CHAPTER 8 Investment Products and Markets:

Mutual fund (investment company)

Corporation that uses it’s capital to purchase investment vehicles instead of plant and equipment.

Suitability (who are they best for?)

Best return ; minimizing risksLimited amount of money

How do you make money?

Dividends or interest from within portfolioCapital gains from within the portfolioCapital gains from the shares of the portfolio

MUTUAL FUND BASICS

What is the difference between an open-end and a closed-end mutual fund?

Open ClosedUnlimited shares Limited sharesAlways primary market trade on an exchangeReflects the value of the portfolio supply and demand also impact value

What are the three primary advantages of a mutual fund?

DiversificationProfessional money mgtliquidity

TYPES OF MUTUAL FUNDS (objectives)

Aggressive Growth

Growth

International/Global

International should only have investments outside the US

Global could include US investments

Growth and Income

Fixed Income

Balanced/Equity Income

Specialty/Sector

Asset Allocation

Money Market

Index

Loads

Commissions

Front-end - pay up front

Redemption – pay to redeem

Contingent deferred sales charges – pay a decreasing commission if sell within a certain period of time (CDSC)

FEES AND EXPENSES

Management Fees and Operating Expenses

12b-1 Fees

Trustee Fees

Expense Ratio

Ratio of expenses to NAV

Higher the ratio, better the manager must perform to generate a desired return.

The more expensive it is to own the investment

Higher returns could offset higher expenses (or not)

Mutual Fund Basics

The People

Investment Advisor

Day to day investment decisionsMoney manager

Custodian / Transfer Agent

BookkeeperSafekeeping securities and cash

Analysis of Mutual Funds

Three basic areas

1) first you select funds that match investment objectives.

2) next rank funds by statistical performance measures

This can be done manually or via software

Morningstar has a filter that can assist

The premium filter allows ranking by different statistics

3) non-statistical measures

Really not a ranking tool

Most mutual funds either by law or necessity provide the same services

That is not to say that customer service quality is the same!!

Prospectus

READING MUTUAL FUND PROSPECTUS

INVESTMENT OBJECTIVES AND POLICIES

RISK FACTORS

INVESTMENT RESTRICTIONS

PAST PERFORMANCE

FUND INFORMATION

COSTS AND FEES

MISCELLANEOUS INFORMATION

A document provided by mutual fund that describes in some detail the characteristics of this mutual fund.

The components are mandated by law

A mutual fund is always a primary market transaction; unlike stocks

This requires a prospectus be provided at or before the sale of any mutual fund.

A prospectus has a life of 13 months

Classes of Shares

What is meant by share class?

No distinction between portfoliosMarketing of the loads and expenses

Class A shares

Front load; lower fees; no redemption load

Class B

CDSC condition al deferred sales charge

No front load; only a redemption load if sold within a certain time frame; higher initial fees higher than “A” but then they are lowered after time

Class C

No load; usually higher fees

These fees never reduce

Misc other classes

Institutional shares have a variety of combinations of fees and loads

• How to choose between Class A and B

– Class A shares have a front load

• they also have a declining load schedule as investment increases

– Class B shares are CDSC; but have higher initial expenses

• As holding period increases, potential redemption load decreases

• Eventually become Class A

• If have large sum or will be investing over time, Class A may be more expensive

• If do not have a large sum to invest, the choice is really about when to pay the load. (up front or over time)

• Not a clear choice all the time. Regulation has dictated how and when some classes can be

Mutual Funds Restrictions

a list of restricted investment vehicles and strategies will be listed in the prospectus.

Potential list

No margin or short sales

No underwriting except their own shares

No investment in commodities

No private placement

No controlling interest

No more 5% value of total assets

No more 10% voting stock

No borrowing except for emergencies and only from a bank.

Diversified Investment Companies

The 5% and 10% rule actual applies to 75% of the mutual funds cash

The remaining 25% of cash can be invested in any security or company.

Prices

NAV (Net Asset Value)

Equivalent of share price

Represents the current value of one share of the investment portfolio

POP (public offering price)

Incorporates the load

NAV = $12 with a 5.75% load

What is the POP of a mutual fund with a NAV of 37.25, and a 4.5% front load?

