Segregated Funds 101

Segregated Funds – Introduction

Segregated funds, like mutual funds, have been available to Canadian investors for many decades. The variety and range of both increased dramatically during the late 1990s as more and more investors looked for better returns than those available from traditional savings instruments.

 segregated Funds vs- Mutual Funds

Mutual funds and Segregated funds are similar in some ways: Both pool the funds of many individual investors; both are redeemable on demand; and both provide investment returns based on the market values of securities held within their portfolios. In fact, some people consider segregated funds as mutual funds with insurance wrappers or the insurance industry’s mutual fund equivalent.  Its chief distinction from a mutual fund is its guarantee that, regardless of the fund performance, at least a minimum percentage of the investor’s payments into the fund will be returned when the fund matures.

Investors should be aware of some basic differences between the two investments. Each mutual fund sells and buys back securities at the value of the assets held in the fund (net asset value). The mutual fund’s assets are owned by the specific mutual fund. Investors own the mutual fund through units or shares of the fund.

In contrast, each segregated fund is a pool of assets owned by an insurance company. Each pool of assets is kept separate or “segregated” from other assets owned or managed by that insurance company. Investors do not own units of a segregated fund. Rather, they buy an insurance contract called an Individual Variable Insurance Contract or IVIC which offers them the opportunity to buy one or more segregated funds. The segregated fund investor doesn’t buy units of the segregated fund. He pays premiums to the insurance company based on the value of the segregated fund when he is buying. He also doesn’t sell units of his fund. Instead the insurance company returns his premiums based on the value of the investments in the segregated fund. The end result is the same for an investor in a segregated fund or mutual fund: They get liquidity when they require it.

Segregated Fund Features

  • The insurance company guarantees that if an individual holds an investment in a segregated fund for 10 years he or she will get the higher of market value, or depending on the specific policy, 75% or 100% of the investment on the maturity date. This is called the maturity guarantee. The maturity guarantee makes segregated funds especially popular with individuals who are concerned about long-term stock market volatility. An investment in a segregated fund gives them the comfort of knowing that no matter how poorly a market performs, they will get no less than 75% or 100% of their investment back (usually 100%). However, investors should consider the fact that out of more than 100 diversified Canadian equity funds, (including both segregated and mutual funds) only one had a negative 10 year return at the period ending March 31, 1999. No dividend, US, international or fixed income fund had a negative 10 year return in that time period.
  • The insurance company will also pay a death benefit guarantee if the annuitant (the person who is insured under the contract) dies before the maturity date.
  • As insurance policies, which name specific beneficiaries, segregated funds may also offer creditor protection. This feature makes them the choice of many business people and professionals who may have high exposure to personal liability. However, they may not be “creditor proof” if they are purchased after a financial problem develop and are purchased in anticipation of litigation or bankruptcy.

 

They are also excluded from probate which can lead to significant savings in some provinces and make segregated funds an important consideration in estate planning.

Segregated Funds – Costs

Investors should note the costs involved in obtaining these added features. At the present time, management expense ratios or MERs of segregated funds and protected funds are generally higher than comparable equity funds. The cost of the maturity guarantee and death benefit guarantee can add about 40 to 80 basis points (100 basis points is one percentage point) to the management expense ratio of most segregated funds with 100% maturity and death benefit guarantees compared with similar mutual funds. As well, insurance companies have the right to change the management fee they charge with 90 days’ notice.

 Segregated Fund Investments

Segregated funds and mutual funds invest in many of the same asset classes including Canadian equity, U.S. equity, international equity, balanced and fixed income as well as some specialty areas. The additional costs vary depending on what type of fund you choose as your investment. For example, the cost of maturity guarantee for a money market fund would be low, while the cost for an international equity fund may be high. Many segregated funds invest only in a specific underlying mutual fund and are marketed as the segregated equivalent of that mutual fund.

What is a protected Mutual Fund?

Several mutual fund companies have introduced protected funds that have capital guarantees and in some cases death guarantees. However, these protected mutual funds are not segregated funds and do not have some of the other characteristics that make segregated funds held through an appropriate option for some investors.

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