Clients Want to Know: “What Are the Different Types of Investments?”

Clients want to know: “What are the different types of investments?”

After reading this, you should understand:  The different types of investments from which your client can choose

The Right Investment Account

Before investing can begin, an account must be opened to which the investor deposits the money he or she has earmarked for investment. There are two types of accounts in which investments can be made. You have been introduced to registered accounts earlier in this module, and will learn about them in depth in the Retirement module. It is important to know that contributions to registered accounts are strictly limited, and overcontribution results in harsh penalties.

When an investor has maximized his or her registered plan contributions, he or she will turn to non-registered accounts for investing. All categories of investments are available on a non-registered basis. The investor with non- registered investments will declare all interest, dividends, and capital gains or losses every year in his or her income-tax return.

However, the non-registered account owner has one advantage not available to the registered plan owner: he or she can deduct from income tax any interest charged on a loan acquired in order to invest.

Scott borrowed $25,000 last year to buy shares in his brother’s company. He is able to deduct the interest on the loan charged during the year on his income- tax return for the year.

LLQP

Types of Investments

There are several categories of investments available, each with its own risk- return characteristics. These categories are: Cash; Debt investments; Equity investments; Managed investments; Annuities.

Each investment category is comprised of securities that share many similarities. However, it is their differences that form the basis for the concept of diversification, or asset allocation.

Diversification simply means not putting ―all of your eggs in one basket.‖ Diversifying savings across types of investments lessens risk.

Guaranteed Cash Investment The most conservative category of investments is cash. Cash includes all short- Certificates (GICs) Interest-paying term interest-bearing investments, such as savings accounts, Guaranteed investments in which principal and interest Investment Certificates (GICs), and term deposits. are guaranteed

Term deposit Short-term investments are generally considered to be investments that are held A term deposit is a deposit to a savings for three years or less. account for a set period of time. Savings accounts are provided by banks and trust companies. Deposits earn interest at the rate posted by the institution. The rate will move up and down according to the general economic climate. Of course, one of the great advantages of savings accounts is the speed and ease with which withdrawals can be made (liquidity). Bank savings accounts can be accessed at any time, either personally at a bank branch, electronically through an ATM, or online by means of a computer account.

Guaranteed Investment Certificates (GICs) and term deposits are certificates of deposit.

GICs guarantee principal and interest. The interest rate is fixed for the term of the Equity securities Stock, both common GIC (up to 10 years), unless a portion of the return is linked to either a Canadian and preferred or global stock market index. This form of GIC is called an index-linked GIC. It combines the safety of a deposit with the growth potential of an equity

security.

Types of Investments

GICs are available from insurance companies, banks, and trust companies as Redeemable A redeemable redeemable and non-redeemable investments. Non-redeemable GICs cannot investment can be be cashed before maturity, unless the owner suffers extreme financial hardship converted to cash. or dies. Sometimes banks will allow a client to cash a GIC or term deposit for a fee, which is often presented in the form of a lower interest rate.

Both redeemable and non-redeemable GICs are transferable.

GICs are RRSP-eligible, and they can be used as collateral for a loan.

The return on all GICs is considered interest income for tax purposes.

Compound-interest GICs and term deposits normally cannot be redeemed until the expiration of the term.

An index-linked GIC will have a portion of its return linked to a stock-market index. That portion of the Fixed-income return is variable. securities An investor makes a lump sum investment in a fixed-income security and typically What is not a key difference between “redeemable” and “non-redeemable” deposits? receives interest (an income stream) and,

at the end of a A Capital liquidity specified term (the B Contractual rate of return maturity date) they C Premature redemption fees receive the principal D Capital guarantee (the maturity value).

Treasury bills Short-term Debt Investments investments issued by the federal Debt investments are known as fixed-income securities. The most common government. fixed-income securities are: Bonds Canada Savings Bonds; Represent a debt of a government or Treasury bills; and corporation to the bondholder. Bonds.

A fixed-income security is like holding an IOU. There is a borrower and a lender, and the investor is the lender. The borrower is called the issuer. The issuer of the security promises to repay the lender the principal on a specified date, and to pay interest at set amounts and on set dates.

Issuers of fixed-income securities include governments at all levels within Canada, foreign governments, and corporations.

Canada Savings Bonds (CSBs) Canada Savings Bonds (CSBs) are issued by the federal government. They may be purchased (at capped limits) by individuals, estates, and certain trusts, and offer regular or compound interest. A minimum interest rate is guaranteed for one or more years, depending on the issue. Some issues have higher interest rates in the initial year(s) than in the later years, but the interest rate for later years can be set higher by the government.

CSBs are available in denominations from $100 (for a compound interest bond) to $10,000. They can be cashed at any bank at any time. They do not rise or fall in price and may always be cashed at their full par value, plus interest. Purchasers must be Canadian residents with a Canadian address. CSBs can be used as collateral.

CSBs are on sale from October to April. If a CSB is cashed within three months of its issue date, the holder receives face value without interest. If cashed after three months of issue, the holder receives interest for each fully elapsed month from the issue date.

Canada Savings Bonds are available for purchase via payroll deduction, as well as through financial institutions.

CSBs are attractive in uncertain markets because of competitive interest rates and their liquidity. They are available for purchase by cash or payroll deduction.

Regular-interest CSBs pay interest annually, either by cheque or deposit, on each annual anniversary. Compound-interest CSBs accumulate simple and compound interest that is paid at redemption or on maturity. Both compound-interest bonds and regular-interest bonds may be exchanged for each other under specified conditions.

Canada Savings Bonds can be redeemed in person at any bank or trust company on any regular business day.

See: www.csb.gc.ca

Treasury Bills (T-bills) Treasury bills (T-bills) are also issued by the federal government. They are short- term investments — say, terms of 91 or 182 days and a maximum of 365 days — issued in multiples of $1,000.

Treasury bills pay no interest, but are sold at a discount below the par, or face, Par Par is the face value, and mature at par. The return is the difference between the issue price and value of a treasury par at maturity. This return is taxable as income. bill or bond.

Treasury bills can be redeemed on any business day.

Canada Savings Bonds (CSB) and government-issued Treasury bills (T-bills) are often equated with cash. Which security offers the best liquidity?

A CSBs B T-bills C CSBs can be redeemed at any financial institution; T-bills have to be sold through a stockbroker or mutual fund dealer. D There’s no appreciable difference.

Bonds Bonds are issued by: All three levels of Canadian government (federal, provincial, and municipal); Corporations.

Government Bonds The federal government is the largest issuer of bonds in Canada. Federal government bonds are available in multiples of $1,000. Bonds either have coupons attached, which can be detached and cashed, or have interest paid by cheque. When the coupons have been removed from the bond, it is called a stripped bond.

The maturity dates for bonds are specified as money-market (due in less than 1 year), short-term (5 years to maturity), medium-term (5 to 10 years to maturity), and long-term (more than 10 years to maturity).

N.B. The government guarantees payment of the principal and interest on a government bond by its power of taxation.

Government of Canada Real Return Bonds are linked to the Consumer Price Index (CPI). Semi-annual interest and the final redemption value are calculated by an inflation compensation component. This means that the interest payment is calculated on the face amount of the bond, plus CPI since issue (or the last interest payment). The redemption value at maturity is the original face amount, plus inflation from issue date.

Government expenses, such as military spending, are supported by the issue of government bonds. Canadian government bonds are amongst the safest bonds issued

anywhere in the world. Investments Types of

Canada Premium Bonds are very similar to CSBs, but offer higher interest rates when issued. They may be redeemed without penalty only once a year, on the anniversary date of issue and during the 30 days following.

Currently, the government provides a RRSP option, in which Canada Savings Bonds and Canada Premium Bonds can be held as RRSPs. Existing Canada Savings Bonds and Canada Premium Bonds can be transferred into a RRSP or new purchases can be made in a RRSP account. There are no fees, and certificates for new purchases are not issued. The maximum purchase amount is $200,000 per type of registration.

Provincial bonds are issued as a means to fund public works, and are guaranteed by the province that issues them. These bonds are available in amounts of $500, $1,000, $5,000, $10,000, and $25,000, and are marketed through dealers and banks.

Most provinces also issue provincial Treasury bills and savings bonds. These can only be purchased by residents of the province at certain times of the year, and are redeemable every six months in all provinces except Quebec, where they can be redeemed at any time.

The different types of provincial savings bonds are: The step-up bond, in which the interest increases over time; The variable rate bond, in which interest varies; The fixed-rate bond, in which interest is fixed.

Savings bonds are RRSP-eligible and can be purchased in small denominations Debenture (e.g., $100). A debenture is a bond that is supported by the general credit- Most municipal bonds are term debentures (they mature at the end of the worthiness of the issuing corporation, term) or serial bonds (that is, a part of the bond matures each year over its term), rather than being and most are non-callable. secured by any specific asset(s).

Corporate Bonds Callable bond A callable bond can be A corporate bond is evidence of a corporate debt. Corporate assets are pledged as redeemed before the maturity date under security for the bond. certain conditions set by the issuer.

When a corporation issues a bond, it pledges assets, such as transportation equipment, as collateral.

Order the following from least to greatest risk: (1) corporate bonds, (2) debentures, (3) Government of Canada bonds, (4) “municipal bonds,” (5) provincial bonds.

A 3, 1, 2, 4, 5 B 5, 2, 4, 3, 1 C 3, 5, 4, 1, 2 D 3, 5, 4, 2, 1

Equity Investments While debt investments preserve capital and provide regular investment income in the form of fixed-interest payments, equity investments offer long-term growth or capital appreciation potential and little income. The two chief kinds of equity investments are equity-income securities and equity-growth securities.

Equity-Income Securities

Dividends A preferred share is a type of share that entitles the owner to a dividend (either Unlike dividends a fixed or floating dividend) ahead of any dividends paid to common received by the par policy owner, share shareholders and to a stated dollar amount per share in the event of corporate dividends are a return of a portion liquidation. However, there is no guarantee that the preferred shares will receive of company profits a dividend payment. to share owners.

There are different types of preferred shares, based on how dividends are paid.

With cumulative preferred shares, if the dividend is not paid in one year, the dividend may accumulate and roll over to another year. Non-cumulative preferred shares do not roll over.

Participating preferred shares pay the preferred dividend, plus the common share dividend. Convertible preferred shares may be converted to another type of share (usually common shares) of the corporation under certain conditions. Redeemable preferred shares may be redeemed at the corporation’s option at a set price and under certain conditions. Preferred shares offer modest growth and modest tax-preferred income.

Equity-Growth Securities Equity growth securities are designed to offer long-term capital appreciation potential.

Publicly traded companies issue common and preferred shares. A common share is a type of share that represents ownership in a company and has voting rights. Dividends are paid on common shares if declared by the board of directors of the company.

What is the key difference between a “par dividend” and a “stock dividend”?

A There is no difference, just different phrases to describe the same function B “Stock dividends” are generated by equity securities, whereas “par dividends” are earnings paid to all insurance policyholders. C “Stock dividends” are a return of a portion of corporate profits to shareholders, whereas “par dividends” represent earnings paid to owners of participating whole life insurance policies. D None of the above

Common and preferred shares of public companies are traded on the stock exchange on which they are listed. In the U.S., the Dow Jones is reserved for 30 blue chip companies and the NASDAQ is used for over- the-counter trading. In Canada, stocks are traded on the TSX and the TSX Venture Exchange.

The Mechanics of Trading Common shares are issued by all public companies, that is those companies that are listed on a stock exchange. They can be purchased through an investment dealer, a stock broker, or a discount brokerage. The largest companies are listed on the Toronto Stock Exchange (TSX). The TSX and other stock-market indices are statistical tools that are used to measure the state of the market and the economy.

