Chapter 10
IN THIS CHAPTER
Taking advantage of management investment companies
Understanding face-amount certificate companies and UITs
Reviewing REITs
Looking at annuities
Examining life insurance
Reviewing investment company rules
Diversification is key when you’re helping customers set up a portfolio of securities, and it’s fairly easy when your customer has a good deal of money to invest. But what if an investor has limited resources? Certainly, such investors can’t afford to buy several different securities, and you don’t want to limit your customer to only one (heaven forbid it should go belly up). Packaged securities to the rescue! These securities, such as open-end funds, closed-end funds, face-amount certificate companies, UITs, real estate investment trusts (REITs), and annuities, offer variety within one security by investing a customer’s money in a diversified pool of securities … for a cost, of course. A bit of profit-driven teamwork can ensure your customers’ investments are much safer than, say, the blackjack tables in Vegas.
In this chapter, I cover topics relating to investment companies, REITs, and annuities. Open-end (mutual) funds and closed investment funds are only the beginning. I also discuss face-amount certificate companies and trusts like unit investment trusts (UITs). The “Investment Company Rules” section at the end of this chapter can help you round out your studies, and the practice questions in this chapter may put you in that question-answering mood. You'll notice, as with other chapters, that there is a bit of an overlap between the information you learned when taking the Securities Industry Essentials Exam and the information you'll see in this chapter.
The Investment Company Act of 1940 divides investment companies into three main types: management investment companies, face-amount certificate companies, and unit investment trusts. This section focuses on management investment companies, which the Series 7 tests more than the other types. I cover the other types in the aptly named “Considering Other Investment Company Options” section later on.
Management investment companies are either open-end or closed-end funds. Management companies are, by far, the most familiar type of investment company. The securities held by the management companies are actively managed by portfolio managers.
Management companies have to be either open-end or closed-end funds. Make sure you know the difference between the two.
An open-end fund is more commonly known as a mutual fund. As with closed-end funds, mutual funds invest in many different securities to provide diversification for investors. The key difference is that mutual funds are constantly issuing and redeeming shares, which provides liquidity for investors. Because open-end fund shares are continuous offerings of new shares, a mutual fund prospectus must always be available. You need to understand the makings of the net asset value and the public offering price when taking the Series 7 exam:
Public offering price (POP): For mutual funds, the public offering price (the ask price) is the NAV plus a sales charge.
If a mutual fund doesn’t charge a sales charge, it’s called a no-load fund.
If the fund provides a summary prospectus, it must include items like the fund’s name and ticker symbol, the class of shares, the fund’s investment strategies, investment objectives, costs of investing, investment advisors, financial compensation, risks, performance, and so on. The summary prospectus may include an application that investors can use to purchase shares. Potential investors can also request a full prospectus prior to investing. If an investor purchases via a summary prospectus, he must either receive or be provided online access to a full prospectus.
On an ongoing basis, funds must include in their prospectus annual report graphs comparing the performance of the fund to a proper index (S&P 500, NASDAQ composite, and so on), items and/or strategies that may have affected the performance in the past year, and the name of the fund’s manager.
Note: Expenses of a mutual fund include salaries for the board of directors; management (investment advisor) fees for the person or persons making the investment decisions for the fund; custodial fees for the safeguarding of assets (cash, securities, and so on) held by the fund; transfer agent fees for keeping track of investors, sending distributions, and sending proxies; and 12b-1 fees if any 12b-1 fees are fees paid by a mutual fund out of the fund assets to cover promotional expenses such as advertising, printing, and mailing of prospectuses to new investors, and so on. If there are 12b-1 fees, they must be included in the prospectus.
In addition to a prospectus, mutual fund investors may request a Statement of Additional Information (SAI). The SAI provides more detail about the fund and its investment risks and investment policies. The SAI is not sent automatically. However, if requested, the SAI must be delivered within 3 business days.
