NASAA 2010 Investment Adviser Training Variable & Equity Indexed Annuities Chad Hartwick State of Michigan

NASAA 2010 Investment Adviser Training These views are my own views and not necessarily those of NASAA or the State of Michigan

NASAA 2010 Investment Adviser Training Annuities in General Parties involved Parties involved Insurance Company Insurance Company Contract Owner Contract Owner Annuitant / Insured Annuitant / Insured Beneficiary Beneficiary Contract between the owner (usually the annuitant) and the insurance company. Contract between the owner (usually the annuitant) and the insurance company. Primary aim is to help protect individuals from outliving their expected income. Primary aim is to help protect individuals from outliving their expected income.

NASAA 2010 Investment Adviser Training Annuities in General Two Phases – Accumulation, Annuitization Two Phases – Accumulation, Annuitization Annuities provide a guaranteed periodic income for a designated period of time or the life of the annuitant. Annuities provide a guaranteed periodic income for a designated period of time or the life of the annuitant. Annuities are commonly accumulated on a tax deferred basis. Annuities are commonly accumulated on a tax deferred basis. Single Premium Single Premium Deferred Deferred

NASAA 2010 Investment Adviser Training Annuities – Fees & Charges Mortality and Expense (M&E) – Insurance coverage Mortality and Expense (M&E) – Insurance coverage Surrender Charges Surrender Charges Optional rider/benefit fees Optional rider/benefit fees Sub-account expenses (Variable) Sub-account expenses (Variable) Administrative Administrative

NASAA 2010 Investment Adviser Training Annuity - Types Fixed – pays a current interest rate based upon the performance of the insurer with a guaranteed minimum. Fixed – pays a current interest rate based upon the performance of the insurer with a guaranteed minimum. Indexed – pays an in interest rate linked to the performance generally of an equity index, with limitations. Guaranteed minimum. Indexed – pays an in interest rate linked to the performance generally of an equity index, with limitations. Guaranteed minimum. Variable – Allows the owner to invest in sub-accounts. (mutual funds) Variable – Allows the owner to invest in sub-accounts. (mutual funds)

NASAA 2010 Investment Adviser Training Variable Annuities VAs are hybrid securities products issued by insurance companies. VAs are hybrid securities products issued by insurance companies. They bundle mutual fund like accounts with insurance-type components. Often referred as a mutual fund inside an insurance wrapper. They bundle mutual fund like accounts with insurance-type components. Often referred as a mutual fund inside an insurance wrapper. They are deemed retirement planning tools and are treated accordingly from a tax perspective. They are deemed retirement planning tools and are treated accordingly from a tax perspective. Complex and evolving. Complex and evolving.

NASAA 2010 Investment Adviser Training VAs cont - Regulators Product (company, contract, prospectus) Product (company, contract, prospectus) State Insurance Department State Insurance Department Securities Exchange Commission Securities Exchange Commission Sale (advertising, agents, suitability) Sale (advertising, agents, suitability) State Insurance Department State Insurance Department Securities Exchange Commission Securities Exchange Commission FINRA FINRA State Securities Department (THIS IS YOU) State Securities Department (THIS IS YOU)

NASAA 2010 Investment Adviser Training VAs cont – MF vs VA Three differences between Mutual Fund and Variable Annuities – The insurance wrapper. Three differences between Mutual Fund and Variable Annuities – The insurance wrapper. Payments Payments Tax – deferral Tax – deferral Guaranteed death benefit Guaranteed death benefit

NASAA 2010 Investment Adviser Training VAs cont – payments Usually several types to choose from Usually several types to choose from Irreversible Irreversible Rarely used, approx 1% of deferred variable annuities are annuitized. Rarely used, approx 1% of deferred variable annuities are annuitized.

