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FAQs LINKS
QUESTIONS AND ANSWERS ABOUT INVESTMENT PRODUCTS
Q: What are the risks of a variable annuity?
Q: How can a company offer an above-market rate for a certificate of deposit?
Q: What should I be aware of regarding hedge funds and funds of hedge funds?
Q: What are the rules for starting an investment club? Can I receive a small fee for investing for other members?
Q: Should I invest in a offshore “high-yield” bank debenture program that promises high returns in a short period of time?
Q: What are the risks of investing in viatical or life settlement contracts?
Q: What are the risks of investing in charitable gift annuities?
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QUESTIONS AND ANSWERS ABOUT SPECIFIC INVESTMENT PRODUCTS
Q: What are the risks of a variable annuity?
A: A variable annuity is a contract between you and an insurance company, under which the insurer agrees to make periodic payments to you, beginning either immediately or at some future date. You purchase a variable annuity contract by making a single payment or a series of payments.
A variable annuity typically offers a range of investment options. The value of your investment will vary depending on the performance of the investment options you choose. Investment options for a variable annuity typically are mutual funds that invest in stocks, bonds, money market instruments, or some combination of the three.
Although variable annuities typically invest in mutual funds, they differ from mutual funds in several important ways:
First, variable annuities let you receive periodic payments for the rest of your life (or the life of your spouse or some other person you designate). This feature offers protection against the possibility that you will outlive your assets.
Second, variable annuities have a death benefit. If you die before the insurer has started making payments to you, your beneficiary is guaranteed to receive a specific amount—typically at least the amount you paid to purchase the annuity. Your beneficiary will get a benefit from this feature if, at the time of your death, your account value is less than the death benefit amount.
Third, variable annuities are tax-deferred. That means you don’t pay taxes on the income and investment gains from the annuity until you withdraw the money. You can also transfer money from one investment option to another without paying taxes at the time of the transfer. When you withdraw your money, however, your annuity income will be taxed at ordinary income rates, rather than (usually lower) capital gains rates. In general, the benefits of tax deferral will outweigh the costs of a variable annuity only if you hold it as a long-term investment to meet retirement and other long-range goals.
NOTE: Other investment vehicles, such as IRA, 401(k), and Keogh accounts, may provide similar tax-deferred income benefits, without some of the drawbacks of annuities.
Be Aware of the Risks…
Surrender charges: If you withdraw money from a variable annuity during a certain period after a purchase payment (typically 6-8 years, but in some cases 10 years or longer), the insurance company usually will assess a “surrender” charge (typically some percentage of your account value or of the amount withdrawn).
Other charges may apply. The insurer may deduct charges for mortality and expense risk (typically up to 2% a year), for administrative fees, for underlying fund fees, and for other fees and expenses. You need to be aware of the amount of these fees, as they may adversely affect the value of your annuity investment account.
“Bonus credits.” Some companies will try to sell annuities with “bonus credits” they claim will more rapidly increase the value of your account. The problem is, these annuities typically also include larger surrender charges and other charges, as well as limitations on certain features, such as the death benefit, based on the time you may hold the annuity before your death.
Exchanges. The Internal Revenue Code permits certain tax-free exchanges with respect to variable annuities. However, the annuity you receive in exchange frequently has limitations that may affect its value, particularly if you are not able to hold the annuity for a long time.
Questions to Consider Before Investing in a Variable Annuity:
• Will you use the variable annuity primarily to save for retirement or a long-term goal?
• Are you investing in the variable annuity through a retirement plan or IRA (which would mean you are not receiving any additional tax-deferral benefit from the variable annuity over some other investment)?
• Are you willing to take the risk that your account value may decrease if the underlying mutual fund investment options perform badly?
• Do you understand all the features of the variable annuity?
• Do you understand all the fees and expenses the variable annuity charges?
• Do you intend to remain in the variable annuity long enough to avoid paying any surrender charges if you have to withdraw money?
• If a variable annuity offers a bonus credit, will that bonus outweigh any higher fees and charges the product may charge?