POP=37 .251−.045

=39.005

Who gets the extra 1.755?

Break Point Qualification

NAV= Assets - Liabilities# of shares

POP= NAV1−load%

POP=121−.0575

=12.73

How can you “beat” break points?

Large Sum purchaseLetter of intent Can back date 90 days Have 13 months to break the point Not a contractual arrangementAccumulated funds

Redemption of shares

How do you “sell” the shares

In the stock market shares are sold back through the brokerage. They are purchased by another investor.

With mutual funds the process is different. The mutual fund company by law must “redeem” the shares within 7 days of a request. It is the mutual fund that buys the shares from the old shareholder.

Remember these shares are retired and never sold to another investor.

Services

Reinvestment Privilege

Current income and capital gains are automatically reinvested (buy more shares)

No load charged

You must request distribution in cash if you want it.

Conversion Privilege

Can move share between same fund family funds at no load.

Taxable though unless in a retirement account

Systematic Withdrawals (investments)

Can request to have funds automatically deposited to or withdrawn from an account

MUTUAL FUND RATING SERVICES

MORNINGSTAR

Industry’s best resource for comprehensive, unbiased and accurate mutual fund information

LIPPER

Leading global mutual fund information company analyzing fund companies and financial intermediaries

STANDARD & POOR’S

Leading global provider for mutual fund information and analysis

THOMAS FINANCIAL

Global provider of data, analysis, and information tools

TRADITIONAL INDEX FUNDS

Index funds hold shares in all the companies that make up an index like S&P 500

NOT true. They rarely hold the shares of all. They attempt to create a “clone”

ADVANTAGES

Fewer Capital Gains

Keeping Pace with Selected Index

Painless Strategy

Lower Cost

PITFALLS OF INDEX FUNDS

Downside Risk

Skewed Weighting Systems

Do they actually copy the index?

Divergence Between Index Funds

How can different index funds have different returns?

Narrow Focus

Lose the Value Added by Money Managers

Increased Volatility

VARIABLE ANNUITY

CONCEPTS OF variable annuity

Like an IRA that is not deductible

Tax deferred investment vehicle

Variety of investment options

Guarantees protected by an insurance component

BENEFITS

Diversified Investment Portfolio

No Limit on Annual Investment

Upon death, beneficiaries are guaranteed face value or higher market value

Pay for this

VA company may permit annual payout without penalty

Watch for forced annuitization

Tax-deferred Growth Of Funds

DRAWBACKS

High Mortality and Expense Charge

Depends on the contract

The “shares” in the VA are institutional shares that might not have any load and very low expenses

Contingent Deferred Sales Charges

If in for the long term this is not an issue

If you need the cash in 4 – 5 years, VA is not the answer.

Penalty for Withdrawal Before 59-1/2

Variable Annuity Funding Sources

Where does the money come from?

Liquidation of Earnings

Withdrawal from taxable savings plan

Life insurance death benefit proceeds

Other lump sums (inheritance, sale of business)

Cash value life insurance or annuities (1035 Exchanges)

VARIABLE IMMEDIATE ANNUITY

Assumption here is annuitization

What is annuitization?

Convert lump sum to a systematic cash flowSounds like what you want.Lose control of assets / insurance company owns the cashLose return opportunitiesWhat happens at death

Nondeductible IRAs vs. Nonqualified Annuity

NonQualified IRA Annuity

Contributions (after-tax dollars) X X

Earnings accumulate tax-deferred X X

Earnings taxed upon withdrawal X X

Principal can be withdrawn tax free X X

10% tax penalty applies to withdrawals X X before age 59 1/2

No minimum distribution at age 70½ X

Unlimited payments to contract X

Who May be Right for a Nonqualified Annuity

Has Long-term savings goals and/or is planning for retirement

Has reached their maximum 401(k) and IRA contribution limits

Wants family protection in the form of a death benefit

Wants to grow their assets tax deferred

Wants ability to move among funding options tax free

Wants lifetime income

We’re all familiar with IRAs. We know that there are a variety of IRAs that we can offer our clients, including the traditional IRA (tax deductible, contributions are made with pre-tax money, annual contribution limits, etc.) and non-deductible IRAs (non-deductible contributions made with after-tax money). To give you a frame of reference, this slide helps illustrate the similarities between the non-deductible IRA which you’re familiar with and a nonqualifed annuity that you may not be familiar with.

