Segregated funds are not quite what they used to be, financial advisors say. Some of the attractive features of these products have been diluted in recent years and, as a result, their high fees have become harder to justify.
However, in an environment in which many investors simply want the comfort of knowing that their retirement savings are safe, seg funds still hold appeal for many clients.
"Since the market crash of '08-09," says Mark Coutts, financial advisor with Toronto-based Coutts Financial Services Inc., which operates under the banner of Waterloo, Ont.-based Sun Life Financial (Canada) Inc., "I have seen a paradigm shift in a lot of investors' thinking."
Typically, clients nearing the end of their working lives are most concerned about the certainty and preservation of their capital, says Coutts: "As people head toward retirement and, all of a sudden, they can see the light at the end of the tunnel, they're saying, 'Hey, I'm not too worried about growth anymore in my investments; I'm really concerned about preservation. I want to keep what I have'."
With many clients having adopted this mentality in recent years, Coutts says, virtually any product offering strong protection of the assets acquired over many years has gained in popularity.
These products include a wide range of seg funds, which are offered by insurance companies and have the features of both insurance policies and mutual funds. Seg funds include a death benefit, as well as a guarantee of the return of a predetermined percentage of the original investment - usually 75% or 100% - once the units in the fund have been held for a specific period of time, usually 10 or 15 years.
"The biggest advantage of a segregated fund," says Coutts, "is for the client who wants the peace of mind of knowing that [the] capital is guaranteed."
In recent years, however, the insurance companies that offer seg funds have made changes to their products. Like the many changes being made to guaranteed minimum withdrawal benefits (GMWBs), these changes are being driven by the providers' responses to today's volatile market conditions, which have made it riskier to offer products with guarantees. The tougher regulatory climate, with its emphasis on capital requirements, also is a factor, as is the extended period of ultra-low interest rates. (For more on GMWBs, see story page B12.)
As a result, many insurers that offer seg funds have scaled back the guarantees associated with their products. And the length of time that clients are required to hold their units in the seg fund to be eligible for the guarantee also has been extended.
Many insurers previously had offered seg funds with a guaranteed return of 100% of principal after 10 years. As an added bonus, "reset" options used to allow clients to lock in investment gains periodically, thereby setting a new 10- or 15-year guarantee period.
Now, most seg funds with a 10-year maturity date guarantee only 75% of the capital. This means that clients will have to wait for 15 years if they want to receive the 100% capital guarantee. In addition, there now are fewer opportunities to lock in gains, according to Asher Tward, vice president of estate planning at TriDelta Financial Partners Inc. in Toronto.
Tward adds that most seg fund providers have scaled back the variety of products that they offer, leaving clients with fewer investment options - especially at the aggressive end of the investing spectrum.
"Many years ago," Tward says, "the environment was different, and segregated funds actually worked well because you could get [100%] 10-year maturity guarantees, you could get very good fund choices and you could get resets. Most of that has fallen by the wayside - but the fees are still high."
Indeed, the management fees on seg funds can be hefty. At levels typically between 50 and 100 basis points higher than the fees on comparable mutual funds, some seg funds' management expense ratios are as high as 4%. In an environment in which returns are already very low, this fee level can limit the potential for growth substantially.
"The fees are high, so the net returns on most [seg] funds aren't very good," says Tward. "You don't have a chance to make a lot of money."
For clients whose primary goal is to preserve their nest egg, however, the fees may be worthwhile, according to Bill Bell, president of Bell Financial Inc. in Aurora, Ont.: "Segregated funds have an additional fee above a mutual fund. But it's not the same thing - [seg funds are] providing you with some protection and estate privileges. The question you have to ask is: 'Am I paying for a guarantee that's valuable to me?'"
Bell considers traditional seg funds to be most appropriate for clients who are saving for retirement and are highly concerned about losing money in the markets.
"While you're accumulating [assets, seg funds] protect you from markets being down," he says. "In fact, we've had lots of people in the past three or four years collecting on those guarantees because of the markets that we saw in the mid-2000s."
Once clients start drawing on their savings in retirement, however, Bell adds, traditional seg funds are not the ideal investment vehicle. He believes retirees are better off with products that generate a stream of income and, more important, guarantee that income for the duration of the client's life, such as GMWB products.
Increasing lifespans also may be a factor for some clients. "We all have to start worrying about running out of money," Bell says. "[GMWBs] are designed to protect you from the ups and downs of the market, and give you an income that you can't outlive."
However, Bell adds, seg funds can still play an important role for some retirees - especially from an estate planning perspective. The death benefit feature means that upon the death of the seg fund unitholder, the amount of principal guaranteed under the seg fund contract will be paid directly to the designated beneficiary, thus bypassing probate fees.
"If the client is worried about the estate," Bell says, "then segregated funds obviously fit the bill."
A key advantage of the death benefit is that it's not time-sensitive, Tward says. So, if the client dies a year after buying units in a seg fund, the beneficiary still receives the full amount of the original guarantee - even if some of the value of the original investment has been lost in a market downturn.
"There's value in that, from an estate planning perspective," says Tward. "And it's worth paying for, in some cases.
If you do decide that seg funds are a good fit for a particular client, Coutts says, it's important to avoid putting more of that client's savings than necessary into the seg fund.
That's because the client will be paying the premiums over an extended period of time. The amount of time your client will have to wait for the benefits also means that the client will need other income for shorter-term needs.
Therefore, it's advisable for you to ensure that your clients have sufficient funds elsewhere in their portfolios to meet these more immediate needs.
"You need to be careful how much of [clients'] savings goes into the product," Coutts says. "It doesn't make sense to overinvest in segregated funds unnecessarily, because you're paying the higher fee." IE
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