What Is Annuitization?

Annuitization is the process of converting an annuity investment into a series of periodic income payments. Annuities may be annuitized for a specific period or for the life of the annuitant. Annuity payments may only be made to the annuitant or to the annuitant and a surviving spouse in a joint life arrangement. Annuitants can arrange for beneficiaries to receive a portion of the annuity balance upon their death.

Understanding Annuitization

The concept of annuitization dates back centuries, but life insurance companies formalized it into a contract offered to the public in the 1800s.

Individuals can enter into a contract with a life insurance company that involves the exchange of a lump sum of capital for a promise to make periodic payments for a specified period or for the lifetime of the individual who is the annuitant.

How Annuitization Works

Upon receiving the lump sum of capital, the life insurer makes calculations to determine the annuity payout amount. The key factors used in the calculation are the annuitant’s current age, life expectancy, and the projected interest rate the insurer will credit to the annuity balance. The resulting payout rate establishes the amount of income that the insurer will pay whereby the insurer will have returned the entire annuity balance plus interest to the annuitant by the end of the payment period.

The payment period may be a specified period or the life expectancy of the investor. If the insurer determines that the investor’s life expectancy is 25 years, then that becomes the payment period. The significant difference between using a specified period versus a lifetime period is that, if the annuitant lives beyond their life expectancy, the life insurer must continue the payments until the annuitant’s death. This is the insurance aspect of an annuity in which the life insurer assumes the risk of extended longevity.

Annuity Payments Based on a Single Life

Annuity payments based on a single life cease when the annuitant dies, and the insurer retains the remaining annuity balance. When payments are based on joint lives, the payments continue until the death of the second annuitant. When an insurer covers joint lives, the amount of the annuity payment is reduced to cover the longevity risk of the additional life.

Annuitants may designate a beneficiary to receive the annuity balance through a refund option. Annuitants can select refund options for varying periods of time during which, if death occurs, the beneficiary will receive the proceeds. For instance, if an annuitant selects a refund option for a period certain of 10 years, death must occur within that 10-year period for the insurer to pay the refund to the beneficiary. An annuitant may select a lifetime refund option, but the length of the refund period will affect the payout rate. The longer the refund period is, the lower the payout rate.

Changes to Annuities in Retirement Accounts

In 2019, the U.S. Congress passed the SECURE Act, which made changes to retirement plans, including those containing annuities. The good news is that the new ruling makes annuities more portable. For example, if you change jobs, your 401(k) annuity from your old job can be rolled over into the 401(k) plan at your new job.

However, the SECURE Act removed some of the legal risks for retirement plans. The ruling limits the ability for account holders to sue the retirement plan if it doesn’t pay the annuity payments—as in the case of bankruptcy. Note that a safe harbor provision of the SECURE Act prevents retirement plans (and not annuity providers) from being sued.

The SECURE Act also eliminated the stretch provision for those beneficiaries who inherit an IRA. In years past, a beneficiary of an IRA could stretch out the required minimum distributions from the IRA over their lifetime, which helped to stretch out the tax burden.

With the new ruling, non-spousal beneficiaries must distribute all of the funds from the inherited IRA within 10 years of the death of the owner. However, there are exceptions to the new law. By no means is this article a comprehensive review of the SECURE Act. As a result, it’s important for investors to consult a financial professional to review the new changes to retirement accounts, annuities, and their designated beneficiaries.

What Is an Arbitrageur?

An arbitrageur is a type of investor who attempts to profit from market inefficiencies. These inefficiencies can relate to any aspect of the markets, whether it is price, dividends, or regulation. The most common form of arbitrage is price.

Arbitrageurs exploit price inefficiencies by making simultaneous trades that offset each other to capture risk-free profits. An arbitrageur would, for example, seek out price discrepancies between stocks listed on more than one exchange by buying the undervalued shares on one exchange while short selling the same number of overvalued shares on another exchange, thus capturing risk-free profits as the prices on the two exchanges converge.

In some instances, they also seek to profit by arbitraging private information into profits. For example, a takeover arbitrageur may use information about an impending takeover to buy up a company’s stock and profit from the subsequent price appreciation.

Understanding an Arbitrageur

Arbitrageurs are typically very experienced investors since arbitrage opportunities are difficult to find and require relatively fast trading. They also need to be detail-oriented and comfortable with risk. This is because most arbitrage plays involve a significant amount of risk. They are also bets with regards to the future direction of markets.

