Chapter 3: Investment Companies and Life Insurance Products

Equity Funds

Equity funds invest in equity securities, also known as common stock. Within the category of equity funds, there are three major types of funds: growth, income, and a third, combination type called "growth and income." Equity funds also may be categorized as growth, value, or blend. These and other types of equity funds are discussed in the following paragraphs.

Exchange Traded Notes (ETNs)

Exchange-Traded Notes (ETNs) are unsecured debt usually issued by a bank that promises to pay an amount based on the performance of an index, minus fees. Unlike other debt securities, however, ETNs do not pay interest. They also do not offer principal protection. Because ETNs are debt securities, investors do not have a claim to any securities. Instead, investors loan the issuer a certain amount of money and receive a promise from the issuer to repay their loan at a future date, based on the performance of the index being tracked. So investors who hold their ETNs to maturity will receive a cash payment that is linked to the performance of the index from the trade date to the date of maturity. Like other debt securities, they are subject to credit risk, because the issuing bank could go out of business. ETNs do not suffer from tracking risk, because the amount they pay is based on a promise to reflect the index rather than a process that is meant to track the index.

Exchange Traded Fund (ETFs)

Exchange-traded funds, or ETFs, are a type of UIT that contains stocks, bonds, or other assets. The assets are usually chosen so that they track an index. Like closed-end funds, ETFs are bought and sold on an exchange through broker-dealers, and individual ETF shares are not redeemable. The exception is that large investors or institutions can purchase a creation unit and redeem it for the underlying assets. The market price of the ETF remains close to the per-share net asset value (NAV) of the underlying assets. This is different from closed-end funds, whose prices are determined by supply and demand, because the shares cannot be redeemed. For this reason, the SEC classifies ETFs as open-end companies or unit investment trusts, even though, in most other ways, ETFs are more similar to closed-end funds.

What is the definition of diversification according to the Investment Company Act of 1940?

For the exam, you will need to know the definition provided by the Investment Company Act of 1940. This act defines diversified as any fund that has: • 75% or more of its assets invested in cash, cash items, or securities • Out of those 75% of its assets, a maximum of 5% of its assets held in any one company • Out of those 75% of its assets, a maximum holding of 10% of the voting securities of any one company A non-diversified company is one that does not meet the above criteria.

International Mutual Funds

International mutual funds, also known as foreign stock funds, invest in countries outside the investor's country of residence. Generally, these companies focus on long-term capital appreciation, although some also produce current income.

Inverse ETFs

Inverse ETFs use similar derivative products to profit from the decline of an index of underlying stocks. Both of these products are complex and carry high risks. They are designed to yield their performance on a very short period of time, usually over a day or a month. They are not meant to be held beyond the given period (day or month), and the riskiness of non-traditional ETFs is compounded the longer they are held.

Redemption Order

Mutual funds must redeem shares upon request. The mutual fund has seven calendar days from the date of its receipt of the redemption order to comply with the request. An investor can place a redemption order through a registered representative or directly to the mutual fund company in writing, by telephone, by fax, or through the company's website. Shares will be redeemed at the NAV per share (forward pricing) on the order day, minus any back-end load and fees.

What are the benefits of mutual funds?

Mutual funds provide diversification against unsystematic risk. Unsystematic risk is a type of risk that is specific to a company or an industry. For example, a software company faces the risk of not keeping up with ever-changing hardware. This is unsystematic risk, because it is not a risk that faces every company. (Systematic risk, on the other hand, is the risk that the entire market will decline, thereby hurting every company in the market.) The primary way to minimize unsystematic risk is portfolio diversification—the more different kinds of securities in a portfolio, the smaller the influence on a portfolio of bad luck or poor management in a few companies or industries. The mutual fund manager rebalances the fund when necessary to maintain diversification and manage risk.

What are the two phases of a variable annuities?

1. Accumulation Phase 2. Annuity Phase

What are the risks associated with non-public REITs?

Non-traded REITs are illiquid, meaning they generally cannot be sold readily on the open market. • Although the market price of a publicly traded REIT is readily available, it can be difficult to determine the value of a share of a non-traded REIT. Non-traded REITs may not provide an estimate of their value per share until 18 months after their offering closes. • Investors may be attracted to non-traded REITs by their relatively high dividend yields compared to those of publicly traded REITs. Unlike publicly traded REITs, however, non-traded REITs frequently pay distributions in excess of their funds from operations. To do so, they may use offering proceeds and borrowings. This practice reduces the value of the shares and the cash available to the company to purchase additional assets, thus restricting capital growth. • The assets of non-traded REITs typically are managed by someone other than an officer or employee of the REIT. This external manager receives a flat fee and an incentive fee to manage the portfolio. Questions may arise as to whether this manager has the best interests of the REIT's shareholders in mind.

