Wouldn't it be great if you could purchase an investment that benefits from growth in the financial markets and also has a no-loss guarantee? If you are a Canadian citizen, you can do exactly that by investing in a segregated fund.
Segregated funds consist of professionally managed investment portfolios that guarantee to return a predetermined percentage of the investment at maturity or upon the death of the investor. These funds derive their name from the fact that their assets are set aside to pay policy holders and are not part of the issuing insurance company's general assets.
Segregated funds began as a pension plan product, but over time they began to catch the attention of the investing public. In the late 1990s, mutual fund companies began to work with insurance companies to create segregated funds that mirrored popular mutual funds. (Read more about mutual funds in Analyzing Mutual Fund Risk.)
The Investment Benefits of a Mutual Fund
Segregated funds are often described as "mutual funds with a guarantee." While they do function like mutual funds, they are actually annuity contracts with mutual fund-like characteristics. Those characteristics include professional money management, a variety of investment portfolios (including, as previously noted, many that mirror popular mutual funds), diversification and profits that are subject to tax unless held in a tax-deferred investment vehicle. (To learn more about the segregated funds and mutual funds, check out the answer to our frequently asked question How do segregated funds differ from mutual funds?)
The Protection of an Annuity
While they offer mutual fund-like investment benefits, segregated funds are actually variable annuity contracts. Issued by life insurance companies, they offer a guaranteed return on the initial investment of at least 75% if held for at least 10 years or upon the death of the account holder. Some segregated funds offer an option for the return of 100% of the original investment. Segregated funds are protected by Assuris, formerly the Canadian Life and Health Insurance Compensation Corporation, or Comp Corp. If the insurer that issued the fund fails, Assuris provides $60,000 worth of protection per account (as of 2009).
In addition to the opportunity to participate in investment gains and the assurance of a minimum investment return guarantee, segregated funds also offer a host of additional benefits.
Segregated funds offer a variety of "reset"options, by which the amount of money covered by the guarantee increases. For example, many funds offer a three-year reset. So, if a $100,000 account increases in value to $125,000 over the course of three years, an investor with a 100% guarantee would see the minimum amount of his or her guarantee rise from the original investment amount of $100,000 to include the $25,000 gain. The number of times such increases are available varies by contract, and accepting an increase may extend the contract's maturity date. Additional deposits to an existing account result in a different maturity date for each additional deposit. In this example, if the fund had a 10-year maturity date, the guarantee would be honored if the fund was held to 10 years from the date of the reset to $125,000. (To learn more, read How Your Annuity Company Determines Renewal Rates.)
Investors can generally withdraw 10% of the assets they have invested in a segregated fund each year without any penalty. That figure rises to 20% in retirement accounts. Penalties exist in the form of deferred sales charges that often start out much higher than regular mutual funds. These charges often decrease by set amounts each year until they reach 0%.
Protection From Creditors
From a legal perspective, the rights of life insurance beneficiaries trump those of creditors. This means that assets held in segregated funds are generally protected if the account holder files for bankruptcy, as long as assets weren't moved into the account strictly for the purpose of creditor evasion. This protects spouses, children, grandchildren and others should the account holder encounter financial difficulties. (To find out other ways to protect your family from creditors, read Protect Your Personal Assets.)
To meet the requirement for protection, the annuity contact must have been in place for at least two years. Also, estate taxes must not be owed on a registered retirement savings plan (RRSP) or registered retirement income fund (RRIF).
Assets held in segregated funds are not subject to probate. Proceeds go directly to the designated beneficiary upon the death of the account holder. This speeds up the process and minimizes the costs associated with wealth transfer. (Read Skipping-Out On Probate Costs to learn how to avoid the high costs associated with the transfer of your estate.)
Segregated funds offer a host of features and benefits, but those amenities aren't free. The cost of investing in segregated funds is often significantly higher than the cost of investing in similar mutual funds. While partial withdrawals are available, penalties for early redemption of amounts in excess of the designated limits are often up to 6% in the first year, declining 1% per year until reaching 0%. This penalty can make it difficult and expensive to access assets prior to maturity. (To learn more about fund fees, and how to avoid them, be sure to read Stop Paying High Mutual Fund Fees.)
Should an investor wish to transfer funds in order to change the underlying investments, there may be an additional fee. Many segregated funds also restrict the number of transfers that can be made.
The Best of All Worlds
Segregated funds offer a unique investment option for investors seeking to participate in the financial markets. They provide an opportunity to benefit from the upside potential, but protect from the possibility of losing money. The peace of mind provided by insurance protection might be worth the price of admission.
Be sure to read all documentation and understand the various fees and contract stipulations before investing, as segregated funds vary significantly from provider to provider. Likewise, purchasing segregated funds from well-established, highly-rated insurance companies will minimize the risk that the contract provider will go out of business.