His timing was fortunate. In 1998, just as Sang Lee began promoting his new financial advisory business in Vancouver, the federal government introduced the Canada education savings grant program. For the first time, Canadians who saved for their children’s post-secondary schooling in registered savings plans could receive matching grants of up to $400 a year per child.

Free money from the government — Canadian families took notice.

Lee initially launched his business selling only insurance but, in his meetings with clients, it quickly became clear that the newly immigrant clients he aimed to serve placed a high priority on saving for the education of their children.

“With new immigrants from Asia, many come to Canada because of their children’s
education. [Education savings plans] fit well with these clients,” he says.

Lee quickly saw education savings plans as an important niche for his fledgling business and he became licensed with Heritage Education Funds Inc. , a pooled registered education savings plan. Seven years later, he has built a substantial business and is president of B.C. First Life Insurance Brokerage Ltd. Some 35% of his assets under management are in RESPs with Heritage.

Pooled plans and self-directed registered education savings plans — the two major types of RESPs — have become popular ways to save for post-secondary education. And with good reason.

Parents who establish RESPs when their children are young and stick with the plans can build sizable resources to help pay tuition and other expenses. With increases in tuition costs far outstripping the rate of inflation in recent years, the nest egg created by contributing regularly to an RESP and taking advantage of the CESG can come in very handy.

Under an RESP, contributions of up to $4,000 a year for each child are allowed, with a lifetime contribution limit of $42,000 per child. Unlike RRSPs, contributions are not tax-deductible, but all earnings generated inside the plan are tax-sheltered. When the money is withdrawn, earnings from contributions are taxed in the hands of the student, who will probably pay little or no taxes.

There are single and family plans; this gives contributors the option of naming a single beneficiary in the former case and more than one beneficiary in the latter. In family plans, beneficiaries must be related by blood or adoption to the subscriber.

The CESG provides a matching grant equal to 20% of contributions up to $2,000 a year, or a maximum annual payment of $400. (In January 2005, the CESG was increased on the first $500 contributed by families with a qualifying net income: a 40% boost if the child’s family has an annual net income of $35,000 or less, or 30% if the child’s family has a net income of $35,001-$70,000.) CESGs are available up to and including the year in which a beneficiary turns 17, so the maximum grant received by a child born in 1998 or later will be $7,200 (18 years multiplied by $400 a year).

Pooled plans

Pooled plans had a head start on self-directed RESPs, with their roots stretching back to the 1960s. They differ from self-directed RESPs in several areas, such as investment strategy, fees and method of payout.

In a pooled group plan, investors typically commit to the purchase of a specific number of units in a plan and a long-term investment schedule set out by the company.
Contributions — pooled with other plan participants — are based on actuarial tables that estimate what the company will need to finance post-secondary education years down the road. The amount an investor will have at the end of the contract will depend on the rate of return earned and the number of other plan participants who attend post-secondary school.

There is a less common pooled plan sold by some companies, known as an “individual” plan (a bit of a misnomer, as it can be purchased for one beneficiary or more). It is more flexible than the group plan because an investor can choose any contribution amount. In this case, contributions are also pooled with those of other plan members for investment purposes.

Advisors and clients have no input into the investment decisions, which are made by a professional team, much like what occurs in a pension plan. But, unlike pension plans, securities regulation limits scholarship plans to fixed-income investments.

@page_break@This may be a big plus for clients who prefer not to have to decide how to invest their money, says Peter Lewis, vice president of plan administration at the Toronto-based Canadian Scholarship Trust Foundation. “Some people are not comfortable with making their own investment decisions. We do that for them with stable fixed-income investments.”

He believes this investment strategy provides a good risk/return ratio: “For risk-averse clients, this is a good option.”

Because clients typically commit to long-term investment plans, it is paramount that they understand the rules regarding missed payments. The Ontario Securities Commission notes that “if you miss a contribution, your account may go into default and you may lose your plan membership.” Consequences vary by company, but could mean clients in default getting back their contributions less fees and forfeiting all earnings.

