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How Segregated Funds Work!

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:

  1. Their guarantee of principal
  2. The fees associated with them
  3. The ability to bypass probate fees
  4. Protection from Creditors

Guarantee of Principal:

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.

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FT About the author: FT is the founder and editor of Million Dollar Journey (est. 2006). Through various financial strategies outlined on this site, he grew his net worth from $200,000 in 2006 to $1,000,000 by 2014. You can read more about him here.

{ 24 comments… add one }
  • Wolf Stone May 7, 2007, 12:42 pm

    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 !!

  • FrugalTrader May 7, 2007, 12:44 pm

    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.

  • florch May 8, 2007, 2:38 am

    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.

  • FrugalTrader May 8, 2007, 7:49 am

    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.

  • florch May 8, 2007, 12:31 pm

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

  • ezboy May 8, 2007, 7:32 pm

    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

  • Mike May 8, 2007, 11:02 pm

    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.

  • florch May 9, 2007, 1:09 am

    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.

  • Patrick May 9, 2007, 5:35 pm

    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!)

  • FrugalTrader May 9, 2007, 7:03 pm

    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.

  • blogger August 10, 2007, 2:10 pm

    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.

  • aurora November 14, 2007, 10:54 pm

    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.

  • c-drive October 16, 2008, 4:13 pm

    Garbage products. The benefits are not worth the added expense. There hasn’t been a 10 year period in the history of the NA equity markets where the protection criteria would prove to be valuable. Not to mention that it’s even worse for money market, income and balanced seg funds.

    Index funds provide an MER of 1% and no fees or comissions with all the growth potential.

    If you value creditor protection above all, you’re a loser anyways.

  • Carl Brodie March 16, 2009, 2:00 am

    Hi c-drive,

    “The benefits are not worth the added expense. There hasn’t been a 10 year period in the history of the NA equity markets where the protection criteria would prove to be valuable.”

    Welcome to the first time in North American history where the protection criteria was valuable.

    Frugal Trader

    Manulife has the 75 series which generally has MERs within the 2-3 range. They are usually not more than 30 bps higher than a mutual fund.

    If you need some protection, it is not such an extortionate fee.

    Thanks,
    Carl

  • Kay June 28, 2009, 3:23 pm

    The word Principle is spelt PRINCIPAL. Why do so many people always make this mistake? thank you

  • Kathryn June 28, 2009, 6:51 pm

    Kay: I hate to break it to you but ‘principal’ is an adjective that means primary and is most often used to describe the principal of a school.

    Principle is a noun which means a general truth or assumption.

    FT used the correct spelling. So many people spell it this way because they are right!

  • Kathryn June 28, 2009, 7:07 pm

    I stand corrected. It’s a mistake I was making too! The correct spelling for monetary principle is ‘principal’ so it should read ‘The Guarantee of Principal’.

    http://www.grammarmudge.cityslide.com/articles/article/992333/8562.htm

  • cannon_fodder June 29, 2009, 12:59 am

    Kay/Kathryn,

    The principal reason for correctly spelling ‘principal’ is that those individuals (and I’m not sure if they are in the minority or not) went to school where the principal had many cherished principles – principal among them was gooder grammar and korrect speling.

    Or, there is an accepted principle that to reduce your mortgage balance quickly, divert a principal portion of discretionary income towards the principle.

  • Steven October 10, 2009, 4:16 am

    It should be spelled as “principal” in this context. Check your local dictionary or dictionary.com.

    • FT FrugalTrader October 10, 2009, 9:06 am

      Thanks Steven, I’ve made that spelling error in a good few of my old posts.

  • Casius December 19, 2011, 10:26 pm

    Kay,

    Although I am entering this duscussion well beyond its initial posting, just for the record, there is no such word as ‘spelt’ unless you are British. Otherwise here in Canada (and in the USA) the more common version is ‘spelled’

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