Open-end (mutual) funds

An open-end fund is more commonly known as a mutual fund. As with closed-end funds, mutual funds invest in many different securities to provide diversification for investors. The key difference is that mutual funds are constantly issuing and redeeming shares, which provides liquidity for investors. Because open-end fund shares are continuous offerings of new shares, a mutual fund prospectus must always be available. You need to understand the makings of the net asset value and the public offering price when taking the Series 7 exam:

• Net asset value (NAV): Fortunately, the net asset value or net asset value per share is determined the same way for both open and closed-end funds — by dividing the value of the securities held by the fund by the number of shares outstanding; however, with open-end funds, the NAV is the bid price. When investors redeem shares of a mutual fund, they receive the NAV. Mutual funds can’t ever trade below the NAV.

• Public offering price (POP): For mutual funds, the public offering price (the ask price) is the NAV plus a sales charge.

  If a mutual fund doesn’t charge a sales charge, it’s called a no-load fund.

Because mutual funds are new issues, investors must receive a prospectus (for more on what a prospectus is, see Chapter 5) and/or a summary prospectus. Certainly prospectuses for mutual funds include their holdings, investment strategy, fees, expenses, graphs of the fund’s performance, and so on. Every prospectus for every security must contain a disclosure stating that the SEC does not approve of the issue. I assume that this is the SEC’s way of not being sued if investors lose money. The SEC just clears the issue.

If the fund provides a summary prospectus, it must include items like the fund’s name and ticker symbol, the class of shares, the fund’s investment strategies, investment objectives, costs of investing, investment advisors, financial compensation, risks, performance, and so on. The summary prospectus may include an application that investors can use to purchase shares. Potential investors can also request a full prospectus prior to investing. If an investor purchases via a summary prospectus, he must either receive or be provided online access to a full prospectus.

On an ongoing basis, funds must include in their prospectus annual report graphs comparing the performance of the fund to a proper index (S&P 500, NASDAQ composite, and so on), items and/or strategies that may have affected the performance in the past year, and the name of the fund’s manager.

Note: Expenses of a mutual fund include salaries for the board of directors; management (investment advisor) fees for the person or persons making the investment decisions for the fund; custodial fees for the safeguarding of assets (cash, securities, and so on) held by the fund; transfer agent fees for keeping track of investors, sending distributions, and sending proxies; and 12b-1 fees if any 12b-1 fees are fees paid by a mutual fund out of the fund assets to cover promotional expenses such as advertising, printing, and mailing of prospectuses to new investors, and so on. If there are 12b-1 fees, they must be included in the prospectus.

In addition to a prospectus, mutual fund investors may request a Statement of Additional Information (SAI). The SAI provides more detail about the fund and its investment risks and investment policies. The SAI is not sent automatically. However, if requested, the SAI must be delivered within 3 business days.

Closed-end funds

Unlike open-end funds, closed-end funds have a fixed number of shares outstanding (hence the word closed). Closed-end funds act more like stock than open-end funds because they issue new shares to the public, and after that, the shares are bought and sold in the market. Because they trade in the market, they’re often called publicly traded funds. Although the net asset value of closed-end and open-end funds is figured the same, the public offering price is determined a little differently:

• Net asset value (NAV): The net asset value or net asset value per share is the parity price where the fund should be trading. You determine it by dividing the value of the securities held by the fund by the number of shares outstanding. Only closed-end funds may trade below the NAV (at a discount).
• Public offering price (POP): For closed-end funds, the public offering price (the ask price) depends more on supply and demand than the NAV. Investors of closed-end funds pay the POP (current market price) plus a broker’s commission.

Note: Although closed-end funds are not purchased from and redeemed with the issuer, they do offer a high degree of liquidity. After the initial offering, they can be purchased or sold either on an exchange or over-the-counter (OTC).

Open and closed: Focusing on their differences

You can expect at least a few of the Series 7 questions relating to investment companies to test you on the differences between open-end and closed-end funds. Table 10-1 should help you zone in on the major distinctions.

Forward pricing

Because open-end funds hold a basket of securities that are purchased from and redeemed by the issuer, there is no current NAV. Any purchases or sales that take place during the trading day are held until the close of the market until the next NAV can be computed. All redemptions of mutual fund shares are completed at the next computed NAV (the redemption price).

