Friday, August 21, 2009

The lone pollster wants to hear about Segregated Funds

What’s a Segregated Fund? Seg funds as I will occasionally refer to them, are investments sold by insurance companies. They get the name Segregated because the assets and investments are held separated or segregated from the other assets of the insurance company. The reason for this is that the insurance company can go bust and your investments will still be there.

Segregated Funds are most easily compared to a Mutual Fund, they are typically a fund or basket of stocks, bonds and securities wrapped up in a package. Segregated Funds versions of popular Mutual funds are often provided by the insurance arm of the investment firm. Third party funds are also available based on popular Mutual Funds from dealers like Fidelity, AIM Trimark, Dynamic and others. Segregated funds can be used in RRSP, RESP, TFSA and non-registered accounts. They don’t tend to have the breadth of choice available in the Mutual Fund or Electronically Traded Funds (ETF) markets but they have an excellent selection of asset classes covered. They also don’t sport as many tax options such as corporate class mutual funds.

If they are so similar why not just buy a Mutual Fund? While there are lots of similarities there are also a lot of differences, most of these have to do with guarantees. Remember Seg Funds are sold by life insurance companies; they are essentially a life insurance contract. Because of this they inherit several benefits of life insurance, namely they can have a beneficiary, and they bypass probate fees. Segregated Funds also have guarantees which no Mutual Fund has. The two main guarantees are the Death Benefit Guarantee and the Maturity Guarantee.

Death Benefit Guarantee, because they are life insurance seg funds have a beneficiary, they also have a death benefit which is paid to this beneficiary at the time of the owners death. The catch is that unlike a traditional life insurance policy with a flat face amount the face amount of the seg fund varies with the performance of the investment. However, to be called a seg fund all policies must provide a minimum 75% guarantee. This is to say that if you invest $100 in a seg fund, the market tanks and the investments are only worth $50 at the time of your death, the insurance company will pay your beneficiary the guaranteed amount of $75. Most insurance companies also offer funds with a 100% guarantee; every dollar you pay into a fund is guaranteed to be paid back to your beneficiary at the time of your death, regardless of the current market value.

Maturity Guarantee, seg funds also have a maturity date, the maturity date is usually 10 or 15 years after the first date of purchase. The maturity date operates similar to the death benefit guarantee except you don’t have to die, good thing that. Again 75% is the minimum guarantee, if an investor purchases $100 of Seg Funds today and had a 75% guarantee, they are guaranteed to be paid back the higher of the current market value or 75% of their original investment. 100% guarantees are also available but usually carry a 15 year maturity date. Insurance companies can afford to do this because there are very few occasions in history where 10 year returns have been negative. The exception to the rule is right now, some investments, specifically those in the NASDAQ index, are indeed negative over 10 years. There are several insurance companies, most notable Transamerica which are currently paying out large sums of money to Seg Fund holders due to their maturity date guarantees.

Resets are another special feature of Segregated Funds. While options vary, policies are available with guarantee reset options. Resets allow you to lock in the current market value of your investment as the new guarantee. For example if you originally invested $100 in a 75% guaranteed seg fund and it had grown in value over 4 years to $150 you could use a reset which would now increase your guaranteed amount from $75 to $112.50. Should the market take a turn for the worse and your investment drop in value to $80 you would receive an extra $32.50 thanks to your guarantee. One important thing to note is that using a reset will also extend the maturity date. In the above scenario where the reset is used in year 4 the maturity date would be pushed out another 10 years from that point. So the owner would not be able to collect on the guarantee until 14 years into the contract.


Creditor protection is another benefit of segregated funds, especially for business owners. If for whatever reason you were sued for a million dollars, lost and were unable to pay the fine; your creditors can come after your other assets, your home, your cars, your savings and your RRSP’s. One thing they are not allowed to come after is your life insurance, specifically a life insurance policy with an irrevocable beneficiary. Now remember segregated funds are a form of variable life insurance, and you can designate an irrevocable beneficiary.
Assume a business owner is married, but his wife doesn’t own any shares in the company. The company has a segregated fund policy which is used as key person insurance on the business owner, a legitimate use. The company is sued for a million dollars, which it cannot repay. The creditors can then turn to the shareholders for further reimbursement. Mr. Business Owner could potentially lose his company, his home and his life savings due to the lawsuit. However, he was smart and appointed his wife as an irrevocable beneficiary to the segregated fund policy. He has effectively relinquished control of the policy to his wife, she has to sign in order to make any changes to the policy, she will not sign the policy over to the creditors, and since she doesn’t own any shares is not a party to the lawsuit. The money is safe.
Now there have been court cases over this where the business owner knows fair well that he is going to be sued and lose. Liquidating all of one’s assets and dumping them into a segregated fund policy is not going to stop a judge from turning over the policy to a creditor in a fraudulent case like this. However, there is a good history of this method working for regular deposits and amounts which cannot be attributed to directly and intentionally hiding money from a pending lawsuit.

The fees charged for segregated funds are higher than Mutual Funds because there has to be a way to provide for all of the guarantees. A Mutual Fund might have a fee of 1.65% where an identical Segregated Fund might charge 2.45%, furthermore increasing the death benefit guarantee from 75% to 100% will typically add another 15 base points, while increasing the maturity date guarantee will add a further 20 base points. Typical Management Expense Ratios (MER’s) for seg funds run from about 2.1-3.1% depending on the asset class and fund manager.

Segregated Funds are an excellent choice of investment for business owners and more conservative investors. The maturity and death benefit guarantees are very popular, especially in today’s current economic turmoil. The fees charged are higher than those of ETF’s or Mutual Funds but they provide a valuable service in the form of guarantees and security. Segregated Funds are an excellent choice for a novice investor as well as for the average person who simply wants a secure base on which to build their savings.

E.O.&E.

4 comments:

  1. O.K. I have a question, what the heck is an allocation (in reference to a dividend seg fund)I was told that my div for 08 was over $5000 but it does not show up in the unit values or as cash. Where did the dividend go?

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  2. Most of the time any dividends paid into a Seg Fund are reinvested in the form of new units.

    Take a look at the total number of units you purchased with deposits/contributions, and compare that to the end of year total number of units. I bet you have more units at the end of the year than you bought in the course of the year.

    In a nutshell if you receive $100 worth of dividends, and the unit value is $20/unit the dividends automatically purchases 5 additional units.

    Another way some companies do things is increase the value of each unit by the amount of the dividend. in this case you should see an increase in the value of your units. You might not see it as it could be hidden due to other losses in the fund.

    from Industrial Alliance Pacific's Seg Fund Information Folder

    4.2 Reinvestment of Income
    Income from dividends, interest and net capital gains earned from the investments of the Fund assets will be automatically
    reinvested in the particular Fund to increase the current value of the Units.


    You also tend to get better reporting if the money is Non-Registered as Dividends are taxed differently. If the fund is in an RRSP it all gets taxed as interest so they don't bother tracking the dividends separately.

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  3. I will have a closer look at the number of units before and after Jan 1 and see if there was an increase in the number, thanks.

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