Unlike open-end funds, closed-end funds have a fixed number of shares outstanding (hence the word closed). Closed-end funds act more like stock than open-end funds because they issue new shares to the public, and after that, the shares are bought and sold in the market. Because they trade in the market, they’re often called publicly traded funds. Although the net asset value of closed-end and open-end funds is figured the same, the public offering price is determined a little differently:
Note: Although closed-end funds are not purchased from and redeemed with the issuer, they do offer a high degree of liquidity. After the initial offering, they can be purchased or sold either on an exchange or over-the-counter (OTC).
You can expect at least a few of the Series 7 questions relating to investment companies to test you on the differences between open-end and closed-end funds. Table 10-1 should help you zone in on the major distinctions.
TABLE 10-1 Comparing Open-End and Closed-End Funds
Category |
Closed-End |
Open-End |
Capitalization |
One-time offering of securities at the IPO (Initial Public Offering) price (fixed number of shares outstanding). |
Continuous offering of new shares (no fixed number of shares outstanding). |
Pricing the fund |
Investors purchase at the current market value (public offering price, or POP) plus a commission. |
Investors purchase at the next computed net asset value (NAV) plus a sales charge. See “Forward pricing” earlier in this section. |
Issues |
Common stock, preferred stock, and debt securities. |
Common stock only. |
Shares purchased |
Shares can be purchased in full only. |
Shares can be purchased in full or fractions (up to three decimal places). |
Purchased and sold |
Initial public offerings go through underwriters; after that, investors purchase and sell shares either over-the-counter or on an exchange (no redemption). |
Shares are sold and redeemed by the fund only. See “Forward pricing” earlier in this section. |
Exchange privileges |
No exchange privileges. |
Shares may be exchanged (converted) within the family of funds. For argument’s sake, a customer may wish to exchange his Fidelity Mid-Cap Growth Fund for a Fidelity Intermediate-Term Bond Fund. |
Withdrawal plans |
After the initial public offering, the securities are sold in the market and therefore, the issuer cannot set up a withdrawal plan for investors. |
Mutual funds allow systematic withdrawal plans which allow investors to automatically receive a specific amount from the fund each month as the issuer automatically redeems the shares necessary (see the next item). |
Automatic reinvestment of dividends and capital gains |
This is not available for closed-end funds. |
Mutual funds allow investors to choose whether they wish to receive capital gains and dividends or to automatically reinvest the gains and dividends to purchase more shares. |
Because open-end funds hold a basket of securities that are purchased from and redeemed by the issuer, there is no current NAV. Any purchases or sales that take place during the trading day are held until the close of the market until the next NAV can be computed. All redemptions of mutual fund shares are completed at the next computed NAV (the redemption price).
As an extra service, many mutual funds offer systematic withdrawal plans as a way of redeeming shares. This type of plan is ideal for someone who's at the retirement age and is looking for a little extra cash each month while still keeping the balance invested. Withdrawal plans can be set up as a fixed dollar amount periodically, a fixed share amount redeemed periodically, or a fixed amount of time (for example, redeeming all the shares over a 10-year period).
Not all mutual funds offer systematic withdrawal plans, but if they do, as a registered rep, you must disclose the risks involved to your client. Some of the risks include the client running out of money, and no guaranteed rate of return.
For an investment company to avoid being taxed as a corporation, it must distribute (pass-through) at least 90 percent of their net investment income to shareholders. Net investment income is the amount received in dividends and interest less expenses. In the event that it distributes 90 percent or better, the investment company is only taxed on the amount of net investment income not distributed to shareholders.
For an investment company to be considered diversified, it must meet the 75-5-10 test. (The 75, 5, and 10 represent percentages.) So for an investment company to claim it's diversified, no more than 5 percent of the 75 percent can be invested in one company. In addition, out of the 75 percent portion, the investment company cannot own more than 10 percent of the outstanding shares of any company. The remaining 25 percent can be invested in any way. If an investment company doesn't meet the 75-5-10 test, it is considered non-diversified.
Unlike investors in face-amount certificate companies and unit investment trusts (see “Considering Other Investment Company Options,” later in this chapter), investors of open-end and closed-end funds have many choices available. Investors may be looking for safety, growth, a combination, and so on. This section gives you a glimpse into those investment choices.