Arbitrageurs play an important role in the operation of capital markets, as their efforts in exploiting price inefficiencies keep prices more accurate than they otherwise would be.

Examples of Arbitrageur Plays

As a simple example of what an arbitrageur would do, consider the following.

The stock of Company X is trading at $20 on the New York Stock Exchange (NYSE) while, at the same moment, it is trading for the equivalent of $20.05 on the London Stock Exchange (LSE). A trader can buy the stock on the NYSE and immediately sell the same shares on the LSE, earning a total profit of 5 cents per share, less any trading costs. The trader exploits the arbitrage opportunity until the specialists on the NYSE run out of inventory of Company X’s stock, or until the specialists on the NYSE or LSE adjust their prices to wipe out the opportunity.

An example of an information arbitrageur was Ivan F. Boesky. He was considered a master arbitrageur of takeovers during the 1980s. For example, he minted profits by buying stocks of Gulf oil and Getty oil before their purchases by California Standard and Texaco respectively during that period. He is reported to have made between $50 million to $100 million in each transaction.

The rise of cryptocurrencies offered another opportunity for arbitrageurs. As the price of Bitcoin reached new records, several opportunities to exploit price discrepancies between multiple exchanges operating around the world presented themselves. For example, Bitcoin traded at a premium at cryptocurrency exchanges situated in South Korea as compared to the ones located in the United States. The difference in prices, also known as the Kimchi Premium, was mainly because of the high demand for crypto in these regions. Crypto traders profited by arbitraging the price difference between the two locations in real-time.

What Is Anti Money Laundering (AML)?

Anti money laundering (AML) refers to the web of laws, regulations, and procedures aimed at uncovering efforts to disguise illicit funds as legitimate income. Money laundering seeks to conceal crimes ranging from small-time tax evasion and drug trafficking to public corruption and the financing of groups designated as terrorist organizations.

AML legislation was a response to the growth of the financial industry, the lifting of international capital controls and the growing ease of conducting complex chains of financial transactions.

A high-level United Nations panel has estimated annual money laundering flows at $1.6 trillion, accounting for 2.7% of global GDP in 2020.

Understanding Anti Money Laundering (AML)

AML regulations in the U.S. have expanded from the 1970 Bank Secrecy Act’s requirement that banks report cash deposits of more than $10,000 to a complex regulatory framework requiring financial institutions to conduct due diligence on customers and to seek out and report suspicious transactions. The European Union and other jurisdictions have adopted similar measures.

Know Your Customer

For banks, compliance starts with verifying the identity of new clients, a process sometimes called Know Your Customer (KYC). In addition to establishing the customer’s identity, banks are required to understand the nature of a client’s activity and verify deposited funds are from a legitimate source.

The KYC process also requires banks and brokers to screen new customers against lists of crime suspects, individuals and companies under economic sanctions, and “politically exposed persons”—foreign public officials, their family members and close associates.

Money laundering can be divided into three steps:

• Deposit of illicit funds into the financial system
• Transactions designed to conceal the illicit origin of the funds, known as “layering”
• Use of laundered funds to acquire real estate, financial instruments or commercial investments

The KYC process aims to stop such schemes at the first deposit window.

Customer Due Diligence

Customer due diligence is integral to the KYC process, for example by ensuring the information a potential customer provides is accurate and legitimate. But it is also a constant process extending to customers old and new, and their transactions.

Customer due diligence requires ongoing assessment of the risk of money laundering posed by each client and the use of that risk-based approach to conduct closer due diligence for those identified as higher non-compliance risks. That includes identifying customers as they are added to sanctions and other AML lists.

According to the U.S. Treasury’s Financial Crimes Enforcement Network, the four core requirements of customer due diligence in the U.S. are:

• Identifying and verifying the customer’s identity
• Identifying and verifying the identity of beneficial owners with a stake of 25% or more in a company opening an account
• Understanding the nature and purpose of customer relationships to develop customer risk profiles
• Conducting ongoing monitoring to identify and report suspicious transactions and update customer information 

Customer due diligence seeks to detect money laundering strategies including layering and structuring, also known as “smurfing”—the breaking up of large money laundering transactions into smaller ones to evade reporting limits and avoid scrutiny.

One rule in place to foil layering is the AML holding period, which requires deposits to remain in an account for a minimum of five trading days before they can be transferred elsewhere.

