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CHAPTER 8 Investment Products and Markets: Mutual fund (investment company)Corporation that uses it’s capital to purchase investment vehicles instead of plant and equipment.Suitability (who are they best for?)Best return ; minimizing risksLimited amount of moneyHow do you make money?Dividends or interest from within portfolioCapital gains from within the portfolioCapital gains from the shares of the portfolioMUTUAL FUND BASICSWhat 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 valueWhat are the three primary advantages of a mutual fund?DiversificationProfessional money mgtliquidityTYPES OF MUTUAL FUNDS (objectives)Aggressive Growth GrowthInternational/GlobalInternational should only have investments outside the USGlobal could include US investmentsGrowth and IncomeFixed IncomeBalanced/Equity IncomeSpecialty/Sector Asset AllocationMoney MarketIndexLoads CommissionsFront-end - pay up frontRedemption – pay to redeemContingent deferred sales charges – pay a decreasing commission if sell within a certain period of time (CDSC)FEES AND EXPENSESManagement Fees and Operating Expenses12b-1 FeesTrustee FeesExpense RatioRatio of expenses to NAVHigher the ratio, better the manager must perform to generate a desired return.The more expensive it is to own the investmentHigher returns could offset higher expenses (or not)Mutual Fund Basics The PeopleInvestment AdvisorDay to day investment decisionsMoney managerCustodian / Transfer AgentBookkeeperSafekeeping securities and cashAnalysis of Mutual FundsThree basic areas1) first you select funds that match investment objectives.2) next rank funds by statistical performance measuresThis can be done manually or via softwareMorningstar has a filter that can assistThe premium filter allows ranking by different statistics3) non-statistical measuresReally not a ranking toolMost mutual funds either by law or necessity provide the same servicesThat is not to say that customer service quality is the same!!ProspectusREADING MUTUAL FUND PROSPECTUSINVESTMENT OBJECTIVES AND POLICIESRISK FACTORSINVESTMENT RESTRICTIONSPAST PERFORMANCEFUND INFORMATIONCOSTS AND FEESMISCELLANEOUS INFORMATIONA document provided by mutual fund that describes in some detail the characteristics of this mutual fund.The components are mandated by lawA mutual fund is always a primary market transaction; unlike stocksThis requires a prospectus be provided at or before the sale of any mutual fund.A prospectus has a life of 13 months56134041656000Classes of SharesWhat is meant by share class?No distinction between portfoliosMarketing of the loads and expensesClass A sharesFront load; lower fees; no redemption loadClass BCDSC condition al deferred sales chargeNo 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 timeClass CNo load; usually higher feesThese fees never reduceMisc other classesInstitutional shares have a variety of combinations of fees and loads342899205105How to choose between Class A and BClass A shares have a front loadthey also have a declining load schedule as investment increasesClass B shares are CDSC; but have higher initial expensesAs holding period increases, potential redemption load decreasesEventually become Class AIf have large sum or will be investing over time, Class A may be more expensiveIf 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 marketed.00How to choose between Class A and BClass A shares have a front loadthey also have a declining load schedule as investment increasesClass B shares are CDSC; but have higher initial expensesAs holding period increases, potential redemption load decreasesEventually become Class AIf have large sum or will be investing over time, Class A may be more expensiveIf 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 marketed.1123950-165735005721351466850068262518478500Mutual Funds Restrictionsa list of restricted investment vehicles and strategies will be listed in the prospectus.Potential listNo margin or short salesNo underwriting except their own sharesNo investment in commoditiesNo private placementNo controlling interestNo more 5% value of total assetsNo more 10% voting stockNo 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 cashThe remaining 25% of cash can be invested in any security or company.768355397500PricesNAV (Net Asset Value)Equivalent of share priceRepresents the current value of one share of the investment portfolioPOP (public offering price)Incorporates the loadNAV = $12 with a 5.75% loadWhat is the POP of a mutual fund with a NAV of 37.25, and a 4.5% front load?Who gets the extra 1.755?Break Point Qualification6159507556500How 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 fundsRedemption of sharesHow do you “sell” the sharesIn 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.ServicesReinvestment PrivilegeCurrent income and capital gains are automatically reinvested (buy more shares)No load chargedYou must request distribution in cash if you want it.Conversion PrivilegeCan move share between same fund family funds at no load.Taxable though unless in a retirement accountSystematic Withdrawals (investments)Can request to have funds automatically deposited to or withdrawn from an account MUTUAL FUND RATING SERVICESMORNINGSTARIndustry’s best resource for comprehensive, unbiased and accurate mutual fund informationLIPPERLeading global mutual fund information company analyzing fund companies and financial intermediariesSTANDARD & POOR’SLeading global provider for mutual fund information and analysisTHOMAS FINANCIALGlobal provider of data, analysis, and information tools TRADITIONAL INDEX FUNDSIndex funds