Series 7: Retirement Plans (Variable Annuities)
A variable annuity prospectus includes an AIR illustration using a 5% rate. This means that the:
return could be less than 5% The AIR in a variable annuity prospectus is the "Assumed Interest Rate." It is a conservative illustration of how much the contract holder will receive in payments if the separate account grows at the AIR. If the account grows faster than the AIR, the payments increase. If the account grows slower than the AIR, the payments will decrease.
Payments into a variable annuity contract are deposited to the insurance company's:
separate account Monies deposited to a variable annuity are deposited into a separate investment account (that is, separate from the insurance company's general investment account). The separate account buys shares of a designated mutual fund. The performance of the mutual fund shares held in the separate account determines the amount of the annuity received.
If the actual interest rate earned in the separate account underlying a variable annuity contract is lower than the "AIR," the annuity payment:
will decrease The "AIR" is the "Assumed Interest Rate." This is used as an illustration of the annuity payment that will be received if the separate account grows at the AIR. If the assets grow at an interest rate that is higher than the AIR, then the annuity payment will increase. Conversely, if the assets grow at an interest rate that is lower than the AIR, then the annuity payment will decrease.
A customer has invested $20,000 in a variable annuity. In the first year, the NAV increases to $21,100. At what rate will the $1,100 gain be taxed?
0 There is no tax deduction for contributions made to a variable annuity contract. The major advantage is the tax-deferred build-up of earnings in the separate account. When distributions are taken, they are taxable at ordinary income tax rates.
Which statement is TRUE about the taxation of dividends, interest and capital gains in the separate account during the accumulation phase?
All dividends, interest and capital gains are tax deferred During the accumulation phase of a variable annuity contract, all dividends, interest and capital gains earned from the securities in the separate account must be reinvested and build tax deferred. The tax deferral of the build-up is the major benefit of buying a variable annuity.
When comparing fixed annuities to variable annuities, which statements are TRUE? I A fixed annuity account grows at a guaranteed rate II A variable annuity account grows at a guaranteed rate III A fixed annuity is suitable for a customer seeking preservation of capital IV A variable annuity is suitable for a customer seeking preservation of capital
I and III Fixed annuity premiums are invested in an insurance company's general account and grow at a guaranteed rate (which is usually fairly low). There is no investment risk. At retirement, the customer received a fixed periodic payment for life. Variable annuity premiums are invested in an insurance company "separate account" which buys shares of a designated mutual fund. The account grows based on the performance of the underlying mutual fund, so the investor is subject to investment risk. A fixed annuity ensures a fixed guaranteed growth rate, while the growth rate of a variable annuity can go higher, or lower, or negative. So for preservation of capital, a fixed annuity is best.
The owner of a variable annuity has which of the following rights? I Right to vote for the sales charge imposed on purchases II Right to vote to change the separate account's investment objective III Right to vote for the Board of Trustees IV Right to vote for the dissolution of the trust
II, III, IV The sales charge imposed on purchases is decided by the variable annuity's Board of Trustees. The unit holder can vote for the Board of Trustees and can vote to change the investment objective of the separate account. In addition, terminating the trust (a very unlikely event) would require unit holder approval as well.
Any changes in value of a variable annuity accumulation unit are directly related to changes in the:
Value of the securities funding the separate account Since the separate account of investments funds a variable annuity, accumulation unit values are directly influenced by changes in the values of the securities in the separate account.
A 60-year old man wishes to receive an annuity payment for himself and his beneficiary for at least 15 years. The recommended payout option is:
life annuity - period certain A life annuity-period certain will pay for one's life, however if that person dies early, the annuity will still pay for a designated period. In this case, the period certain would be 15 years. A life annuity simply pays for one's life. Once that person dies, payments cease. A unit refund annuity pays the remaining balance as a lump sum if the annuitant dies "early". The annuity option that chooses installments for a designated amount allows the annuitant to choose the monthly amount to be received. Payments continue for that amount until the account is exhausted.
Variable annuities are:
non-exempt securities that must be sold with a prospectus Variable annuities differ from other products sold by insurance companies in that the purchaser bears the investment risk; as opposed to the insurance company bearing the investment risk. For example, if an insurance company achieves poor investment results, this does not affect the amount of death benefit that one gets from a traditional insurance policy; if the separate investment account funding a variable annuity achieves poor investment results, the annuity payment will drop. Because the purchaser bears the investment risk in a variable annuity contract, these are defined by the SEC as a non-exempt security that must be registered and sold with a prospectus.