Growth and Income Funds

A growth and income fund or combination fund combines characteristics of the equity growth fund and the equity income fund. The growth and income fund bridges the needs for future growth and current dividends. These funds invest in a combination of stocks of companies with strong growth potential and well-established companies that provide decent dividends.

Variable Annuities

A variable annuity is an annuity whose distributions are variable from one period to the next, because some or all of the investor's contributions are invested in securities that vary in value. Funds from variable annuities are kept in accounts that are separate from the insurance company's general account, often referred to as separate accounts. Within a separate account, the investor chooses from several possible subaccounts that operate like mutual funds. If the investments in the subaccounts perform well, the periodic payments to the annuitant will be larger, but if they perform poorly, the payments will be smaller. The investor rather than the issuer bears the investment risk.

What is the nature of the board of directors for mutual funds?

An elected board of directors manages the mutual fund company. The board helps choose and manage the investment adviser, custodian, and transfer agent and establish the company's investment policy. Members of the board of directors are elected by fund shareholders. At least 40% of the members of the board of directors must be non-interested persons. This means they are not involved with the company or its investment adviser, custodian, or transfer agent, except through their work on the board.

Investment Company

An investment company is a company whose primary business is to invest in and issue securities. It collects and pools money from a number of clients and invests it in packages of securities whose profits and losses are shared in proportion to the clients' ownership share of that package. In this way, investment companies offer investors in securities an economical way to diversify risk. Investment companies are also known as packaged securities.

What companies can issue annuities?

Annuities are investment vehicles used to provide steady income to an individual after retirement, often until death. An annuity is a contract between an individual and an insurance company. The individual, called the annuitant, invests money with the insurance company, either as a lump sum or in periodic payments. At some agreed-upon time, the insurance company begins distributing payments to the annuitant. Payments may be made monthly, in a lump sum, or irregularly, based on the wishes of the annuitant. The size of the payments depends on the amount deposited.

Conversion Privilege

Conversion privilege. Another way an investor can save money on sales charges is when a mutual fund offers a conversion/exchange privilege for funds within a "family." The investor can sell shares of one type of fund and buy shares of a different fund within the family at the NAV rather than the POP. That benefit encourages the investor to stay within the family. The IRS considers this type of move, even though it is within a family, to be a taxable event. All gains or losses are recognized on the date of the sale.

Net Asset Value (NAV)

The cost of a mutual fund is determined by the net asset value (NAV) of the fund. The NAV is the book value of the fund and is calculated by determining the fair market value of the securities in the fund and subtracting the fund's expenses (liabilities). The book value is then divided by the number of shares in the fund to yield the NAV per share.

Transfer Agent

The transfer agent issues new shares to buyers and cancels the shares that shareholders redeem. The transfer agent, also known as the customer services agent, distributes income to the shareholders and sends out the shareholder reports. The transfer agent can conduct transactions for investors if a registered representative is unavailable when needed. The custodian for a mutual fund may also serve as its transfer agent.

A REIT must uphold what requirements in order to be considered qualified by the IRS?

To qualify with the IRS, a REIT must uphold the following requirements: • Annually, at least 75% of the REIT's gross income must be real estate-related income (for example, rents) • Annually, at least 95% of the REIT's gross income must be real estate-related income (for example, rents) and dividends and interest from any source • At least 75% of its total assets must be invested in real estate • It must be managed by a board of directors or trustees • It must have a minimum of 100 shareholders (the "100 Shareholder Test") • It must distribute at least 90% of its income annually to its shareholders

Underwriters

Underwriters sponsor mutual funds, which means they market and sell shares to the public either directly or through broker-dealers. Underwriters prepare sales literature for the fund as part of their services.

Universal Life Insurance

Universal life insurance is a type of whole life insurance that provides the purchaser with more flexibility in terms of the death benefit and the premiums. Universal life insurance premiums can be adjusted depending on the amount of coverage the purchaser desires, allowing her to save money if she decides she or the insured doesn't need as much coverage.

Whole Life Insurance

Where term life insurance covers the insured for a certain "term," whole life insurance is meant to cover an insured for their "whole" life. Whole life insurance is an insurance product that has an insurance component and an investment component. Because of this additional benefit, it is much more costly than term life insurance. The purchaser pays set premiums, which are locked in over the life of the insured, and the insurance company guarantees a minimum amount of payout upon death.

Surrender Period and Surrender Fee

With a deferred annuity, the annuitant may not have access to funds for up to 10 years. The length of time that the investor must wait before withdrawing money from the annuity without penalty is called the surrender period. If the annuitant needs the money before the end of the surrender period, he can surrender the contract by paying a surrender fee. The surrender value of the account will be the value in the account at the time of surrender minus the surrender fee.

