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.
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.
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:
·
65 per
cent in stocks;
·
35 per
cent in bonds; and
·
5 per
cent in cash.
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, B.Comm.,
CFP is Senior Investment Analyst with Sterling Mutuals Inc. He can be reached
at dhallett@sterlingmutuals.com. Sterling Mutuals is registered as a mutual
fund dealer in Ontario, British Columbia, and Manitoba.