Area of Law: Investments and Securities
Answer # 262
What are segregated funds?Region: Ontario Answer # 262
While sometimes considered similar to mutual funds, segregated funds, or guaranteed investment funds, as they are sometimes called, are actually a form of life insurance. When an investor purchases segregated funds, he or she is entering into a contract called an “Individual Variable Annuity Contract.” The contract is designed to provide the contract holder with an opportunity to set aside money by making premium payments in the form of deposits. These deposits will be allocated to one or more funds selected by the contract holder with the assistance of a life insurance licensed representative. The contract will be based on the life of a person, called an annuitant, who is named by the investor in the application.
The most important feature of segregated funds contracts is that they allow contract holders to participate in the potential growth in the financial markets while at the same time, the contract guarantees certain payments to contract holders or their beneficiaries as a buffer against the downside risks experienced in these markets from time to time.
There are two basic benefits which are guaranteed in segregated funds contracts: one is a deposit maturity guarantee and the other is a death benefit guarantee.
Deposit maturity guarantee
The deposit maturity guarantee is applicable on the deposit maturity date, which is generally on the tenth anniversary of the investor’s deposit. The issuer of the contract guarantees that the value of the investor’s units will be no less than the guaranteed minimum amount, which, depending on the terms of the specific segregated funds contract, will be between 75% and 100% of the original amount deposited. While most contracts are for a 10-year period, some segregated funds require deposits to be made for at least 15 years to qualify for the 100% guarantee.
The deposit maturity guarantee will be subject to reduction if the contract holder has made cash withdrawals during the 10-year contract. Naturally, investors are hopeful that market conditions over a 10-year period will have trended upward. If the segregated funds chosen by the investor have indeed fared well, the contract will mature at an amount higher than the original amount deposited and a new guaranteed minimum amount will be established for the next 10-year period.
One of the features of some segregated fund contracts is a “reset feature.” With certain exceptions for contract holders that are beyond the eligible age, a contract holder can reset the clock and lock in gains in favourable markets. In this way, a higher guaranteed minimum amount is established for the investor, but then a further 10-year period is commenced in respect of the deposit maturity guarantee.
Death benefit guarantee
The other guarantee available in a segregated funds contract is a death benefit guarantee. This guarantee usually provides that, upon written notification of the death of the annuitant, the beneficiary is entitled to receive the greater of the market value of the policy, or 75% or 100% of the net deposits, less proportionate market value reductions for withdrawals and fees. Accordingly, if market conditions at the time of death of the contract holder are less favourable than at the time of the deposit, the contract issuer will top up the value of the contract to the deposit value, less applicable service charges.
In addition to the two basic benefits guaranteed in segregated funds contracts, there are two important features of segregated funds contracts that investors should be aware of. The first feature is potential Creditor Protection, and the second is the opportunity to avoid estate administration taxes.
Protection from creditors
Creditor protection may be possible because provincial insurance laws provide that life insurance contracts, including annuity contracts such as segregated funds, may be exempt from seizure by creditors if the owner has designated certain related persons as the beneficiary of the contract. The beneficiary can be a spouse, child, parent or grandchild of the annuitant. However, since creditor protection may be lost under certain circumstances, it is advisable to discuss your individual situation with a lawyer.
Avoidance of estate administration taxes (probate fees)
The second feature that attracts many investors to segregated funds is the opportunity to avoid estate administration taxes, formerly known as probate fees. If the death benefit is paid directly to a beneficiary, it is not included as part of the estate of the contract holder and accordingly, provincial estate administration taxes on this amount may be avoided. Once again, this may depend on whether the contract is held in the name of the individual or as part of a trusteed registered plan and legal advice should be sought to determine if estate administration taxes can be avoided.
The specific terms of the guarantees and other features important to investors vary from contract to contract. Careful regard should be had to the terms set out in the Information Folder for the segregated funds that the investor is contemplating. The Information Folder must be supplied to any prospective purchaser of segregated funds.
The segregated funds contract may be registered as a Registered Retirement Savings Plan or a Registered Income Fund under the Income Tax Act, in which case the contract holder must also be the annuitant. In addition, the contract may be designated as a locked in RRSP or locked in retirement account, or a life income fund under certain pension legislation.
Before investing in segregated funds, whether for registered retirement savings plans or otherwise, one should review the sales and management fees along with all other terms contained in the information folder. A life insurance licensed advisor should be able to satisfactorily answer questions before you sign the application.
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