Do you really need a seg fund?
Tips on building guarantees into your portfolio
Last week, we saw why segregated funds, as a group, will see their annual costs (specifically insurance premiums for maturity guarantees) go through the roof. This new legislation will make seg funds with annual fees north of 4 per cent commonplace among this once popular group of investment funds. High fees are likely to drive many investors out of these funds, despite the sometimes valuable financial planning and legal benefits. Let's first go over, in more detail, the benefits provided by seg fund contracts.
Seg fund benefits
Let's start with guarantees. Upon maturity (ten years) and upon death, a seg fund contract will guarantee that you'll receive at least 75 per cent of net policy deposits (or market value, whichever is greater) over that period. While 75 per cent had always been the legislated minimum, most companies have long structured their contracts to provide 100 guarantees. Investors over seventy-five years of age will have a lower proportion of their net deposits guaranteed due to the generally higher mortality rates among that age group.
The key thing here is the fact that these guarantees are provided "per contract". An insurance premium is calculated based on the volatility and risk of each separate fund and charged accordingly. However, let's say an investor holds one seg fund policy, which holds a US equity fund, an international equity fund, and a Canadian equity fund. By holding all of these funds under the same contract, risk has been reduced by the investor's chosen mix of funds. The investor, however, still pays the insurance premium to cover the guarantee based on the higher risk scenario of holding each of these funds separately. In other words, investors holding a portfolio of seg funds under one contract are overpaying for the guarantee, and would actually get more value by holding the three funds in three separate contracts. As a result, some insurers actually limit the number of contracts that one individual may hold.
Estate planning can be facilitated through the use of seg funds because, like an insurance policy, a beneficiary can be designated to receive the proceeds upon death - possible for registered (RRSP, RRIF, etc.) and non-registered contracts. It simply isn't possible to designate a beneficiary on a non-registered account at a bank, brokerage, or investment firm - only for registered accounts.
Just as mutual funds flow through taxable income (interest, dividends, and capital gains) each year, so do seg funds. The difference: seg funds can actually flow through realized capital losses to policyholders whereas mutual funds cannot. In a year where the fund manager's buying and selling has been unsuccessful and losses are realized, a mutual fund must keep the losses in the fund until future gains "eat them up". It's really a timing difference that works in favour of seg fund investors.
Finally, seg funds have the potential to protect the contract's proceeds until they are passed on to the designated beneficiary. For instance, if a father has a seg fund contract with his daughter as beneficiary, the funds will be protected from any of the father's creditors. However, once the daughter receives the funds, they are no longer protected unless reinvested into a new seg fund contract. The timing of the investment into the seg fund contract is crucial to determining the potential for creditor protection - it's not a sure thing.
Though not needed for most investors, the maturity guarantee is naturally appealing to the more conservative crowd - people that may not feel comfortable getting into equities any other way. However, I'd argue that these people aren't just conservative, they're not well educated on investment issues. The only ten-year period that has seen North American stock markets end in a loss position was around the time of the infamous 1929 crash. While we can't guarantee that won't happen again, it's highly unlikely (at least that's my opinion). The other thing of which weary investors should be aware is the fact that a conservative asset mix may, in itself, have built-in safeguards against a loss of capital over ten year periods.
The safeguard of balanced portfolios
By making a few return assumptions, we can illustrate how a balanced portfolio can insulate most investors from long-term losses of capital. Let's start with a typical balanced portfolio:
Let's further assume that the 40 per cent in bonds and cash will generate an average net return of 4 per cent annually. In this case, your stock component could lose half of its value over the entire ten-year period and you'd still be left with nearly 90 per cent of your original investment. What if you wanted to make sure you retained your full initial investment? Given this asset mix and the stated assumptions, your stocks could be down by almost a third at the end of ten years and you'd still have a portfolio value that is equal to your starting amount ten years earlier. Finally, if all you wanted was to equal the minimum 75 per cent guarantee that many seg funds offer, your stock component could fall by more than 73 per cent and you'd still accomplish the task.
Given the above return assumptions and a 50-45-5 split between stocks, bonds, and cash, respectively shows that your portfolio would be worth exactly what you started with after ten years, even if your stocks lost nearly half of their value over that time frame. We can go through several more examples, but I think you get the idea.
While this is an interesting exercise, it's more educational than anything. If you're using bond funds rather than bonds, there is a little more uncertainty. That said, buying and holding, for example, a stripped bond will lock in a return that is guaranteed by a provincial or the federal government. Also, if reality differs from the assumptions made, there is no regulatory body or consumer protection fund to make sure that you get your guarantee. In this regard, the "guarantees" aren't quite equal. However, for practical purposes, investors with balanced portfolios should not pay much, if anything, for seg fund maturity guarantees because they just aren't that valuable. That's especially true given the prohibitively high MERs about to hit the world of seg funds this year. Ironically, the new sky-high MERs may make it more likely for the guarantee to kick in since they eat so deeply into investor returns.
If you invest in a seg fund, make sure it's for the estate benefits or potential creditor-proofing. Even for an all-stock portfolio, the chance of loss over a ten-year period is slim. However, for investors holding at least 25 per cent of their portfolios in fixed income (i.e. bonds and/or cash) the maturity guarantee isn't worth much on a portfolio basis. Instead, see if you can build it better yourself or with the help of a skilled and trusted financial advisor.
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 firstname.lastname@example.org
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