hold shares in all the companies that make up an index like S&P 500NOT true. They rarely hold the shares of all. They attempt to create a “clone”ADVANTAGESFewer Capital GainsKeeping Pace with Selected IndexPainless StrategyLower Cost PITFALLS OF INDEX FUNDSDownside RiskSkewed Weighting SystemsDo they actually copy the index?Divergence Between Index FundsHow can different index funds have different returns?Narrow FocusLose the Value Added by Money ManagersIncreased VolatilityVARIABLE ANNUITYCONCEPTS OF variable annuityLike an IRA that is not deductibleTax deferred investment vehicleVariety of investment optionsGuarantees protected by an insurance componentBENEFITSDiversified Investment PortfolioNo Limit on Annual InvestmentUpon death, beneficiaries are guaranteed face value or higher market valuePay for thisVA company may permit annual payout without penaltyWatch for forced annuitizationTax-deferred Growth Of FundsDRAWBACKSHigh Mortality and Expense ChargeDepends on the contractThe “shares” in the VA are institutional shares that might not have any load and very low expensesContingent Deferred Sales ChargesIf in for the long term this is not an issueIf you need the cash in 4 – 5 years, VA is not the answer.Penalty for Withdrawal Before 59-1/2Variable Annuity Funding SourcesWhere does the money come from?Liquidation of Earnings Withdrawal from taxable savings planLife insurance death benefit proceedsOther lump sums (inheritance, sale of business)Cash value life insurance or annuities (1035 Exchanges)VARIABLE IMMEDIATE ANNUITYAssumption here is annuitizationWhat 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 AnnuityContributions (after-tax dollars) X X Earnings accumulate tax-deferred X XEarnings taxed upon withdrawal X XPrincipal can be withdrawn tax free X X10% tax penalty applies to withdrawals X X before age 59 1/2 No minimum distribution at age 70? XUnlimited payments to contract Xcenter0We’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.00We’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.Who May be Right for a Nonqualified AnnuityHas Long-term savings goals and/or is planning for retirementHas reached their maximum 401(k) and IRA contribution limitsWants family protection in the form of a death benefitWants to grow their assets tax deferredWants ability to move among funding options tax freeWants lifetime incomeHas received unexpected lump sum payment and needs to invest long-termLiquidity 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 AnnuityNet worth is less than $100,000IRAs and 401(k) not fully fundedShort-term investors with higher liquidity needsInsufficient discretionary income/ emergency fundsMay need access to money prior to age 59?1035 exchange basicsWhat 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.143219186438center0Let’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.020000Let’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.Defer Taxable GainAssume: $20,000 Premiums Paid$25,000 Cash Value$5,000 Taxable Income Upon Surrender-9969580645001946330480First, 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.020000First, 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.Save Tax LossAssume:$20,000 Premiums Paid$15,000 Cash Value$5,000 Loss792480698500022225014668500center0Another 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.020000Another 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.center0Some 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. 020000Some 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 FeesAsset Based FeesMortality & Expense Risk ChargePay for the guaranteesStep-up chargesCreates guarantee of upward growing portfolio value (floating floor)Fund Fees and ExpensesPaid to the mutual fundsUsually institutional fund classes so lower feesContingent Deferred Sales ChargesContract Administrative Chargescenter0Now 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.There is also a $30 annual contract administrative charge that goes to pay for the cost of administering the contract - things like annual statements to the contract owner, customer correspondence, issuing the contract and providing telephone customer service support. 020000Now 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.There is also a $30 annual contract administrative charge that goes to pay for the cost of administering the contract - things like annual statements to the contract owner, customer correspondence, issuing the contract and providing telephone customer service support. Impact of Taxes on WithdrawalsWithdrawals Subject to Income Tax on Amounts Not Previously Taxed10% IRS Early Withdrawal Penalty < 59?EXCEPTION:Substantially Equal Payments - 72(t)/(q)Payments Must Continue for Longer of 5 Years or Age 59?Step-Up Benefits – a moving floor of the value of the contract. Not all contracts permit this. 48387028257500Distribution of Death Benefit ProceedsBeneficiaries have right to:Annuitize Contract; orTake lump-sum paymentSpousal Beneficiaries may elect to continue contract under his/her nameDeath benefit proceeds subject to estate and income taxesAsset AllocationAsset Allocation is the process of combining different asset classes in varying proportions to help achieve the best possible return for the lowest amount of riskOver 92% of a portfolio’s return rests on Asset Allocation decisions1206505143500right000REBALANCING A PORTFOLIORebalancing is not a market timing strategyReturn a portfolio to a preset allocation based on risk tolerances It is a systematic approach to maintaining a consistent risk profile ................
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