Segregated Funds: A Comprehensive Overview

Segregated Funds

• Insurance contracts offered exclusively by life insurance companies.
• Offer guarantees to protect investments, but with higher costs than mutual funds.
• Suitable for investors seeking income or growth with limited risk.

Advantages of Segregated Fund Contracts

• Maturity and death benefit guarantees.
• Growth secured by reset.
• Funding flexibility through ongoing deposits.
• Ease of monitoring value.
• Potential for guaranteed income.
• Professional management.
• Diversification.
• Tax benefits.
• Switches between funds.
• Ability to withdraw (redemption).
• Estate planning, including exemption from probate fees.
• Investor protection.
• Potential creditors protection.
• Potential absence of medical underwriting.
• Right of rescission.

Maturity and Death Benefit Guarantees

• Protect against loss of principal.
• Maturity guarantee: Pays out at least 75% of deposits on the maturity date if the market value is lower.
  • Maturity date: typically ten years from the first deposit but can extend to the annuitant's age 100 or beyond.
• Death benefit guarantee: Pays out at least 75% of deposits if the annuitant dies during the contract term.
• Withdrawals reduce the sum on which guarantees are calculated, but the guarantee percentages remain the same.
• Guarantees can be equal (75%/75% or 100%/100%) or differ (75%/100%).
• Insurer makes up the difference if the contract value is less than the guarantee.
• Key information needed to understand guarantees:
  • Principal amount invested.
  • Guarantee percentage (75% or 100%).
  • Market value at maturity or death.

Maturity Guarantee

• Provides downside protection by establishing a minimum contract value at maturity.
• Offers unlimited upside potential.
• Policy owner options at maturity:
  • Withdraw the value of the investment.
  • Extend the contract.
• Payout Scenarios:
  • If market value > guarantee value, receive market value.
  • If market value < guarantee value, receive guarantee value.
• The insurer uses financial reserves to cover the difference (top-up).
• Partial or full contract surrender before maturity forfeits the maturity guarantee.
• Withdrawals reduce the sum protected by guarantees but do not change the percentages.
• Example Scenarios with 10,000 Investment and 75% Guarantee:
  • Scenario 1: Market value at maturity is 8,360. Michael receives 8,360.
  • Scenario 2: Market value at maturity is 6,360. Michael receives 7,500 (guarantee) + 1,140 top-up.
  • Scenario 3: Market value at maturity is 13,200. Michael receives 13,200.
  • Scenario 4: Surrender after four years, market value is 7,120. Michael receives 7,120.

Death Benefit Guarantee

• Beneficiary receives at least 75% of the sum deposited if the annuitant dies during the contract.
• The amount paid to the beneficiary is the greater of the market value or the death benefit guarantee.
• Advantages:
  • Protection from fund losses.
  • Guarantee applies from day one.
  • No medical underwriting typically required.
  • Unlimited upside potential.
• The death benefit may be reduced by a sales charge but may be waived by some insurers.
• The investment value is not subject to probate fees if there is a named beneficiary that is not the estate of the deceased.
• Example Scenarios with 10,000 Investment and 75% Guarantee:
  • Scenario 1: Market value at death is 12,640. Patricia receives 12,640.
  • Scenario 2: Market value at death is 6,300. Patricia receives 7,500 (guarantee) + 1,200 top-up.

Resetting Guarantees to Help Secure Growth

• Segregated funds offer a chance to lock-in increases in value through a process known as "reset".
• When the contract value rises, the investor can set the guaranteed values at that higher level.
• Subsequent losses only impact the investor if withdrawals are made before maturity.
• The ability to participate in gains and potentially hold onto them moving forward has incredible potential for the investor
• Downside: Reset typically delays the maturity date.
• Both policy owner and beneficiary can benefit from reset.
• Example: Initial deposit of 20,000, 75% guarantees are 15,000. If the market value increases to 50,000 and the guarantees are reset, the guarantees will now amount to 37,500 (50,000 × 75%).
• Some insurers offer automatic reset; others leave the decision to the policy owner.
• Not all insurers offer reset.
• Limitations may include additional fees or separate reset options for maturity and death benefit guarantees.
• Example: Hassan deposits 5,000 (75% guarantees = 3,750). After two years, the market value is 7,000. Reset increases guarantees to 5,250 (7,000 × 75%) and resets the maturity date.