All of the following are purchase and payout options for variable annuity contracts EXCEPT:
Periodic payments; Immediate annuity An investor can buy a variable annuity contract with a lump sum payment. Once the moneys are used to purchase accumulation units, annuitization can occur immediately or can occur years in the future. An investor can also make periodic payments into a variable annuity contract, but cannot annuitize until payments stop. Thus, there is no option of periodic payments with an immediate annuity. The annuity must be deferred until the payments are completed.
Which of the following statements are TRUE regarding a life annuity? I The shorter the expected annuity period, the larger the monthly payment II The longer the expected annuity period, the larger the monthly payment III A life annuity usually pays the largest amount of all of the annuity payment options IV A life annuity usually pays the smallest amount of all of the annuity payment options
I and III The shorter the time period to "expected death" when the separate account is annuitized, the larger the monthly payment will be; conversely the longer the time period to "expected death" when the separate account is annuitized, the smaller the monthly payment will be. Regarding annuity payment options, this must be looked at from the standpoint of the insurance company, that has a large pool of annuitants to cover. The insurance company can afford to pay a larger payment to those persons who it expects will be paid for the shortest time period; it will make smaller monthly payments when it expects to pay for a longer time period. A life annuity lasts only for that person's life - this is the shortest expected period of the annuity payment options. A life annuity with period certain continues to pay for a fixed time period if the person dies early; a joint and last survivor annuity pays a spouse when one person dies; a unit refund annuity pays a lump sum if a person dies early.
Which of the following statements are TRUE regarding mutual funds and variable annuities that are in the accumulation phase? I Distributions to mutual fund shareholders are taxable to the holder in the year the distribution is made II Distributions to mutual fund shareholders are tax deferred III Distributions to variable annuity holders are taxable to the holder in the year the distribution is made IV Distributions to variable annuity holders are tax deferred
I and IV When a mutual fund distribution is made, tax liability arises, Thus, the distribution is taxable in the year the distribution is received. Dividends and capital gains in variable annuity separate accounts build tax deferred; no tax is due until the holder is retired and commences withdrawals.
The purchaser of a variable annuity bears which of the following risks? I Interest rate risk II Expense risk III Mortality risk IV Investment risk
I and IV only Both mortality risk (the risk that the annuitant lives longer than expected) and expense risk (the risk that expenses of running the separate account are higher than expected) are borne by the issuer of a variable annuity contract. The customer assumes the investment risk, since the annuity payment varies with the performance of the securities funding the separate account. With any investment, customers assume legislative risk and interest rate risk. Legislative risk for a variable annuity contract would be Congress changing the tax law. Interest rate risk is inherent in any product that gives the holder a stream of payments - if market interest rates rise, the value of the stream of payments decreases.
Which of the following annuity payment options will pay the estate of the annuitant if the full value of the account was not received?
Unit Refund Annuity If the holder of a unit refund annuity dies before receiving the full investment value from the separate account, his or her estate gets a "refund" of the remaining value.
The owner of a variable annuity has all of the following rights EXCEPT the right to vote:
for the sales charge imposed by the trust Sales charges that are imposed upon purchase are decided by the variable annuity's Board of Trustees. The unit holder can vote for the Board of Trustees and can vote to change the investment objective of the separate account. In addition, terminating the trust (a very unlikely event) would require unit holder approval as well.
All of the following are features of variable annuities EXCEPT:
insured against losses Because the separate account is invested in a mutual fund, the portfolio that funds the annuity is professionally managed. The unit holder has the right to vote to change the objectives of the separate account, just like a fund shareholder. Variable annuity purchasers take on investment risk - the separate account can lose money, causing the annuity payments to fall. There is no insurance against losses in the separate account (unless a separate rider is purchased for this). Variable annuities offer a "death benefit" during the accumulation phase. If the owner dies before annuitization, the insurance company will return the greater of all payments made, or NAV, to a beneficiary.
The "death benefit" associated with a variable annuity contract: I applies during the accumulation phase II applies during the annuity phase III prior to annuitization, the insurance company will pay to a beneficiary, at least the amount invested in the contract IV after annuitization, the insurance company will pay for the insured's burial expenses
I and III The "death benefit" of a variable annuity contract is not really much of one. If the contract holder dies prior to annuitization, the insurance company pays the greater of current NAV or the amount invested to a beneficiary. If the contract holder dies after annuitization, there is no more "death benefit."
Which statement is TRUE regarding a variable annuity offering a GMIB?