The key difference between open-end and closed-end funds is the method of capitalization. An open-end (mutual) fund is a continuous offering of new securities, whereas a closed-end fund is a one-time offering of new securities.

Systematic withdrawal plans

As an extra service, many mutual funds offer systematic withdrawal plans as a way of redeeming shares. This type of plan is ideal for someone who's at the retirement age and is looking for a little extra cash each month while still keeping the balance invested. Withdrawal plans can be set up as a fixed dollar amount periodically, a fixed share amount redeemed periodically, or a fixed amount of time (for example, redeeming all the shares over a 10-year period).

Not all mutual funds offer systematic withdrawal plans, but if they do, as a registered rep, you must disclose the risks involved to your client. Some of the risks include the client running out of money, and no guaranteed rate of return.

Regulated investment companies (RIC): Regulated under Subchapter M

For an investment company to avoid being taxed as a corporation, it must distribute (pass-through) at least 90 percent of their net investment income to shareholders. Net investment income is the amount received in dividends and interest less expenses. In the event that it distributes 90 percent or better, the investment company is only taxed on the amount of net investment income not distributed to shareholders.

Diversified investment company

For an investment company to be considered diversified, it must meet the 75-5-10 test. (The 75, 5, and 10 represent percentages.) So for an investment company to claim it's diversified, no more than 5 percent of the 75 percent can be invested in one company. In addition, out of the 75 percent portion, the investment company cannot own more than 10 percent of the outstanding shares of any company. The remaining 25 percent can be invested in any way. If an investment company doesn't meet the 75-5-10 test, it is considered non-diversified.

Types of mutual funds

Mutual funds come in many types and flavors depending on your client's needs. Mutual funds can specialize in holding stocks, preferred stocks, short-term bonds, intermediate-term bonds, long-term bonds, or any combination of those. Here are some types of mutual funds:

• Money market fund: This fund (as you’ve probably guessed) invests in money market instruments (short-term debt securities). You need to know the specifics of this fund more than other types of funds. Here are the key points:
  • It usually provides a check-writing feature (you’re given a checkbook) as a way of redeeming shares.
  • It’s always no-load (there’s no sales charge).
  • It computes dividends daily and credits them monthly.
  • There’s no penalty for early redemption.
• Equity (stock) fund: The primary objective of an equity fund is to provide growth for investors. Equity funds invest primarily in stocks but may hold a small amount of cash or cash equivalents such as money-market securities. Equity funds can be further broken down by investment objectives such as growth, aggressive growth, value, international, and so on.
• Fixed-income (bond) fund: Like an income fund, the objective of a fixed-income fund is to provide current revenue to investors. The difference is that fixed-income funds only invest in debt securities not common stock or preferred stock.
• Interval fund: This type of investment company periodically offers to buy back a stated portion of fund shares from its shareholders. It is up to each shareholder whether she decides to accept the offer or to continue to hold the shares.

Volatility ratings

There are companies that provide volatility ratings for bond mutual funds. The volatility ratings typically take into account the credit rating of the bonds held, sensitivity to market conditions and general economy, the market price volatility of the portfolio, the fund's performance, interest rate risk, prepayment risk, currency risk, and so on. If these volatility ratings are going to be used in retail communications, there are certain FINRA rules that must be followed:

• The volatility rating cannot be described as a “risk” rating.
• The ratings must be the most recent ones (the most recently completed calendar quarter).
• The ratings must be clear, concise, and understandable and based exclusively on objective, quantifiable factors.
• The ratings must include the method used to determine the volatility.
• A toll-free telephone number and/or a website must be provided for the rating company.

Fund objectives

The single most important consideration for customers who invest in packaged securities is the fund’s investment objectives. This feature surpasses even the sales charge or management fees. As a registered rep, one of your primary jobs will be to help investors decide which type of fund would be best for them. The test-designers want to know you can handle that job. Comparing like-type funds is secondary. I list funds based on their investment objectives below:

• Income fund: The primary objective of an income fund is to provide current revenue (not growth) for investors. This type of fund invests most of its assets in a diversified portfolio of debt securities that pay interest and in preferred and common stock of companies that are known to pay consistent dividends in cash.

