Chapter 20. Segregated Funds and Other Insurance Products CSI GLOBAL EDUCATION INC. (2013) 20 1

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1 Chapter 20 Segregated Funds and Other Insurance Products 20 1

2 20 Segregated Funds and Other Insurance Products CHAPTER OUTLINE What are the Different Segregated Fund Features? Maturity Guarantees Death Benefi ts Creditor Protection Bypassing Probate Cost of the Guarantees Bankruptcy and Family Law Comparison to Mutual Funds How are Segregated Funds Taxed? Impact of Allocations on Net Asset Values Tax Treatment of Guarantees Tax Treatment of Death Benefi ts How are Segregated Funds Regulated? Monitoring Solvency The Role Played by Assuris What are other Insurance Products? Guaranteed Minimum Withdrawal Benefi t Plans Portfolio Funds Summary 20 2

3 LEARNING OBJECTIVES By the end of this chapter, you should be able to: 1. Identify and describe the various features of segregated funds. 2. Describe the tax considerations of investing in segregated funds. 3. Discuss the regulation of segregated funds, including the role played by OSFI, Assuris and other regulatory agencies. 4. Describe the features of guaranteed minimum withdrawal plans and other insurance products. ROLE OF INSURANCE PRODUCTS Segregated funds are unique in that they are insurance-based investment products with special features and benefi ts. Although they share many similarities with mutual funds, the insurance features make them quite different. In the previous chapter we learned about the features and risks of investing in mutual funds. Investors must realize that the value of their investment can certainly increase when markets do well, but if markets do poorly or if the fund is poorly managed, there is also the opportunity for loss. Segregated funds give you the upside potential of market gains, but also in certain circumstances protect you from the loss of your investment. Because one needs to be a licensed life insurance agent to sell segregated funds in Canada, this chapter provides you with an overview of the product, including the features and benefi ts and some of the background needed to assess the tax and regulatory aspects of investing in segregated funds. Understanding the risk and return characteristics of the different types of funds is important and necessary to make an intelligent, well-informed and effective decision on the type of product to invest in. 20 3

4 KEY TERMS Allocation Annuitant Assuris Benefi ciary Canadian Life and Health Insurance Association Incorporated (CLHIA) Contract holder Creditor protection Death benefi t Guaranteed minimum withdrawal benefi t plans Individual variable insurance contracts (IVICs) Insurable interest Irrevocable benefi ciary Maturity guarantee Notional units Probate Reset Revocable benefi ciary Segregated fund 20 4

5 TWENTY SEGREGATED FUNDS AND OTHER INSURANCE PRODUCTS 20 5 WHAT ARE THE DIFFERENT SEGREGATED FUND FEATURES? Segregated fund contracts and other widely held investment funds offer professional investment management and advice, the ability to invest in small amounts, regular client statements, and other services. They combine investments and related services in an integrated package. In the case of segregated fund contracts, investments and certain elements of insurance contracts are combined. Segregated funds, however, also have unique features that enable them to meet special client needs, such as maturity protection, death benefits and creditor protection. Unlike other types of investment funds, segregated funds are regulated by provincial insurance regulators because they are insurance contracts contracts known as individual variable insurance contracts (IVICs), between a contract holder and an insurance company. It is worthwhile noting that individuals must be licensed to sell life insurance in order to sell segregated funds. Because of the insurance benefits they offer, segregated funds are more expensive than uninsured funds, particularly in the form of higher MERs, an important point to consider when advising on or investing in a segregated fund. Because of their legal structure, segregated funds do not issue actual units or shares to investors, since this would imply ownership. Instead, an investor is assigned notional units of the contract, a concept that measures a contract holder s participation and benefits in a fund. This concept also makes it possible to compare the investment performance of segregated funds with those of mutual funds. Essentially, the contract covers the following three parties: The Contract Holder The person who bought the contract. A segregated fund contract can be held within registered plans such as RRSPs, RESPs and RRIFs. When the contract is held outside a registered plan such as an RRSP, the contract holder does not have to be the person whose life is insured by the contract. When the contract is held in a registered plan, the contract holder and the annuitant must be the same person. The Annuitant The person on whose life the insurance benefi ts are based. There are restrictions on whose life a contract holder can base a contract. The general rule in most provinces is that the contract holder, at the time that the contract is signed, must have an insurable interest in the life or health of the annuitant. Otherwise, the proposed annuitant must consent in writing to have his or her life insured.