Bonus Annuities

ome insurers offer bonus annuities, which give annuity holders bonus credits for switching to them. Bonus annuities pay out an extra 1% to 5% of what the investor contributes and can be for either fixed or variable annuities. Setting up a bonus annuity requires paying a fee. In addition, bonus annuities often have exceptionally long surrender periods, so the representative and the compliance officer must make sure the investor is aware and can wait for the length of the surrender period to get his investment back. If not, the investor will forfeit the bonus and also have to pay a surrender fee. Representatives should be particularly wary of recommending bonus annuities to older people who may need to withdraw their funds before the surrender period ends.

Beneficial Interest

the value that a shareholder receives from a stock when its legal title is held by a broker or other custodian.

What are the settlement options for annuity investors at annuitization stage?

• Life income. The insurer pays the annuitant an income during his lifetime. When the annuitant dies, benefits stop. Because this option is likely to be the shortest amount of time, and therefore the least expensive for the insurance company, the annuitant will receive the largest monthly check with this option. • Life with period certain. The insurer pays the annuitant an income during his lifetime. As part of the initial contract, the annuitant chooses a "period certain" during which payments will continue even if the annuitant dies. For example, the investor may choose a period certain of 20 years. If the annuitant dies during that 20 years, his named beneficiary will receive payments for the remainder of the period. An annuitant who chooses life with period certain will receive medium sized monthly checks. • Joint life with last survivor. The insurer pays the annuitant an income during his lifetime. In addition, the annuitant names a survivor beneficiary who also will receive payments from the same account for her lifetime. Payments are made to the annuitant and the beneficiary until both have passed away. The joint life with last survivor option will have the smallest monthly checks because payments must continue through the lives of both people.

What are the settlement options for life insurance policies?

• Lump sum. The entire amount is paid upon death. • Fixed amount. The amount is put into an interest bearing account, and the beneficiary receives a fixed amount over regular increments of time until the amount runs out. • Fixed period. The amount is put into an interest-bearing account, and the beneficiary receives payments at regular intervals over a fixed period until the money runs out. • Life income. The amount is annuitized so that the beneficiary receives a certain guaranteed amount of money over his life.

Why are ETFs considered to be more tax efficient than mutual funds?

1. Most mutual funds are actively managed. This means that portfolio managers are frequently buying and selling securities within the fund, resulting in capital gains distributions on which the investor must pay taxes. In contrast, ETFs typically track an index and are not actively managed, requiring fewer transactions that may result in capital gains distributions. 2. When investors in mutual funds redeem their shares, the mutual fund may be forced to sell securities to come up with the money to redeem the shares, resulting in a capital gain for the fund. In contrast, ETF investors rarely redeem their shares. Instead, they sell their shares to others so the ETF is not forced to sell securities to meet redemption requirements.

Real Estate Investment Trust (REIT)

A Real Estate Investment Trust (REIT) is a type of company that is modeled on a mutual fund. A REIT buys, develops, manages, and sells a portfolio of income-producing properties. Because a REIT is a trust, it sells shares of beneficial interest. The holder of these shares receives benefits from the assets held by the trust—in this case, real estate—but does not own the actual assets. By owning a REIT, investors can take part in real estate's potential benefits, including price appreciation and income, without the added burden of owning and managing property.

Assumed Interest Rate (AIR)

A projected estimate of the rate of return on an annuity contract.at-the-market offering

A shares

A shares are sold at a public offering price of NAV plus front-end sales charge. The load comes off the top of the amount invested, reducing the amount of money available to buy shares. Thus, if an investor has $10,000 to invest in a mutual fund and there is a 5% front-end load, $500 will go to the broker selling the fund and only $9,500 will be used to purchase shares. Sales charges can be reduced through breakpoints, as illustrated above. A shares may include an annual maintenance fee (12b-1 fee); this fee is usually lower for A shares than for B shares or C shares. A shares are most appropriate for accounts with a large enough investment to benefit from a breakpoint.

Annuities

Annuities are investment vehicles used to provide steady income to an individual after retirement, often until death. An annuity is a contract between an individual and an insurance company. The individual, called the annuitant, invests money with the insurance company, either as a lump sum or in periodic payments. At some agreed-upon time, the insurance company begins distributing payments to the annuitant. Payments may be made monthly, in a lump sum, or irregularly, based on the wishes of the annuitant. The size of the payments depends on the amount deposited.

How do fees loop into this?

As might be expected, those performing the roles described above earn fees for their work. The investment adviser receives a management fee, generally a percentage of the portfolio's value, and is paid out of the fund's net assets. The investment adviser may be paid an incentive bonus if it meets or exceeds a performance benchmark. The mutual fund company also pays the custodian and the transfer agent fees. As explained above, the underwriter recovers its costs through a sales charge. If the mutual fund company acts as its own underwriter, its fees related to sales are recovered through 12b-1 fees.

What are the shareholder of mutual fund holding rights?

