Segregated funds: Are the investment guarantees worth it?

When someone offers you a guarantee, it’s usually in their best interest, not yours

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Q: We have recently retired and our financial advisor is very positive on us putting some part of our savings into a segregated fund, since it guarantees a minimum 3% annual return and a full return of capital in 10 years.

We like the security of this, but are concerned about the lost opportunity of having these funds invested in ETFs for the 10-year period even with the risk that markets could correct for some period of time.

—Andy

A: I have a general rule of thumb about guarantees and it is that buyers should beware, Andy. When someone offers you a guarantee, it is usually in their best interest, not yours. Extended warranties, for example, are priced so that they are profitable for the offeror, not so that you are likely to come out ahead as a consumer.

Segregated funds are the insurance industry’s spin on mutual funds. They generally have a principle guarantee of either 75% or 100% of your capital after 10 years, or in the event of your death.

In the case of a segregated fund with a 10-year principle guarantee, the reason the offer is skewed in the favour of the issuer is that 10-year periods where stock markets go down are few and far between. In fact, since 1900, the only two short-lived periods when the S&P 500 was negative over 10 years were the periods ending in the late 1930s following the Great Depression and those ending in 2009 at the lows of the subprime mortgage crisis. So 99% of the time, 10-year returns were positive for U.S. stocks.

For Canadian stock markets, since 1960, more than 90% of the time the TSX has returned over 6% over 10 years. And in no 10-year period have TSX returns been negative.

What about that 3% return guarantee? The TSX has returned over 3% in more than 99% of the 10-year periods since 1960, Andy.

One thing that is also guaranteed about segregated funds in addition to the principle guarantee is high fees. Seg fund fees tend to be higher than typical Canadian mutual funds, which are high as a group to begin with. If you’re giving away 3% of your investment’s return each year in fees, you are almost guaranteeing that you will lag the potential performance of an ETF portfolio—let alone most mutual fund returns.

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While there are good active managers who do outperform their benchmark over long periods of time, I’m afraid you’re not likely to find them running an insurance company’s segregated fund line-up. And few managers can overcome the 3% fee hurdle that most segregated funds are faced with in the first place.

The point, Andy, is that a 10-year principle guarantee is virtually worthless based on stock market history. It may sound good to a consumer, but stocks generally don’t go down over 10 years. A balanced portfolio of stocks and bonds is likely to beat the 3% you’ve been promised handsomely.

One point that investors should be aware of as it relates to segregated funds is that mutual funds are subject to new fee disclosure regulation that comes into place next July. Segregated funds are exempt. For some reason, the insurance industry has yet to commit to disclose fees the same way the investment industry has committed to in 2016. So segregated may be more appealing to advisors because they won’t need to disclose how much they’re getting paid to put you in them.

And I hate to be a pessimist, but the segregated fund will probably pay your advisor 1% a year for the next 10 years. If he’s not licensed to sell ETFs, he may not be able to offer them to you. Hopefully he’s told you that, instead of simply arguing why segregated funds are better.

And if he’s licensed to sell index funds—the mutual fund industry equivalent of an ETF—his own 10-year return in the form of a trailer fee from the fund company is likely to be less than the segregated fund would pay him. So it may just be that the seg fund recommendation is actually in the best interest of your financial advisor’s own retirement instead of yours.

Ask a Planner: Leave your question for Jason Heath »

Jason Heath is a fee-only, advice-only Certified Financial Planner (CFP) at Objective Financial Partners Inc. in Toronto. He does not sell any financial products whatsoever.


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7 comments on “Segregated funds: Are the investment guarantees worth it?

  1. I can get 3.4% to 3.5% on provincial strip bonds that are in the 15 to 16 year range. I know if I put my RRSP of $10,000, it will be at least $17,000 to $17,400 by maturity, principal and interest paid back. A 70% to 74% total return is not bad with interest rates today.

    Reply

  2. Dana Smith, I never heard these before and googled it and found out that they are basically compound interest vehicles that pay at maturity. I found a few places where 3.48% 25 to 30 year provincial strip bonds are available today in the current interest rate environment.

    I have accumulated $436,000 in RRSP’s, $42,500 in TFSA’s and $25,000 in laddered 1-3 year GIC’s, savings accounts over the last 10 years from working and saving hard.

    The problem is I have now $375,000 for the last 3 weeks now matured GIC’s that were locked-in for 5 years with 3.00% to 3.5% interest rates and now the best out there is 2.5% to 2.55% for 5 year RRSP, TFSA GIC rates. They are just sitting in 0.75% to 1.00% RRSP savings accounts.