Unlisted stocks trade on the over-the-counter (OTC) market. The market worth of the company determines whether the company trading occurs on an exchange or OTC.

Companies in the energy sector are some of the largest publicly traded companies in Canada. Their shares are listed on the TSX, and in some cases on foreign stock exchanges.

In order to trade, the investor establishes an account that may be registered or non-registered, and then either issues instructions for trading, or if dealing with a discount house, does the trading himself or herself over the Internet. Debt and equity investors make their own investment decisions, such as when to buy, sell or hold, and they alone are responsible for all gains, break-evens, and losses.

Investors pay a commission or flat fee for each trade they make or instruct their broker to make on their behalf.

Regular bonds and stocks can be bought and sold (traded) on any regular business day through a duly licensed securities firm or stock brokerage. They are therefore ideal for the investor who has a need for liquidity, as long as the investor is prepared to accept the price at which the stock is trading on the day he or she wants or needs to redeem shares.

These securities incur a modest transaction fee in the form of a fixed sum and/or a percentage of the transaction value. What a client receives from a disposition is the market value of the security sold, less attending fees, such as commissions. The general rule for dispositions of securities and receipt of sale proceeds is 72 business hours after the day of trading (T+3).

What are the risks incurred when selling a stock?

A Selling a stock is a process that is never guaranteed. Futures B When you sell a stock, you incur sales commissions. These contracts C Selling a stock incurs capital gains and/or capital losses. involve a D All of the above commitment to buy or sell a specific quantity of an asset, at a specific price, for “I called my broker delivery during a to sell the shares I specific period of had bought at $22 time. each. Their value

had dropped to $8 Option each. I had to sell, A contractual right or because I needed obligation to buy or the money, but the sell a specific loss in value hurt.” quantity of a security at a specific price, within a stipulated time period.

Warrants A derivative is a financial product that is derived from and based upon another These are certificates financial product, such as a stock-market index, a commodity, or a foreign that grant the holder the opportunity to currency. Common derivatives include futures, options, warrants, and buy shares in a company at a stated forwards. price over a specific period. They are usually issued in Disposing of sophisticated securities such as futures, forwards, options and conjunction with a new issue of shares warrants is a complicated and risk-ridden undertaking. Clients who have such or bonds of the securities should be referred to a person who is entirely qualified to deal with company. such investments. Forwards A forward is an agreement to buy or Do derivatives incur a greater risk of capital loss? sell an asset at a specified point in the A No, as long as complete disclosure about the product has been made. future at a price B No, they are simply electives that are attached to a mainstream financial product. specified on the date C It depends on the kind of derivative. the agreement is D Yes, common derivatives such as forwards, futures, options, rights, and made. warrants are treated as high-risk securities.

Managed Investments Investors who buy managed investments leave operational decisions to professional investment managers and management teams (hence, ―managed‖ investments). These managers, not the investor, are responsible for generating an investment’s rate of return.

The two best-known kinds of managed investments are mutual funds and segregated funds.

Mutual Funds An investment in mutual funds begins with the selection by an individual of a fund that suits his or her investment objectives according to the Know Your Client form that the investor will have completed with his or her mutual-fund salesperson. Once a suitable fund has been identified and money deposited into an account, the investor’s ownership in the fund is represented by units; the value of the units rise and fall, based on the value of the assets within the fund.

The deposit that the investor makes is pooled with the deposits of other investors. The deposits are invested on behalf of the individuals by professional fund managers. These managers are highly trained portfolio managers who choose investments for the fund based on the investment objective of the fund.

The investment objective may be risk or return related, or to invest in a geographic area, in companies of a certain size, or in securities of one industry or related industries.

The mutual fund’s pool of capital is invested in either debt or equity securities, mortgages, or real estate. Some funds confine their investments to stocks or bonds, or money-market investments, while other funds do not have any restrictions.

Investing according to ethical principles can be an investment objective. Mutual funds are available on this basis, in addition to many other objectives.

A mutual fund is an open-ended investment fund in which new units are continuously sold to new investors and existing units are redeemed upon demand (the fund buys them back) by investors who want to sell their units. The fund is the legal owner of all of the securities that are held in the portfolio of the fund.

Why are mutual funds and segregated funds called “managed investments”?

A These investment vehicles are pools of money contributed by investors with similar investment objectives. B Each fund is managed by a professional investment manager or management team. C Managers purchase securities in accordance with the goal or mandate of the fund. D All of the above

Investing in China and Asian markets has been the focus of some emerging markets mutual funds.

Information about a mutual fund is provided to the investor in a prospectus. The simplified prospectus typically is used to provide both general disclosure and specific information about the fund itself.

Unitholders have the right to withdraw their investment by submitting their units Net Asset Value to the fund itself. This right is called the right of redemption. The fund pledges (NAV) NAV is the amount to purchase these units at any time at the Net Asset Value (NAV) at the time of the investor receives per unit when units the redemption. are redeemed. It is calculated as the net assets in the The purchaser of a mutual fund has the right to rescind or cancel a lump-sum portfolio, minus liabilities of the fund, purchase. However, notice must be given within two business days after divided by the receiving the prospectus or the written confirmation of the purchase to the number of units outstanding. organization from which the purchase was made.

Mutual funds provide all three types of investment returns — interest, dividends, and capital gains.

The return on a mutual fund flows through to unitholders, so as to avoid double taxation. This means that the mutual fund company itself does not pay ―corporate‖ tax on income, dividends, or capital gains; they are passed on to the unitholders of the fund, who must pay the tax.

Taxation of Mutual Funds Taxes must be paid yearly on funds held in non-registered plans. A mutual fund held in a registered plan is taxed when the plan is deregistered or when the funds are withdrawn. An investor may receive interest, dividends, and/or capital gains from his or her investment, depending on the type of fund in which that investor has bought unit.

Interest: A mutual fund may pay interest either monthly or quarterly to the investor. The investor may re-invest this interest in the fund or take it as cash if the account is non-registered.

Dividends: A mutual fund may pay dividends to the investor quarterly, semi- annually, or at the end of the calendar year. The investor may re-invest these dividends in the fund, or take them as cash if the account is non-registered.

Capital Gains: An investor may incur capital gains, either through buying and selling in the portfolio itself or through the sale of his or her units in the fund. In the first instance, the fund may sell securities in its portfolio and receive a capital gain on the sale. A capital gain will be passed on to investors in proportion to the number of units held. The investor may re-invest this money in the fund or take it as cash if the account is non-registered.

If the fund incurs a capital loss, it is not passed on to the unitholders; capital losses are offset against future capital gains within the portfolio of the fund.

When an investor sells his or her units in the fund and a capital gain on the sale results, the capital gain is taxable in the hands of the investor. If there is a capital loss on the sale of the units, it can be applied only against capital gains and not against other income.

The benefits of mutual-fund investing include the ability of the investor to diversify among many companies, industries, or locales. Such diversification lessens the risk that is experienced by the investor who concentrates holdings. In addition, the investor acquires the investment expertise of the fund manager.

Cashing Out from a Mutual Fund Most mutual funds can be sold on any business day and the receipts received within as little as three business days. Not all mutual funds can be redeemed easily. Many funds have a 90-day redemption restriction to prevent ―fund flipping.‖ Other funds that invest in less liquid securities, such as real estate, small businesses, and trust units, may take longer to liquidate. Also, what a client receives is always subject to any administration and/or redemption fees and market valuations on the day redemptions are completed.

Investors in real estate mutual funds may find the fund requires a much longer period for redemption.

Characteristics of Mutual Funds Fund Objective Invests in Risk Returns

Asset Income and Similar to balanced Greater than a Better than a allocation capital gains funds, except there balanced fund; balanced fund; while preserving are no restrictions on moderate to potential to receive capital the proportions of high risk interest, dividends investments held in and capital gains any one asset class Balanced To earn income Fixed-income Riskier than An average of the and capital gains securities and stocks; bond funds, less performance of bond while preserving the fund manager risky than equity funds and equity capital shifts the weighting funds; subject to funds; can receive of various asset interest rate, interest, dividends classes to achieve inflation, and and capital gains investment objectives market risks Bond Conservative Short- and long-term Generally low; Income and capital funds will government bonds some interest- gains; better returns emphasize rate risk and than mortgage or income while inflation risk money-market funds aggressive funds have more emphasis on capital gains Dividend Dividend income Usually preferred Moderate; some Better than a bond and preservation shares for a more interest-rate and fund; most likely to of capital stable income, with business risks receive dividend some common shares income that have a history of dividends Equity Capital gains and, Stocks, futures, and Risky; subject to High potential for in some cases, to options market and capital gain returns earn dividends interest-rate risks Funds of Capital gains A portfolio of index Lower risk than Lower potential Funds funds to match the other funds returns market and sectors within that market Global To earn capital Equities outside Very high; Offers the greatest Equity gains and to Canada; these can be subject to opportunity for hedge against a further specified by market risk growth on a global declining geographic region, basis; mostly capital domestic such as Japan or Asia gain returns currency Income Income and Invest in bonds or Low; interest- Income and dividend capital preferred shares rate and income preservation inflation risk Index Capital gains A portfolio that Less risky than Less than an equity parallels a stock- an equity fund fund; capital gains market index Inter- Above-average A portfolio, primarily Less risk than Better than domestic national long-term capital of equities listed on investing in one equities; mostly growth foreign exchanges, market; subject capital gain returns and some foreign to political and debt securities currency risks

Money Stable returns and Treasury bills; Very low As interest; lower Market preservation of very short-term than return on capital government Treasury bills, securities; because of Bankers’ management fees acceptances; commercial paper Mortgage To earn income A diversified Low; more Interest and capital from investing in portfolio of mostly default risk than gains; mortgages and residential money-market returns generally preserve capital mortgages; funds lower than bond some funds invest in funds commercial and industrial mortgages Real Long-term Income-producing Liquidity risk, Above average; estate growth through real properties and since there may better than equity capital mortgages be lengthy funds and less than appreciation and redemption specialty funds; reinvestment of delays mostly interest and income capital gains Specialty Capital gains A particular type of Consistent with Diversification is Equity security, industry, or the risk absent in order to try sector; a commodity; associated with to obtain high a special niche (e.g., the sector (e.g., returns; mostly ethical funds) gold fund will capital gain returns rise or fall with the price of gold)

A balanced fund will invest in a variety of industries, companies, and geographic areas.

Segregated Funds As a licenced insurance professional, you will quickly discover that segregated investment funds, or ―seg funds,‖ are an important investment for your clients and your practice.

Segregated funds have many similarities with mutual funds. For instance, both are managed investment products. However, a segregated fund is an insurance contract governed by the Uniform Life Insurance Act, while mutual funds are governed by provincial securities laws.

N.B. To sell a segregated fund to an investor, you must have your life licence; a mutual fund salesperson must be licensed by the Investment Funds Institute of Canada.

A segregated fund is a pool of funds held by an insurance company. These funds are separate (hence, segregated) from the other assets of the insurance company. Each insurer offers many types of segregated funds from which their customers can choose, since various segregated funds suit various client needs. This, of course, is similar to the wide range of mutual funds available to address client objectives. + FILE See file 42 for a comparison of mutual Often, segregated funds and ―IVICs‖ are discussed interchangeably. This is funds and seg. funds. because Individual Variable Insurance Contract (IVIC) is the full and proper name for the contract that buys into a segregated fund.

Similarities between Segregated Funds and Mutual Funds Both segregated and mutual funds provide their investors with: Professional management; The ability to invest regularly in small dollar amounts; Regular statements and reports; Diversification; The ability for funds to be held in a registered plan, such as a Registered Retirement Savings Plan (RRSP); Automatic reinvestment of allocations; The ability to transfer between funds under one management umbrella.