The contract guarantees a minimum growth rate for the separate account at the time of annuitization A "GMIB" is a Guaranteed Minimum Income Benefit. It is an optional rider offered by many variable annuity contracts. It guarantees that when the separate account is annuitized, if the account has not grown at the guaranteed minimum rate, then the account will be annuitized as if it grew at that guaranteed minimum rate. So if the separate account grows by only 2% a year; and the GMIB is 5%; then the account will be valued at annuitization based on compounding at the 5% minimum benefit. Note that the GMIB does not apply during the accumulation phase; it only applies during the annuity phase. This is a very popular rider, but it does come at a cost.
Which of the following statements are TRUE about variable annuities? I Investment risk is carried by the purchaser of the annuity II Salespeople must register with both FINRA and the State Insurance Commission III Variable annuities are considered to be securities regulated by the Investment Company Act of 1940 IV Annuity payments may not be reduced because of increased expenses experienced by the insurance company
I, II, III, IV Investment risk in a variable annuity is carried by the purchaser. The issuer gives an expense guarantee, limiting the amount of expenses that the issuer can charge against the contract. To sell variable annuities, both an insurance and a securities registration are required. Variable annuities are considered to be securities because the purchaser bears the investment risk.
Which of the following statements are TRUE for both mutual funds and variable annuities? I Asset appreciation is untaxed for both II Dividend and capital gains distributions are taxable each year for both III Both have portfolios that are managed IV Both are regulated by the Investment Company Act of 1940
I, III, IV Both variable annuities and mutual funds are regulated under the Investment Company Act of 1940; have managed portfolios; and asset appreciation is untaxed. Mutual fund asset appreciation is taxable only when a capital gains distribution is made. Dividend and capital gain distributions made by variable annuity separate accounts must be reinvested and are tax deferred. Dividend and capital gain distributions from other investment companies do not have to be reinvested and are always taxable, whether reinvested or not.
Which rollover would result in a tax event?
Exchange of a variable annuity contract for a life insurance contract Section 1035 "tax-free" exchanges permit "like-for-like" exchanges without tax due. Thus, Choices A and D are tax free. It also permits a life insurance policy to be exchanged for a variable annuity without tax due, making Choice B tax-free. This is allowed because an individual might no longer need the death benefit and has a policy with built up cash value. This can be converted into a fixed or variable annuity, with payments to continue for life, without tax due upon conversion. Of course, the IRS is happy about this because the taxable annuity payments will start earlier than the payment of the taxable death benefit. If a variable annuity is exchanged for any insurance policy, this is NOT a like-kind exchange, and tax will be due on any appreciation in the separate account. The stance of the IRS is that the individual is only doing this to delay receipt of payments that are taxable (because the variable annuity payments would have been received earlier than the taxable death benefit.)
In a variable annuity contract, the number of I accumulation units is fixed II accumulation units can vary III annuity units is fixed IV annuity units can vary
II and III During the accumulation phase of a variable annuity contract, new money that is invested buys additional accumulation units of the separate account (analogous to buying shares of a mutual fund). Once the account is annuitized, payments into the separate account must stop. The accumulation units owned at that moment are converted into a fixed number of annuity units (the number of annuity units received is based on that person's expected mortality). The monthly annuity payment is the fixed number of annuity units times the unit value (which will vary with the performance of the underlying mutual fund held in the separate account).
A client surrenders a variable annuity contract 5 years after purchase because of poor performance. The customer invested $50,000 and redeemed it when the NAV was $40,000, however the customer only received $37,000 because a $3,000 surrender fee was imposed. The tax consequence is:
$10,000 deductible ordinary loss and $3,000 non-deductible loss If a customer surrenders a variable annuity contract early (typically due to poor performance or a pressing financial need), then the customer's cost basis is the amount invested and the sale proceeds is the amount received on redemption. Any loss is deductible as an ordinary loss, but any portion of the loss due to the surrender fee is not deductible! If a customer invested $50,000 in a variable annuity and redeemed it when the NAV was $40,000, however the customer only received $37,000 because a $3,000 surrender fee was imposed, then of the $13,000 ordinary loss, $10,000 is deductible and $3,000 is non-deductible.
A customer contributed $20,000 to a variable annuity contract. The account value has grown over the years and the NAV is now $35,000. The customer is now age 60, and takes a lump-sum distribution of $20,000 to pay for expenses. Which statement is TRUE?
