If there is one thing you know about segregated funds it is that they are too expensive. Without question, the Management Expense Ratio (MER) for a segregated fund in Canada is more expensive than a comparable mutual fund.
At face value though, that is no more helpful than saying an Aston Martin is more expensive than a Toyota Corolla. You’re paying for something, after all.
What Are Segregated Funds?
Segregated funds are types of investment funds offered through life insurance companies.
The term “segregated” simply refers to the fact that the assets in these funds must be kept separate (or “segregated”) from an insurance company’s general investment fund.
Segregated Funds vs. Mutual Funds
A segregated fund shares many similarities with a mutual fund like similar investment options, a net asset value calculated daily, and (with very few exceptions) redemptions upon demand. At the end of the day, they are contracts of insurance.
Another way of looking at a segregated fund is that it is like a mutual fund with an “insurance wrapper” around it. The extra cost you are paying then is for this “wrapper”. So let’s unwrap it to see what you are getting!
Benefits of Segregated Funds
There are four main aspects to the insurance component in a segregated fund in Canada:
- Estate planning
- Death benefit guarantee
- Creditor protection
- Maturity guarantee
The greatest benefit of segregated funds is in the area of estate planning. Basically, this involves the ability to be able to designate a beneficiary or beneficiaries on any type of contract. Most importantly, this includes contracts purchased with non-registered money.
With a beneficiary, the payout on a segregated fund avoids probate fees and passes outside your will. In a mutual fund contract purchased with non-registered funds, probate is only avoided through the addition of joint owners. This can be problematic and lead to unforeseen tax and other consequences when adult children are brought in as joint owners.
In segregated funds where adult children are designated beneficiaries, they have no say in the management of the funds during the life of the annuitant.
The estate planning built into a segregated fund contract can go quite a bit deeper.
- You can have secondary beneficiaries in addition to primary beneficiaries. If the primary beneficiary predeceases the annuitant, funds would then be paid to the secondary beneficiary.
- You can also have a Successor Annuitant to the contract. A Successor Annuitant “steps in” to the existing contract upon the death of the primary annuitant and the contract simply carries on.
For example, suppose a couple with children and grandchildren. One spouse purchases a segregated fund contract with non-registered money and designates the other spouse as joint owner and Successor Annuitant of the contract. They designate the adult children as beneficiaries and their grandchildren as secondary beneficiaries. They have now potentially built three levels of estate planning into one contract.
Death Benefit Guarantee
The death benefit guarantee provides that upon the death of the annuitant, the insurance company will pay the greater of the contract’s market value at the date of death or 75% to 100% of the amount invested.
Since we cannot know when we will pass away, the death benefit guarantee proves very valuable.
Suppose a 75-year-old purchased an equity fund in a segregated fund contract in September 2019. They had the misfortune of passing away on March 23, 2020 - the low point in equity markets from today’s perspective. It is likely the value of their contract on March 23 was less than what they initially invested. In this situation, the insurance company would step in and top up the contract to its guaranteed value before paying out.
Since segregated funds are contracts of insurance, they are generally considered to be protected from creditors. Consider these points when using segregated funds as creditor protection:
- The contract cannot be purchased in anticipation of bankruptcy.
- There needs to be an individual beneficiary, such as a spouse or children. This aspect is most valuable to self-employed individuals.
- It is of greatest value in the case of non-registered funds or TFSAs. In regards to RSP and RIF money, federal bankruptcy legislation was changed to provide creditor protection. Before purchasing a contract for this reason, we recommend consulting the current insurance regulations for your province and obtaining independent legal advice.
All segregated fund contracts will have a maturity date. This will be the date when either the contract ends, or in the case of some older contracts when it renews.
The maturity date is when the age of the person the contract is based on (the annuitant) turns 100. The maturity guarantee provided by the insurance company will state that they will guarantee the contract will be worth no less than 75% to 100% of the amount of money invested on that date.
From my perspective, this is the least valuable aspect. For example, suppose you invested in a segregated fund contract at age 75 and lived until 100. In that 25 year period, you made no withdrawals from the contract. The likelihood that the market value of your contract would be less after 25 years would be quite unlikely.
The features outlined above must be subjectively valued by investors to make sense. In many cases, the perceived value may be much less mathematical than “peace of mind”: knowing an asset will quickly and efficiently pass to a beneficiary.
Do segregated funds make sense in your financial plan? Talk to your Scrivens advisor to find out.