Well, a segregated fund is explained in easiest terms as a mutual fund run through a life insurance company. Similar to a mutual fund, investors contribute capital that is used to purchase the type of investments specified in the fund’s Information Folder (similar to a prospectus used for mutual funds). Therefore, there are various types of equity, bond, and cash based segregated funds.

Technically, segregated funds are actually Individual Variable Insurance Contracts. The investor doesn’t own a piece of the underlying investment pool, as in a mutual fund, but instead owns the policy itself that represents the pool.

As an insurance policy, there are some very key guarantees and subsidiary benefits associated with the ownership of segregated funds. However, there are some “downsides” too that an investor must keep in mind.

When one buys into a segregated fund the purchaser is given two guarantees: the maturity guarantee and death benefit guarantee. The maturity guarantee specifies that at maturity (10 years or more) the investor will be guaranteed a percentage (75%-100% depending upon product) of their original investment back (minus any withdrawals) or the market value, whichever is greater. The death benefit guarantee says that if the investor dies before the maturity date, a percentage (75%-100% depending upon product) of their principal investment (minus withdrawals) or the market value, whichever is greater, will be paid to the beneficiaries.

Another advantage of segregated funds is the potential creditor protection and beneficiary designation. As an insurance contract, the Uniform Life Insurance Act specifically protects the beneficiary designation of a spouse, child, grandchild or parent from execution or seizure by creditors, as a matter of public policy. This provides potential creditor protection. It’s “potential” because of the fact that the Bankruptcy and Insolvency Act is a countervailing force to the Uniform Life Insurance Act. Whether a protection from creditors stands up in court has a lot to do with the age of the segregated fund investment. The “rule of thumb” is that if the investor has had the segregated fund contract for at least three years, there’s a chance that it may be protected. If the investor has had the contract for five years or more the protection is thought to be almost absolute.

Unique to this type of investment is the fact that, as an insurance product, it has a designated beneficiary. Having a designated beneficiary means that in the event of the death of the owner, the assets do not go through the will. Instead, they go directly to the beneficiary of the contract, therefore avoiding the need for probating the asset. This has two important elements. One, it avoids the cost associated with probate. But, in Alberta the maximum fee is only $400, so that’s no big deal. Second, and more importantly, it preserves the privacy of the testator. As you know, anyone can go down to the court and receive a copy of a testator’s will for a small fee. Some people don’t want any “Joe Blow” to know what their last wishes were.

A disadvantage of segregated funds has to do with their fees, which in most cases are higher than mutual funds. As insurance companies need to “insure” the amount of assets that are put in segregated funds (i.e. maturity and death benefit guarantees) there is an insurance fee that is added to the management expense ratio (MER). The higher the guarantees that are provided, the higher the MER. Lately, a number of Canadian insurance companies have begun to rethink their 100% principal guarantees. Increased costs for insurers are leading to price and product changes.

There are some very good reasons that segregated funds can be the perfect investment for you. But, you have to be careful as some of the insurance companies have MERs that are just unacceptable as far as I’m concerned.

That’s The Simple Truth