To their credit, pooled plans have become more flexible in recent years and clients usually can negotiate a reduction in monthly payments, for example, because of a change in their financial circumstances.

Or, if a client has to stop contributions entirely, many plans permit converting the above-mentioned group plan to an individual plan so the savings now grow on their own. (In this case, contributions are still pooled with those of other plan members for investment purposes but a client will not earn the same level of payout at the end of the plan as members of the group plan who are stuck with the predetermined investment schedule for the full term.) In some cases, clients may have to forfeit earnings but would keep original contributions and the CESG.

Fees associated with pooled plans (known as “scholarship trusts”) can be complex and should be carefully reviewed before signing on. A typical plan will include some or all of the following: enrolment or membership fees, administration fees, investment management fees, depository fees and trustee fees. Fees are usually paid up front or within the first couple of years of contributions. Some plans repay membership fees (but not management fees) to the students who attend post-secondary school.

“They have the potential to receive all or part of the membership fees back as a bonus,” says Thomas Gleig, B.C. sales director with Heritage. That would apply in the case of a student who attended post-secondary school for a full four years, he says.

(Two other big Canadian pooled plans are Burlington, Ont.-based Children’s Education Funds Inc. and USC Education Savings Plan Inc. , based in Toronto.)

Typically, education funding is paid out to the student over four years, not in a lump sum.
When a child is ready for post-secondary education (and has turned 18), the investor contributions are returned and used to fund the first year of school. Subsequent payments, which include earnings on contributions as well the CESG and earnings on it, are paid out to fund the second year and beyond.

Advisors should explain to clients what happens to their money if their children do not attend post-secondary school. This will depend on which of the two types of pooled plans clients are in. In the case of an individual plan, investors receive the contributions back, less the fees paid to the company. The earnings on the contributions, known at the Canada Revenue Agency as “accumulated income payments,” may be rolled into the investors’ RRSPs if there is contribution room (to a maximum of $50,000) or withdrawn if there is not. If they are withdrawn as income, there are tax consequences: clients are taxed at their marginal rate and hit with an additional 20% in penalties (12% in Quebec).
And all of the CESG must be repaid to the government.

With the more common pooled group plan, when children do not attend post-secondary school, contributions are returned, less any fees, but investors don’t get any of the growth earned over the years. Instead, those assets are distributed to remaining plan members, as mentioned above. This boosts the amount of funding available to those who do go on.
Again, the CESG must be repaid if the children don’t attend post-secondary school.
Termination rules for pooled RESPs vary. Some plans stipulate the money must be withdrawn before the children turn 21; others give an age limit of 25.

Advisors who want to sell pooled plans must become registered as a scholarship plan dealer with the securities commission in their province by meeting several criteria, including: choosing a sponsoring scholarship trust dealer with which to align themselves and completing a training course approved by the provincial regulator (each scholarship trust dealer typically has its own course).

Some advisors may have reservations recommending pooled plans based on last year’s report by the OSC, which cast a shadow over the industry. The report cited problems at most of the large dealers in areas such as “business practices, sales practices and disclosure practices.”

Criticisms ranged from lack of proper record-keeping to weaknesses in reviewing whether investments were suitable for clients and lack of disclosure regarding the fees associated with some plans. And some salespeople were found to lack adequate knowledge of the products they were selling. The result of the report was conditions imposed on operations at the offending companies.

But, slightly more than a year later, the industry appears to be back on solid ground. Eric Pelletier, spokesperson for the OSC in Toronto, says most of the conditions have now been lifted, with a couple of exceptions.

Advisors considering joining forces with any scholarship trust dealer can get details on the firm’s status with regulators at the OSC’s Web site (www.osc.gov.on.ca — go to the “dealers and advisors” section, select “registrants lists” and look up the company in the alphabetized listings).