As shareholders, account owners are entitled to vote on matters of material importance. A majority vote of outstanding shares is required if an investment company wishes to: • Change its investment objectives • Approve or change its investment adviser or manager • Ratify its independent auditors • Change its fee structure, including its 12b-1 fees Shareholders also have a right to vote for a board of directors.

Annuity Phase

At a certain point, the customer must annuitize the contract and begin receiving monthly payments. This is called the annuity phase. The monthly payments will vary depending on the performance of the investments in the customer's separate account and on the customer's choice of payment.

Automatic Reinvestment

Automatic reinvestment. An investor may receive dividends and capital gains in the form of a check or may automatically reinvest in more shares. Automatic reinvestment occurs at the NAV and does not incur sales charges, saving the investor money. Reinvested dividends, income, and capital gains are subject to taxation. Retirement plans typically reinvest automatically, because there are considerable tax penalties for early withdrawals.

B shares

B shares are sold at the NAV with no up-front sales charge. Thus, the full amount of the investor's money is available to buy shares. They are subject to a back-end charge when the shares are redeemed if not held for the number of years specified in the prospectus. B shares often convert to A shares if held for a time period, also specified in the prospectus. The back-end charge is assessed on the appreciated value of the shares, so the reduction in price could be substantial. Annual maintenance (12b-1) fees are higher for B shares than for A shares. B shares are more appropriate for accounts not large enough to reach breakpoints and for investors who intend to hold the shares for a long period of time.

Balanced Funds

Balanced funds contain equities for appreciation and bonds for income. The objective of a balanced fund is to achieve lower volatility than an equity fund and higher returns than a bond fund. In addition, a balanced fund offers diversification across stocks and bonds. If the stock market is down, there is a good chance the bond prices in the fund will be up. This type of fund can have any percentage of stocks versus bonds, and the percentages may vary over time, based on the fund manager's objectives and actions. The prospectus provides the fund's philosophy, from which the investor can decide whether its management style is compatible with the investor's needs.

Blend Funds

Blend funds combine growth funds and value funds. This type of fund will appeal to investors who seek capital appreciation for the future and dividends for now, along with substantial diversification.

Bond Funds

Bond funds are also known as fixed-income funds. In general, they are less volatile than equity funds, although within bond funds, yield and risk vary. Bond funds range from absolutely safe (U.S. Treasury) bonds that pay low yields to higher-risk corporate bonds that can pay higher yields. There are also different types of taxable and tax-exempt bond funds. Municipal bond funds typically avoid federal and sometimes state income tax. Bond funds do not mature like individual bonds—shares can be sold any time without considering bond maturity dates. Both the share price and yield should be considered when choosing a bond fund.

What are prohibited mutual fund practices?

Breakpoint sales, selling dividends, late trading, holding customer orders, and holding customer payments

Breakpoint Sales

Breakpoint sales. Because breakpoints can be confusing to investors, registered representatives should help their clients understand and take advantage of breakpoints. If the investor is a few dollars shy of a breakpoint, the representative should advise the investor of this, even if it means the commission is reduced. When a rep fails to do this and sells a mutual fund to a client in an amount just under the breakpoint, the result is a breakpoint sale. Breakpoint sales are prohibited by FINRA.

C shares

C shares have no front-end or back-end sales charges, except for a 1% back-end charge if the investor sells within one year. Annual expenses are higher for C shares than for A shares and B shares. Thus, C shares are the most expensive for investors who are investing for long periods of time and are best for investors who do not want to hold the shares for long.

Dollar Cost Averaging

Dollar cost averaging. Dollar cost averaging is an investment strategy in which an investor makes regular, periodic purchases of the same dollar amount in the same security or securities. An investor who employs this strategy will end up purchasing more shares when the price of the security is low and fewer shares when the price is high. This strategy helps an investor avoid making a large investment when the price of a security is high or selling a large amount when the price is too low. Thus, dollar cost averaging lowers the average cost per share of the investment over time. Moreover, dollar cost averaging can reduce emotional involvement in a stock, which can lead to selling when shares go down and buying as they go up.

What is the inherent main risk with ETFs?

ETFs track an index by owning a basket of investments that are held by a custodian and to which each shareholder has a pro rata claim. ETFs tend to track their indexes well, but tracking is inherently imperfect due to such issues as cash held, fund fees, and how liquid an asset or a market is. Thus, ETFs are subject to tracking risk, which is the risk that the fund will not adequately mimic the index.

Are leveraged and inverse ETFs suitable for investors?

FINRA has advised its member firms that inverse and leveraged ETFs are not generally suitable for retail investors, especially investors who will not be actively monitoring their portfolios. In addition, they are not suitable for investors who plan to hold them for more than one trading session (day or month). For the exam, remember that they are not suitable for an investor who wishes to buy and hold. Because they rely on derivatives, they are also riskier than other comparable funds.

