Unit 9: Insurance Company Products

A 38-year-old investor places $25,000 into a single premium qualified deferred variable annuity. Twenty years later, with the account valued at $72,000, the investor withdraws $50,000. If the investor is in the 25% marginal income tax bracket, the total tax liability is A) $17,500. B) $11,750. C) $12.500. D) $16,450.

A) Explanation Because this is a qualified annuity, the entire withdrawal is taxable. In this case, it is all $50,000. That $50,000 is taxed at the marginal rate of 25%. Furthermore, because the investor is younger than 59½ (38 + 20 = 58), there is the additional 10% penalty tax. Effectively, this is a 35% tax on $50,000. LO 9.d

If a 42-year-old customer has been depositing money in a variable annuity for five years, and he plans to stop investing but has no intention of withdrawing any funds for at least 20 years, he is holding A) accumulation units. B) annuity units. C) mutual fund units. D) accumulation shares.

A) Explanation The customer, in the accumulation stage of the annuity, is holding accumulation units. The value of the customer's account is converted into annuity units if and when the customer decides to annuitize the contract. LO 9.c

All of the following statements about variable annuities are true except A) a minimum rate of return is guaranteed. B) the number of annuity units becomes fixed when the contract is annuitized. C) such an annuity is designed to combat inflation risk. D) the rate of return is determined by the underlying portfolio's value.

A) Explanation The return on a variable annuity is not guaranteed; it is determined by the underlying portfolio's value. Variable annuities are designed to combat inflation risk. The number of annuity units becomes fixed when the contract is annuitized; it is the value of each unit that fluctuates. LO 9.a

One of the distinguishing differences between variable annuities and mutual funds is that variable annuities A) have a separate account. B) generally have lower surrender charges. C) offer a guaranteed rate of return. D) are considered securities.

A) Explanation The variable part of a variable annuity is the separate account. That is what makes it a security product similar to a mutual fund. The only guarantee with a variable annuity is that, once annuitized, payments will continue for life (or the designated period certain). The amount of those payments will vary based on the performance of the separate account. One of the negative features of variable annuities is that they typically have surrender charges that can last a decade or longer. LO 9.a

A 58 year-old investor owns a single premium deferred variable annuity with a current value of $500,000. The original investment was $150,000 and the contract has a death benefit provision. If the investor suddenly passes away and the beneficiary receives a lump sum payout, A) the beneficiary will owe ordinary income taxes on $350,000. B) the beneficiary will owe ordinary income taxes on $500,000. C) the beneficiary will owe ordinary income taxes on $350,000 plus 10% penalty if under 59½. D) the beneficiary will owe ordinary income taxes on $500,000 plus 10% penalty if under 59½.

A) Explanation When receiving the death benefit in a lump sum, the beneficiary's tax situation is the same as if the owner surrendered the policy with one critical difference. Surrender before reaching age 59½ leads to the 10% tax penalty, but that penalty is waived in the case of death. It is only the deferred earnings (in this question, the $350,000 difference between the initial deposit and the current value) that is subject to taxes. As is always the case with annuities, the taxation is always as ordinary income, never capital gains. LO 9.d

FINRA Rule 2330 states: no member or person associated with a member shall recommend to any customer the exchange of a deferred variable annuity unless such member or person associated with a member has a reasonable basis to believe the exchange suitable, taking into consideration whether A) the customer's health has declined since the purchase of the initial annuity. B) the customer has had another deferred variable annuity exchange within the preceding 36 months. C) the new annuity has a higher assumed interest rate. D) the customer is at least 59½ and will not be subject to the 10% tax penalty.

B) Explanation FINRA Rule 2330 specifies the suitability conditions surrounding the recommended exchange of an existing deferred variable annuity contract for a new one. Included in the list of considerations is determining if the customer has made another variable annuity exchange within the previous 36 months. Unlike life insurance, where the insured's health is important, there are no health questions on an annuity application. It is safe to assume that any annuity exchange will be done under the provisions of Section 1035. This means there are no tax consequences. The assumed interest rate is for internal purposes; it is not a differentiator when deciding which variable contract to purchase. LO 9.e

If the owner of a variable annuity dies during the accumulation period, any death benefit will A) be paid to the issuing company to complete the plan. B) be paid to a designated beneficiary. C) be returned to the separate account. D) be paid to any legal heirs as recognized by the annuitant's state of domicile.

B) Explanation The accumulation period of a variable annuity may continue for many years. If the annuitant should die during that time, any death benefit would be paid to a beneficiary designated by the annuitant at the time the annuity was purchased. LO 9.c

FINRA Rule 2330, which deals with members' responsibilities regarding variable annuities, applies under which of the following circumstances? I) The initial purchase of a deferred variable annuity. II) The initial purchase of an immediate variable annuity. III) The initial subaccount allocations. IV) The initial subaccount reallocations. A) I, II, III, and IV B) I and III C) I, II, and III D) II and IV

B) Explanation This rule applies to recommended purchases and exchanges of deferred (not immediate) variable annuities and recommended initial subaccount allocations (there is no such thing as initial reallocations). On the other hand, this rule does not apply to reallocations among subaccounts made or to funds paid after the initial purchase or exchange of a deferred variable annuity. LO 9.e

A registered representative explaining variable annuities to a customer would be correct in stating that I) a variable annuity guarantees an earnings rate of return. II) a variable annuity does not guarantee an earnings rate of return. III) a variable annuity guarantees payments for life. IV) a variable annuity does not guarantee payments for life. A) I and III B) II and IV C) II and III D) I and IV

C) Explanation A variable annuity does not guarantee an earnings rate because earnings will depend on the performance of the separate account. However, it does guarantee payments for life (mortality). LO 9.a

An 18-year-old, unmarried high school student sought a safe investment for a $30,000 bequest until after she graduated from college. Her intent was to use the funds for the down payment on a house after graduation. Her agent recommended she choose a variable annuity as a safe haven for the funds. This recommendation is unsuitable because A) the investment grows tax deferred. B) withdrawal of her cost basis is tax free. C) her situation exposes her to surrender charges and early withdrawal penalties. D) an 18-year-old can't own a variable annuity.