• Does the variable annuity have features, such as long-term care insurance, that you could purchase separately for less money?
• Have you consulted with a tax advisor and considered all the tax consequences of purchasing the variable annuity, including the effect of annuity payments on your tax status in retirement?
• If you are exchanging one annuity for another, do the benefits of the exchange outweigh the costs, such as any surrender charges you will have to pay if you withdraw your money during the surrender charge period of the new annuity?
Generally, the exchange or replacement of insurance or annuity contracts is not a good idea, for a variety of reasons:
• “Bonus” or “premium” payments the insurance company makes to you are usually offset by other charges you pay the insurance company out of the investment funds.
• Other contract provisions, like surrender charges, eventually expire with an existing contract. However, new charges may be imposed with a new contract or may increase the period of time for which the surrender charge applies.
• You may also have to pay higher charges, such as annual fees for the new contract.
• You may not need the costly new features of the new contract.
• In many instances your broker is getting paid a higher commission for a variable annuity than he or she would for the sale of another securities product, such as a stock, bond, or mutual fund.
You should specifically ask the person recommending that you exchange your variable annuity the following:
• What is the total cost to me of this exchange?
• What does the change in the surrender period or other terms mean for me?
• What are the new features being offered? Why do I need or want those features?
• Are those features worth the increased cost?
• Will you be paid a commission for the exchange, and if so, how much is it?
• Is there a “free-look” period when I can cancel the transaction and receive a refund?
Avoid signing any exchange form or agree to exchange or purchase an annuity until you study all of the options carefully, have all of your questions answered, and are satisfied that the exchange is better than keeping your current contract.
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How can a company offer an above-market rate for a certificate of deposit?
A: Some companies will offer you above-market certificate of deposit rates, but the rate is usually only for the short-term (less than one year). While discussing the terms of the transaction, the salesperson may try to “switch” you into another investment opportunity that pays higher commissions such as variable annuities. Even if you resist the sales pressure and buy only the certificate of deposit, the company now has contact information to formulate a call-back list.
With this list, the company often contacts customers in hopes of convincing them to reconsider purchasing an annuity or other high-commissioned product, explaining how much money the investor could have made. And if you’re on the Federal Trade Commission’s “Do Not Call” list and complain about recurring phone calls, your complaint may not be valid since you have already established a business relationship with the company. Although this is a legal type of “bait and switch,” you need to make certain the investment product you’re buying is suitable for your financial situation.
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Q: What should I be aware of regarding hedge funds or funds of hedge funds?
A: Neither federal or state securities laws contain exact legal definition of the term “hedge fund.” Hedge funds are basically private investment pools for wealthy, financially sophisticated investors. Traditionally, they have been organized as partnerships or limited liability companies, with the general partner (or managing member) managing the fund’s portfolio, making investment decisions, and normally having a significant personal investment in the fund.
To get positive investment performance, hedge fund managers use sophisticated investment strategies and techniques that may include, among other techniques:
• short selling (sale of a security you do not own)
• arbitrage (simultaneous buying and selling of a security in different markets to profit from the difference between the prices)
• hedging (buying a security to offset a potential loss on an investment)
• leverage (borrowing money for investment purposes)
• concentrating positions in securities of a single issuer or market
• investing in distressed or bankrupt companies
• investing in derivatives, such as options and futures contracts
• investing in volatile international markets
• investing in privately issued securities
Managers are paid based on the fund’s performance. Performance fees of 20 percent of profits are common, along with a fixed annual asset-based fee of 1 to 2 percent. Because they are usually only open to limited numbers of wealthy, financially sophisticated investors and do not advertise or publicly offer their securities, private hedge funds are usually not required to register with the SEC. As a result, unregistered private hedge funds do not provide many of the investor protections that apply to registered investment products, such as mutual funds. For example, hedge funds generally are not subject to numerous mutual fund rules, such as regulations:
• requiring a certain degree of liquidity,
• limiting how much can be invested in any one investment,
• requiring that fund shares be redeemable,
• protecting against conflicts of interests,
• assuring fairness in pricing of the fund shares,
• requiring disclosure of information about a fund’s management, holdings, fees and expenses, and performance, and
• limiting the use of leverage.