• First the terminology. “Non-deductible” contributions are made with after-tax dollars. When a variable annuity is purchased with after-tax dollars (e.g., cash, life insurance proceeds), this is considered the purchase of a “nonqualified” contract. For nonqualified contracts, there is no tax deduction for the amounts paid into the contract.

• Like a non-deductible IRA, any growth on the variable annuity contract accumulates tax deferred until the client takes a withdrawal. Consequently, no current income taxes are due on the variable annuity contract until money is withdrawn, hopefully at some point in the future when the client is in a lower tax bracket.

• Note: This should not be confused with a Roth IRA.

Has received unexpected lump sum payment and needs to invest long-term

Liquidity is now a key determinate on whether the variable annuity contract can even be offered. This is a change due to misdeeds of agents taking advantage of senior citizens and others. Why would brokers want to issue this type of security? MONEY!!! Variable annuities pay higher commissions than mutual funds.

Who May NOT be Right for a Nonqualified Annuity

Net worth is less than $100,000

IRAs and 401(k) not fully funded

Short-term investors with higher liquidity needs

Insufficient discretionary income/ emergency funds

May need access to money prior to age 59½

1035 exchange basics

What is a 1035 exchange?

Conversion from one insurance vehicle to another.Avoids tax consequences if done properly.

This is a conversion of one insurance type vehicle for another. This is a non-taxable exchange.

Defer Taxable Gain

Assume:

$20,000 Premiums Paid

$25,000 Cash Value

$5,000 Taxable Income Upon Surrender

Let’s look at two sales ideas for the Variable Annuity regarding 1035 Exchanges. One is to defer a taxable gain and the other is to save a tax loss.

Save Tax Loss

Assume:

$20,000 Premiums Paid

$15,000 Cash Value

$5,000 Loss

First, let’s look at deferring a taxable gain and assume we have a client who has $25,000 of cash value in a life insurance policy, and they have paid $20,000 in premiums.

If they were to simply surrender that contract and take the proceeds and buy a Variable annuity contract, their cost basis would be $20,000 and they would pay taxes on the gain in the contract which would be the $5,000.

If they do a 1035 Exchange, the new cost basis of Variable annuity is $20,000, and there are no taxes currently due. The important thing is that the funds are directly transferred into the annuity (the money goes from one insurance company to the other so the client does not take possession of any of the insurance policy’s assets).

While there are many reasons to move the cash value of a life insurance policy into an annuity, it’s important to remember that this type of exchange has tax implications for the beneficiary. There is no income tax due on death benefit proceeds received from a life insurance contract. However, any portion of the death benefit proceeds from an annuity contract that have not previously been taxed are taxable to the beneficiary.

Another situation that can be considered is to save the tax loss of a life insurance policy. For instance, we have a life insurance policy with $15,000 of cash surrender value, and the premiums paid total $20,000.

If the client were to surrender this policy and move the proceeds to a Variable annuity policy, the cost basis is $15,000.

However, if they do a 1035 Exchange into a Variable annuity policy, the cost basis of the Variable annuity policy is $20,000. Under a 1035 Exchange, the $15,000 that goes into the annuity contract can grow by $5,000 back up to its original premiums paid amount ($20,000) before growth will be considered taxable earnings.

Because the $5,000 growth gets us back to the original cost basis, there would be no gain in the contract. This is the way to save a tax loss inside of a Variable annuity policy on a 1035 Exchange.

Some of the rules about a 1035 Exchange:

• Client must exchange the entire value of an existing policy; there are no partial 1035 Exchanges.

• Clients cannot transfer a policy into an existing policy; you must purchase a new annuity contract.

• Both the owner and the annuitant under the new contract must be the same as the owner and the annuitant (insured) under the old contract.

• Life insurance policy loans cannot be transferred.* If they were to be exchanged for the annuity, they would become immediately taxable.

• You can exchange a life insurance policy for an annuity, and an annuity for another annuity, but you cannot exchange an annuity for a life insurance policy.

* In some cases, it may be appropriate for the loan to be “netted” against the cash value.