It is possible for a segregated fund investor and a mutual fund investor to build a portfolio consisting of funds with different investment objectives. This further increases the diversification within the contract or account.

Professional Management Professional money managers are hired to run segregated funds and mutual funds and deliver the best possible results to their investors. This type of expertise is simply not available to the average investor who attempts to manage his or her own money.

Regular Investment Segregated funds and mutual funds can be purchased with a lump-sum payment or through regular deposits. These regular deposits can be made monthly, quarterly, semi-annually, or annually. The amount of money for each deposit can be as low as $25, although each company sets its own minimum deposit requirements.

Investing even small amounts on a regular basis helps to form a habit of saving, and allows the investor to take advantage of dollar cost averaging.

Regular Reporting Both types of funds issue reports to their customers regularly, so customers can monitor performance and results.

Diversification Diversification is vital in a portfolio for one important reason: it lessens risk. Mutual funds and segregated funds acquire a wide variety of assets suitable to their ―type.‖ A Canadian equity fund, for instance, buys shares in a number of companies to spread risk across the board. It can be difficult for the individual investor to achieve this kind of diversification and risk protection, because most

Use for Registered Plans Both segregated funds and mutual funds can be held in registered plans, such as RRSPs. This will be discussed in greater detail later in this section.

Automatic Reinvestment of Allocations Both mutual and segregated funds will make periodic payments of interest, dividends, or capital gains, based on the amount and type of assets held in the fund. Within a mutual fund, these payments are called distributions; within a seg fund, they are called allocations. In both funds, these payments can be automatically reinvested. This helps to compound growth within the fund.

Ability to Transfer between Funds Each segregated and mutual fund management company offers a variety of funds to suit its clients’ needs. Usually it is possible to make a limited number of switches between a manager’s funds without additional costs. Above that pre-set number, charges will apply.

Exclusive Features of Segregated Funds Only segregated funds offer: A maturity guarantee and a death-benefit guarantee; Bypass of probate; Creditor protection; Bankruptcy protection; The reset feature; Favourable tax treatment.

The Maturity Guarantee and the Death-Benefit Guarantee + FILE The maturity guarantee together with the death-benefit guarantee is called the See file 43 for more details on the principal guarantee. The maturity guarantee provides for the return of at least maturity guarantee. 75% of deposits 10 years after the date the contract is signed by the investor. The death-benefit guarantee provides for the payment to a beneficiary of at least 75% of deposits if the owner of the contract should die during the period of the contract. If the market value of the contract is greater than the 75% guarantee when the contract matures or the contract owner dies, then the larger amount is received. Some companies offer up to a 100% guarantee, but again, if the market value is greater, the market value supersedes the insurer’s guarantee. What does this give the investor? In one word: safety.

The maturity guarantee means that deposits have unlimited potential for growth while limiting the risk of loss. The term of investment for a segregated fund is ten years. The maturity guarantee will apply on that date if the contract is funded by one deposit. Similarly, a death benefit guarantee is at least 75%, and it promises that the segregated fund will pay out at least 75% of the amount invested on the death of the annuitant of the contract.

As mentioned, though each company is a little different, their maturity guarantees are essentially either 100% or 75% of the deposits, less any withdrawals. However, there are some very significant differences in how maturity guarantees are applied.

Some contracts are deposit-based, which means that a deposit made into the contract will mature exactly 10 tears from the date of deposit. Many are policy- based, which means that, if a deposit is made every year, the result is a series of ten 10-year guarantees. The other type of guarantee is contract-based and few companies offer this now, as it can result in higher payouts. Contract-based means that all the deposits mature at the end of the10-year period.

Example: Maturity Guarantee Assumptions Deposit frequency is annual on February 1 over ten years Amount is $10,000 per year Guarantee is 75%

Deposit-Based 10 years after the date of the first deposit, the guarantee is $7,500, as that is all that has been on deposit for the ten years. After 11 years, the guarantee will be another $7,500, or $15,000 total. This will continue until the entire $75,000 is guaranteed at the end of 20 years from the date of deposit.

Policy-Based To calculate maturity guarantees, many companies use the end-of-the-year method, in which all deposits made during the year mature on December 31, 10 years later. This is called the policy-based guarantee.

Contract-Based After 10 years the guarantee is $7,500 times 10 deposits, or $75,000. Clearly, if this is an important factor, then a client should try to select a company that offers a contract-based guarantee. This type of guarantee is now offered by very few companies.

Date of Deposit Amount of Amount deposited Maturity Date Maturity Cumulative deposits during the (Deposit -based) Guarantee maturity calendar year (assumed guarantee @75%) 1 Feb 2010 $10,000 $10,000 1 Feb 2020 $7,500 $7,500 1 Feb 2011 $10,000 $10,000 1 Feb 2021 $7,500 $15,000 1 Feb 2012 $10,000 $10,000 1 Feb 2022 $7,500 $22,500 1 Feb 2013 $10,000 $10,000 1 Feb 2023 $7,500 $30,000 1 Feb 2014 $10,000 $10,000 1 Feb 2024 $7,500 $37,500 1 Feb 2015 $10,000 $10,000 1 Feb 2025 $7,500 $45,000 1 Feb 2016 $10,000 $10,000 1 Feb 2026 $7,500 $52,500 1 Feb 2017 $10,000 $10,000 1 Feb 2027 $7,500 $60,000 1 Feb 2018 $10,000 $10,000 1 Feb 2028 $7,500 $67,500 1 Feb 2019 $10,000 $10,000 1 Feb 2029 $7,500 $75,000

Example: Deposit-based Guarantee

Date of Deposit Amount of Amount deposited Maturity Date Maturity Cumulative deposits during the (Policy-based) Guarantee maturity calendar year (assumed guarantee @75%) 1 Feb 2010 $10,000 $10,000 31 Dec 2020 $7,500 $7,500 1 Feb 2011 $10,000 $10,000 31 Dec 2021 $7,500 $15,000 1 Feb 2012 $10,000 $10,000 31 Dec 2022 $7,500 $22,500 1 Feb 2013 $10,000 $10,000 31 Dec 2023 $7,500 $30,000 1 Feb 2014 $10,000 $10,000 31 Dec 2024 $7,500 $37,500 1 Feb 2015 $10,000 $10,000 31 Dec 2025 $7,500 $45,000 1 Feb 2016 $10,000 $10,000 31 Dec 2026 $7,500 $52,500 1 Feb 2017 $10,000 $10,000 31 Dec 2027 $7,500 $60,000 1 Feb 2018 $10,000 $10,000 31 Dec 2028 $7,500 $67,500 1 Feb 2019 $10,000 $10,000 31 Dec 2029 $7,500 $75,000 Example: Policy-based Guarantee

Date of Amount of Amount Maturity Date Maturity Cumulative

Example: Contract-based Guarantee

Deposit deposits deposited during (Contract- based) Guarantee maturity the calendar year (assumed @75%) guarantee 1 Feb 2010 $10,000 $10,000 1 Feb 2020 $7,500 $7,500 1 Feb 2011 $10,000 $10,000 1 Feb 2020 $7,500 $15,000 1 Feb 2012 $10,000 $10,000 1 Feb 2020 $7,500 $22,500 1 Feb 2013 $10,000 $10,000 1 Feb 2020 $7,500 $30,000 1 Feb 2014 $10,000 $10,000 1 Feb 2020 $7,500 $37,500 1 Feb 2015 $10,000 $10,000 1 Feb 2020 $7,500 $45,000 1 Feb 2016 $10,000 $10,000 1 Feb 2020 $7,500 $52,500 1 Feb 2017 $10,000 $10,000 1 Feb 2020 $7,500 $60,000 1 Feb 2018 $10,000 $10,000 1 Feb 2020 $7,500 $67,500 1 Feb 2019 $10,000 $10,000 1 Feb 2020 $7,500 $75,000

Bypass of Probate Probate is a legal process in place in all provinces to prove the validity of a will. It acts as a death tax, because each province levies a charge against the value of assets in the estate of a person who dies. This charge may apply to bank accounts, stock portfolios, and real estate — in short anything owned by the deceased that passes through his/her estate. Life insurance contracts are exempt from probate fees when they include a named beneficiary; RRSPs can also exempt for the same reason.

These are beneficiary-designated accounts and bypass the estate, because they are paid out directly to the named beneficiary. If no beneficiary has been named, the proceeds of a life insurance policy or a registered account forms a part of the estate and will attract probate tax.

N.B. Segregated fund contracts are exempt from probate as long as the beneficiary is not the estate.

There are two very real benefits to being exempt from probate: one, probate fees are saved (and these can run into thousands of dollars); two, the beneficiary can receive the money much faster than he or she would if the contract had to go through probate. Mutual funds do not offer this benefit.

Creditor Protection + FILE It is a rare person indeed who dies without some debts. Virtually everyone owes See file 44 for an money to either an institution, such as a bank holding a mortgage, or an agency, example of creditor protection. such as Canada Revenue Agency for income tax. People who own their own businesses are especially likely to owe money to suppliers, partners, or employees. These people or companies become creditors on the death of the person who owes them money. They are entitled by law to sue the deceased’s estate to recoup their losses.

However, creditors cannot lay claim to the proceeds of a segregated fund contract during the lifetime of the contract holder when a spouse, child, grandchild, or parent of the life insured has been named as the beneficiary of the policy, or an irrevocable beneficiary has been named in the contract.

If it can be shown that these beneficiaries were named with the specific intent to defeat creditors of the life insured, the creditors may, however, seek redress during the lifetime of the contract holder. No claim may be made after death. If the proceeds go to the estate because a beneficiary was not named, creditors can make claims against the estate.

Bankruptcy Protection Similar to the protection offered from creditors, segregated funds are exempt from seizure in bankruptcy proceedings as long as the purchase of the segregated fund was made in good faith and not to avoid debts. Generally, to be protected, the segregated fund must have been purchased one year or more before the individual declares bankruptcy. If the investor was not solvent when the purchase was made — even if it was more than a year prior to declaring bankruptcy — any purchase made up to five years before declaring bankruptcy can be seized.

Reset Feature Reset Feature Remember the booming Canadian and U.S. stock markets of early 2008? People The reset feature is who owned mutual funds that were invested in these markets saw astounding used when an investor wants to levels of performance — followed in the same year by a rapid and sharp decline increase the value of the contract for in the markets and in the value of their mutual funds. Now, imagine if those same guarantee people had decided in July 2008 that they did not want to lose those gains, that purposes. The value is “reset” at they wanted to ―lock‖ the value of their funds in at those high levels. Mutual a higher amount and the maturity funds do not provide that ability — the investor can sell his or her shares or ride date of the the roller coaster! But some segregated funds do allow their values to be locked contract is then “reset” to ten years in. This is called the reset feature. from the date the value is changed. The process to reset is simple — the investor tells the agent that he or she wants to reset (some companies will accept verbal instructions; others need these instructions in writing) and the investor gets the end-of-day close price on the day the reset request was received. The number of resets is limited; two to four a year is usual.

N.B. The result of resets is that growth in the value of the fund is locked-in. Those gains on paper become real and cannot be eroded by a downturn in the fund’s value. As the fund continues to grow in value, more resets can be used to lock-in the fund value at ever higher levels.

Surely such generosity on the part of the insurance companies must have a downside. Well, it has. When the contract is reset, the maturity date is adjusted to ten years from the reset date. But, there is yet another bonus— the death and maturity guarantee benefits will immediately be based on the reset amount and so will be higher than when the contract was purchased.

