Variable Annuities Better Known As Segregated Funds In Canada

By Ivon T Hughes
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Variable Annuities/Segregated Funds

Variable annuities, also called segregated funds, are contracts between investors and insurance companies. They are similar to mutual funds but have added features that insure and guarantee deposits at maturity and death.

This variable annuity (segfund) is suitable for long term growth and offers creditor protection and estate planning strategy advantages.

Segregated funds offer the following features:

  • Separate account – segregated funds are separated from the general assets of the insurance companies.
  • Diversification – with segregated funds you can invest in different types of funds that suit your investment goals.
  • Guaranteed death benefit – the beneficiary can be guaranteed a proportion of the amount originally invested, minus withdrawals.
  • Liquidity – many segregated funds allow withdrawals up to 10% of the segregated fund's value without penalty.
  • Privacy – at death, the amount due is paid directly.
  • Early redemption – there is a redemption fee that may apply if the fund is redeemed early.
  • Market value fluctuation – the value of a segregated fund is subject to market value fluctuations.

Only life insurance companies can issue segregated fund contracts.

Why buy variable annuities (segfunds)?

An investment made in a variable annuity or segregated fund contract offers you the combination of the growth potential of a mutual fund and guarantees of a life insurance company.

Those benefits include:

  • Guarantees that offer investment protection
  • Guarantees that cover death benefits
  • Potential creditor protection
  • The right to assign a beneficiary
  • Advantages of tax and estate planning
  • An option that allows you reset your guarantee to a higher amount

Some additional contractual features that segregated fund contracts offer include:

  • Flexibility that allows switching between funds offered within a contract at no cost
  • Diversification through a selection of income, growth, and balanced funds
  • Liquidity that allows for prompt redemption of all or part of your investment

Features Of Segregated Fund Contracts

  • A guaranteed maturity benefit of 75 – 100 percent (your choice) of premiums after deduction of previous withdrawals. This guarantee is effected on a stated maturity date, usually after 15 years of contract issuance.
  • A guaranteed death benefit of 75 – 100 percent (your choice) of premiums after deduction of previous withdrawals. When the insured person dies, the benefit is payable to the assigned beneficiary of the contract.
  • Potential creditor protection - where the beneficiary of a contract is a child, spouse, parent or grandchild of the insured individual (or, in Quebec cases, the contract owner), when the named beneficiary is irrevocably designated, it is impossible for a segregated fund to be seized.

Optional Features Of Segregated Fund And Variable Contracts

The following may also be offered:

  • Resets. This allows you to occasionally reset the guarantee for the purpose of locking in increases in the market value of the segregated funds. This privilege is a way of extending the date the involved contributions will mature.

Your Investment Options

With segregated fund contracts, you from, income, growth, dividend and balanced funds with portfolios that are well-diversified.

At Time Of Purchase

At the time of purchase, an information folder will be given to you, describing:

  • Major features and benefits of your contract
  • The choice of investment options covered by the contract
  • Key information regarding the fund options (e.g., type of fund, previous performance, and fees and costs)

During the purchase, you will have to make decisions about:

  • The investment types
  • The guarantee options
  • Will you name a beneficiary?

Ensure that before you sign the application form, you are aware of all issues concerning the contract. A policy contract will also be given, indicating the terms of the agreement as well as your rights regarding future contributions, withdrawals in cash, and guaranteed death benefit and maturity values.

What happens on the policy maturity date?

On the policy maturity date, unless indicated, all segregated funds units allocated to your policy will be redeemed.

RRIFs, Spousal RRIFs, PRIFs, LIFs, LRIFs and LRIFs policies

Following the policy maturity date will, life annuity payments will commence if you have not chosen an alternative.

Costs and Fees

Certain fees are attached with the funds management and with your transactions. The Management and Operating Expenses Ratio (MER) is total percentage of your money used as annual expenses of the fund. These annual expenses cover fees (e.g., for accounting, investment managers and administration), and your advisors’ compensation. The costs of guarantees covered by your contract are sometimes included, even though some insurers charge separately for these guarantees. More volatile funds or higher guarantees normally attract a higher MER. Transaction fees, otherwise called loads, are amounts charged on all your transactions. You are either charged front-end loads (i.e. initial sales charges), back-end loads (i.e. deferred sales charges) or no-load funds. The first deduction is the initial sales charge, which is deducted from the amount you contribute to front-end load funds. That implies that a lesser amount than the actual deposit is invested in the fund. On the other hand, a deferred sales charge is the amount deducted from your withdrawal in back-end load funds (in the early years of your contract). That implies that you get less than your actual withdrawal. Also, additional fees may be charged for riders as optional benefits.

Variable Annuity Risks

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There are various types of risks associated with variable annuities and which are common to most types of investments. The following is a brief summary of the types of risks which could be associated with variable funds.

Commodity Risk

Segregated fund that invests in natural resource companies will be affected by chnages as commodity prices tend to be cyclical.

Credit Risk

Credit risk is comprised of default risk, credit spread risk and down grade risks which can have a negative impact.

