Past performance does not guarantee future results

A segregated fund ("seg fund") is like a mutual fund with minimum guarantees at death and maturity.

• pool of funds an insurer holds separately from its other assets
• an Individual Variable Insurance Contract (IVIC) buys into a segregated fund
• started in 1961 to manage money for pension plans
• many different segregated funds available
• can be held in registered plans
  • RRSPs, locked-in pensions (LIRA, LIF, LRIF), RESPs

See the comparison with mutual funds.

Other links

• segregated fund trusts

Target Market

Segregated funds can be good choices for the following clients

• risk-averse
  • the principal guarantee on death and maturity → safety and growth
  • generally more important when older
• any age
  • e.g., available to non-min and up to age 80
  • RRSP or LIRA: terminate by age 71
• financially secure
  • able to leave money invested for 10⁺ years
• over age 55 and needing estate preservation
  • guaranteed benefits + bypass probate + faster payout
• in poor health
  • guaranteed the death benefit available without evidence of insurability
• entrepreneurs, small business owners, professionals
  • creditor protection — unavailable with other investment products

Regulation

Segregated funds are exempt from provincial security regulations if they offer minimum guarantees on deposits net of withdrawals:

• maturity guarantee: 75% when the contract terminates (minimum of 10 years)
• death benefit guarantee: 75% upon death of the policyowner

Insurers require approval from the CLHIA and provincial regulators before offering a segregated fund.

Withdrawals

Withdrawals can be made from a segregated fund if:

• contract not locked in
• annuitant/owner is alive
• beneficiary is revocable

If withdrawals are made, the guarantee is adjusted.

Income Allocation

• can use income allocated to increase unit value or buy more units
• taxable to the policyowner in year of allocation
• income maintains its original character
• tax annually on interest, dividends and realized capital gains (unrealized capital gains are only taxed when realized)
• policyowner’s ACB is adjusted for the allocation of income (prevents double taxation)

Advantages of Segregated Funds

Segregated funds have a number of exclusive features

1. principal guarantee
   • maturity guarantee
   • death benefit guarantee
2. bypass probate
3. creditor protection
4. bankruptcy protection
5. reset option
6. favorable tax treatment

Principal Guarantee

see segregated fund principal guarantee

Segregated funds reward the selection of risky investments because the principal guarantee limits the risk of losses.

Maturity Guarantee

• minimum of 75% of deposits less withdrawals on maturity
• maturity is at 10 years from the date of the last deposit
• can be for each deposit or for the whole policy
• no guarantee if the contract is terminated before the maturity date

Death Benefit Guarantee

• the beneficiary will receive at least 75% of the initial deposit less withdrawals
• no underwriting is required even though there is a death benefit

Bypass Probate

• exempt from probate unless the named beneficiary is the estate
  • permitted for life insurance contracts including segregated funds
• saves money
• saves time

Creditor Protection

Same as the creditor protection for life insurance.

• normally RRSPs do not have creditor protection
  • so putting a segregated fund inside and RRSP can be beneficial

Bankruptcy Protection

• as long as the purchase was made in good faith and not to avoid debts
• must generally purchase at least one year before bankruptcy
• if not solvent at the time of purchase, purchases during the five years preceding bankruptcy can be seized

(same as for life insurance?)

Reset Option

• can lock in gains so that the principal guarantee is based on the new higher values
• can usually apply resets 2-4 times per years
• the maturity date becomes 10 years from the reset date

Favorable Tax Treatment

• capital gains and losses flow to policyowners on an ongoing basis
  • can offset capital gains with capital losses

Parties

There are three parties to a segregated fund contract

1. Contract Holder (policyowner)
   • the owner
2. Annuitant
   • receives the proceeds at maturity
   • can be the contract holder (required for an RRSP)
     • if not, the contract holder needs insurable interest in the annuitant

• no evidence of insurability required regarding the annuitant

1. Beneficiary
   • receives the death benefit when the contract holder dies
     • no underwriting is required even though there is a death benefit
   • can be more than one person
   • can be revocable or irrevocable
     • if irrevocable, the contract holder needs the beneficiary’s permission to make changes (e.g., resets, withdrawals, surrender, naming another beneficiary)
   • can be named in the Will of the contract holder (the designation closest to death prevails)

