Are segregated funds my best investment choice like my adviser says?

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By Julie Cazzin with Andrew Dobson

Q: My wife Anita will be 54 years old this year and has about $300,000 invested with an adviser who wants to move it all into segregated funds. She expects to work for another 10 years at her job as a marketing consultant. I looked at the performance and the costs (in terms of fees and penalties) of the funds the adviser recommends, but I don’t see the value in making the move. I know there could be a major market downturn of 30 per cent or more over the next few years, but my fear is that the adviser is just looking for the commissions. How can we tell if this is really in my wife’s best financial interest? — Thanks, William

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FP Answers: Segregated funds can offer several features in one product wrapper, William. These funds can offer professional management, diversification, principal guarantees and ease of estate planning. Unfortunately, these features come at a cost that can be significantly higher than even higher-cost products such as traditional mutual funds.

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For example, segregated fund fees may range from two per cent to four per cent, while mutual fund fees may range from 0.5 per cent to 2.5 per cent. In both cases, a portion of the fee, called a trailer fee, is paid to the adviser. This often leads to confusion on the consumer side as to why someone should pick segregated funds over other options when they look similar to their mutual fund counterparts.

Segregated funds are like mutual funds in that they provide a way to invest in stocks and bonds without requiring large minimum investment amounts or the need to pick your own stocks and bonds. You are pooling your assets with other investors so that the investment manager can provide diversified portfolios at scale. The core difference between a segregated fund and a mutual fund is that segregated funds are insurance contracts, which means they can offer various principal guarantees on the amounts invested in their funds.

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For example, it is common for segregated funds to offer death and maturity value guarantees. This means you can lock in the amount invested by purchasing contracts with these guarantees.

Typically, a death benefit guarantee is offered at 75 per cent or 100 per cent, meaning that if the fund value, net of withdrawals, drops below either of those thresholds at death, the insurer will make up the difference. As these are insurance contracts, they may also be eligible for coverage via Assuris, a non-profit that provides guarantees to insurance contracts should the member provider default on its ability to cover policy claims.

The second guarantee is the maturity guarantee. As these are contracts, they have a contract time period built into their terms. For example, an investor could purchase a segregated fund with a 10-year maturity guarantee of 100 per cent. This means that at the 10-year mark, if the fund value, net of withdrawals, is below the initial capital, the purchaser could redeem at the guaranteed amount instead of the lower market value.

A fund owner may also have the option to reset their guarantee at maturity. For example, at the end of term, if the fund value exceeds the initial capital, you could reset the guarantee to a higher amount, keeping in mind that this also resets the term of the contract.

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These guarantees may sound appealing, but the likelihood of a diversified portfolio having a negative rate of return over a long period such as 10 years is virtually nil, William.

Segregated funds also allow investors to name beneficiaries on non-registered contracts, which is not available when buying mutual funds. This has an estate-planning benefit, because similar to a tax-free savings account or registered retirement savings program account, a non-registered segregated fund can be paid seamlessly to a named beneficiary. This can speed up the estate settlement and avoid probate and legal fees.

A segregated fund may also provide creditor protection in the event of a lawsuit. This feature may appeal to a business owner with a higher likelihood of being sued.

These enhanced features, over and above mutual funds, may entice an investor to seek out segregated funds or an adviser to recommend them. The problem with using these funds is that they are expensive relative to non-insurance options such as mutual funds, let alone exchange-traded funds.

Some advisers are only licensed to sell insurance products, so segregated funds may be the product of choice for these advisers. Other advisers may be dually licensed to sell mutual funds and insurance. The point is that you may be offered an investment by sheer virtue of your adviser’s licensing.

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Another fee consideration about the funds proposed to your wife is that they may also have something called a back-end load. These are deferred costs associated with a segregated fund that are payable if an investor redeems the fund or transfers out during a specific term. These typically start at five per cent of the initial fund purchase and can increase the upfront commission an adviser receives when they sell a segregated fund.

A first response to your wife’s adviser’s proposal could be to ask them about the rationale of this strategy and what instigated this switch. I would also ask them to go through the pros and cons to see if they raise some of the points above.

I would posit this final point: Is a higher fee, potentially two to three percentages points over similar mutual fund or exchange-traded fund alternatives, worth the guarantees and benefits provided?

Andrew Dobson is a fee-only, advice-only certified financial planner (CFP) and chartered investment manager (CIM) at Objective Financial Partners Inc. in London, Ont. He does not sell any financial products whatsoever. He can be reached at adobson@objectivecfp.com.

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