When Dawn Hawley bought her life insurance policies, she faced a common anxiety: that upon her death, one of her beneficiaries might squander the cash that was meant to help him over many years.

In her heart of hearts, she knew that her spendthrift son, now 20 years old, wouldn’t be able to handle an inheritance. Her solution to ensuring that the life insurance benefit would last was to use the life insurance policy to fund a testamentary trust — a trust that comes into effect after her death.

“My son would fly to Japan to buy 16 racing vehicles,” says Hawley, a wealth and estate specialist at ATB Insurance Advisors Inc. a unit of ATB Financial of Edmonton.

While life insurance is an excellent way for a client to leave a tax-free lump sum to a beneficiary, many clients share Hawley’s concern that their children are unprepared for the responsibility that comes with large amounts of cash. With a testamentary trust, someone else takes over the management of the assets in the trust for the benefit of the beneficiary.

In Hawley’s case, she designated a friend to distribute the cash to her son according to a set of rules set out in the trust. The trust, which was set up outside her estate, allows her friend, acting as trustee, to fund her son’s expenses for a broad range of purposes, described as “maintenance, education and upbringing.”

“I call it ‘ruling from the grave’,” says Hawley, who holds both the certified and registered financial planner designations and who speaks publicly about trusts to advisors and clients of ATB.

Trusts are a common way to control the distribution of assets from beyond the grave, so to speak. But using a life insurance policy to fund the trust is an underused strategy of which many of your clients can take advantage, say practitioners such as Hawley.

“It’s underused,” says Frank Arekion, insurance specialist and vice president of wealth management at BMO Nesbitt Burns Inc. in Toronto. “Most people don’t know about it.”

“Insurance is perfect for a trust, no matter what your client’s wealth is, no matter what the circumstances are,” adds Wendy Templeton, vice president of wealth transfer and estate planning at Nesbitt Burns in Toronto.

Clients will know exactly how much money will fund the trust, she adds, because the policy payout is fixed.

The tax advantages of trusts can be myriad if they are structured properly and, in combination with life insurance, their financial efficiency can be powerful. Because of how the Life Insurance Act is written in Canada, life insurance grows tax-free and is distributed tax-free after death. For that reason, Templeton calls it “the last great legal tax shelter. It doesn’t get any better than that.”

Once the trust takes effect, the income it generates for the beneficiary is taxed at its own graduated tax rate, says Hawley: “As if it were a separate person.” That means the trust is often taxed at a lower rate than the beneficiary.

The cost of building a trust around a life insurance policy, in addition to the cost of the life insurance premiums themselves, can be low — especially compared with the benefit, Hawley says: “This is a very affordable way of doing extended planning while minimizing costs.”

But Hawley would never recommend the trust structure unless a client already owns or needs life insurance. In that case, the trust can be a way of making sure the policy owner’s intentions are carried out after that person’s death.

“You need to identify a need,” she says. “Then, when we put the insurance in place, we have to make sure we’re satisfying that need with a trust structure.”

In Hawley’s instance, she wanted her son to benefit from her life insurance policy for as long as possible after her death. This is sometimes called a “spendthrift trust.” The concept also applies to trusts constructed for adult dependents who are disabled.

> Distribution Of Assets

Other clients may simply want to provide in the case of their untimely death for children who are under 18. And the simplest way to control assets that will be distributed to a minor is within the life insurance policy itself, says Hawley.

If your client dies having named a beneficiary who is under the age of 18, the province in which that person resides will determine how the proceeds are handled. For example, in Ontario, the proceeds are paid to a court and distributed to the beneficiary when he or she reaches 18 years of age. In Alberta, a public trustee controls the assets.

@page_break@Some measure of control is available before the child turns 18 — if you can find the right type of policy, Hawley says. Many life insurance companies allow the policyholder to name a trustee on the beneficiary form.

“That trustee will then be able to use the proceeds for the benefit of the minor until age 18,” she says. “The downside is the beneficiary gets [the policy’s assets] at 18.”

If you want to control the assets after the beneficiary turns 18, you must draft a life insurance trust declaration. “That way, you can control the distribution of the cash for a much longer period of time,” Hawley says.

> Building The Trust

To build a trust for a client, an advisor will need to bring the client together with an estate and trust lawyer who is “well versed in the area of wills, estates and trusts,” says Hawley.

The lawyer will create a trust, which is a three-way legal relationship between the person who sets up the trust (your client), the person your client names to control the assets in the trust (the trustee) and the person who will own the assets after the client’s death (the beneficiary).

The trust must meet three specific conditions in order to be valid: your client, technically called the “settlor,” must declare his or her intention to create a trust; the subject matter included in the trust must be specified; and the beneficiaries must be named.

The life insurance company must be notified of your trust as well, says Arekion. The policy must be identified by its name and number, and the manufacturer must be made aware of the trust arrangement. “This is the No. 1 potential mistake, from a financial advisor perspective,” he says.

The life insurance trust declaration must state that the proceeds of the policy are to be administered by the trustee on behalf of the beneficiaries under the conditions set out in the declaration.

Each province grants certain powers to trustees. “Your client can give the trustee additional powers,” says Hawley.

> Fringe Benefits Of Trusts

Finally, clients may also like the fringe benefits of trusts. They can keep their beneficiaries’ assets from creditors or claimants and avoid probate fees.

An important part of Hawley’s spendthrift trust for her son is that it exists outside her will, and does not become part of her estate. A will is a public document that must undergo public probate by law in every province except Quebec. Through this process, an estate’s assets become available to other claimants. If a trust is drafted properly, it is not part of the estate and, therefore, not subject to probate.

Avoiding probate can save the trust’s beneficiaries a substantial sum: probate fees are about 1.5% of total estate assets in Ontario and 1.4% in British Columbia, for example.

Furthermore, being outside of the estate, the trust’s funds become available to your beneficiary much sooner, Hawley says: “When we have assets in an estate, normally they cannot be distributed until we get a clearance certificate from the Canada Revenue Agency. That takes an awful lot of time.”

Insurance policies generally pay out within a few weeks, at which point the trustee can start using the funds in the way the client has requested, she adds.

“Advisors are not often aware of how grateful their clients are when they see the trust in front of them,” says Templeton. “They appreciate the referral, and this is one of the instances in which, as financial professionals, we provide clear material benefit.”

Hawley is not as concerned about her 23-year-old daughter, who has a knack for handling money. And Hawley can now rest easy that things will be under control should she die while her son is still reckless with cash.

If her son becomes more financially responsible during her lifetime, she can always change the conditions of her trust. And, after her death, once her son reaches the age of 30, the trust is structured to distribute the remaining funds to him at that point. IE