C) Explanation The funds are not liquid due to the surrender fees, and there is also a 10% penalty on withdrawals of earnings before age 59½. LO 9.d

An 18-year-old, unmarried high school student sought a safe investment for a $30,000 bequest until after she graduated from college. Her intent is to use the funds for the down payment on a house after graduation. Her agent recommended she choose a variable annuity as a safe haven for the funds. This recommendation is A) suitable due to the relative safety of the investment. B) unsuitable because the return on something as conservative as a variable annuity tends to be low. C) unsuitable because her situation exposes her to surrender charges and early withdrawal penalties in exchange for insufficient benefits. D) suitable due to the death benefit features of a variable annuity.

C) Explanation This customer has no spouse or dependents, which negates the value of the death benefit. The funds are not liquid due to the surrender fees, and there is also a 10% penalty on withdrawals before age 59½. LO 9.b

A registered representative's customer is speaking of a variable life insurance contract she owns. She makes several statements regarding the contract. Which of the following is not an accurate statement concerning a variable life insurance contract? A) The portion of the premium invested in the insurance company's general account is used to provide for the minimum guaranteed amount of the death benefit. B) There is no guarantee regarding the investment results of the separate account. C) The policy provides a minimum guaranteed death benefit. D) The death benefit can never be more than the guaranteed benefit.

D) Explanation The minimum guaranteed death benefit is provided by that portion of the payment invested in the insurance company's general account. The remainder of the premium is invested in the separate account. While there is no guarantee on how investments in the separate account will perform, depending on its investment performance, the separate account could provide for a larger death benefit than the minimum guaranteed amount. LO 9.a

Your 65-year-old client owns a nonqualified variable annuity. He originally invested $29,000 four years ago, and it now has a value of $39,000. If your client, who is in the 28% tax bracket, makes a lump-sum withdrawal of $15,000, what tax liability results from the withdrawal? A) $4,200 B) $0 C) $3,800 D) $2,800

D) Explanation This annuity is nonqualified, which means the client has paid for it with after-tax dollars and has a basis equal to the original $29,000 investment. Consequently, the client pays taxes only on the growth portion of the withdrawal ($10,000). The tax on this is $2,800 ($10,000 × 28%). Because the client is older than age 59½, she does not pay 10% premature distribution penalty tax. LO 9.d

John is the annuitant in a variable plan, and Sue is the beneficiary. Upon John's death during the accumulation period, Sue takes a lump-sum payment. What is her total tax liability? A) It is the proceeds minus John's cost basis taxed as ordinary income at Sue's tax rate. B) The entire amount is taxed as ordinary income because it is not life insurance. C) It is the ordinary income on the proceeds over the cost basis plus 10% of the net gain (if any) if Sue is younger than 59½ years old. D) None because it is the proceeds from a life insurance company

A) Explanation Annuity death benefits are generally paid in a lump sum. The beneficiary is taxed at ordinary income rates during the year the lump sum is received. The amount taxed is the amount of the lump-sum payment minus the deceased's cost basis in the investment. LO 9.d

All of the following statements concerning a variable annuity are correct except A) variable annuities will protect an investor against capital loss. B) the invested money will be professionally managed according to the issuer's investment objectives. C) a majority vote from the shareholders is required to change the investment objectives. D) an insurance and securities license is needed to sell a variable annuity.

A) Explanation As the name implies, the investment performance of a variable annuity's portfolio (separate account) can vary, and the investor bears the risk of any potential decline in its value. Many variable annuities invest the separate account in mutual funds. LO 9.a

A registered representative (RR) recommends a variable annuity (VA) with an income rider to a client. The client's investment objectives, tax bracket, investment experience, and risk tolerance all align well with a VA recommendation. The client agrees to purchase the contract and informs the RR that he will be cashing out a VA he purchased two years ago to fund the new contract and will forward the check as soon as he receives it. Based on this information, the RR should A) reevaluate whether the recommendation for the VA contract is still suitable based on the client's proposed funding of the investment. B) suggest to the client that perhaps a loan or refinancing his vacation home might be a better way to fund the contract purchase. C) contact the issuer of the client's existing VA contract to facilitate the client's surrender of the contract. D) complete all paper work to purchase the annuity contract and obtain the client's signature immediately.

A) Explanation Funding a VA contract by cashing out either life insurance policies or existing VA contracts, especially those held for a short time, is not suitable. These contracts come with high surrender charges. Suggesting that loans or drawing equity from a home to fund VA contracts have also been targeted as abusive sales practices. Of the answer choices given, the best would be to reevaluate the recommendation based on the new information tendered by the client. LO 9.e

Your client owns a variable annuity contract with an annual interest rate (AIR) of 4%. In March, the actual net return to the separate account was 8%. If this client is in the payout phase, how would her April payment compare to her March payment? A) It will be higher. B) It will be lower. C) It cannot be determined until the April return is calculated. D) It will stay the same.

A) Explanation If the separate account of a variable annuity with an AIR of 4% had actual net earnings of 8% in March, the April payment will be higher than the March payment. LO 9.c

An investor purchased a single premium deferred variable annuity 20 years ago. The premium deposit was $50,000. The account is now worth $200,000 and the investor is still working. When does the investor have to begin taking required minimum distributions? A) Never with a nonqualified annuity B) At age 72 or when no longer working, whichever is later C) At age 59½ D) At age 72

A) Explanation On the exam, unless stated to the contrary, every annuity is nonqualified. One of the benefits of nonqualified annuities is that there is no age at withdrawals must commence. In general, earnings withdrawn prior to age 59½ are subject to the additional 10% penalty on top of tax at ordinary rates. LO 9.d

A 45-year-old investor takes a lump-sum distribution from a nonqualified variable annuity. How is the distribution taxed? I) The entire amount is taxed as ordinary income. II) The growth portion is taxed as ordinary income. III) The growth portion is taxed as a capital gain. IV) The growth portion is subject to a 10% penalty. A) II and IV B) II and III C) I and IV D) III and IV

A) Explanation On withdrawals from a nonqualified annuity, taxes are paid only on the amount that exceeds cost basis (the amount paid into the annuity). In this case, the investor is taking a lump-sum distribution before reaching age 59½ and must pay an additional 10% penalty on the taxable amount. LO 9.d

One of the features of variable insurance products is the ability to withdraw money from the policies. Which of the following statements is correct? A) Withdrawals from variable annuities are taxed on a LIFO basis, while those from variable life are taxed on a FIFO basis. B) Withdrawals from variable annuities are taxed on a FIFO basis, while those from variable life are taxed on a LIFO basis. C) Withdrawals from both are taxed on a LIFO basis. D) Withdrawals from both are taxed on a FIFO basis.