Funding Flexibility Through Ongoing Deposits

• The principal deposited is called the deposit or premium.
• Deposits can be made as a lump sum or a series of deposits.
• Maturity guarantee may be applied to individual deposit dates or to the contract date.
• Guarantee may be based on each date the customer makes a deposit, each deposit has its own maturity guarantee (of 75% or 100% of deposit value), the length of which is based on the term-to-maturity in the contract (ten years or more).
• Example: Sandra has a deposit date-based contract with a 15-year term-to-maturity. She deposits 2,000 initially and then 2,000 every year thereafter on January 1 for two years for a total of three separate deposits. At the start of her contract, her maturity guarantee is 1,500 (1 × (2,000 × 75%)) in fifteen years. At the end of 16 years, her maturity guarantee is 3,000 (2 × (2,000 × 75%)). At the end of 17 years, her maturity guarantee is 4,500 (3 × (2,000 × 75%)).

Ease of Monitoring Value

• Investors receive an attributed number of units based on the investment amount and the fair market value.
• Investors can monitor performance and value changes.
• Information may be included in annual statements.
• Increase may indicate that a reset is in order. A decrease could suggest a fund switch is in order.
• Example: An investor invests 1,000 in ZYX fund, in which units have a market value of 10, he is attributed 100 units (1,000 ÷ 10). If the market value of the units increases to 12, his investment will be valued at 1,200 (12 × 100).
• Unit values are determined by NAVPU (net asset value per unit).
• NAVPU = \frac{\text{total value of assets – liabilities}}{\text{number of units outstanding}}
• NAVPU is determined on each valuation day.
• Unit values increase/decrease with asset values, but the number of units remains constant unless additional deposits or withdrawals are made.
• Segregated funds allocate taxable income and realized capital gains and/or losses to non-registered contract owners. These earnings are not distributed to investors in the form of cash. Instead the earnings remain invested in the fund and increase the value of the fund and therefore the NAV per unit.
• Interest, dividends, and capital gains increase the adjusted cost base (ACB). Capital losses decrease the ACB. The change to the ACB is tracked by the insurance company.
• If an investor wants cash from the fund, he must make a withdrawal by redeeming fund units.

Guaranteed Income

• Segregated fund contracts return their value (or the guaranteed value, if higher) on maturity.
• The default is typically that the insurer will take the value of the contract and use it to fund an annuity on maturity
• Some contracts offer a guaranteed stream of payments before maturity.
• Available as Guaranteed Minimum Withdrawal Benefit (GMWB) and Guaranteed Lifetime Withdrawal Benefit (GLWB).
• Provide maturity and death benefit guarantees.
• May not be suitable for all investors due to complex rules and requirements.

Guaranteed Minimum Withdrawal Benefit (GMWB) and Guaranteed Lifetime Withdrawal Benefit (GLWB)

• Based on initial deposits.
• GMWB: Regular payments over a set period.
• GLWB: Payments as long as the annuitant is alive.
• Three phases:
  • Savings phase: Accumulation with potential for market value increase and credit earnings (e.g., 5% of initial deposit) for years without withdrawals. Withdrawals reduce the value of deposits made into the plan and thus of the corresponding credits and final guaranteed minimum withdrawal amount.
  • Payout phase: Regular withdrawals based on the guaranteed minimum withdrawal balance. The annual income guarantee is not affected, and insulated against market performance.
  • Benefits phase: When the contract value equals zero, annual income continues to be paid by the insurer.
• Extra withdrawals may be penalized.
• Payout value may be reset at set time periods, for example, every three years.
• The payout also increases if more premiums are contributed after the initial deposit.
• Amount received is based on payout beginning at a specified age and lasting for a specific period or for life.
• Lifetime income addresses longevity risk.

Professional Management

• Professional investment managers are hired by the insurance company.
• Managers are compensated by fees within the management expense ratio (MER).
• The insurer can change the manager.
• Fund managers are highly educated and trained.
• Allows investors to achieve objectives without active involvement in day-to-day management.
• The life insurance agent’s responsibility is to work with the client to ensure his objectives are being met in the fund investment.
• The agent must be prepared for regular client meetings in which performance and other factors about the fund will be discussed.

Diversification

• Segregated funds are highly diversified-managers use a wide range of investments.
• Reduces risk by spreading it over various investments.
• Investor protected by maturity and death benefit guarantees even if all diversified assets lose value.