  • Default risk is that the issuer of a bond or other fixed income security may not be able to pay.
  • Credit spread risk is the risk that there wil be an increase in the difference between the interest rate of an issuer's bond and the interest rate of an issuer's bond and the interest rate of a bond.

Derivative Risk

Derivatives are securities derivedfrom, an underlying asset.

The risks includes:

  • The value of a derivative may chnage due to chnages in interest rates.
  • It may be difficult to sell a derivative in time.
  • One party may fail to make a promised payment.

Equity Risk

Enquity investments, such as stocks are affected by stock market conditions where the company shares trade and by general economic and financial conditions. Equity segregated funds are generally more volatile.

Fixed Income Investment Risk

Fixed income investmnets, such as bonds carry several risks including a number of other factors may affect the price of a fixed income investment.

Foreign Currency Risk

The value of securities issued in foreign currencies is affcted by chnages in the value of the Canadian dollar. If the Canadian dollar goes down the value of an investment held in that currency goes up. The reverse occurs when the dollar rises.

Foreign Investment Risk

The value of segregated funds may be affected by general global and specific economic conditions in a particular country.

Index Risk

A segrergated fund with "Index" in the fund name is considered an index fund.

Interest Rate Risk

nterest rate risk is the risk of a change in interest rates.

Income Tax

This is a general sumamry of income tax considerations for Canadian residents based on the Income Tax Act of Canada does not take into account any provencialtax laws.

Tax status of segregated funds

The segregated funds generally do not pauy income tax because all their icnome tax and realized capital gains and losses are allocated to you and other policy owners.

The segregated funds may have foreign tax withheld on income that is earned on their investments.

Non-Registered Policies

You must reportthe investment income allocated to you by the segregated funds including:

  • Interest
  • Dividends from taxable canadian companies
  • any other investment income

When you redeem units of a segregated fund, which you will realize a capital gain or a caital loss. Your capital gain will be the amount by which the value of the redemptioon exceed the zdjusted cost basisis of the units. The reverse is true for a loss.

Know Your Advisor

You can only purchase a segregated fund contract from an advisor licensed to sell life insurance in your province. The advisor may work independently, for a financial service firm, or for a specific insurance company. He/she may also have license to sell other insurance types and/or investment products including property and casualty insurance, bonds, stocks and mutual funds.

You will be given a written disclosure about the company your advisor is representing, and any conflict of interest as well as his/her payment details. Based on your advisor’s professional qualification, he/she is in a right position to assist you with the analysis of your plan for retirement income, estate planning and insurance needs. He/she can also provide recommendations to meet those needs and offer ongoing services, such as updating your investment, beneficiary change and rebalancing your portfolio. It is a normal practice for your advisor to get a commission when you enter into a contract and make direct contributions to a fund. These commissions are usually deducted from your front-end loads and/or annual expenses. Your advisor may continue to get commission for ongoing services throughout the period in which you hold the fund. This is referred to as “trailer” or “trailing” commission and is usually included in the MER attached to your fund.

No-load funds are funds that don’t charge front- or back-end loads, and they usually carry higher trailer commissions, which is often reflected in a higher MER. At the time of purchase, you will be provided with all the information that includes the details of trailer commissions, as well as how the issuer of the segregated fund calculates them, and expected services an investor should get.

Your advisor can help you with commission rates for the funds you have in mind, and may also help you compare them with similar funds.

Managing Your Contract

You have a list of segregated funds within your contract to choose from at time of purchase. For those having an ongoing contract, change of funds is possible at any time. SWITCHING FROM ONE FUND TO ANOTHER.

With majority of segregated fund contracts, you are permitted to switch between segregated funds offered within a contract without having to pay any charges or changing the levels of your guarantees. There may be tax consequences attached to switches, except in a case when your segregated fund contract is held in a registered account, such as an RRSP.

Redeeming a Segregated Fund Investment

A great benefit enjoyed by those who invest in segregated funds is the ease of redeeming their values (liquidity). As far as segregated funds is concerned, you can decide to surrender or redeem your contract for cash in part or in full, any time you wish. However, the value of your guarantees is affected when you make partial withdrawals. Another thing to consider is the effect of timing on the amount payable when you cash in. For contracts redeemed at maturity or when the insured person dies, you or your beneficiary have the right to receive the greater of:

  • The amount guaranteed by your contract; or
  • The current market value of your entire investment after any withdrawal fees have been deducted.

This is to say that the payable amount, in any case, is not less than the amount guaranteed by your contract, and if the performance of your investment has been good enough, the amount is usually more.

The case is not so when you choose to redeem your segregated fund (partially or in full) before the maturity date. This is because the guarantees on your contract are not applicable to such withdrawals. What you will receive in such cases is the current market value of your investment after deduction of any applicable fees, which include deferred sales charges. This amount is mainly dependent on whether the market value of the funds has decreased or increased. It may be more, or less than the originally invested amount.

Ivon T Hughes

About the Author

Ivon T. Hughes

Ivon T Hughes is a leading expert in life annuities in Canada. His website is a recognized authority on annuities. He's also an established insurance and investment broker, through The Hughes Trustco Group since 1972. Recently, he's been redefining how annuities are sold in Canada.


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