6 20 6 CANADIAN SECURITIES COURSE VOLUME 2 The Beneficiary The person who will receive the benefi ts payable under the contract upon death of the annuitant. (A contract may have more than one benefi ciary.) The contract holder may designate one or more benefi ciaries, or may designate his or her estate as the benefi ciary. The benefi ciary does not have to be a person. It could, for instance, be a charitable organization. A revocable designation offers greater fl exibility, because the contract holder can alter or revoke the benefi ciary s status. In the case of an irrevocable designation, the contract holder cannot change the rights of a benefi ciary without the benefi ciary s consent. Maturity Guarantees One of the fundamental contractual rights associated with segregated funds is the promise that the contract holder or the beneficiary will receive at least a partial guarantee of the money invested. In fact: Provincial legislation requires that the maturity guarantee be at least 75% of the amount invested over a contract term of at least a ten-year holding period or upon the death of the annuitant. To offer greater capital protection, many insurers have increased the minimum statutory guarantee to 100% of the amount invested. The 100% guaranteed funds feature higher management expense ratios than the 75% guaranteed funds, reflecting the higher risks of offering full maturity protection after ten years. These guarantees whether full or partial appeal to people who want specific assurances about their potential capital loss. With a maturity guarantee, a client may participate in rising markets without setting a limit on potential returns. At the same time, subject to the ten-year holding period, the client s invested capital is protected from loss. AGE RESTRICTIONS Insurance companies offering ten-year maturity guarantees that exceed the statutory requirement of 75% may impose restrictions on who qualifies for the enhanced guarantee. Example: The restriction might be that the individual on whom the death benefi ts are based must be no older than 80 at the time that the policy is issued. Alternatively, the purchaser might receive a reduced level of protection under the policy once he or she reaches a certain age. RESET DATES Although segregated fund contracts have at least a ten-year term, they may be renewable when the term expires, depending on the annuitant s age. If renewed, the maturity guarantee on a tenyear contract would reset for another ten years. A reset allows contract holders to lock in the current market value of the fund and set a new ten-year maturity date.

7 TWENTY SEGREGATED FUNDS AND OTHER INSURANCE PRODUCTS 20 7 Reset dates can be anywhere from daily to once a year. The daily reset feature benefits clients in rising or falling markets. In a rising market, when the net asset value of fund units is increasing, daily resets enable contract holders to continually lock in accumulated gains. In a falling market, when net asset values are falling, contract holders will also be protected, because the guarantee is based on the previous high. Table 20.1 provides a simplified example of how the daily reset works when the market value of a fund s assets is either rising or falling: TABLE 20.1 DAILY RESET VALUES Date Accumulated Value Guaranteed Maturity Value Impact of Reset New Maturity Date Jan. 4, 2013 $10,000 $10,000 None Jan. 4, 2023 Jan. 5, 2013 $9,900 $10,000 Protects against $100 market loss Jan. 6, 2013 $10,125 $10,125 Locks in $125 market gain Jan. 5, 2023 Jan. 6, 2023 Death Benefits The death benefits associated with segregated funds meet the needs of clients who want exposure to long-term asset classes while ensuring that their investments are protected in the event of death. The principle behind the death benefits offered by a segregated fund is that the contract holder s beneficiary or estate is guaranteed to receive payouts amounting to at least the guaranteed amount, excluding sales commissions and certain other fees. The amount of the death benefit is equal to the difference, if any, between the guaranteed amount and the net asset value of the fund at death. Table 20.2 illustrates the death benefits when the market value of the units held in the segregated fund is below, the same as, or higher than the original purchase price. To simplify the illustration, it is assumed that the fund has been held long enough that any deferred sales charges are no longer applicable. TABLE 20.2 DEATH BENEFITS Guaranteed Amount Market Value at Death Death Benefit Total Amount Paid to Beneficiary $10,000 $8,000 $2,000 $10,000 $10,000 $9,000 $1,000 $10,000 $10,000 $10,000 None $10,000 $10,000 $11,000 None $11,000

