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What are segregated funds?
Many people hesitate to invest because they are concerned about market volatility and the risk of losing their capital. One way to lower that risk is by prioritizing fixed-income assets, although these usually provide lower returns.
Another option worth considering is segregated funds, an insurance-based investment that combines the growth potential of mutual funds with built-in guarantees. Depending on the product, they can protect 75% to 100% of your original investment.
While segregated funds might appear like a safe choice, it’s crucial to understand how they operate, what they cost and whether they align with your financial goals before investing.
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What are segregated funds?
A segregated fund is a type of individual variable insurance contract available only through insurance companies. It combines investment growth potential with the protective features of an insurance policy. Your money is pooled with that of other investors and invested in a diversified mix of assets, including stocks, bonds, and money market funds.
What makes segregated funds unique is their built-in guarantees, which usually protect between 75% and 100% of your initial investment at maturity or upon death. Since they are designed as insurance products, they can also avoid the probate process, making them a useful option for estate planning.
How segregated funds differ from mutual funds
Segregated funds are often compared to mutual funds, as both products pool investor money and are professionally managed. However, there are a few differences. Segregrated funds generally cost more than mutual funds, so investors must decide if the insurance benefits justify the extra expense. Typically, younger investors choose mutual funds for their growth potential, while those approaching retirement often prioritize the security of having their principal protected with segregated funds.
That said, since there are other investment products available, such as exchange-traded funds (ETFs), bonds, and individual stocks, it’s possible to build a diversified portfolio at a reasonable cost.
How segregated funds work
Segregated funds are investment products available exclusively through insurance companies, which is why insurance advisors often promote them.
At their core, segregated funds are contracts between you and the insurer. Your money is pooled with other investors’ and professionally managed by a portfolio manager. What sets these funds apart is that the insurer keeps the fund’s assets separate from its own corporate holdings, hence the term “segregated.” This structure helps safeguard your investment if the insurance company experiences financial trouble.
When you invest, you’re buying units in the fund. Like mutual funds, the value of those units will rise or fall with market performance.
Types of segregated funds
Segregated funds come in various types, each designed to meet different investor goals and preferences. While some investors may choose a single fund, others create a diversified portfolio by investing in multiple funds to spread risk and boost potential returns.
These are the most common types of segregated funds:
● Equity segregated funds: These funds invest primarily in stocks, offering the potential for higher long-term growth. However, they also come with greater volatility and risk, making them better suited for investors with a longer time horizon and higher risk tolerance.
● Fixed income segregated funds: Designed to preserve capital, these funds focus on lower-risk investments such as bonds, government securities, and money market instruments. They provide more stable returns, though with limited growth potential.
● Balanced segregated funds: Combining equities and fixed income investments, balanced funds aim to strike a middle ground between growth and stability. Some lean more toward capital appreciation, while others prioritize risk reduction.
● Specialty segregated funds: For those interested in targeting specific sectors or regions, specialty funds offer focused exposure. Popular themes include technology, emerging markets, and socially responsible investing.
Benefits and drawbacks of segregated funds
Segregated funds offer the potential for investment growth along with insurance protection features that set them apart from traditional mutual funds. Although this combination can be appealing, it usually involves higher fees. Therefore, it’s important to carefully evaluate the advantages and disadvantages before investing your money.
Pros of segregated funds
● Principal guarantee: Segregated funds come with a built-in guarantee that protects part of your original investment. Depending on the product, this guarantee usually covers between 75% and 100% of your initial contribution.
● Lower estate taxes: Death benefits from segregated funds are paid directly to your named beneficiaries, bypassing the estate process. This can help streamline the transfer of assets and reduce probate fees.
● Creditor protection: Segregated funds can provide protection from creditors in certain situations. This protection is due to their classification as insurance products instead of direct investments.
Cons of segregated funds
● Higher fees: Segregated funds usually charge higher fees than mutual funds or ETFs. These increased costs directly affect your investment returns over time. A 1% difference in annual fees can significantly decrease your wealth growth over decades.
● Limited growth: Guarantees and insurance features can limit a fund’s exposure to higher-growth assets, as these protections come at an added cost. Those expenses may drag down overall performance over time.
● Your money is locked in: Because segregated funds include a guaranteed portion, your investment is usually locked in until the maturity date, which is typically 10 years. You can withdraw early, but this may lead to penalties and a payout that’s less than your original investment.
Final thoughts
Segregated funds can be a strong choice for investors looking for a mix of market exposure and built-in protection. With features like principal guarantees, estate planning advantages, and potential creditor protection, they provide peace of mind that traditional investments might not offer. However, these benefits come with costs, including fees and less flexibility. The choice is up to you.
Barry Choi is a paid spokesperson of Sonnet Insurance.
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