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CHAPTER 8 Investment Products and Markets:
Mutual fund (investment company)
Corporation that uses it’s capital to purchase investment vehicles instead of plant and equipment.
Suitability (who are they best for?)
Best return ; minimizing risksLimited amount of money
How do you make money?
Dividends or interest from within portfolioCapital gains from within the portfolioCapital gains from the shares of the portfolio
MUTUAL FUND BASICS
What is the difference between an open-end and a closed-end mutual fund?
Open ClosedUnlimited shares Limited sharesAlways primary market trade on an exchangeReflects the value of the portfolio supply and demand also impact value
What are the three primary advantages of a mutual fund?
DiversificationProfessional money mgtliquidity
TYPES OF MUTUAL FUNDS (objectives)
Aggressive Growth
Growth
International/Global
International should only have investments outside the US
Global could include US investments
Growth and Income
Fixed Income
Balanced/Equity Income
Specialty/Sector
Asset Allocation
Money Market
Index
Loads
Commissions
Front-end - pay up front
Redemption – pay to redeem
Contingent deferred sales charges – pay a decreasing commission if sell within a certain period of time (CDSC)
FEES AND EXPENSES
Management Fees and Operating Expenses
12b-1 Fees
Trustee Fees
Expense Ratio
Ratio of expenses to NAV
Higher the ratio, better the manager must perform to generate a desired return.
The more expensive it is to own the investment
Higher returns could offset higher expenses (or not)
Mutual Fund Basics
The People
Investment Advisor
Day to day investment decisionsMoney manager
Custodian / Transfer Agent
BookkeeperSafekeeping securities and cash
Analysis of Mutual Funds
Three basic areas
1) first you select funds that match investment objectives.
2) next rank funds by statistical performance measures
This can be done manually or via software
Morningstar has a filter that can assist
The premium filter allows ranking by different statistics
3) non-statistical measures
Really not a ranking tool
Most mutual funds either by law or necessity provide the same services
That is not to say that customer service quality is the same!!
Prospectus
READING MUTUAL FUND PROSPECTUS
INVESTMENT OBJECTIVES AND POLICIES
RISK FACTORS
INVESTMENT RESTRICTIONS
PAST PERFORMANCE
FUND INFORMATION
COSTS AND FEES
MISCELLANEOUS INFORMATION
A document provided by mutual fund that describes in some detail the characteristics of this mutual fund.
The components are mandated by law
A mutual fund is always a primary market transaction; unlike stocks
This requires a prospectus be provided at or before the sale of any mutual fund.
A prospectus has a life of 13 months
Classes of Shares
What is meant by share class?
No distinction between portfoliosMarketing of the loads and expenses
Class A shares
Front load; lower fees; no redemption load
Class B
CDSC condition al deferred sales charge
No front load; only a redemption load if sold within a certain time frame; higher initial fees higher than “A” but then they are lowered after time
Class C
No load; usually higher fees
These fees never reduce
Misc other classes
Institutional shares have a variety of combinations of fees and loads
• How to choose between Class A and B
– Class A shares have a front load
• they also have a declining load schedule as investment increases
– Class B shares are CDSC; but have higher initial expenses
• As holding period increases, potential redemption load decreases
• Eventually become Class A
• If have large sum or will be investing over time, Class A may be more expensive
• If do not have a large sum to invest, the choice is really about when to pay the load. (up front or over time)
• Not a clear choice all the time. Regulation has dictated how and when some classes can be
Mutual Funds Restrictions
a list of restricted investment vehicles and strategies will be listed in the prospectus.
Potential list
No margin or short sales
No underwriting except their own shares
No investment in commodities
No private placement
No controlling interest
No more 5% value of total assets
No more 10% voting stock
No borrowing except for emergencies and only from a bank.
Diversified Investment Companies
The 5% and 10% rule actual applies to 75% of the mutual funds cash
The remaining 25% of cash can be invested in any security or company.
Prices
NAV (Net Asset Value)
Equivalent of share price
Represents the current value of one share of the investment portfolio
POP (public offering price)
Incorporates the load
NAV = $12 with a 5.75% load
What is the POP of a mutual fund with a NAV of 37.25, and a 4.5% front load?