8 20 8 CANADIAN SECURITIES COURSE VOLUME 2 As the table shows, death benefits are paid only when the market value of the fund is below the guaranteed amount. When the market value of the segregated fund at death is $9,000, the beneficiary will receive the market value and a death benefit payment of $1,000 above the market value. Therefore, in addition to the payment of the $9,000 market value of the fund, the total payment to the beneficiary is $10,000. When the market value at death is above the guaranteed amount, there is no death benefit payable because the beneficiary receives the full market value of the investment which is higher than the guaranteed amount. Creditor Protection Segregated funds may offer protection from creditors in the event of bankruptcy. This protection is not available through other managed investment products such as mutual funds. Creditor protection is available because segregated funds are insurance policies. The fund s assets are owned by the insurance company rather than the contract holder. Insurance proceeds generally fall outside the provisions of bankruptcy legislation. Creditor protection can be a valuable feature for clients whose personal or business circumstances make them vulnerable to court-ordered seizure of assets to recover debt. Business owners, entrepreneurs, professionals or other clients who have concerns about their personal liability are among those who might welcome the creditor protection offered by a segregated fund. Example: Suppose that a self-employed professional died and left a non-registered investment portfolio of $300,000 and business-related debts of $150,000. If the portfolio were made up of mutual funds, creditors would have a claim on half of the portfolio, leaving only $150,000 for the surviving family members. In most provinces, except Québec, the estate would also be subject to probate fees based on the size of the estate. If the entire portfolio had been held in segregated funds, $300,000 would be payable directly to the deceased person s benefi ciaries. Creditors could claim nothing, and the benefi ciaries would receive their money promptly and without having to deduct a portion for probate fees. Creditor protection does not apply under all circumstances. In order for the assets held in the contract to be eligible for creditor protection, the purchase must not be made with the intention of avoiding potential creditor action, and a beneficiary must be named. Bypassing Probate Segregated funds can help clients avoid the costly probate fees levied on assets held in investment funds. Probate refers to the legal process of administering the estate of a deceased person. The ability to bypass probate is one of the key estate-planning advantages of segregated funds. Segregated fund contracts are not regarded as part of the deceased s estate. The proceeds of segregated funds pass directly into the hands of the beneficiaries. There is no waiting for probate to be completed. Nor can payment be delayed by a dispute over the settlement of the estate. Moreover, by passing assets directly to beneficiaries through a segregated fund, contract holders can ensure that their beneficiaries save on fees paid to executors, lawyers and accountants.

9 TWENTY SEGREGATED FUNDS AND OTHER INSURANCE PRODUCTS 20 9 Cost of the Guarantees In addition to the costs incurred by mutual funds, such as sales fees, switching fees, trailer fees and management expense ratios, segregated funds have added costs related to death benefits and maturity guarantees. Assessing the true value of the insurance in segregated funds is a difficult issue. Certainly the management expense ratios for segregated funds are higher than those of comparable mutual funds. Bankruptcy and Family Law Under federal bankruptcy law, segregated funds are not normally included in the property divided among creditors. For example, a bankruptcy trustee cannot change a beneficiary designation to make the proceeds of the contract payable to the contract holder s creditors. Under the federal Bankruptcy and Insolvency Act, the proceeds of a segregated fund may be subject to seizure if it can be proven that the purchase was made within a certain period before the bankruptcy, normally within one year. But if the client was legally insolvent when the contract was purchased, the segregated fund purchases could be challenged as far as five years back. Complete the following Online Learning Activity Segregated Funds Review Complete the Segregated Funds Review activity to learn more about the features of segregated funds. Comparison to Mutual Funds Table 20.3 highlights some of the key similarities and differences between segregated funds and mutual funds. TABLE 20.3 SIMILARITIES AND DIFFERENCES BETWEEN SEGREGATED FUNDS AND MUTUAL FUNDS Features Segregated Funds Mutual Funds Legal status Insurance contract Security Who owns assets of fund Nature of fund units Insurance company Units have no legal status, and serve only to determine value of benefi ts payable Fund itself, which is a separate legal entity Units are legal property which carry voting rights and rights to receive distributions

