Little-known facts about segregated funds

Since the early 60s, Canadian life companies have been offering segregated (“seg”) funds, the insurance industry’s version of mutual funds.  They have enjoyed a great increase in popularity since the mid-90s as investors search for investment vehicles providing a combination of better returns and capital guarantees. 

The name seg fund is easier to remember than the true name of these investments: individual variable insurance contract. 

The “seg” name derives from the fact that the assets in these funds are held separately from the insurer’s own assets, hence “segregated”.  Let’s compare seg funds and their better-known mutual fund cousins.

While there are similarities, there are many important differences.  Seg funds have values that vary according to the market value of their specific group of assets (Treasury bills, common shares, bonds and debentures, real estate or mortgages) like a mutual fund. The difference is in the details, and this is where seg funds get interesting.

Maturity and Death Benefit Guarantees
Seg funds must offer a minimum guarantee of 75% of the initial investment, and some insurerprovide a 100% benefit.  The guarantee applies only if you, the investor, (also referred to as the annuitant) hold the contract until maturity (at least 10 years, or until age 90).  A withdrawal of the funds prior to the maturity date will invalidate the guarantee.

There are two types of guarantees; contract-based or deposit-based. Contract-based confers the guarantee on all deposits made into the fund up to the 10-year maturity.  Deposit-based means that subsequent deposits will have their own 10-year maturity date.  The reset feature available in some segregated fund products can also affect the maturity benefit – in certain contracts, the maturity date is moved back 10 years from the date of reset every time the owner chooses to lock in gains by exercising the option.

If the annuitant dies before the date of maturity, the guaranteed value will be paid to the beneficiaries, less any withdrawals made prior to death.  The death benefit and the maturity benefit may differ.  The policy may guarantee 75% at maturity, but pay 100% at death.  Also, the annuitant’s age may play a role in determining the payout.  Some insurers may reduce the death benefit guarantee as the client ages (e.g., 100% until age 75 reducing to 80% thereafter).

Creditor Protection
Because seg funds are insurance products, they can offer potential creditor protection in some circumstances provided a preferred beneficiary has been named under the contract.  These would include a spouse, child, grandchild or parent.  But the transfer of assets must be legitimate, and not done for the purposes of hiding assets.  If creditor protection is important for you, look into it closely before investing.

Estate Planning Advantages
As with life insurance, a named beneficiary in the seg fund contract will receive the funds directly, eliminating delays and costs often associated with probate.  This can also provide a degree of privacy in the estate distribution process, as the beneficiary need not be named in the will.

There are important tax differences in how seg and mutual funds allocate capital gains and losses.  A mutual fund investor purchasing at year-end may face a capital gains distribution on the net realized gains that have accumulated in the fund during the entire year.  A segregated fund, however, allocates income on a time-weighted basis.  The investor will receive an amount proportionate to the time that they were actually invested in the fund.

Mutual funds can distribute only capital gains.  Losses in a mutual fund can only be claimed upon redemption.  Seg funds can also allocate capital losses.  So holders of non-registered seg funds can claim capital losses against capital gains from other investments, without having to sell their units.

These tax advantages are not understood by most investors, so if you’re in a high tax bracket you may want to take a closer look.