POP=37 .251−.045
=39.005
Who gets the extra 1.755?
Break Point Qualification
NAV= Assets - Liabilities# of shares
POP= NAV1−load%
POP=121−.0575
=12.73
How can you “beat” break points?
Large Sum purchaseLetter of intent Can back date 90 days Have 13 months to break the point Not a contractual arrangementAccumulated funds
Redemption of shares
How do you “sell” the shares
In the stock market shares are sold back through the brokerage. They are purchased by another investor.
With mutual funds the process is different. The mutual fund company by law must “redeem” the shares within 7 days of a request. It is the mutual fund that buys the shares from the old shareholder.
Remember these shares are retired and never sold to another investor.
Services
Reinvestment Privilege
Current income and capital gains are automatically reinvested (buy more shares)
No load charged
You must request distribution in cash if you want it.
Conversion Privilege
Can move share between same fund family funds at no load.
Taxable though unless in a retirement account
Systematic Withdrawals (investments)
Can request to have funds automatically deposited to or withdrawn from an account
MUTUAL FUND RATING SERVICES
MORNINGSTAR
Industry’s best resource for comprehensive, unbiased and accurate mutual fund information
LIPPER
Leading global mutual fund information company analyzing fund companies and financial intermediaries
STANDARD & POOR’S
Leading global provider for mutual fund information and analysis
THOMAS FINANCIAL
Global provider of data, analysis, and information tools
TRADITIONAL INDEX FUNDS
Index funds hold shares in all the companies that make up an index like S&P 500
NOT true. They rarely hold the shares of all. They attempt to create a “clone”
ADVANTAGES
Fewer Capital Gains
Keeping Pace with Selected Index
Painless Strategy
Lower Cost
PITFALLS OF INDEX FUNDS
Downside Risk
Skewed Weighting Systems
Do they actually copy the index?
Divergence Between Index Funds
How can different index funds have different returns?
Narrow Focus
Lose the Value Added by Money Managers
Increased Volatility
VARIABLE ANNUITY
CONCEPTS OF variable annuity
Like an IRA that is not deductible
Tax deferred investment vehicle
Variety of investment options
Guarantees protected by an insurance component
BENEFITS
Diversified Investment Portfolio
No Limit on Annual Investment
Upon death, beneficiaries are guaranteed face value or higher market value
Pay for this
VA company may permit annual payout without penalty
Watch for forced annuitization
Tax-deferred Growth Of Funds
DRAWBACKS
High Mortality and Expense Charge
Depends on the contract
The “shares” in the VA are institutional shares that might not have any load and very low expenses
Contingent Deferred Sales Charges
If in for the long term this is not an issue
If you need the cash in 4 – 5 years, VA is not the answer.
Penalty for Withdrawal Before 59-1/2
Variable Annuity Funding Sources
Where does the money come from?
Liquidation of Earnings
Withdrawal from taxable savings plan
Life insurance death benefit proceeds
Other lump sums (inheritance, sale of business)
Cash value life insurance or annuities (1035 Exchanges)
VARIABLE IMMEDIATE ANNUITY
Assumption here is annuitization
What is annuitization?
Convert lump sum to a systematic cash flowSounds like what you want.Lose control of assets / insurance company owns the cashLose return opportunitiesWhat happens at death
Nondeductible IRAs vs. Nonqualified Annuity
NonQualified IRA Annuity
Contributions (after-tax dollars) X X
Earnings accumulate tax-deferred X X
Earnings taxed upon withdrawal X X
Principal can be withdrawn tax free X X
10% tax penalty applies to withdrawals X X before age 59 1/2
No minimum distribution at age 70½ X
Unlimited payments to contract X
Who May be Right for a Nonqualified Annuity
Has Long-term savings goals and/or is planning for retirement
Has reached their maximum 401(k) and IRA contribution limits
Wants family protection in the form of a death benefit
Wants to grow their assets tax deferred
Wants ability to move among funding options tax free
Wants lifetime income
We’re all familiar with IRAs. We know that there are a variety of IRAs that we can offer our clients, including the traditional IRA (tax deductible, contributions are made with pre-tax money, annual contribution limits, etc.) and non-deductible IRAs (non-deductible contributions made with after-tax money). To give you a frame of reference, this slide helps illustrate the similarities between the non-deductible IRA which you’re familiar with and a nonqualifed annuity that you may not be familiar with.
