Segregated Funds: Mutual Funds with Insurance
An Introduction to Insurance and Risk Management – Part 6
Doesn’t this Post Belong Under Investment Planning?
While segregated funds are investment products, the fact that they have certain insurance features and can only be bought through someone who is life-insurance-licensed, I have placed this topic under the category of insurance and risk management.
What Are Segregated Funds?
As the title of this post indicates, they are mutual funds with an insurance component. Segregated funds offer guarantees with respect to maturity and death benefits. Segregated funds have a bit of a confusing structure to them in that what you purchase is an insurance contract that pays out certain benefits based on the value of a pool of assets that are segregated from other pools held by the insurance company, thus the name. You do not actually own the underlying fund or funds directly.
However, segregated funds are like mutual funds in that you have access to professional investment management, diversification and the ability to invest in small amounts. The distinctive features of segregated funds, though, are the maturity guarantees, death benefit guarantees, the bypassing of probate and creditor protection.
Because of the insurance benefits they offer, segregated funds are more expensive than mutual funds, which means they tend to have higher management expense ratios (MERs) than comparable mutual funds. Before considering a segregated fund over a mutual fund, as with other forms of insurance, it is wise to consider the likelihood that the risks you are insuring against will actually occur.
Advantages of Segregated Funds
Maturity Benefit Guarantee
The legislation concerning segregated funds requires that at a minimum, the issuing insurance company guarantee that at least 75% of the invested money will be returned over a minimum 10-year holding period. Some contracts will provide a 100% guarantee.
Some segregated fund contracts also allow the contract holder to reset the guarantee amount. Consider a scenario where you bought a segregated fund contract with a 75% guarantee and invested $10,000. You are therefore guaranteed to get at least $7,500 returned to you if held to maturity. Three years into your 10-year holding period, the fund has gained an impressive 50%. It is now worth $15,000. If you reset the guarantee based on the current amount, you are now guaranteed a return of $11,250 (75% x $15,000). However, your 10-year holding period has also been reset.
Death Benefit Guarantee
Similar to the maturity guarantee that applies when you are alive, as these are contracts issued by life insurance companies, your beneficiaries are guaranteed to receive 75% (or 100% depending on the contract terms) of the amount invested when you die. While this is a comfort, it should be noted that if you seek to buy a segregated fund contract after age 80, for example, you may not be able to get what you want as the likelihood of your imminent death has increased to the point that the insurance company is no longer willing to accept the risk.
As segregated funds are an insurance product, were you to die, your named beneficiaries would receive the proceeds directly. They should therefore receive payment sooner and the probate fees on your estate would be reduced.
If you go bankrupt, fail to pay your debts, or have potential exposure to liability from a lawsuit, and you have named certain beneficiaries (spouse, child, grandchild, parent) in your contract, your creditors cannot go after the assets in the segregated fund. There is a caveat to this, however. If it is found that you purchased the segregated fund in anticipation of going bankrupt, your creditors can still make a claim against those assets.
Disadvantages of Segregated Funds
As with all insurance products, in order to offset your risk, you must pay an insurance company to take it on. Although the underlying assets of a segregated fund contract may be regular mutual funds, the insurance component is going to add to the costs, potentially as much as 1 percent more than the MER of a standard mutual fund. Given that these are typically actively managed funds, that means you are quite likely to pay a greater than 3 percent MER.
Potential Penalties for Early Withdrawals
When you buy a segregated fund, the maturity guarantee is only applicable if you stay in the fund for the full 10 years, assuming a 10-year maturity. You have every right to cash out in advance, but you will only get the current market price, which may be less than your investment. Furthermore, it is possible that you will pay a penalty for an early redemption.
Should You Invest in Segregated Funds?
With research continually finding that the single most reliable indicator of superior investment returns is investment costs, the high fees of segregated funds are a difficult pill to swallow. I’m inclined to suggest that a properly diversified, low-cost investment portfolio that takes your time horizon into account is a good way to manage the risks of investment loss.
I also have a hard time finding the maturity benefit to be that important. Over 10 years, it is unlikely that even a high-priced segregated fund will lose more than 25 percent of its original, so a 75% guarantee is probably not that likely to pay off. That benefit is even less likely to be realized if you were to invest in a segregated fund with a balanced asset mix of equity and fixed-income investments. A 100% guarantee will be somewhat more likely to pay off, but you are probably going to pay more for that extra bit of security. It is important to determine whether this form of insurance is worth it.
The death benefit, including the fact that you can name beneficiaries, is a different matter, especially if you believe there is some likelihood that you might die before the maturity date is reached. But again, is the cost for the insurance worth the benefit?
Nevertheless, if the benefits that segregated funds provide appear to be of some value to you despite the costs, then consulting with a licensed insurance representative should be your next step.
In my next post, I will discuss annuities.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, accounting or legal decisions.