Segregated funds

What Are Segregated Funds?

Segregated funds are a unique type of investment fund primarily offered by Canadian insurance companies in the form of individual variable life insurance contracts. Falling under the broader category of investment products, segregated funds combine the growth potential often associated with pooled investment vehicles with the security features of life insurance. These funds are termed "segregated" because the assets are held separately from the insurance company's general assets, providing a layer of protection for investors.⁵⁹

Unlike traditional investments, segregated funds offer specific guarantees to the policyholder, such as a maturity guarantee and a death benefit, which can protect a portion of the initial capital invested.⁵⁸ Investors in segregated funds do not own units or shares directly; instead, they hold a segregated fund contract with the insurance company.

History and Origin

Segregated funds emerged as a financial product blending investment growth with insurance protection, largely gaining prominence in the Canadian market. They are structured as deferred variable annuity contracts with life insurance benefits.⁵⁷ Over the years, the regulatory framework governing these products has evolved to better reflect the risks and complexities involved. For instance, the Office of the Superintendent of Financial Institutions (OSFI), Canada's federal financial regulator, has periodically updated its capital requirements for segregated fund guarantee risks to enhance risk sensitivity and modernize capital rules.⁵⁵, ⁵⁶ These regulatory adjustments, such as those implemented in the early 2000s and further refined with new accounting standards, aim to ensure that insurance companies maintain sufficient reserves for the guarantees provided by segregated funds.⁵³, ⁵⁴

Key Takeaways

• Segregated funds are investment products that include insurance guarantees, such as maturity and death benefits.⁵¹, ⁵²
• They are structured as private contracts between policyholders and Canadian insurance companies, distinct from publicly traded investments.⁵⁰
• A key feature of segregated funds is their potential for creditor protection and estate planning advantages.⁴⁸, ⁴⁹
• While offering protection, segregated funds generally come with higher fees compared to other pooled investment options.⁴⁶, ⁴⁷
• The Office of the Superintendent of Financial Institutions (OSFI) oversees the capital requirements for segregated fund guarantees in Canada.⁴⁴, ⁴⁵

Interpreting Segregated Funds

Segregated funds are interpreted as a hybrid financial instrument, balancing investment exposure with risk mitigation. The primary interpretation revolves around the guarantee levels they offer, typically 75% or 100% of the capital invested, which applies at contract maturity or upon the policyholder's death.⁴³ This feature appeals to investors with a lower risk tolerance who prioritize capital preservation.⁴² The inclusion of a death benefit means that upon the policyholder's passing, the designated beneficiary receives the greater of the guaranteed amount or the current market value, often bypassing probate.⁴⁰, ⁴¹

Furthermore, the "reset" option in many segregated funds allows policyholders to lock in market gains by adjusting their guarantee to a higher fund value, though this usually extends the maturity date of the contract.³⁸, ³⁹ Understanding these features is crucial for evaluating whether segregated funds align with an individual's financial goals and long-term investment horizon.

Hypothetical Example

Consider an investor, Sarah, who deposits $100,000 into a segregated fund with a 75% maturity guarantee and a 10-year maturity period.

1. Initial Investment: Sarah invests $100,000.
2. Market Fluctuations: Over the next 10 years, the underlying portfolio of the segregated fund experiences market volatility.
3. Scenario A (Growth): If, at the end of 10 years, the market value of Sarah's segregated fund has grown to $120,000, she receives the full market value of $120,000. Her capital appreciation is realized.
4. Scenario B (Decline): If, due to a market downturn, the market value of her segregated fund has dropped to $60,000 after 10 years, the maturity guarantee kicks in. Sarah is guaranteed to receive 75% of her initial $100,000 investment, which is $75,000, even though the market value is lower.
5. Death Benefit Scenario: If Sarah were to pass away before the 10-year maturity and the fund's market value was $60,000, but the contract had a 75% death benefit guarantee, her beneficiary would receive $75,000.