10 20 10 CANADIAN SECURITIES COURSE VOLUME 2 TABLE 20.3 SIMILARITIES AND DIFFERENCES BETWEEN SEGREGATED FUNDS AND MUTUAL FUNDS Cont d Features Segregated Funds Mutual Funds Who regulates their sale Who issues them Main disclosure document Provincial insurance regulators Mainly insurance companies; also a small number of fraternal organizations Information folder Provincial securities regulators Mutual fund company Prospectus How often valued Usually daily, and at least monthly Usually daily, and at least weekly Redemption rights Required fi nancial statements Sellers qualifi cations Maturity guarantees Government guarantees Protection against issuer insolvency Death benefi ts Creditor protection Probate bypass Right to redeem is based on contract terms Audited annual fi nancial statement Licensed life insurance agents; BC, Saskatchewan and PEI also require successful completion of a recognized investment course, such as those offered by the CSI, IFIC or potentially by CAIFA Minimum of 75% of deposits after 10 years. Companies may offer guarantees up to 100% None Assuris, a not-for-profi t organization, provides up to $60,000 per policyholder per institution in compensation against any shortfalls in policy benefi ts resulting from the insolvency of a member fi rm (restricted to death benefi ts and maturity guarantees) Yes, may be subject to age or other restrictions Yes, under certain circumstances Yes, proceeds of contract held by deceased contract holder may be passed directly to benefi ciaries, avoiding probate process Redeemed upon request Audited annual fi nancial statement and semi-annual statement for which no audit required Licensed mutual fund representatives or registered brokers None None The Mutual Fund Dealer Association (MFDA) Investor Protection Corporation (IPC), a not-for-profi t corporation, provides protection up to $1,000,000 to eligible customers of MFDA members as a result of a member s insolvency None None None

11 TWENTY SEGREGATED FUNDS AND OTHER INSURANCE PRODUCTS Complete the following Online Learning Activity Comparison between Segregated Funds and Mutual Funds Review and print this Comparison between Segregated Funds and Mutual Funds summary sheet. HOW ARE SEGREGATED FUNDS TAXED? Segregated funds are insurance contracts, but are taxed as if they were trusts. The insurance company itself, which is the legal owner of the assets of the segregated fund, does not pay taxes on income earned by the fund. The fund s net income whether in the form of dividends, capital gains or interest is deemed to be the contract holder s income. In non-registered accounts, this income is taxable in the current year. The amount of income deemed to have been earned by each contract holder is calculated using a procedure known as allocation. A percentage of the fund s total income is allocated to each unit, according to the terms of the segregated fund contract. Most funds allocate income to a contract holder based on the number of units held, and the proportion of the calendar year during which those units are held. For instance, a segregated fund contract held for six months of the year would receive half the per-unit allocations accorded to a contract held for the full year. Impact of Allocations on Net Asset Values The different ways in which mutual funds and segregated funds flow through income to unit holders is reflected in what happens to the net asset values (NAV) of the funds. With a mutual fund: Net asset values fall when a distribution is made, because income and capital gains may accumulate inside the fund and are then paid out. Periodically (usually annually or quarterly), the mutual fund makes distributions to existing unit holders, each time deducting the value of the distribution from the fund s assets. The NAVPU declines by the amount of the distribution. Most distributions are reinvested in the fund, and the new units are issued to the unit holders. Therefore, although the NAVPU declines, the unit holder owns more units. With segregated funds: The fund does not suffer a decline in the NAV after an allocation of income. Instead, the segregated fund contract receives additional income, which is allocated to existing units.

12 20 12 CANADIAN SECURITIES COURSE VOLUME 2 In most cases, these allocations are held in the policy, though they may also be redeemed by the contract holder and received as cash. Although the calculation of the tax impact of the allocation method is beyond the scope of the course, we can say that: Segregated fund NAVPU is the same for all contract holders at any given point in time. The NAVPU at which an investor purchases a segregated fund varies depending on when during the year the fund is purchased. Income allocations do not reduce the NAVPU of a segregated fund. Segregated fund allocations per unit are paid throughout the year. One of the advantages of segregated fund contracts over mutual funds is the fact that capital losses, as well as capital gains, can be passed on to the contract holder. This is not true of mutual funds, where capital losses cannot be flowed through to unit holders. They must be kept in the fund and used in future years to offset capital gains. Tax Treatment of Guarantees Payments from a segregated fund contract s maturity guarantees are taxable. If the proceeds of the contract (after commissions) are less than the adjusted cost base, income tax is payable on the guaranteed amount. However, the contract holder can use the difference between the market value of the segregated fund and the adjusted cost base as a capital loss. The net effect is zero if the guarantee is considered to be a capital gain. If the guarantee paid is considered to be income, then the policyholder must pay tax on the full amount, but can use only 50% of any capital loss declared. If the proceeds exceed the adjusted cost base, the contract holder is taxed on the difference. The following examples illustrate the amount of tax payable under three different scenarios: Scenario I: The maturity value exceeds the original cost of the contract. Scenario II: The maturity value is less than the guaranteed amount. Scenario III: A reset provision has been used, making the maturity guarantee $30,000 higher than in the original contract. Resetting the maturity guarantee extends the policy over a new ten-year period. Even if the reset is used to lock in a capital gain, it does not constitute redemption and therefore does not trigger a taxable event. Under each scenario, it is assumed that $100,000 was invested in a lump sum on a deferred sales charge basis, and that the policy was held long enough that there are no redemption fees applicable when the policy is surrendered. The calculations are based on a 100% maturity guarantee.

