When do segregated funds make sense?

If you’re close to retirement, transferring money from a LIRA to seg funds probably doesn’t make sense

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Q: We have $320,000 in a balanced portfolio in a LIRA. Our insurance agent wants us to transfer this money to segregated funds. I don’t think this is a wise move for us as we are close to retirement age. Am I right? And when do segregated funds make sense?

— Roger

A: You are right to be skeptical. 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 commission for selling them.

A “seg fund” is not actually a mutual fund: it’s an insurance product. That’s why they are often recommend by insurance advisors, who are often not licensed to sell other types of investments. If all you sell is hammers, every problem looks like a nail.

Seg funds come with a number of benefits that sound appealing. First, they have a maturity guarantee, which sets a minimum value for the fund after a specified period (often 10 years). In other words, if you invest your $320,000 in a seg fund with a 100% guarantee, you’d have assurance that it will be worth at least $320,000 at maturity, even if markets tank.

The funds also have a life insurance component, so if you pass away and your fund has declined in value, you’ll receive a payment that makes you whole again. Moreover, because they’re insurance products, seg funds are protected from your creditors if you declare bankruptcy. They can also be used to pass assets directly to your beneficiaries when you die, thereby avoiding probate fees.

The problem is that these benefits come at an extremely high price: many seg funds have fees well over 3% annually. When you consider what you’re getting, it’s simply not good value. Consider the maturity guarantee: the odds of a balanced portfolio showing a significantly negative return after 10 years is very low and not worth insuring. All of the other benefits of seg funds can be obtained in other, much cheaper ways, too.

Dan Bortolotti, CFP, CIM, associate portfolio manager with PWL Capital in Toronto

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4 comments on “When do segregated funds make sense?

  1. “Consider the maturity guarantee: the odds of a balanced portfolio showing a significantly negative return after 10 years is very low and not worth insuring.”
    However a market downturn in 2 years could cause a balanced portfolio to lose 20% or more. If Roger passes away when the market downturn has occured, then the losses are locked in during the estate settlement process. A segregated fund would pay out the initials $320,000 in that case.

    Although I agree with you Dan, in this case segregated funds are not a good idea. You’re right, many insurance agents pitch segregated funds as an investment product. This is wrong. Segregated funds should be seen as an alternative to life insurance. Not an alternative to investments.

    Typically, the only time that segregated funds make sense is if there is a high chance of early death vs a long-term investment objective.

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  2. This is typical of the answers I see from people who have not taken the time to fully learn seg funds. While I agree that it generally makes more sense to hold mutual funds in a registered portfolio (the exception being as a hedge for a loss averse client who will stay invested in the markets because of a guaranteed value – I understand that the mathematical benefit of the guarantee is essentially nil, but the behavioural benefits can be significant), there are good reasons to hold seg funds. The first relates to the stronger creditor protection afforded insurance contracts as contrasted with registered plans. RRSPs and LIRAs are only protected in the event of a personal bankruptcy, while personally owned seg funds with the proper beneficiary named provide creditor protection in a broader set of circumstances. The second relates to confidentiality. This can be a double-edged sword, as confidentiality is not always desirable. But in cases where, for example, a parent wants to leave a larger amount to one child, maybe because that child has dependent disabled children of their own, a seg fund can provide confidentiality that would not be available in a will and which is very difficult (though not impossible) to obtain in a registered plan. Finally, many pundits overstate the costs of seg funds. While some are very expensive (you can find MERs > 4%), a few companies (IA and Empire, notably) carry seg funds that have MERs very similar to mutual funds. There are no bad products, just bad implementations. And I would agree that clients should examine the reasons for this recommendation – is the advisor in question mutual funds licensed? If not, then I would also be suspicious. But you have not fully explored the fact that there could actually be benefits to using seg funds.

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    • I think what Dan is saying is that the few benefits of seg funds apply to so few people, and these few benefits can be achieved in other less expensive ways, so there is really no time when these products are worth the high costs. The problem is the financial incentives for insurance agents to promote these products are so high, it’s difficult for them to overcome that bias and be objective about their advice.

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  3. I don’t know why anyone would buy these. For people like me in my early 30’s, strip bonds from various provinces in Canada are as high as 3.6% to 3.7% simple interest or stated interest rate, yield.

    Those long term 15 to 30 year bonds that are good for compounding interest in RESP’s, RRSP”s, TFSA’s etc. as 3.6% to 3.7% rates of interest will become as high as 6.29% to 6.58% after compound interest is taken into account over decades.

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