Mutual funds come in many types and flavors depending on your client's needs. Mutual funds can specialize in holding stocks, preferred stocks, short-term bonds, intermediate-term bonds, long-term bonds, or any combination of those. Here are some types of mutual funds:
There are companies that provide volatility ratings for bond mutual funds. The volatility ratings typically take into account the credit rating of the bonds held, sensitivity to market conditions and general economy, the market price volatility of the portfolio, the fund's performance, interest rate risk, prepayment risk, currency risk, and so on. If these volatility ratings are going to be used in retail communications, there are certain FINRA rules that must be followed:
The single most important consideration for customers who invest in packaged securities is the fund’s investment objectives. This feature surpasses even the sales charge or management fees. As a registered rep, one of your primary jobs will be to help investors decide which type of fund would be best for them. The test-designers want to know you can handle that job. Comparing like-type funds is secondary. I list funds based on their investment objectives below:
Income fund: The primary objective of an income fund is to provide current revenue (not growth) for investors. This type of fund invests most of its assets in a diversified portfolio of debt securities that pay interest and in preferred and common stock of companies that are known to pay consistent dividends in cash.
Income funds are considered much safer (more conservative) investments than growth funds. You can assume for Series 7 exam (and real-life) purposes that income funds are better investment choices for retirees and investors who are looking for a steady cash flow without much risk.
Growth fund: This fund is exactly what you’d expect it to be; growth funds invest most of their assets in a diversified portfolio of the common stock of relatively new companies, looking for big increases in the stock prices. Growth funds offer a higher potential for growth but usually at a higher risk for the investor. This type of fund is ideal for an investor who’s looking for long-term capital appreciation potential.
Because of the inherent risk of investing in growth funds, they’re better for younger investors who can take the risk because they have more time to recover their losses.
Funds must disclose their average annual returns to help investors,representatives, investment advisers, and so on be able to compare like funds quickly. Securities laws require each fund to disclose the returns for 1-, 5-, and 10-year periods. If the fund hasn't been in existence for 10 years, it must disclose the returns since inception. The performance as well as being online is also disclosed in the fund's prospectus.
You’ve probably heard about hedge funds but aren’t exactly sure what they are. For the Series 7 exam, you do need to know a little bit about them. Because they aren’t open- or closed-end funds, unit investment trusts, or face amount certificate companies, they are an exception to the standard definition of investment company under the Investment Company Act of 1940. In addition, because they are considered private investment companies (sold privately under Regulation D) and are only open to sophisticated (accredited) investors, they are exempt from SEC registration. As such, many hedge funds have limited available information. Hedge funds often require a very high initial investment — sometimes $500,000 or more and therefore have limited or no liquidity. In addition, many have lock-up provisions, which means that investors will not be able to redeem or sell shares during that time.
Hedge funds hold a pool of investments and are professionally managed like mutual (open-end) funds but have a lot more flexibility. Hedge funds have a wide array of investment styles, models, and vehicles. Some are even blind pool/blank check investments where there's no stated goal. Hedge funds are typically much more aggressive in nature and may buy securities on margin, sell securities short, purchase or sell options, and so on in an attempt to maximize gains. I guess you can almost think of them as a “whatever it takes to make money” type of fund.
The fees, costs, and expenses for investing in a hedge fund are typically around 2 percent per year for a management fee. In addition, many hedge funds charge as much as 20 percent of the profits made after a certain goal is reached.
Taxation on hedge funds is similar to that of direct participation programs because they are set up as pass-through entities. So the fund itself is free of taxes, and the gains and losses are passed through to the investors who are taxed at the individual level.
Investors who have the extra funds available may be able to receive a reduced sales charge for large dollar purchases. Breakpoints and the letter of intent are available to investors of open-end funds and unit investment trusts. Because closed-end funds, after the initial offering, are traded in the market, investors do not receive breakpoints. Dollar cost averaging and fixed share averaging are most often used for open-end fund purchases but may apply to other investments as well.