13 TWENTY SEGREGATED FUNDS AND OTHER INSURANCE PRODUCTS EXHIBIT 20.1 Invested Amount Maturity Guarantee Market Value at Redemption Maturity Guarantee Paid Capital Gain Taxable Capital Gain Scenario I $100,000 $100,000 $130,000 $0 $30,000 $15,000 Scenario II $100,000 $100,000 $95,000 $5,000 $0 $0 Scenario III $100,000 $130,000 $110,000 $20,000 $30,000 $15,000 Scenario I Client redeems $100,000 deposit after ten years for proceeds of $130,000. The market value of the policy at maturity exceeds the adjusted cost base. Tax consequences: 50% of the capital gain of $30,000 is taxable in the year of redemption. Scenario II Client redeems $100,000 deposit after ten years for proceeds of $95,000 in current market value. Since the net market value at maturity is less than the adjusted cost base, the client is paid $5,000 as the maturity guarantee. Tax consequences: The maturity guarantee of $5,000 is taxable as a capital gain, but it is reduced to $0 by the $5,000 capital loss incurred because the client s $100,000 deposit is now worth only $95,000. Scenario III Client chooses to reset the maturity guarantee after five years, locking in the gain in market value to $130,000 and extending the policy. Ten years after the reset date, the policy matures at a market value of $110,000. The client receives a $20,000 maturity guarantee, for total proceeds of $130,000. Tax consequences: No capital gains liability is triggered at the time of the reset. However, at the time of redemption (15 years after the original deposit), the capital gain of $30,000 ($10,000 from the increase in market value and $20,000 from the maturity guarantee) is taxable in the year in which it is paid out. These are very simplified examples, as they assume there were no distributions paid by the issuing company over the period specified. In reality, distributions would likely be paid every year. Tax is paid on these distributions in the year that they were paid and cannot be taxed twice. Fortunately, the issuing company keeps track of these distributions and the adjusted cost base is reported on the recipient s T3 slip.

14 20 14 CANADIAN SECURITIES COURSE VOLUME 2 Tax Treatment of Death Benefits When the insured person dies, the contract is terminated and the beneficiaries receive the market value of the segregated fund plus death benefits, if any. If the contract holder is not the same person as the annuitant, the contract remains in force when the contract holder dies, but the deceased owner is deemed to have disposed of the contract at fair market value. This deemed disposition will normally trigger a capital gain or a capital loss. If the contract holder took advantage of the provision allowing his or her spouse to be named as the successor owner, the contract can be transferred to the spouse at its adjusted cost base, thereby deferring any capital gains liability. If the contract owner and annuitant is the same person, the gain or loss will be reflected on the owner s terminal tax return for the year of death. Example: A client purchases a segregated fund contract for $100,000. The contract provides for a 100% guarantee at death. Five years later, the client dies. At the time of the client s death, the market value of the segregated fund is $80,000. The death benefi t payment would be $20,000. Assuming the fund was held in a non-registered plan, the client would report a $20,000 gain, but the client would also have an offsetting capital loss of $20,000. Because the fund declined from $100,000 to $80,000, there would be no tax impact as the two would cancel each other out. HOW ARE SEGREGATED FUNDS REGULATED? For the most part, segregated fund contracts are subject to the provincial legislation governing all life insurance contracts. Each province and territory has accepted the Canadian Life and Health Insurance Association Inc. (CLHIA) guidelines as the primary regulatory requirements. Federal insurance regulators do not regulate the sale of segregated funds. Monitoring Solvency The Office of the Superintendent of Financial Institutions (OSFI) is responsible for ensuring that federally regulated insurance companies are adequately capitalized under the requirements of the federal Insurance Companies Act. OSFI s key requirements for segregated fund contracts include: The maturity guarantee payable at the end of the term of the policy cannot exceed 100% of the gross premiums paid by the contract holder. (This rule also applies to contracts carrying reset features, which allow the contract holder to lock in gains and set a new ten-year term to maturity.) The initial term of the segregated fund contract cannot be less than ten years. There can be no guarantee of any amounts payable on redemption of the contract before the annuitant s death or the contract maturity date.