Here is how the reset feature works for Charles Lalonde, who opened his account on June 1, 1995, with $100,000.

How Resets Affect the Maturity Date

Date Deposit Value Reset Maturity date Maturity Death guarantee* benefit June 1, 1995 $100,000 June 1, 2005 $75,000 $75,000 Nov. 18, 1998 $103,000 no June 1, 2005 $75,000 $75,000 Apr. 30, 1999 $127,000 yes Apr. 30, 2009 $95,250 $95,250 Sept. 7, 2000 $141,500 yes Sept. 7, 2010 $106,125 $106,125 Oct. 12, 2001 $104,200 no Sept. 7, 2010 $106,125 $106,125 *based on 75% maturity guarantee

Resets are not appropriate for clients who do not want their money in a segregated fund for longer than ten years. There is no requirement to reset the account: it is only an option. However, resets are an excellent feature for those who really do not care if they ever receive the value of the contract for their own use but do want to increase the amount of money their beneficiaries will receive.

What is the one drawback to a segregated fund’s “reset feature”? A This feature allows segregated fund investors to “lock in” their losses. B Resets can be requested only up to four times each year. C When the contract is reset, the maturity date is adjusted to 10 years from the reset date. D Death and maturity guarantees are based on the reset amount, and may be lower than they were when the contract was originally purchased.

Favourable Tax Treatment Segregated funds receive favourable tax treatment, because capital gains earned by the fund, and any capital losses, are reported to segregated fund contract holders on an ongoing basis. Capital losses can be deducted from capital gains. The taxation of segregated funds is covered in detail later in this section.

N.B. Mutual fund owners receive capital gains but do not receive capital losses on an ongoing basis to offset capital gains.

Buying the Product The steps in the buying process are: Acquiring the contract; Determining the type of account; Receiving the necessary documents.

Acquiring the Contract A segregated fund is sold in the form of a contract. A contract is a legally binding agreement between its parties. A segregated fund contract has a minimum of three parties: the insurance company, the contract holder, and the beneficiary.

The contract holder is the owner of the contract. This is the person who signs the contract and is responsible for the deposit or deposits made to the contract. When the contract holder completes the contract, he or she must also designate the annuitant. This is the person to receive the proceeds on maturity of the contract. The owner and annuitant can be the same person or two different people. When the contract is a registered plan (e.g., an RRSP), the owner and annuitant must be the same person.

I have a segregated fund contract that is an RRSP. I am both the contract owner and the annuitant, because I will receive the proceeds of the contract on maturity to help fund my retirement.

When the annuitant is a person other than the contract holder, the contract holder must choose someone in whom he or she has an insurable interest. Recall that an person in which the contract holder has an insurable interest is a person who would suffer a financial loss if the contract holder died.

The contract holder also designates the beneficiary in the contract. The beneficiary receives all amounts payable if the contract holder dies. There are no rules about who the beneficiary can be, unlike those that restrict who the annuitant can be. There can be more than one beneficiary, and the beneficiary can be a person (―my best friend, Fred‖) or a group of people (―all the members of my ski club‖), a group (such as a charity), a trustee (for instance, when the beneficiary is a minor), or the estate of the contract holder.

Who can a “contract holder” designate as his or her “beneficiary”?

A Immediate family members only B Immediate family members and the contract holder’s estate only C The estate only D Any association, estate, group, trustee, or person

Further, the beneficiary can be revocable or irrevocable. As with all insurance contracts, if the beneficiary is revocable, the contract holder can change the beneficiary as he or she chooses. In this case, the contract holder completely controls the contract. However, when the beneficiary is irrevocable, the contract holder must have the permission of the beneficiary to make changes, including resets, withdrawals from the contract, surrender of the contract, and the naming of another beneficiary. In this case, the beneficiary is, in effect, in control of the contract. 274 Copyright © 2011 Oliver Publishing Inc. All rights reserved. Types of Investments

The beneficiary can be named in the contract or in the will of the contract holder. If the contract holder happens to name two different beneficiaries for the same contract — one in the will and another in the contract — the beneficiary who was designated closest to the date of death of the contract holder will prevail.

Is a contract “annuitant” different from a contract “beneficiary”?

A Yes, only when a segregated fund account is registered B Yes, an annuitant is the person who is to receive the proceeds of the contract when it matures (after 10 years) C No, they must differ when the contract is held inside an RRSP D None of the above

The Purchase Details: The price at which the investor acquires his or her ―units‖ is the value of a unit on the day the order is made. If the investor chooses a money-market fund, proceeds will be debited or credited to the client on the day following the order. Other types of segregated funds take three business days.

Loads and Fees: Loads and fees are two separate expenses that must be paid by the segregated-fund investor. Loads, also called sales charges, are what the investor pays to buy into a fund; fees, usually called the management expense, cover the cost of running the fund each year.

Fees for a segregated fund cover expenses, including: Legal, audit, registration, and banking charges; Administration, record-keeping, and accounting fees; Costs of printing statements and disclosure documents, filing documents with regulators, and mailing statements to clients; Taxes.

Sales charges are either: Applied when each deposit is made (called a front-end load), or On a deferred basis, or At the end of the contract (called a back-end load), or Never charged (called a no-load fund)

Front-end loads: If a client pays a front-end load, when he or she withdraws or redeems all or part of the investment, there are no additional sales charges.

Front-end sales charges are deducted from gross premiums and, therefore, reduce the amount of investment capital that goes into the segregated fund. This option might best suit the long-term investor whose expectations are to remain a plan

holder over the long-term and who looks to the fund to produce steady growth over a number of years.

How does a “front-end load” affect invested capital?

A Sales charges are deducted from capital before it is invested, and this means less than the original intended amount of money is available for growth. B “Front end loads” are often negotiable, and can be reduced substantially, resulting in a comparatively higher rate of return on the investment over the long term. C “Front end loads” often mean a lower fund-management fee. D All of these answers

Deferred sales charge: The deferred sales charge (DSC) is the most popular choice. The investor agrees to pay a sales charge if he or she redeems all or part of the original investment during an agreed-upon number of years. The sales charge declines over this period until, by about year six or seven, the charge is eliminated.

N.B. Management expense fees are higher for segregated funds than for mutual funds to cover the cost of the maturity guarantee and death benefit guarantee.

For example, if a deferred sales charge is set at 5%, the schedule for all or partial redemption might be:

Year Sales Charge 1 5% 2 4.5% 3 4% 4 3% 5 1.5% 6 0

If the annuitant dies before the deferred sales charge has been eliminated, the charge may be applied on the value of the contract at the time of death. If the value is greater than the initial investment, a sales charge will be made on the amount of growth in the contract — the difference between the principal amount (the initial investment) and the market value at death. This charge can actually reduce the amount the beneficiary will receive.

No-load: Infrequently, a fund is offered with no loads; that is, it has no sales charge. A no-load fund often compensates for the absence of a sales charge by charging a higher management expense fee. Plans sold with ―no-load‖ fees levy annual fees on the total value of the fund. Thus, annual fees will increase proportionately with the long-term growth in the fund.

How does a “back-end load” or “deferred sales charge” affect invested capital?

A While there is no upfront sales charge, there is a declining redemption fee schedule. B “Deferred sales charges” can be used to offset capital gains realized on the sale of non-registered funds. C “Back-end loads” or ”deferred sales charge” funds normally carry a higher management fee, which can eat away at fund values over the long haul. D All of the above

Determining the Type of Account Segregated funds are eligible to be held inside: registered pension plans, such as Registered Retirement Savings Plans (RRSPs) a locked-in pension plan, such as a locked-in Registered Retirement Savings Plan a Registered Education Savings Plan (RESP)

Choosing a registered pension plan account: When the client chooses the segregated fund to be held inside a RRSP, contributions will be tax-deductible. It will not be necessary to pay tax on the income earned within the plan until the plan is terminated or funds are withdrawn.

When the contract is an RRSP, it must be terminated before the end of the year that the annuitant turns 71, or it must be converted into a RRIF.

N.B. Putting the segregated fund into a RRSP is a good choice for those who are saving for retirement. When the contract is a registered plan, the owner and annuitant must be the same person.

As a locked-in plan: A segregated fund contract can also be registered as a locked-in plan. Locked-in plans are used when a pension is transferred from a company pension plan to an employee who is retiring or leaving the company. More on locked-in plans is provided in the Retirement module.

Choosing an RESP account: Segregated funds are also available for RESPs (Registered Education Savings Plans) to help parents or other relatives save for a child’s post-secondary education.

To use a segregated fund as an RESP, it is important to begin the plan before the child is eight or nine years old, so that the full maturity guarantee will be effective. The benefits are the ability to earn larger returns while being protected from loss of the investment, just as they are for anyone buying a segregated fund.

When a segregated fund is a registered plan, the _____ and the ____ must be ____.

A Owner, subscriber, the beneficiary B Subscriber, annuitant, the owner C Owner, annuitant, different D Owner, annuitant, the same

Receiving the Necessary Documents The documents a client must receive before completing a segregated fund contract include: The Information Folder; A Summary Fact Statement; Financial Statements.

The client must sign a receipt acknowledging that he or she has received these documents.

The Information Folder The Information Folder is the prospectus equivalent for a segregated fund. This is the key document describing the contract. It must be identified on its cover or first page as the Information Folder. An agent must deliver a copy of the Information Folder (as filed with the Insurance Regulator in that jurisdiction) before a prospective policy owner signs an application to purchase an IVIC. In addition, the agent must, at the time of delivery, obtain a signed acknowledgement from the client stating that he or she has received a copy of the Information Folder.

The agent must also ensure that the Information Folder contains the audited financial statements and notes to those financial statements for the segregated fund in question; must review the one-page executive summary found at the beginning of the Information Folder with the client, and point out his or her rights under the contract.

The Information Folder provides many details, including the following: The guaranteed benefits; A description of benefits that are not guaranteed and that will vary according to market conditions; How benefits are determined; Maturity, redemption, and surrender options; How to make a purchase and a transfer, and the minimum dollar amounts for each, whether lump-sum or periodic;

How the price of units is determined on purchase, transfer, or withdrawal including charges; A summary of withdrawal charges; How and when the units are valued; Whether the contract will be offered continuously or for a limited time; A statement of fund investment policies and information on how the contract holder can obtain the complete investment policy, if desired; A description of the tax status of the fund and of contract holders; A statement of current management fees as a percentage of net assets of the fund, and other expenses that can be charged against these assets; An executive summary of one-page in length.

The Information Folder for a real estate fund will stress the long-term nature of the investment and its relative lack of liquidity.

When the contract is a registered plan, the Information Folder requires the following: That segregated funds are just one option for retirement savings; That there may be changes to certain regular benefits of the contract; That registered contracts are better for long-term investment than short- term; That all aspects of registration should be discussed with the agent or insurer.

The Summary Fact Statement The Summary Fact Sheet is the equivalent of the simplified prospectus used to sell mutual funds. Think of this as the snapshot of the fund. It includes: a summary of performance of the fund investment policies a list of its three largest holdings, though most companies provide a far more complete list

Financial Statements Audited financial statements must be provided to contract holders at the time of purchase and also annually. These statements must include: A statement of changes in net assets of the segregated fund; A statement of assets and liabilities; A statement of investment operations and expenses for the previous year; A statement of unit values for the previous five years, if applicable; A schedule of investment holdings at the previous year-end; A statement of transactions in the investment portfolio of the fund during the previous year. Copyright © 2011 Oliver Publishing Inc. All rights reserved. 279 LLQP

If you, as the agent making a proposal to a client about segregated funds, feel that you want to add in writing your own personal touches to the package of documents: beware! What can and cannot be said about segregated funds is strictly controlled and enforced by insurance regulators. In fact, any additional proposals must be prepared by the insurer and filed in advance with the Superintendent of Insurance.