Charges and Fees

Asset Based Fees

Mortality & Expense Risk Charge

Pay for the guarantees

Step-up charges

Creates guarantee of upward growing portfolio value (floating floor)

Fund Fees and Expenses

Paid to the mutual funds

Usually institutional fund classes so lower fees

Contingent Deferred Sales Charges

Contract Administrative Charges

Some of the rules about a 1035 Exchange:

• Client must exchange the entire value of an existing policy; there are no partial 1035 Exchanges.

• Clients cannot transfer a policy into an existing policy; you must purchase a new annuity contract.

• Both the owner and the annuitant under the new contract must be the same as the owner and the annuitant (insured) under the old contract.

• Life insurance policy loans cannot be transferred.* If they were to be exchanged for the annuity, they would become immediately taxable.

• You can exchange a life insurance policy for an annuity, and an annuity for another annuity, but you cannot exchange an annuity for a life insurance policy.

* In some cases, it may be appropriate for the loan to be “netted” against the cash value.

Now let’s take a look at the charges associated with a variable annuity contract.

First, there are 2 charges which are deducted daily from the assets of the separate account - in essence, from your client’s contract value. Both are illustrated on an annualized basis. The mortality and expense risk charge (M&E) is 1.25%, and the sub-account administrative expense charge is 0.15%, for a total annualized cost of 1.40% of assets. These charges are designed to cover the company’s expenses for providing death benefit guarantees, annuity payout guarantees and fund valuation, as well as the distribution expenses like commissions. This percentage is fairly standard in the industry, particularly in the nonqualified annuity market.

The underlying funds to which a client allocates his or her money also have certain fees and expenses which go toward providing day-to-day portfolio management and paying their custodian and transfer agent. The range of these fees is generally from 0.64% to 1.64%. They vary by fund and fluctuate daily as the fund’s assets increase or decrease in value. Fund expenses as of the end of the most recent calendar year are illustrated in the Fee Table of the prospectus. However, these fees are typically less than the mutual fund fees. They are referred to as institutional fees. They are the classes of funds referred to in the mutual fund section as others.

Impact of Taxes on Withdrawals

Withdrawals Subject to Income Tax on Amounts Not Previously Taxed

10% IRS Early Withdrawal Penalty < 59½

EXCEPTION:

Substantially Equal Payments - 72(t)/(q)

Payments Must Continue for Longer of 5 Years or Age 59½

Step-Up Benefits – a moving floor of the value of the contract. Not all contracts permit this.

Now let’s take a look at the charges associated with a variable annuity contract.

First, there are 2 charges which are deducted daily from the assets of the separate account - in essence, from your client’s contract value. Both are illustrated on an annualized basis. The mortality and expense risk charge (M&E) is 1.25%, and the sub-account administrative expense charge is 0.15%, for a total annualized cost of 1.40% of assets. These charges are designed to cover the company’s expenses for providing death benefit guarantees, annuity payout guarantees and fund valuation, as well as the distribution expenses like commissions. This percentage is fairly standard in the industry, particularly in the nonqualified annuity market.

The underlying funds to which a client allocates his or her money also have certain fees and expenses which go toward providing day-to-day portfolio management and paying their custodian and transfer agent. The range of these fees is generally from 0.64% to 1.64%. They vary by fund and fluctuate daily as the fund’s assets increase or decrease in value. Fund expenses as of the end of the most recent calendar year are illustrated in the Fee Table of the prospectus. However, these fees are typically less than the mutual fund fees. They are referred to as institutional fees. They are the classes of funds referred to in the mutual fund section as others.

Distribution of Death Benefit Proceeds

Beneficiaries have right to:

Annuitize Contract; or

Take lump-sum payment

Spousal Beneficiaries may elect to continue contract under his/her name

Death benefit proceeds subject to estate and income taxes

Asset Allocation

Asset Allocation is the process of combining different asset classes in varying proportions to help achieve the best possible return for the lowest amount of risk

Over 92% of a portfolio’s return rests on Asset Allocation decisions

REBALANCING A PORTFOLIO

Rebalancing is not a market timing strategy

Return a portfolio to a preset allocation based on risk tolerances

It is a systematic approach to maintaining a consistent risk profile