• First the terminology. “Non-deductible” contributions are made with after-tax dollars. When a variable annuity is purchased with after-tax dollars (e.g., cash, life insurance proceeds), this is considered the purchase of a “nonqualified” contract. For nonqualified contracts, there is no tax deduction for the amounts paid into the contract.
• Like a non-deductible IRA, any growth on the variable annuity contract accumulates tax deferred until the client takes a withdrawal. Consequently, no current income taxes are due on the variable annuity contract until money is withdrawn, hopefully at some point in the future when the client is in a lower tax bracket.
• Note: This should not be confused with a Roth IRA.
Has received unexpected lump sum payment and needs to invest long-term
Liquidity is now a key determinate on whether the variable annuity contract can even be offered. This is a change due to misdeeds of agents taking advantage of senior citizens and others. Why would brokers want to issue this type of security? MONEY!!! Variable annuities pay higher commissions than mutual funds.
Who May NOT be Right for a Nonqualified Annuity
Net worth is less than $100,000
IRAs and 401(k) not fully funded
Short-term investors with higher liquidity needs
Insufficient discretionary income/ emergency funds
May need access to money prior to age 59½
1035 exchange basics
What is a 1035 exchange?
Conversion from one insurance vehicle to another.Avoids tax consequences if done properly.
This is a conversion of one insurance type vehicle for another. This is a non-taxable exchange.
Defer Taxable Gain
Assume:
$20,000 Premiums Paid
$25,000 Cash Value
$5,000 Taxable Income Upon Surrender
Let’s look at two sales ideas for the Variable Annuity regarding 1035 Exchanges. One is to defer a taxable gain and the other is to save a tax loss.
Save Tax Loss
Assume:
$20,000 Premiums Paid
$15,000 Cash Value
$5,000 Loss
First, let’s look at deferring a taxable gain and assume we have a client who has $25,000 of cash value in a life insurance policy, and they have paid $20,000 in premiums.
If they were to simply surrender that contract and take the proceeds and buy a Variable annuity contract, their cost basis would be $20,000 and they would pay taxes on the gain in the contract which would be the $5,000.
If they do a 1035 Exchange, the new cost basis of Variable annuity is $20,000, and there are no taxes currently due. The important thing is that the funds are directly transferred into the annuity (the money goes from one insurance company to the other so the client does not take possession of any of the insurance policy’s assets).
While there are many reasons to move the cash value of a life insurance policy into an annuity, it’s important to remember that this type of exchange has tax implications for the beneficiary. There is no income tax due on death benefit proceeds received from a life insurance contract. However, any portion of the death benefit proceeds from an annuity contract that have not previously been taxed are taxable to the beneficiary.
Another situation that can be considered is to save the tax loss of a life insurance policy. For instance, we have a life insurance policy with $15,000 of cash surrender value, and the premiums paid total $20,000.
If the client were to surrender this policy and move the proceeds to a Variable annuity policy, the cost basis is $15,000.
However, if they do a 1035 Exchange into a Variable annuity policy, the cost basis of the Variable annuity policy is $20,000. Under a 1035 Exchange, the $15,000 that goes into the annuity contract can grow by $5,000 back up to its original premiums paid amount ($20,000) before growth will be considered taxable earnings.
Because the $5,000 growth gets us back to the original cost basis, there would be no gain in the contract. This is the way to save a tax loss inside of a Variable annuity policy on a 1035 Exchange.
Some of the rules about a 1035 Exchange:
• Client must exchange the entire value of an existing policy; there are no partial 1035 Exchanges.
• Clients cannot transfer a policy into an existing policy; you must purchase a new annuity contract.
• Both the owner and the annuitant under the new contract must be the same as the owner and the annuitant (insured) under the old contract.
• Life insurance policy loans cannot be transferred.* If they were to be exchanged for the annuity, they would become immediately taxable.
• You can exchange a life insurance policy for an annuity, and an annuity for another annuity, but you cannot exchange an annuity for a life insurance policy.
* In some cases, it may be appropriate for the loan to be “netted” against the cash value.