Utmost care must be taken when speaking of future performance. It is easily implied that, because the past returns on a segregated fund have achieved a certain level, future returns would be equally good. Making such statements is absolutely prohibited. The agent must stress and the client must understand that past performance does not guarantee future results.

Why must the client receive the documents before completing the purchase of an IVIC?

A To fully understand what is being purchased B In order to assess the risk of the investment C Because there is no rescission period for an IVIC D All of these answers

N.B. Advertising, in all forms — print, radio, television, or any other format — for segregated funds must also emphasize that past performance does not guarantee future results.

New Disclosure Requirements and Rescission Right for Segregated Funds

New ―Fund Facts‖ and ―Key Facts‖ disclosure documents were implemented in January 2011, and these documents make it easier for consumers to understand and make informed investment decisions concerning individual variable insurance contracts (IVICs) and segregated funds.

Fund Facts and Key Facts provide consumers with information before they make the decision to invest. The new documents help consumers by providing an explanation of the potential benefits, risks, and costs of investing in a fund.

All Fund Facts must be presented in a standard format, and since all insurers will be using the same Fund Facts format, consumers will be able to easily compare funds offered by several insurers.

Key Facts replaces the Executive Summary of the Information Folder, which also now includes Fund Facts. The agent must provide consumers with the new folder

The other delivery requirements for the information folder are unchanged. The agent must provide the information folder to the consumer prior to taking an application for an IVIC, and must obtain the client’s written or electronic acknowledgement of receipt (including voice mail or a similar recording).

Consumers may still choose to receive the information folder in person, by mail, or by fax, or they may choose to receive the information folder electronically, via e-mail, or by viewing the folder online. If the information folder is delivered electronically, the consumer must be specifically directed or linked to it.

Rescission Right Consumers also have a new ―cooling off‖ period that allows them to change their minds and ―rescind,‖ or cancel, their purchase of an IVIC and/or segregated-fund selection made under the IVIC within two business days of the confirmation of their purchase. The agent must ensure that the clients are aware of this right.

The Growth of Value in a Segregated Fund Your client has just received his first annual segregated-fund financial statement. He is having some problems understanding the statement and asks you, ―Just how is the value of the fund units determined?‖

To help you answer this type of question, it will help you to revisit mutual fund investing. When a person invests in a mutual fund, he or she buys units or shares in the fund. These units or shares are owned by the investor. A segregated fund is a little different. The segregated fund investor does not receive units or shares and does not directly own a piece of the fund. But because the investor wants to be able to monitor the growth of his or her investment, and be able to compare that investment with other returns, the investor is assigned notional units in the fund, proportionate to his or her investment. Notional units are not real; they exist to give the investor a ―notion‖ of ownership.

The assets of the segregated fund determine the worth of the client’s investment. If an asset base is mortgages, real estate, or derivatives, their valuation follows different rules, since it is difficult, for example, to value real estate on a frequent basis.

When a segregated fund allocates income to the contract holder, the income will be based on the number of ―notional‖ units held and the part of the calendar year during which the units are held. So, units that are held for six months would receive half the amount allocated to units held for a full year. This is called time- weighting. For example, if a contract holder were to receive $1/unit for 1,000 units in the contract at the end of the year, but had only held the contract for six months, he or she would receive $0.50/unit.

Which answer below describes a difference between a mutual fund and a segregated fund?

A Segregated funds have capital guarantees, mutual funds do not. B Mutual funds have consumer protection provided by the Mutual Fund Dealers Association, whereas segregated funds offer consumer protection through Assuris. C Segregated funds offer creditor protection, but mutual funds do not. D All of the above

Performance Indicators It pays to keep your clients well informed on all investments, and your client deserves to hear all news from you, good as well as bad.

Performance on seg funds can be easily monitored in several ways on a daily basis from: Newspapers; The Internet; Information and statements from the insurance or fund companies.

How Value Grows The value of units held in a segregated fund ―grows‖ differently than that of mutual fund units.

In brief, at the time of allocation for a segregated fund, the number of units stays the same, but the value of each unit increases. At the time of allocation for a mutual fund, the net asset value per share declines, while the number of units the investor holds increases. The following table shows this process.

Type of Number NAV/unit Total Income Total value NAV Number of Fund of units value earned after units after on of units during distribution distribution Jan.1 year/unit Segregated 1,000 $10 $10,000 $1.00 $11,000 $11 1,000 Fund Mutual 1,000 $10 $10,000 $1.00 $11,000 $9 1,111.11 Fund

Issuers must value their segregated funds on at least a monthly basis, although some funds are valued on a daily or weekly basis. Remember that the holder owns a contract to which fund units are credited; he or she does not actually hold assets in the fund.

If the fund is established with $200,000 in securities, and the insurer decides that the initial value of each unit will be $20, then 10,000 units are created and held by the fund.

If the fund increases in value to $250,000 through interest and/or capital appreciation of the securities, the value of those units would increase to $25 ($250,000 10,000 units). However, before this calculation is made, management fees are deducted. So, if the management fees in the example are $2,000, the value of the units is:

$250,000 – $2,000 = $24.80 10,000

If the investor has a plan that contains 10 units, the value of his or her IVIC is:

10 x $24.80 = $248.00

Clients will receive statements from the fund manager every time they make a deposit, a withdrawal, or a transfer between funds. Summary Fact Statements are usually sent semi-annually, and will show any changes since the previous statement. The Statement also shows the value of the holdings and the unit value of each fund. The annual financial statement reports fund investment management and performance.

If the client is an inexperienced or nervous investor, you may need to provide reassurance when results are not as hoped or expected. You must remind your client that segregated funds are a long-term investment — held ideally for a minimum of 10 years.

Some investors will not be comfortable with this approach and may want to switch funds. Most companies allow a maximum number of switches per year before charges apply.

A new segregated fund cannot report performance figures until the first year of operations is complete. After the first year, results are reported for the next year- to-date during the course of the year. Established funds report for the year-to- date, 1 year, 3 years, 5 years, and 10 years. All segregated funds report this way, so comparisons between funds can be made easily.

If a segregated fund investor held 5,000 units @ $10.00 per unit on January 1, and investment income generated throughout the calendar year amounted to $2.00 per unit: 1) how many units does the investor now own; 2) what was the fund’s NAV; 3) what was the total value of the client’s portfolio after the income distribution?

A 6,000; $10; $50,000 B 6,000; $12; $72,000 C 5,000; $12; $60,000 D None of the above

Proceeds of a Segregated Fund You now have an idea of ownership together with the net asset value of each notional unit. This net asset value will determine how much the contract holder will receive when: The contract matures or the owner/annuitant dies; A withdrawal, called a redemption, is made; The contract is surrendered.

Maturity or death The proceeds of a segregated fund contract are calculated as:

the net asset value of the contract holder’s fund units on redemption + (plus) the value of any guarantees or benefits – (minus) any deductions, such as switching fees and early redemptions.

If the contract holder owns more than one fund, each fund value is calculated separately.

A contract that is held in a locked-in plan must stay in a locked-in plan after maturity until the contract holder retires, or until death.

The contract holder or beneficiary can choose to: Receive a lump-sum payment; Accrue interest on the proceeds; Receive monthly instalments of a fixed amount; Receive monthly instalments for a fixed period of time; Receive a combination of fixed and variable income; Receive an annuity.

The annuity option offers the owner or beneficiary three choices. It can be received in monthly instalments guaranteed for life (minimum 10 to 15 years); as a joint-and-last-survivor annuity for the contract holder and his or her spouse; or as a variable annuity.

The variable annuity takes the units credited to the contract and converts them to annuity units. The number of annuity units paid each month to the contract holder or beneficiary is based on his or her age, gender, and the prevailing interest rate. Payment of this number of units is guaranteed monthly, for life. However, the value of each annuity unit will fluctuate, based on the performance of the segregated fund during the preceding month, so the actual payments received each month will vary.

Annuities are covered in more detail later in this chapter.

On the death of the annuitant of a contract held in a RRIF, payments may continue over time if the beneficiary is the annuitant’s spouse, dependent children, or grandchildren. If the beneficiary is someone else, the proceeds will be paid in a lump sum.

Withdrawals A contract holder can make a withdrawal from the segregated fund when: The contract is not locked in; The annuitant/owner is alive; The beneficiary is revocable.

+ FILE Withdrawals can be made in a lump sum or as periodic payments. Sometimes the See File 45 for important information insurance company will require that a minimum withdrawal amount be made or on calculating withdrawals from an that a minimum account balance is maintained. The fund contract can specify a IVIC. withdrawal amount and, if this amount is exceeded, a hefty early-withdrawal fee (in the range of 6% in the first year) can be charged.

When a withdrawal is made, the value of the contract decreases. The guarantees of the contract apply to the adjusted (lesser) value. When a deposit is made, the value of the contract increases. Then the guarantees apply to the adjusted (higher) value on the maturity of the contract.

When a withdrawal is made, the maturity and death-benefit guarantees must be adjusted accordingly, since the value of the contract has been reduced. This adjustment is made by either the linear reduction method (that reduces the value by the dollar amount withdrawn) or the proportional reduction method

(that reduces the value according to the number of units surrendered, compared to the number of units in the contract prior to withdrawal).

There can be a significant difference in the adjustment, depending on which of these two methods is used. For example, Sarah bought 500 units in a seg fund at $20/unit, for a total value of $10,000. Two years later, the value of the units has increased to $25/unit; the total value of her investment has increased to $12,500. She withdraws $1,000 by surrendering 40 units ($1,000 $25 = 40). The balance of units in the fund is reduced to 460 (500 – 40 = 460).

If the guarantee in her contract calls for 100% return of her initial deposit, the linear-reduction method indicates a new balance of $9,000 in her contract ($10,000 – $1,000 = $9,000).

The proportional-reduction method indicates that the value in the fund is reduced by 8% to $9,200 (460 500 = 0.92; $10,000 x 0.92 = $9,200).

All policy withdrawals are deemed to be partial dispositions with tax consequences, and they will decrease the adjusted cost basis (ACB) of the contract. The withdrawal must be reported for tax purposes and tax paid on it when appropriate.

For example, Jan’s policy has a fair market value of $150,000, and an ACB of $140,000. She withdraws $30,000; thus she is deemed to have disposed of 20% of the contract ($30,000 $150,000 = 20%). She must therefore report a capital gain of 20% on the difference between the ACB and the fair market value of the policy of $2,000 ($150,000 – $140,000 = $10,000 x 20% = $2,000).

Surrender of the Contract If the contract is surrendered, the contract holder will receive the net asset value of the units less any applicable charges. The maturity guarantee will not apply.

The Segregated Fund Investor Profile You now understand the many benefits of segregated funds and how they work. Who among your clients or prospective clients will make the best candidates for this type of investment?

Instead of looking at people by their demographic group (e.g., baby boomers), it may help to look at the characteristics of people who will make good segregated- fund investors. These people include: The risk-averse; Those who are not restricted by age; Those with sufficient financial resources, or who are financially secure; Entrepreneurs, small business owners, corporate directors, and professionals; Investors over 55 needing estate-preservation benefits; Investors in poor health.

The Risk-Averse: The guarantees offered by segregated funds make them a good choice for the risk-averse, especially when one of the low-risk funds is selected.

While clients that fall into this category may be any age, they are principally represented by those in the 55+ age group. People of this age have worked hard for their savings — and they are looking at retirement in the near future. They cannot afford to lose what they have saved. However, they might benefit from the growth their investments can make in a segregated fund that is a more aggressive investment than they would normally choose. They need to hear about the features of safety plus growth.