However, the general prohibitions against securities fraud still apply.
Funds of hedge funds are pooled investments in several unregistered hedge funds. Unlike the underlying private hedge funds, the fund of funds itself can register with the SEC under the Investment Company Act of 1940. In addition, the fund of fund’s securities also can be registered for sale to the public under the Securities Act of 1933. Registered funds of funds can have lower minimum investments than private hedge funds (some as low as $25,000).
A registered fund of hedge funds can be offered to an unlimited number of investors. However, unlike an open-ended mutual fund, investors have no right of redemption—shares cannot be redeemed directly with the fund unless the fund offers to redeem them. Nor are the shares usually listed on a securities exchange like Exchange-Traded Funds (ETFs). With very limited exceptions, a secondary market is not available, so you won’t be able to sell your investment readily.
Investing in a fund of hedge funds is risky because it involves:
Unregistered Investments. Funds of hedge funds generally invest in several private hedge funds that are not subject to the SEC’s registration and disclosure requirements. Many of the normal investor protections that are common to most traditional registered investments are missing. This makes it difficult for both you and the fund of funds manager to assess the performance of the underlying hedge funds or independently verify information that is reported. All of this can make it easier for an unscrupulous hedge fund manager to engage in fraud.
Risky Investment Strategies. As noted above, hedge funds very often use speculative investment and trading strategies. Many hedge funds are honestly managed, and balance a high risk of capital loss with a high potential for capital growth. The risks hedge funds incur, however, can wipe out your entire investment. If you can’t afford to lose your entire investment, then perhaps hedge funds and funds of hedge funds are not for you.
Lack of Liquidity. Hedge funds, both the unregistered and registered variety, are illiquid investments and are subject to restrictions on transferability and resale. Unlike mutual funds, no specific rules govern hedge fund pricing. Registered hedge fund units may not be redeemable at the investor’s option and probably no secondary market for the sale of the hedge fund units. In other words, you may not be able to get back the money you invested in the hedge fund when you want out of the investment.
Adverse Tax Consequences. The tax structure of registered fund of hedge funds may be complex. Receipt of important tax information may be delayed. This may require you to obtain an extension to file your income tax return.
High Fees and Expenses. Expenses in funds of hedge funds are significantly higher than most mutual funds. For example, one such fund of funds has an annual asset base fee of 2.15 percent. In comparison, mutual funds have expense ratios averaging 1.36 percent. The manager of this fund of funds also gets 10 percent of any annual gain that exceeds an 8 percent return. Because it invests in a number of private hedge funds, a fund of funds also bears part of the fees and expenses of those underlying hedge funds as well. You should be sure you understand the fee structure of any fund of hedge funds in which consider investing.
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Q: What are the rules for starting an investment club? Can I receive a small fee for investing for other members?
A: An investment club is a group of people who pool their money to make investments. Usually, investment clubs are organized as partnerships and, after the members study different investments, the group decides to buy or sell based on a majority vote of the members. Club meetings may be educational and each member may actively participate in investment decisions. The members of investment clubs generally share equally (or in proportion to the money they put in) in any profits and losses of the club, and in any expenses it may incur.
Investment clubs usually do not have to register, or register the offer and sale of their own membership interests, with the SEC. But since each investment club is unique, each club should decide if it needs to register and comply with securities laws. An investment club must register with the SEC as an investment company under the Investment Company Act of 1940 if all of these three conditions apply:
1. The club invests in securities,
2. The club issues membership interests that are securities, and
3. The club is not able to rely on an exclusion from the definition of an investment company.
For example, a “private investment company” may not need to register with the SEC. To qualify, an investment club must NOT:
• make, nor propose to make, a public offering of its securities, and
• have more than 100 members.
