The Pros and Cons of using Segregated Funds

The Pros and Cons of using Segregated Funds

From Wahad Butt

The key to any investment strategy is diversification, long-term planning and a degree of protection. It is therefore no surprise that many investors use segregated funds as an integral part of their long-term investm...

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Mutual Funds v Segregated Funds

Before we look at the advantages and disadvantages of segregated funds, many readers may be a little confused about the similarities yet differences between mutual funds and segregated funds.

The major difference is that mutual funds are classed as investments whereas segregated funds are classed as an insurance policy. Therefore, segregated funds can only be offered by an insurance company even though the policy will be invested into mutual funds.

When buying into a mutual fund you are literally buying a share of an investment vehicle set up by an investment company. If for example the company managing the mutual fund was to suffer insolvency then shareholders would have limited protection. A segregated fund (insurance policy) is held in trust for the investor and therefore sheltered from any financial difficulties.

Factors to consider when investing in segregated funds

On the surface many people might automatically assume that mutual funds/segregated funds both offer exposure to investment markets with the potential for capital growth. This is correct. However, when looking at segregated funds there are other issues to take into consideration.

Pros of investing in segregated funds

In order to consider the suitability of segregated funds there are a number of pros and cons to take into consideration. This is still a relatively specialised area of investment, deemed as an insurance policy as opposed to an investment, and therefore different regulations come into play. However, there are numerous benefits which include:

When looking at your investments as a whole, it is very important to look at the longer term and instigate a degree of tax planning where possible. If a beneficiary is named on your segregated funds contract then upon your death the funds will not be subject to probate fees. This is because in practice segregated funds are a type of insurance policy as opposed to the direct ownership of investments.

While contract details will vary for each segregated fund provider you can generally expect to have between 75% and 100% of your principal investment guaranteed (if you hold for the full term). This means that in the unlikely event that the mutual investment funds, in which your funds are generally invested, lost all of their value then your capital would still be protected to a varying degree.

The vast majority of insurance policies are fairly basic, you pay a premium for a degree of protection and if certain conditions are met then a payment would be made. When investing in segregated funds the majority of your capital will be invested in mutual funds. As segregated funds tend to have a minimum 10 year term you would expect to see a degree of capital growth over that period. Upon maturity of the investment policy you would receive the market value of the policy or in a worst-case scenario the protected principal element of between 75% and 100%.

Mutual funds have been a popular means of investing for the future for many years now. Therefore, it will be no surprise to learn that you can pick and choose individual mutual funds to specialise in areas such as real estate, technology, individual indices and countries to name but a few options. Many segregated fund providers will also give you this degree of flexibility so that you can focus on a particular area of investment. However be warned, segregated funds tend to err on the side of caution placing stability ahead of risk and steady long-term returns ahead of volatility.

Unfortunately, we live in a world where litigation and legal battles can have a huge impact on the long-term financial stability of companies and individuals. Therefore, with particular emphasis on the self-employed and small business owners, you will be pleased to learn that segregated funds offer a degree of protection from creditors. Even in the event of bankruptcy/lawsuits, as long as you have a family member named as a beneficiary, your segregated funds may well be protected from your creditors. The ability to place investment funds into a protected investment vehicle allows individuals to plan ahead and offer a degree of financial stability for their families.

As we touched on above, because segregated funds with a named beneficiary are not part of probate on death, the financial details relating to your segregated fund investments will not be made public. The traditional course of action upon the granting of probate is publication of an individual’s estate which becomes a public record. Either the protected element of your initial investment or the market value is immediately paid out to your named beneficiaries upon death - thereby bypassing probate.

Many segregated funds will offer what is termed “reset protection” which effectively means that as your segregated funds increase in value you can “reset” the protected element. For illustration purposes, let us assume that you saw a 30% increase in your segregated fund investment during the first seven years of your policy. This would leave a relatively large gap between the current market value and the protection based on your principal investment. So, you could decide to “reset” the protected element which will be based on the current market value of your policy. While there may be fees incurred with this type of transaction, and you would also reset the term of your segregated fund policy to between a minimum of 10 to 15 years, it can still be very useful.

Cons over investing in segregated funds

When you look at the basic theory of investment it all comes down to the risk/reward ratio. The higher the risk the higher the potential reward required to make up for taking the additional risk. The lower the risk, the lower the potential reward required because of the lower element of risk to your capital. While seen as long-term and relatively low risk, there are some disadvantages of investing in segregated funds over for example direct investment in mutual funds such as:-

Segregated funds, classified as insurance policies, tend to attract higher fees than mutual funds. In many ways this is a reflection of the protection offered when investing through a segregated fund vehicle. As we touched on above, if you invested directly in a mutual fund and all of the investments went to zero then you would lose all of your money. If you invested in a mutual fund through a segregated fund vehicle then even in this extreme scenario, between 75% and 100% of your principal investment would be protected.

All investments should be considered on a long-term basis although there will be scenarios where short-term funding may be required. When offering segregated policies, insurance companies will also view these on a long-term timescale when calculating their management income and other fees. Therefore, if you decide to redeem your segregated fund investment early then you will likely be faced with redemption fees.

While the exact terms may vary from insurance company to insurance company, segregated fund investments tend to have a minimum term of 10 years. If you cash in your investment before the minimum term is up it is likely that you would receive the market share at the time. The degree of protection, traditionally between 75% and 100% of your principal investment, would not be relevant for early redemptions. When locking up your funds for a period of 10 years this can seem excessive but if it forms part of your overall tax/estate planning you should hopefully have other investments which are more liquid and more readily available.

While there may be opportunities to invest in highly focused niche mutual funds, via your segregated policy vehicle, there will be restrictions erring on the side of caution. It is not in the best interests of the segregated policy provider to encourage speculative investment while offering varying degrees of protection for the initial principal investment. Segregated funds should be seen as more of a backbone of your portfolio as opposed to the more speculative element.

There is no secondary market as such for segregated funds as you will simply be cashing in your investment once the minimum term has been reached or redeeming early. There may also be additional fees to take into consideration when redeeming your segregated investment. It is important not to be under the assumption that segregated investments are readily tradable investments. They are specific policies/investment vehicles set up for individuals to investment in mutual funds and the like.

Wrapping up

While there are some similarities between mutual funds and segregated funds, there are also a number of very stark differences. For many people segregated funds offer a degree of stability and backbone to their long-term investments as well as being a useful tool for tax/inheritance planning. The terms and conditions which apply to individual providers will vary and it is essential that you take professional financial advice.

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