Age Restrictions: Some clients are excluded outright from segregated fund contracts by virtue of their age. Minors, for instance, are prevented from entering into any type of enforceable contract. On the other end of the spectrum, some insurers require that a person be under 80 years of age when issued a segregated fund contract.

Of course, contracts that are held in a RRSP or locked-in retirement account must be terminated no later than the end of the year in which the contract holder turns 71. Some insurers set the termination date for non-registered contracts to be the end of the year in which the annuitant turns 100.

A segregated fund that is a Registered Education Savings Plan account would be a good choice for a young family saving for a child’s education.

Clients Who Are Financially Secure: Segregated fund investment pays off when the investment matures after the full 10-year period. It is not intended for use as an emergency fund or for short-term savings or gains. For this reason, segregated funds are suited to clients who can ―park‖ their money for 10 years and will not need this money for short-term requirements.

Entrepreneurs, Small Business Owners, and Professionals: Due to the creditor protection available to segregated fund holders that is unavailable through other investment products, segregated funds will have appeal to those whose personal or professional circumstances expose them to the claims of creditors. This can include those who are sole proprietors, have personally guaranteed business liabilities, the self-employed, and professionals.

Investors Over 55 Needing Estate-Preservation Benefits: Segregated funds provide the beneficiary with a guaranteed benefit without going through probate. This effectively increases the value of the segregated fund investment because it means there will be no probate fees applied against the benefit. Also the beneficiary will receive the funds much sooner than if probate were involved.

Investors in Poor Health: There is no requirement to prove evidence of good health when an investor acquires an IVIC. Therefore, if an investor is in poor health and concerned that market volatility will affect an investment during the 10-year period that will be covered by the maturity guarantee, an IVIC will ensure that the beneficiary receives the guaranteed death benefit.

For which of the following is an IVIC not suitable?

A 55+-year-old investors looking for estate-preservation benefits. B Risk-averse investors C Debt-ridden investors D Investors looking for capital liquidity

If the policy owner dies, the proceeds from a seg fund can go directly to beneficiaries to save the expense of probate fees.

Tax and the Segregated Fund The favourable tax treatment of segregated funds is yet another feature of this investment product. Tax issues arise: Annually; On the maturity guarantee; For the death benefit guarantee; For registered contracts; For non-registered contracts.

Annual Taxation Issues When deposits are made to the segregated fund, they grow, stay the same, or decrease in value. Growth may come in the form of interest, dividends, or capital gains.

Growth is dispersed to each contract holder in a process called growth allocation. This involves allocating, or assigning, a percentage of the fund’s total growth to each unit. As we saw earlier in the discussion of time-weighting, most funds allocate the growth to each contract holder, based on the number of units held and the proportion of the year the units were held. For example, the contract holder who bought units in November would receive a much lower allocation than a contract holder who bought units in January of the same year.

N.B. The annual allocation is made on December 31. The contract holder must declare the allocation as income on his or her tax return. It is taxed in the year it is received, unless the contract is registered (as an RRSP, for instance).

A benefit of segregated funds is that both gains and losses on the portfolio of the fund are passed on to contract holders. This means that, if there is a net capital gain on the portfolio, it is passed on the contract holders (for tax purposes), and the same applies to net capital losses. Net losses that are passed on to the contract holders can therefore be deducted from capital gains on the same or other investments that the holder has, in the same way as any other capital loss (for tax purposes). Net capital losses on the portfolio of mutual funds are not passed on to the mutual fund unitholders until the units are sold; therefore, they cannot deduct capital losses from the fund’s portfolio from other capital gains that the unitholder may have earned elsewhere until units are sold.

As an example: If Newco shares had been purchased at $2.50/share and had decreased in value to $1.50/share, and had then been sold by the fund at that price ($1.50/share), $1.00/share would be the capital loss. The segregated-fund

contract holder can deduct the loss ($1.00/share) from other capital gains that have been earned that year. The loss also can be carried back three years or forward indefinitely. This gives the contract holder lots of time to make use of such a loss. Fifty percent (50%) of the net capital gain (net of losses) is taxed at the contract holder’s marginal tax rate (MTR).

Sales charges can be claimed as a capital loss when the contract is surrendered or matures.

Switching between funds in the same fund family is usually considered a taxable event, and will trigger a capital gain or capital loss in the year the switch occurs. Some insurers, however, take the position that such a transfer is an ―internal transaction‖ and that the switch does not require tax reporting.

If money has been borrowed to invest in the segregated fund, the interest cost of borrowing is a deductible expense for tax purposes, as long as the contract is not held within a registered plan.

What is the big tax advantage of owning an IVIC?

A If you borrow to invest in a registered IVIC, the loan interest is tax-deductible. B A non-registered IVIC can be converted to a prescribed term-certain annuity at maturity. C There are no capital gains dividends paid by IVICs. D All capital gains and losses are calculated for segregated fund investors each year, and can be applied to offset each other for tax purposes in the year received, or deferred until a later year.

Maturity Guarantee Tax Issues The amount of tax that will be paid depends on whether the proceeds are greater than the adjusted cost basis (ACB) of the contract. The adjusted cost basis of a segregated fund is calculated as the amount paid for its purchase, plus allocations, plus any commissions or other related expenses.

When the proceeds are greater than the ACB of the contract, capital gains tax is payable on the difference between the cost and the proceeds. For example: a $100,000 contract that, on maturity, is worth $125,000, would attract capital gains tax on $25,000, and, since 50% of capital gains are taxed, capital gains tax would be applied to $12,500 at the investor’s marginal tax rate.

When proceeds are less than the cost of the contract, capital gains tax is payable on the guarantee amount, but it is reduced by the capital loss on the investment. For example, a $100,000 contract that, on maturity, is worth $75,000 would require a guarantee payment to the contract holder of $25,000 if the guarantee is

100%. The maturity guarantee of $25,000 is taxed as a capital gain, but it is reduced to zero by the $25,000 capital loss incurred by the investor.

If the guarantee is considered to be income, the contract holder pays tax on the full amount of the guarantee and can deduct 50% of the capital loss.

If a $100,000 IVIC is worth $140,000 at maturity, and costs incurred over the life of the contract amount to $10,000, how is the $140,000 treated for tax purposes?

A Tax is calculated on the entire $140,000. B The annuitant would pay tax on $40,000 at his MTR. C The $40,000 would be a capital gain, and only $20,000 would be taxed at the annuitant’s MTR. D The annuitant would only pay tax at his MTR on $15,000 ($140,000 – $100,000 – $10,000 = ACB x 50% x MTR).

Death-Benefit Guarantee Tax Issues The death benefit is received by the beneficiary of the contract tax-free when the guarantee is paid. If the market value of the contract exceeds the guarantee, capital gains tax will be due on the difference between the guarantee and the contract value.

Why is an IVIC’s “death benefit” tax-free?

A A segregated investment fund is an insurance contract. B Proceeds from an insurance policy that has been paid on the death of the policy owner is always tax-free. C Only subsequent earnings on the “death benefit” amount will be taxed. D All of the above are correct

Taxation of Registered Contracts An RRSP must be terminated before the end of the year in which the contract holder turns 71, even if the contract has not reached maturity. If the segregated fund contract is terminated and fully redeemed in that year, the contract holder will have to pay tax on the full amount of the withdrawal. To defer this tax liability, the RRSP can be converted to a Registered Retirement Income Fund (RRIF) or an annuity. Tax does not have to be paid on a registered plan when switches between funds are made.

Taxation of Non-Registered Contracts Insurers provide annual reports (called plan allocations) to contract holders. These detail amounts credited to the contract and taxable realized capital gains or losses in the fund. A contract holder must declare plan allocations for tax purposes in the year that they are received.

The contract holder may claim tax dividend credits, and any capital losses in the contract may also be used to offset capital gains incurred in other investments over the past three years or at any time in the future.

When a non-registered contract is disposed of, the amount of taxable income + FILE See File 46 for a case reported for taxation purposes will depend on whether the proceeds are taken as a study based on an lump sum or as an annuity. IVIC.

Generally speaking, what is the tax status of withdrawals made from registered and non-registered IVICs?

A Fully taxable at MTR, not taxable; B Fully taxable at MTR, partially taxable; C Only accrued earnings are taxable for both contract types; D Fully taxable, fund-generated allocations are taxable, but recipients can claim capital losses, capital gains exemptions, carry-forwards, loan interest expense, fund management fees and expenses, and dividend tax credits.

The Guaranteed Minimum Withdrawal Benefit (GMWB) and the Guaranteed Lifetime Withdrawal Benefit (GLWB) Products

Since early 2009, the guaranteed minimum withdrawal benefit (GMWB) and the guaranteed lifetime withdrawal benefit (GLWB) products have been introduced to the Canadian markets. These products are not new, but are enhancements to the standard segregated-funds products. There are two reasons why these products are receiving such attention:

1. The Baby Boomers are now retiring, and they want to ensure that their lifetime savings will provide them with a guaranteed lifetime income so that they will not outlive their resources. 2. Recent market downturns caused by the recession have forced providers to offer alternatives and guarantees to retirees.

The concept of the GMWB and the GLWB is not new. It has in the past been applied to deferred annuities. The segregated fund contract or an IVIC is a form of deferred annuity contract that hitherto gave a guarantee only on the accumulations or account value. Recall that the maturity guarantee and death benefit guarantees offered by segregated funds make up a minimum of 75% of the premiums paid into the contract.

GMWB and GLWB products now offer, in addition to these accumulation guarantees, an income guarantee for retirees. These products generally have two phases:

1. The investment, or accumulation, phase, in which the consumer is free to invest new premiums into the contract. The Maturity and Death benefit guarantees apply, as in all segregated fund contracts. The accumulation phase may extend until the retirement of the accountholder. Generally, this is 15 to 20 years. 2. The retirement, or payout, phase, in which the fund guarantees a minimum payout from the fund for a stated period (say 15 years). This is called a Guaranteed Minimum Withdrawal Benefit (GMWB) or, if it covers the lifetime of the accountholder, called the Guaranteed Lifetime Withdrawal Benefit (GLWB). The minimum age at which a person may begin the payout phase is generally fixed by each insurer (a common example would be at age 55).

Essentially the GMWB and GLWB are percentages of a guaranteed benefit base (GBB), which is a notional amount. The Guaranteed Benefit Base (as we are calling it here) is named differently by various insurers, and the way they calculate it may vary among them. The base in general is calculated by most insurers as:

GBB = Deposits + Bonuses and/or Crystallized gains – Surrenders

Bonus: During the accumulation phase, the GBB is increased by a bonus (say, 5%) of the current GBB, for each year in which surrender was not made. The bonus only increases the value of the GBB, which, as mentioned, is a notional amount and has no impact on the market value of the account.

Crystallized gains: These are gains that are added to the deposits when a reset occurs. Most insurers offer an automatic reset periodically (say, every three years), when the premiums will be made equal to the account value, in case the account value is more than the current GBB.

The Guaranteed Minimum Withdrawal Amount (GMWB) = A percentage of the year-end GBB Assume GMWB = 7% of GBB Note that a surrender of less than — or equal to — the GMWB does not affect the GMWB for future years. However, if the withdrawal is more than the GMWB, it may reduce the GMWB for the future.

The GBB can be increased by bonuses, resets, and new premium deposits. The GBB is decreased by surrenders, and the GMWB is adjusted downward if the surrender is more than the GMWB.