Tax Benefits

• Simplified tax reporting because the insurer tracks the ACB.
• Interest, dividends, and capital gains increase unit value and increase the investor’s adjusted cost base (ACB) per unit.
• The investor with a non-registered contract receives the earnings on a flow-through basis. Meaning capital losses are used to reduce capital gains in the year in which the loss occurs. If a loss cannot be fully used in that year, it can be carried back to the three previous years or forward indefinitely.
• Segregated fund death benefits bypass probate when a beneficiary other than the owner’s estate is named.
• Example: Henry invests 1,000; receives 200 units at 5 each. At year-end, a 100 allocation raises the unit value to 6. The ACB becomes 1,100. The 100 allocation is reported as 50 interest and 50 capital gain. At a 36% marginal tax rate, Henry pays 18 tax on the interest (50 × 36%) and 9 on the capital gain (25 × 36%).

Switches Between Funds

• Investors can switch funds to suit changing risk tolerance or address dissatisfaction with performance or MER.
• The agent should give the policy owner the most recent Fund Facts document for any fund the client is thinking about investing in.
• The value of existing fund units is determined on the valuation date, which is either the day of the switch request or the next valuation date.
• Contract guarantees are not affected by fund switches.
• The number of switches the investor may make per year without incurring a switching fee may be limited.
• An investor may incur a tax liability when a switch is made.

Ability to Withdraw (Redemption)

• Investors can make withdrawals at any time.
• The withdrawal process begins by the investor informing the insurer that issued the fund contract of the amount he wishes to withdraw.
• The maturity guarantee and death benefit guarantee of the contract are reduced as a result of the withdrawal.
• A withdrawal may trigger tax. The contract owner receives a tax reporting slip from the insurer so that the withdrawal may be taken into consideration in the tax return for that year.

Exemption From Probate Fees

• Avoid probate fees by naming a beneficiary other than the estate.
• Allows for quick transfer of assets to beneficiaries.

Investor Protection

• Assuris protects investors if an insurer becomes insolvent.
• Coverage is needed only when the guarantees of the segregated fund contract at maturity or death are higher than the market value of the contract.
• Assuris guarantees up to 100,000 or 90% of guarantees, whichever is higher.
• Example: Mark has deposited 150,000. He is guaranteed to receive 112,500 on maturity. On maturity, the market value of his contract is 98,000. Mark receives 101,250 since it is greater than 100,000.

Potential Creditor Protection

• Segregated fund contracts may offer protection from creditors.
• Protection may apply if the spouse, parent, children or grandchildren is named as a beneficiary in the contract or if the beneficiary is irrevocable.
• Legal opinion should be sought.

Absence of Medical Underwriting

• No medical underwriting is typically required.
• Beneficiary receives guaranteed minimum payment regardless of the policy owner's or annuitant's health.

Right of Rescission

• Investors can cancel the contract within a specific time limitation.
• Usually, two business days are permitted from the date of delivery of the confirmation statement.
• The investor receives the lesser of the amount of premium paid or the value of fund units on that date if it is a valuation date.

Types of Segregated Funds

• Classified by the Canadian Investment Funds Standards Committee (CIFSC) into five asset classes:
  • Cash.
  • Fixed income.
  • Equity.
  • Commodity.
  • Other.
• Actual fund names may not reflect their asset class.
• Proper classification is important so that funds can be correctly compared and aligned with investor risk tolerance.
  *Each fund is highly diversified

Money Market Funds

• Invest at least 95% in cash or cash equivalents.
• Lowest-risk funds with low return rates.

Bond Funds

• Invest in fixed-income securities.
• Categorized by bond duration (short-term, medium-term, long-term).
• Generally low-risk with low return rates.
• High-yield (junk) bond funds carry higher risk.

Equity Funds

• Also known as growth funds.
• Invest in stocks to generate dividend income and capital gains.
• May be diversified across different types of businesses or concentrated in a particular sector.
• Higher risk than other fund types.
• Fund growth is achieved when stocks held by the fund are sold at a higher price than their purchase price and by reinvesting dividends paid on fund holdings.
• The increase in price is the capital gain on the stock.

Equity Funds by Market Capitalization

• Categorized by market capitalization (cap) to fine-tune risk.
• Types include small-cap, mid-cap, and large-cap funds.
• Royal Bank of Canada is a large-cap company with a market cap of 140.64 billion (May 2022); Air Canada is a medium-cap company with a market cap of 6.04 billion (May 2022) and Extendicare is a small-cap company with a market capitalization of 649.33$$ million (May 2022)

Income Funds

• Based on bonds with growth from interest income and potential capital appreciation.
• May include high-quality stocks.
• Lower-risk fund.

