Using Segregated Funds to Mimic a Trust

ACES Blog | written by: Robert Hurdman, Investment Specialist
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Let’s first take a quick snapshot of what a trust really is and what it is not. There are a number of types of trusts, all with various idiosyncrasies, but with many common traits. First, a trust is a separate legal entity with a defined lifespan of 21 years. The trust is created by a settlor, is managed by a trustee(s) for the eventual enrichment of the beneficiaries. Trusts may be created during the settlor’s lifetime (Inter vivos trusts) or at the time of the settlor’s death (testamentary trusts). Assets are placed into a trust, usually at the assets’ FMV so some tax may be created for the settlor, and are managed by the trustee(s) on behalf of the beneficiaries. At the trustee’s discretion, subject to the conditions of the trust, assets are passed out to the beneficiaries at the trust’s ACB, so no tax is created. Tax is ultimately paid by the beneficiary when the asset is disposed. One common misconception about trusts is that they are good tax planning vehicles - but nothing could be further from the truth. Any income earned by a trust that is not passed on in a specific tax year is taxed at the top marginal tax rate inside the trust. If the income is passed on to the beneficiaries, they are ultimately responsible for the tax at their, potentially lower, tax bracket. Just remember trusts were created long before income tax came into being so trusts are largely about asset control, not tax planning. Finally, trusts can be very expensive to setup and their ongoing costs are significant as well. Compare this with the relatively low cost of setting up a segregated fund and the lower, annual MER’s.

Though a seg fund is itself not a trust, it does share a limited number of common traits with a full blown trust. For example, trusts are not terribly efficient tax vehicles nor are seg funds. Regular trusts have trustees which act like the owner of a seg fund contract. Assets inside a trust are creditor proof and, under very specific conditions, so are seg fund assets.

Overall, the fact that both trusts and seg funds can offer creditor protection along with the fact the trustee/owner of a trust or seg fund is the manager of the assets but not typically the beneficiary are two of the main common points between the vehicles.

Let us now turn to three examples of how segs can work like a trust but without the higher costs.

Example one, imagine parents who would like to provide money for their children. There are many reasons they may not want to provide a lump sum of cash or a gift of an investment account, including a child who is unable to manage the investment due to age, disability or personality, or potential unwanted access to the assets by the spouse of the child. Like a trust, the owner of a seg fund retains control over the asset. So like a trust, the disbursement of assets is controlled by someone other than the beneficiary. Another way assets in a seg fund may be controlled is through the use of an irrevocable beneficiary designation. With an irrevocable beneficiary, the owner of the seg fund assets cannot access the assets without the irrevocable beneficiary’s permission. When assets are distributed from a trust they are done so at the complete discretion of the trustee. Under a seg fund, contract beneficiary designations may be structured in almost any fashion to create a similar distribution of assets. Also with a seg fund, if the owner does not want the beneficiary to receive a lump sum, then an annuity option may be selected and generate a similar result.

In example two, let us consider a mixed family with children from separate marriages. As stated above, the beneficiary designation of a seg fund can be put in place such that different children from different families can be allocated different amounts. This application is also very useful when there is a family farm or family business involved. One child may take the farm or business, and others are allocated money through the seg funds. The seg fund assets do not form part of the estate and are kept hidden from public scrutiny, so only the beneficiaries know who received what assets.

For the third example, consider the role of the executor. The probate process can take months or years to complete, and a prudent executor will not begin distributing assets until probate is complete and tax liabilities are addressed. Not only does this delay inheritance, but it prolongs the work of the executor. With seg funds, a named beneficiary makes clear the will of the former owner, and it also speeds the process of distribution to just a couple of weeks. Like trusts, bypassing the estate seg funds greatly simplifies the role of the executor and the speed in which assets are distributed.

There are instances where a trust may be the best tool for managing family wealth. In many cases however, seg funds can be used to achieve the same goals at a lower cost, with less need to involve lawyers, accountants and trustees for setup and changes, and simpler management for the owner and executor.