Fixed Annuity

Fixed annuities are often compared to CDs (certificates of deposit), because they have similar features. In a fixed annuity, the customer's investment is deposited into the insurance company's general account. This means that the insurance company is responsible for investing the client's money as it sees fit and for providing a fixed payment based on the amount of the client's deposit over the client's life. The insurance company thus bears the investment risk.

Growth Funds

Growth funds contain stocks of growing companies. These companies commonly reinvest their earnings into expansion, acquisitions, and research and development and therefore pay low or no dividends. Growth stocks are said to be expensive—that is, their price-to-earnings ratios are high—because the market perceives the companies' potential future earnings as high. Investors who invest in growth funds have capital appreciation as their primary goal. Such investors have relatively long-term investment horizons and do not require regular income from this investment and, thus, are willing to wait for a company to hit it big in the future.

General vs. Separate Accounts

In a fixed annuity, the customer's investment is deposited into the insurance company's general account. This means that the insurance company manages these funds within the same pool as its funds for other insurance products. Annuitants receive a fixed monthly payment for life that is guaranteed by the insurance company. In a variable annuity, the insurance company manages the funds in a separate account from its other insurance products. Typically, the investor chooses from several subaccounts that operate like mutual funds. The performance of the variable annuity in the accumulation and annuitization phases depends on the performance of the separate account, in particular, the performance of the subaccounts chosen by the investor. Therefore, the amount of the investor's monthly payment depends on the performance of the investments in the subaccount.

Accumulation Phase

In the first phase, the customer contributes money into the annuity account. This is called the accumulation phase. As the customer contributes more, the account grows in value. Also, the account grows (or shrinks) depending on the performance of the securities in the sub-accounts.

Income Funds

Income funds, in contrast, buy stocks of well-established companies that pay nice dividends. Equity income funds typically produce higher returns than money market or bond funds but are still considered to be relatively conservative investments. Because equity income funds are more volatile than money market and bond funds, they are more appropriate for investors with investment horizons longer than a year.

Late Trading

Late trading. Late trading is the practice of placing mutual fund orders after the fund has calculated its daily NAV. As noted earlier, investors who buy and sell shares of mutual funds receive the forward price, which is the NAV calculated at the end of the trading day. Typically, the NAV is calculated when markets close at 4:00 p.m. ET. If an order to buy or sell comes in after the NAV has been calculated, the investor should receive the NAV that is calculated on the following day. Late trading refers to filling orders after the close of trading at the NAV for that day. This practice gives these customers an information advantage—they can sell shares when the NAV is higher than expected and buy shares when the NAV is lower than expected. Late trading also allows customers to benefit from any breaking news that comes out after regular market hours. For these reasons, the SEC and FINRA prohibit late trading. All purchasers of mutual fund shares should have equal access to information on any given day.

Leveraged ETFs

Leveraged ETFs use derivative products such as equity futures and swaps to receive daily returns two to three times above the returns of the index they are tracking. They usually have a multiplier in their names, such as 2x or 3x, to represent how many times the performance of the index they are designed to produce. The term "ultra" can also signify a leveraged ETF. For example, a triple-leveraged ETF is one that projects returns three times the tracked index.

Further info on closed-end funds

Like open-end funds (mutual funds), closed-end management companies offer shares of a fund made up of a portfolio of securities. Unlike open-end funds, however, closed-end funds raise capital through an initial public offering (IPO), after which they no longer issue new shares. Closed-end funds also differ from mutual funds in that they can be traded on the secondary market like a stock. For this reason, we say that shares of closed-end funds are negotiable, since their ownership can be transferred across individuals. Closed-end funds purchased during an IPO are not subject to sales loads, but the broker will usually charge a commission on the trade. Since they are sold only once by the investment company, closed-end funds do not incur the ongoing cost of creating and redeeming shares, and they typically have lower expense ratios than open-end funds. Because of its fixed nature, the closed-end fund structure gives the portfolio manager freedom to maintain a long-term strategy. The fund can hold positions through market declines, because it does not need to sell securities frequently to maintain enough cash for redemptions. That said, closed-end funds are actively managed and the managers do buy and sell securities within the fund. After shares are sold in an IPO, the investment company continues to manage the funds. Ongoing maintenance expenses are deducted directly out of the fund through a reduction in the NAV. While there is no direct relationship between NAV and the prices of closed-end funds in the secondary market, because prices of closed-end funds are driven by supply and demand, closed-end funds are often referred to as trading at either a premium or a discount to the fund's NAV. Closed-end funds normally trade at a discount to NAV. Closed-end shares can be purchased on margin and can be sold short. Purchases and sales of closed-end fund stock require payment of a commission, which adds to the cost of a purchase and subtracts from the proceeds of a sale.

What are the two types of management companies?

