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Segregated funds provide RRSP investors peace of mind for a price

by Wayne Cheveldayoff, 2004-01-23

Is it worth paying for a guarantee that youíll probably never use? Thatís the key question regarding the use of segregated funds instead of mutual funds in an RRSP.

For practical purposes, segregated funds and mutual funds are very similar, as they both invest in stocks and/or bonds. But segregated funds provide a certain degree of protection that mutual funds donít have.

Whereas a mutual fund leaves investors vulnerable to a loss, a segregated fund guarantees the return of up to 100 per cent of the original investment after 10 years or if the investor dies.

Segregated funds carry this guarantee because they are legally an insurance contract (more specifically, a variable annuity contract), whereas mutual funds are a trust.

Most insurance companies offer segregated funds and some also insure funds managed by mutual funds. In fact, many of the popular funds from well-known fund companies like Templeton, Mackenzie and AIM Trimark are available as either mutual funds or segregated funds. In all, there are around 1,500 segregated funds in the Canadian investment marketplace.

The guarantee, of course, comes with an extra cost, as any insurance would. This cost depends on the specific insurance provisions being offered.

The management expense ratios (MERs) for segregated funds average about half a percentage point higher than for mutual funds, although some are as much as a full percentage point higher. In fact, a few segregated funds that invest in equities have MERs that exceed 4 per cent. In contrast, equity mutual fund MERs are usually in the 2.5 to 3 per cent range.

The amount of additional cost depends on the nature of the guarantee involved. Some segregated funds offer only a guarantee of initial investment upon death. Others add in a guarantee of 75 per cent (most common) or 100 per cent (most expensive) of initial investment after 10 years.

An additional feature in some is the ability to reset this guarantee several times a year. For example, if the segregated fund was valued at $10 per unit when you bought it and now, three years later, it is worth $13 per unit, you can reset the guarantee at $13, although you would have to wait a full 10 years from today to collect it.

One benefit of segregated funds is creditor protection. Since the funds are held within an insurance contract and insurance contracts are normally exempt from claims by creditors, segregated funds could be a good place to invest for people running unincorporated businesses or professionals worried about being sued. However, for those people already having financial difficulty, this is unlikely to be a solution, as the courts tend to disqualify such evasive initiatives if someone knows they are going bankrupt.

One drawback to segregated funds is the higher MERs drag down performance. The loss of a half or a full percentage point of annual return can mean a big difference over time to the growth of an RRSP.

However, there is no black-and-white statement that can be made as to whether this extra cost is worth it. It all depends on each personís situation and mental tolerance for risk.

The protection from creditors may be worth it for some. Similarly, the death benefit could be worth it for older investors in their sixties and seventies if there is a desire to make 100 per cent sure the beneficiaries of an estate receive at least the amount initially invested.

As an estate-planning tool, the payout of segregated funds to beneficiaries is treated as an insurance payment, so it bypasses the estate. This can save on probate fees and also direct funds to beneficiaries on a discrete basis, as they wouldnít be part of a will.

On just the basis of North American investment experience over the past 50 years, the initial investment guarantee would not appear necessary. There have been few instances of an investment being under water for as long as 10 years.

However, this is where ďpeace of mindĒ may come in for some investors. As many investment documents warn, past performance is no guarantee of future performance. And, anyway, insurance is about protecting against the impact of things we donít want to happen.

The guarantee could protect against a Japanese-style demolition of stock investments. Over the past 13 years, Japan has experienced a prolonged bear market in stocks, with the Nikkei market index now approximately a third of what it was when it peaked in 1990.

If that kind of lengthy slump in stocks were to happen here, the investors in segregated funds would be 75 or 100 per cent protected, whereas mutual fund investors that held on would be out of luck.

Aside from what may actually happen in the future, having a guarantee may allow the worrying type of investor to sleep at night while still benefiting from the upside of equities.

Such a guarantee of initial investment in equities is also available in other forms in the investment market. For example, some banks offer deposit notes that are tied to the performance of a stock index.

Therefore, anyone pondering a guarantee of this kind should check around and consult an investment advisor.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at and he can be contacted at

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©2004 Wayne Cheveldayoff