Balanced Funds

• Invest in stocks and bonds to balance growth and safety.
• Also known as balanced growth or balanced income funds.
• The risk associated with these funds depends on how the balance is weighted.
• Stocks are higher-risk; bonds are lower. When there is an even split, risk is averaged out.
• Suited for investors wanting stock exposure but not the full volatility.

Target Date Funds

• Combine equity and fixed-income investments to decrease risk over time.
• Asset allocation shifts from higher to lower risk as the target date approaches.
• Suitable for retirement planning.

Dividend Funds

• Invest in companies with a history of paying dividends.
• May also invest partly in bonds.
• Considered low to medium-risk.

Mortgage Funds

• Hold residential, commercial, and industrial mortgages.
• Low-risk mortgage funds are a type of fixed-income fund.
• Risk of default by mortgage holders.

Real Estate Equity Funds

• Invest at least 90% in retail, commercial, industrial, and residential properties.
• Earn income from mortgages and have potential for capital gains as property values increase.
• Suitable for long-term investment.
• Illiquid investment.

Index Funds

• Mirror an index, such as the S&P/TSX Composite index.
• Passive investing because the investment manager mimics the index chosen for his particular fund and maintains the same securities in the same weight.

Fund of Funds

• Invest in other funds to benefit from managerial expertise and diversification.
• The risk of the fund is entirely a result of the underlying funds in the portfolio and its investment objective.

Specialty Funds

• Appeal to specific investor wants and needs.
• Investors less concerned about the risk of the fund since their primary goal is to support a cause or belief.
• Specialty funds do not have the mass appeal or assets of their large segregated fund cousins, such as equity funds. However, specialty fund categories such as socially responsible funds fill important investment objectives for their investors.
• The risk of specialty funds lies with the fund’s objective and investment strategy used by the fund manager. Each one should be carefully studied to determine if its risk is suitable for the investor.

Industry-Specific Funds

• Specialize in a particular industry.
• Risk depends on the industry's volatility and prospects.

Geographically Specific Funds

• Focus on investments within a country, outside a country, or in a selection/region of countries.
• Political and currency risks are associated with investing outside Canada and similar developed nations.

New Introductions

• Funds evolve based on consumer interests.

Suitability of Funds

• Insurers and intermediaries must comply with applicable laws and regulations in the provinces or territories where they act, and are expected to implement the principles of the Fair Treatment of Customers (FTC).
• Suitability of investments for the client is a priority.
• FTC is relevant to the choice and recommendation of funds by the agent. He is required to act ethically and in good faith and is prohibited from engaging in abusive practices.
• The life insurance agent’s role is to be aware of his clients’ needs to ensure funds, whether new or old, align with client needs, interests and objectives.

Segregated Fund Contract Limitations

• Identified limitations:
  • Risk to capital.
  • Sales charge option.
  • Management expense.
  • Penalties.
  • Age restrictions.

Risk to Capital

• Investors could lose up to 25% of their capital with 75% guarantees.
• Fixed term-to-maturity makes it a long-term investment.
• Capital invested in segregated funds is unprotected.
• The chart presents how a 75% maturity guarantee leaves 25% of the investment unprotected, and a 100% maturity guarantee leaves all of the investment fully protected
• Risks depend on underlying investments (e.g., bonds are lower risk than equities).

Sales Charge Options

• Front-end load (FEL): A fee charged at the beginning of the contract, known as its front end that reduces the investor deposit.
• Fee for service: Some contracts allow the client and agent to negotiate a fee the customer will regularly pay the agent for his services.
• No-load/FEL Zero: No fee is charged when making a deposit. The insurer does not pay the agent an upfront commission at that time.
• Advisor chargeback: The insurer immediately pays the agent an upfront commission based on the amount the customer has deposited. The insurer also pays the agent a trailing commission.
• Deferred sales charge (DSC): The customer invests money in a segregated fund without paying a sales charge at the time of sale. The insurer pays the agent an upfront commission based on the amount the customer invests, and also pays the agent a trailing commission.
• Agents should always review the fees or loads of a contract at the time it will be under client consideration and recommend the option that is most suitable for the customer’s circumstances and needs.

Front-End Load Sales Charge Option

• Fee charged at the beginning, reducing the investor deposit.
• The customer is not required to pay a sales charge when he makes withdrawals from the fund.