Funds have an investment adviser (portfolio manager) who gets paid a percentage of the value of the securities held in the fund. Therefore, one way to entice investors to spend more is to reduce the sales charge when they spend a certain minimum amount of money. That’s where the breakpoint comes in.
Management investment companies divide purchase amounts into different tiers. Within a certain range, investors all pay the same sales charge percentage. But when investors spend enough to put them in the next tier (when they hit the breakpoint), they get a reduced sales charge. Breakpoints have no set schedule, so they vary from fund to fund.
Here are a few key points for you to remember for the Series 7 exam:
TABLE 10-2 Breakpoints for ABC Growth Fund
Purchase Amount |
Sales Charge |
$1–$9,999 |
7% |
$10,000–$19,999 |
6% |
$20,000–$39,999 |
4% |
$40,000 and up |
2% |
Another discount, rights of accumulation, allows shareholders to receive a reduced sales charge when the amount of the funds held plus the amount purchased is enough to reach a breakpoint. So, using Table 10-2, if the investor initially purchased $8,000 worth of ABC Growth Fund, she would pay a sales charge of 7 percent. Let's say that the market has been quite bullish and the NAV of the shares purchased has increased $15,000 and she decides to purchase an additional $7,000 of the fund. Under rights of accumulation, her sales charge on the $7,000 purchase would only be 4 percent because adding the NAV of $15,000 and the purchase of $7,000 would bring the investment to more than $20,000. There is no time limit for rights of accumulation.
A letter of intent (LOI) signed by an investor allows her to receive a breakpoint (quantity discount) right away with the initial purchase, even if the investor hasn’t yet deposited enough money to achieve the breakpoint. This document states that as long as the investor deposits enough within a 13-month period, she will receive the discounted sales charge right away.
Here are a few specifics about the letter of intent that you need to know for the Series 7:
Here’s how a letter of intent may work. Suppose, for instance, that Mr. Smith purchased $2,000 worth of ABC Growth Fund two months ago and has another $7,000 to invest in the fund right now. Mr. Smith believes that he’ll keep investing in ABC Growth Fund and would like to get a reduced sales charge for investments of $10,000 and up. (See Table 10-2 for the breakpoints.)
Mr. Smith signs a letter of intent and wants to apply it to his previous purchase. Because his previous purchase was two months ago, Mr. Smith has only another 11 months to invest the remaining $8,000 into ABC Growth Fund. Mr. Smith will receive the 6 percent sales charge on his $7,000 investment right now, which will be reduced by the overage he paid on the previous investment of $2,000. In other words, he’ll pay only $400 sales charge on the current investment ($420 for this transaction minus the $20 overpaid from the previous investment) when he invests the $7,000. As long as Mr. Smith deposits the additional $1,000 by the end of the letter of intent’s time frame, he’ll pay the 6 percent sales charge. However, if Mr. Smith doesn’t live up to the terms of the agreement, ABC Growth fund will sell the shares held in escrow to pay for the difference in the sales charge.
If an investor is employing the dollar-cost-averaging formula, she is investing the same dollar amount into the same investment periodically. Although dollar cost averaging is primarily used for mutual funds, people can use it for other investments as well. Dollar cost averaging benefits the investor when the price of the security is fluctuating. The investor ends up buying more shares when the price is low and fewer shares when the price is high by depositing the same amount of money each time she makes a purchase.
The following question tests your understanding of dollar cost averaging.
Mrs. Johnson deposits $1,000 into DEF growth fund in four separate months. The purchase prices of the fund are as follows:
What is the average cost per share for Mrs. Johnson?
(A) $40.00
(B) $44.44
(C) $45.00
(D) $48.35
The correct answer is Choice (B). On the surface, this question may look very easy to you and you may jump to Choice (C), but Choice (C) is the average price per share, not the average cost. Remember that because Mrs. Johnson is investing the same amount of money each month, she’s able to buy more shares when the price is low and less when the price is high. In the first and fourth months, when the price was $40 per share, she was able to buy 25 shares each time. In the second and third months, she was able to buy only 20 shares each time:
Over the four months, Mrs. Johnson invested a total of $4,000 and purchased a total of 90 shares (25 + 20 + 20 + 25). The average cost per share is $44.44:
You should be prepared to calculate the average cost per share, the average price per share ($45), and the amount saved per share ($0.56).
