Selectpath Benefits & Financial

Minding your own business - Segregated funds 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 financial 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 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 $500,000 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 invest some of her business’ accumulated savings in segregated funds as a form of life insurance, since term insurance at Sandra’s age may be prohibitively expensive – or she may even be “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. Some 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 are 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 saves 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.

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; 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 funds 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 funds Sandra is considering buying as part of her succession plan can help her shield business assets from creditors as well. Her advisor suggests that she may also want to move some of her personal savings into segregated funds so her family’s standard of living isn’t compromised 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 build an emergency fund
Sandra is a risk-averse 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 segregated funds for this purpose, too. They can offer greater growth potential than traditional GICs and are redeemable at any time. Furthermore, because they offer a broad selection of investment choices, segregated funds enable Sandra to access the security of fixed-income investments if she chooses. Depending on the product Sandra chooses, segregated funds may offer a 100 per cent maturity guarantee after a set period of time (usually more than 15 years). In other words, Sandra is guaranteed to get back the money she puts in, no matter what effect the markets have on the underlying investment funds and as long as she holds the contract until it matures.

This approach appeals to Sandra. She feels that she takes enough risks just being an entrepreneur and although she doesn't want to experience volatility in her investments, she hasn't been completely satisfied by the returns offered by traditional GICs.

MUTUAL FUNDS VS. SEGREGATED FUNDS:
AN ESTATE PLANNING COMPARISON

	Mutual fund account	Segregated fund contract
Original deposit	$200,000	$200,000
Market value at time of death`1`	$180,000	$176,000`2`
Deferred sales charges (4.5%)`3`	$9,000	Waived by some issuers
Probate and executor/accountant/legal fees`4`	$8,905	None
Death benefit top-up	None	$40,000`5`
Amount paid to beneficiaries	$162,095	$216,000
Time before beneficiaries receive this amount	Months	Weeks

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 funds 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 province to province and will depend on the complexity of the estate.
5. This amount assumes the segregated fund provides a minimum 4% simple interest escalating death benefit as is found with the Manulife GIF encore product. Not all segregated funds offer this feature. This amount could be higher or lower depending on the product purchased and the death benefit guarantee features available.

Join the first percentile!
Segregated funds can be a valuable part of any business' succession, creditor protection and emergency fund plan. Yet only a small percentage are taking advantage of them as a risk management tool.

Segregated funds offer different features and benefits, so it’s important to carefully choose the contract that’s right for you. Talk to your financial 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.

* 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 the estate and are not subject to probate fees.

Manulife Investments is the brand name identifying the personal wealth management lines of business offered by Manulife Financial and its subsidiaries in Canada. As one of Canada’s largest integrated financial services providers, Manulife Investments offers a variety of products and services including segregated funds, mutual funds, principal protected notes, annuities and guaranteed interest contracts.

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Manulife Investments is the brand name identifying the personal wealth management lines of business offered by Manulife Financial and its subsidiaries in Canada. As one of Canada’s largest integrated financial services providers, Manulife Investments offers a variety of products and services including segregated funds, mutual funds, principal protected notes, annuities and guaranteed interest contracts.

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