Insuring your money; the case for, and against, segregated funds.

The British comic Spike Milligan once said that the best cure for seasickness is to sit under a tree. Having survived the recent stock market storm, Canadians may be wondering if it's time to man the lifeboats and head for shore. Segregated funds appear to offer the shade they seek.

The Toronto Stock Exchange Composite Index finished 2003 up 24%. That's great news if you made most of your investments 12 months ago. For the thousands of investors who bought into the market at its previous peak in 2000, however, last year's terrific performance just means they're back where they started. Having finally recovered their capital, many investors are looking for ways to make sure they don't lose it again--and segregated fund promoters are offering them a solution.

Segregated funds, or just "seg funds" for short, are similar to mutual funds in that they're pools of investment capital. You buy units in the fund, and the managers of the fund then invest that money in securities. And, like mutual funds, there are hundreds of varieties to choose from, e.g. balanced, bond, equity, and specialty.

But seg funds are an insurance product, and only available through insurance companies and licensed insurance advisers. They are called "segregated" because the fund assets are kept separate from the insurance company's other assets. It's because of their special status that they can include a few bells and whistles that standard mutual funds can't.

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The feature that's most often touted in segregated fund advertisements is the capital protection, often referred to as "portfolio insurance" by financial advisers. Whatever amount of money you invest in a segregated fund, the insurance company guarantees that you will receive at least 75% (some companies offer 100%) of it back after a 10-year period.

For example, Jane Doe invests $10,000 in a segregated fund. The markets soar, and Jane's investment is now worth $50,000--that's what she'll take home. On the other hand, should the markets wind up in the proverbial toilet, she'll still walk away with $7,500 even if the underlying value of the fund is really only $1.57. But keep in mind that the capital guarantee only kicks in after 10 years have elapsed. Should Jane cash in at year nine, she'll get market value.

Now, should Jane die while the markets are down, another feature of the segregated fund contract will kick in--the death benefit. Unlike the capital guarantee, this feature is available throughout the term of the contract. If Jane died in year six and her investment was only worth $10 at the time, her heirs would still receive at least 75% of her original contribution. Since the money paid to her heirs is classed as a life insurance benefit, the difference between the $7,500 and the $10 market value would not be subject to taxation, which is good news for her beneficiary.

Being able to name a beneficiary on the segregated fund contract also means that segregated funds can be used to reduce costs in an estate. If a mutual fund investor leaves his non-registered investment portfolio to his niece, those funds will first have to pass through his will and be subject to provincial probate fees. These fees vary from province to province, but can be fairly significant. In Quebec, there are no probate fees. However, in Ontario, for example, probate fees amount to 1.5%--meaning a $100,000 portfolio would be subject to what amounts to a $1,500 tax. Had he invested in a segregated fund and named his niece as beneficiary, those funds would have bypassed probate and been transferred to her directly upon his death.

Creditor protection is yet another benefit of segregated fund ownership. Under insurance law, contracts in which a "preferred beneficiary" has been named (i.e. a spouse, child, grandchild or parent) may be protected against the claims of creditors. That's not to say someone can transfer all of his assets into a seg fund the day before he declares bankruptcy and expect to emerge unscathed, but there is legal precedent provided the arrangements were made well in advance. For this reason, many business owners consider investing in seg funds so that the failure of their venture doesn't also mean a retirement spent in abject poverty.

All these features are, of course, not provided by the issuing companies out of the goodness of their hearts. To pay for the additional costs associated with insuring the assets of the investor, seg funds need to charge their unitholders hefty management fees--often one or even two percentage points more than no-load mutual funds. Some advisers will tell you that's a relatively small price to pay for peace of mind, but what if you're paying for insurance that you'll probably never need?

Of the 656 mutual funds with 10 year track records, as of the beginning of 2004 only 32 of them (less than 5%) had ever lost money over a decade--and many of these losers were highly specialized funds that got clobbered in the recent collapse of the Japanese markets. The fact of the matter is that a well-diversified investor who paid for portfolio insurance never collected.

If you're looking at segregated funds for this year's RRSP contribution, consider the likelihood that you'll actually use the features for which you're paying higher management fees. If you tend to worry and have an emotional need to know that your capital is guaranteed, that's fine. But an even better reason for buying segregated funds would be to better manage the distribution of your estate or your liability as a business owner.

Andrew Rickard ([e-mail]) is a Certified Financial Planner and freelance writer based in Toronto.