You need to know two basic formulas to determine the sales charge and public offering price of open-end funds. Yes, every chapter seems to have more formulas, but these formulas are pretty straightforward and shouldn’t cause you too many sleepless nights.
The sales charge, which is set at a maximum of 8½ percent, is part of the public offering price (POP), or ask price, not something tacked on afterward like a sales tax. One of the tricks for calculating the sales charge for open-end funds is remembering that the POP equals 100 percent. Therefore, if the sales charge is 8 percent, the net asset value (NAV) is 92 percent of the POP. The formula for determining the sales charge percent is as follows:
The following question tests your expertise in calculating the sales charge of a mutual fund.
ABC Aggressive Growth Fund has a net asset value of $9.20 and a public offering price of $10.00. What is the sales charge percent?
(A) 6.8 percent
(B) 7.5 percent
(C) 8 percent
(D) 8.7 percent
The right answer is Choice (C). The first thing that you have to do is set up the equation. Start with the POP of $10.00 and subtract the NAV of $9.20 to get $0.80. Next, divide the $0.80 by the POP of $10.00 to get the sales charge of 8 percent:
When taking the Series 7 exam, you may be asked to figure out the public offering price of a mutual fund when you’re given only the sales charge percent and the NAV.
Remember, the sales charge is already a part of the POP, so the sales charge is not equal to the sales charge percent times the NAV. Use the following formula to figure out how much an investor has to pay to buy shares of the fund when you know only the NAV and the sales charge percent:
The following question tests your ability to answer a POP question.
DEF Aggressive Growth Fund has a NAV of $9.12 and a POP of $9.91. If there is a 5 percent sales charge for investments of $30,000 and up, how many shares can an investor who is depositing $50,000 purchase?
(A) 5,045.409 shares
(B) 5,208.333 shares
(C) 5,219.207 shares
(D) 5,482.456 shares
The answer you want is Choice (B). Don’t let the decimals throw you off; mutual funds can sell fractional shares. This investor isn’t going to be paying the POP of $9.91 per share because she’s receiving a breakpoint for a large dollar purchase (see “Breakpoints,” earlier in this chapter). To figure out the POP for this investor, set up the formula:
After working out the formula, you see that the investor is paying $9.60 per share instead of $9.91. Next, determine the number of shares the investor can purchase by dividing the amount of the investment by the cost per share:
This investor is able to purchase 5,208.333 shares because of the breakpoint. Without the breakpoint, the investor would have been able to purchase only 5,045.409 shares.
As I explained earlier in this chapter, most mutual funds charge a sales charge (also known as a load) that’s built into the public offering price (POP). However, most charge up front, some charge constantly, some charge when redeeming, and some don't charge a load at all. Depending on how investors are charged, mutual funds are broken down into classes:
Something else that investors should be concerned about is a fund's expense ratio. To determine a fund's expense ratio, you have to divide the fund's expenses (management fees and operating costs) by the funds average net assets. So if the expense ratio of a fund is 2 percent, that means that the fund is charging $2 for every $100 invested. The higher the expense ratio, the more the fund is eating into your profits.
A couple of other types of investment companies — face-amount certificate companies and unit investment trusts (UITs) — aren’t as popular as they used to be. Unfortunately, even though you may never sell any, you do need to know them for the Series 7 exam. You probably won’t see more than a question or two on these topics. However, exchange-traded funds (ETFs) are becoming increasingly popular, and your chance of having a question on ETFs and/or inverse ETFs is around 100 percent.
A face-amount certificate is a type of packaged security that’s similar to a zero-coupon bond (see Chapter 7); investors make either a lump sum payment or periodic payments in return for a larger future payment. The issuer of a face-amount certificate guarantees payment of the face amount (a fixed sum) to the investor at a preset date. Very few face-amount certificate companies are around today.
