Segregated Funds Pros and Cons

Posted on August 19, 2015 and updated December 4, 2018 in Financial Advisors, Life Insurance Canada News 6 min read
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Are you looking for ways to invest your money towards a comfortable retirement and need some ideas? If so, you may be interested in segregated funds. We’ll review the pros and cons of segregated funds and take a deeper look into what they are so you can make an informed decision and whether its the right retirement investment for you.

Essentially, segregated funds are similar to mutual funds and are often referred to as “mutual funds with an insurance policy wrapper.”

What are Mutual Funds?

Mutual funds are stocks and bonds pooled together by a group of investors and are managed by professionals. Since there is a number of investors, there are different types of portfolios depending on individual risk levels.

One of the main advantages of both mutual funds and segregated funds is that they give small investors access to diversified portfolios of bonds, equities and securities which they wouldn’t typically have access to with a smaller investment.

What are Segregated Funds?

Segregated funds are essentially the same thing as mutual funds, except they have a layer of added insurance protection, which comes at a premium in the form of higher management fees.

One main characteristic of segregated funds is they are guaranteed to protect part of your investment, usually 75% to 100%. If the value of your investment drops below the guaranteed level, the investor will be able to get back the shortfall after a specific term which is usually ten years.

Segregated fund contracts will allow you to periodically lock-in the guarantee level when your segregated fund increases in value, but this also resets the 10 year term. Therefore, the downside to exercising a reset option is that you would have to wait longer to get your original capital back should there be a sudden downturn in the fund value.

Main Difference Between Mutual Funds and Segregated Funds

Another major difference between the two investments, aside from the fees and guarantees, is that segregated funds can only be sold by insurance companies, because they are individual insurance contracts.

Whereas many other types of financial institutions can sell mutual funds because there is no insurance contract, only an investment component. Many industry experts speculate on the reason for life insurance companies having the exclusive rights to sell segregated funds, claiming it is the only way insurance carriers could compete with other investment fund dealers in the free market.

What do Advisors Think of Segregated Funds?

If you are working with an investment advisor to build your portfolio, they probably either like them or they don’t and their opinions hinge on how they see segregated funds as a long-term investment.

Pro: Advisors for segregated funds think the built-in protection is worth paying the higher fees, particularly when it comes to riskier portfolios.

Con: Advisors against segregated funds say that other investments are better because they don’t see the guarantee that comes from paying higher fees as a benefit to investors. They see the added insurance cost as corroding investment returns, which greatly affects long-term investments negatively.

As you can see, the higher fees play a big role when it comes to segregated funds. So the question to ask yourself is do you think the higher fees are worth it for you. So now we’ll take a look at more pros and cons.

Segregated Fund for Estate Planning

Segregated funds are a popular estate planning investment because of the combination of growth potential and the security of a life insurance policy.

Guaranteed Income: Generally, retirement segregated funds also come with a guaranteed lifetime income element. Investors can choose when they will withdraw income and how much they will withdraw – and the income is protected. This investment is appealing to investors who are risk averse because they get exposure to the stock markets, but don’t risk losing their capital.

Creditor protection for self-employed individuals: If the insurance policy portion names an immediate family member as a beneficiary, the funds are protected from creditors.

Segregated Fund Expense Ratio Comparison – Con

Management Expense: The management expense for segregated funds can be as high as 3.3%, while an average mutual fund is 2.4%; which can significantly put a dent in returns in the long-run.

The main pros and cons of segregated funds can be summarized as follows:

Segregated Funds Pros

  • The principal investment is guaranteed: Depending on the specific contract, 75% to 100% of the initial investment is guaranteed, provided it is held for a set time, which is usually 10 years. If the value of the segregated fund rises, many policies allow investors to reset the guaranteed amount to take into account the higher value.
  • Death Benefit is Guaranteed: Depending on the insurance contract, beneficiaries will be paid out 75% to 100% of the investors contributions, tax free. As well, these monies aren’t subject to probate fees, provided the beneficiary is named.
  • Creditor Protection for self-employed business owners: There is the potential to add creditor protection to a segregated fund policy, which is beneficial if you’re an investor who operates their own business.

Segregated Funds Cons

  • Higher Fees: To cover the cost of the insurance component, segregated funds have higher fees.
  • Money is Locked-in: Investors have to keep their money in the segregated fund until the maturity date to take advantage of the guarantee. If they cash out prior to that date they will get the current market value of their investment minus early withdrawal fees.
  • Early Withdrawal Penalties: If the investment is cashed out prior to the maturity date there may be a stiff penalty.
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Storoszko & Associates, Tax Professionals
Storoszko & Associates, Tax Professionals

Hi Gerry,

The fund management fees can only be claimed as an investment expense, if the fee is paid separately from the investment (invoiced or charged separately by the fund manager or advisor). If the fees are included in the return of the investment fund, they cannot be claimed as an investment expense for tax purposes.

I hope this has answered your question.

Regards,
Storoszko & Associates
Canadian & US Tax Specialists
http://www.storoszko.net
647 367 3477
Twitter: @Storoszko_Assoc

Gerry Prince
Gerry Prince

Regarding Segregated funds, can a person claim the management fees for income tax purposes?
Thank you