  Income funds are considered much safer (more conservative) investments than growth funds. You can assume for Series 7 exam (and real-life) purposes that income funds are better investment choices for retirees and investors who are looking for a steady cash flow without much risk.

• Balanced fund: A balanced fund is a combination of a growth fund and an income fund. Balanced funds invest in common stocks, preferred stocks, long-term bonds, and short-term bonds, aiming to provide both income and capital appreciation while minimizing risk. These funds don’t get hammered too badly when the market is bearish but usually underperform when the market is bullish.

• Growth fund: This fund is exactly what you’d expect it to be; growth funds invest most of their assets in a diversified portfolio of the common stock of relatively new companies, looking for big increases in the stock prices. Growth funds offer a higher potential for growth but usually at a higher risk for the investor. This type of fund is ideal for an investor who’s looking for long-term capital appreciation potential.

  Because of the inherent risk of investing in growth funds, they’re better for younger investors who can take the risk because they have more time to recover their losses.

• Value fund: A value fund invests in stocks that are considered undervalued based on fundamentals. The stocks purchased by this type of fund are ones that the fundamental analysts believe should be and will be trading at a higher price based on things such as the earnings of the company and comparisons to other companies.
• Specialized (sector) fund: A specialized or sector fund is a type of fund that invests primarily in the securities of a single industry or geographical area. A specialized fund may invest only in financial services, healthcare, automotive stocks, Japanese securities, and so on. Because specialized funds are limited in their investments, you can assume that they’re a little riskier (more volatile) than the average fund.
• International or global fund: An international fund invests in companies based anywhere outside of the investor’s home country. A global fund invests in securities located anywhere in the world, including the investor’s home country. Although international and global funds may be good to round out a portfolio, they aren’t without their risks. Along with the risk that investors face by just investing in securities in general, holders of international and global funds also face currency risk, which is the risk that the currency exchange rate between the U.S. and foreign issuers will hurt investors. There’s also the additional risk that politics in a particular country will harm the value of the fund.

Fund performance

Funds must disclose their average annual returns to help investors,representatives, investment advisers, and so on be able to compare like funds quickly. Securities laws require each fund to disclose the returns for 1-, 5-, and 10-year periods. If the fund hasn't been in existence for 10 years, it must disclose the returns since inception. The performance as well as being online is also disclosed in the fund's prospectus.

Hedge funds: What are they?

You’ve probably heard about hedge funds but aren’t exactly sure what they are. For the Series 7 exam, you do need to know a little bit about them. Because they aren’t open- or closed-end funds, unit investment trusts, or face amount certificate companies, they are an exception to the standard definition of investment company under the Investment Company Act of 1940. In addition, because they are considered private investment companies (sold privately under Regulation D) and are only open to sophisticated (accredited) investors, they are exempt from SEC registration. As such, many hedge funds have limited available information. Hedge funds often require a very high initial investment — sometimes $500,000 or more and therefore have limited or no liquidity. In addition, many have lock-up provisions, which means that investors will not be able to redeem or sell shares during that time.

Hedge funds hold a pool of investments and are professionally managed like mutual (open-end) funds but have a lot more flexibility. Hedge funds have a wide array of investment styles, models, and vehicles. Some are even blind pool/blank check investments where there's no stated goal. Hedge funds are typically much more aggressive in nature and may buy securities on margin, sell securities short, purchase or sell options, and so on in an attempt to maximize gains. I guess you can almost think of them as a “whatever it takes to make money” type of fund.

The fees, costs, and expenses for investing in a hedge fund are typically around 2 percent per year for a management fee. In addition, many hedge funds charge as much as 20 percent of the profits made after a certain goal is reached.

Taxation on hedge funds is similar to that of direct participation programs because they are set up as pass-through entities. So the fund itself is free of taxes, and the gains and losses are passed through to the investors who are taxed at the individual level.

Some hedge funds are set up as a fund of funds. So instead of an investor investing in one particular hedge fund, she is investing in a fund that pools many hedge funds together as a way of mitigating the risk of investing in one fund. The fees of investing in a fund of hedge funds are typically higher than investing in just a single hedge fund. In addition, there may be a longer lock-up period.