A) Explanation One advantage to withdrawing cash value from a variable life insurance policy is that it receives FIFO treatment. That means there is no tax until the withdrawal reaches the cost basis (premiums paid) of the policy. With annuities, the taxation is LIFO. Therefore, the first money withdrawn is taxable. In addition, if the policyowner is not yet 59, the 10% penalty applies. **This question deals with material not covered in your LEM, but it relates to recent rule changes and/or student feedback. LO 9.e

An investor begins a periodic payment deferred variable annuity purchase program. One respect in which this differs from purchasing a mutual fund is that A) the investor in the variable annuity contract reports no taxable consequences during the accumulation period. B) the variable annuity contract will generally have lower expenses than the mutual fund. C) the mutual fund will generally have a surrender charge for early withdrawal and variable annuities only charge for surrender when annuitizing. D) there is a minimum guaranteed return with the variable annuity, while there are no guarantees with the mutual fund.

A) Explanation One of the features of annuities is the tax deferral of all earnings until the money is withdrawn. Mutual fund distributions are taxable when received. On the other hand, when the annuity accumulation is withdrawn, everything above the cost basis is taxed as ordinary income (10% penalty if younger than 59½)—there is never any capital gains treatment with annuities. Variable annuities invariably have higher expense ratios than mutual funds with similar portfolios. Surrender charges are found with annuities. Do not confuse those with the conditional deferred sales charge (CDSC) applied to certain mutual fund share classes. LO 9.d

A 38-year-old investor places $25,000 into a single premium deferred variable annuity. Twenty years later, with the account valued at $72,000, the investor surrenders the policy. If the investor is in the 25% marginal income tax bracket, the total tax liability is A) $16,450. B) $11,750. C) $18,000. D) $25,200.

A) Explanation Only the deferred growth is taxable. In this case, it is the difference between the surrender value of $72,000 and the cost basis of $25,000. That $47,000 is taxed at the marginal rate of 25%. Furthermore, because the investor is younger than 59½ (38 + 20 = 58), there is the additional 10% penalty tax. Effectively, this is a 35% tax on $47,000. LO 9.d

The Investment Company Act of 1940 has a number of rules relating to variable life insurance policies. All of these are included except A) the maximum allowable sales charge is 8.5% of the premium payment. B) the free-look provision for 45 days after execution of the application. C) the minimum cash value loan provision after 3 years. D) the variable life contract exchange provision is good for a minimum of 24 months.

A) Explanation The 8.5% maximum sales charge is the FINRA rule relating to mutual funds. The Investment Company Act of 1940 requires that sales charges on a fixed-premium variable life contract may not exceed 9% of the payments to be made over the life of the contract. The contract's life, for purposes of this charge, is a maximum of 20 years. LO 9.e

Although there are general suitability rules that always apply, FINRA's Rule 2330 on variable annuity suitability specifies that, to be considered suitable, there is a reasonable basis to believe that the customer has been informed—in general terms—of various features of A) immediate variable annuities. B) deferred variable annuities. C) deferred annuities of all types. D) single premium variable annuities.

B) Explanation FINRA's primary suitability concern is with deferred variable annuities. That does not mean there are no requirements for being careful with the others, it is just that most of the violations have involved the deferred VA. LO 9.e

Which of the following are not defined as securities? A) Closed-end investment companies B) Fixed annuities C) Preferred stocks D) Variable annuities

B) Explanation Fixed annuities are not included in the long list of items that are defined as a security, primarily because the element of risk is not included. LO 9.a

Bob Smith, who is in his 40s, has just become covered by an extremely generous defined benefit retirement plan at his company. He has decided he no longer needs his variable annuity for retirement purposes and wants to use the money for a trip to Africa. Over the past 10 years, he has invested $60,000 in the annuity, and its net value is now $80,000. If Bob should go ahead and surrender the annuity, the tax consequences will be A) capital gains tax on $60,000 and a $6,000 penalty. B) ordinary income tax on $20,000 and a $2,000 penalty. C) ordinary income tax on $60,000 and a $6,000 penalty. D) capital gains tax on $20,000 and a $2,000 penalty.

B) Explanation If an annuity is cashed in, the growth and accumulation portion of its value ($20,000 in this case) is taxable as ordinary income. If the annuitant is under the age of 59½, he must also pay a 10% penalty on the growth withdrawn, a penalty of $2,000 in this case. LO 9.d

A customer has an investment objective of keeping pace with inflation while assuming moderate risk. Which of the following recommendations would best meet the customer profile? A) IPO B) Variable annuity C) Money market fund D) Variable life insurance policy

B) Explanation Insurance companies introduced the variable annuity as an opportunity to keep pace with inflation. For this potential advantage, the investor, rather than the insurance company, assumes the investment risk. A variable life insurance policy should be purchased primarily for its insurance features, not its investment features. LO 9.a

A 38-year-old investor places $25,000 into a single premium deferred variable annuity. Twenty years later, with the account valued at $72,000, the investor withdraws $25,000. If the investor is in the 25% marginal income tax bracket, the total tax liability is A) $6,250. B) $8,750 C) $17,500. D) $0.00

B) Explanation Only the deferred growth is taxable on a LIFO (last-in, first-out) basis. In this case, it is the amount of the withdrawal in excess of the cost of $25,000. Using LIFO, all of the withdrawal is part of the $47,000 in earnings that have been generated. That $25,000 is taxed at the marginal rate of 25%. Furthermore, because the investor is under 59½ (38 + 20 = 58), there is the additional 10% penalty tax. Effectively, this is a 35% tax on $25,000. Remember, all annuities are nonqualified unless stated otherwise in the question. LO 9.d

Changes in payments on a variable annuity correspond most closely to fluctuations in A) the Dow Jones Industrial Average. B) the value of underlying securities held in the separate account. C) the prime rate. D) the cost of living.