A unit investment trust (UIT) is a registered investment company that purchases a fixed (unmanaged) portfolio of income-producing securities (typically bonds) and holds them in trust, which means that a UIT acts as a holding company for its investors. Then the company issues redeemable shares (units) that represent investors’ interest in the trust. Unlike mutual funds, UITs are set up for a specific period of time and have a set termination date. Any capital gains, interest, and/or dividends are passed on to shareholders at regular intervals.
UITs have a finite number of shares outstanding and are distributed in the primary market at the initial public offering (IPO) price. Because a limited number of shares are outstanding and they must be redeemed with the issuer or sponsor, liquidity is very limited.
Like mutual (open-end) funds, UITs can be purchased by type, such as growth, income, balanced, international, and so forth.
Here are the two main categories of these trusts:
Exchange-traded funds, or ETFs, are closed-end index funds that are traded on an exchange. ETFs provide investors with diversification along with ease of trading, the ability to sell short, and purchase shares on margin.
Inverse ETFs (also known as Short ETFs or Bear ETFs) are exchange-traded funds that are designed using many derivative products, such as options to attempt to profit from a decline in the value of the underlying securities (for example, the S&P 500). Inverse ETFs can be used to profit from a decline in a broad market index or in a specific sector, such as the energy or financial sectors.
When compared to mutual funds, ETFs have some distinct advantages, including the ability to purchase shares on margin, ease of trading (mutual funds have forward pricing but ETFs can be traded any time throughout the day at the current bid or ask price), and lower operating costs.
There are a couple of disadvantages when comparing ETFs to mutual funds: Investors are charged commissions when buying and selling and because they are so easy to trade, and investors are more likely to trade excessively instead of holding their positions.
A real-estate investment trust (REIT) is a trust that invests in real-estate-related projects such as properties, mortgage loans, and construction loans. REITs pool the capital of many investors to manage property and/or purchase mortgage loans. As with other trusts, they issue shares to investors representing their interest in the trust. REITs may be listed on an exchange or can trade over-the-counter (OTC) (see Chapter 14 for more info on markets). They also provide real-estate diversification and liquidity for investors.
REITs are distributed in the primary market at the IPO price. Unlike mutual funds, which are redeemed with the issuer, REITs are traded (bought and sold) in the secondary market to other investors. In addition, REITs have a finite number of shares outstanding, like closed-end funds. Because REITs are traded in the secondary market, their price may be at a discount or premium to the NAV, depending on investor sentiment.
Equity REITs take equity positions in real-estate properties; the income is derived from rent collected or profits made when the properties are sold. Mortgage REITs purchase construction loans and mortgages. The trust receives the interest paid on the loans and in turn passes it on to the owners of the trust (the investors). Hybrid REITs are a combination of equity and mortgage REITs. Hybrid REITs generate income derived from rent and capital gains (like an equity REIT) and interest (like a mortgage REIT).
REITs can avoid being taxed like a corporation if
Don’t kill yourself worrying too much about REITs (not that you would); you won’t get more than one or two questions on the Series 7 exam relating to REITs.
REITs typically offer investors stable dividends based on the income the REIT receives. Unlike other equity securities, dividends received from REITs are not qualified, meaning that the tax rate due cannot be reduced based on the holding period and investor's tax bracket (See Chapter 15 for more on qualified dividends). However, dividends from REITs do receive a special tax benefit, which is 20 percent of the income distributed is deductible (tax-free). If the REIT distributes income based on the sale of a property, it will pass through either short- or long-term capital gains to the investor based on the holding period of the property sold. If investors decide to sell their REITs, they may have a gain or loss depending on their cost basis and the selling price. In addition, the gain or loss may be long- or short-term depending on the investor's holding period.
Annuities are similar to mutual funds, except annuities are designed to provide supplemental retirement income for investors. Life insurance companies issue annuities, and these investments provide guaranteed payments for the life of the holder. The Series 7 exam tests you on the two basic types of annuities: fixed and variable. Because variable annuities are considered securities and fixed annuities are not (because of the guaranteed payout by the insurance company), most of the annuity questions on the Series 7 exam are about variable annuities.