Don’t let the variety of funds distract you too much. So many different funds are out there that the choices could drive you crazy. I list the main types, but funds can invest by objective (as previously listed) or composition, such as with foreign stock funds (which invest in foreign securities), tax-exempt funds (which invest in municipal bonds), U.S. government funds, and so on. The composition of the fund should help you match it with your customer’s objectives. For instance, a customer looking for safety and income may invest in a U.S. government bond fund.

Breakpoints

Funds have an investment adviser (portfolio manager) who gets paid a percentage of the value of the securities held in the fund. Therefore, one way to entice investors to spend more is to reduce the sales charge when they spend a certain minimum amount of money. That’s where the breakpoint comes in.

Management investment companies divide purchase amounts into different tiers. Within a certain range, investors all pay the same sales charge percentage. But when investors spend enough to put them in the next tier (when they hit the breakpoint), they get a reduced sales charge. Breakpoints have no set schedule, so they vary from fund to fund.

Here are a few key points for you to remember for the Series 7 exam:

• Breakpoints must be disclosed in the prospectus.
• Breakpoints are not available to partnerships or investment clubs (several people pooling money together to receive reduced sales charges).
• Breakpoints are generally available to individual investors, joint accounts with family members, and corporations.

Here's a hypothetical example of breakpoints for fictional ABC Growth Fund (summarized in Table 10-2). For this fund, persons investing less than $10,000 would pay a sales charge of 7 percent, persons investing between $10,000 and $19,999 would pay a sales charge of 6 percent, persons investing between $20,000 and $39,999 would pay a sales charge of 4 percent, and persons investing at least $40,000 would pay a 2 percent sales charge.

Another discount, rights of accumulation, allows shareholders to receive a reduced sales charge when the amount of the funds held plus the amount purchased is enough to reach a breakpoint. So, using Table 10-2, if the investor initially purchased $8,000 worth of ABC Growth Fund, she would pay a sales charge of 7 percent. Let's say that the market has been quite bullish and the NAV of the shares purchased has increased $15,000 and she decides to purchase an additional $7,000 of the fund. Under rights of accumulation, her sales charge on the $7,000 purchase would only be 4 percent because adding the NAV of $15,000 and the purchase of $7,000 would bring the investment to more than $20,000. There is no time limit for rights of accumulation.

Letters of intent

A letter of intent (LOI) signed by an investor allows her to receive a breakpoint (quantity discount) right away with the initial purchase, even if the investor hasn’t yet deposited enough money to achieve the breakpoint. This document states that as long as the investor deposits enough within a 13-month period, she will receive the discounted sales charge right away.

Here are a few specifics about the letter of intent that you need to know for the Series 7:

• The investor has 13 months after the first deposit to live up to the terms of the letter of intent in order to maintain the reduced sales charge.
• The LOI may be backdated for up to 90 days, meaning that it may apply to a previous purchase. However, remember that if the LOI applies to a previous purchase, the 13-month period starts from the date of that previous transaction.
• While the investor is under the letter of intent, shares are held in escrow to pay for the difference in the sales charge. If the investor doesn’t live up to the terms of the obligation, the fund sells the shares held in escrow.

Here’s how a letter of intent may work. Suppose, for instance, that Mr. Smith purchased $2,000 worth of ABC Growth Fund two months ago and has another $7,000 to invest in the fund right now. Mr. Smith believes that he’ll keep investing in ABC Growth Fund and would like to get a reduced sales charge for investments of $10,000 and up. (See Table 10-2 for the breakpoints.)

Mr. Smith signs a letter of intent and wants to apply it to his previous purchase. Because his previous purchase was two months ago, Mr. Smith has only another 11 months to invest the remaining $8,000 into ABC Growth Fund. Mr. Smith will receive the 6 percent sales charge on his $7,000 investment right now, which will be reduced by the overage he paid on the previous investment of $2,000. In other words, he’ll pay only $400 sales charge on the current investment ($420 for this transaction minus the $20 overpaid from the previous investment) when he invests the $7,000. As long as Mr. Smith deposits the additional $1,000 by the end of the letter of intent’s time frame, he’ll pay the 6 percent sales charge. However, if Mr. Smith doesn’t live up to the terms of the agreement, ABC Growth fund will sell the shares held in escrow to pay for the difference in the sales charge.

