Segregated Funds
Although not a completely accurate description, segregated funds have been called “mutual funds sold by insurance agents.” With the decline in many mutual funds, segregated funds have received additional attention, as they provide a guarantee that investors will not lose their capital if the fund declines in value.
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A “no loss” investment may sound appealing, but it comes at the price of higher management fees. Segregated funds are a product sold by insurance agents and regulated by the insurance industry. These funds have two characteristics that differentiate them from traditional mutual funds:
• the original capital contributions are guaranteed
• segregated funds are not subject to probate upon the death of the owner
Guarantee of Capital Contributions – Built into the management fee of a segregated fund is an additional cost for insurance. The cost will vary by company and type of fund, but this premium may add from .25% to .75% of a percentage to the management fees. This insurance coverage provides a guarantee that if the value of the segregated funds declined over a predetermined period of time, the owner of the funds would recover any loss from the insurance company. This may sound too good to be true, but let’s look at the “fine print.” The loss protection guarantee contained in segregated funds is based on the following concepts:
Guarantee Period – There are two standard guarantee dates – ten years or the date of death. The standard capital guarantee is for a period of ten years. Thus, if an individual invests $10,000 in segregated funds and in ten years the fund had declined in value to $8,000, the investor would receive $10,000 from the insurance company. If the funds are worth $9,000 after three years when the unit holder wished to dispose of the funds, the investor would not be reimbursed for the loss, as the ten-year waiting period had not expired. The second guarantee period is the segregated fund holder’s date of death. Returning to our previous example, if the individual invested $10,000 today and died in two years, the beneficiary would receive the greater of $10,000 or the value of the segregated funds on the date of death.
Guarantee Amount – Although a 100% return on capital is the standard guaranteed amount, some companies offer a 75% guarantee in exchange for a lower insurance charge built into the management fee.
Reset Amounts – It may be possible to reset the ten-year guarantee period offered by segregated funds. Although there are variations by fund, resets can normally be triggered by either additional capital contributions or advising the insurance company to implement the reset option to lock in any gains that have been generated. Assume an individual invested $10,000 in a segregated fund and within three years the fund had grown to a value of $15,000. The fund may allow the investor to lock in the $15,000 as the guarantee amount, rather than the original contribution of $10,000. If this option is selected, the ten-year guarantee period will be “reset” on the original contribution plus the increase in value.
Age Restrictions – Since the insurance company has to cover any losses if the owner of the segregated funds dies, there may be restrictions on the age of individuals that are allowed to purchase these funds. For example, a fund may invoke two types of age restrictions. It may not allow anyone over a certain age to purchase the funds or it may reduce the guaranteed amount once the investor reaches a certain age. For example, a fund may state that 100% of the capital is guaranteed until age 75 and from that point forward only 75% of the capital contributions are protected.
On the surface, segregated funds may sound like the perfect investment as the unit holder can participate in the gains of the stock market with no possibility of a loss, other than the potential opportunity cost involved. Since segregated funds have an upside, with only a minimal downside, they may appear to be an ideal investment vehicle for risk adverse individuals. However, despite the poor returns over the past decade, it is extremely rare for a stock index to decline over a ten year. As a result, investors who purchased segregated funds have paid an insurance premium built into the management fee to guarantee against any potential downside, but few investors have collected on the guarantee.
Avoiding Probate Fees – A basic estate planning strategy is to implement various tactics to reduce or eliminate probate fees. Since segregated funds are an insurance product, they are not included in the base for any probate fee calculation. This offers two potential advantages to investors. The first advantage is that no probate fee is paid on the value of the segregated fund and secondly it offers certain privacy advantages. Since probate is a public process, the details of the will may not be kept secret. Thus, if an individual wishes to leave funds to a beneficiary, while maintaining the confidentiality of both the amount and the recipient, naming the selected individual as the beneficiary of the segregated funds may achieve this objective.
Conclusion – Should investors purchase segregated funds, rather than “regular” mutual funds or exchange traded funds? Unless the individual places a great emphasis on avoiding probate fees, it may be appropriate to pass on the segregated fund option. Since a “basket” of similar investments can be sold as either mutual funds or segregated funds, the segregated fund will have a lower rate of return as they have the additional cost of an insurance premium built into the management fee.