B) Explanation Payments from a variable annuity depend on the securities' value in the separate account's underlying investment portfolio. LO 9.c

An individual purchases a variable life insurance policy. Under federal law, the individual is entitled to a complete refund of all premiums paid if the request is made within A) the first 30 days after the policy was delivered to the owner. B) 45 days from the execution of the application, or for 10 days from the time the owner receives the policy, whichever is longer. C) 10 days from the execution of the application, or for 45 days from the time the owner receives the policy, whichever is longer. D) the first 24 months after the policy was delivered to the owner.

B) Explanation The Investment Company Act of 1940 specifies a free-look period for the purchaser of a variable life insurance policy. That period is the longer of 45 days after the execution of the application or 10 days after the actual policy is delivered to the owner. The 24 months is the minimum time limit for the exchange of the variable policy into another form of permanent insurance. LO 9.e

A separate account will invest in a number of different securities. The separate account is not likely to invest in A) money market funds. B) municipal bonds. C) equity funds. D) corporate stock.

B) Explanation The earnings on dollars invested into a variable annuity accumulate tax deferred, which is why variable annuities are popular products for retirement accumulation. As with all tax-deferred accounts, municipal bonds are not appropriate investments because interest earned on municipals is already tax exempt at the federal level. LO 9.a

A customer is choosing a payout option for a variable annuity. Maximizing monthly income for the rest of his life is the customer's key objective. This annuitant has no living relatives, so beneficiaries are not a concern. Which of the following options available would best meet the needs of this annuitant? A) A life with a 5-year period certain payout option B) A straight life payout option C) A life with a 20-year period certain payout option D) Take random withdrawals from the contract

B) Explanation The largest monthly check an annuitant can receive for the rest of his life is generated by a straight life (life income or life only) payout option. Though there is no beneficiary designation during the annuitization, this is not an issue for this annuitant. Life with period certain will produce a smaller check for life because the insurance company will guarantee payments to a beneficiary for a certain time designated in the contract, should the annuitant die within that period. But again, the need to designate beneficiaries is not an issue for this annuitant. Random withdrawals do not guarantee how long the money will last because large withdrawals can deplete the funds before the annuitant dies. LO 9.b

In a variable life annuity with 10-year period certain, a contract holder receives A) fixed payments for 10 years, followed by variable payments for life. B) a minimum of 10 years of variable payments, followed by additional variable payments for life. C) 10 years of variable payments. D) variable payments for 10 years, followed by fixed payments for life.

B) Explanation The owner of a life annuity with 10-year period certain will receive payments for life, subject to a minimum of 10 years. If the contract holder dies before the period expires, the remaining payments are made to the beneficiary. For example, if a life annuity with a 10-year period certain contract holder died after five years, payments would continue for five more years to the beneficiary and then stop. LO 9.b

Which of the following must be registered as investment companies under the Investment Company Act of 1940? I) Closed-end investment companies II) Separate accounts of insurance companies offering variable products III) Variable annuity contracts IV) Variable life insurance policies A) II and III B) I and II C) III and IV D) I and IV

B) Explanation Under the Investment Company Act of 1940, face amount certificate companies, unit investment trusts, open- and closed-end management companies, and separate accounts of insurance companies used to fund variable annuity and variable life contracts must register with the SEC as investment companies. Note that the separate account is registered as an investment company, not the variable contract. LO 9.a

Many life insurance companies offer variable products. Determining benefits usually depends on the actual performance of the selected separate account subaccount(s) compare to an assumed interest rate (AIR). Which of the following statements reflects that determination? I) Actual performance compared to the AIR affects the cash value of a variable life insurance policy II) Actual performance compared to the AIR affects the death benefit of a variable life insurance policy III) Actual performance compared to the AIR affects the value of an accumulation unit of a variable annuity IV) Actual performance compared to the AIR affects the value of an annuity unit of a variable annuity A) I and III B) II and IV C) II and III D) I and IV

B) Explanation When the actual performance of the separate account exceeds the AIR, the death benefit of a variable life insurance policy will increase. When the performance is less than the AIR, the death benefit reduces, but never below the guaranteed minimum. There is no assumed interest rate for the cash value. That is, the insurance company makes no projections as to its growth. With variable annuities, it is the annuity unit where the performance versus the AIR is important. In order to set up lifetime payments, the insurance company makes certain assumptions about returns. If the returns are higher, the value of the annuity (payout) unit increases and vice-versa. During the accumulation period, there are no assumptions; the insurance company never projects how much the money will grow. LO 9.c

A customer who has contributed to an IRA and an employer matching 401(k) plan continuously for many years, wants to purchase an annuity contract to add additional monthly income once retired. Given that all of the current retirement investments are subject to market risk, the customer wants these new funds to have no market risk exposure. One of the following options would achieve that objective, but a suitability discussion regarding its risk should also occur. Which option is it? A) Variable annuity contract with a discussion regarding legislative risk B) Variable annuity (VA) contract with a discussion regarding interest rate risk C) Fixed-annuity contract with a discussion regarding purchasing power risk D) Fixed-annuity contract with a discussion regarding timing risk

C) Explanation A VA with its investments in the separate account subject to market risk would not align with the customer's objective. Therefore, only a fixed annuity could be considered as suitable. However, a discussion should occur regarding the risks that are associated with a fixed annuity: purchasing power risk. The fixed payment that the annuitant receives loses purchasing power over time as a result of inflation. LO 9.a

All of the following statements regarding variable annuities are true except A) insurance companies keep variable annuity funds in separate accounts from other insurance products. B) variable annuities are classified as insurance products. C) variable annuities offer the investor protection against capital loss. D) variable annuities may only be sold by registered representatives.

