Segregated Funds: Structure, Regulation & Tax

• In this chapter, additional types of managed products are discussed, including their structure, characteristics, regulatory issues, and tax considerations.

Segregated Funds

• Segregated funds are pooled investments, similar to mutual funds, but considered insurance products, where the insurance company uses the proceeds to purchase underlying assets and sells units to investors.
• Segregated funds offer professional management, advice, the ability to invest small amounts, and provide client statements, similar to mutual funds.
• Segregated funds offer unique features to meet client needs, such as maturity protection, death benefits, and creditor protection.
• Segregated funds are regulated as individual variable insurance contracts by provincial insurance regulators.
• The Canadian Life and Health Insurance Association Inc. provides guidelines that are accepted by each province and territory as primary regulatory requirements.
• The Office of the Superintendent of Financial Institutions (OSFI) ensures that federally regulated insurance companies are adequately capitalized.
• Assuris protects against the loss of policy benefits if a member company becomes insolvent, providing maximum compensation of $60,000 or 85% of promised amounts.
• Investors are assigned notional units, which measure a contract holder's participation and benefits in a fund.
• The contract covers three parties: the contract holder (the purchaser), the annuitant (whose life is insured), and the beneficiary (who receives benefits upon the annuitant's death).
• Beneficiary designations can be revocable or irrevocable.
• Segregated funds offer maturity guarantees, promising at least partial return of the invested money, which provincial legislation requiring the guarantee to be at least 75% of the investment amount after 10 years.
• Reset dates allow contract holders to lock in the fund's current market value and set a new 10-year maturity date. Death benefits ensure that the beneficiary or estate receives payouts of at least the guaranteed amount.
• Segregated funds offer creditor protection due to the assets being owned by the insurance company, typically shielding them from bankruptcy legislation.
• Bypassing probate is a advantage of segregated funds, where proceeds pass directly to beneficiaries.
• Segregated funds have higher management expense ratios (MERs) than comparable mutual funds due to the added costs of guarantees.
• Segregated funds are taxed as trusts and the insurance company does not pay taxes on the fund's income.
• Segregated fund net income is deemed to be the contract holder's income and is taxed in the current year in non-registered accounts.
• Payments from maturity guarantees are taxable.
• Death benefits are tax-free.
• Segregated funds differ from mutual funds in legal status, ownership, nature of units, regulation, and protection against issuer insolvency.

Labour-Sponsored Venture Capital Corporations (LSVCCs)

• LSVCCs are managed investment funds sponsored by labour organizations to provide capital for small to medium-sized firms.
• The advantages of LSVCCs are federal and provincial tax credits and a 15% federal credit applies to an annual investment, with some provinces offering additional credits.
• LSVCC shares are eligible for RRSPs and RRIFs, providing further tax savings.
• Disadvantages of LSVCCs include the high-risk nature of the investments, complicated redemption rules, and higher costs due to MERs.

Closed-End Funds

• Closed-end funds are pooled investment funds that raise capital by selling a limited number of shares.
• The fund's manager uses the capital to purchase securities based on a specific mandate and closed-end funds generally have lower management fees than mutual funds with similar investment objectives.
• Prices of closed-end funds are based on market supply and demand, potentially leading to funds trading at a discount or premium relative to their NAVPS.
• Underyling assets can include preferred shares of Canadian financial institutions, foreign-based manufacturing companies, business trusts, real estate investment trusts (REITs).
• Flexibility to buy back shares periodically, known as interval funds or closed-end discretionary funds.
• The closed-end fund product structure is ideally suited to alternative investment strategies since the alternative investment manager does not have to concern herself with managing fund liquidity over the life of the fund (at least as it pertains to investor redemption requests).
• Advantages of closed-end funds include diversification, investment opportunities like short selling, flexibility for money managers to focus on long-term strategies, and easier tracking of adjusted cost base.
• Disadvantages include potential for trading at prices that do not reflect NAVPS, less liquidity, lack of automatic reinvestment and foreign income is not eligible for the federal dividend tax credit.

Income Trusts

• An income trust is similar to a closed-end fund, but investors buy ownership interests in the trust, which holds interests in a company's assets.
• Two major categories are REITs (real estate investment trusts) and business trusts.
• Income trusts react to changing interest rates similarly to fixed-income securities and are affected by market conditions and economic cycles like equities.
• REITs consolidate capital to invest in and manage real estate portfolios and are publicly traded, and pay out a high percentage (95%).
• REITs have the folowing risks: quality of the properties, state of the rental markets & tenant leases, costs of debt financing, natural disasters & access to liquidity.
• Liquidity is a major benefit of REIT ownership.
• Business Trusts: Business trusts purchase the assets of an underlying company, usually in the manufacturing, retail, or service industry.
• Income trusts are taxed like corporations, however Canadian REITs have different taxation rules.

Listed Private Equity

• Private equity finances firms unable or unwilling to find capital through public means.
• Listed private equity companies are investment companies that use capital to purchase or invest in other companies, with shares traded on a stock exchange.
• Investment holdings can include companies that are publicly traded on a stock exchange or that are privately held.
• Private equity investors can use methods to provide finance to firms such as leveraged buyout, growth capital, turnaround, early-stage venture capital and late-stage venture capatal.
• Advantages of listed private equity include access to legitimate inside information and the ability to influence management.
• Disadvantages of listed private equity include illiquid investments and dependence on key personnel.