Market GBB GMWB Value (After GBB Bonus GBB After (Assume Date Transaction Amount Transaction) On Bonus Trans. 7%) Remarks

Initial 4-Jan-09 Premium $100,000 $100,000 $100,000 - $100,000 $7,000 31-Dec-09 End-of-year - $108,000 $100,000 $5,000 $105,000 $7,350 5-Apr-10 Premium $50,000 $170,000 $150,000 - $155,000 $7,350 31-Dec-10 End-of-year - $180,000 $150,000 $7,500 $162,500 $11,375 No effect on GSA since the amount surrendered is less than the GMWB 24-Jun-11 Surrender ($10,000) $172,000 $150,000 - $152,500 $11,375 of $11,375 No bonus as there was a No surrender in 31-Dec-11 End-of-year - $175,000 $150,000 Bonus $152,500 $11,375 2011 Reset considers the GBB to be the higher of the current GBB or the reset 31-Dec-12 End-of-year Reset $180,000 $180,000 $9,000 $189,000 $13,230 value 20-Jun-13 Surrender ($20,000) $155,000 $155,000 - $155,000 $13,230 GBB affected as withdrawn amount is greater than GMWB. GBB will be the lesser of (current GSB - Surrender or Market No value after 31-Dec-13 End-of-year - $155,000 $155,000 Bonus $155,000 $10,850 surrender)

If the surrender amount is less than the GMWB, some insurers allow for a deferral of the difference and a future surrender can be for the GMWB +

Once the accountholder enters the payout phase, or on maturity of his contract, the accountholder has an option of converting the contract to a payout phase. The account holder may opt to receive benefits in one of two ways:

1. A fixed period, such as 15 or 20 years, as stated in the contract. 2. A lifetime withdrawal base on the account holder’s life, or a joint option.

For the fixed-period option, the GMWB calculated based on the date of maturity will be applied, generally after a special reset on maturity. No bonus will be calculated once the payout phase has commenced. The plan holder may withdraw more than the GMWB, but this will have a downward effect on the GMWB. However, if the plan holder has a RRIF or a LIF account, there will be no downward adjustment to the GMWB if the RRIF or LIF minimums are more than the GMWB.

For the lifetime withdrawal benefit, however, the GLWB is calculated as a percentage of the Guaranteed Benefit Base (GBB), based on the age of the plan holder when the option is exercised. The GLWB is naturally a smaller percentage than the GMWB, because it provides for the life of the annuitant. Typically, the GWLB rates are as follows:

Age of the annuitant GLWB Rate when option exercised Age 55 to 59 4.0% Age 60 to 64 4.5% Age 65 to 69 5.0% Age 70 to 74 5.5% Age 74 to 79 6.0%

GLWB is calculated much the same way as GMWB. Any surrender in excess of GLWB will lead to a downward adjustment of future GWLB.

The advantages to be obtained from these products is peace of mind, because the GMWB and GLWB are guaranteed amounts that can be withdrawn every year in the payout phase, even if the market value of the account would be inadequate to provide the benefit otherwise. Thus, these products provide a protection against market downside risk, while the consumer enjoys the upside of the market through resets. This is of particular importance to people nearing retirement or to retired persons, as they cannot afford to see their lifetime savings eroded by a wild market downturn. The disadvantage is, of course, that the fees one pays for these products are a little more than for products without GMWB and GLWB benefits. As an agent you must bring out these features to the consumer.

Annuities Annuities have traditionally been a very strong investment product for insurers. Although their popularity may have declined somewhat in recent years, due to the availability of many new investment products and the current low rates of interest, annuities continue to play an important role as a provider of income among the universe of investments. Your level of knowledge and understanding about annuities must equal or exceed that for segregated funds.

The word ―annuity‖ has as its root the same word that appears in the word ―annual.‖ Knowing this may help you to remember that an annuity is an investment that pays a sum of money annually (yearly), or at other regular intervals — monthly, quarterly, or bi-annually. Thus, it provides an income to the person who receives the annuity, who is called the annuitant. The payment to the annuitant is called the benefit. The benefit is comprised of capital paid by the policy owner to the insurer, plus interest and investment income earned on the capital.

Flow of Capital capital policy owner capital insurer benefit annuitant interest and investment income

Since the benefit is paid on a regular basis, annuities are positioned as a product that can provide an income during retirement, after the prime source of regular income, such as a wage or salary, stops.

Annuities can be registered or non-registered. All income from a registered annuity is taxable; only the interest portion of payments from a non-registered annuity is taxable.

“My father started an annuity for me long before registered plans even existed. However, this means I declare only the interest portion of the annuity benefit for tax purposes instead of having to declare the entire benefit from a registered annuity.”

The Structure of an Annuity To understand an annuity, you must know: When do benefits begin? Are benefits guaranteed? The types of annuities? Is there inflation protection? How long are benefits paid? How many lives are covered? Can withdrawals be made, or the contract surrendered?

Annuity Benefit Timing Annuity benefits can be either: Immediate; or Deferred.

An Immediate Annuity Benefit An immediate annuity provides its first payment at the end of the first annuity period after the annuity is purchased. If the annuity period is one year, the first benefit is received one year after the annuity has been purchased. If the annuity period is one month, the first benefit is received one month after the annuity has been purchased. The annuity is typically purchased with a single premium, because benefit payments begin so quickly. Any annuity which makes its first payment within 12 months of purchase is called an immediate annuity.

An immediate annuity that is non-registered has the advantage of being available in a prescribed form.

A Prescribed Annuity: A prescribed annuity contract spreads the capital of the Prescribed annuity Annuity payments contract owner evenly over the expected benefit period. The balance of each are a blend of capital payment is interest. A non-prescribed annuity contract pays more interest in the and interest. The capital is spread early years of the contract and more capital later. evenly over the expected payment period and the The total amount of income reported under a prescribed annuity is the same as balance of each payment is the that of a non-prescribed annuity over the duration of the annuity — only the interest. The interest timing of the reported income differs. The prescribed annuity owner pays tax on portion is subject to tax, while the capital the same amount of income for his or her annuity every year over the benefit portion is tax-free. period, whereas the non-prescribed annuity contract owner pays tax on higher amounts of reported income in the early years of the contract, and then on less income over time.

For example, Joseph receives a $1,000 monthly annuity benefit. If his annuity is prescribed, the benefit every month for the duration of the annuity would be $875 capital and $125 interest. Tax will be due on the $125. If his annuity is non- prescribed, the benefit — still $1,000 per month — might be structured as $450 capital and $550 interest. Tax will be due on $550. In year ten, the monthly benefit would consist of $895 capital and $105 interest. Tax will be due on $105.

The advantages of a prescribed annuity to an annuitant include: Paying less tax during the contract’s early years, since less interest is reported during this period. This leaves the annuitant with more net income, which effectively raises the contract’s value. Knowing precisely how much income tax will be reported for tax purposes every year.

To qualify as a prescribed annuity: A contract must provide a level benefit, that is, a set amount (except for a joint-and-last-survivor annuity, in which payments may be reduced for the surviving annuitant); The payments must start within the calendar year following purchase; The annuitant must own the contract; The contract must, if a term-certain annuity, mature no later than when the annuitant reaches age 90. This maturity stipulation applies to the younger of two annuitants when dealing with a joint-and-last-survivor annuity. The joint annuitant can be a spouse or common-law partner, a brother, sister, or a spousal or Common Law Partner trust. If a life annuity is purchased with a guaranteed term, the term cannot continue after the annuitant reaches age 90.

A Deferred Annuity Benefit Deferred Annuity An annuity that If an annuitant does not begin receiving benefits until a year or more has passed, begins at a future then he or she has a deferred annuity. date. The annuity can be purchased with either a single premium or a series A deferred annuity is not available on a prescribed basis, however it provides of premiums. unique advantages to the contract owner, in that the contract can be protected from the claims of creditors.

Deferred annuities offer creditor protection that other forms of managed investment products (such as mutual funds) cannot. Annuities are in many ways like insurance policies. Their creditor protection arises because the ownership in the underlying assets of the annuity resides with the insurance company, and not the policy owner.

A beneficiary of the annuity must be named in order for the annuity to be eligible for creditor protection. In all cases where the beneficiary is irrevocable, the contract is creditor-protected, or, in case of a revocable beneficiary, if the named beneficiary belongs to the preferred class of the annuitant However, the annuity owner may waive this protection if the contract is expressly pledged as security for a loan.

This creditor protection can be an attractive feature for those whose business or personal circumstances expose them to the seizure of assets to satisfy debt.

+ FILE Deferred annuities and Guaranteed Investment Certificates (GICs) address many See File 61 for a comparison of of the same investment needs and objectives: security, guaranteed returns, and deferred annuities interest income. However, deferred annuities offer advantages not available to a and GICs. GIC investor. The GIC investor does not enjoy creditor protection. The GIC pays out a lump sum on maturity whereas a deferred annuity contract pays out in the form of a payout annuity. Both a deferred annuity contract and a GIC are subject to market value adjustments and penalties for early withdrawal.

Annuity Benefit Guarantees Benefits of an annuity are either: Fixed; Variable.

When the Benefit Is Guaranteed A fixed benefit is a guaranteed benefit. The benefit is determined by the interest rate offered by the insurer when the annuity contract is written. The amount paid in each benefit payment received by the annuitant.

When the Benefit Is Not Guaranteed When the benefit is not guaranteed, its amount will vary from payment to payment. This type of payment is called a variable benefit. It is received through investment in a variable annuity.

A variable annuity is funded by premiums that buy units in an investment fund. The investment fund invests in common stocks. It is established as an account by the insurer, and is separate from other accounts. The value of the fund and its units, therefore, are directly related to stock-market performance.

It is well-known that the stock market moves up and down. When this occurs, the fund and unit values will move up and down. Because the fund and unit values will vary from day to day, so too will the values of a variable annuity and its benefit.

The annuitant is not guaranteed to receive a certain amount of money from the units, only a certain number of units. As the value of these units rises and falls according to the market value of assets held in the investment fund, so too will the benefit derived from the units.

In theory, a variable annuity keeps pace with inflation, because prices of common stocks are expected to keep pace with consumer prices. However, when purchasing a variable annuity, the buyer assumes an investment risk that he or she does not assume when purchasing a fixed benefit annuity contract.

Types of Annuities Annuities provide an income for: A specified period of time, called a term; Life.

A Term-Certain Annuity Whereas term life insurance provides life coverage for a specified period of time or to a specified age, a term certain annuity provides an income for a specified time or to a specified age.

A term-certain annuity, also known as an annuity certain or a fixed-term annuity, pays the annuitant a guaranteed income for either: A defined period of time (e.g., five years); A period ending at a specified age of the annuitant, at which time the annuity matures; or A specified period, equal to the number of years from the annuitant’s age at purchase to age 90, or until the annuitant’s spouse turns 90.

A term-certain annuity can be bought with either a single premium (a lump sum) or a series of premiums over a period of time.

If the annuitant dies before the term is completed, an income is paid to a beneficiary, either for the balance of the term or as a lump sum, or to the annuitant’s estate.

“I bought a 10-year deferred term-certain annuity when I was 57 with $200,000 I received from my mother’s estate. It is invested at 4.12%. I’ll begin to receive a monthly benefit when I am 65, which will pay me a portion of the principal with interest earned at that rate for ten years.”

A term-certain annuity is not an exclusive insurance product. It can also be purchased from a bank.

A term certain annuity provides complete security. The annuitant knows in advance both how long he or she will be receiving income, how much will be received, and when. Annuity payments can be received monthly, quarterly, bi- annually, or annually.

+ FILE A Life Annuity See File 47 for an illustration of a life A life annuity makes income payments for the lifetime of the annuitant. In this annuity. way, it is similar to permanent insurance, which also provides life insurance for the entire lifetime of the insured. Like permanent insurance, a life annuity is available only from an insurer.

