SEGregated funds

A segregated (seg) fund is actually an insurance contract with two parts: an investment that produces the return and an insurance policy that covers the risk. The seg fund is like a mutual fund, you are pooling your money with other people to share investment gains, but because life insurance companies issue segregated funds, there is a guarantee attached that protects the investor's principal from sudden market declines. Think of such an investment as a mutual fund with a safety net.


A built-in guarantee

Insurance companies are required by law to build added protection into investment products. Seg fund policies guarantee that most of your initial investment is protected in the event of death or at the time of maturity. Depending on the provider, this guarantee may vary from 75 to 100 per cent of the principal amount.

For example, if you invested $25,000 in a 10-year seg fund policy with a 100 per cent guarantee, you would receive your initial investment plus profits made from market gains at the time of maturity. If the value of the seg fund policy has fallen below $25,000 at maturity, the principal remains protected. You can periodically "lock in" the protection on the principal when the policy has escalated in value. This resets your 10-year guarantee period.


Seg fund or mutual fund

Whether a particular seg fund is any more or less attractive than a mutual fund, however, will depend on your personal circumstances, and the investment strategy that you have worked out with your Care financial advisor.

Like mutual funds, segregated funds contain a diversified group of solid investments. They come in various sizes and asset mixes, and benefit from the experience of a qualified portfolio manager. Where the two types of funds part company is in flexibility and the added cost of insuring the principal.

Entrepreneurs and small business owners may want to consider the potential creditor protection offered by seg fund policies. Because they are insurance policies, they enjoy creditor protection under provincial insurance legislation.


The cost of a guarantee

While a disciplined, long-term approach to the market is always advised, a guarantee is not for everybody. Some investors may not want to incur the added cost of guaranteeing the principal invested in a seg fund. That cost varies depending on the insurance company.

Some seg funds have higher management expense ratios than mutual funds. Some guarantee only 75% of principal, to keep the MER lower. Some make the 100% guarantee an option that the consumer can pay for.

Some investors see such a guarantee as unnecessary since it is highly unlikely that market values will be lower than the principal investment over any 10-year period. Others view the added cost as an investment in peace of mind.


Seg fund advantages

There are other advantages to a seg fund policy.

One is the reset option. As a seg fund investor, you can protect profits inside the fund. What it does is allow fundholders to lock in gains when market values are high. If, for example, your $50,000 seg fund policy has increased in value by $11,000, you can use the reset option to protect the full $61,000. Once again, the reset option is not for everybody since it also resets the 10-year clock on the fund's guarantee.

Seg fund policies are also a solid estate planning tool. Upon death, the market value or the guaranteed principal is paid out directly to the beneficiary without being subject to provincial probate fees.


The following chart summarizes many of the important differences and similarities between Segregated Fund and Mutual Funds.

 

Segregated Funds

Mutual Funds

Overview

Your net premiums are invested in the segregated funds of an insurer which, in turn, invests in securities such as stocks, bonds and money market investments. Segregated Funds are insurance products.

Money is pooled and invested on behalf of unit holders in securities such as stocks, bonds and money market investments.

Regulated by

Provincial Life Insurance Acts

Securities Legislation

Capital Growth Potential

Yes

Yes

Track unit value in the newspaper

Yes

Yes

Diversify investments

Yes

Yes

Financial Protection

At death and maturity, premiums minus withdrawals are usually guaranteed, between 75% and 100%.

No guarantees on investment performance. Theoretically, you could lose everything.

Death Benefit

Beneficiaries receive either the guaranteed death benefit or the market value depending on which is greater.

The estate or beneficiaries 2 will get the market value only – there are no guaranteed minimums.

Probate Protection

At death, proceeds can be paid directly to a named beneficiary, avoiding the estate administration process, and the cost of probate fees.

At death, proceeds are an asset of the estate and are subject to the estate, administration process and legal fees. It could be some time before the estate can distribute the mutual funds.

Creditor Protection

Designations in favour of a parent, spouse, child or grandchild may result in the insurance money being exempt from seizure. This is sometimes referred to as "creditor protection". 

The money cannot have been deposited as:

  • Part of a fraudulent conveyance (transferring money to keep it out of reach of existing creditors).
  • Within a specific time period before bankruptcy

No protection against the claims of creditors.

RRSP Eligible

Yes

Yes

RESP Eligible

Yes – only one company though

Yes

Taxation Implications for non-registered investments

You are only taxed on the income you actually receive. Taxation is based on how long you own the Segregated Fund units within the income period.

  • E.g. if you buy units one day before the fixed date, you are only assessed for one day's income. The unit seller is assessed for income made before the end date.

You can use capital losses to offset capital gains from other sources. 

For accounting purposes, acquisition fees are excluded from the adjusted cost base and treated separately .

You could be taxed on income you never received. Taxation is based on who owns the mutual fund units on a given date at the end of the income period.

  • E.g. if you buy units one day before the end date, you are assessed for all income earned in that period, even though you did not benefit from that income.

Capital losses must be carried forward by the fund and are not allocated to you, the unit holders. 

Acquisition fees are included in the adjusted cost base.

Under what circumstances might these be more suitable?

Non-registered or registered funds. 

Investors approaching retirement. 

Investors who like the security of guarantees.

Business owners who want creditor protection.

Non-registered and registered funds. 

Investors who want a wide variety of specialized fund choices in their investments. 

Investors willing to give up guarantees for potential increased returns.

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