Management companies come in two types. A closed-end fund issues a fixed number of shares in an IPO. The shares can be traded with other investors in a secondary market, but cannot be sold back to the company. Open-end management companies are what most people know as mutual funds. Mutual funds offer to the public shares of a portfolio of securities in the form of a fund. Every time investors purchase shares of the fund, new shares are issued by the mutual fund company. Additionally, when investors wish to sell their shares, they must sell them back to the mutual fund company. The mutual fund company will then "redeem" them and expire the shares. Thus, open-end funds offer a continuous issuance of new shares, and because the shares are issued new, they always need to be sold with a prospectus.

Money Market Funds

Money market funds are an additional type of mutual fund. (Money market accounts, in contrast, are a type of bank deposit account and will not be addressed here.) Money market funds invest in high-quality, short-term debt instruments, such as commercial paper, banker's acceptances, Treasury bills, and repurchase agreements. They are nearly as safe and liquid as bank accounts, with a higher yield. Money market funds pay dividends based on prevailing short-term interest rates. Money market funds are perfect for investors who require liquidity but would like to earn more interest than if they kept their money in a bank account. Money market funds in the United States are regulated by the Investment Company Act of 1940, as amended. Money market fund securities must be highly liquid and of the highest quality. Money market funds are not as safe as government-insured bank deposits, nor are they guaranteed. Money market funds are managed to maintain a stable NAV of $1 per share. The debt instruments in which a mutual fund invests usually do not produce capital gains or losses. This quality results in the principal in a money market fund remaining relatively constant and keeping risk close to nil. The $1 NAV price is not guaranteed, but the fund is managed, so it will not go below the $1 NAV price (or "break the buck") even if the market changes. The "buck" has been "broken" a few times, but it is a very rare occurrence.

What are the large limitations around EIAs?

Participation Rate and Caps The upside return of an equity-indexed annuity is limited in a couple of ways. One of these is the participation rate, which is the rate at which the annuitant can participate in the returns of the index. For example, when an annuity has a participation rate of 80%, the investor will benefit to a maximum of 80% of the increase in the annuity's index. If the index goes up 10%, the investor would receive 80% of 10%, or 8% (0.1 x 0.80 = 0.08). Equity-indexed annuities also may be subject to caps on performance. If an EIA has a cap, the annuitant will not receive a return higher than the cap, even if the increase in the index return times the participation rate is higher than the cap. For example, suppose an EIA has a 90% participation rate with a 12% cap. At the end of the year, the benchmark index has increased by 20%. Without the cap, the investor would receive 90% of 20% or an 18% increase in rate of return (0.9 x 0.2 = 0.18). With the cap, however, the investor would receive a 12% increase.

How REITs make money?

REIT shareholders receive dividends from investment income (primarily rent). They also receive capital gains distributions when properties are sold. REITs do not pass through losses to shareholders, unlike a real estate limited partnership (RELP) or a real estate Direct Participation Program (DPP). Another difference between REITs and real estate DPPs is that REITs acquire and develop properties mostly to keep in their portfolios rather than to resell after development.

Front-end vs. Back-end Loads

Sales charges, or "load," can be part of the mutual fund share purchase or sale. Sales charges that are included in the investor's purchase of shares are called a front-end load. Sales charges that are included in the investor's sale of shares are called a back-end load. The percentage of back-end load may decline over time and may even disappear after several years (see Breakpoints section). These declining charges are called contingent deferred sales charges, because the sales charge is deferred until the investor sells, and the percentage charged is contingent on when the sale occurs. That is, it is possible for the back-end load to be zero by the time the investor sells the stock.

Section 1035 Exchanges

Section 1035 of the Internal Revenue Code allows annuity holders to exchange one annuity contract for another without suffering any tax consequences. While 1035 Exchanges may seem like a great deal for the investor, representatives need to be sensitive to the fact that some exchanges may not be beneficial for the client. In addition, FINRA penalizes representatives who encourage their clients to switch annuities in order to earn additional commissions.

Sector Mutual Funds

Sector mutual funds invest in a specific industry or sector of the economy and, therefore, are not as diversified as other types of mutual funds. Sector funds may have appreciation potential when there is an increased demand for the product or service the sector provides. They are also subject to higher risk and volatility than broader-based funds. They may lead or lag the economic cycle or react in opposition to it.

Selling Dividends

Selling dividends. FINRA prohibits the practice of selling dividends. Selling dividends is when a registered representative encourages a customer to buy shares of a mutual fund right before the mutual fund pays a dividend. This practice is prohibited, because on the ex-dividend date, the net asset value of the mutual fund is adjusted downward to reflect the dividend, so the customer would receive no net benefit from buying the shares right before the dividend. In fact, the customer would come out a loser, because he would be taxed on the dividend, whereas he would not be taxed on the adjustment for the dividend had he waited to buy at the lower price.