The main thing for you to remember about fixed annuities is that they have fixed rates of return that the issuer guarantees. Investors pay money into fixed annuities, and the money is deposited into the insurance company’s general account. After the investor starts receiving payments from the fixed annuity (usually monthly), the payments remain the same for the remainder of the investor’s life. Because of the guaranteed payout, fixed annuities are not considered securities and therefore are exempt from SEC registration requirements.
Insurance companies introduced variable annuities as a way to keep pace with (or hopefully exceed) inflation. In a fixed annuity, the insurance company bears the inflation risk; however, in a variable annuity, the investment risk is borne by the investor. Because the investors assume the investment risk, variable annuities are considered securities and must be registered with the SEC. All variable annuities have to be sold with a prospectus, and only individuals who hold appropriate securities and insurance licenses can sell them.
The money that investors deposit is held in a professionally-managed separate account (separate from the insurance company’s other business) because the money is invested differently. The separate account is invested in securities such as common stock, bonds, mutual funds, and so on, with the hope that the investments will keep pace with or exceed the inflation rate. Separate accounts must be registered with the SEC as investment companies. Income and capital gains generated are credited to the separate account. Also, if the investments in the separate account lose money, it is charged to the separate account. The separate account is unaffected by the insurance company's other business.
The assumed interest rate (AIR) is a projection of the performance of the securities in the separate account over the life of the variable annuity contract. If the assumed interest rate is 4 percent and the performance of the securities in the separate account is equal to 4 percent, the investor receives the payouts that she expects. However, if the securities outperform the AIR, the investor receives higher payouts than expected. And unfortunately, if the securities held in the separate account underperform the AIR, the investor gets lower payouts than expected.
Investors have choices when purchasing annuities and getting distributions. During the accumulation phase, investors will decide how to allocate their investment options. For example, investors may decide to put 30 percent into a particular bond fund, 50 percent into a U.S. stock fund, and 20 percent into an international stock fund. Investors may also choose a lump-sum payment or multiple payments, depending on their needs. Investors also have a choice regarding how they want to get their distributions at retirement.
Insurance companies aren't setting up annuities for investors just because they like to help people out, they receive money for doing so. Even though the initial sales loads might be minimal or non-existent for investors purchasing annuities, they will get charged pretty heavy sales charges (surrender charges) if they close out the annuity too early. The insurance company makes additional money on management fees and other expenses. Some additional charges that investors should be aware of depending on the variable annuity offered could be charges for stepped-up benefits, guaranteed minimum income benefits, and long-term care insurance. All the applicable charges would be found in the variable annuity prospectus.
Payments into both fixed and variable annuities are made from after-tax dollars, meaning that the investor can’t write the payments off on her taxes. However, payments into both fixed and variable annuities grow on a tax-deferred basis (they aren’t taxed until the money is withdrawn). If an investor has contributed $80,000 into a variable annuity that’s now worth $120,000, the investor is taxed only on the $40,000 difference because she has already paid taxes on the contribution. If an annuitant dies during the pay-in phase, most annuity contracts require a death benefit to be paid to the annuitant’s beneficiary. The death benefit is typically the greater of all the money in the account or some guaranteed minimum.
Note: During the pay-in phase, an investor of a variable annuity purchases accumulation units. These units are similar to shares of a mutual fund.
Investors have a few payment options to select when purchasing fixed or variable annuities. Here’s the rundown of options:
Investors of both fixed and variable annuities have several payout options. These options may cover just the annuitant (investor) or the annuitant and a survivor. No matter what type of payout option the investor chooses, she will be taxed on the amount above the contribution. The earnings grow on a tax-deferred basis, and the investor is not taxed on the earnings until withdrawal at retirement.
Note: During the payout phase of a variable annuity, accumulation units are converted into a fixed number of annuity or annuitization units. Investors receive a fixed number of annuity units periodically (usually monthly) with a variable value, depending on the performance of the securities in the separate account.