$15,000 of the distribution is taxable and $5,000 is not taxable Variable annuity contributions are not tax-deductible. Earnings in the account build tax-deferred. When distributions are taken, tax is due on the portion that represents the tax-deferred build-up. The portion that represents the original contribution (already taxed dollars) is returned without any further tax due. If a lump-sum distribution is taken, the IRS uses LIFO (Last-In; First-Out) accounting. The Last-In Dollars are the tax-deferred build-up, so these are the First-Out dollars and they are 100% taxable! Any distribution above and beyond the build-up amount is a tax-free return of original capital. In this example, the customer contributed $20,000 and this has grown, tax-deferred, to $35,000. If a lump sum distribution of $20,000 is taken, the first dollars out are the $15,000 of never taxed build-up and this amount is taxable. The remaining $5,000 is a partial tax-free return of the original $20,000 investment (which was not tax deductible).
Which statements are TRUE about variable annuities? I Contributions are tax deductible II Contributions are not tax deductible III Distributions are taxable IV Distributions are not taxable
II and III Variable annuity contributions are not tax-deductible. Earnings in the account build tax-deferred. When distributions are taken, tax is due on the portion that represents the tax-deferred build-up. The portion that represents the original contribution (already taxed dollars) is returned without any further tax due.
A 50-year old man owns a non-qualified variable annuity contract that has appreciated substantially over the years. He wishes to annuitize the account for additional income using IRS Rule 72t. How will the first payment be taxed?
Part ordinary income and part cost basis Instead of taking a lump sum distribution, the owner of a variable annuity contract can "annuitize" and receive annuity payments for life. Each payment has 2 components - an earnings portion that is taxable and a return of capital portion (cost basis) that is not taxable. The non-taxable portion represents the return of the original investment that was made with "after tax" dollars. IRS Rule 72t gives a way for payments to be taken from the annuity prior to age 59 1/2 without the 10% penalty tax being applied. Rule 72t basically requires that annual payments deplete the account over that individual's expected life (the IRS has 3 approved methods for this). The rule also requires that a minimum of 5 annual "Substantially Equal Periodic Payments" (SEPPs) be taken, but that payments must continue until at least age 59 1/2.
A customer has invested $30,000 in a variable annuity contract. The current NAV is $50,000. The customer dies prematurely at the age of 50. What is the tax consequence?
The cost basis in the contract is $30,000 and the $20,000 of build-up is taxable at ordinary income tax rates Even though assets are valued for estate tax purposes at the market value as of the date of death (commonly known as a "stepped up" basis), the assumption underlying this is that the asset was purchased with already-taxed dollars. The contributions made are the "already-taxed" dollars in a non-qualified annuity. The build-up represents never- taxed dollars. These are still taxable before they are included in the estate. (This estate tax treatment is true for qualified retirement accounts as well - upon death, the never-taxed assets in the account will be taxed at ordinary income tax rates before they are included in the taxable estate of the deceased individual).
All of the following terms are associated with a variable life insurance policy EXCEPT:
annuitization Variable life is a derivation of whole life. Like whole life, it is permanent insurance with level premiums and a fixed minimum death benefit. Permanent means that as long as the premium is paid, the policy remains in force. For both whole life and variable life, the premium has 2 components - part of the premium pays for insurance; the rest of the premium is invested and grows cash value. In a whole life policy, the excess premium is invested safely in the insurance company's general account and grows at a fixed lower rate, while in a variable life policy it is invested in a separate account. The separate account purchases accumulation units that represent shares of a designated mutual fund. If the mutual fund performs well, the variable life policy will build cash value at a faster rate than a whole life policy. The cash value can be borrowed from the policy for personal use; can be borrowed to pay current premiums due; or can be borrowed to purchase additional coverage. Annnuitization does not occur with a variable life policy - it only occurs with an annuity contract. (Finally, note that the variable annuity prospectus must include a bold disclaimer that if the separate account loses substantial value, which can happen in a bear market, then the purchaser can be required to pay additional premiums to keep the face amount of the policy in force, or that the coverage amount could be reduced.)
Which statement is TRUE when a non-qualified variable annuity is annuitized prior to age 59 1/2 under the provisions of IRS Rule 72t?
Each payment received will be partially taxable but the 10% penalty tax will not be applied Instead of taking a lump sum distribution, the owner of a variable annuity contract can "annuitize" and receive annuity payments for life. Each payment has 2 components - an earnings portion that is taxable and a return of capital portion (cost basis) that is not taxable. The non-taxable portion represents the return of the original investment that was made with "after tax" dollars. IRS Rule 72t gives a way for payments to be taken from the annuity prior to age 59 1/2 without the 10% penalty tax being applied. Rule 72t basically requires that annual payments deplete the account over that individual's expected life (the IRS has 3 approved methods for this). The rule also requires that a minimum of 5 annual "Substantially Equal Periodic Payments" (SEPPs) be taken, but that payments must continue until at least age 59 1/2.