If one member of an investment club is compensated for providing advice regarding the club’s investments, that person may need to register as an investment adviser, according to the Investment Advisers Act of 1940. Also, if one person selects investments for the club, that person may have to register as an investment adviser.
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Q: Should I invest in an offshore “high-yield” bank debenture program that promises high returns in a short period of time?
A: These programs often claim investors’ funds will be used to purchase and trade “prime bank” financial instruments on clandestine overseas markets to generate huge returns in which the investor will share. However, neither these instruments, nor the markets on which they allegedly trade, exist.
To give the scheme an air of legitimacy, the promoters distribute documents that appear complex, sophisticated, and official. The sellers often tell potential investors how they have special access to programs that otherwise would be reserved for top financiers on Wall Street, London, Geneva, or some other world financial center. Promoters tell investors that returns of 100 percent or more are possible with little to no risk.
The promoters of these schemes target individuals and entities, including municipalities, charitable associations, and other nonprofit organizations. These promoters have also demonstrated remarkable audacity, advertising in national newspapers, such as USA Today and the Wall Street Journal. People tend to believe that ads appearing in print are credible and true. But in reality, newspaper editors are not responsible for verifying the validity and accuracy of the advertiser’s claims.
Some promoters avoid using the term “prime bank note,” and tell prospective investors that their programs do not involve prime bank instruments in an effort to demonstrate that their programs are not fraudulent. Regardless of the terminology, the basic pitch—that the program involves trading in international financial instruments—remains the same, and investors should continue to be vigilant against such fraud.
Signs of banking-related investment fraud include:
• Excessive guaranteed returns. These fraudulent investment pitches typically offer or guarantee spectacular returns of 20 to 200 percent monthly, absolutely risk free. Promises of unrealistic returns at no risk are hallmarks of prime bank fraud.
• Fictitious financial instrument(s). Despite having credible-sounding names, the supposed “financial instruments” at the heart of any prime bank scheme simply do not exist. Exercise caution if you’ve been asked to invest in a debt obligation of the top 100 world banks, Medium Term Bank Notes or Debentures, Standby Letters of Credit, Bank Guarantees, an offshore trading program, a roll program, bank-issued debentures, a high-yield investment program, or some variation on these descriptions. Promoters often claim the offered financial instrument is issued, traded, guaranteed, or endorsed by the World Bank, International Monetary Fund, Department of Treasury, International Chamber of Commerce, of an international central bank.
• Extreme secrecy. Promoters claim that transactions must be kept strictly confidential by all parties, making client references unavailable. They may characterize the transactions as the “best-kept secret” in the banking industry, and assert that, if asked, bank and regulatory officials would deny knowledge of such instruments. Investors may be asked to sign nondisclosure agreements.
• “Exclusive opportunity.” Promoters often claim that investment opportunities of this type are by invitation only, available to only a handful of special customers, and historically reserved for the wealthy elite.
• Claims of inordinate complexity. Investment pitches frequently are vague about who is involved in the transaction or where the money is going. Promoters may try to explain away this lack of specificity by stating that the financial instruments are too technical or complex for nonexperts to understand.
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Q: What are the risks of investing in viatical and life settlement contracts?
A: Viatical or life settlement contracts allow life insurance policyholders to “cash out” of their policies while they are still alive. Investors pay for the right to receive the future death benefits by purchasing an interest in the policies, usually through a viatical company. Viatical settlements concern terminally ill individuals, while life settlements concern people who simply wish to sell their life insurance policies for the immediate cash benefit.
But investing in viaticals is not like buying certificates of deposit. Viaticals have risks you need to consider before you buy:
Viatical investments are not liquid investments. You receive a return only when the insured dies. In some cases, you may cancel your investment within seven calendar days of the purchase.
The rate of return is not guaranteed. The return depends on when the insured dies, which is very unpredictable. Medical advances can further complicate that unpredictability.
The death benefit may not be paid. The insurer may not pay the death benefit if premiums have not been paid or the policy was obtained fraudulently. To prevent a policy from lapsing, you may have to pay premiums.