15 TWENTY SEGREGATED FUNDS AND OTHER INSURANCE PRODUCTS The Role Played by Assuris Assuris is the insurance industry s self-financing provider of protection against the loss of policy benefits in the event of the insolvency of a member company. Assuris is financed by assessments levied on its members, and is incorporated federally as a nonprofit organization. The federal government, along with most provinces, requires life insurers to be members of Assuris and to pay its levies. The Assuris guarantee covers only the death benefits and maturity guarantees in a segregated fund contract. The assets of the funds themselves are not eligible for Assuris protection, because they are segregated from the general assets of the insurance company. Segregated fund holders therefore enjoy a built-in form of protection against an insurance company s insolvency. Assuris role is to top up any payments made by a liquidator to fulfill the insurance obligations under a segregated fund contract. The maximum compensation that can be awarded under an individual segregated fund policy is up to $60,000 or 85% of the promised guaranteed amounts, whichever is higher. These limits apply both to amounts held by individuals in registered plans, such as RRSPs, RRIFs and life income funds, and to contracts held outside registered plans. Complete the following Online Learning Activity Segregated Fund, Features and Tax Considerations Segregated funds and mutual funds are different in many ways: structure, benefi ts, costs, tax treatment, distribution and regulation. Sometimes one fund is more appropriate than another fund for a given client. Under which circumstances is one fund more appropriate than the other? In these activities, you will test your understanding of segregated funds. Complete these Scenarios and True and False activities. WHAT ARE OTHER INSURANCE PRODUCTS? In the past, segregated funds were the domain of insurance companies. Recently, the entry of mutual fund companies and the growing popularity of segregated funds for investors have led to significant product expansion in segregated funds. The result has been variations of and enhancements to the basic structure of the traditional segregated fund contract.

16 20 16 CANADIAN SECURITIES COURSE VOLUME 2 Guaranteed Minimum Withdrawal Benefit Plans When clients near their retirement, losses in their portfolio can be particularly serious. Earlier in the investment cycle, good years can balance off bad years, but in retirement the extra return from later good years can be lost, since part of the portfolio has to be withdrawn for income. To counter the risk of retirement funds being impaired by a few bad years at the wrong time, insurance companies have developed guaranteed minimum withdrawal benefit (GMWB) plans. A GMWB is similar to a variable annuity. With a variable annuity the amount of monthly payment to the annuitant varies according to the value of the investments in a segregated fund into which premiums are placed. Many variable contracts provide a floor below which benefits may not fall. The floor for benefits is usually equal to 75% of premiums paid, regardless of what happens to the value of the variable annuity fund. GMWB plans provide a guaranteed minimum annual payout typically 5% to 7% of the amount invested no matter how the investments perform. Every three years, throughout the term of the plan, if the underlying fund has increased in value, the guaranteed amount is reset upwards. If the investment value is reset higher, the guaranteed payout increases or the plan withdrawal schedule is extended. If the investment value drops, however, the payout amount is guaranteed and cannot be reduced. GMWB plans are a combination of investments and insurance. They can be bought in lump sum by transferring registered or non-registered savings plans to the GMWB. The insurance company then provides a variety of investment funds to choose from. The underlying investments can be based on a variety of indexes, funds, etc. These plans have another advantage besides guaranteeing principal repayment and the possibility of sharing in the increased value of a mutual fund an annual 5% guaranteed bonus allocated to the account for each calendar year that the client does not make any withdrawals. Example: If a client buys the plan several years before withdrawals begin, the guarantee increases by a 5% bonus each year until withdrawals start, even if the fund decreases in value. During this period, if the market rises, the three-year reset is in effect. This reset compounds the value of the 5% increases in the guarantee. If a client starts to take payments immediately after purchasing the plan, she will be susceptible to earlier losses in the portfolio. In other words, she may never be able to receive more than the principal repayment. It is necessary to purchase the plan several years in advance of withdrawal, in order to build up the guarantee. The bonuses come in those years regardless of the behaviour of the underlying fund. These plans are especially suitable for clients with 5 to 10 years to retirement, who cannot afford significant losses in their portfolio during that time. These clients also want to be able to share in the growth of selected financial markets.

