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The Value of Investment Guarantees
Have segregated funds lost their appeal?

At one time, segregated funds (investment funds sold by life insurance companies) were the best-kept secret in the investment business. Skilled money managers, potential creditor protection, capital guarantees after ten years or upon death, and competitive annual fees made these vehicles very attractive from a financial planning perspective. This was such an attractive market to which mutual fund companies began flocking, to repackage their most popular and successful funds by adding an insurance wrapper around the underlying fund to provide the great active management and financial planning benefits. The catch: as expensive as some mutual funds were, these new seg funds were even more costly (in terms of annual fees or MERs - management expense ratios). In my opinion, the higher fees of the mutual fund company-sponsored segregated funds made them somewhat unattractive compared to the more traditional alternatives. Now the fees are rising across the board.

Segregated funds - explained

Segregated ("seg") funds are investment funds offered by insurance companies and are technically insurance policies known as variable annuity contracts. Seg funds differ from mutual funds in a number of ways, but mainly in that they offer a principal guarantee upon maturity (10 years) and upon death, and the ability to creditor-proof the funds. The maturity guarantee usually states that, at the end of ten years, a policyholder can cash in their policy and receive the greater of the net investment or the current value, whichever is higher. Death guarantees are similar except there isn't a minimum fixed time frame needed for the guarantee to kick in - it's triggered upon death. Seg fund fees have two main components: management/operating expenses and insurance premium. Like mutual funds, seg funds charge annual fees for investment management and operating expenses - MER. In addition, there is an insurance fee to cover the "guarantees" mentioned above. The total of the two add up to the total seg fund fees.

Just like any other type of insurance, the insurer sets aside a reserve out of the insurance premium in case they actually have to top-up somebody's policy upon death or after ten years. It is this reserve that has recently been scrutinized by regulators.

Segregated funds - traditional vs. new crop

There are two distinct groups of seg funds: traditional and new. For both types, the maturity and estate guarantees (i.e. the insurance portions) are underwritten by an insurer and offer the same general benefits highlighted above. With traditional seg funds, the insurer also handles the marketing and investment management of the funds. Examples of traditional seg funds have been available for several years from firms like Canada Life, Maritime Life, Royal Life, Standard Life, etc. The new wave of seg funds have marketing and investment management duties handled by a mutual fund company and usually see a popular mutual fund offered in seg fund form. For example, CI Global Boomernomics fund (a mutual fund) is one of the many funds which was repackaged and offered as CI Global Boomernomics GIF (Guaranteed Investment Fund - a seg fund). Fees are higher because as the number of hands are dipping into the cookie jar rises, they'll be fewer cookies left over (fees will also be higher).

Reason for rising fees

Mutual fund fees are generally high in Canada, so when many fund companies came to market with seg versions of their funds a few years ago, many were priced aggressively (i.e. low insurance premium) to minimize the impact on overall fees. However, the growing popularity of seg funds caused regulators to review the actuarial calculations made when these funds' insurance costs were originally priced. Many suspected the insurance premiums charged (and hence the reserves held by insurers) on these funds were inadequate, and regulators have recently confirmed this sentiment. Bottom line: insurance premiums, and total fees, for seg funds are on the rise. How much are fees rising? Well it varies and the numbers are all over the map.

Affected funds and companies

Getting back to our CI Global Boomernomics example, the regular fund has a MER of 2.35 per cent annually, while its seg sister charged 0.60 per cent per year to cover maturity and death guarantees (for a total cost of 2.95 per cent). As a result of the recent probe into insurance reserves for these funds, the insurance premium charged to investors is tripling to 1.80 per cent per year - bringing total fees to 4.15 per cent. Transamerica Life was known as one of the more aggressive insurers in pricing these premiums, so all seg funds underwritten by them are likely to see huge increases in fees. In fact, 13 of CI's 23 GIF funds will see annual fees rise north of 4 per cent per year. AIC is another firm whose seg funds are underwritten by Transamerica so fees can be expected to go through the roof. As expected, Transamerica's own seg funds are skyrocketing in cost - with equity funds rising by an average of 1.13 per cent annually.

At the other end of the spectrum are those that won't be affected at all like Maritime Life, Standard Life, and Canada Life. These firms had priced their funds appropriately and have adequate reserves to satisfy regulators. In the middle, firms like Royal and SunAlliance are hiking fees moderately, by an average of 0.24 per cent for equity funds - ranging from 0.05 to 0.40 per cent.

Yet other firms will deal with this issue by reducing the useless "bells and whistles" to new seg fund contracts. This means many maturity guarantees will be reduced from 100 per cent to the legislated minimum of 75 per cent. Insurers must abide by the contracts in which they've already entered, but rising costs just may drive investors away. In some cases, like the old Trimark seg funds, they are allowing policyholders to cash out with no deferred sales charges.

Recommendation

As with so many things, investors should always evaluate what they get against what they're paying. I personally place little, if any, value on the maturity guarantee, though the death guarantee and creditor-proofing can be valuable. However, 4 per cent per year is a steep price to pay.

Next week: how to build your own seg fund.

Dan Hallett, CFA, CFP is the President of Dan Hallett & Associates Inc. in Windsor Ontario. DH&A is registered as Investment Counsel in Ontario and provides independent investment research to financial advisors. He can be reached at dha@danhallett.com
 
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