Talking to clients: Segregated funds

Introduction to the concept

Investing in segregated or “seg” funds is similar to buying into a mutual fund — a large number of individual consumers purchase units in a fund, and the manager of that fund invests that money directly into securities.

As with mutual funds, the investor simply chooses the fund that best suits their particular goal or need (e.g., a bond fund, a Canadian blue chip fund, a growth fund and so on). By buying a fund rather than purchasing stocks and bonds directly, you’ll benefit from professional money management and diversification.

Insurance Product

Seg funds, however, are an insurance product. They are called “segregated” because the fund assets are kept separate from the insurance company’s other assets. As such, they are able to offer a number of risk-management features not available in traditional mutual funds.

Maturity Guarantee

Provided you leave money invested in a segregated fund for a minimum of 10 years, the insurance company guarantees that you will receive at least 75% (some companies offer as much as 100%) of your initial investment.

For example, if $100,000 invested in 2000 dropped in value the consumer could still count on receiving $75,000 in 2010 even if the markets had plummeted and the actual market value was only $20,000 in 2010. If the markets are up, on the other hand, you will receive the market value.

Death Benefit

Seg funds also provide a death benefit should the investor die while their investments are down. If you invest $100,000 but die when your portfolio is only worth $20,000, your heirs will receive at least $75,000. Unlike the maturity guarantee, which requires a minimum 10-year holding period, this feature is available throughout the term of the contract.

If this were a non-registered investment, the payment of the $55,000 “top up” would be treated as a capital gain in the year of death. However, in this example we also see a loss of $80,000 ($100,000 investment reduced to $20,000 market value at death) which would reduce this gain to zero for tax purposes.

Naming a Beneficiary

Because they are insurance products, seg funds also allow you to name a beneficiary — which can help to reduce estate delays and fees.

If a mutual fund investor were to leave a $100,000 non-registered investment portfolio to his nephew, those funds will first have to pass through his will and would be subject to provincial probate fees (in Ontario, for example, that would attract a $1,500 tax). Holding seg funds allow money to transfer directly to loved ones without facing the costs and delays normally associated with probating a will.

Creditor Protection

Under insurance law, contracts where a “preferred beneficiary” has been named (i.e., a spouse, child, grandchild or parent) may be protected against the claims of creditors.

That’s not to say someone can transfer all of his assets into a seg fund the day before he or she declares bankruptcy and expect to avoid all claims, but there is legal precedent provided the arrangements were made well in advance. For this reason, many small business owners consider investing in seg funds as insurance against the possible failure of their venture.

Management Fees

These extra features mean there are additional costs to segregated funds that are not present in mutual funds. The management expense ratio (MERs) of a segregated fund may be one or two percentage points higher than a mutual fund.

You might think of it as paying an insurance premium on your investment portfolio. Realize, however, that of the more than 500 funds with long-term track records, less than 40¹ have ever lost money over a 10-year period — so if you are buying segregated funds for the capital guarantee alone, you may be paying for insurance you don’t really need.

Conclusion

Only you can decide how much your peace of mind is worth and if your individual circumstances make segregated fund investing worthwhile. If you have any specific questions or would like to discuss the matter in greater detail, I’d be happy to help!

1. Source Globefund.com, as of January 31st, 2006.