Segregated Funds

….. They Look Like and Smell Like Mutual Funds

In appearance, segregated funds are very similar to mutual funds. Segregated funds pool money from a number of investors with similar investment objectives. The return produced by these funds is derived from the performance of an underlying basket of securities. Investors may redeem or make additional purchases at any time, based on the fair market value of the underlying basket of securities, net of any liabilities.

So far all of the features are identical, so where is the difference? The difference basically lies within the product construction and segregated fund features.

Product Construction

Segregated funds are insurance contracts issued by insurance companies. Individual investors purchase insurance contracts, called Individual Variable Insurance Contracts, from a particular sponsoring insurance company. The contract allows the investor to invest in the segregated fund. The terms and conditions of the contract are regulated by insurance laws of the province or territory where the insurance company resides.

Segregated funds do not actually issue units or shares. The individual makes a purchase by paying a premium to the insurance company. The insurance company turns around and injects the dollars through the segregated fund, often purchasing directly in an underlying mutual fund. For redemption, the insurance company returns the premiums to the investor. Both the purchase and redemption will occur at the fair market price of the net assets of the segregated fund.

As the name suggests, the assets of the segregated funds are separate or segregated from all other assets of the insurance company. In theory, the insurance company turns around and appoints a fund company to manage the segregated fund assets. In practice, the fund companies partner with insurance companies to issue segregated funds. Since segregated contracts are insurance policies, they must be sold through financial advisors licensed to sell life insurance.

Segregate Fund Features:

Some of the benefits of owning a segregated fund include maturity and death guarantees, creditor protection, probate fee exemption, and also temporary foreign content relief.

Part or all of the principal invested is guaranteed on the maturity date or on the contract annuitant’s death date. No guarantees occur before these dates. Firms usually guarantee either 75% or 100% of the principal. The higher level of guarantee would be affiliated with a higher management expense ratio. The maturity date is normally 10 years out from initial purchase, except when resets are selected. Some companies allow annual or semi annual resets where the investor may lock in their gains. But after each reset, the maturity date will be extended for another 10 years.

Under various Provincial laws, because segregated fund investments are considered part of an insurance contract, your investments may be afforded creditor protection in the event of bankruptcy. Note: Protection will only apply if the segregated fund was purchased prior to the occurrence of any financial difficulties of the annuitant. If you choose a registered segregated fund plan, there are no trustee fees. You’ll pay no transfer fees for moving money between funds within one policy. Also, when you designate a named beneficiary, the assets within your segregated funds flow directly to him/her bypassing estate and potential probate fees. the annuitant.

All these great features, so where is the catch?

Since there are no free rides in this world, all of these benefits do come at a cost. The cost  for segregated funds may range from 30bps to 50bps more than mutual fund costs. Based  on a theoretical $100,000 investment with the maturity term of 10 years and annual returns  of 7%. If we used 40bps as the additional insurance cost, the difference in the rate of return for purchasing a direct mutual fund versus a segregated fund is as follows:

Direct mutual fund Segregated funds
Initial investment $100,000 $100,000
Net annual return 7% 6.6 (7%- 0.4%=6.6%)
Value at end of 10 years $196,715 $189,484

* A difference of $ 7231.00  or  7.2% of the principal investment for insurance protection.

So is this reasonable? It all depends on the probability of cashing in on the guarantee. If  you are young, you usually have time on your side. However, as retirement draws closer you may be well advised to consider the benefits of these guarantees.

So is it worth it for the client?

For the faint at heart, weak in health, those in high risk of generating liability, the self-employed or business owners segregated funds will be appropriate.

For some clients, the payment of 7.2% of initial investment to guarantee principal at the end of 10 years, may be considered too high.   However, if the markets and negative returns continue to perform as they have for the past couple of years or so, they may have wished that they had the guarantees. Personally, I believe it is better to be safe than sure (or sorry), then wish you had!