When segregated funds make sense

Segregated funds are structured very much like mutual funds, but are issued through an insurance company rather than an investment or fund company. As a result, segregated funds – also known as individual variable annuities – are governed by the Insurance Act. Segregated funds are more expensive than conventional mutual funds but some investors may feel the additional cost is worth it.

Each insurance company has different features with respect to their own segregated funds. The comments below may not apply to all types of segregated funds, but helps to provide a general overview. Within each section we will compare segregated funds against regular mutual funds.

Guarantees: Segregated funds come with two types of guarantees. The first type is a death benefit guarantee. This guarantee generally provides for the higher of the original principal invested or the current market value in the event of death. The second type of guarantee is the maturity guarantee. The maturity guarantee is normally between 75 and 100 per cent of the original deposit. In order for the maturity guarantee to apply the holding period is generally 10 years. Mutual funds have no guarantees.

Resets: Certain types of segregated funds allow contract holders to reset the maturity and death benefit guarantees. Resets are only done when the market value is greater than the original amount invested. Not all segregated funds have the ability to reset and are generally only permitted to certain ages (i.e. age 90).

Scenario 1: Three years ago an individual invested $50,000 into Segregated Fund A. Today the fund is worth $70,000. You may choose to reset the maturity and death benefits from that date. This means that the guarantees noted above are now based on the $70,000 and not the original $50,000 and the maturity date is 10 years from the reset date.

Scenario 2: Seven years ago an individual invested $50,000 into Segregated Fund B. Today the fund is worth $35,000. This individual should not reset the contract as the market value is below the original investment. Mutual funds have no reset ability.

Fund Selection: Individuals investing in a particular segregated fund contract may be able to select from a group of different funds. A particular series of segregated funds may have a group of brand name funds to choose from. The selection for individual mutual funds is generally far greater. The fund contract may allow the unit holder to switch within certain funds in the group without resetting the maturity date.

Probate: With a segregated fund contract a beneficiary is named. Provided the estate does not name the beneficiary the death benefit proceeds bypass the estate and are distributed more efficiently to the beneficiary. Probate fees generally do not apply to segregated funds when beneficiaries are named and general administration fees are typically lower. Mutual funds held in an individual account may be subject to probate fees.

Age Limitation: Most segregated fund contracts may only be established for those individuals under certain ages (i.e. 90 years old). Mutual funds have no maximum age limits.

Creditor Protection: Segregated funds may be protected from creditors if a spouse, child, grandchild or parent is named as the beneficiary. Younger professionals and entrepreneurs may find this feature particularly beneficial. Mutual funds may not have this same creditor protection feature.

Fees: Both segregated funds and mutual funds have fees attached to them. The fees are often referred to as the management expense ratio (MER). The more benefits that a segregated fund has, the higher its MER. The following lists the same underlying fund and the annual MER:
• 2.78% Segregated Fund – series I
• 2.35% Segregated Fund – series II
• 2.19% Mutual Fund

The highest MER relates to Segregated Fund – Series I with 2.78 per cent. The fees are higher than the other two primarily because it has a 100 per cent maturity guarantee. Segregated Fund – Series II has lower fees than the series I but only has a maturity guarantee of 75 per cent. Both Segregated Funds have a 100 per cent death benefit guarantee. The Segregated Funds are invested in the same underlying fund as the regular Mutual Fund. The MER on the Mutual Fund is the lowest at 2.19 per cent; however, this fund has no maturity guarantees and no death benefit. The MER comparison highlights that the above benefits come at a cost.

Who Should Invest?

Segregated funds are suitable for a wide range of individuals. Professionals and entrepreneurs in higher risk professions may be attracted to the creditor protection features. Individuals with a lower tolerance for risk may want to ensure their equity investments have some protection. Seniors may benefit the most if they implement segregated funds into their estate plan.

Before implementing any strategy noted in our columns we recommend that individuals consult with their professional advisors (insurance consultant, financial advisor, accountant and estate lawyer).