If you’ve consulted a financial advisor, it’s possible they’ve thrown in the term “segregated funds”—or “seg funds,” as the insiders say. So what are they?
What are segregated funds
But what exactly are segregated funds? Well, they share some qualities with mutual funds, but they’re mainly sold by Canadian insurance companies and are not traded on a public market. That means that in order to buy a segregated fund, you’d have to purchase it directly from an insurance company. The fund basically consists of individual, variable insurance contracts that offer certain guarantees and advantages not available in traditional mutual funds. Think of it like investing in insurance that appreciates, except that instead of buying stocks you’re buying contracts, and do not represent ownership of the investment company through shares.
That’s also where the name comes from: Because the fund is totally separate from the insurance company’s general investment funds, and you’re not investing in the company itself by investing in the segregated fund, it’s, well, segregated.
So how is this investing? Well, the individual insurance contracts that you buy through segregated funds then invest in underlying assets like mutual funds, thereby helping your contract appreciate in value over time. But since investing always involves an element of risk, there is a chance you could incur losses. That’s why segregated funds include a guarantee to protect part of the money you invest, covering at least 75% of it, and sometimes even 100%. So even if the underlying fund that the segregated fund is based on loses money, you’ll still get some or even all of your principal investment back.
But of course, there’s always a catch. In order to actually benefit from this policy, you must hold the fund until maturity—meaning until a certain period of time has passed (usually at least 10-15 years). If you withdraw your money before the designated time period is up, you lose the guarantee, and you’ll just receive the current market value of your investment, minus any fees. You usually also have to pay an additional fee for this guarantee policy.
Another reason people choose segregated funds is because they offer creditor protection. So if you’re potentially facing bankruptcy, creditor protection ensures that the funds in your segregated fund aren’t seized by creditors. However, this is only possible if you’ve named a family member as a beneficiary of the segregated fund policy. A beneficiary is a family member you’ve chosen to receive the proceeds of your fund after your death. This protection is particularly beneficial for freelancers or small business owners, since it can protect your personal assets from professional liability.
Examples of segregated funds
The most common kind of segregated fund is the one administered by life insurance companies like Sun Life, Equitable Life of Canada, Alliance Financial Group, Empire Life, and Industrial Alliance, as well as by the Royal Bank of Canada. Many companies that administer mutual funds will also likely have segregated funds options.
But if you have a workplace pension that is managed by an insurance company, then you also have your pension tied up in a segregated fund. The only difference is that these pension funds don’t carry the insurance guarantees that you can get from segregated funds bought with an insurance company. But because they are still insurance contracts, they’ll still have creditor protection if you name a beneficiary for the policy.
Advantages and disadvantages of segregated funds
Segregated funds can definitely form a productive part of a well-balanced investment portfolio, but it’s important to talk to the insurance provider you’re thinking of buying from in order to get all the information on the past performance of the fund, as well as any additional fees or conditions. And remember, past performance is never an indicator of future performance. Here are certain advantages and disadvantages you should consider if you’re interested in buying into segregated funds:
Advantages
Your principal investment is protected: Because of the guaranteed payout that protects your initial investment, you know you’ll get 75% to 100% of your investment back, regardless of the market price at the time of the fund’s maturity date. Just remember that investments must be held until the date of maturity; if you withdraw before that, then you forfeit the guarantee.
Guaranteed death benefit: This is why segregated funds are also associated with life insurances (and why you should name a beneficiary on your policy). Upon your death, there’s a guarantee that 75% to 100% of your initial investment will be passed on to your beneficiary, tax free.
Easy estate transfer: Speaking of passing on assets to your beneficiary, any beneficiary named on the segregated fund will have the proceeds of the fund paid directly to them after your death, without having to deal with probate. Probate can be a lengthy and expensive process, so having the proceeds paid directly to your beneficiary can make a stressful situation much easier on your loved ones.
Potential creditor protection: If you’ve named a beneficiary to your policy, segregated funds also offer protection from creditors seizing your assets in case of bankruptcy or in the event of a lawsuit. As mentioned before, this might be particularly important for freelancers or small-business owners.
“Reset” options allow for more growth: Some segregated funds might offer a “reset” option, which is applied if the market value of your policy increases so significantly that you’d like to increase the amount covered in the guarantee (a.k.a. the amount you get back no matter what). This means you protect your initial investment, plus any gains the portfolio made. The only thing to keep in mind here is that hitting the reset button will also most likely extend the period of time you have to wait before you can access your money, usually an additional 15 years.
Disadvantages
Limited liquidity: Because your money is locked in until the maturity date (otherwise you forfeit the guarantee of a return of principal investments), you really don’t have access to it unless you want to take a chance on receiving the current market value on your investment, which might mean a loss. There’s also a chance you’ll have to pay a penalty.
Higher fees: Compared to mutual funds, segregated funds usually have higher management expense ratios (MERs). That’s because the fees cover the cost of insurance features. You may also have to pay commission if the fund is bought or sold.
Early withdrawal penalties: If you decide to withdraw from the fund before the maturity date, you’ll likely have to pay a penalty, in addition to forfeiting any principal guarantee or a guaranteed death benefit.
How to invest in segregated funds
If you decide that you want to add segregated funds to your financial portfolio, then it’s relatively easy to get started. In this sense, it’s pretty similar to how to invest in mutual funds:
Select the segregated fund you want to invest in. You can find segregated mutual fund information by applying a filter on databases like Globefunds and Morningstar, or go directly to the insurance company you want to buy from. Just make sure to do all of your research, including on the performance of the fund, which the relevant insurance company is obligated to report. That information will usually be on the website where the fund is offered, and will include annual returns and fees. Just remember: Past performance is not a guarantee of future performance.
Choose your accounts. Segregated fund managers will often let you combine your investments into a retirement account such as a Registered Retirement Savings Plan (RRSP) or a Tax-Free Savings Account (TFSA).
Select your funds. Many insurance companies will have a variety of segregated funds that, like mutual funds, focus on different aspects of the market. The underlying investments that back your segregated fund can be in international equity, in the Canadian market, or in a specific sector like real estate.
Read your contract carefully! Always make sure you understand all the terms and conditions and have a clear overview of all the fees so that there aren’t any nasty surprises down the road.
While segregated funds can be a valuable part of a balanced financial strategy, the high fees can be off-putting for many investors. In that case, purchasing your own mutual fund might be a more affordable strategy for you. Or if you really want to save on fees, going the robo-advisor route, where an algorithm creates a low-cost portfolio calibrated to your needs, might be more appropriate for you—especially if the idea of having to pick your own funds is making you break out in nervous sweat.
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