What Are Segregated Funds?
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.
Related: How Index Funds Compare To Equity Mutual Funds
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.
Related: Mutual Fund Fees: The High Cost Of Canadian 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.
Tax treatment
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.
Legal status
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.
In conclusion
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.
Mutual funds in general, and segregated funds in particular, are a hazard to your financial health. Nobody should be invested in these things regardless of whether they are part of an insurance plan or not. In the real world, you pay for services rendered. In the mutual fund world, you pay regardless of whether any service is provided or not (especially for accounts under six figures).
In order to determine whether or not there is any value in investing with seg funds, the costs of the investment vs. the insurance need to be analyzed. Insurance agents will invariably cloud the issue by mixing features of the investment product with those of the insurance product and gloss over the costs altogether.
@Alan: These products are not all bad. There are some advantages for the right people, but obviously not for everyone. We have to make sure we don’t get sucked into the hype of over-zealous salespeople and ask, ask, ask about all the details. You can’t make good decisions without all the information. Segregated funds that are wrapped around insurance products need to be “disassembled” so you know what you’re getting into.
@Boomer: You’ve done a fine job of explaining the basic features (and pitfalls) of seg funds but to my mind it is the rare individual who can take advantage of them. Their high cost structure is such that the odds are heavily stacked in favour of the insurance company. In an environment where conservatively managed investment returns are in the 5% range, give or take a point or two, paying 3% in fees shrinks that to near zero. Since the investor (i.e. the policy holder) is assuming virtually all of the risk for the underlying investment, he/she is not being compensated for said risk. Sure there are capital guarantees, but they are essentially worthless after factoring in inflation and the 10 year time frame.
The issue I have with seg. funds, and whole life insurance policies in general, is that they are sold as vehicles for building wealth when in fact their primary function is to preserve wealth and they don’t do it very well.
@Alan: I agree with everything you’ve said. The only real advantage in my mind is the creditor protection which may be of value to a few business owners.
To pay so much in fees for a 10 year guarantee is basically useless when there are other products that will give you the safety without any fees.
I have issues with how insurance companies wrap their products together so there’s no transparency on how the individual products can benefit the purchaser.
what other products are available with no fees
@dianne cassidy: There are no fees to purchase GICs and term deposits which are 100% safe and up to $100,000 CDIC insured per bank. You could look into high interest savings accounts, especially through ING, PC Financial and credit unions.
Government of Canada bonds have the highest guarantee. Also provincial bonds are a good bet. Keep them until maturity. You may pay a minor up front fee if you purchase them through a broker.
Market growth GICs will also give you stock market exposure while keeping your original principal safe.
My financial planner is advising me to move my mutual funds (Franklin Templeton Balanced income and Balanced Growth) to a 75% guaranteed Standard Life Segregated Fund (has the above FT funds in it.
My gut is saying no. Any advice?
@Pat Werden: My gut is saying your financial planner is anticipating a hefty commission from this fund. The guarantee on segregated funds can cost you up to 30% more in fees. Is the guarantee worth this to you? Are you satisfied with the funds you currently have?
I would ask for the reason behind the suggestion and see if it makes sense to you.
Pat, segregated funds are first and foremost an insurance product, product being the operative term. The first question is do you need more insurance? If so, why would you use such an expensive form of insurance rather than an appropriate term policy?
Segregated funds combine insurance and investment features into a single package but, as Boomer says, it comes at a price. You pay fees multiple times with these products which essentially make the investment portion worthless and begs the question … what am I paying for? In this case, fees are paid to the money manager (Franklin Templeton) for managing the money, fees are paid to Standard Life for the life insurance component, fees are paid to the planner for selling you this garbage and all of it is on an ongoing basis, i.e. you pay these fees at best annually, at worst monthly.
Your financial planner, and the financial services industry in general, operates in a structural conflict of interest. They are incentivized to sell product and keep those customers in those products, not look after their customers financial health. They operate behind a smokescreen of probity but there is a very weak legal framework protecting the public short of outright fraud (and even that is rarely prosecuted). There is a movement to introduce a more professional atmosphere in the industry and actually introduce a fiduciary duty similar to the legal and medical professions but the industry is adamantly opposed to it for obvious reasons. Buyer beware.
Thanks everyone for your advice. Will stay where I am.
After reading the comments, now I am really disappointed. I just put in a good chunk of money into the Manulife Pension Builder plan. I guess I made a big mistake in trusting my Qtrade investor who works for CS Alterna. Alterna hires Qtrade to service their clients. So much for trusting them to offer something worthwhile. I has been only three weeks ago that I placed my money into this fund. Would you know if I could cancel it and get my money back.
@Diane Monette: There’s often a “cooling off” period for up to 30 days if you change your mind about a purchase.
If you are certain this investment is not for you, contact your investment advisor as soon as you can.
Mention is made in the article about those expecting to pass within 10 years (possibly due to a critical illness of some sort). Seg funds come with both a maturity AND death benefit guarantee and if a client happens to pass away during a market downturn, the death benefit guarantee can be a real blessing to the beneficiary/estate.