Segregated Funds Information Resource

Ownership Structure

Segregated Funds are a deferred annuity contract between an insurance company and a policy owner. The policy owner makes deposits through the contract and the insurance company invests the money in Segregated Funds. Segregated Funds are an asset of the insurance company and are similar, in essence, to money held in trust for the investor. The segregated nature protects the investor against the insolvency of the insurance company.

Mutual Funds, are owned by the investor and are managed by the investment management company. The securities in the funds (owned by the investor's pooled resources) are maintained in safekeeping by the custodian of the fund.

Maturity Guarantees

While each company is a little different, they are essentially either 100% or 75% of the deposits less any withdrawals. However, there are some very significant differences on how they are applied. Many are deposit based which means that if a deposit every year they end up with a series ten, 10 year guarantees. The other is Contract Based and few companies offer this now as it can result in higher guarantee payouts. Contract based means that all the deposits mature at the end of the10 year period.

Example: Maturity Guarantees Assumptions:

Deposit frequency is annual on January 1st over ten years

Amount is $5000

Guarantee is 100%

Deposit Date Based.

After 10 years the guarantee is $5000 as that is all that has been on deposit for the ten years. After 11 years, the guarantee will be another $5,000.

Contract Date Based

After 10 years the guarantee is $5,000 times 10 deposits or $50,000. Clearly, if this is an important factor, then select a company that offers a contract based guarantee and there are only two that offer this now. Let us help you select the right one.

Death Guarantees

Death Guarantees are one of the primary reasons for the growth in Seg Fund sales. This feature guarantees that should the annuitant pass away and the market is down from when they purchased the funds or more importantly did a reset, the difference is guaranteed to be made up.

Two situations where this is useful: if you are looking after a Senior's estate and are frustrated by the low returns of a GIC, you can invest in a conservative Seg Fund and there is no risk that you will loose any money should the senior pass away when the market is down. Better yet, if the market goes up, you can reset the guarantee and lock in the profits (see the reset discussion to follow)

Another use is for leveraging which we will also discuss later. But if the borrower dies and the market is down, again the estate does not make up the difference, the insurance company does and the small extra fee is excellent insurance value. I like to sell Segregated Funds for leveraging as it is a long term hold and one never knows when the market will take a downturn. The last thing I want to do is see a widow and ask her for money to make up the difference between the loan and portfolio value.

Guarantee Resets

Clients have the ability to restart the 10 year maturity guarantee at a chosen higher market value of the investment which has the same effect of selling a contract and immediately re-purchasing the same, but it does not trigger a disposition (capital gains) nor potential surrender fees. It resets the death benefit guarantee as well.

Reset terms also vary from company to company. Some do not reset unless the advisor directs it, another does one atomically every year on the deposit anniversary date. This is good if the advisor does not do resets as they are at least done every year, but the timing may not be the best and there is no manual reset allowed. A very few allow for up to two resets a year at any time.

Our systems make it very easy to do a reset. We ask you to sign a permission sheet and then we will email you when we feel it is a good time to do a reset and all you need to do is reply to the email within three days with your authorization to do so.

Example: Resets And Death Benefit Guarantee

The death benefit ultimately paid will be the greater of the market value or the most recent Death Benefit Guarantee Amount. The example below is on a segregated fund with a 100% guarantee upon death. In the following example, two resets are done as the market reaches new highs. While we do not know the exact peak of the market, with two resets a year, one can use them to set it on the way up. After it is reset at $33,000 June 1, 2007, the market value of the fund(s) drops to $29,000 by October 15, 2009 when the annuitant (person) dies.

There is a significant difference between Mutual Funds and Segregated Funds. The Seg Fund guarantee was reset at $33,000 and the insurance company makes up the difference between the $29,000 market value and the $33,000 guarantee or $4,000. With a mutual fund, the estate would receive the market value of $29,000. These funds are paid out to the beneficiaries within a few weeks of the company getting the death certificate with no wills variation problems or probate fees. Mutual Funds are paid into the estate if not transferred directly to the spouse.

Having identified the advantages of resets, ask your agent how many times he does this. On average only about 15% of advisors actually do resets and of these only 5% do it more than once a year based on the stats from one of the leading funds.

At IDC we have the systems in place to utilize this important feature efficiently using email for your permission to reset.

Example: Actual Top – Up payments in 2005

These guarantees are good but what has the experience been. Transamerica looked at its death claims in 2005 and of the 1,074 death claims, 803 required top ups and a total of $20.8 million was paid out in death claim top-ups. The average value of the death claim was $42,000 and the average top-up was $26,000. This begs the obvious question, what happened to cause such poor performance that top ups were required of this size.