Variable annuity contracts: I have the issuer bear the investment risk II have the purchaser bear the investment risk III are non-exempt securitiesIV are exempt securities
II and III Variable annuities differ from other products sold by insurance companies in that the purchaser bears the investment risk; as opposed to the insurance company bearing the investment risk. For example, if an insurance company achieves poor investment results, this does not affect the amount of death benefit that one gets from a traditional insurance policy; if the separate investment account funding a variable annuity achieves poor investment results, the annuity payment will drop. Because the purchaser bears the investment risk in a variable annuity contract, these are defined by the SEC as a non-exempt security that must be registered and sold with a prospectus.
Which of the following statements are TRUE about variable annuities? I To sell variable annuities, salespersons must be registered with FINRA II To sell variable annuities, salespersons do not have to be registered with FINRA III To sell variable annuities, salespersons must be registered with the State Insurance Commission IV To sell variable annuities, salespersons do not have to be registered with the State Insurance Commission
I and III To sell a variable annuity, salespersons must be registered with FINRA with either a Series 6 (mutual funds and variable annuities only) license or Series 7 (general securities) license. In addition, the salesperson must be registered with the State Insurance Commission (since these products are sold by insurance companies; and insurance companies are regulated only at the state level).
A registered representative that wishes to recommend a variable annuity to a customer must make reasonable efforts to obtain the customer's: I intended use of the variable annuity II investment time horizon III existing assets including insurance holdings IV liquidity needs
I, II, III, IV Consider this to be a learning question. To recommend a variable annuity, the representative should make reasonable efforts to obtain the customer's age, annual income, financial situation and needs, investment experience, investment objectives, intended use of the deferred annuity, investment time horizon, existing assets including life insurance, liquidity needs, liquid net worth, risk tolerance, tax status and any other information that is needed to make a recommendation to the customer. Just to make sure this happens, FINRA requires that the representative sign a statement that this was done.
Variable annuity contracts contain which of the following guarantees? I Interest Rate Guarantee II Investment Guarantee III Mortality Guarantee IV Expense Guarantee
III and IV Variable annuity contracts contain a mortality guarantee and an expense guarantee. If one dies later than expected, the company continues to pay the annuity. If expenses rise, the company absorbs them above a set percentage. However, no guarantee is given for the rate of return (investment guarantee or interest rate guarantee) - this is only given for a fixed annuity.
An "annuity unit" of a variable annuity contract is a(n):
accounting measure of the annuity amount to be received by the owner Once a variable annuity contract is annuitized, accumulation units are converted to annuity units. These determine the annuity payments to be made.
An "accumulation unit" of a variable annuity contract is a(n):
accounting measure of the owner's interest in the separate account An accumulation unit is an accounting measure used for valuing a variable annuity holder's interest in the separate account.
All of the following terms are associated with variable life insurance EXCEPT:
flexible premium All variable products invest premiums into a separate account that purchases accumulation units of the separate account. The separate account itself holds shares of a designated mutual fund. Variable life is similar to whole life in that it is permanent insurance with a fixed annual premium. A "flexible" premium that can be adjusted up or down by the policyholder is only available in a "universal" life insurance policy (such as VULI - Variable Universal Life Insurance). Part of the fixed premium pays for insurance; the rest of the premium is invested in the separate account. Variable life builds cash value like a whole life policy that the customer can borrow out. The amount of cash value depends on the performance of the mutual fund held in the separate account. The amount of insurance purchased (the "death benefit") is a "target" that is met if the separate account grows at a predetermined rate (say 4% a year). While the "target" death benefit is a fixed dollar amount (say $1,000,000), if the separate account performs well, the policy can pay the fixed death benefit plus the excess cash value at death; and if the separate account goes down in value substantially (which can happen in a bear market), the insurance company can require additional premium payments to maintain the fixed coverage amount or can reduce the coverage amount. This is the "variable" part of a variable life policy!
During the accumulation phase of a variable annuity:
payments can be made into the plan; but distributions may not be taken from the plan During the accumulation phase of a variable annuity contract, money can be paid into the plan; but distributions cannot be taken. When distributions commence in the annuity phase, no more monies can be paid into the plan. Thus, the accumulation phase allows payments to be made into the plan; but distributions cannot be taken out of the plan.
An annuitized account in a variable annuity is most similar to:
pension payments Once a variable annuity separate account interest is "annuitized," the holder gets a fixed number of annuity units. Each month, the holder gets a payment equal to the fixed number of units x the unit value (which varies based upon the performance of the underlying investments). The payments continue for life. Thus, an annuitized account is most similar to pension payments.