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How Segregated Funds Work!

Written by FrugalTrader on May 7, 2007 filed under Stock Investing

A reader commented on how Segregated funds can work well with the Smith Manoeuvre, so I decided to do some digging into this investment vehicle.

From my research, segregated funds are similar to mutual funds except that they are sold by insurance companies. How are they different? They are different in 4 main ways:

Their guarantee of principle
The fees associated with them
The ability to bypass probate fees
Protection from Creditors

Guarantee of Principle:

Provincial legislation states that if a policy holder purchases a segregated fund for a 10 year term or longer, the segregated fund must guarantee at least 75% of the invested capital. Some segregated funds provide greater than 75% capital protection if you invest longer than 10 years.

The Fees Associated with Segregated Funds:

There is no doubt that Segregated funds are more expensive than mutual funds. This is due to the guarantee that these funds provide. The higher the guarantee, the higher the Management Expense Ratio (MER) involved. From the funds that I’ve been looking at, MER’s range from 5-6% for a 100% guarantee, 3-5% for 75% guarantee, and 2-3% for no guarantee.

Ability to Bypass Probate Fees:

As a segregated fund is basically an insurance policy, the beneficiary of the policy will be given the insurance proceeds without having to pay any probate fees.

Protection from Creditors:

If I were to pass away today with debts, my estate would be responsible for paying for it. If I had a segregated fund, my beneficiary(s) would obtain the insurance proceeds without having to pay off my estate first. Also, if I owned segregated funds and was facing bankruptcy, the segregated fund is protected from creditors (some exceptions apply).

How can I buy them?

As stated above, Segregated funds are insurance policies, so the salesperson must be a qualified insurance sales rep.

As I have never purchased a segregated fund before, this is a very basic review on how it works. As mentioned by a comment on the Smith Manoeuvre, this may be a viable way to protect your capital while performing the Smith Manoeuvre. In my opinion though, they are far too expensive from an investment standpoint.

15 Comments, Comment or Ping

1. Wolf Stone

So they provide capital protection but do they also provide capital growth and do segregated come in different varieties/options?? Good overview..at least i have some idea about segregated funds now !!

May 7th, 2007 @ 12:42 pm
2. FrugalTrader

Wolf: Some segregated funds allow you to “lock in” your gains a certain number of times / year. This feature though, will most likely make your fund even more expensive.

May 7th, 2007 @ 12:44 pm
3. florch

Probate bypass on investments…Can only insurance companies provide this (as opposed to banks)?

The reason I ask is that I was talking to a friend about this and they told me that to bypass probate you need to have a second level beneficiary listed on each account. I went to TD where I have my RRSP and trading accounts and they looked at me like I had 10 heads.

Sometimes I’m amazed by how much bank employees with titles like “Investment Consultant” don’t know. Anybody know? Sorry to drag this off on a tangent. I’ll post this on RFD as well as a new topic.

May 8th, 2007 @ 2:38 am
4. FrugalTrader

Florch, You can only bypass probate on your RRSP if you pass the proceeds to your spouse. Just make sure that you have your spouse named as your beneficiary on your account.

May 8th, 2007 @ 7:49 am
5. florch

Thanks - I do. I’m sure that applies to non-RRSP as well then.

May 8th, 2007 @ 12:31 pm
6. ezboy

FT:”Wolf: Some segregated funds allow you to “lock in” your gains a certain number of times / year. This feature though, will most likely make your fund even more expensive.”

FT, lock-in your gains usually do not make the fund more expensive. The way it works is that it reset your guarantee for another 10 years. For example, if you purchase a fund for $10,000 this year, three years from now, the market price of the fund grows to $12,000. If you decide to lock-in the gain, the $12,000 principal protection applies to 13 years from now. As you can see, you don’t really gain any extra protection by locking in your gain, so no extra fee should be charged.

EZ

May 8th, 2007 @ 7:32 pm
7. Mike

florch - Thanks - I do. I’m sure that applies to non-RRSP as well then.

It doesn’t apply to non-RRSP. It’s only RRSP accounts where you can name a beneficiary. I would assume that non-rrsp $$ goes through probate.

May 8th, 2007 @ 11:02 pm
8. florch

Thanks Mike, of course you are right. I should have talked to my source to clarify my post.

The point of the second level beneficiary was that if you and your spouse are hit by a bus at the same time, there would be a beneficiary (IE your kids) outside of probate. TD had no provision for this. Our wills are clear on this but in order to keep this outside of the estate you would need this provision.

Sorry for the vagueness of the first post, and thanks for the replies.

May 9th, 2007 @ 1:09 am
10. Patrick

I’m told by my financial advisor that I can deduct the interest payed on a segregated leveraged $80,000 loan against my current tax year’s income. (line 232 “other deductable amounts”)

I’m told by a revenue Canada agent (who seemed to know about as much as I did) reading line 221 in the tax guide which says “However, if the only earnings your investment can produce are capital gains, you cannot claim the interest you paid.

Sure pray for a good answer here! (and thanks!)

May 9th, 2007 @ 5:35 pm
11. FrugalTrader

As long as there is a “potential” for your fund to pay dividends ie. holding stock, then you can deduct the interest. Probably better to talk to an accountant first though.

May 9th, 2007 @ 7:03 pm
13. blogger

Once FA commented they are poor investment vehicle. If you do need to invest in Seg Funds, make sure it is an equity based high performance fund. Getting insurance for bond or stable value fund does not make sense.

Aug 10th, 2007 @ 2:10 pm
14. aurora

Don’t compare straight seg funds (also called annuities, or variable annuity contracts) with the investment portion of a Universal Life policy in terms of fees. The UL’s are much higher. There are seg funds that have MER’s of 2.1% for with 75% guarantee for instance. And that is with 90% equity holdings, 10% guaranteed securities - plus automatic re-balancing over the years (80-20, 70-30, etc.) which makes sense when it’s an RRSP account. Legally speaking, the investment portion of a UL is in fact a type of annuity. Upon death the beneficiary gets the life insurance proceeds as well as the investment portion tax free, however all of the income tax is collected by the government beforehand in case of an RRSP account. The remainder is probate and/or capital gains free, unlike a non-annuity investment (i.e. mutual fund, GIC, property, etc.) which can incur probate and/or capital gains. Only RRSP accounts transferred to the spouse avoid capital gains and the subtraction of income tax. The subject of UL requires special attention because of the nature of the product. One must understand each in detail in order to draw comparisons.

Nov 14th, 2007 @ 10:54 pm