Loads and Fees

Loads

A load is a one-time sales charge applies applies when you buy into a fund

• no load: has a higher Management Expense Ratio
• frontend: applied to each deposit
• deferred sales charge (DSC) or backend: most popular
  • applies at maturity or surrender on the larger of the amount invested or the market value
  • applies even upon death
  • do not affect the ongoing investment performance —> you may never pay them
  • often decrease and disappear

Fees

Fees are ongoing management expenses charged each year to cover the costs of running the fund

• higher than for mutual funds due to the cost of the principal guarantee on death and maturity
• also see Management Expense Ratios

Measuring Growth

* mutual fund: you directly own a share of the fund

• segregated fund: no direct ownership → notional units
  • income allocations are time-weighted
    • e.g., own units for 7 months → get income allocation for 7/12 of year
• allocation
  • mutual fund: Net Asset Value stays the same → number of units increases
  • segregated fund: number of units stays the same → unit value increases
    • Unit Value = (Fund Value - Management Fees)/(Number of Units)

• all segregated funds show performance: Year To Date, 1 year, 3 years, 5 years, 10 years (where available)
  • performance cannot be reported until the first year of operations is complete

Withdrawals

• permitted when
  • contract not locked-in
  • annuitant/owner is alive
  • beneficiary is revocable
• taxed as a partial disposition
• guarantees reduced
  • linear reduction

* proportional reduction

Proceeds at Maturity or Death

• Proceeds at Maturity or Death = Net Asset Value + Value of any Guarantees or Benefits - Allowable Deductions
  • allowable deductions: switching fees, early redemption charges
• calculated separately for each fund
• can
  • receive lump sum payment
  • accrue interest on the proceeds
  • receive fixed monthly installments
  • receive monthly installments for a fixed length of time
  • receive a combination of fixed and variable income
  • annuity with level or variable payout

Taxation

Annual Taxation

• fund declares interest, dividends, capital gains
• growth allocated on December 31, based on
  • the number of units held
  • the length of time held during the year
• both capital gains and capital losses are allocated
  • mutual funds are unable to allocate capital losses until sold
• sales charges can be claimed as capital losses at surrender or maturity
• switching between funds in the same family is usually a taxable event
• allocation are taxable in the year received
  • can claim dividend tax credit, capital losses
• interest on loans taken to invest in segregated funds is tax deductible
  • exception: unless held in RRSPs

Taxation of the Maturity Guarantee

• Adjusted Cost Basis = Purchase Price + Commissions + Other Related Expenses
• Capital Gain or Loss = Proceeds of Disposition - Adjusted Cost Basis
• if there is a capital loss, any maturity guarantee is taxed as a capital gain which can be offset by the capital loss

Taxation of the Death Benefit Guarantee

• beneficiary receives the death benefit tax-free

Taxation Of Registered Contracts

• tax on withdrawals in the year made
• must terminate contract by the end of the calendar year the policyowner turned 71
  • even if the segregated fund contract has not matured
  • generally convert RRSP to RRIF or life annuity to defer taxes

The Buying Process

Before you buy a segregated fund, your advisor must give you the following

• information folder
• summary fact statement
• financial statements

and you will sign a receipt to acknowledge that you have received this information

(In contrast, with a mutual fund you are deemed to have received a prospectus after it has been mailed to you. No proof of receipt is needed.)

Information Folder

• like a prospectus for mutual funds
• key document
• describes the policy contract
• your advisor must give you one and get your signed acknowledgment
• includes
  • audited financial statements
  • notes to the audited financial statements
  • identification of guaranteed benefits and nonguaranteed benefits
  • that benefits fluctuate
  • charges on withdrawals
  • how benefits are determined
  • tax status of the segregated fund and policyowners ("contractholders"_
  • management fees, …

Summary Fact Statement

• like a simplified prospectus for mutual funds
• snapshot of the fund, including
  • historical performance
  • investment policies
  • three largest single holdings (though more are often included)
• updates sent regularly (e.g., semiannually)

Financial Statements

• included in the Information Folder at the time of purchase
• must be current and audited
• updated sent annually