Understanding segregated funds

Most people know the basic concept of how mutual funds work: a number of investors pool their money and then a portfolio manager invests these combined assets in a specific market, such as Canadian stocks, U.S. bonds, precious metals, etc. Among their many benefits, mutual funds provide diversification to help manage risk and enhance returns, plus they offer professional management and economies of scale (i.e., most individuals can’t access a particular basket of securities on their own).

Fewer people have heard about segregated funds, although that wasn’t always the case. Segregated funds are similar to mutual funds, only they provide additional insurance features. In the past, segregated fund contracts were popular because they guarantee a contract holder’s invested principal (typically 75% or 100% of the amount) over a predetermined period, even if markets collapse.

However, in the late 1980s and well into the 1990s, markets were strong and seemed to be regularly reaching new highs. Many people felt no need to pay an extra fee for the principal guarantees offered by segregated funds, since markets kept gaining. Then the “technology bubble” burst around year 2000 and investors lost a lot of money. In light of the massive global financial crisis of 2008 – 09, and increased market volatility since, segregated funds – with their principal guarantees – are attractive once again.

Benefits of segregated funds

Segregated fund contracts are sold by insurance companies, which means they provide several insurance benefits that mutual funds do not. As discussed, the principal guarantee can give investors peace of mind when markets are unstable and the potential arises for big losses.

Many people also cite creditor protection as an important reason why they choose segregated funds. If the contract holder declares bankruptcy, creditors may not be able to legally seize the segregated fund contract.

Another popular aspect of segregated funds is the death benefit guarantee. If the segregated fund contract holder dies, the named beneficiary of this contract is entitled to receive 75% to 100% of the premiums paid to fund the contract. The payout may also be excluded probate or other taxes. If this is the case, the full amount goes to the beneficiary.

If an investor is comfortable entering a contract and committing money for a given period of time, and if he or she believes that additional insurance benefits (relative to mutual funds) are worth the higher fees, then segregated funds can make good sense.

Our Segregated Funds course can help you learn much more about this important insurance product.