    I am seriously considering transferring my matured RRSP’s from the 3 financial institutions I have with them. If I get a 3.48% interest rate and lock-in the longest 30 year maturities I found online, my $375,000 will be worth more than a million dollars, $1,046,462 is what I get from my compound interest calculator. This is about $22,382 interest accumulated per year in my RRSP.

    I am 32 years old and will still have about $128,500 left over in soon maturing GIC’s, RRSP’s, TFSA’s if I really have a financial crunch of unexpected sorts. I will be 62 years old when I am nearing retirement when this big chunk of money matures.

    The only trepidation I have is that I noticed interest rates on these strip bonds were around 4.2% to 4.3% just only almost 2 years so I don’t know if I wait over the next 6 to 12 months and get such rates, my $375,000 RRSP will be $1,290,000 or about $247,000 more at maturity. This is an extra $8,233 more annual compound interest in my RRSP.

    However, if rates fall more, as I noticed reading alot of material on this last night, these same 30 year rates were around 3.05% just 9 months ago back in February this year. I remember just about 7 years ago I was getting 4.00% to 4.25% on 5 year RRSP, GIC rates. Everyone keeps saying interest rates will rise but they keep acting like a yoyo but always lower every 5 year period my GIC’s, RRSP’s mature but TFSA’s not yet.

    I am saving the maximum in my RRSP’s and TFSA’s, $24,000 and $10,000 respectively plus another $2,500 a month in my non-registered accounts, GIC’s, savings etc. I have no debts and my expenses are quite low compared to my income, 21% of my gross income $133,000 a year. This includes the $1,200 a month+utilities I pay to rent a nice 3 bedroom house and decent size lot which is $1,000 a month cheaper than buying at today’s higher real estate prices. Being debt free is such a great feeling. All this is what is keeping me afloat with these 2.2% to 2.5% GIC rates.

    I wish I knew about these longer term compound interest government strip bonds years back. I will be closely tracking interest rates over the next few days and weeks and will be considering locking in for 30 years my $375,000 RRSP.

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  3. I shopped around too for these provincial, government bond strip bonds and you can get from 3 to 4 different provinces, 3.00% for 12.25 years to 13.25 years.

    This would be about 44% to 48% total compound interest until maturity. This does not look too bad considering an continuing, dropping interest rates for savers and others looking for more interest on their money.

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  4. I used to own mostly equity mutual funds, 85% of my entire portfolio and 15% were in GIC’s. Now, as I am approaching closer to retirement, I am 57 years old now, I have sold off 75% of that and left a modest 10% in mutual fund equities.

    Now, I have 30% in equity ETF’s, 15% in REIT’s, 30% in bond ETF’s, 20% in GIC’s. I am concerned that the equity market is too high right now but I have enough income and GIC’s that if I need to ride out 5 to 7 years of a terrible stock and bond market, I will have still money left over.

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  5. Sorry, my mistake, I have 10% in REIT’s not 15%.

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  6. I know interest rates are low today compared historically but I have $250,000 in RRSP’s and TFSA’s which is about 80% of all my money, $313,000 but I am still only 32 years old and will be continue to save, invest $4,500 a month and hopefully more for another 30 years plus until I retire.

    I was reading some of the comments here and I was looking to see if there were any provincial government strip bonds that mature around 69 to 71 years old right around RRIF time.

    There is a Hydro-Quebec 2055-February-15 that costs $26.75 and knowing this, my $250,000 in RRSP’s, TFSA’s would be worth about $934,579 at maturity. This is about $17,361 interest accruing yearly or $1,446.75 per month which is about 33% of what I am saving, investing in my RRSP’s, TFSA’s monthly.

    For me to save the $250,000 again in RRSP’s and TFSA’s, it would only take me about 55 months which does not include any interest, earnings on that money and on my remaining $63,000.

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  7. What the writer has glossed over are some of the other benefits of segregated funds: creditor protection (in some instances) and by-passing probate (in non-registered accounts). These are very important features for business owners and seniors, respectively.

    I do not discount the fact that seg funds are expensive, or that they have limited upside potential. However, for many seniors, having the benefit of NOT paying 1.4% probate fees (in BC – other provinces will vary, obviously) or having assets locked up for months (or even years) in probate is worth the cost. Typically, life insurance companies will release the funds to rightful heirs within two weeks of receiving a valid death certificate. And, the beneficiaries are kept confidential (there is no public record).

    Reply

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