Fee For Service

• Client and agent negotiate a regular fee paid by the customer for his services.
• The insurer facilitates the customer’s annual payment to the agent by withdrawing an amount from the contract to pay the agent.
• The customer is not required to pay an additional fee through the insurer or otherwise at time or deposit.

No Load / FEL Zero Sales Charge Option

• The customer invests money in a segregated fund without paying a fee when they make their deposit.
• The insurer does not pay the agent an upfront commission at that time. However, the insurer pays the agent a trailing commission.

Advisor Chargeback Sales Charge Option

• The customer invests money in a segregated fund without paying a charge at that time.
• The insurer immediately pays the agent an upfront commission based on the amount the customer has deposited.
• The insurer also pays the agent a trailing commission.
• Agents only recommend the advisor chargeback option when it is suitable for their customers’ needs.

Deferred Sales Charge (DSC)

• The customer invests money in a segregated fund without paying a sales charge at the time of sale.
• The insurer pays the agent an upfront commission based on the amount the customer invests, and also pays the agent a trailing commission.
• If the customer withdraws money, or makes certain other transactions, within a specified time after making the deposit, then the customer must pay a redemption fee to the insurer: the deferred sales charge.

Management Expense

• The management expense is the combination of the management fee for a fund, its operating expenses, taxes and, often, the cost of providing guarantees. When these expenses are added together and expressed as an annual percentage of the total value of the fund, it becomes the management expense ratio (MER).
• The management fee compensates the fund company for the cost of investment management by a portfolio manager, trailing commissions and fund oversight.
• The operating expenses include administration, legal fees, marketing and other similar costs.
• Tax is charged as the provincial HST rate that applies where the investor lives and is charged on management fees and administration fees.
• The MER of segregated funds is typically higher than the MER for an equivalent mutual fund.
• The MER of a segregated fund must generally pay to maintain a reserve to uphold segregated fund maturity and death benefit guarantees.
• MERs are charged whether the market value of the fund increases or loses ground. They reduce investor returns.
• Example: 5% value increase with 3% MER = 2% net gain. 5% value decrease with 3% MER = 8% net loss.
• Higher MERs are associated with funds requiring more active management and decision making.
• Over time MER expenses can significantly diminish returns. They are an important disadvantage of both segregated fund and mutual fund investing.
• Investors must be notified of the change.

Trailing Commission

• Sales compensation incorporated in the MER.
• Pays the agent for ongoing advice as long as the investor holds the fund.
• Calculated as a percentage of the market value of the fund.

Penalties

• Withdrawals and surrender may be penalized, reducing the sum received by the investor.
• Such penalties are applied against the value of the contract and reduce the sum received by the investor.

Age Restrictions

• Age restrictions apply for establishing and making deposits to a contract.
• A RRIF contract sets the last age for authorized transfer, for instance from a roll-over of a spouse’s RRIF, at 90.
• Segregated fund contracts held on a non-registered basis and tax-free savings accounts (TFSAs) could have maximum issue age stipulations that should be checked before discussing with older clients.

Segregated Fund Taxation

• Taxation depends on whether the contract is taxable/registered or non-taxable, and on the form of investment income earned.

Tax on Deposits

• Deposits or premiums paid into a non-registered plan or a TFSA for a segregated fund purchase are not tax-deductible.
• Deposits or premiums paid into a registered plan, except when it is a registered education savings plan (RESP) or registered disability savings plan (RDSP), are tax-deductible.

Tax on Allocations

• Investment growth can be earned in both non-registered and registered contracts in forms of interest, dividends, capital gains or losses, and foreign income.
• Non-registered contracts: income growth is allocated to the investor for tax purposes. The investor also reports the capital gain or loss on the switch of units and certain other events that occur within the fund.
• Registered contracts: income growth is allocated to the investor, but not reported for annual tax purposes.

Tax on Withdrawals

• Non-registered contracts: withdrawals incur a capital gain or loss based on the ACB.
• Registered contracts: withdrawals are subject to withholding tax.
• TFSA: withdrawals are tax-free.

Tax on Maturity Guarantee and Death Benefit Guarantee

• The top-up amount contributed by the insurer is taxable if the market value is less than the guarantees.
• Non-registered contracts: top-up is taxable as a capital gain.
• Registered contracts: top-ups are taxable as income (surviving spouse can defer tax by rolling proceeds into RRSP or RRIF).
• TFSA: top-ups are not taxable.