Term Life Insurance

Temporary life insurance is known as term life insurance and is similar to paying rent. The purchaser pays premiums that provide a guaranteed death benefit to a beneficiary if the insured dies during a specified period of time. If the insured does not die during this period, the option is available to renew the insurance policy, although renewing will be much more expensive, because the insured is now at a higher risk for death. Unlike an annuity, term life insurance does not build any cash value. The premium is paid to the insurance company and is never returned to the purchaser. Thus, a term policy has no cash value. Term life has to be renewed at increasingly higher rates. This kind of policy might be most suitable for younger individuals who want to protect their children or spouse in case of an accident but don't have a lot of money to spend on life insurance.

12b-1 fees

The 12b-1 fees, also called maintenance fees or distribution fees, are fees that are charged to recoup the expenses of selling, marketing, and distributing the fund. They include advertising costs, such as printing materials and mailing prospectuses. They also include the salaries of the sales people, but they do not include transaction costs for buying and selling securities in the fund.

How does the AIR payout?

The AIR is an expected rate at which the annuitant and insurance company agree that the annuity will grow annually. This expected rate is not an actual rate but simply an "assumed" rate. Each month the AIR is compared to the account's actual return rate. If the account returns are better than the assumed rate, that means the annuity units have increased in value and the monthly check for the current month will be greater than that of the previous month. If the account returns are the same as the AIR, the check will be the same as it was the previous month. If the actual performance is worse than the AIR, that means the annuity units have decreased in value, and the current month's check will be smaller than that of the previous month.

What are the three types of investment companies that the Investment Company Act of 1940 define?

The Investment Company Act of 1940 defines three types of investment companies: face-amount certificates, unit investment trusts, and management companies. Face-amount certificates are debt securities backed by assets such as real property or other securities. Because face-amount certificates are not very common, we will focus primarily on the other two. A unit investment trust is a holding company that purchases a pool of securities and holds them until a set termination date. The pool of securities does not change from the time that the trust was created, so the trust is considered unmanaged. A management company, by contrast, manages and trades the securities within a portfolio and does not have a set termination date.

Who regulated the annuity marketplace?

The annuity marketplace is primarily regulated at the state level by the state's insurance commissioner. Fixed and indexed annuities are regulated almost solely at the state level, because they are not considered securities and, therefore, fall outside SEC jurisdiction. Variable annuities are regulated by the SEC and FINRA, as well as by each state, because they are considered to be securities, and require anyone selling them to have a securities license. Like other types of income, annuities are ultimately defined and governed by the Internal Revenue Code.

Mutual Fund

The best-known investment company product is the mutual fund, known formally (legally) as an open-end investment company. A mutual fund is an investment portfolio managed by a professional investment adviser, so mutual funds offer sophisticated investment management that most investors would not be able to achieve on their own.

Custodian

The custodian, a bank or stock exchange member broker-dealer, holds the mutual fund's shares and monetary funds. The custodian is responsible for performing the accounts receivable and accounts payable functions for the mutual fund company. When the portfolio manager trades securities within the fund, it is the custodian that receives the proceeds from sales and releases the required funds for purchases. The custodian also maintains records of dividends and interest received from the company's investments. The custodian must keep a company's assets physically segregated from those of other companies and restrict access to those assets to certain officers and employees of the mutual fund company.

Death Benefit

The death benefit is the amount that will be paid at death to the beneficiary.

Equity Indexed Annuity (EIA)

The equity-indexed annuity (EIA) is a type of fixed annuity that tracks the performance of an index. An index is a statistical measurement used to measure the performance of a market. Indexes may measure either stock or bond markets, or different sections of the market. Someone who invests in an EIA receives a return that is directly related to the performance of a particular index.

Guaranteed Death Benefit

The insurance company does provide a minimum guaranteed death benefit that comes out of the insurance company's general account. The death benefit may rise above the minimum guaranteed amount, depending on the separate account performance, but never drop below. How much the death benefit rises will be based on the performance of the separate account, but also on an assumed interest rate for the account. If the subaccount performs better than the AIR, the death benefit will grow. If the subaccounts perform worse than the AIR, the death benefit will shrink, but never below the guaranteed level.

"No Load" vs. "Load" Fund

The price that is charged to the public is called the public offering price (POP). The public offering price is equal to the per-share NAV, plus a sales charge (if the fund is a "load" fund). If the mutual fund is a "no-load" fund, POP = NAV. If the mutual fund is a "load" fund, POP = NAV + sales charge. Load usually is the commission paid to brokers, but sometimes mutual funds that do not use brokers still will charge a sales load.

High-water mark method

The return is the difference between the highest point and the start of the term. The highest point is based on several select points throughout the life of the annuity, such as annual anniversaries.

Point-to-point method

The return is the difference in the index between two points in time, such as the beginning of the contract and the end of the contract.