This is actually an excellent example of what we see above. Resets were made in early 2000 before the market collapsed and many were invested in more volatile tech oriented funds so they guaranteed the profits not the original capital investment. After the collapse of 2000, many investors choose a very conservative portfolio so it takes longer to recover the losses.

Age restrictions on Death Benefit Guarantees

Typically, companies reduce the amount of the Death Benefit guarantees after the client reaches the age of 75 or older. Some may also restrict the ability to make Segregated Funds deposits after a certain age (typically 75). This reflects the increased risk of sudden death experienced with increasing age

This is where we can help as one company maintains 100% death benefit guarantee throughout the life of the contract with a reasonably generous definition of what age they will still issue it at. If that is an important consideration for your planning please ask about it.

Succession Planning and Probate – Huge Differences Mutual Funds:

Will be a part of the deceased's estate and distributed according to the will after the will is probated (fees)

Segregated Funds:

Segregated Funds are insurance contracts and a beneficiary can be named to receive any proceeds upon the death of the life insured which leads to the following benefits:

• can bypass the estate (and probate) through a named beneficiary designation.
• Privacy preserved
• The fund will not form part of the value of the estate (no probate fees or other fees like accountants, executors and lawyer fees )
• Money liquidated and received by beneficiary typically much quicker
• Not subject to the settlement of the estate
• Not typically subject to the estate creditors' claims if the named beneficiary is a member of the family like spouse, parent, child or grandchild.

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Creditor Protection

Because it is an insurance product, it offers creditor protection from policyholder's creditors while policyholder is alive but if it can be shown to have been purchased to avoid potential known creditor actions, it could be challenged.

This is where we can help by recommending the use of Segregated Funds for other than this reason. There is also the subject of on going discussion as it gives Segregated Funds an advantage over Mutual Funds and there are active discussions about legislated changes to this protection. In addition, certain beneficiary designations are stronger than others, such as, spouse, same-sex partner, child, grandchild or parent of the life insured OR if the Beneficiary is designated irrevocably

Segregated Fund Fees

The insurance companies are required by the regulators to set aside a reserve for the guarantees they offer in the Segregated Funds and the fee charged for the guarantee is based on the guarantee offered. For many people, they are more interested in the creditor protection than the death guarantee (eg the person dies at a down market) so the insurance companies recently introduced different death and maturity guarantees – 75% and 100% with the lower guarantee having a lower associated fee. The 75% is more common on maturity guarantees to keep the fees down while 100% is more common on death guarantees.

Many people find that the higher costs involved are offset by the peace of mind of knowing regardless of what the market does, they can't lose their money as long as they stay the course until they reach the maturity date

There are two basic types of funds – those run by the Insurance Company itself and “clones” of actual Mutual Funds. The MER's can be between 17 and 175 basis points more than a Mutual Fund where 100 basis points equals one percent. Those that are run by Insurance Companies themselves will tend to be on the lower end. We can help you asses the value of the additional costs versus the benefits and returns. There are many good options where the additional fee is only about 0.5% which, for many, is a small premium for the additional benefits. This is supported by the surge in the purchase of Seg Funds.

Example: Potential Estate Fees Seg Fund Savings

Savings - $150,000 GIC at Financial Institution @ 4.0 % annual return and an estate valued at over $50,000 for probate fees.

Mutual Funds

After both you and you spouse, if any, have passed on, and your Mutual Funds are left to the beneficiaries through a will, your estate could face some or all of the following fees in addition to taxes.

•  Potential Executor Fee* $150,000 times 1.5 % = $2,250

•  Probate Fees on Estate $150,000 times 1.5 % = $2,250**

•  Legal Fees on Will Distribution** $150,000 times 1.5 % = $2,250

•  Accounting Fees* on final Tax returns** $150,000 times 1.0 % = $1500

Total fees = $8,250

* Ontario is $15 per $1,000 and B.C. is $14 over $50,000 – used 15%

** Actual fees can vary from none to more than this – used as an example

Segregated Funds

After both you and you spouse, if any, have passed on, and you're Segregated Funds are left to selected beneficiaries through the beneficiary selection on the contract:

•  Potential Executor fee 0 %

•  Probate Fees 0 %

•  Legal Fees* 0 %

•  Accounting Fees* 0 %

Total fees = 0 - A saving of $8,250

The differences continue as a will is a public document, which means anyone who wants to can see your Will know all about your affairs. In addition, funds are not dispersed until the will is settled and any children or people identified in the will can dispute it and tie it up in courts for months or even years.