This example illustrates how segregated funds aim to protect a portion of the initial investment, offering a degree of security against adverse market movements.

Practical Applications

Segregated funds find practical application in several areas of personal finance and wealth management, particularly in Canada. They are often utilized by individuals seeking a balance between investment growth and principal protection.

• Estate Planning: Segregated funds offer distinct estate planning advantages. By naming a beneficiary directly, the proceeds can bypass the complexities and potential delays of probate, allowing for a quicker and more private transfer of assets to heirs.³⁶, ³⁷
• Creditor Protection: In certain circumstances, segregated funds may offer creditor protection. If a specific type of beneficiary, such as a spouse or child, is named, the assets held within the fund may be exempt from the claims of creditors in the event of bankruptcy or legal challenges.³⁴, ³⁵ This feature is particularly relevant for small business owners or professionals.³³
• Retirement Planning: For those nearing or in retirement, segregated funds can provide a sense of security due to their maturity guarantees, helping to preserve capital invested for future income needs.
• Regulatory Oversight: The Financial Services Regulatory Authority of Ontario (FSRA) is actively working on enhancing transparency for segregated funds by requiring insurers to provide consumers with enhanced annual statements that clearly disclose total costs and investment performance, aiming to align disclosure with the securities sector.³¹, ³²

Limitations and Criticisms

While segregated funds offer unique benefits, they also come with certain limitations and criticisms. A primary concern is their cost structure. The management expense ratio (MER) for segregated funds is typically higher than that of comparable mutual funds, reflecting the cost of the embedded insurance guarantees.²⁹, ³⁰ This higher fee can significantly impact long-term returns.²⁸

Critics argue that the value of the guarantees might not always outweigh the increased fees, especially for investors with a long investment horizon and a higher risk tolerance.²⁷ Furthermore, the "reset" feature, while beneficial for locking in gains, often comes with an extension of the contract's maturity date, potentially tying up capital for a longer period.²⁶ Some financial experts suggest that attempting to time the market by investing in segregated funds during periods of volatility, solely for their capital guarantees, may not be an optimal strategy.²⁴, ²⁵ It is crucial for potential investors to weigh the added security against the higher costs and longer commitment that segregated funds often entail.

Segregated Funds vs. Mutual Funds

Segregated funds and mutual funds are both popular pooled investment vehicles that allow investors to combine their capital for diversification and professional management. However, key differences exist, stemming primarily from their legal structures and embedded features.

The primary point of confusion between the two often lies in their shared function as professionally managed investment pools. However, the fundamental distinction is that segregated funds are insurance products with embedded guarantees and associated benefits, while a mutual fund is purely an investment vehicle subject to market fluctuations.⁹

FAQs

What is the main purpose of segregated funds?

The main purpose of segregated funds is to provide investors with a combination of potential investment growth and the security of capital protection through maturity guarantee and death benefit guarantees, typically offered by insurance companies.⁸

Are segregated funds protected from creditors?

Yes, segregated funds can offer potential creditor protection in certain situations, particularly when a specific family member is named as the beneficiary in the contract. This can be a valuable feature for business owners.⁶, ⁷

Do segregated funds always guarantee 100% of my initial investment?

Not always. Segregated funds typically offer guarantees of at least 75% of your initial deposits at maturity or death. Some contracts may offer a 100% guarantee, but this often comes with higher fees.⁵ The specific guarantee level depends on the terms of the individual segregated fund contract.

Are segregated funds regulated?

Yes, segregated funds are regulated. In Canada, they are primarily governed by life insurance legislation and overseen by regulatory bodies such as the Office of the Superintendent of Financial Institutions (OSFI) at the federal level, and provincial regulators like the Financial Services Regulatory Authority of Ontario (FSRA).³, ⁴

Can I withdraw money from a segregated fund before maturity?

While it is generally possible to redeem investments in a segregated fund before its maturity date, doing so may result in the loss of the embedded guarantees and could incur penalties or charges. Segregated funds are typically designed for long-term investing.¹, ²