Tax-Sheltered Annuities (TSAs)

There are some annuities in which contributions are made with pre-tax dollars. These are sometimes called tax-sheltered annuities (TSAs). Because they are funded with money that has not yet been taxed, all of the distributions will be taxed at the annuitant's ordinary income level. As with nonqualified annuities, any withdrawals occurring before the age of 59 1/2 will be subject to an early withdrawal penalty of 10% of the previously untaxed portion of that withdrawal. Because none of the money in the account has been subject to taxes, the annuitant will be taxed on the entire distribution amount.

Fixed vs. Variable vs. Index Annuities

There are two types of annuities: fixed annuities and variable annuities. Fixed annuities pay a rate of return guaranteed by an insurance company and are not considered securities. Variable annuities pay a variable rate of return, depending on the investments chosen by the annuitant, and are considered securities. Indexed annuities are a type of annuity that tracks an index and pays a rate of return based on the performance of that index. Indexed annuities are currently considered to be a type of fixed annuity but may, in the future, be classified as securities, due to their participation in the market.

Annual reset indexing method

This method "locks in" the gain each year, based on the change in the index from the beginning of the year to the end of the year (any declines are ignored). Thus, the gain is credited each year, rather than at the end of the contract.

When can UITs be redeemed?

UIT units also may be redeemed on any business day prior to their termination date. Unit holders who cash in early will receive the NAV for their units by tendering them to the trustee. If enough units are redeemed early to threaten the trust's ability to pay off all the unit holders who want their principal, the sponsoring company may raise some cash by reoffering (offering to sell) to other investors the units that were redeemed early. There is no active secondary market for UITs.

What about UITs and their "termination date"?

UITs have a stated termination date that varies according to the type of investments in the portfolio. A UIT in bonds generally terminates when the last bond reaches maturity. A UIT containing a mix of 5-, 10-, and 20-year bonds will terminate in 20 years. Equity (stock) UITs typically mature in 15 months to 5 years. Unit holders receive their share of the principal at termination; any income earned is distributed to investors in periodic payments of dividends or interest.

Do unit holders typically pay a sales charge? What do the other fees look like?

Unit holders generally pay a sales charge, but because units are not actively managed there are no investment management fees and transaction costs are minimal. The sales charge may be collected up front or in installments by deducting from the distributions. If a unit holder redeems the units early, before a sales charge has been fully paid, the sponsor will collect the unpaid amount from the redemption payment.

Unit Investment Trusts (UITs)

Unit investment trusts (UITs) are "pooled investments" like open-end and closed-end funds. UITs are investment companies that buy and hold a fixed portfolio of securities that are put into a trust and sold in "units" (also known as "shares of beneficial interest" as in other trusts) to unit holders. The Investment Company Act of 1940 defines UITs and states that UITs are organized under a trust indenture, contract of custodianship, agency, or similar instrument and have no board of directors. Unit investment trusts issue redeemable securities like an open-end fund. Like a closed-end fund, however, UITs offer investors a one-time offering of a fixed number of units, generally in $1,000 blocks. Because the units are issued new, they must be sold with a prospectus. UITs are not actively managed and the UIT does not employ an investment adviser, so the securities within the portfolio rarely change.

Value Funds

Value funds invest in companies whose stocks are trading for less than the portfolio managers think they are actually worth. These companies may be thought of as being out of favor. Even though their share price may be depressed, these companies often keep paying dividends. Thus, their price-to-earnings ratios are relatively low and their dividend yields relatively high. Value funds are considered to be more conservative than growth funds, because they invest in stocks that are perceived to be boring and to have low or no growth potential. Investors in value funds are betting that eventually the depressed stocks' prices will rise.

Variable Life Insurance

Variable universal life insurance is a combination of variable and universal life insurance. The policyholder is still able to invest in separate accounts as a way to grow cash value, but the monthly premiums are flexible. The individual must pay enough in premiums to keep the policy from lapsing. This amount will vary depending upon the performance of the separate account.

What are the advantages and disadvantages for variable life insurance products?

Variable universal life insurance is a combination of variable and universal life insurance. The policyholder is still able to invest in separate accounts as a way to grow cash value, but the monthly premiums are flexible. The individual must pay enough in premiums to keep the policy from lapsing. This amount will vary depending upon the performance of the separate account.

What are the three methods of EIAs gaining in an index?

• Point-to-point method. The return is the difference in the index between two points in time, such as the beginning of the contract and the end of the contract. • High-water mark method. The return is the difference between the highest point and the start of the term. The highest point is based on several select points throughout the life of the annuity, such as annual anniversaries. • Annual reset indexing method. This method "locks in" the gain each year, based on the change in the index from the beginning of the year to the end of the year (any declines are ignored). Thus, the gain is credited each year, rather than at the end of the contract.