Investors may redeem their shares at any time, even if they’re under a letter of intent.

Dollar cost averaging

If an investor is employing the dollar-cost-averaging formula, she is investing the same dollar amount into the same investment periodically. Although dollar cost averaging is primarily used for mutual funds, people can use it for other investments as well. Dollar cost averaging benefits the investor when the price of the security is fluctuating. The investor ends up buying more shares when the price is low and fewer shares when the price is high by depositing the same amount of money each time she makes a purchase.

Dollar cost averaging results in an average cost per share that is lower than the average price per share if the price of the fund fluctuates.

The following question tests your understanding of dollar cost averaging.

Mrs. Johnson deposits $1,000 into DEF growth fund in four separate months. The purchase prices of the fund are as follows:

• Month 1: $40
• Month 2: $50
• Month 3: $50
• Month 4: $40

What is the average cost per share for Mrs. Johnson?

(A) $40.00

(B) $44.44

(C) $45.00

(D) $48.35

The correct answer is Choice (B). On the surface, this question may look very easy to you and you may jump to Choice (C), but Choice (C) is the average price per share, not the average cost. Remember that because Mrs. Johnson is investing the same amount of money each month, she’s able to buy more shares when the price is low and less when the price is high. In the first and fourth months, when the price was $40 per share, she was able to buy 25 shares each time. In the second and third months, she was able to buy only 20 shares each time:

Over the four months, Mrs. Johnson invested a total of $4,000 and purchased a total of 90 shares (25 + 20 + 20 + 25). The average cost per share is $44.44:

If you use your sense of logic and watch for ways to eliminate answer choices, you may get away with doing very little math. Here, you can answer the question by finding the average price per share, which is not what the question is looking for. With dollar cost averaging, buying more when the price is low drives the average cost down; therefore, the average cost per share has to be between the minimum price per share ($40) and the average price per share ($45). The only number that fits these criteria is $44.44, or Choice (B).

You should be prepared to calculate the average cost per share, the average price per share ($45), and the amount saved per share ($0.56).

Sales charge percent

The sales charge, which is set at a maximum of 8½ percent, is part of the public offering price (POP), or ask price, not something tacked on afterward like a sales tax. One of the tricks for calculating the sales charge for open-end funds is remembering that the POP equals 100 percent. Therefore, if the sales charge is 8 percent, the net asset value (NAV) is 92 percent of the POP. The formula for determining the sales charge percent is as follows:

The following question tests your expertise in calculating the sales charge of a mutual fund.

ABC Aggressive Growth Fund has a net asset value of $9.20 and a public offering price of $10.00. What is the sales charge percent?

(A) 6.8 percent

(B) 7.5 percent

(C) 8 percent

(D) 8.7 percent

The right answer is Choice (C). The first thing that you have to do is set up the equation. Start with the POP of $10.00 and subtract the NAV of $9.20 to get $0.80. Next, divide the $0.80 by the POP of $10.00 to get the sales charge of 8 percent:

To help you remember that the ask (offer) price of a fund is the same as the POP, remember to ask your POP about it.

Public offering price (POP)

When taking the Series 7 exam, you may be asked to figure out the public offering price of a mutual fund when you’re given only the sales charge percent and the NAV.

Remember, the sales charge is already a part of the POP, so the sales charge is not equal to the sales charge percent times the NAV. Use the following formula to figure out how much an investor has to pay to buy shares of the fund when you know only the NAV and the sales charge percent:

The following question tests your ability to answer a POP question.

DEF Aggressive Growth Fund has a NAV of $9.12 and a POP of $9.91. If there is a 5 percent sales charge for investments of $30,000 and up, how many shares can an investor who is depositing $50,000 purchase?

