Series 7 Packaged Products Practice Questions
Question 1
An investor with an existing $45,000 balance in a mutual fund makes an additional $6,000 purchase. The fund's sales charge schedule is 5% below $50,000 and 4% at $50,000 or more. Using rights of accumulation, what sales charge rate applies to the new $6,000 purchase, and why?
- A. 4%, because the combined account value of $51,000 exceeds the $50,000 breakpoint
- B. 5%, because the new $6,000 purchase alone does not reach the breakpoint
- C. 4.5%, an average of the two applicable rates
- D. 5%, because rights of accumulation cannot be combined with an existing account balance
Show answer and explanation
Correct answer: A. 4%, because the combined account value of $51,000 exceeds the $50,000 breakpoint
Rights of accumulation permit an investor to add the current NAV value of existing holdings in the same fund (or fund family, if applicable) to a new purchase to determine which breakpoint applies. Here, $45,000 (existing) + $6,000 (new) = $51,000, which exceeds the $50,000 breakpoint, so the reduced 4% sales charge applies to the new $6,000 purchase. Evaluating only the new purchase in isolation (choice B) ignores the whole purpose of rights of accumulation. There is no averaging of rates (choice C), and rights of accumulation by definition do combine with existing holdings (choice D is the opposite of the rule).
- A. Rights of accumulation let the investor add the existing $45,000 to the new $6,000, and since $51,000 crosses the $50,000 breakpoint, the lower 4% rate applies to the new purchase.
- B. This ignores rights of accumulation, which specifically exist to let prior holdings count toward reaching a breakpoint rather than judging the new purchase in isolation.
- C. Sales charges don't blend or average across breakpoints — once the combined balance qualifies for a lower tier, that lower rate applies to the new purchase in full.
- D. This misstates the rule; rights of accumulation exist precisely to combine the existing balance with new purchases for breakpoint purposes.
Question 2
To qualify as a regulated investment company under Subchapter M of the Internal Revenue Code, a mutual fund must satisfy each of the following requirements EXCEPT:
- A. The fund must distribute at least 90% of its net investment income to shareholders
- B. The fund must derive at least 90% of its gross income from dividends, interest, and gains from securities transactions
- C. The fund must guarantee shareholders a minimum annual rate of return
- D. The fund must satisfy asset diversification requirements regarding the composition of its portfolio
Show answer and explanation
Correct answer: C. The fund must guarantee shareholders a minimum annual rate of return
To qualify as a regulated investment company under Subchapter M and receive conduit tax treatment, a fund must distribute at least 90% of net investment income to shareholders (choice A), derive at least 90% of gross income from securities-related sources (choice B), and meet asset diversification tests (choice D). No provision of Subchapter M — or of the Investment Company Act generally — allows or requires a fund to guarantee a minimum rate of return to shareholders; investment company shares (other than certain guaranteed insurance products) are not principal- or return-guaranteed, making choice C the requirement that does not exist.
- A. Distributing at least 90% of net investment income is an actual Subchapter M requirement, so this is not the exception being asked for.
- B. Deriving at least 90% of gross income from qualifying sources (dividends, interest, gains) is an actual Subchapter M requirement, so this is not the exception.
- C. There is no requirement — and no ability — for a mutual fund to guarantee shareholders a minimum rate of return; this is the correct exception since it's not a Subchapter M requirement at all.
- D. Meeting asset diversification requirements is an actual Subchapter M requirement, so this is not the exception being asked for.
Question 3
A client owns a nonqualified variable annuity that has underperformed and wants to move its value into a different insurance company's variable annuity without triggering current income tax. The appropriate method is:
- A. Surrender the contract and use the proceeds to purchase a new annuity within 60 days
- B. A Section 1035 exchange conducted directly between the two insurance companies
- C. A trustee-to-trustee transfer under ERISA
- D. Request a return-of-premium rider payout and reinvest the proceeds
Show answer and explanation
Correct answer: B. A Section 1035 exchange conducted directly between the two insurance companies
IRC Section 1035 permits tax-free exchanges of one annuity contract for another, but only when conducted as a direct exchange between insurance carriers. Surrendering the contract and personally receiving the proceeds, as in choice A, would trigger recognition of any taxable gain — annuities do not get the benefit of an IRA-style 60-day rollover.
- A. Incorrect — surrendering and personally receiving funds triggers a taxable event; annuities lack a 60-day rollover exception.
- B. Correct.
- C. Incorrect — ERISA governs qualified employer retirement plans, not nonqualified annuities.
- D. Incorrect — not a recognized tax-free method and would likely be taxable.
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A client purchases a variable annuity and receives the contract on March 1. The state-mandated free-look period is 10 days. On March 8, the client requests to cancel. What is the client entitled to receive?
- A. The premium paid minus the applicable surrender charge
- B. The full premium paid, since the request falls within the free-look period and no surrender charge applies
- C. Nothing, because annuities cannot be cancelled within the first year
- D. The premium paid minus a flat administrative processing fee
Show answer and explanation
Correct answer: B. The full premium paid, since the request falls within the free-look period and no surrender charge applies
The free-look period exists specifically to let a client review the contract without penalty. A cancellation made within that window returns the client's investment (premium paid, or in some states the contract value if higher) without any surrender charge being deducted. Surrender charges only apply to withdrawals or cancellations that occur after the free-look period has expired.
- A. Surrender charges do not apply to a cancellation made within the free-look period — the client is not subject to any early-withdrawal charge.
- B. Correct. Within the free-look period, the client is entitled to a full refund of premium with no surrender charge applied.
- C. Annuities are cancellable during the free-look period by design — this describes the opposite of the actual protection the free-look period provides.
- D. No administrative fee should be deducted from a free-look cancellation; the client receives the full premium back.