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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