C) Explanation A variable annuity is both an insurance and a securities product. An annuitant assumes the investment risk of a variable annuity and is not protected by the insurance company from capital losses. LO 9.a

Your customer, who still works, informs you that she will be funding a variable annuity (VA) you have recommended from two sources: a refinancing of her primary home where she will be able to draw out equity that has built up since it was purchased 15 years ago, and cashing out another VA she recently purchased within the past two years without a lifetime income rider like the one you have recommended. Based only on these facts, the VA recommendation is A) suitable if she has enough equity in the home to fund the variable annuity without cashing out the other VA contract. B) not suitable because a lifetime income rider is only for someone who is already retired. C) not suitable. D) suitable regardless of funding sources.

C) Explanation Based on the information given in the question, the VA recommendation would not be suitable. Refinancing a home to draw out equity has been identified by FINRA as an abusive sales tactic regarding the sales of VAs. Cashing out life insurance policies or VAs where steep surrender charges are likely to exist, particularly in the earlier years of those contracts, is also considered abusive. Life income riders are best suited for those who anticipate a lengthy retirement and are generally not yet retired when making the VA purchase. LO 9.e

An important basic characteristic of common stocks that makes them a suitable type of investment for the separate account of variable annuities is A) the yield is always higher than mortgage yields. B) the yield is always higher than bond yields. C) changes in common stock prices tend to be more closely related to changes in the cost of living than changes in bond prices. D) the safety of the principal invested.

C) Explanation Because common stocks are not fixed-dollar investments, they have the opportunity to keep pace with inflation. LO 9.a

A client has purchased a nonqualified variable annuity from a commercial insurance company. Before the contract is annuitized, your client, age 60, withdraws some funds for personal purposes. What is the taxable consequence of this withdrawal to your client? A) A 10% penalty plus the payment of ordinary income tax on funds withdrawn in excess of the owner's basis B) A 10% penalty plus the payment of ordinary income tax on all of the funds withdrawn C) Ordinary income taxation on the earnings withdrawn until reaching the owner's cost basis D) Capital gains taxation on the earnings withdrawn in excess of the owner's basis

C) Explanation Contributions to a nonqualified annuity are made with the owner's after-tax dollars. Distributions from such an annuity are computed on a last-in, first-out basis, with the income taxed first. Once the cost basis is reached, any further withdrawals are a nontaxable return of principal. Because the client is older than 59½ at the time of distribution, the additional 10% penalty tax is not incurred. LO 9.d

With regard to a variable annuity, all of the following may vary except A) value of annuity units. B) value of accumulation units. C) number of annuity units. D) number of accumulation units.

C) Explanation During the accumulation phase, the number of accumulation units will increase as additional money is invested. When the contract is annuitized, the annuitant is credited with a fixed number of annuity units. Once annuitized, the number of annuity units does not vary. The value of accumulation and annuity units varies with the investment performance of the separate account. LO 9.c

Once a variable annuity has been annuitized A) each annuity unit's value and the number of annuity units vary with time. B) the number of annuity units is fixed, and their value remains fixed. C) each annuity unit's value varies with time, but the number of annuity units is fixed. D) each annuity unit's value is fixed, but the number of annuity units varies with time.

C) Explanation During the payout period, payments are based on a fixed number of annuity units established when the contract was annuitized. The value of an annuity unit varies from month to month according to the performance of the separate account, in comparison to the assumed interest rate. LO 9.c

One of the specific concerns that the regulators have with variable annuities is sales personnel recommending that an investor switch from an existing contract to a new one. It would generally raise a "red flag" if the customer A) has had another deferred annuity exchange within the preceding 36 months. B) elects to make the exchange under the provisions of IRS Section 1035. C) has had another deferred variable annuity exchange within the preceding 36 months. D) has had another deferred variable annuity exchange within the preceding 60 months.

C) Explanation FINRA Rule 2330 frowns on recommending the exchange of one deferred variable annuity for another within a period of 36 months. This only applies to deferred variable annuities. When an exchange takes place, it is generally under the provisions of IRS Section 1035 - no red flag raised there. LO 9.e

The holder of a variable annuity receives the largest monthly payments under which of the following payout options? A) Life annuity with period certain B) Joint and last survivor annuity C) Life annuity D) Joint tenants annuity

C) Explanation Life annuity has the largest payout because less risk is assumed by the insurance company; there is no beneficiary in the event the annuitant dies. LO 9.b

One of your customers purchased a fixed premium variable life insurance policy five years ago. The face value of the policy is $2 million and the current cash value is $107,237. The customer calls you and asks about taking a policy loan. Although the exact details are in the prospectus, you know that the minimum amount that could be borrowed is A) $107,237.00. B) $96,513.30. C) $80,427.75. D) $1,500,000.00.

C) Explanation Once a variable life insurance policy has been in effect for at least three years, the policy must allow for a policy loan equal to a minimum of 75% of the current cash value. LO 9.e

On April 15, 2016, your client purchased a variable life insurance policy with a death benefit of $450,000. The November 2019 statement showed a cash value of $28,000. If the client wanted to borrow as much as possible, the insurance company would have to allow a loan of at least A) $21,000. B) $14,000. C) $25,200. D) $28,000.

C) Explanation Once a variable life policy is in force for a minimum of three years (this one is a bit longer than that), there is a requirement to make the loan provision available. At the three-year mark, that minimum becomes 75% of the computed cash value. Seventy-five percent of cash value of $28,000 is $21,000. LO 9.e

An individual purchases a single premium deferred variable annuity. There will be income tax ramifications in all of the following situations except A) surrender of the contract. B) death prior to annuitization. C) during the accumulation period. D) during the payout period.

C) Explanation One of the features of annuities, fixed and variable, is that there are no taxes during the accumulation phase. However, anytime money comes out of the account, whether when annuitized, surrendered voluntarily, or not (as in death), any earnings are subject to taxation. LO 9.d

You have a 70-year-old client who is in excellent health. Both parents lived into their late 90s and the client is concerned about outliving her money. What product guarantees that she will receive monthly payments for life, no matter how long that will be? A) Whole life insurance B) An index fund C) An annuity D) A 30-year term policy

C) Explanation One of the unique characteristics of an annuity (variable or fixed) is that it guarantees monthly payments for the life of the annuitant. Life insurance provides a death benefit, but not income. An index fund carries no guarantees. LO 9.a

Which of the following characteristics is not shared by both a mutual fund and a variable annuity's separate account? A) The investment portfolio is managed professionally. B) The client may vote for the board of directors or board of managers. C) The payout plans provide the client income for life. D) The client assumes the investment risk.

