Investing with Guarantees: Segregated Funds

December 16, 2011

If you’re like most people, you’ve gone to the bank do your investing. You didn’t realize that you had other options. If you weren’t interested in GICs, you were likely sold a mutual fund.

What’s a Mutual Fund?
A mutual fund is a collection of stocks and bonds that are put together into a portfolio. A fund manager and a team of analysts actively watch all the companies within the fund and make the decisions regarding when to buy or sell each company. It can also hold fixed income products like government or corporate bonds. The fund has to be run according to a given set of parameters which indicate if the fund is for a conservative, moderate or more aggressive investor. The funds are categorized by these parameters.

In most cases, when you’re invested in a mutual fund, you are actively invested in the market. You can make money if the fund does well, but you can also lose money if the fund does poorly.

How about a Segregated Fund?
Segregated funds are essentially mutual funds sold through insurance companies. You get the same active management, and in some cases the same management companies but with one big difference. Segregated funds have a way of managing your long term risk by adding a component of insurance to your investment. Let me explain.

Like a mutual fund, you can lose money if the markets go down. But, when you initially purchase the fund you get to choose how much of your money you want to guarantee that you’ll get back at a point of time in the future. You can guarantee 75% or 100% of your deposits, and the guaranteed amount becomes payable either on death or 10 or 15 years from when you opened the contract, respectively. Now that in and of itself isn’t incredibly exciting but, what does get exciting is an additional feature that allows you to reset your guaranteed level when the markets have done well. When the value of your account has gone up, you can tell the insurance company that you want that new higher level to become the new level of guarantee. If the markets subsequently go back down, you get the new guaranteed amount, after a new 10 to 15 year period. These contracts do have age restrictions for these resets, and there is also a cost for this feature. The management expense ratio, which is the fee that you pay to the fund company to manage your funds for you, is higher to account for the additional insurance protection provided by the guarantees. The insurance company is actually putting the extra money aside to ensure they can live up to their guarantee.

Preparing for the Future
Segregated funds work best with long term time horizons and can be very helpful during retirement planning, as you know ahead of time the amount of the guarantee. When timed correctly, the purchase of these funds can help protect your nest egg from an untimely down market right before retirement. Segregated funds also have death benefit guarantees to make sure that on your death, your beneficiary will receive at least all the money you deposited, less withdrawals. In addition, as segregated funds are insurance company contracts, at your death, your money passes outside of your will directly to a named beneficiary. The advantage of having your money pass outside of the will is that the money does not become subject to probate fees. You beneficiary designation is part of a private contract, so there is confidentiality around who has been named as beneficiary and how much they will receive.

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