When you name a beneficiary to a Segregated Fund, creditors cannot go after the beneficiaries for any monies owed by you when you pass away. Also, the death benefit is paid out directly to the named Beneficiary usually within 6 to 10 business days after the Insurance Company receives the proper death documentation,

In addition, with the death benefit guarantee, the funds could have been invested in a fund that generated a higher return than 4%.

Finally, the tax paid by the estate will likely be less as the GIC income is taxed as interest income – the highest rate. The seg fund would have had some capital gains and dividend income and the gains would be taxed at a lower rate again offsetting the higher MER – see below.

Taxation

A segregated fund is considered a trust for tax purposes. This is important for two reasons:

• The segregated fund will allocate all taxable income and realized capital gains to investors. This avoids having income taxed inside the fund at the top marginal rate.
• The fund acts as a conduit, that is income and capital gains retain their characteristics as they flow through to the investor and appear on the T3 in the same way they were realized in the fund. In other words, dividends will be reported as dividends, interest as interest and so on.

There are two taxable events arising from investing in funds – Mutual Funds or Segregated Funds

• Income allocation (controlled by company)
• Disposition (controlled by investor)

We will also talk about the impact of acquisition costs and easy of accounting for taxation at the end.

Income Allocation:

Different and yet the same

Mutual Funds will “flow through” the income to the individual investor. The investor may physically receive the income or it will be reinvested to purchase more units.

With Mutual Funds, you could be taxed on income you never received as taxation is based on who owns the mutual fund units on a given date at the end of the income period.

• E.g. if you buy units one day before the end date, you are assessed for all income earned in that period, even though you did not benefit from that income .

Seg funds will retain and reinvest the income internally and, adjust the unit value to reflect the income distribution. The investor does not receive the income in the form of a physical payment.

With Segregated Funds, you are only taxed on the income you actually receive as taxation is based on how long you own the Segregated Fund units within the income period.

• E.g. if you buy units one day before the fixed date, you are only assessed for one day's income. The unit seller is assessed for income made before the end date.

Capital Loss

Another segregated Fund advantage since Mutual Funds cannot distribute negative capital gains distributions. Capital losses are carried forward to be used against future gains within the fund.

Segregated Funds have the ability to flow through capital losses (138.1(3) of the Income Tax Act) to the individual investor (which can in turn be used to offset other capital gains realized in the same year)

In a year, for example, where there are both capital gains and losses to report, gains will be reported in the capital gains box (Box 21-- same as a mutual fund) and losses will be reported in the "Insurance Segregated Fund Capital Losses" (Box 37 -- only available to Segregated Funds).

With Segregated Funds, the investor gets to choose when to claim the capital losses as capital losses not used in the current year can be carried back three years or carried forward to future years. This is not the case with Mutual Fund investments.

One cautionary point that I have never seen mentioned anywhere else but did occur to one of our clients. Taxable gains are the responsibility of the estate not the beneficiary.

Capital Gains

Income through disposition is treated equally in both Segregated Funds and Mutual Funds unless it is a death claim.

Example: Capital Gains on a death claim are different with a Seg Fund.

I have never seen a discussion on this elsewhere but it happened to one of our clients. One of our clients passed away from an automobile accident in her mid 20's. She had a seg fund worth about $12,000 when she passed away and had named a beneficiary with who she was no longer talking but had not changed it. The funds were paid out within weeks and there was nothing that could be done to prevent it although the executor, her father, did not want it to happen. In all cases, the beneficiary must be current.

More importantly, the capital gains that had been earned on the fund flowed through to the estate and had to be paid out of the estate. We contacted the beneficiary, to at request a cheque to cover this but it was not forthcoming and there was no recourse. This has interesting implications.

Acquisition Costs

For accounting purposes, acquisition fees are excluded from the adjusted cost base and treated separately while for Mutual Funds, acquisition fees are included in the adjusted cost base.

Seg Funds report all taxable events – easier accounting

Another advantage related to Segregated Funds is that the insurer tracks the cost base for each investor and all taxable events are reflected on a T3. There is no additional accounting required by the investor.

With a mutual fund, only the distributions relating to fund activity are reflected on the investor's T3. If an investor redeems any of their units, they must calculate the gain and loss and report these on their tax return.