Charges and Fees
Asset Based Fees
Mortality & Expense Risk Charge
Pay for the guarantees
Step-up charges
Creates guarantee of upward growing portfolio value (floating floor)
Fund Fees and Expenses
Paid to the mutual funds
Usually institutional fund classes so lower fees
Contingent Deferred Sales Charges
Contract Administrative Charges
Some of the rules about a 1035 Exchange:
• Client must exchange the entire value of an existing policy; there are no partial 1035 Exchanges.
• Clients cannot transfer a policy into an existing policy; you must purchase a new annuity contract.
• Both the owner and the annuitant under the new contract must be the same as the owner and the annuitant (insured) under the old contract.
• Life insurance policy loans cannot be transferred.* If they were to be exchanged for the annuity, they would become immediately taxable.
• You can exchange a life insurance policy for an annuity, and an annuity for another annuity, but you cannot exchange an annuity for a life insurance policy.
* In some cases, it may be appropriate for the loan to be “netted” against the cash value.
Now let’s take a look at the charges associated with a variable annuity contract.
First, there are 2 charges which are deducted daily from the assets of the separate account - in essence, from your client’s contract value. Both are illustrated on an annualized basis. The mortality and expense risk charge (M&E) is 1.25%, and the sub-account administrative expense charge is 0.15%, for a total annualized cost of 1.40% of assets. These charges are designed to cover the company’s expenses for providing death benefit guarantees, annuity payout guarantees and fund valuation, as well as the distribution expenses like commissions. This percentage is fairly standard in the industry, particularly in the nonqualified annuity market.
The underlying funds to which a client allocates his or her money also have certain fees and expenses which go toward providing day-to-day portfolio management and paying their custodian and transfer agent. The range of these fees is generally from 0.64% to 1.64%. They vary by fund and fluctuate daily as the fund’s assets increase or decrease in value. Fund expenses as of the end of the most recent calendar year are illustrated in the Fee Table of the prospectus. However, these fees are typically less than the mutual fund fees. They are referred to as institutional fees. They are the classes of funds referred to in the mutual fund section as others.
Impact of Taxes on Withdrawals
Withdrawals Subject to Income Tax on Amounts Not Previously Taxed
10% IRS Early Withdrawal Penalty < 59½
EXCEPTION:
Substantially Equal Payments - 72(t)/(q)
Payments Must Continue for Longer of 5 Years or Age 59½
Step-Up Benefits – a moving floor of the value of the contract. Not all contracts permit this.
Now let’s take a look at the charges associated with a variable annuity contract.
First, there are 2 charges which are deducted daily from the assets of the separate account - in essence, from your client’s contract value. Both are illustrated on an annualized basis. The mortality and expense risk charge (M&E) is 1.25%, and the sub-account administrative expense charge is 0.15%, for a total annualized cost of 1.40% of assets. These charges are designed to cover the company’s expenses for providing death benefit guarantees, annuity payout guarantees and fund valuation, as well as the distribution expenses like commissions. This percentage is fairly standard in the industry, particularly in the nonqualified annuity market.
The underlying funds to which a client allocates his or her money also have certain fees and expenses which go toward providing day-to-day portfolio management and paying their custodian and transfer agent. The range of these fees is generally from 0.64% to 1.64%. They vary by fund and fluctuate daily as the fund’s assets increase or decrease in value. Fund expenses as of the end of the most recent calendar year are illustrated in the Fee Table of the prospectus. However, these fees are typically less than the mutual fund fees. They are referred to as institutional fees. They are the classes of funds referred to in the mutual fund section as others.
Distribution of Death Benefit Proceeds
Beneficiaries have right to:
Annuitize Contract; or
Take lump-sum payment
Spousal Beneficiaries may elect to continue contract under his/her name
Death benefit proceeds subject to estate and income taxes
Asset Allocation
Asset Allocation is the process of combining different asset classes in varying proportions to help achieve the best possible return for the lowest amount of risk
Over 92% of a portfolio’s return rests on Asset Allocation decisions
REBALANCING A PORTFOLIO
Rebalancing is not a market timing strategy
Return a portfolio to a preset allocation based on risk tolerances
It is a systematic approach to maintaining a consistent risk profile