NASAA 2010 Investment Adviser Training VAs cont – Tax Deferral Earnings grow tax deferred Earnings grow tax deferred Earnings that are withdrawn are taxed as ordinary income not capital gains. Earnings that are withdrawn are taxed as ordinary income not capital gains. Withdrawing $$ prior to 59 ½ may mean IRS penalties (10%), interest is withdrawn first and are fully taxable. Withdrawing $$ prior to 59 ½ may mean IRS penalties (10%), interest is withdrawn first and are fully taxable. Over 60% of VA sales are already Qualified Over 60% of VA sales are already Qualified

NASAA 2010 Investment Adviser Training VAs cont – Death Benefit Principal protection at death of owner Principal protection at death of owner Can provide insurance to the uninsurable Can provide insurance to the uninsurable Actual benefit may not be “large” relative to cost (i.e. expensive insurance) Actual benefit may not be “large” relative to cost (i.e. expensive insurance) Benefit to the beneficiary!!!!!!!!! Benefit to the beneficiary!!!!!!!!!

NASAA 2010 Investment Adviser Training VAs – Investment Selections Sub – accounts (clone funds) Sub – accounts (clone funds) Offer wide range of choices including multiple fund families Offer wide range of choices including multiple fund families Ability to move from one fund to another w/o commissions, taxes, or loads Ability to move from one fund to another w/o commissions, taxes, or loads Usually will have some fixed and money market funds as well Usually will have some fixed and money market funds as well

NASAA 2010 Investment Adviser Training VAs – fees & expenses M&E – 1.25% M&E – 1.25% Administrative fee - $30 Administrative fee - $30 Mutual fund fees – 1% Mutual fund fees – 1% Surrender fees – 8 years 8% Surrender fees – 8 years 8% Optional rider/benefit fees Optional rider/benefit fees Bonus Annuity Bonus Annuity Higher M&E Higher M&E Higher Surrender fee Higher Surrender fee

NASAA 2010 Investment Adviser Training VAs cont – Riders & Benefits Long term care Long term care Guaranteed minimum withdrawal Guaranteed minimum withdrawal Guaranteed minimum income Guaranteed minimum income Principal protection Principal protection Enhanced death benefit Enhanced death benefit May have a waiting period / age limits May have a waiting period / age limits Cost $$$$$$ Cost $$$$$$

NASAA 2010 Investment Adviser Training VAs cont - Suitability 3 Phases 3 Phases Suitability of the product Suitability of the product Payout Payout Tax Deferral Tax Deferral Death Benefit Death Benefit Suitability of the sub-accounts Suitability of the sub-accounts To aggressive To aggressive Not aggressive enough Not aggressive enough Suitability of the riders/benefits Suitability of the riders/benefits

NASAA 2010 Investment Adviser Training VAs cont – Suitability rules FINRA Rule 2310 – Recommendations to Customers (Suitability) (a) In recommending to a customer the purchase, sale or exchange of any security, a member shall have reasonable grounds for believing that the recommendation is suitable for such customer upon the basis of the facts, if any, disclosed by such customer as to his other security holdings and as to his financial situation and needs. (b) Prior to the execution of a transaction recommended to a non- institutional customer, other than transactions with customers where investments are limited to money market mutual funds, a member shall make reasonable efforts to obtain information concerning: (1) the customer's financial status; (2) the customer's tax status; (3) the customer's investment objectives; and (4) such other information used or considered to be reasonable by such member or registered representative in making recommendations to the customer. (c) For purposes of this Rule, the term "non-institutional customer" shall mean a customer that does not qualify as an "institutional account" under Rule 3110(c)(4).

NASAA 2010 Investment Adviser Training VAs cont – Suitability rules FINRA rule 2330 – Members Responsibilities Regarding Deferred Variable Annuities FINRA rule 2330 – Members Responsibilities Regarding Deferred Variable Annuities More specific suitability requirements on deferred VA transactions More specific suitability requirements on deferred VA transactions Principal review and approval Principal review and approval Supervisory procedures Supervisory procedures Training for agents and principals Training for agents and principals Notable exceptions Notable exceptions NASD Notice Members 96-86, NASD Notice Members 96-86, 99-35

