Segregated fund

A segregated fund is a combined investment and insurance product sold by a life insurance company in Canada. Seg funds are similar to mutual funds in that they give access to a pool of securities like stocks or bonds. The current value of a seg fund fluctuates according to the market value of the underlying securities. Seg funds offer potential creditor protection, which can be of interest to business owners; they can also bypass the probate process if a beneficiary is named.

Additional characteristics of seg funds depend on whether you buy them (1) as part as workplace pension plan or group RRSP administered by an insurance company, or (2) on a retail basis.. In the first case, "these segregated funds do not carry an insurance guarantee and do not have the higher fees associated with retail segregated funds". This article focusses on the second case, seg funds purchased on a retail basis, which have additional features, i.e. maturity and death guarantees. These guarantees can have an emotional appeal to nervous investors and seg funds are marketed accordingly.

Retail seg funds offer a guarantee on the principal (initial capital invested), ranging from 75% to 100%, but you have to hold the fund for the entire guarantee period, typically 10 to 15 years, to benefit from the guarantee. Any withdrawals made during the guarantee period (i.e. before maturity) reduce the guarantee. There may also be a death benefit, meaning that the named beneficiary will get either the current market value or the guaranteed amount, whichever is higher at the time of death.

The Ontario Securities Commission warns that "If you cash out before the maturity date, the guarantee won’t apply. You’ll get the current market value of your investment, less any fees. This may be more or less than what you originally invested". Another downside is that seg funds tend to have significantly higher fees (the management expense ratios or MERs) than similar mutual funds, to cover the cost of the insurance features (the death and maturity benefits). Finally, there may be penalties if you cash out before the maturity date.

Few unbiased financial planners would recommend segregated funds under any circumstances. In almost all cases, they only make sense for the agents who collect fat commissions for selling them.

Dan Bortolotti, MoneySense

How they work

Seg funds, due to their insurance component, can be sold only by licensed life insurance representatives. Seg funds are fully segregated from the insurance company's general investment funds, hence the name.

The insurance regulators' definition of a seg fund is: "a specified and distinct group of assets the Insurer holds with respect to an IVIC, in which a Customer can invest by allocating monetary deposits to notional units of the segregated fund under an IVIC". An Individual Variable Insurance Contract (IVIC) is "an individual contract of life insurance under which the Insurer’s liabilities vary in amount depending upon the market value of a specified group of assets in segregated funds".

In other words, technically, the customer is buying a an Individual Variable Insurance Contract, not units of an investment fund.

Seg funds became popular in Canada in the late 1990s, and had reached over 300 billion dollars in assets by 2016.

Very high fees

Morningstar reports that "the average (seg fund) fee for a 75% capital guarantee is 2.92% and for a 100% capital guarantee, 3.27%". Bloomberg mentions instances of MERs above 4%. According to the The Canadian Council of Insurance Regulators, seg fund MERs are typically 0.5% to 1.5% higher than those of similar mutual funds.

To the uninitiated, this may seem like a reasonable extra fee if the added features are worth it. But adding an 1% or even 1.5% extra fee to a mutual fund that already costs 2% per year can dramatically reduce the end value of an investment after several decades. And there are broadly diversified portfolios that cost 0.25% or less per year, rather than the 2% typical of many actively managed mutual funds. So really, the comparison in fees should be between 0.25% on an asset allocation ETF that DIY investors can buy in a discount brokerage account versus, say, a 3% fee on a seg fund. For example, suppose you invest $10k a year for 30 years, and the return is 5% a year (plausible for a balanced fund). Based on the Ontario Securities Commission's Fee calculator:

• Without fees, theoretically, you would end up with $697,608;
• With a 0.25% fee, you would have $666,796;
• With a 3% fee, you end up with $413,794, having paid $283,813, or 41%, in fees.

Embedded commissions, other advisor incentives and conflicts of interest

Financial advisors who are only licenced to sell insurance products might recommend seg funds to investors, since these advisors don't have access to mutual funds or exchange-traded funds. These advisors are paid by commission, including upfront or embedded commissions. Insurance regulators (the Canadian Council of Insurance Regulators, CCIR, and the Canadian Insurance Services Regulatory Organizations, CISRO) are concerned that "upfront commission may motivate advisors (particularly less experienced advisors who have lower incomes) to sell [segregated funds] to customers for whom the product is not suitable".

The insurance regulators note that "beyond Upfront Commission, Insurers may provide other payments or benefits to Intermediaries beyond the commission set out in the Information Folder and Fund Facts documents" and that "Insurers and Intermediaries are not required to disclose these other compensation arrangements to Customers".

