
- Age
- Sex
- Account performance vs. the assumed interest rate (AIR)
What is the assumed interest rate (AIR)?
A benchmark “assumed interest rate” for the separate account’s performance. When an investor annuitizes a contract, they trade their accumulation units in for annuity units.
AIR is not a guaranteed rate of return, it is only used to adjust the value of the annuity units up or down, based upon the actual performance of the separate account.
The annuity payments change with the value of the AIR. (if AIR increases, payment increases, and vice versa)
How is the investor’s annuity payment using AIR calculated?
Number of annuity units owned by the investor multiplied by value of the annuity unit
When is the AIR relevant?
Only relevant during payout phase of the contract when the investor is receiving payments and owns annuity units. Not during the accumulation stage.
How are contributions made to an annuity (regarding taxes)?
Made with after-tax dollars; money deposited is allowed to grow tax deferred. When investor withdraws money, only growth is taxed (taxed as ordinary income).
What are 3 types of withdrawals from an annuity contract?
- Lump sum
- Random
- Annuitizing
Which withdrawals are done last in, first out (LIFO)? What portion counts as the last money and how is this taxed?
Lump sum and random withdrawals. Growth portion of the contract is always considered to be last money that was deposited and is taxed at the ordinary income rate of the annuitant.
What happens if the annuitant is under age 59.5 and takes a lump sum or random withdrawal?
Withdrawal will be subject to a 10% tax penalty, as well as ordinary income taxes
(Variable annuity contacts sometimes allow borrowing from contract as long as interest is charged on loan and repaid by investor, not subjected to taxes)
What does an investor receive when they annuitize the contract? How is it determined what is taxable?
Monthly payments, part of which is investor’s cost base and the other which is the distribution of the account’s growth.
To determine how much of each payment is taxable and how much is the return of principal, the investor would look at the exclusion ratio.
What contracts are not subject to the 10% tax penalty?
Contracts that are annuitized prior to age 59.5 under a life-income option nor are withdrawals due to disability or death
What are sales charges of annuity contract?
No maximum sales charge.
Sales charge is assessed and must be reasonable in relation to total payments over life of the contract.
Most annuity contracts have back-end sales charge or surrender charges similar to a contingent deferred sales charge.
How are investment management fees determined in annuity contracts?
Individuals running separate account are compensates for their management of account through a fee-based agreement. Fee is deducted from separate account to cover management expense.
The more aggressive the portfolio, the larger the management fee will be.
What are the similarities (4) and differences (5) between variable annuities and mutual funds?
Variable annuity vs. mutual fund: Similarities: All have investment advisers, custodian banks, transfer agent and voting rights Differences: Max sales charge: No max vs. 8.5% Management: Board of managers vs. BOD Tax of growth and reinvestments: Tax-deferred vs. currently taxed Lifetime income: Yes vs No Costs and fees: Higher vs. lower
What is difference between qualified vs. nonqualified? (5)
Qualified vs. Nonqualified:
Contributions: Pretax vs. After-tax
Growth: Tax-deferred vs. Tax-deferred
Participation must be allowed: For everyone vs. Corporation may choose who gets to participate
IRS approval: Required vs. Not required
Withdrawals: 100% taxed as ordinary income vs. Growth in excess of cost base is taxed as ordinary income
Are annuities qualified or nonqualified?
Money used to purchase an annuity has already been taxed, making an annuity a nonqualified product
What are the different types of individual retirement account (IRA)?
- Traditional
- Roth
- SEP
- Educational
Are contributions to traditional IRAs tax deductible?
They may or may not be tax deductible, depending on the individual’s level of adjusted gross income and whether the individual is eligible to participate in an employer-sponsored plan.
Individuals who do not qualify to participate in an employer-sponsored plan may deduct their IRA contributions, regardless of income level.
What is a traditional IRA? How much can a person contribute?
Allows individual to contribute a maximum of 100% of earned income or $5500 per year or up to $11K per couple.
If only one spouse works, the working spouse may contribute $5500 to an IRA for themselves and $5500 to a separate IRA for their spouse, under the nonworking spousal option.
Investors over 50 may contribute up to $6500 of earned income to their IRA.
Regardless of whether the IRA contribution was made with pretax or after-tax dollars, the money is allowed to grow tax deferred.
How are withdrawals from a traditional IRA taxed? Penalty tax?
Taxed as ordinary income regardless of how the growth was generated in the account.
Withdrawals from an IRA prior to age 59.5 are subject to a 10% penalty tax as well as ordinary income taxes (this will be waived for first-time homebuyers or educational expenses for the taxpayer’s child, grandchildren, or spouse. This will also be waived if payments are part of a series of substantially equal payments.
When must withdrawals from IRA begin? What will happen if they don’t make withdrawals that are sufficient in size and frequency?
Withdrawals from an IRA must begin by April 1 of the year following the year in which the taxpayer eraches 70.5.
Individual will be subject to a 50% penalty on the insufficient amount
What happens if an individual makes a contribution to an IRA that exceeds 100% of earned income or $5500 (whichever is less)?
Subject to a penalty of 6% per year on the excess amount for as long as the excess contribution remains in the account.
What is a Roth IRA? What are contribution limits? Penalties?
A nonqualified account (made after-tax dollars). Same contribution limits apply for Roth IRAs. Roth IRA has same contribution limits as traditional ($5500), any contribution made to a Roth IRA reduces the amount that may be deposited in a traditional IRA and vice versa. All contributions deposited in a Roth IRA are allowed to grow tax deferred and all of the growth may be taken out of the account tax free provided individual has reached 59.5 and assets have been in account for at least 5 years. Same 10% penalty tax as traditional IRA.
What are rules for individuals taking distributions from Roth IRA by a certain age?
No requirements.
What is a simplified employee pension (SEP) IRA?
Used by small corporations and self-employed individuals to plan for retirement.
A SEP IRA is attractive to small employers because it allows them to set up a retirement plan for their employees rather quickly and inexpensively.
What are the contribution limits for SEP IRA?
Contribution limit for a SEP IRA far exceeds that of traditional IRAs.
Contribution limit is the lesser of 25% of the employee’s compensation or $54K per year.
Employees can either make their annual IRA contribution to their SEP IRA or to traditional or Roth IRA.
What are the terms for participation in an SEP IRA? (3)
Employee must be at least 21 years old, have worked during 3 of the last 5 years for the employer, and have earned at least $550.
What are the rules for employer contributions?
Employer may contribute between 0-25% of the employee’s total compensation to a maximum of $54K. Contributions to all SEP IRAs, including employer’s SEP IRA must be made at the same rate.
All eligible employees are immediately vested in the employer’s contributions to the plan.
What are the terms for SEP IRA taxation?
Employer’s contributions to a SEP IRA are immediately tax deductible by the employer. Contributions are not taxed at the employee’s rate until the employee withdraws the funds. Employees may begin to withdraw money from the plan at age 59.5. All withdrawals are taxed as ordinary income and withdrawals prior ot age 59.5 are subject to 10% penalty tax.
When must contributions to IRAs be made?
April 15th of the following calendar year, regardless of whether an extension has been filed by the taxpayer.
Contributions may be made between Jan 1 and April 15 for the previous year, the current year, or both.
What form must all IRA contributions must be made?
Cash
Where are all IRA accounts held?
In the name of the custodian for the benefit of the account holder. Traditional custodians include banks, broker dealers, and mutual fund companies
