Segregated Funds are similar to mutual funds in how they structure themselves. They are both pools of investor funds that invest in various financial instruments and various sectors with the hopes that at the end of each day, the fund is worth more than when the day started. Whereas Mutual Funds are offered by banks and investment companies, segregated funds are offered by life insurance companies exclusively and that gives them the ability to offer extra protections that the banks and investment companies cannot.
The main differences between segregated funds and mutual funds in Canada are:
- Guarantee of capital invested
- Periodic re-sets of guarantees
- Probate treatment
- Estate planning flexibility
- Creditor protection
Segregated funds guarantee some or all of your investment. Many Mutual Fund investors will remember 2008, and some will also remember 2000-2001. When the markets were going up in the years leading up to both those crashes, everyone was talking about how things were different “this time” and were pilling money into their investment account. And they were making money. On they did on paper at least.
One of the greatest traders of all time, Jesse Livermore, is quoted in “Reminiscences of a stock operator” written by Edwin Lefevre in 1923, and his voice speaks through the decades to still rings true today.
“The big money in booms is always first made by the public – on paper. And it remains on paper.”
Sound familiar? He was talking about how the public becomes emboldened when the markets are going up, and become the reason the market moves back in 1923. But greed often sets in, and market professionals see it before the public. By the time the inevitable crash that always follows a market run-up occurs, the professional money is long gone, and the public is left holding the bag.
In 1997, US Federal Reserve chairman Alan Greenspan tried to warn the public in his now famous “irrational exuberance” speech and that the stock market was on an “unsustainable track”, but the public only see “potential” profits, and ignore “potential” losses. So they continued to buy, then borrow and buy until the dotcom bubble burst. It had created millionaires and billionaires, but it also wiped many of those out in about 2 months. Did we learn out lesson?
It happened again in 2008, with the US housing market collapse, and subsequent global recession, and guess what happened? Many investors were left holding the bag again. That is when something changed in investor mentality. With people looking at 30%, 40% or even 50% losses on their investment and retirement accounts, some people had to severely alter their retirement strategy, and work a few years longer than they thought in some cases. Security of principal became more important than the possibility of profits and Segregated Funds with their guarantees came into the spotlight.
Segregated funds can offer more guarantees for protecting your principal than mutual funds. Seg funds will guarantee a predetermined percentage of your investment (usually 75% or 100%) once the fund units have been held for a specific period of time.
What are “resets”?
They also carry features that mutual funds can’t such as principal guarantee resets. That means that if you invest $10,000 in a seg fund, that amount can be guaranteed, and if the market takes that fund up to $12,500, then you can reset the guarantee to the new amount. If the market falls back down to $10,000, then you are still guaranteed your $12,500 at maturity of the contract. If the market falls to $8,000 or $6,000 even, as would have been the case in 2008, you still have your $12,500 guaranteed. Some insurance companies even offer monthly automatic resets. That means that every month your fund will reset to either the highest market value or carry the highest value the fund has attained since you’ve owned it. That is a nice feature, and don’t look for it in mutual funds.
An alternative to life insurance
Life insurance can be a key component of every estate plan and although today there are many options for no-medical life insurance with new ones showing up almost every month, what if you’ve tried to get life insurance and have been denied? If that is truly the case, contact me for options, but if that is truly the case and you want the estate preservation benefits of life insurance in your estate plan, you should consider investing in some segregated funds.
- The beneficiaries receive the proceeds of the funds quickly, often within 5-7 days
- The contract is confidential and only you and the beneficiary need to know
- The proceeds of the contract bypass probate, if non-registered
- Guarantees on your money can be reset, even monthly
What does an estate payout look like?
Mutual Funds, Stocks, GICs Bank accounts, etc.
↓ Estate and Probate ↓
|Estate and Probate|
|5-7 Days for Payout
Weeks, Months or Years?
Segregated fund flexibility
You can customize your inheritance payout any way you like. 100% lump sum, 100% annuity (payments over time until the full amount is paid out to avoid lump sum payments) or a combination lump sum and annuity. Let’s look at an example:
Laura is 32, financially savvy and gets 100% lump sum
Her brother Brad is 27, not financially savvy and in an unstable relationship. Brad gets 10% lump sum and 90% in an annuity that pays out every year.
As you can see, with very little work you have set up an incredibly robust estate plan by using the flexibility of segregated funds.
You don’t have to wait until your loved ones are mourning your loss ta make use of the flexibility of segregated funds. You can also do this while you are still here.
Let’s assume you wanted to gift your child part or all of their inheritance now when they likely need it most, and it could help them the most. Maybe, you worry that perhaps your hard-earned dollars will end up at a fancy car dealership instead of helping build for your beneficiaries’ future. Well, because segregated funds are offered by insurance companies and the payout is directly to a named beneficiary, you can gift them an amount in a segregated fund contract (talk to your accountant about tax implications) but you can designate yourself as the irrevocable beneficiary. That means that every time that they want to withdraw funds from the account, they will need your signature and you therefore maintain some control over how the money might be spent.
Segregated funds truly can be the MVPs of the estate planning world
Although it is not necessarily an estate planning tool, segregated funds also carry another benefit in the form of creditor protection, but according to Keith Masterman in an article for Advisor.ca, there are certain situation in which this creditor protection may be lost:
If the seg fund was purchased while the investor was experiencing financial hardship or was aware that he or she would be facing such difficulties, then the creditor protection could be challenged.
Segregated funds in a non-bankruptcy situation may not provide creditor protection from CRA income tax liabilities.
Creditor protection may be waived for seg funds when dealing with a dependant.
Creditor protection for seg funds is usually only available when a family member (spouse, child, grandchild or parent) is named on the policy.
You may not buy segregated funds for creditor protection, but it is another nice feature that come with them.
What about the fees?
The fees, or management expense ratios (MER) for seg funds is often higher as there is an insurance component, but the insurance companies have recently begun lowering these and in some cases can be even cheaper than mutual funds. Fee reduction is a hot topic in the investment industry right now, any fee reduction of either fund is welcomed. Nobody enjoyed the 2008 crisis, but if the evolution of the segregated funds is what came out of it, then we did at least learn some lessons.
Now that you know the difference between segregated funds and mutual funds, it is time to examine why they are so important to estate planning, and that is their ability to have a beneficiary appointed and skip over the probate wall. The guaranteed account value or market value of the account (whichever is higher when you die) will be paid out by the life insurance company directly to the beneficiary.
We’ve already learned the importance of placing as much of the estate as possible outside the reach of probate fees, and segregated funds need to a part of that, especially as you approach retirement. From an estate planning perspective as you near age 65, you should be considering moving part of your portfolio into segregated funds because of the estate preservation properties they can offer you. Talk to your advisor.
We covered the basics of segregated funds for estate planning in this post, but it is important you also do your own research to determine if segregated funds are right for your particular situation. It is important that you seriously consider both when you are assembling your estate plan.
Segregated funds are mutual funds after years of evolution and are getting cheaper. They offer guarantees, resets of those guarantees, creditor protection and they are not subject to probate, as they are considered a life insurance contract. They are one of the key ingredients to include when you are assembling your estate plan.
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