17 TWENTY SEGREGATED FUNDS AND OTHER INSURANCE PRODUCTS GMWB plans provide the potential for growth but with a guaranteed income floor that provides a secure income stream as a base. The income stream can also be assured for the life of the investor. This provides further peace of mind, knowing that the investment can provide income for life. GMWB plans come with fees levied to manage the underlying mutual fund(s) and fees levied to fund the GMWB guarantee. The investor may have to pay sales charges when depositing or withdrawing from the contract depending on the sales charge option of the fund(s) chosen. During the course of 2012, several insurance companies signifi cantly modifi ed their GMWB plans, many also suspended the sales GMWB due to adverse market conditions. Portfolio Funds Portfolio funds, which invest in other funds instead of buying securities directly, allow investors to hold a diversified portfolio of segregated funds through a single investment. The responsibility for choosing or rebalancing the asset mix usually rests with the fund company. Management expenses for portfolio funds are generally higher than for stand-alone segregated funds and guaranteed investment funds, because the investor pays for the asset allocation service, on top of the management costs for the underlying funds.

18 20 18 CANADIAN SECURITIES COURSE VOLUME 2 SUMMARY 1. Identify and describe the various features of segregated funds. A segregated fund is a life insurance product that shares many similarities with mutual funds. The insurance component offers such features as maturity protection, death benefits and creditor protection. The contract holder is the person who bought the segregated fund contract. The annuitant is the person on whose life the insurance benefits are based. The beneficiary is the person or persons who will receive the benefits payable under the contract on the death of the annuitant. In registered plans only, the contract holder and the annuitant must be the same person. Provincial regulations require that beneficiaries receive a guarantee of at least 75% to a maximum 100% of the return of the money invested over a contract term of at least a ten year holding period. Depending on the annuitant s age, the contract may be renewable when the term expires. If renewed, the maturity guarantee on a ten-year contract would reset for another ten years. If a contract holder dies, the holdings in the fund bypass probate and pass directly to the beneficiaries. Creditor protection is available because segregated funds are insurance policies. The fund s assets are owned by the insurance company rather than the contract holder, and insurance proceeds generally fall outside the provisions of bankruptcy legislation. To benefit creditor protection, the purchase must not be made with the intention of avoiding potential creditor action, and a beneficiary must be named. The management expense ratio (MER) on a segregated fund is typically higher than that on a comparable mutual fund because of the insurance components. 2. Describe the tax considerations of investing in segregated funds. Net income earned from a segregated fund is deemed to be the contract holder s income and is taxable in the current year. The appropriate percentage of the income is allocated to the contract holder, generally based on the number of units held and the proportion of the calendar year in which the units were held. The allocations are reported annually on a T3 slip, although they are made throughout the year.

19 TWENTY SEGREGATED FUNDS AND OTHER INSURANCE PRODUCTS Payments from maturity guarantees are taxable. The amount taxed is the proceeds, less sales charges, minus the cost of the contract (which is the original amount deposited plus any allocations). 3. Discuss the regulation of segregated funds, including the role played by OSFI, Assuris and other regulatory agencies. Generally, segregated fund contracts are subject to the provincial legislation governing life insurance contracts, but there are some differences between jurisdictions. The contracts are subject to the guidelines on guarantee provisions of The Office of the Superintendent of Financial Institutions (OSFI). In the case of insolvency of a fund, Assuris guarantees cover the death benefits and maturity guarantees of the fund contract and will top up any payments made by a liquidator to fulfill these insurance obligations. All communications considered advertisements are governed by Canadian Life and Health Insurance Association (CLHIA) guidelines. 4 Describe the features of guaranteed minimum withdrawal plans and other insurance products. Guaranteed minimum withdrawal plans are similar to variable annuities in that the amount of the monthly payment varies according to the value of investments. The GMWB option gives the planholder the right to withdraw a certain fixed percentage of the initial deposit every year until the entire principal is returned, no matter how the fund performs. Portfolio funds invest in other funds instead of buying securities, thus allowing investors to hold a diversified portfolio of segregated funds through a single investment.

20 20 20 CANADIAN SECURITIES COURSE VOLUME 2 Online Frequently Asked Questions CSI has answered many frequently asked questions about this Chapter. Read through online Module 20 FAQs. Online Post-Module Assessment Once you have completed the chapter, take the Module 20 Post-Test.