If you’ve ever consulted a financial advisor, it’s possible they’ve thrown in the term “segregated funds”—or “seg funds,” as industry insiders say. So what are they?
What are segregated funds
A segregated fund is an insurance contract. It shares some qualities with mutual funds in the sense that it includes a pooled investment that is invested in stocks, bonds, or other securities. But it also includes an insurance policy wrapper that guarantees a portion of the money you invest. Because these are insurance contracts, they’re mainly sold by Canadian insurance companies through licensed insurance advisors and are not traded on a public market. The name “segregated fund” comes from the fact that your money is kept in a pool that’s legally separate, or segregated, from the insurer's own assets.
So how is this investing? Well, the individual insurance contracts that you buy through segregated funds then invest in underlying assets similar to mutual funds, thereby helping your contract potentially appreciate in value over time. But since investing always involves an element of risk, there is a chance you could incur losses. That’s where 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 assets that the segregated fund invests in loses money, you’ll still get some or even all of your principal investment back.
What’s the difference between segregated funds and mutual funds?
The difference between segregated funds and mutual funds is that segregated funds are sold by insurance companies and usually include guarantees that protect your initial investment. Segregated funds also tend to have less flexibility and higher fees than mutual funds.
Segregated fund policies can offer guarantees for maturity and death benefits. Meaning, when the policy reaches its maturity date, or when you pass away, if your investment is worth less than its guaranteed value, the insurance protection would kick in.
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, iA Financial, Empire Life, and Industrial Alliance, as well as by RBC Insurance.
Advantages and disadvantages of segregated funds
It’s important to talk to the insurance provider you’re thinking of buying from in order to get all the information on the underlying investments, as well as any additional fees and 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. Also keep in mind that this protection is on the value at maturity (usually 10 to 15 years) - it’s worth considering that a well-diversified portfolio finishing down more than 25% after more than a decade has been rare, historically. (https://www.vanguard.ca/en/insights/global-6040-portfolio-steady-as-it-goes)
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 may offer protection from creditors seizing your assets in case of bankruptcy or in the event of a lawsuit. This might be particularly useful for freelancers or small-business owners.
“Reset” options: Some segregated funds might offer a “reset” option, which is applied if the market value of your policy increases and you would like to increase the amount covered in the guarantee (i.e., the amount you get back no matter what). That said, it also restarts the maturity clock, so it is essentially the same as buying a new contract.
Disadvantages
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. These fees can have a big impact on returns.
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.
Guarantees can shrink: after the age of 80, death-benefit guarantees often fall.