NASAA 2010 Investment Adviser Training VAs cont – Inappropriate sales Recommending a purchase for somebody with few liquid assets, or short term need for funds (not liquid products) Recommending a purchase for somebody with few liquid assets, or short term need for funds (not liquid products) Overly aggressive sub-account choices Overly aggressive sub-account choices 1035s – surrender charges 1035s – surrender charges 1035s – loss in death benefits - stripping 1035s – loss in death benefits - stripping Riders that will not reasonably benefit the customer Riders that will not reasonably benefit the customer No economic benefit No economic benefit High commissions, 5-6%, no breakpoints High commissions, 5-6%, no breakpoints

NASAA 2010 Investment Adviser Training VAs cont – Managed VAs Are you kidding me?????? Are you kidding me?????? Some VAs are structured for this Some VAs are structured for this May be very expensive with the added management fee May be very expensive with the added management fee Are they automatically rebalancing? Are they automatically rebalancing? What are they managing? What are they managing?

NASAA 2010 Investment Adviser Training VAs cont - Supervision Firm’s Responsibilities Firm’s Responsibilities Establish standards of conduct it expects from its registered representatives Establish standards of conduct it expects from its registered representatives Disseminate and enforce these standards relating to suitability Disseminate and enforce these standards relating to suitability Provide ongoing sales practice and product knowledge training for its registered representatives Provide ongoing sales practice and product knowledge training for its registered representatives Establish policies and procedures regarding sales practices and investment products Establish policies and procedures regarding sales practices and investment products

NASAA 2010 Investment Adviser Training VAs cont - Supervision Firm’s Responsibilities Firm’s Responsibilities Develop and enforce suitability standards to be used in the investment process Develop and enforce suitability standards to be used in the investment process Monitor and supervise the sales activities of its registered representatives through the use of management, oversight and exception reports Monitor and supervise the sales activities of its registered representatives through the use of management, oversight and exception reports Conduct the appropriate follow-up with the representative Conduct the appropriate follow-up with the representative If necessary, correct any transactions that are determined to be unsuitable for the customer If necessary, correct any transactions that are determined to be unsuitable for the customer

NASAA 2010 Investment Adviser Training Equity Indexed Annuities A fixed (what?????) annuity product that allows investors to participate in market like returns. A fixed (what?????) annuity product that allows investors to participate in market like returns. They offer a minimum guaranteed return. Typically this guarantee is based on 90% of premium and interest rate is typically 3%. They offer a minimum guaranteed return. Typically this guarantee is based on 90% of premium and interest rate is typically 3%. May be credited at the end of the surrender period. May be credited at the end of the surrender period.

NASAA 2010 Investment Adviser Training EIAs cont – Regulation Not a security – 1933 Act exception Not a security – 1933 Act exception Rule 151 – Safe Harbor Rule 151 – Safe Harbor Annuity is issued by an insurer subject to supervision of State Insurance Commissioners Annuity is issued by an insurer subject to supervision of State Insurance Commissioners Insurer assumes the investment risk under the contract Insurer assumes the investment risk under the contract Contract is not marketed primarily as an investment Contract is not marketed primarily as an investment Not sold by prospectus Not sold by prospectus Less demanding sales practice than variable annuities Less demanding sales practice than variable annuities Some companies are registering them Some companies are registering them

NASAA 2010 Investment Adviser Training EIAs cont - Characteristics Commission rates are typically from 7-13% Commission rates are typically from 7-13% Surrender periods are typically in the 10 year range but may go as high as 18 years. Surrender periods are typically in the 10 year range but may go as high as 18 years. Various indexes may be used, the S&P 500 is the most popular. Various indexes may be used, the S&P 500 is the most popular. Guarantees are secured by purchasing of bonds by the insurance company. Guarantees are secured by purchasing of bonds by the insurance company. Equity returns are typically paid by purchasing options. Equity returns are typically paid by purchasing options.

NASAA 2010 Investment Adviser Training EIAs cont - Variables Crediting Methods Crediting Methods Participation Rates Participation Rates Spread / Margin / Asset Fee Spread / Margin / Asset Fee Caps Caps Flexibility in Allocations Flexibility in Allocations

NASAA 2010 Investment Adviser Training EIAs cont – Crediting Methods Annual Reset (Ratchet) – Looks to the change in the index from the beginning of the year to the end. All losses are ignored. Annual Reset (Ratchet) – Looks to the change in the index from the beginning of the year to the end. All losses are ignored. High Water Mark – Asses the index value at various points in the year and compares to the start of the term. High Water Mark – Asses the index value at various points in the year and compares to the start of the term. Point-to-Point – Compares the index value two distinct points. Point-to-Point – Compares the index value two distinct points. Do not get the benefit of dividends. Do not get the benefit of dividends.