C) Explanation Only variable annuities have payout plans that provide the client income for life. LO 9.a

A 58-year-old investor owns a single premium deferred variable annuity with a current value of $500,000. The original investment was $150,000 and the contract has a death benefit provision. If this investor wished to exchange this policy for one offered by a competing company, A) the tax-free exchange privilege applies only when the exchange is within the same insurance company. B) the investor would be liable for ordinary income taxes on $350,000. C) using a 1035 exchange would avoid any current taxation. D) the investor would be liable for ordinary income taxes plus the 10% penalty on $350,000.

C) Explanation Section 1035 of the Internal Revenue Code permits the exchange of an annuity to another annuity, whether issued by the same or a competing company, with the tax-deferral on earnings continuing. These exchanges can also be made from an insurance policy to an annuity, but not from an annuity to an insurance policy. LO 9.d

A customer has contributed $1,000 a year for 10 years to his tax-deferred nonqualified variable annuity. The value of the separate account is now $30,000. If the customer takes a withdrawal of $10,000, what are the tax consequences? A) Two-thirds of the withdrawal is taxable as ordinary income. B) There is no tax, as the withdrawal is considered return of capital. C) The entire $10,000 is taxable as ordinary income. D) Any tax due is deferred.

C) Explanation The $30,000 contract value represents $10,000 of contributions and $20,000 of earnings. When a partial withdrawal is made from an annuity, the earnings are considered to be taken out first for tax purposes (or last-in, first-out). Therefore, ordinary income taxes will apply to the entire $10,000. In addition, if the customer is not at least 59½, there will be an additional tax penalty of 10%. LO 9.d

Variable annuities generally include an assumed interest rate. This is A) the annual rate at which annuity payments will increase. B) the rate used to illustrate the future growth prospects of the contract. C) the annual rate of return required to maintain the level of annuity payments. D) the annual dividend rate that will be paid to contract holders.

C) Explanation The assumed interest rate (AIR) is the rate the insurance company assumes the separate account will earn during the payout period. If the assumption is wrong, the monthly payments will be adjusted accordingly. If the separate account earns more than the AIR, the next month's payment is increased. If the separate account earns less than the AIR, the next month's payment is reduced. If the account earns the assumed rate, monthly payments will not change. LO 9.c

FINRA Rule 2330 deals with a member's responsibility in the sale of certain insurance company-based products. Specifically the concern is with A) taking loans against the cash value of a variable life insurance policy. B) subsequent changes to the separate account allocations in a deferred variable annuity. C) purchases and sales of deferred variable annuities. D) purchases and sales of deferred annuities.

C) Explanation This FINRA rule applies to purchases and sales of deferred variable annuities and initial allocations to the separate account. It does not apply to fixed annuities or variable life insurance. Because it only deals with the purchase or sale or initial allocations, a client with a deferred variable annuity wishing to change the separate account allocation does not come under the rule. LO 9.e

A 38-year-old investor places $25,000 into a qualified single premium deferred variable annuity. Twenty-two years later, with the account valued at $72,000, the investor surrenders the policy. If the investor is in the 25% marginal income tax bracket, the total tax liability is A) $16,450. B) $25,200. C) $11,750. D) $18,000.

D) Explanation Because this is a qualified annuity, the entire withdrawal is taxable. The surrender value of $72,000 has a cost basis of $0.00. That $72,000 is taxed at the marginal rate of 25%. Because the investor is older than 59½ (38 + 22 = 60), there is no additional 10% penalty tax. Effectively, this is a 25% tax on $72,000. LO 9.d

All of the following investment strategies offer either fully or partially tax-deductible contributions to individuals who meet eligibility requirements except A) defined contribution plans. B) Keogh plans. C) IRAs. D) variable annuities.

D) Explanation Contributions to a nonqualified variable annuity are not tax deductible. Contributions to an IRA may be tax deductible, depending on the individual's earnings and participation in a company-sponsored qualified retirement plan. LO 9.d

Your customer owns a variable annuity contract. The assumed interest rate (AIR) stated in the contract is 5%. In January, the realized rate of return in the separate account was 7%, and she received a check in February based on this return for $200. In February, the rate of return was 10%, and she received a check in March for $210. For her April check to be $210, what rate of return would the separate account have to earn in March? A) 10% B) 7% C) 3% D) 5%

D) Explanation Each month's payout depends on the actual earnings compared to the AIR. If the actual rate of return equals the assumed interest rate, the check will stay the same. We don't compare one month's return to another's; we compare the actual to the assumed. If the actual is higher, the following month's check goes up. If the actual is lower, the following month's check goes down. And, as stated earlier, if the actual equals the assumed, there is no change. LO 9.c

For a retired person, which of the following investments would provide the greatest protection against inflation? A) Corporate bonds B) Fixed annuities C) Municipal bonds D) Variable annuities

D) Explanation Fixed-income instruments, like bonds and fixed annuities, are subject to purchasing power risk. Variable annuities provide protection from inflation because their monthly income can increase depending on the separate account's performance. LO 9.a

You have a 45-year-old client whose traditional IRA contributions are at the maximum. The client would like to provide a larger cushion for retirement and asks for your advice. After reviewing the client's goals, you realize that a $25,000 single premium deferred variable annuity purchase would be the ideal solution. When approaching the client with this recommendation, the client tells you that cash of that magnitude is not readily available. Which of the following would you recommend? A) Take a home equity loan to fund the deposit B) Open a Roth IRA to double the amount of allowable IRA contributions C) Purchase the deferred variable annuity on margin D) Begin a periodic payment deferred annuity program

D) Explanation In this case, if the client cannot supply the funds for the single premium annuity, but in all other respects, the product is suitable, then a period payment program would work. FINRA specifically warns about using mortgage equity (a home equity loan) to fund a deferred variable annuity. Although one can have both types of IRA, the annual maximum cannot exceed the current (2020) level of $6,000 total between them. Variable annuities are not marginable securities. LO 9.e

A 38-year-old investor places $25,000 into a single premium deferred variable annuity. Twenty-two years later, with the account valued at $72,000, the investor surrenders the policy. If the investor is in the 25% marginal income tax bracket, the total tax liability is A) $25,200. B) $16,450. C) $18,000. D) $11,750.