(A) 5,045.409 shares

(B) 5,208.333 shares

(C) 5,219.207 shares

(D) 5,482.456 shares

The answer you want is Choice (B). Don’t let the decimals throw you off; mutual funds can sell fractional shares. This investor isn’t going to be paying the POP of $9.91 per share because she’s receiving a breakpoint for a large dollar purchase (see “Breakpoints,” earlier in this chapter). To figure out the POP for this investor, set up the formula:

After working out the formula, you see that the investor is paying $9.60 per share instead of $9.91. Next, determine the number of shares the investor can purchase by dividing the amount of the investment by the cost per share:

This investor is able to purchase 5,208.333 shares because of the breakpoint. Without the breakpoint, the investor would have been able to purchase only 5,045.409 shares.

Loads

As I explained earlier in this chapter, most mutual funds charge a sales charge (also known as a load) that’s built into the public offering price (POP). However, most charge up front, some charge constantly, some charge when redeeming, and some don't charge a load at all. Depending on how investors are charged, mutual funds are broken down into classes:

• Class A (front-end load): The investor pays the load when purchasing shares of the fund. Quite often, Class A shares will impose a sales charge based on the assets held. The asset-based sales charge is often around 1/4 percent per year. However, Class B and C shares often charge closer to 1 percent per year. Note: Asset-based sales charges are not paid by investors directly but are taken out of the assets held by the fund to compensate brokers, pay for advertisements, pay for prospectuses,12b-1 fees, and so on.
• Class B (back-end load): In addition to having higher asset-based sales charges than Class A shares, investors pay a load when redeeming shares of the fund, which is also known as a contingent deferred sales charge (CDSC). The CDSC is usually not charged if the investor holds the shares for enough years (typically around 6). Typically in about 2 years after the CDSC is eliminated, the Class B shares are converted into Class A shares and the yearly asset-based sales charge is lowered accordingly.
• Class C (level load): Investors do not pay a front-end sales charge but pay an annual asset-based sales charge similar to what Class B shares pay for the first several years. The difference is that Class C shares do not convert to Class A shares so the annual asset-based sales charges remain at the same high level no matter how long the shares are held. If shares are held for a long period of time, Class C shares end up costing investors more.
• Class D (no load): Investors don’t pay a sales charge but may be charged some sort of transaction fee. Class D shares are not typically available to all investors. Class D shares are only available to certain retirement plans and brokerage firms.

Expense ratio

Something else that investors should be concerned about is a fund's expense ratio. To determine a fund's expense ratio, you have to divide the fund's expenses (management fees and operating costs) by the funds average net assets. So if the expense ratio of a fund is 2 percent, that means that the fund is charging $2 for every $100 invested. The higher the expense ratio, the more the fund is eating into your profits.

You can definitely expect a question or two relating to taxes on mutual funds. This is covered in detail in Chapter 15.

Separate account

The money that investors deposit is held in a professionally-managed separate account (separate from the insurance company’s other business) because the money is invested differently. The separate account is invested in securities such as common stock, bonds, mutual funds, and so on, with the hope that the investments will keep pace with or exceed the inflation rate. Separate accounts must be registered with the SEC as investment companies. Income and capital gains generated are credited to the separate account. Also, if the investments in the separate account lose money, it is charged to the separate account. The separate account is unaffected by the insurance company's other business.

Assumed interest rate

The assumed interest rate (AIR) is a projection of the performance of the securities in the separate account over the life of the variable annuity contract. If the assumed interest rate is 4 percent and the performance of the securities in the separate account is equal to 4 percent, the investor receives the payouts that she expects. However, if the securities outperform the AIR, the investor receives higher payouts than expected. And unfortunately, if the securities held in the separate account underperform the AIR, the investor gets lower payouts than expected.

Fees

Insurance companies aren't setting up annuities for investors just because they like to help people out, they receive money for doing so. Even though the initial sales loads might be minimal or non-existent for investors purchasing annuities, they will get charged pretty heavy sales charges (surrender charges) if they close out the annuity too early. The insurance company makes additional money on management fees and other expenses. Some additional charges that investors should be aware of depending on the variable annuity offered could be charges for stepped-up benefits, guaranteed minimum income benefits, and long-term care insurance. All the applicable charges would be found in the variable annuity prospectus.