One type of embedded commission is the deferred sales charge, which clients have to pay if they redeem a seg fund early. In Ontario those charges were banned starting on June 1st, 2023. Other provinces are expected to follow.

Despite the ban on deferred sales charges, there is still an "Advisor Chargeback option" available, i.e. another type of embedded commission. The regulators write that "When a Customer invests money on an Advisor Chargeback basis, it introduces a potential conflict of interest for the Intermediary. An Intermediary may benefit financially if the Customer stays invested to the end of the chargeback period, even if staying invested is not aligned with the Customer’s interests".

Suitability and standard of care

Insurance regulators write that "Behavioural economic studies have shown the investors tend to minimize any potential conflicts of interest of their intermediary, and believe that although the intermediary is receiving compensation from fees, the intermediary is acting in the best interest of the customer". The regulators consider that seg fund clients "do not have a clear understanding of the duty of care owed to them by their intermediaries". Intermediaries may not have a legislative duty to act in the best interests of their clients; instead, the standard of care is that products sold by life insurance agents must be "appropriate for the needs of the client", i.e. suitable.

"To understand the difference between a "suitability" and "best-interest" standard, think of a student seeking advice at an electronics store about her need for a laptop. The salesperson recommends a highly priced unit with an expensive extended warranty — all designed to generate the highest commission. The laptop is suitable — it will satisfy the student’s needs. It clearly isn’t the best solution and a disclosure obligation isn’t likely to stand in the way of a motivated salesperson. If the salesperson had been bound by a "best-interest" standard, he would recommend a simpler, more reliable and affordable unit."

In their 2016 report, the regulators reviewed complaint and examination files related to seg funds. They found that over 80% of complaints are related with suitability: "consumers typically complained that they had not understood features such as the lock-in period for guarantees or how fees/charges were calculated.

Who might want to look at seg funds?

Despite the very high fees and the potential conflicts of interest, some investors might still want to evaluate if seg funds are right for them.

Estate planning

Seg funds are sometimes marketed as an estate planning tool (e.g., ). The idea is that you can name a beneficiary on the insurance contract. After you die, these funds skip probate (in the provinces in which this concept applies) and go directly to the beneficiary. The payments can be a lump sum or in the form a payout annuity.

Investors interested by this characteristic of seg funds should calculate how much they will pay in extra fees to skip probate. Also, note that since in most provinces, RRSPs and RRIFs can have beneficiaries, this feature (skipping probate) of seg funds is only relevant for non-registered accounts.

Creditor protection

Business owners in risky industries might value the potential creditor protection offered by seg funds. However, this mostly applies to non-registered accounts. RRSPs and RRIFs can also be protected from creditors without using seg funds: "As long as you placed your money in one of those plans 12 months or more before declaring bankruptcy, it’s off limits to the people you owe".

Who might not want to buy them

For an investor who does not value or need the estate planning or creditor protection features, the only remaining features to examine are the maturity and death guarantees.

Maturity guarantee

With the maturity guarantees, the investor is concerned that the investment might decline in value in nominal terms (before inflation). This concern applies mostly to equities (stocks), which are more volatile than fixed income investments such as bonds.

But there are very few 10 year, let alone 15 year, periods during which broad stock market indices lose money in nominal terms. So if you invest in a broad low-cost index exchange-traded fund (ETF) of equities, and reinvest the dividends, the odds that the final value will be less than the initial value are quite limited. For example, according to one estimate, since 1900, "99% of the time, 10-year returns were positive for U.S. stocks". And "the possibility of losing money over 15 years is practically nil" according to Morningstar again based on US stock market history. The same logic of very low probability of nominal loss over 10-15 years also applies to balanced portfolios.

Plus, remember that if you opt for a less expensive 75% guarantee, it would only apply if your original investment has lost more than 25% over a 10 year or 15 year period. The guarantee is slightly more likely to apply on an actual seg fund, since the fees reduce the performance of the fund, compared to index returns. (For a seg fund with a 3% MER, the fund must return at least 3% per year before fees, to avoid losing money after fees.)

In the words of an experienced Financial Wisdom Forum member, "If you are really worried about equities losing money, increase your fixed income allocation instead".

Death benefits

What about the death benefit? For a young investor, death is unlikely but could be of high consequence for dependents: what that person needs is likely to be term life insurance, not a seg fund. This is easily demonstrated using an example.

Anne's case

Anne S. is a 30 year-old single mother from PEI. She has diligently saved money throughout her twenties, and inherited something from her late father Mathew, so she now has $100 000 to invest. She is asking herself whether that should go into a seg fund like her friend Gilbert B. is suggesting. The seg fund has an MER of 3% per year, and she is interested by the death benefit to protect her daughter Diana in case she (Anne) gets hit by the proverbial bus during a stock market downturn. Anne is a member of the Financial Wisdom Forum where people are telling her to put her money into an asset allocation ETF instead, and get some term insurance. The seg fund would cost Anne $3000 in fees per year, compared with about $250 for the asset allocation ETF, a difference of $2750.