D) Explanation Only the deferred growth is taxable. In this case, it is the difference between the surrender value of $72,000 and the cost basis of $25,000. That $47,000 is taxed at the marginal rate of 25%. Because the investor is older than 59½ (38 + 22 = 60), there is no additional 10% penalty tax. Effectively, this is a 25% tax on $47,000. LO 9.d

A registered representative with ABC Securities has recently become aware of a new variable annuity. As tax time is approaching, the representative decides to recommend the variable annuity to all of her customers as an attractive addition to their portfolios. The representative should I) recommend the variable annuity to all of her clients because the tax advantage almost always results in a greater return. II) recommend the variable annuity to those clients whose needs and objectives match the investment. III) recommend the variable annuity to all of her clients because of the performance potential of the subaccounts. IV) not recommend the investment to all of her clients in spite of the tax advantages and additional features. A) II and III B) I and III C) I and IV D) II and IV

D) Explanation Recommendations may be made only when it is suitable for the customer's needs. Therefore, she would not recommend the variable annuity to all because some of them may not be able to benefit from those tax advantages. LO 9.d

An important feature of scheduled premium variable life insurance policies is that A) the cash value can never fall below the guaranteed minimum amount. B) purchasers must understand that there are no guarantees with these policies. C) the death benefit can never fall below the guaranteed minimum amount. D) better than expected performance of the separate account can lead to reduced premiums.

D) Explanation Scheduled (fixed) premium variable life always has a guaranteed death benefit. Cash values cannot be guaranteed, only the death benefit. Better than expected performance of the separate account will lead to increased cash values, but it will not affect the premiums. LO 9.a

One of your customers owns a variable annuity. When asking about how the performance of the separate account is measured, you would respond that A) the primary determinant is the assumed interest rate (AIR). B) the separate account performance is the same for all subaccounts. C) the insurance company's actuaries compute the separate account performance. D) the separate account performance depends on the performance of the selected subaccounts.

D) Explanation Some insurance company separate accounts have dozens of different subaccounts. These subaccounts range from highly aggressive to highly conservative. It is the performance of the specific subaccounts selected by the investor that determines the value of their accumulation unit. The actuaries get involved when determining the payout because that depends on life expectancy. Similarly, the AIR comes into play only during the payout phase. LO 9.c

A married couple intending to work another 2-4 years wants to fund a variable annuity to add monthly income during their retirement years. Having used all other available retirement investment vehicles, they want to invest $150,000 in savings toward the retirement objective. They note that these funds need to be paid out for as long as they live. Which of the following would be the most suitable and cost effective? A) A single life with period certain contract on one of the spouses with the other the named beneficiary B) Two separate joint with last survivor contracts C) Two separate life income contracts—one for each spouse D) A single joint with last survivor contract

D) Explanation The most suitable option, and one considered effective for married couples, is a single joint and last survivor contract. These contracts cover both lives and will continue to make payments until the last spouse dies. Dividing the funds available so as to fund two separate contracts, whether they be joint with last survivor or life income, would not be cost efficient for spouses. A life with period certain contract guarantees payments for a specified number of years to a named beneficiary if the annuitant dies during that time. However, at the end of the period certain, the payments to the named beneficiary (the spouse) will stop. This would not align with the couple's criteria for coverage as long as they both live. LO 9.b

Your customer in her early 30s has received a modest inheritance from a relative. Listing tax-deferred growth as an objective for retirement income, which of the following investments is most suitable? A) Growth mutual funds B) Corporate debt securities C) Tax-free municipal bonds D) A variable annuity

D) Explanation Variable annuities offer tax-deferred growth and are suitable for achieving supplemental retirement income. Ideally, they should be funded with readily available cash rather than using funds liquidated from existing investments. None of the other investments listed here offer tax-deferred growth. LO 9.e

Variable annuity salespeople must register with all of the following except A) FINRA. B) the state insurance department. C) the SEC. D) the state banking commission.

D) Explanation Variable annuity salespeople must be registered with FINRA and the state insurance department. Registration with FINRA is de facto registration with the SEC. No registration is required by the state banking commission. LO 9.a

If your customer invests in a variable annuity and chooses to annuitize at age 65, which of the following statements are true? I) She will receive the annuity's entire value in a lump-sum payment. II) She may choose to receive monthly payments for the rest of her life. III) The accumulation unit's value is used to calculate the total value of the account. IV) The annuity unit's value represents a guaranteed return. A) II and IV B) I and III C) I and IV D) II and III

D) Explanation When a variable contract is annuitized (distributed in regular payments, not as a lump sum), the number of accumulation units is multiplied by the unit value to arrive at the account's current value. An annuity factor is taken from the annuity table, which considers, for example, the investor's sex and age. This factor is used to establish the dollar amount of the first annuity payment. Future annuity payments will vary according to the separate account's performance. LO 9.b

If your customer invests in a variable annuity and chooses to annuitize at age 65, which of the following statements are true? I) She will receive the annuity's entire value in a lump-sum payment. II) She may choose to receive monthly payments for the rest of her life. III) The accumulation unit's value is used to calculate the total value of the account. IV) The annuity unit's value represents a guaranteed return. A) I and III B) II and IV C) I and IV D) II and III

D) Explanation When a variable contract is annuitized (distributed in regular payments, not as a lump sum), the number of accumulation units is multiplied by the unit value to arrive at the account's current value. An annuity factor is taken from the annuity table, which considers, for example, the investor's sex and age. This factor is used to establish the dollar amount of the first annuity payment. Future annuity payments will vary according to the separate account's performance. LO 9.c

An accumulation unit in a variable annuity contract is A) an accounting measure used to determine payments to the owner of the variable annuity. B) fixed in value until the holder retires. C) none of these. D) an accounting measure used to determine the contract owner's interest in the separate account.