Looking at the pay-in phase

Payments into both fixed and variable annuities are made from after-tax dollars, meaning that the investor can’t write the payments off on her taxes. However, payments into both fixed and variable annuities grow on a tax-deferred basis (they aren’t taxed until the money is withdrawn). If an investor has contributed $80,000 into a variable annuity that’s now worth $120,000, the investor is taxed only on the $40,000 difference because she has already paid taxes on the contribution. If an annuitant dies during the pay-in phase, most annuity contracts require a death benefit to be paid to the annuitant’s beneficiary. The death benefit is typically the greater of all the money in the account or some guaranteed minimum.

Note: During the pay-in phase, an investor of a variable annuity purchases accumulation units. These units are similar to shares of a mutual fund.

Investors have a few payment options to select when purchasing fixed or variable annuities. Here’s the rundown of options:

• Single payment deferred annuity: An investor purchases the annuity with a lump sum payment, and the payouts are delayed until some predetermined date.
• Periodic payment deferred annuity: An investor makes periodic payments (usually monthly) into the annuity, and the payouts are delayed until some predetermined date; this is the most common type of annuity.
• Immediate annuity: An investor purchases the annuity with a large sum, and the payouts begin within a couple months.

Most annuities in which investors are making scheduled deposits provide a waiver of premium during the pay-in phase if the annuitant becomes disabled or is confined to long-term care.

Getting the payout

Investors of both fixed and variable annuities have several payout options. These options may cover just the annuitant (investor) or the annuitant and a survivor. No matter what type of payout option the investor chooses, she will be taxed on the amount above the contribution. The earnings grow on a tax-deferred basis, and the investor is not taxed on the earnings until withdrawal at retirement.

Note: During the payout phase of a variable annuity, accumulation units are converted into a fixed number of annuity or annuitization units. Investors receive a fixed number of annuity units periodically (usually monthly) with a variable value, depending on the performance of the securities in the separate account.

When an investor purchases an annuity, she has to decide which of the following payout options works best for her:

• Life annuity: This type of payment option provides income for the life of the annuitant (the individual covered by the annuity); however, after the annuitant dies, the insurance company stops making payments. This type of annuity is riskiest for the investor because if the annuitant dies earlier than expected, the insurance company gets to keep the leftover annuity money. Because it’s the riskiest type of annuity for the annuitant, it has the highest payouts of all the options.
• Life annuity with period certain: This payout option guarantees payment to the annuitant for a minimum number of years (10, 20, and so on). For example, if the annuitant were to purchase an annuity with a 20-year guarantee and die after 7 years, a named beneficiary would receive the payments for the remaining 13 years.
• Joint life with last survivor annuity: This option guarantees payments over the lives of two individuals. As you can imagine, this type of annuity is typically set up for a husband and wife. If the wife dies first, the husband receives payments until his death. If the husband dies first, his wife receives payments until her death. Because this type of annuity covers the lifespans of two individuals, it has the lowest payouts.

All annuities have a mortality guarantee. This guarantee means that the investor receives payments as long as she lives, even if it’s beyond her life expectancy. This is a risk for the insurance company so it typically charges each account around 1.25 percent per year to cover that risk.

Early withdrawal penalty

As with most other retirement plans, annuity investors are hit with a 10 percent early withdrawal penalty if they withdraw the money prior to age 59½. Yes, that’s correct — the 10 percent penalty is added to the investor’s tax bracket. Typically, retirement plans include a waiver of the 10 percent penalty in cases such as the purchase of a first home, age 55 and separated from work, death, or disability.

Death benefit

If the annuity holder dies before the insurer has started making payments, the beneficiary is guaranteed to receive a specified amount. That specified amount is typically at least the amount that was paid into the annuity even if the account value is less than the guaranteed amount. However, that amount could be lowered if withdrawals have been made from the account. The death benefit is a common option. Investors should understand that additional benefits cost additional money.

Surrender value

The surrender value or cash surrender value of an annuity comes into play when an annuity is voluntarily terminated (cashed in) before its maturity. In that case, the annuity holder will receive the cash value less surrender fees. Quite often, the cash surrender value will be less than what the annuity holder has paid in premiums. Typically the surrender fees, which are a percentage of the cash value, decrease the longer the policy is kept in force.

Investors are usually better off maximizing other investment vehicles such as IRAs, and 401(k)s prior to investing in variable annuities.