What are Segregated Funds and how do they work?

Want to invest money in investment funds without taking 100% of the market risk?  If so, segregated funds can be a suitable option. 

A segregated fund is part investment solution, part insurance product.

As an investment tool, it offers capital appreciation. At the same time, the insurance aspect of it protects your money — as well as your family, business, and estate. It ensures you will retain some or all of your principal capital no matter what, besides offering creditor protection and a death benefit.  

So what exactly is a segregated fund? How does it work? And is investing money in it worth the cost? Let’s dig in and find out. 

What are Segregated Funds?

A segregated fund is basically “a mutual fund meets a life insurance plan”. It has an investment component similar to a mutual fund, which allows you to invest money in stocks, bonds, or other securities. However, your exposure to risk is rather limited. 

While segregated funds share some qualities with mutual funds, they are sold exclusively by Canadian insurance companies. So if you want to purchase a segregated fund, you would have to buy it directly from an insurance broker (like Dundas Life) that works with major Canadian insurers.

When you buy a segregated fund, the insurance provider invests your premiums in an underlying asset. However, since risk is inherent to investing, there is a chance you could lose capital, even all of it. That’s where the “insurance factor” of segregated funds comes in. It guarantees you will retain up to 75% - 100% of your initial capital even if the underlying asset performs poorly. 

But there’s a catch.  

You must hold on to your segregated fund until the expiry of its maturity period — typically 10 to 15 years from the date of purchase. If you withdraw funds early, you will lose this protection and receive just the current market value of your segregated fund, minus any fees. Although this guarantee comes at a cost, it can give peace of mind to those who don’t want to take 100% of the market risk.

The Death benefit and creditor protection are the other two unique features. The above-mentioned guarantee also applies to the death benefit part of your segregated fund. That means if you pass before the maturity date, your beneficiary will get at least 75% to 100% of the original investment.

When a beneficiary is named, the segregated fund offers an extra layer of protection in the event of insolvency or bankruptcy. This feature can be particularly important for business owners or self-employed worried about potential creditor claims. It allows them to protect their retirement savings and meet their estate planning objectives. 

Key Features:

• Segregated funds are sold exclusively by insurance companies
• Segregated funds offer both capital appreciation and death benefits. They also include and guarantees and benefits commonly not found in other investment solutions
• They have higher fees compared to mutual funds 

Segregated Funds vs. Mutual Funds

Both mutual funds and segregated funds are pooled investments. But segregated funds are more than an investment vehicle. They also have many features of an insurance contract, making it different from mutual funds in the following aspects. 

How Segregated Funds Work?

Segregated funds are technically an insurance contract, not an investment product. As such, they have distinct features that other investment solutions don’t have. 

Here’s how they work:

1. You can buy a segregated fund only from a life insurance company

There are no surprises here since only insurance companies can sell insurance contracts. It’s worth mentioning that once you buy a segregated fund contract, you will have limited access to your money until the contract matures. 

2. You get maturity guarantee

Traditionally, segregated funds guarantee a return of 75% or 100% of the initial capital at maturity. 

3. You must hold on to the fund for a certain period

A segregated fund contract typically lasts 10 to 15 years. If you access the money invested in a segregated fund before the maturity date, you will lose the principal guarantee. Plus, you will pay a penalty.

4. Your contract has a death benefit 

If you pass before the contract ends, your beneficiary will receive the market value of your fund’s investments or the guaranteed principal, whichever is higher. 

5. You have multiple payout options

Typically, life insurance companies offer policyholders multiple payout options. You can receive the entire amount at one go upon maturity or in monthly, quarterly, half-yearly, or yearly installments.  

Benefits of Segregated Funds

Some of the main benefits of segregated funds are as follows: 

1. Maturity and death benefit guarantee

The most obvious advantage of segregated funds is the maturity and death benefit guarantee. Investors who want to stick to the path of minimum risk may take comfort in knowledge that much or all of their initial capital will be protected, regardless of the performance of the underlying asset. Depending on your contract, you can retain anywhere up to 70% to100% of the initial investment at maturity or death. 

For example, Sharon invests $100,000 in a segregated fund contract and designates her spouse, Edward, as the beneficiary. As per the policy’s terms, Sharon is guaranteed to receive at least 75% of the initial capital at death or the end of the maturity period (15 years). If at the time of Sharon’s death, her plan’s market value is $130,000, her husband will get the full $130,000.

If at that time the plan’s market value is $60,000, Edward will receive $75,000 (i.e. the guaranteed amount). If in 15 years the policy’s worth $130,000, Sharon will get the full $130,000. If at maturity the policy’s market value is $60,000, Sharon will receive $75,000.