D) Explanation When money is deposited into the annuity, it is purchasing accumulation units. LO 9.b

When a person is calculating cost basis for a nonqualified variable annuity, the person is using A) the after-tax dollars contributed. B) the dollars contributed minus any gains at the time of payout. C) the earnings in excess of dollars contributed. D) the pretax dollars contributed.

A) Explanation For a nonqualified variable annuity, cost basis for the annuitant would use the after-tax dollars contributed. LO 9.d

A customer has a nonqualified variable annuity. Once the contract is annuitized, monthly payments to the customer are A) partially a tax-free return of capital and partially taxable. B) 100% taxable. C) 100% tax free. D) 100% tax deferred.

A) Explanation The investor has already paid tax on the contributions, but the earnings have grown tax deferred. When the annuitization option is selected, each payment represents both capital and earnings. The money paid in will be returned tax free, but the earnings portion will be taxed as ordinary income. LO 9.d

Variable annuities must be registered with I) the state banking commission. II) the state insurance commission. III) the Securities and Exchange Commission (SEC). IV) FINRA. A) II and III B) II and IV C) III and IV D) I and III

A) Explanation A variable annuity is a combination of two products: an insurance contract and a mutual fund. Therefore, variable annuities must be registered with the state insurance commission and the SEC. LO 9.a

A customer is receiving annuitized payments from a variable annuity. The annuitized payments are viewed for tax purposes as A) part earnings and part cost basis. B) all return of cost basis and nontaxable. C) earnings only and taxable. D) exempt from taxes.

A) Explanation Annuitized payments from a variable annuity are viewed for tax purposes as part earnings and part cost basis. The earnings are taxable, but the cost basis is returned tax free. LO 9.d

Which of the following statements regarding variable annuities are true? I) The number of accumulation units is always fixed throughout the accumulation period. II) The number of accumulation units can rise during the accumulation period. III) The number of annuity units is fixed at the time of annuitization. IV) The number of annuity units rises once annuitization begins. A) II and III B) I and III C) II and IV D) I and IV

A) Explanation The number of variable annuity accumulation units can rise during the accumulation period when additional units are being purchased. When a variable annuity contract is annuitized, the number of annuity units is fixed. LO 9.c

A joint life with last survivor annuity I) covers more than one person. II) continues payments as long as one annuitant is alive. III) continues payments only as long as all annuitants are still alive. IV) guarantees payments for a certain period. A) II and IV B) I and II C) III and IV D) I and III

B) Explanation A joint life with last survivor contract covers multiple annuitants and ceases payments at the death of the last surviving annuitant. LO 9.b

A 38-year-old investor places $25,000 into a qualified single premium deferred variable annuity. Twenty years later, with the account valued at $72,000, the investor surrenders the policy. If the investor is in the 25% marginal income tax bracket, the total tax liability is A) $11,750. B) $25,200. C) $16,450. D) $18,000.

B) Explanation Because this is a qualified annuity, the entire withdrawal is taxable. The surrender value of $72,000 has a cost basis of $0.00. That $72,000 is taxed at the marginal rate of 25%. Furthermore, because the investor is younger than 59½ (38 + 20 = 58), there is the additional 10% penalty tax. Effectively, this is a 35% tax on $72,000. LO 9.d

All of the following statements about variable annuities are true except A) the rate of return is determined by the underlying portfolio's value. B) such an annuity is designed to combat inflation risk. C) a minimum rate of return is guaranteed. D) the number of annuity units becomes fixed when the contract is annuitized.

C) Explanation The return on a variable annuity is not guaranteed; it is determined by the underlying portfolio's value. Variable annuities are designed to combat inflation risk. The number of annuity units becomes fixed when the contract is annuitized; it is the value of each unit that fluctuates. LO 9.c

FINRA Rule 2330 deals with a member's responsibility in the sale of certain insurance company-based products. Specifically the concern is with A) fixed-index annuities. B) variable life insurance. C) deferred variable annuities. D) immediate variable annuities.

C) Explanation The subject of the FINRA rule is deferred variable annuities. It applies to the sale or exchange of this specific product. LO 9.e

Which of the following would not be covered under the antifraud provisions of the Securities Exchange Act of 1934? A) National exchange-listed securities B) Municipal bonds C) Fixed annuities D) Nasdaq-listed securities

C) Explanation While all securities are subject to the antifraud provisions of the Securities Exchange Act of 1934, fixed annuities are insurance company products not deemed to be securities. Variable annuities would be covered. LO 9.a

A joint and last survivor annuity is a payout option where A) payments continue until age 70½. B) payments continue for a predetermined time. C) payments continue until the death of the primary owner. D) two people are covered and payments continue until the second death.

D) Explanation In a joint and last survivor option, the annuity payment is made jointly to both parties while both are alive. When the first party dies, the annuity payment is made to the survivor. When the second party dies, all payments cease. LO 9.b

A prospectus for a variable annuity contract I) must provide full and fair disclosure. II) is required by the Securities Act of 1933. III) must be filed with FINRA. IV) must precede every sales presentation. A) I and III B) III and IV C) II and IV D) I and II

D) Explanation A variable annuity is a security and must be registered with the SEC, not FINRA. As part of the registration requirements, a prospectus must be filed and distributed to prospective investors. The time of distribution of the prospectus can be before the sales presentation or at the same time as the presentation. It is incorrect to state that it must precede every sales presentation. LO 9.a

A 45-year-old client of yours receives an inheritance of $100,000 and wishes to invest it without having to worry about any taxes being due until she reaches age 68. In addition, the client would like to have some protection against inflation. Which of the following would be the most appropriate recommendation? A) A single premium variable life insurance policy B) An immediate variable annuity C) An S&P 500 index fund D) A single premium deferred variable annuity

D) Explanation There are two benefits to the deferred variable annuity. The first is that taxes on all earnings are deferred until withdrawal. The second is that, if the proper separate account subaccounts are selected, there is potential inflation protection. An index fund will meet the second objective, but, even though index funds tend to be tax efficient, there will be certainly be dividend distributions from an S&P 500 index fund and possibly some capital gains as well. An immediate variable annuity begins payout immediately, so taxes start immediately as well. Variable life will never be an answer to a question unless the question describes a need for life insurance coverage—it cannot be sold strictly as an investment. LO 9.b