When an investor purchases an annuity, she has to decide which of the following payout options works best for her:
As with most other retirement plans, annuity investors are hit with a 10 percent early withdrawal penalty if they withdraw the money prior to age 59½. Yes, that’s correct — the 10 percent penalty is added to the investor’s tax bracket. Typically, retirement plans include a waiver of the 10 percent penalty in cases such as the purchase of a first home, age 55 and separated from work, death, or disability.
If the annuity holder dies before the insurer has started making payments, the beneficiary is guaranteed to receive a specified amount. That specified amount is typically at least the amount that was paid into the annuity even if the account value is less than the guaranteed amount. However, that amount could be lowered if withdrawals have been made from the account. The death benefit is a common option. Investors should understand that additional benefits cost additional money.
The surrender value or cash surrender value of an annuity comes into play when an annuity is voluntarily terminated (cashed in) before its maturity. In that case, the annuity holder will receive the cash value less surrender fees. Quite often, the cash surrender value will be less than what the annuity holder has paid in premiums. Typically the surrender fees, which are a percentage of the cash value, decrease the longer the policy is kept in force.
You may wonder what life insurance is doing in the SIE, which is mainly about investments. Well, the answer is that certain life insurance products, specifically, variable life (VLI) and variable universal life (VUL), have an investment component. Like variable annuities, variable life and variable universal life insurance policies have a separate account for investing. That separate account is kept separate from the insurance company’s general fund. You won’t need to know too much about the aforementioned insurance products, so I’ll keep it brief.
Variable life policies have a fixed premium. As with variable annuities, the investor chooses the investments held in a separate account. The death benefit (face amount) on the policy is fixed to a minimum but not to a maximum. Funds covering the minimum death benefit are kept in the insurance company's general fund. The death benefit may increase depending on the performance of the securities held in the separate account. If the separate account performs poorly, there may be limited or no cash value built up. Policyholders may borrow up to 75 percent of the cash value.
Unlike variable life policies, variable universal life policies do not have fixed premiums. As such, they are sometimes called flexible premium variable life policies. As with variable life policies, the investors can pick the securities held in the separate account. In this case, since the premium is not fixed and the securities held in the separate account may perform poorly, the minimum death benefit and cash value are not guaranteed.
Investors may find that it is advantageous for them to switch life insurance policies or annuities. Under Section 1035 of the Internal Revenue Code, individuals may exchange an insurance policy for another insurance policy or annuity insuring the same person without having to pay taxes on the income and investment gains in the original contract. Investors are also allowed to switch from an existing variable annuity contract to another. However, investors cannot switch from an annuity to life insurance policy without having to pay taxes.
Besides all the other investment company stuff you need to know prior to taking the Series 7, there are some additional Investment Company rules you'll need to touch base with. I've done my best to cover most of the rules prior to this section, but, alas, there are some more. I condensed the rules to just the most important info for your reading pleasure.
It's illegal for any person to use misleading sales literature (whether written or electronic) in connection with the offer or sale of investment company securities. Sales literature is considered misleading if it contains a statement of material fact which is untrue, or it omits a statement of material fact which would be necessary to make a statement not misleading.
Under section 10, the following information must be included with investment company advertisements:
Under FINRA rules, members may only use investment company rankings in retail communications if the rankings were created and published by a Ranking Entity (any independent [independent of the investment company and its affiliates] that provides general information about investment companies to the public and whose services are not procured by the investment company or any of its affiliates to assign the investment company a ranking) or created by an investment company or investment company affiliate that were based off of the performance measurements of a Ranking Entity.
If ranking data is to be used in retail communications, there must not be a statement that implies that an investment company or investment company family is the best performer in a category unless it actually is top ranked.
In addition, the communication with the ranking information must include the name of the category (growth, balanced, international, and so on); the number of investment companies in the category; the name of the Ranking Entity; the length of the period for the ranking; criteria on which the ranking is based; and the normal disclosures (such as “past performance is no guarantee of future results”).
The following rules are taken from the Investment Company Act of 1940: