Post on 01-Jan-2022
transcript
Minding your own business – Segregated fund contracts as a risk management tool
According to Statistics Canada, small businesses are flourishing in Canada, with approximately one million companies currently operating with fewer than 100 employees.
However, small business owners have unique financial
challenges when it comes to succession planning,
protecting their assets from creditors, and investing
funds to sustain their enterprise through a crisis. Let’s
take a closer look at one entrepreneur’s situation and
examine some important strategies she can implement
with the assistance of her advisor.
Sandra owns a neighbourhood dry cleaning business in
Sudbury and runs it with her daughter. She is 55 years old
and starting to think about retiring to spend more time
with her husband, Henry, and their three grown children.
She has been even more eager to scale back her working
hours since her eldest daughter had a baby boy last year.
Sandra is looking forward to being right there on the scene
as her grandson takes his first steps and begins to talk.
Sandra’s personal investing style has always been
conservative. Without much professional financial
advice, she put some money into mutual funds in 2000,
but market volatility quickly drove her back to safer
choices such as Guaranteed Investment Certificates
(GICs). She very much likes the idea of guarantees
protecting at least part of her principal investment.
In contrast, Sandra has always been prepared to take
some risks within her business. When she started her
enterprise 15 years ago, and with no guarantee of
success, Sandra made a heavy initial cash investment to
buy the necessary equipment. She has also
experimented with innovative promotional and
advertising strategies at various times to grow her
company and incorporated her business 10 years ago.
Sandra has always seen these opportunities as a
necessary part of doing business.
What she didn’t realize, until her advisor pointed it out,
was that she was taking some unnecessary risks with her
business. Sandra doesn’t have a succession plan, so there
is no way to say how much of the value of her company
will be passed on to her family if something happens to
her. None of her assets are protected from creditors, which
means both her business and personal holdings are
vulnerable to potential lawsuits and bankruptcy.
Furthermore, Sandra needs to build up an emergency
source of cash that will allow her to keep operating if
something unexpected occurs, such as a cash flow crunch
or the bankruptcy of an important supplier.
STEP #1: DEVELOP A SUCCESSION PLAN
Many small business owners like Sandra haven’t
developed comprehensive succession plans for their
companies. But a succession plan is essential to ensure
that the business continues to operate – if that’s the
owner’s goal – and/or that beneficiaries receive as large
a bequest as possible.
For all business owners, the first step is to determine the
current value of the company and their objectives for its
future. Sandra will have to consider her own goals and
financial needs, the expectations of family members, and
whether any of her employees are willing to take over
the dry cleaning store. If there is no clear successor, she
may have to explore the option of selling her business to
a competitor or simply winding it down upon retirement
or death.
The strategies Sandra’s advisor recommends for her
include planning to make sure she exploits the lifetime
$750,000 capital gain exemption, and considering an
estate freeze to lock in the value of the business today
so any future growth is passed on to her successors. He
also advises Sandra to consider a strategy to pull some
of the retained earnings out of the business and invest
this accumulated savings in a segregated fund contract.
This may also be a consideration in addressing her
insurance needs in a situation where term insurance is
prohibitively expensive or if she is "uninsurable" for
any number of reasons.
A segregated fund contract with a 100 per cent death
benefit guarantee ensures that, at a minimum,
beneficiaries receive Sandra’s principal investment when
she dies. Most insurance companies waive any remaining
deferred sales charges upon death, which can be a
significant benefit as well. Some companies also provide
an escalating death benefit or a reset feature that allows
Sandra to lock in growth and gradually increase the
amount her heirs can be guaranteed to receive.
Another advantage is that the death benefit from a
segregated fund contract is paid directly to the named
beneficiaries without going through probate. Sandra’s
bequests will remain private* and her estate will not
incur probate fees and executor and accountant/legal
fees on the assets in the segregated fund contract. This
can be a significant cost savings (see table). But perhaps
most importantly, bypassing probate can save time. The
beneficiaries of segregated fund contracts generally get
their money within two to three weeks, while estates
can take several months (or years, if the will is
challenged) before paying out funds.
* In Saskatchewan, jointly held property and insurance policies with a named beneficiary are identified on the application for probate despite the fact that these assets do not flow through theestate and are not subject to probate fees. Probate does not apply in Quebec.
When Sandra’s beneficiaries collect their bequests, they
have the option of using the money to keep the business
running smoothly while they take over the company’s
management, or start looking for a buyer. In the
meantime, while Sandra is alive, her money has the
opportunity for continued growth through the underlying
investment funds with built-in downside protection.
STEP #2: PROTECT ASSETS FROM CREDITORS
Entrepreneurs, by their very nature, tend to be optimists.
Few consider the possibility that their businesses may one
day be involved in a lawsuit or forced into bankruptcy. But
if either of these scenarios takes place, it’s not just the
business that may be at risk. Creditors may come after the
business owner’s personal assets as well. So it just makes
sense for business owners to hope for the best, but plan
for the worst.
In Sandra’s case, she may be personally liable for any
debts for which she has given a personal guarantee; any
statutory debts such as wages and vacation pay; any
source deductions owed to the Canada Revenue
Agency; Harmonized Sales Tax (HST) / Goods and
Services Tax (GST) and provincial sales tax; or health and
safety violations, and environmental damage. Business
liability insurance can offer protection against lawsuits
arising from injuries sustained at a place of business or
from using a business’ products, but it does not
safeguard the business owner from the financial
consequences of a business failure. The good news is
that insurance-based investments, such as segregated
fund contracts and Guaranteed Interest Contracts, may
offer creditor protection in the event of a lawsuit or
bankruptcy, as long as the investments were made in
good faith and a proper beneficiary is named.
That means the segregated fund contract Sandra is
considering buying as part of her succession plan can
help her shield personal assets from creditors as well.
Her advisor also points out that moving some of her
personal savings into a segregated fund contract will
protect her family’s standard of living if the business runs
into trouble. Another strategy she can use is to transfer
some of her personal assets – such as the family home –
into her husband’s name since he isn’t involved in
the business.
STEP #3: INVEST CONSERVATIVELY TO BUILDAN EMERGENCY FUND
Sandra is a conservative investor who values stability and
security above flashy returns. She has always invested
her business’s emergency fund assets in traditional GICs.
The disadvantage of this approach is that the money is
barely keeping pace with inflation. Also, it is locked in
for a specific term and may not be available at a
moment’s notice if Sandra needs the funds.
Her advisor suggests that she take a look at a segregated
fund contract for her corporation's investments, too.
They can offer greater growth potential than traditional
GICs and are redeemable at any time (fees may apply).
Furthermore, because they offer a broad selection of
investment choices, segregated fund contracts can
enable Sandra to access the security of fixed-income
investments if she chooses.
This approach appeals to Sandra and she decides to
follow her advisor's recommendation by investing in a
portfolio of lower risk fixed income investments in a
segregated fund contract.
PROTECT YOUR BUSINESS
Segregated fund contracts can be a valuable part of any
business' succession, potential creditor protection and
emergency fund plan. Yet only a small percentage are
taking advantage of them as a risk management tool.
Segregated fund contracts offer different features and
benefits, so it’s important to carefully choose the
contract that’s right for you. Talk to your advisor about
the strategy and products that make sense for your
specific circumstances, and protect the value you’ve built
in your business for yourself and your family.
Mutual funds vs. Segregated fund contracts: An estate planning comparison
Mutual fund Segregated fund account ($) contract ($)
Original deposit 200,000 200,000
Market value at time of death1 180,000 176,0002
Deferred sales charges (4.5%)3 9,000 Waived by most issuers
Probate and executor/accountant/legal fees4 8,905 None
Death benefit top-up None 24,000
Amount paid to beneficiaries 162,095 200,000
Time before beneficiaries receive this amount Months Weeks
Difference NA 37,905
For illustration purposes only.
1 Assumes Fair Market Value has dropped 10% at time of client's death (in the third year of the investment). Underlying investments and fees associated with mutual funds and segregated fundcontracts will vary and by comparison, lead to different rates of return.2 Market value is lower as segregated funds typically have higher Management Expense Ratios (MERs) to pay for insurance features.3 Calculation based on original investment; 4.5% is for illustration purposes only. Deferred sales charges (DSC) schedules will vary depending on funds selected.4 Illustration based on Ontario probate fee schedule, plus we have assumed executor/accountant/legal fees equal to 4% of value of investment flowing through estate. Costs will vary from provinceto province and will depend on the complexity of the estate.
© 2012 Manulife Financial. The persons and situations depicted are fictional and their resemblance to anyone living or dead is purely coincidental. This media is for informationpurposes only and is not intended to provide specific financial, tax, legal, accounting or other advice and should not be relied upon in that regard. Many of the issues discussedwill vary by province. Individuals should seek the advice of professionals to ensure that any action taken with respect to this information is appropriate to their specific situation.E & O E. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing.Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Any amount that is allocated to a segregated fund is invested at therisk of the contractholder and may increase or decrease in value. Manulife, Manulife Investments, the Manulife Investments For Your Future logo, the Block Design, the Four CubesDesign and Strong Reliable Trustworthy Forwardthinking are trademarks of The Manufacturers Life Insurance Company and are used by it, and by its affiliates under license.
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