The structure of a life annuity is quite different from a term-certain annuity. A term-certain annuity is funded by the premium or premiums, and by interest and investment income earned by the insurer on the premium(s) for the length of the term. These premiums, and their interest and investment income, are returned via the benefit to the annuitant.

A life annuity pools the capital, interest, and investment income of a group of annuitants and makes payments from the pool. Within the group, some annuitants will live longer than others. When one annuitant dies, payments cease to that annuitant, but the survivors continue to have access to the money remaining in the pool. Thus, no one can outlive his or her money.

However, once payments from a life annuity begin, they will continue as income until the annuitant dies. If a life annuity is purchased with the annuitant’s own funds, the life annuity may be commutable, in which case a remaining lump-sum payment is made to the annuitant, after deduction of surrender charges.

If a life annuity is purchased with funds from a Registered Pension Fund, the life annuity thus purchased is called a Pension annuity, and it cannot be commuted or surrendered for a lump-sum payment.

Note that pensions received from pension plans are life annuities, and are purchased from an insurance company. If a person is a single person, a single life annuity is purchased for that person. If the person has a partner (a spouse or a common-law partner), a joint life annuity would be purchased, covering both the lives. The normal pension amount is paid until the death of the pensioner and a reduced amount, normally 70% of the pension amount is paid as a survivor pension to the spouse.

“We have a joint-and- last-survivor annuity with a monthly benefit of $1,122. It is not a prescribed annuity, because we did not begin to receive the benefit until about eight years after we acquired the contract. However, because the annuity is not prescribed, we will pay less tax on the benefit as we get older.”

It may be surmised that, for the same amount of pension funds available to buy a pension annuity, a single life annuity would pay out more than a joint life annuity. A married person may not drop his/her spouse from the pension, as pension funds are considered a matrimonial property. In case a person wishes to drop his/her spouse from a pension annuity, in order to obtain a higher payment per year from the annuity, a consent to get dropped must be made available from the spouse for the pension fund to provide a single annuity in place of a joint life annuity. It may make financial sense for the spouse of a pensioner to drop himself/herself from the pension annuity, if he/she has a low life expectancy, because of some terminal illness.

Although all life annuity payments are based on an annuity rate (amount per $1,000 of the purchase price), these rates vary according to: The form and frequency of payment (monthly, quarterly, semi-annually, or annually); The age and gender of the annuitant (because women live longer than men, their life-annuity payments would extend for a longer period of time). The gender will not make a difference for pension annuities, because pension regulations in most jurisdictions prohibit discrimination based on gender. so pension annuities use a unisex mortality table. The interest rate at the time of purchase; Normally there is no medical required when a life annuity is purchased. However, if the annuitant suffers from some major ailment, he may indicate it. In that case, after the necessary medical checks, such as an attending physician’s statement, the annuitant would be offered an Impaired Life annuity, which would pay more per $1,000 than a normal life annuity, considering the reduced life expectancy of the annuitant.

There is often a significant difference in annuity rates offered by different insurers, despite the fact that they must all deal with the same variables — investment rates of return, actuarial assumptions, and actuarial expenses. Accordingly, by comparative shopping, agents can pick the annuity rate that is best for their clients.

The most common types of life annuities are: Life straight annuities (also called life only); Life annuities with a guaranteed number of payments (also called life annuity with period certain); Joint-and-last-survivor annuities; Instalment refund annuities; Cash refund annuities.

Life straight annuity: Life straight annuities pay a guaranteed income for life. The benefit stops with the death of the annuitant. The insurer guarantees the benefit, regardless of how long the annuitant lives, and premium payments end with the last regular payment preceding the death of the annuitant. These annuities pay the highest benefit per $1,000 of purchase price. This is because no extra reserve needs to be set aside by the insurance company for beneficiaries. These annuities are attractive to those who want the highest income possible or those who do not have dependents who would be beneficiaries.

“If I buy a life straight annuity, I will receive the same monthly benefit for the rest of my days. My daughter, Resa, who is my only child and beneficiary, will not receive any of the money I used to buy the annuity.” Life annuity with a Guaranteed number of payments: This annuity is similar to a life straight annuity, but it provides an income that is guaranteed for a specified period of time (e.g., 5, 10, or 20 years) or until the death of the annuitant after that period of time. If the annuitant dies before the end of this period, the balance of the benefits will be paid to the beneficiary until the guarantee period ends. If the annuitant lives longer than the specified period of time, the benefit continues until the last instalment before his or her death, and then nothing more is paid. These annuities pay less than life straight annuities, since the insurer runs the risk of the annuitant living longer than the specified time.

Instalment-refund annuity: An instalment-refund annuity guarantees a set number of income payments equal to the purchase price. If the annuitant dies before receiving the purchase price of the annuity, his or her beneficiary will receive an amount equal to the difference between the guarantee and what was received, paid in instalments.

For example, Norm Hooper buys an instalment-refund annuity with $100,000 that he has received as an inheritance. Norm dies after receiving only $55,000 in annuity payments. His beneficiary receives $45,000 in instalment payments.

Cash-refund annuity: A cash-refund annuity guarantees the annuitant an income for life. If the annuitant dies before receiving payments equal to the purchase price of the annuity, the difference between the purchase price and the

total amount received is paid to either a beneficiary or to the annuitant’s estate in a lump sum.

Coverage of More than One Life + FILE See File 48 for an A joint-and-last-survivor annuity is a life annuity that provides a guaranteed illustration of a joint- income during the course of two people’s lives. On the death of one annuitant, and-last-survivor annuity. the entire income is paid to the survivor for the remainder of his or her life. Typically used by spouses, this annuity can be purchased by any two persons.

Jill and John have a joint- and-last-survivor annuity. When one dies, the other will continue to receive the benefit. When the second of the couple passes away, there will be no payment to a beneficiary.

Comparing Life Annuities

Income Paid No. of After death of annuitant annuitants Life-Straight Annuity For life of annuitant One No payment to beneficiary Life Annuity with a For a specified One If death occurs during specified Guaranteed Number period or period, payments continue to of Payments until death of beneficiary for balance of annuitant after that period; if death occurs after period specified period, no payments to beneficiary Joint-and-Last- For lifetimes of two Two On death of one annuitant, the Survivor Annuity annuitants other receives entire income; on death of surviving annuitant, no payment to beneficiary Instalment-Refund The amount of One If income received is less than Annuity income will equal the purchase price of annuity, the purchase price difference between income and purchase price is paid to beneficiary in instalments Cash-Refund For life of annuitant One If income received is less than Annuity purchase price of annuity, the difference between income and purchase price is paid to beneficiary in a lump sum

Making Withdrawals from an Annuity

Withdrawals from Immediate Annuities Immediate annuities are available in commutable form — meaning they can be cancelled before the contract maturity date and the balance of unpaid payments converted to a lump-sum payment — or in non-commutable form, meaning they cannot be paid out.

The commutable annuity contract sets out the timing of the utilization of this option. Some contracts allow the withdrawal to occur at any time — or if the policy owner can establish a case of extreme hardship.

The actual amount withdrawn will be based upon the present value of the unpaid benefits, discounted to allow for the time value of money.

Withdrawals from Deferred Annuities Deferred annuities allow early withdrawals, and many insurers include a back- end load in these contracts, in which a fee is paid if a withdrawal is made. This fee serves two purposes: it covers initial expenses and is a disincentive for early Accumulation period The period of time the withdrawals. The load is quite often based on a percentage of funds withdrawn, capital deposited to the contract grows and and may decline over the term of the annuity until the withdrawal charge no compounds before longer applies. withdrawals begin.

Accumulated value The accumulated value Because there is a period between the date the annuity is purchased and the is the net amount paid beginning of deferred annuity payments, there is a period of time during which for the annuity plus interest; the amount of the value of the deposit grows. This is called the accumulation period, and the interest earned depends on whether accumulated value increase in value is called the . the annuity is a fixed or variable benefit. Deferred annuity contracts usually grant the contract holder the right to withdraw all or a portion of the annuity’s accumulated value during the accumulation period.

The amount that can be withdrawn from a fixed-benefit contract will be known in advance, but, when dealing with a variable annuity, the amount that can be withdrawn at any given time during the accumulation period is determined by the market value of the assets in the investment fund that underlies the variable contract. This valuation is done daily. Thus, the amount cannot be known in advance with complete certainty.

Insurers may allow one withdrawal without a charge, so long as that withdrawal does not exceed a set percentage of the fair market value (FMV) of the assets held in the annuity. 306 Copyright © 2011 Oliver Publishing Inc. All rights reserved. Types of Investments

For example, a person with a $50,000 annuity may have a contract that allows a free withdrawal of up to 10% of the value of the contract, without payment of a penalty or withdrawal charge. Thus, the person could make a one-time withdrawal of up to $5,000.

Market Value Adjustments When a term-certain annuity contract is surrendered, or an early withdrawal is made, an adjustment will be made to the interest rate on which the fixed-benefit annuity is based. This is termed a market value adjustment (MVA).

There are three possible adjustments:

1. The interest rate credited to the premium is changed to the rate that would have applied for the number of years of the annuity.

For example, let us assume the following rates apply for an annuity: 10 years, available at 10% 9 years, available at 9% 8 years, available at 8.5% 7 years, available at 6% 6 years, available at 5.5% 5 years, available at 4.9%

If a 10-year contract was taken by the policy owner, he or she would be guaranteed to receive 10% interest for the ten years of the contract. However, if the policy owner surrendered the contract after five years, its original interest rate (10%) would be changed to the interest rate that would have applied had the contract been for five years (4.9%) and a deduction made to reflect this change from the surrendered contract.

2. The interest rate credited to the deposit may be changed as a result of a change in interest rates from the date of the premium and the date of the early withdrawal.

For example, if interest rates on withdrawal are 8% and on deposit were 4%, the policy owner might have to pay an additional penalty for the early withdrawal in order to reflect current market conditions. However, if interest rates had gone from 8% on deposit to 4% on withdrawal, there may not be an MVA, because the insurance company has the advantage of being released from its 8% interest obligation.

3. Finally, the interest rate used to calculate either of the two changes above may be reduced by an additional amount (e.g., ¼ of 1%) as a penalty for early withdrawals.

In addition to a market value adjustment, an early surrender or withdrawal charge may be applied, according to a schedule based on the number of years remaining in the annuity until maturity.

Such a schedule might be: 5 years to maturity: 5% 4 years to maturity: 4.5% 3 years to maturity: 3.5% 2 years to maturity: 2% 1 year to maturity: 1%

The percentage in the schedule is applied to the amount being withdrawn, according to the number of years until maturity. For example, if Joan Beam wants to withdraw $100,000 from her annuity two years before the annuity matures, she will be charged $100,000 x 2% = $2,000.

An Annuity for Special Circumstances: A Structured-Settlement Annuity Insurers use a structured settlement annuity to settle a large accident and liability claim that results in serious permanent disability. The insurer registers this annuity as a structured settlement annuity with Canada Revenue Agency. The agency then recognizes that the payments received by the annuitant are tax- free, because they comprise part of a court award.

For example, Jean Faux has been permanently and severely disabled in a motor- vehicle accident. Jean’s claims for pain and suffering, as well as all related claims from his dependents, have been settled with a lump-sum payment by his life insurer. In addition, Jean and his insurer agree that he requires $4,500 per month to cover ongoing medical care for the rest of his life.

Rather than providing Jean with a principal sum large enough to generate such income now and in the future, the insurer purchases a structured-settlement annuity to provide the monthly income that Jean requires. The annuity saves the insurer upfront the principal required to generate such income. Jean’s benefit is tax-free.