Chapter 8 Practice Question Answers
1. Answer: C. With fixed annuities, contributions are deposited into the insurance company’s general account and managed by the insurance company. The insurance guarantees the payment, and, therefore, is responsible for the risk. In contrast, variable annuities utilize separate accounts. The annuitant chooses from several subaccounts that operate like mutual funds. The amount in the account will vary based on the performance of the subaccount. Because insurance companies guarantee a rate of return on fixed annuities, they are not securities. An equity-indexed annuity is an example of a fixed security because there is usually a minimum guaranteed rate of return.
2. Answer: A. When an individual decides to take her money out before the surrender period is over, they must pay a surrender charge, depending on the annuity contract.
3. Answer: B. The performance of an equity-indexed annuity tracks the performance of the stock market index, such as the S&P 500. There is a chance the investor could lose money because the insurance company could go out of business, and often the insurance company will only guarantee a certain percentage of contributions with guaranteed minimum amount of growth.
4. Answer: C. With the last in, first out (LIFO) method, the IRS would tax the deferred tax dollars as early as possible. The first $25,000 of earnings would be taxed at her ordinary income rate. The remaining dollars have already been taxed.
5. Answer: B. Because there is a higher risk and more diversity in separate accounts, there is a higher likelihood of an increase in earnings with a variable annuity. Because variable annuities usually invest in the equity markets, the returns tend to be higher than fixed annuities and, therefore, are more likely to beat inflation. LIFO tax treatment is actually worse for the investor because withdrawals are assumed to be earnings first and, therefore, taxable. Thus, LIFO tax treatment