You’ve probably heard about segregated funds. These funds, sponsored by life-insurance companies, have a substantial presence in Canada.
Guaranties available are presented as 75/75, 75/100 and 100/100, or 75% of capital guaranteed at maturity (15 years) and 75% at death; 75% at maturity and 100% at death; 100% at maturity and 100% at death. When stocks, bonds, and even cryptocurrencies are down, it might be tempting to consider a capital guaranteed product.
In fact, segregated fund providers have already started marketing these products as such. Here’s a type of advertisement segregated fund manufacturers put forward: “Global markets are still volatile, leading an increasing number of investors to search for a safe haven to shelter part of their investments – seg funds may provide that haven.”
Before we go ahead, it’s important to remember that it is never a good idea to try and time the market.
“The ‘time’ to buy a seg fund should not be dependent on recent market conditions,” points out Ian Tam, Morningstar Canada’s Director of Investment Research. “The decision to buy insurance should be based on your current financial and family situation, and whether you believe the added insurance wrapper is worth the addition of fees.” Fees which are very high in the case of segregated funds – but more on that later.
You’ll Get your Capital Back in 15 Years – or if You Die.
An investor must ask himself what kind of capital protection he seeks. A segregated fund offers an investor two kinds of capital protection, explains Marc Johnston, Director, Investments and Retirement, at Groupe Cloutier Investments: either his capital will be guaranteed in 15 years’ time (today’s typical guaranteed deadline), or at the time of his death.
But if an investor hopes to protect his portfolio from capital losses over a period of a few years, especially in the short to medium term, or in a time frame where equity markets show volatility, segregated funds might not be the answer.
Let’s look at the example of an investor who moves his money from a mutual fund to a segregated fund thinking: “If I lose money over the next 12 to 18 months, that’s OK as long as I’m in a segregated fund, because when markets come back and I pull out my money, my full initial capital will be paid back to me. I won’t gain, but I won’t lose either.”
That might not work out the way this investor planned. First, the capital guarantee will kick in only after the investor’s capital has resided in the fund for a specific duration. “Typically 15 years is the deadline that most funds enforce today,” Johnston notes.
Could You Lose Money by Staying Invested For 15 Years Straight?
Aiming at protecting one’s initial capital over a period of 15 years is pointless, Johnston thinks. “An investor who would have been invested in the S&P 500 since 1901 would never have lost money over a period longer than 7.4 years; the possibility of losing money over 15 years is practically nil,” he asserts.
To bring his point closer to home, Johnston reminds us that fifteen years ago, in October 2007, just before the Great Financial Crisis, the S&P 500 reached a summit of 1560 points. Since that time, the index has suffered four major losses in 2008, 2018, 2020 and 2022. Yet, after all those setbacks, the index is two and a half times higher, around 3990. “On an investment made at the height of the S&P 500 in October 2007, he explains, you would have recuperated all your losses by March 2013 and then you would have continued gaining right up to 2022.”
But What About the Resets?
Segregated funds also offer investors a seductive “reset” option. What this means is that if the investor chooses, and if his capital has appreciated, he can “reset” his starting capital guarantee at a higher level.
For example, if his assets have moved up from $100,000 to $125,000 after three years, he can hike the guarantee to that new amount. But at the same time, Johnston warns, “the maturity is also resets to fifteen years later.”
Segregated Funds’ Guarantees Come at a Cost
Perhaps the biggest consideration for investors though, is the high cost of segregated funds. Fees matter. According to Tam, in percentage terms, after 10 years, the impact of a 2% fee results in a difference of 18% less wealth when compared to no fees. After 20 years, that gap balloons to 33%. “You need to be diligent in monitoring the fees you’re being charged, because the fees you pay are detrimental to the amount of wealth you will end up with,” Tam adds.
The fees on segregated funds, especially the ones that come with a 100% guarantee, come in much higher than mutual funds, and way, way higher than exchange traded funds. The average fee for a 75% capital guarantee is 2.92% and for a 100% capital guarantee, 3.27%, while it stands at 2.3% for a basic balanced mutual fund, Johnston reports.
“The difference in these fees when compounded over time with the amount that you invest and contribute, is what you are paying for the guarantee that is offered,” specifies Tam.
“The more you move toward the 100/100 formula, Johnston explains, the higher the fees reach; that last segment is where the hike is the most important. That higher guarantee is very costly for insurance companies to back up with reserves, and that’s why many insurers have abolished it.”
So in short – if you are worried about short-term volatility, segregated funds are not the answer. These products offer many benefits, such as designation of a beneficiary in total confidentiality, bypassing probate and protection against creditors. But those benefits have nothing to do with market volatility protection. And the fees in these funds are quite high, and higher fees always eat into your eventual returns.