Conduct and Practices Handbook Course (CPH) Quiz 38

Hedge funds are private investment funds that are legally restricted to very wealthy individuals, individuals who have an income surpassing the requisite threshold and at least a $1 million net worth. Hedge funds are, in essence, mutual funds for the super wealthy.

Private equity consists of any equity which isn’t quoted on any public exchanges. Private investments might involve funding a private company to develop new technologies, or simply to be more successful in general. Private equity also might involve purchasing a public company for the sake of making it private.

Structured products are securities which are linked to some other underlying asset, such as another security, a group of securities, a commodity, and index, or something else. Structured products can sometimes have a “principal guarantee” feature, which means simply that the principal is guaranteed to return if the investor holds the investment for long enough

Fixed annuities are not considered securities, because all the risk is on the insurance company, not the buyer.

Variable annuities are considered securities, because the purchaser is taking the risk. With variable annuities, investors’ monies are deposited into an account separate from the insurance company’s general account, and the company invests these funds. Variable annuities guarantee payments for life, but don’t guarantee the amount of the payments or the rate of return on the investment.

The surrender charge is meant to cover the cost for keeping the account on the books, and therefore is usually waived for individuals who notify the insurance company of the cancellation sufficiently in advance.

The time during which the purchaser of an annuity is paying into the annuity, up until the time the purchaser begins receiving income payments, is called the accumulation phase.

With life income, the insurance company pays the annuitant until he dies; after the annuitant dies, no payments are given to beneficiaries.

The last option is joint life with last survivor. With this arrangement, two parties, usually husband and wife, are entitled to one payment, and when the first party dies, the other party receives the payments until his or her death.

Money from large numbers of investors is pooled and invested for their mutual benefit in the insurance company’s separate account, just as in a mutual fund. Many of these separate accounts are registered as open-end management investment companies.

Separate accounts refer to specific investment accounts owned by an insurance company. These accounts are isolated from the insurance company’s general investments, which mean that they are not guaranteed by the insurance company (the investments provide a variable rate of return), although it also means that the investments are safe if the insurance company becomes insolvent.

When the annuitant is contributing funds into an annuity, he actually purchases particular units. These units are accumulation units, and they vary in price; a series of fixed contributions by the annuitant might purchase more units or fewer, depending on the units.

Immediate payment annuities are suitable for retired persons who fear they may outlast their retirement savings, but since these annuity payments are cancelled upon the death of the annuitant, they carry the risk, in cases of early death, of significantly decreasing an inheritance.

A waiver of premium is a provision in an insurance contract which waives the policyholder of any obligation to pay further premiums but still be entitled to the insurance benefits. This waiver kicks in due to some serious disability for the policyholder and usually only after the policyholder has been disabled for some period of time (e.g. six months)

Annuitization is the process by which an annuity investment is converted into payments. The fixed annuitization method takes the total account balance for the annuitant and divides it by a particular annuity factor (which factor is derived from an IRS table) to arrive at an equal payment that cannot later be changed.

The assumed interest rate (AIR) is the rate of growth, assumed by the insurance company that is necessary for the underlying investments of an annuity to cover the insurance company’s costs and provide the company with its target profit margin. The AIR enters into the calculation to determine an annuitant’s periodic income payments.

If an annuity gives periodic payments to the annuitant during the annuity’s distribution period, then each payment will be considered as partly a return of the original investment (and thus nontaxable) and partly a gain on the investment (and thus taxable). For fixed annuities (annuities paying a series of fixed payments), the particular composition of principal and gain (i.e. original investment and gain) is determined by an exclusion ratio, which is calculated as follows:
Exclusion Ratio = Original Investment / Expected Total Payout

If an annuitant dies in the accumulation period, then the money will go to the specified beneficiaries, who will have to pay taxes on any gain earned in the annuity up to that point; they will have to pay ordinary income tax rates.

A “life-only annuity” means that payments are made to the annuitant while he is alive, so that the company is not obligated to make any other payments if he dies.

Direct participation programs (DPPs), also called direct participation plans, are flow-through investments. The profits, losses, and income flow through the DPP and to the investors directly. The DPP itself pays no taxes; only the individual investors do. DPPs are organized as limited partnerships, and the two terms are generally used interchangeably.

A limited partnership must have at least one general partner and at least one limited partner, although they usually have more.

The general partner does the actual managing of the business and makes decisions that are legally binding for everyone in the partnership. He may be paid for services as a general partner, and may buy and sell property on behalf of the partnership. The general partner may not borrow money from the partnership (although the partnership may borrow from the general partner).

The limited partner cannot make management decisions, but does have the right to sue the general partner if he believes that the general partner is not acting in the best interests of the partnership. Limited partners are allowed to vote on certain partnership matters, and they can inspect the financial records and accounting books of the partnership if they so desire. But their main role is to put up the money, while the general partner actually runs the business.

Terms for the dissolution of a limited partnership can vary according to the specific agreement of the partnership, but other restrictions apply independently of those terms. While in general partnerships (i.e. non-limited partnerships), any partner can give a notice to the other partners of
his intent to dissolve the partnership, it is not the same with limited partnerships. Only general partners can issue such notice; limited partners are not able to do so. Moreover, unlike general partnerships, limited partnerships are not ended simply by a limited partner’s death, retirement, or
bankruptcy. The fundamental detail to know is that limited partners have lesser abilities to dissolve the partnership than partners do in general partnerships.

Public housing partnerships invest in the construction of low-income and retirement housing. Since these housing programs are government-assisted (e.g. missing rent payments are covered by the U.S. Department of Housing and Urban Development), they are considered the safest form of real-estate partnership.

Raw land partnerships invest in mere land, not purchasing buildings or intending to build on the land. Their aim is to make money on capital gains as the value of the land increases. These are the riskiest form of real-estate DPP.

Equipment leasing partnerships seek to make a profit by purchasing and leasing various assets, such as computers, trucks, or machinery.

Oil and gas partnerships aim to make a profit through various investments involving the extraction of oil and gas

(i)Exploratory oil and gas DPPs search new areas to find new oil and drill for it. This is the riskiest oil and gas DPP, and its activity is also called “wildcatting.”(ii) Developmental oil and gas DPPs search for new reserves in areas near wells that are already extracting oil or gas. (iii) Income oil and gas DPPs purchase wells that already exist. IV) Combination oil and gas DPPs involve any assortment of the previous three.

Tangible drilling costs (TDCs) are any costs for items used in extracting oil or gas that have a salvage value upon disposal (e.g. storage tanks, drills)—basically, the equipment used in drilling. These costs can be deducted as the equipment is depreciated, with the deduction equaling the depreciation expense for that year.