How do segregated funds work?

Segregated funds are like mutual funds: they are both investment products with multiple underlying investments, allowing for diversification. However, unlike mutual funds, segregated funds have other characteristics that I think you should consider, Leslie.

Segregated (seg) funds generally guarantee your principal (premiums paid), both after a certain period of time and upon your death. Depending on the fund contract, 75% to 100% of your principal is protected after 10 years.

Warranties may seem like a good thing to a consumer, but when it comes to financial products, guarantees are often expensive to give and therefore to purchase. It is also highly unlikely that a diversified investment portfolio will have a negative return over a 10-year period, meaning the guarantee can have virtually no value.

Some seg funds also offer guaranteed value resets as the market value rises. However, this may also extend the time horizon over which the warranty applies, extending the 10-year period.

Holding segregated funds in unregistered accounts

If you hold segregated funds in an unregistered account, the proceeds can be paid directly to a beneficiary without going through your estate first, because they are insurance contracts. As such, they are not subject to estate and inheritance taxes. In some provinces, these costs are next to nothing, and in provinces with high estate or estate taxes, the costs are less than 2% of the asset value. However, the estate can be divided more quickly, with no delays in the settlement of the estate, and insurance contracts can remain private, unlike an estate which is passed on through a will and disclosed to all beneficiaries.

It’s worth pointing out, Leslie, that Registered Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds (RRIFs) both allow for beneficiary naming, which can help your estate avoid estate and estate taxes. So that aspect of a segregated fund has no value in a registered account like yours.

Segregated funds can provide creditor protection in the event of bankruptcy. However, in some provinces, RRSP and RRIF assets already have strong creditor protections.

How much are the costs for segregated funds?

Divorced funds can have annual fees ranging from 3% to 4% of your investment. It’s not uncommon for seg funds to have fees 1% to 1.5% higher than comparable mutual funds, which may already have higher fees than other investment options. The question is whether these higher fees are worth the potential benefits. This is an important consideration for any investor, especially a conservative investor in a relatively low interest rate environment.

This post Converting a segregated fund to an RRIF

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