Segregated funds - or seg funds – consist of a pool of investments in securities such as bonds and stocks, similar to mutual funds, but sold by life insurance companies.
Segregated funds are owned by the life insurance company – not the investor – and must be kept separate (segregated) from the company’s other assets.
Unlike regular mutual funds, the company does not issue units. The investor is the holder of a segregated fund contract. All contracts have a maturity date, which is the date at which the maturity guarantee is available to the contract holder – usually after 10 years.
Segregated Funds: The insurance guarantee
The value of the funds fluctuates according to the market. The segregated funds come with an insurance guarantee.
Most come with two forms of guarantee:
- If you hold your money in the fund for 10 years and the portfolio goes down, you get at least a partial refund.
- If you die within 10 years of putting your money in, your heirs will get the greater of the guaranteed death benefit, or the market value.
You are guaranteed at least 75% of the original investment. Manulife was the first to offer a 100% guarantee. This means when a deposit matures and is redeemed, or the annuitant dies, a top-up payment is made (less any previous withdrawals and fees) if the market value is less than the guaranteed amount.
Related: Fund Facts About Mutual Funds
A reset option allows the contract holder to lock in investment gains if the market value increases. This resets the deposit value and restarts the contract term and extends the maturity date. You are usually limited to one or two resets per calendar year.
Cost of the guarantee
Not surprisingly, this guarantee comes with a price. Segregated funds are up to 30% more expensive than regular mutual funds.
Is the guarantee worth the extra cost? It depends on whether you think your investment will drop in price over a 10-year period. In most cases the guarantee will be a waste of money, especially if the fund holds bonds. Taking a 75% guarantee is considerably cheaper, of course, than the 100% guarantee.
There may also be hefty fees if the fund is redeemed prior to maturity, so lack of liquidity can be a concern.
Taxation differs from regular mutual funds (if not in a registered account):
- You are only taxed on income you actually receive.
- You can use capital losses to offset capital gains from other sources.
So, if you buy units one day before the fixed date, you are assessed for one day’s income. With mutual funds you are assessed for all income earned in the period even if you didn’t benefit. Also with mutual funds, capital losses are carried forward by the fund and you are taxed on capital gains.
Segregated funds have a unique legal status compared to regular mutual funds:
- They can’t be claimed by creditors.
- Protection of assets in case of a lawsuit.
- Exempt from probate fees, so may be good for estate planning.
Who would benefit?
Segregated funds would appeal to:
- people who are self-employed, or have a professional corporation, or are at risk of declaring bankruptcy, as their assets are protected.
- people approaching retirement who need equity returns but don’t like the risk and want to be well protected with the security of a guarantee.
- someone who thinks the odds are high that they will die within the next decade.
Segregated funds became popular in the 1990’s. For the insurance companies who run them they represent a lucrative part of their business. However, they are one of the most expensive mutual funds you can buy.
There are many alternative ways to protect your capital without paying such hefty fees, which will take a large bite out of your returns.