ETF plus term insurance
Anne finds out that buying $100k of ten year term insurance would cost her less than $80 per year (PEI postcode, 30 year old female, average health, non-smoker, AM best rating of A- or better, 13 Nov. 2023, term4sale.ca). If she gets the ETF and the term insurance, the total costs are less than $330 a year ($250 MER on the ETF, $78 for the term insurance); if she dies in the next ten years, in this scenario her heirs would get $100k from the term insurance plus the current market value of the ETF, which is extremely likely to be more than zero. For example, if her investment is down 25% at the time of death, her heirs would get a total of $175k. Even with a dramatic 50% investment loss, the heirs would get $150k.

Seg fund
If she instead opts for the seg fund and no term insurance, the most her heirs can inherit in the event of Anne's premature death is the current market value of the seg fund or $100k, whichever is highest (if she gets the 100% guarantee). So if the investments are down by any percentage, her heirs would get $100k. This is obviously a smaller amount than in the first case, and the fees of $3000 a year are almost 10 times higher.

Another way to look at it is: how much 10 year term coverage can Anne get for $2750, the extra cost of the seg fund relative to the asset allocation ETF? The answer is more than $10M of coverage, given her young age. Anne quickly realizes that investing decisions and life insurance decisions should be taken separately.

Older investors

The death benefit feature of seg funds might be more valuable for older investors, but should be compared against other life insurance options.

Guaranteed minimum withdrawal benefit

In the U.S., some variable annuities offer a fixed payout that can, potentially, be augmented by market gains (hence the term "variable"). A number of Canadian life insurance companies have remodelled some seg funds to mimic American-style variable annuities. These products have a guaranteed minimum withdrawal benefit (GMWB) and act somewhat like pension plans. GMWB products are quite different from the 'normal' retail seg funds described above.

With a GMWB product, an investor might, 10 or 15 years before needing the money, buy a policy that promises, say, 4% annual withdrawals on the amount invested. By staying the course each year, with no withdrawals, the annuitant will receive annual bonuses that increase the underlying capital on which the 4% can be withdrawn. And, in favourable markets, the capital underlying the initial investment can be boosted, every three years, by market gains. Market losses are the life insurance company's problem. At the planned age, typically around 65, the annuitant starts withdrawals; penalties apply if the withdrawn amount is more than the guaranteed amount. At death, beneficiaries get the remaining market value.

The Ontario Securities Commission classifies GMWB products "complex investments" and calls their fees "steep", i.e. "significantly higher than for other types of investment funds". As of 2020, only three life insurance companies were still offering GMWB products, after the market peaked in the early 2010s. In 2022, GMWB sales were about $0.4B, compared with $13.7G for traditional seg funds.

A final note is that according to Morningstar, "enrolling in a GMWB and employing an advisor go hand in hand", with the advisor being an insurance agent working for the life insurance company.

Assuris protection

The guarantee on a seg fund is protected by Assuris. If the life insurance company fails, "Assuris guarantees that you will retain up to $100,000 or 90% of your cash value benefit, whichever is higher". For example, if your $50k contract offers a 75% protection after 10 years and the life insurance company fails, Assuris will cover the original guarantee of 75% of your principal at the maturity of the contract.

Alternatives

If you are worried about losing money on equities, ask yourself what is your investment horizon. If it is 10 or 15 years, or more, seg funds can offer some protection, but a stock index is unlikely to be down in value after 10 or 15 years as discussed above. Long term investors who want to reduce portfolio volatility on a year-to-year basis might simply need more fixed income in their asset mix. Look at Portfolio design and construction and consider implementing the chosen asset allocation with very low fee products like index mutual funds, or index ETFs (including asset allocation ETFs). If your time horizon is shorter, remember that the seg fund maturity guarantees will not apply if you sell before the end of the contract period.

For people looking at retirement income solutions, there are alternatives to GMWB products. For example, single premium immediate annuities (SPIAs) provide income for life without the complexity and costs of GMWB products. Life annuities can be combined with self-managed portfolio drawdown (partial annuitization).

See also

• Market-linked GIC

Further reading

• Financial Wisdom Forum topic: "Segregated funds"
• Financial Wisdom Forum topic: "Segregated funds" (not the same as the previous topic)
• Financial Wisdom Forum topic: "segregated funds Sunwise elite plus"; mostly on GMWB products