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This article appears in the June 2021 issue of Investment Executive. Subscribe to the print edition, read the digital edition or read the articles online.

Segregated funds can be valuable tools for the right clients, but they aren’t suitable for everyone. Here’s a seg fund cheat sheet to help you build confidence and inspire you to become a seg fund pro.

What are segregated funds?

A segregated (seg) fund is essentially “a mutual fund meets an insurance policy,” said Justin Ezekiel, director of tax and estate planning with Sun Life Financial Inc. in Vancouver.

In more detail, a seg fund is an insurance contract issued by a life insurance company and regulated by the federal Insurance Companies Act. Seg funds have two parts: a pooled investment component (similar to a mutual fund), plus an insurance policy that protects against the loss of the invested capital when a contract matures. By law, a seg fund must guarantee a return of at least 75% of the original capital, and many provide guarantees for 100%. Seg fund contracts typically have 10- or 15-year terms, with the option to “reset” the term at regular intervals (specified in the contract) to lock in gains.

A policyholder (or owner) owns the seg fund contract. The policyholder may be the annuitant — the insured person on whose life the contract is based — or the annuitant may be a different person, such as the policyholder’s spouse or common-law partner. When the annuitant dies, the value of the seg fund — the original, guaranteed investment, plus any profits from market gains — is paid out, tax-free, to the beneficiary.

Pros of seg funds

Perhaps the most obvious advantage of seg funds is their guarantee: investors with a low risk tolerance may take comfort in knowing that all or part of their original investment is protected, especially during turbulent financial times.

Some financial advisors question the real value of those guarantees. Historically, markets have risen during most 10-year periods. And since the 1920s, for example, the S&P 500 composite index has returned a rolling average of approximately 10% in any given 10-year period.

“I’ve never sold seg funds, except for estate planning purposes,” said Cindy David, president of Cindy David Financial Group Ltd. in Vancouver, “because I thought, ‘Why would you pay an insurance company to offer you a guarantee that they’re super-confident in offering you because they’ve almost never had to pay it out?’”

Still, for clients who prefer to have at least part of their portfolio in guaranteed investments, seg funds provide that guarantee along with the potential for higher returns than GICs via the seg fund’s option to invest in equities. Given the tax advantages that come with earning capital gains rather than interest income, seg funds may be an appropriate choice for clients with a low tolerance for risk.

Al Jones, president of A. Jones Wealth & Estate Planning Inc. in Barrie, Ont., said the real value in seg funds lies in their versatility as a planning tool and their status as insurance products, the latter of which confers benefits such as creditor protection and the ability to designate beneficiaries.

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Creditor protection

The assets held in a seg fund — registered or unregistered — are protected from creditors when a designated beneficiary has been named. This may make seg funds an attractive product for business owners who may be subject to claims from creditors. (In Quebec, the beneficiary is limited to the policyowner’s married or civil-union spouse, ascendants, descendants or anyone named as an irrevocable beneficiary.) However, registered accounts such as RRSPs also are fully protected against creditors in British Columbia, Alberta, Saskatchewan, Manitoba, P.E.I. and Newfoundland and Labrador, which may make seg funds less of a draw in these provinces.

Timeliness, control and privacy

Because seg funds are insurance products, policyholders can name a beneficiary or beneficiaries, whether or not the seg funds are registered. This means that when the annuitant of a seg fund dies, the proceeds bypass the estate and thus bypass probate, Jones said. Furthermore, the proceeds typically are paid to the beneficiary within weeks rather than the months or years that may be necessary to settle an estate.

Seg funds also can be used as a strategy to sidestep or mitigate family conflicts, Jones said, because challenging a beneficiary designation is more difficult than challenging than a will.

(In the 2020 case Calmusky v Calmusky, however, an Ontario Superior Court judge considered a deceased person’s testamentary intentions in naming a RRIF beneficiary, but did not consider provincial estate legislation that permits a designated beneficiary to be named — essentially allowing a beneficiary designation to be successfully contested.)

Beneficiary designations are private, while the contents of a will are not. Consequently, seg funds can be an important estate planning tool for clients who are concerned about privacy or for clients who want to leave different amounts to different children or relatives without other family members knowing. If an investor is concerned about leaving a large sum of money to a potentially irresponsible child, a seg fund can be structured as an annuity that will pay that child a guaranteed monthly amount. (The client could achieve the same purpose with a trust, Jones said, but that process is more cumbersome, generally more expensive and less tax-efficient.)

The ability to designate a beneficiary is especially valuable in Quebec, which does not allow beneficiary designations on registered accounts, said Serge Lessard, regional assistant vice-president of taxation, retirement and estate planning with Manulife Investment Management in Montreal.

