Variable Annuities Flashcards

Question

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 A. I and III B. I and IV C. II and III D. II and IV

Answer 1

The best answer is C. 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).

Answer 2

The best answer is C. 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. 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.

Answer 3

The best answer is A. Because this customer is looking for income in retirement and he or she is only 40 years old, a deferred annuity is the right choice. Because the customer wants preservation of capital, 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. Note that at retirement age, the holder of an annuity can opt for a lump sum payment instead of taking annuity payments, and a fixed annuity guarantees a fixed amount of capital at retirement age, whereas a variable annuity does not.

Answer 4

The best answer is B. 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 receives 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.

Answer 5

The best answer is B. GMIB - Guaranteed Minimum Income Benefit will give a minimum guaranteed growth rate for an additional cost. This guarantee only occurs at annuitization and covers the accumulation phase. The maximum rate that can be earned in the separate account during the accumulation phase is not capped by the GMIB rider.

Answer 6

The best answer is C. 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. This is a very popular rider, but it does come at a cost.

Answer 7

The best answer is C. 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.

Answer 8

The best answer is B. 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.

Answer 9

The best answer is A. 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.

Answer 10

The best answer is A. 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."

Answer 11

The best answer is B. 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."

Answer 12

The best answer is A. 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.

Answer 13

The best answer is D. 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. Since the return will vary based on the performance of the underlying growth mutual fund, it is not true that it will always be higher than the return from a fixed annuity. When distributions are taken at retirement age, they are taxable as ordinary income, so it is not true that there is no tax due when distributions are taken.

Answer 14

The best answer is C. Since this person is above age 59 1/2, any withdrawals from the retirement plan are not subject to the 10% penalty tax for a premature distribution. Since the contribution amount into the variable annuity contract was not tax deductible, this portion of the investment is returned without any tax consequence. Any earnings above this amount are taxed at the customer's bracket.

Answer 15

The best answer is C. 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).

Answer 16

The best answer is D. 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.

Answer 17

The best answer is C. 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.

Answer 18

The best answer is D. 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.

Answer 19

The best answer is C. Section 1035 "tax-free" exchanges permit "like-for-like" exchanges without tax due. Thus, Choices I and IV are tax free. It also permits a life insurance policy to be exchanged for a variable annuity without tax due, making Choice II true. Of course, the IRS is happy about this because the taxable annuity payments will start earlier than the payment of the taxable death benefit. However, a variable annuity cannot be exchanged tax-free for an insurance policy under this tax rule, making Choice III false. If there is a gain in the separate account, it would be taxed upon exchange for a life insurance policy.

Answer 20

The best answer is C. 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.)

Answer 21

The best answer is D. Consider this to be a learning question. To recommend a variable annuity, the representative must have a reasonable basis to believe that the customer would benefit from certain features of these products, such as tax-deferred growth, annuitization, or a death or living benefit.

Answer 22

The best answer is D. Consider this to be a learning question. To recommend a variable annuity, the representative must have a reasonable basis to believe that the customer has been informed, in general terms, about the material features of the variable annuity. These include the potential surrender period and surrender charge, potential tax penalty, mortality and expense fees, charges for and expenses of enhanced riders (a very popular rider, at a cost, is a GMIB - a Guaranteed Minimum Income Benefit), insurance and investment components and market risk.

Answer 23

The best answer is C. 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.

Answer 24

The best answer is C. In a variable annuity contract, the principal amount is never guaranteed. The principal value may increase or decrease, depending on the performance of the separate account. The "investment risk" is borne by the contract holder, not the insurance company. Regarding the statement about the contract holder "losing control of the principal," this relates to the contract holder's ability to change the terms of the payout from the contract. Prior to annuitization, the contract holder is allowed to change his payout option, thus he has control over how the principal will be disbursed. However, once the contract is "annuitized," the contract holder cannot change the payout option - he or she loses control over the principal. (Please note that the term "losing control over the principal" does not refer to how the investment manager decides to invest the funds in the separate account.)

Answer 25

The best answer is D. A GMIB (Guaranteed Minimum Income Benefit) is an optional rider that can be purchased in most variable annuity contracts. At retirement age, if the separate account has not grown by the guaranteed minimum rate, the separate account will still be annuitized based on the guaranteed minimum growth rate - so Choice A is a true statement. Variable annuities offer a "death benefit" during the accumulation phase. If the owner dies before annuitization, the insurance company will return all payments made to a beneficiary - so Choice B is a true statement. One of the annuity options available is a Life Annuity - Period Certain, which guarantees that if the purchaser dies before a minimum time period (say 15 years), the payments will still be made to a beneficiary for the remainder of time until 15 years is completed - so Choice C is true. Choice D is false - the investment return in the separate account depends on the performance of the underlying mutual fund - it will vary and is not guaranteed.