2. Reset guarantees at maturity and death

Many contracts give the policyholder the option to lock in investment gains when their segregated fund grows in value. Normally, doing so will restart the maturity period. 

For example, Robert invests $100,000 in a segregated fund with a 10-year maturity period and 100% death and maturity guarantee on the principal amount. Today, Robert’s policy is worth $120,000, and he decides to reset the principal guarantee to this amount.

Now, if at the time of Robert’s death the value of his plan is $90,000, his beneficiary would still get $120,000. If at the time of maturity (10 years from the reset date) the fund’s value is less than $120,000, Robert would still receive $120,000. 

3. Estate planning

Upon your death, the money in your segregated fund does not flow through your estate; instead, it is paid directly to your beneficiaries. This means the money won’t be subject to probate fees, executor fees, and attorney’s fees. It also means your beneficiaries will receive the death benefit faster, usually within a few weeks of filing a claim. 

4. Creditor protection 

Segregated funds may offer creditor protection, particularly when a parent, spouse, child or grandchild is named as the beneficiary. If you become insolvent, your creditors cannot seize the money in your policy. 

5. Insurer insolvency protection

Assuris, a not-for-profit organization, protects Canadian policyholders if their life and health insurance company becomes insolvent. In the unlikely event of your insurance company failing, Assuris guarantees that a policyholder will retain at least 85% of the guaranteed amount on their segregated fund. When the guaranteed amount is $60,000 or less, the policyholder will retain all of it.  

Drawbacks of Segregated Funds

Segregated funds offer guarantees and benefits that you won’t find in mutual funds, but they are not without potential pitfalls. Knowing about the cons will help you make an informed decision regarding whether a segregated fund is right for you.

1. Higher fees

Alongside many features of a mutual fund, a segregated fund offers many elements of an insurance contract, such as a death guarantee, creditor protection, and insurer insolvency protection. While immensely useful, these features push up the cost considerably. 

According to some estimates, the management fees of segregated funds can be twice that of other similar type mutual fund investments. The management fees typically cover services such as investment advice, making investment decisions, and managing your portfolio. Apart from the management fees, you will pay operation costs (covers all the accounting and administrative work related to your contract) and insurance cost (covers the cost of the principal protection). 

2. Access to your money is limited

Your investment is locked in for a certain period, usually 10 to 15 years. If you withdraw funds from your plan early, it would cost you. You will lose the principal guarantee and will likely pay an early withdrawal penalty. 

Is a Segregated Fund Right for You?

Segregated funds are a good option for an investor with a low tolerance to risk. If you are someone who doesn’t mind settling for a slightly lower growth potential in return for a death and maturity guarantee, a segregated fund could be right for you. 

You may want to consider investing is a segregated fund if you are: 

• A pre-retiree who wants to invest a lump sum without risking the initial capital
• Someone who wants to preserve their legacy and transfer the estate in a cost-effective manner
• A business owners who wants to protect their retirement savings or emergency funds from creditors

Conclusion

Like mutual funds, segregated funds can help you grow your savings. But they also include guarantees and advantages that mutual funds and other investment vehicles don’t offer. Sold exclusively by brokers working with insurance companies, segregated funds can be an option for someone looking for wealth accumulation without having to take 100% of the market risk. 

Curious to learn more? Reach out to a Dundas Life licensed advisor today. We're happy to go over your options with you.

Frequently Asked Questions

Are segregated funds protected from creditors?

Assets in a segregated fund may be protected from creditors. Specifically speaking, if you file for bankruptcy and have named a beneficiary for your segregated fund, the assets held in it are exempt from seizure. This feature makes segregated funds an attractive option for individuals who run a business that might be exposed to creditors.

Are segregated funds covered by any protection plans?

Segregated funds in Canada enjoy Assuris Protection. A not-for-profit organization, Assuris offers protection to policyholders if their life and health insurance company becomes insolvent or bankrupt. 

In the unlikely event of your insurance provider failing, Assuris will pay you at least 85% of your segregated fund’s guaranteed amount. If the guaranteed amount is not more than $60,000, policyholders will retain the entire amount. 

Let’s say you invest $100,000 in a segregated fund that guarantees a return of up to 85% of the original capital. If your insurer ever fails, you would still retain $72,250 (85% of $85,000). 

Can I designate beneficiaries for my segregated funds?

Yes, you can (and should) name a beneficiary for your segregated funds. Because a segregated fund is technically an insurance product, the owner can designate one or more beneficiary. If you name a beneficiary other than the estate, the funds will be paid directly to the beneficiary after your death instead of going through probate — which at times can be expensive and time-consuming.