With scholarship trust plans, compensation varies by company and product, as well as by the length of the client’s investment schedule. But, typically, commissions are similar to those paid in the insurance industry — large up-front payments and small ongoing trailer fees. And repeat business is rewarded. “The more business you generate, the higher the rate of the commission,” Gleig says.

For example, compensation paid by Heritage on its Heritage Plan account is paid up front and calculated on a sliding scale. With an account for a newborn in which clients agree to pay $2,000 a year for 18 years, the commission — paid out as a lump sum — would be about $1,100, more if the advisor was a top producer. That plan has a much smaller management fee — just 58 basis points — than the company’s no-load option, the Impression Plan, which charges 1.95%. In the latter case, the broker receives a smaller up-front sales commission but larger ongoing trailer fees.

Self-Directed & Mutual Fund RESPs

Self-directed RESPs, available through investment dealers, banks or directly from some fund companies, are growing in popularity since the launch of the CESG.

Dwayne Dreger, vice president of corporate affairs with AIM Funds Management Inc. in Toronto, says as of the end of July, AIM had 87,000 accounts under administration, up from 78,000 a year earlier and 63,000 as of December 2002.

As the name suggests, self-directed accounts allow the investor or advisor to select investments for the RESP, which gives total flexibility in investment type and risk level.
Self-directed RESPs also have entirely flexible investment schedules, and contributions can be stopped and started easily and without penalty. Costs for a self-directed plan will vary, depending on the type of investments chosen and who administers the plan.

One of the reasons it may make sense to have an RESP administered directly by a fund company is to save your client the annual fee charged by some investment dealers.

“For clients, because you can only put in $4,000 a year, you really need to hit critical mass before it makes sense to pay those annual fees,” Dreger says.

For most clients, the selection of funds from a single company will be adequate when an RESP is just getting started. Once the account grows, the client can switch over to a self-directed account if greater investment selection is wanted. And clients typically are not actively trading investments in RESPs, Dreger says.

Most mutual funds are purchased on a front-end or deferred-load basis and annual management fees are deducted from the funds, with an ongoing trailer paid to the advisor.
“The trend in RESPs is the same as in all other mutual funds: a slow but discernible shift to [purchase with] front-end loads,” says Dreger.

When the child is ready for post-secondary school, accumulated earnings on all contributions, as well as the CESG and the CESG earnings in the RESP are paid out as an “education assistance payment.” Proof of school enrolment must be provided prior to any withdrawal. (Principal contributions to the RESP can be withdrawn at that time, or any other, with no tax implications.)

If the child does not attend an eligible post-secondary school, planholders will have their contributions returned. The earnings on the investment may be rolled into an RRSP if there is contribution room or withdrawn with tax consequences, and all of the CESG must be repaid to the government.

Self-directed RESPs must be terminated 25 years after they are opened. Any assets left in the plan will be distributed to the Canadian educational institution of the investor’s choice.

Advisors are permitted to establish self-directed RESPs for their clients if they are licensed to sell the relevant investments — that is, as either a mutual fund dealer or an investment dealer.

Helping clients choose

In helping clients decide what type of RESP is best for them, many factors come into play: clients’ investment sophistication, risk tolerance, the amount available to invest, flexibility of payments and time horizon — to name a few.

Clients who want to choose investments or go with a more aggressive strategy that includes equities will want a self-directed plan, while more risk-averse clients could choose either type of plan.

Young clients, who will probably start saving when their children are small, are good candidates for pooled plans, which are designed primarily for people who start contributing before their children are six years old, according to Lewis.

Many scholarship trust plans restrict participation to children registered before the age of 13. So clients with teens are probably more suited to self-directed plans that can be started at any age.

For some advisors, the key consideration is flexibility. George Lukiwski, an advisor with Cherry Financial Services Inc. in Saskatoon, says he came close to signing on with a scholarship trust plan but, in the end, declined. Instead, he favours self-directed RESPs for his clients. He likes the choice that mutual funds offer and believes they are the best
option for most of his clients. IE