A Hidden Treasure in the Financial Planning Arsenal

When most investors and business owners hear the words insurance products, they think of life insurance and annuities and group benefit plans.

Most don’t realize that insurance companies now offer products similar to mutual funds that can play an important role in the construction and management of their investment and retirement assets.

Investors — particularly business owners using stock portfolios, mutual funds, or fee-based investment accounts — have always had two special concerns. First, will their investments have creditor protection should their business fail, and second, other than bonds and GICs, are there any products that provide them with a guarantee on their principal? Well, with segregated funds, the answer is yes to both questions. Plus, proceeds from segregated fund death benefits bypass the estate, avoid probate fees, and reduce possible estate legal challenges upon the death of the annuitant.

Probably the most common question that arises is what are segregated (or “seg” for short) funds? Segregated funds offered by insurance companies are technically insurance policies known as variable annuity contracts. The investment performance is tied to underlying investment funds offered by the issuer. The initial term is usually 10 years, but provisions allow the contracts to be extended should market conditions prove favourable. In essence, an investor enters into a contract with an insurance company that will provide the client with a full principal guarantee on death and a contractual guarantee of either 75 per cent or 100 per cent of the principal as a living benefit.

For example, if a client purchased a $100,000 segregated fund on December 1, 1999, in an equity fund, on December 1, 2009, the client would have been guaranteed a minimum value of $100,000 even though the market value of the underlying fund might have been significantly lower than the original principal, thus preserving the capital of the living benefit. In addition, had the client died at any time after December 1, 1999, the client’s beneficiaries would have received the higher of the market value or the $100,000 death benefit guarantee. Under a 75 per cent market guarantee example, the end value would have a minimum of $75,000.

{advertisement} Segregated funds also have a reset option that allows the holder of the contract to increase the value of the guaranteed portion, usually twice a year, or, in some cases, automatically each year by the insurance company. This means that the original $100,000 investment could theoretically provide the client with increasing guaranteed protection by taking advantage of rising equity markets. Death benefit guarantees are similar except generally no minimum time frame is required for the guarantee to apply — it’s triggered upon death.

Seg funds allow investors to choose from a wide range of equity and fixed income funds and, like mutual funds, seg funds have ongoing management fees. These fees have two main components: management/operating expenses and the insurance premium to cover the capital protection mentioned above. The sum of the two equals the total seg fund fees, generally higher than fees for mutual funds because the insurer has to set aside a reserve out of the insurance premiums in the event of a death claim, as well as the 10-year market-value guarantee. Net of expenses, seg fund performances can provide investors with an attractive rate of return.

Seg funds may not be an ideal investment vehicle for all investors but are well designed for many investor situations. Many business owners risk personal losses in the event of the failure of their business. By choosing seg funds for their personal investments, business owners can make creditor-proof their personal investment assets in the event of bankruptcy or lawsuits against the business owner. However, one limitation needs to be mentioned: the contract must be established at least one year prior to the onset of a business failure or lawsuit.

The second-best application is the family estate-planning benefits. In an age where divorce is commonplace and second marriages equally so, the fair division of family assets along pre-existing lines can be protected through the use of segregated funds. For example, a client came to us recently citing a situation in which his first wife remarried and subsequently died. Her share of the original family assets became the property of her new spouse with no financial benefits passing on to her adult children.

As another example, with mixed marriages and mixed offspring, challenges to the family and business assets can arise upon the death of one or both spouses. The distribution of assets, if seen as unfair by any one of the beneficiaries, can be challenged through the Wills Variation Act, disrupting any original intent of distribution of the assets. In other words, it only takes one offspring to spoil the party and seg funds provide a solution by protecting the pre-existing lines of inheritance.

For estate planning purposes, seg funds do not form part of the will as they are a private contract between an insurance company, the annuitant, and the beneficiaries, thus avoiding public scrutiny and probate fees that can be substantial in a large estate. In addition, seg funds can reduce potential complications and administrative duties of the executors once the annuitant dies. Some view estate planning matters as a necessity for elderly clients; however, the use of seg funds should be especially considered as an option by those individuals in their pre-retirement years.

Segregated funds are not for everyone; however, they are a key tool used in the financial planning process that should not be overlooked. Investors and business owners typically buy professionally managed investment funds to grow their retirement assets. For those who wish the added protection of an insurance guarantee or a means of simplifying intergenerational wealth transfers, the segregated fund approach gives them the performance with the added benefits of an insurance wrapper. These products are implemented into the investment planning process but only by professionals licensed to advise on insurance.

Ian David Clark and Steve Bokor are insurance advisors with PI Financial Services Corp.