NASAA 2010 Investment Adviser Training EIAs cont – Participation Rates Determines how much of an index gain will be credited to the annuity contract. Determines how much of an index gain will be credited to the annuity contract. Example – 80% Participation Rate Example – 80% Participation Rate 10% gain in the index means a 8% credit to the contract. 10% gain in the index means a 8% credit to the contract.

NASAA 2010 Investment Adviser Training EIAs cont – Spread/Margin/Asset Fee May be used instead of or in addition to a participation rate. May be used instead of or in addition to a participation rate. A percentage that will be subtracted from the gain in the index. A percentage that will be subtracted from the gain in the index. Example – 3.5% Spread Example – 3.5% Spread 10% gain in the index means a 6.5% credit to the contract. 10% gain in the index means a 6.5% credit to the contract.

NASAA 2010 Investment Adviser Training EIAs cont – Caps Return credited to the contract is capped with an upper limit. Return credited to the contract is capped with an upper limit. Usually stated as a %. Usually stated as a %. Example – 8% Cap Example – 8% Cap 10% gain in the index means a 8% credit to the contract. 10% gain in the index means a 8% credit to the contract.

NASAA 2010 Investment Adviser Training EIAs cont – Crediting Some insurance company’s are allowed to change participation rates, cap rates, and spreads/asset/margin fees. (OUCH!!!) Some insurance company’s are allowed to change participation rates, cap rates, and spreads/asset/margin fees. (OUCH!!!) Stated in the contract if allowed. Stated in the contract if allowed.

NASAA 2010 Investment Adviser Training EIAs cont - Allocations Many EIAs offer several index options to choose from in addition to a true “fixed” option. Many EIAs offer several index options to choose from in addition to a true “fixed” option. Investors can determine how much of each premium dollar goes into each index choice. Investors can determine how much of each premium dollar goes into each index choice.

NASAA 2010 Investment Adviser Training EIAs cont – Where does it go? Premium breakdown of $1 with a 90% participation rate Premium breakdown of $1 with a 90% participation rate $0.09 Expenses – agent expenses, insurer expenses and profits $0.09 Expenses – agent expenses, insurer expenses and profits $0.63 Guarantee $0.63 Guarantee $0.28 Available for options $0.28 Available for options *** Information and example from NAFA’s Index Annuity Parts – Section 3

NASAA 2010 Investment Adviser Training EIAs cont – Supervision Not much, since they are not securities Not much, since they are not securities FINRA Notice to Members FINRA Notice to Members Raises concerns about associated persons selling EIAs Raises concerns about associated persons selling EIAs “…. The status of any particular EIA under the safe harbor (or under Section 3(a)(8)) will depend on the facts and circumstances” “…. The status of any particular EIA under the safe harbor (or under Section 3(a)(8)) will depend on the facts and circumstances” FINRA Rule 3030 (Outside Business Act) FINRA Rule 3030 (Outside Business Act) FINRA Rule 3040 (Private Securities Trans) FINRA Rule 3040 (Private Securities Trans)

NASAA 2010 Investment Adviser Training EIAs cont – Marketing “Free Lunch” seminars “Free Lunch” seminars Registered Representatives and Broker-Dealers have to be careful Registered Representatives and Broker-Dealers have to be careful Insurance company vs selling agent Insurance company vs selling agent Difficult to explain product w/o discussing investments Difficult to explain product w/o discussing investments Variations of a theme Variations of a theme “Get market returns with no chance to lose $$$” “Get market returns with no chance to lose $$$” Often sold by insurance agents that do not have a security license. Often sold by insurance agents that do not have a security license.

NASAA 2010 Investment Adviser Training Thank you! Have a nice day Have a nice day