Financial institutions are required to develop and implement a written AML compliance policy, which much be approved in writing by a member of senior management and overseen by a designated AML compliance officer. These programs must specify “risk-based procedures for conducting ongoing customer due diligence” and conduct “ongoing monitoring to identify and report suspicious transactions.”

History of Anti Money Laundering

Efforts to police illicit gains have a history stretching back centuries, while the term “money laundering” is only about 100 years old and in wide use for less than 50.

The first major piece of U.S. AML legislation was the 1970 Bank Secrecy Act, passed in part to thwart organized crime. In addition to requiring banks to report cash deposits of more than $10,000, the legislation also required banks to identify individuals conducting transactions and to maintain records of transactions. The U.S. Supreme Court upheld the Bank Secrecy Act’s constitutionality in 1974, the same year “money laundering” entered wide use amid the Watergate scandal.

Additional legislation passed in the 1980s amid increased efforts to fight drug trafficking, in the 1990s to expand financial monitoring and in the 2000s to cut off funding for terrorist organizations.

Anti-money laundering assumed greater global prominence in 1989, when a group of countries and international organizations formed the Financial Action Task Force (FATF). Its mission is to devise international standards to prevent money laundering and promote their adoption. In October 2001, following the 9/11 terrorist attacks, FATF expanded its mandate to include combating terrorist financing.

Another important organization in the fight against money laundering is the International Monetary Fund (IMF). Like the FATF, the IMF has pressed its member countries to comply with international standards to thwart terrorist financing.

The United Nations included AML provisions in its 1998 Vienna Convention addressing drug trafficking, the 2001 Palermo Convention against international organized crime and the 2005 Merida Convention against corruption.

The Anti-Money Laundering Act of 2020, passed in early 2021, was the most sweeping overhaul of U.S. AML regulations since the Patriot Act of 2001. The 2021 legislation included the Corporate Transparency Act, which made it harder to use shell companies to evade anti-money laundering and economic sanctions measures.

The legislation also subjected cryptocurrency exchanges as well as arts and antiquities dealers to the same customer due diligence requirements as financial institutions.

What Is SEC Release IA-1092?

SEC Release IA-1092 is a release from the Securities & Exchange Commission (SEC) that provides uniform interpretations of how state and federal adviser laws apply to those that provide financial services.

SEC Release IA-1092 builds on the Investment Advisers Act of 1940 or the Advisers Act that Congress enacted to protect persons who rely on investment advisers for advice on purchasing and selling securities.

Understanding SEC Release IA-1092

SEC Release IA-1092 is the result of a 1987 collaboration between the Securities & Exchange Commission (SEC) on the federal side and the North American Securities Administrators Association (NASAA) on the state side.

These organizations issued IA-1092 in 1987 as a memo in response to the proliferation of financial planning and investment advice professionals in the 1980s. The act reaffirmed the definition of an investment adviser (IA) as described in SEC Release IA-770 and added some refinements:

• First, pension consultants and advisers to athletes and entertainers were included as providers of investment advice.
• Second, in some cases, firms that recommend investment advisers also had to register themselves.
• Even if an IA did not render investment advice as their principal business activity, simply doing so with some regularity in many cases was enough to require registration.
• If a registered representative of a broker-dealer set up a separate business entity to provide financial planning or investment advice for a fee, they were not allowed to rely on the broker-dealer (BD) exemption from registration. (This became known as a statutory investment adviser.)
• Compensation did not have to be monetary to fall under the definition. Simply the receipt of products, services, or even discounts was also considered compensation.

With regard to sports or entertainment agents, those individuals that negotiated contracts but did not render investment advice were excluded from the definition of an investment adviser.

SEC Release IA-1092 and the Investment Advisers Act of 1940

The Investment Advisers Act of 1940 defines an investment adviser as any person who, either directly or indirectly through writings, engages in the business of advising others on the value or profitability of securities and receives compensation for this.

Guidelines for the Investment Advisers Act of 1940 can be found in Title 15 section 80b-1 of the United States Code, which notes that investment advisers are of national concern, due to:

• Their advice, counsel, publications, writings, analyses, and reports being in line with interstate commerce.
• Their work customarily relating to the purchase and sale of securities that trade on national securities exchanges and in interstate over-the-counter (OTC) markets.
• Their connection with securities issued by companies engaged in interstate commerce.
• The volume of transactions often materially affecting interstate commerce, national securities exchanges, other securities markets, the national banking system, and even the economy as a whole.