Cons of seg funds

A major downside to seg funds is their higher cost relative to ordinary mutual funds. The Canadian Council of Insurance Regulators (CCIR) reports that seg funds typically have management expense ratios 50–150 basis points higher than those of mutual funds. However, for seg funds that offer higher levels of guarantees, the additional costs may be justified by the extra privacy and control, plus the time savings and savings (outside of Quebec) on probate fees and estate administration that seg funds offer, said Marie Gauthier, head of pricing and guaranteed investment products with Manulife Investment Management in Montreal.

For younger investors who are more interested in wealth accumulation and less concerned about estate planning or creditor protection, the extra cost of a seg fund may not make sense. Jones said he typically steers young clients to mutual funds, moving those clients gradually toward seg funds as needs change over time. When younger clients marry, divorce, have children and grandchildren, open a business or begin to orient themselves toward wealth preservation, decumulation and estate planning, seg funds may make sense.

David said she considers seg funds too rigid and complicated because of their minimum 10-year maturity periods and complex contracts. “They’re confusing, they’re expensive and people often think that they’re buying something they’re not,” she said. “Sometimes people don’t realize that they’re getting only a 75% guarantee, [for example], or that they can’t withdraw funds without affecting the guarantee.”

With some seg-fund annuities, for example, “clients may think they’re earning a guaranteed 5% return on capital for life, when what they’re actually getting is a 5% return of their capital,” David said.

Concerns about fee disclosure and arbitrage

Finally, there may be concerns about regulatory arbitrage by advisors who are registered dually as insurance and mutual fund reps moving clients into seg funds in order to take advantage of higher fees and commissions, even when the products aren’t appropriate for their clients. Seg funds have different and, arguably, less stringent fee-disclosure requirements than mutual funds do, which can make the cost of investing in these products more difficult for clients to understand.

In an effort to address these issues, the CCIR established a Segregated Funds Working Group in 2015 to ensure a consistent approach to disclosure for mutual and seg funds and to assess the possibility of regulatory arbitrage. A CCIR position paper released in December 2017 stated the working group found no evidence of arbitrage despite anecdotes to the contrary. “However,” the report stated, “in order to protect consumers, the CCIR seeks to proactively amend standards where appropriate to ensure that intermediaries have little incentive to prioritize their own interests over those of clients.”

In June 2018, the CCIR released a model disclosure document for seg funds that includes sections for disclosing personal rates of return, fund expenses, commissions and trailers, and guarantees.

Let the client’s needs lead

David suggested advisors and investors educate themselves fully on the pros and cons of seg funds. Life insurance, for example, can achieve many of the same objectives as seg funds, but also offer tax-sheltering. Furthermore, life insurance also bypasses the estate and probate process, is paid to the beneficiary tax-free and can be creditor-proof. Generally, the beneficiary named in a life insurance policy cannot be contested. David also encouraged advisors to invest the time and energy to become dually licensed to sell both insurance products and mutual funds — but not just for the sake of having more products to sell: “Make sure you’re an advisor; not a salesperson.”

How are seg funds taxed?

Segregated funds are structured as and taxed in the same manner as inter vivos trusts — trusts created while the donor is alive to hold property for the benefit of others.

Each year, an insurance company allocates income and capital gains (or losses) to the holder of a seg fund and issues a T3 slip to policyholders, said Justin Ezekiel, director of tax and estate planning with Sun Life Financial Inc. in Vancouver. The adjusted cost base (ACB) of a policyholder’s seg fund units will increase or decrease depending on the seg fund’s net allocations over the previous year, but the number of units remains the same.

Insurance companies, as opposed to mutual fund companies, track ACB and provide investors with the capital gains and losses as a result of a sale or redemption. This makes tax reporting easier for the average investor who doesn’t have an accountant or the know-how to calculate these numbers on their own, said Serge Lessard, regional assistant vice-president of taxation, retirement and estate planning with Manulife Investment Management in Montreal.

In the unlikely event that the value of the seg fund is lower at maturity than the original amount invested, the insurance company will top up the amount in order to honour the guarantee. For example, if a client invests $100,000 in a seg fund with a 75% guarantee, and the seg fund’s value drops to $65,000 by maturity, then the insurance company will add $10,000 to top up the return. Currently, the Income Tax Act isn’t clear on how top-up amounts should be taxed. The conservative approach, Ezekiel said, is to tax them as capital gains for non-registered contracts and as income for registered contracts.

If the policyowner redeems all or some of their seg fund units, the transaction is a disposition and the policyowner must report the capital gain or loss on that year’s tax return.

When the annuitant dies, the seg fund policy automatically matures. The beneficiary receives the higher of the fair market value of the policy or the guaranteed amount. The policyowner (or their estate) must report any accrued capital gain on that year’s tax return. If the policyowner and the annuitant are different people, the policy can be transferred to a surviving spouse on a tax-free, rollover basis in the event of the policyholder’s death.

The policyholder also can name a “successor owner,” which allows the policy to pass directly from the deceased policyowner to the successor without passing through the deceased’s estate. This transfer will trigger a deemed disposition, and the deceased’s estate will incur any relevant tax consequences if the successor owner isn’t a spouse.