Funds invested in viaticals may not be eligible for an IRA, 401(k), or Keogh plan. Your investment also may have tax consequences. Consult with your financial professional before investing.
The life expectancy estimate may be inaccurate. Know who is estimating the life expectancy of the insured, and whether that person has the knowledge and experience to make a realistic estimate.
A viatical company should disclose:
• Your right to cancel the investment and receive a refund,
• Contact information for the insurance company that issued the policy,
• The policy number, issue date, and type,
• The policy premiums and terms of policy payments,
• The total value of the policy and your percentage of ownership,
• Whether or not the policy is contestable; if so, the risk that the insurance company may cancel the policy or refuse to pay claims made during the contestable period,
• The contact information for the party responsible converting a group policy to an individual one, including the terms and costs for the conversion,
• The contact information for the party responsible for renewing a term policy, if necessary,
• The amount of your investment that will be set aside to pay premiums,
• The contact information for the party who will be the policy owner and the person who will be responsible for paying premiums,
• The date when you may have to pay premiums, if necessary.
• The separate amounts of your investment that will be used pay the seller’s commission, buy the policy and pay administrative expenses and other transaction costs.
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Q: What are the risks of investing in charitable gift annuities?
A: A charitable gift annuity (CGA) is, in simple terms, a swap. You give money or property to a nonprofit organization—a college, museum, health organization, for example—which in turn promises to pay you a certain amount of money over your lifetime, and upon your death, up to one other person’s lifetime. Income payments can begin immediately or be deferred to a later date.
The agreement is similar to a charitable remainder annuity trust, except that no trust exists. Instead, the nonprofit holds the donation as general assets and the annuity liability becomes a general obligation of the nonprofit.
Laws regulating charitable gift annuities differ from state to state. As of August 2004, Arizona requires that a charity, before it can issue a CGA:
· Have at least $300,000 in unrestricted assets,
· Be in continuous operation for at least three years,
· Have conducted an annual audit by a CPA for the last two years, and
· Provide in writing to anyone considering a CGA, certain information about the charity,
including the fact that copies of its most recent annual audit and interim financial
statements are available for review.
Arizona also bans the payment of commissions to anyone selling charitable gift annuities. If the charity or promoter violates the law regarding CGAs, the purchaser can cancel the annuity contract and bring a court action to recover the annuity amount, with interest, plus taxable court costs and reasonable attorney fees, less any annuity income. For individuals, CGAs offer some advantages:
• The return can be very appealing, particularly in a low interest rate market,
• You get an immediate tax deduction when first setting up the annuity, and
• Your gift is helping the charity fulfill its philanthropic goals.
The disadvantages:
• Your gift is irrevocable (the annuity contract cannot be cashed in and the beneficiary designation cannot be changed),
• After you die, whatever remains of the original gift goes to the nonprofit, not to the
heir(s) of your estate,
• Unlike commercial annuities (variable and fixed) that typically pay slightly higher rates—even though there's no tax deduction—CGAs are NOT guaranteed by a state insurance guaranty fund, and
• Payments of the annuity benefit are only backed by the charity’s assets. If assets are mismanaged, you may not receive income payments.
Additionally, since CGA income payments can be expected to continue for years, you should make certain that the charity’s financial condition is strong enough for it to be around as long you need it to be.
For nonprofits, the programs are another source of donations. Investors also need to be careful about who is promoting the annuity. In one case, the Securities and Exchange Commission charged Mid-America Foundation Inc., of Scottsdale, Arizona, with defrauding hundreds of investors of an estimated $54 million. The company, according to the SEC, “through a nationwide network of commissioned sales agents ... sold charitable gift annuities to elderly investors who sought safe, steady income [and] tax benefits.” (For more info, see the Division’s 2003 press release).
As an investor in a CGA, you need to be sure who is standing behind the payments before putting in your money. You or your financial adviser or accountant, should examine and verify the charity’s audit and financial statements carefully before entering into a CGA contract—even if it’s with a well-known charity.
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