Whether or not your clients should invest in segregated funds inside their RRSPs or RRIFs depends on their specific goals and objectives.

Seg funds are not much different from mutual funds. They invest in similar asset classes, such as fixed-income and equity; they have the same management styles, such as growth and value; they are just as liquid; and they can provide comparable returns.

However, their MERs are significantly higher — on average, about 50 basis points more — than mutual funds, which is the primary argument against their suitability in registered or non-registered plans.

Their higher MERs are largely a result of the cost of the insurance that covers the guarantees they provide, including security of principal and a guaranteed death benefit.
Seg funds may also offer other benefits not provided by mutual funds, such estate preservation and creditor protection.

Indeed, these additional benefits are beyond the scope of core investing in a registered plan and may not be required by all investors. However, if they match your clients’ objectives, investing in seg funds in their RRSPs or RRIFs may be just right — providing they pick the right funds.

“All seg funds are not created equal,” says John Lutrin, executive vice president of Woodbridge, Ont.-based Hub Financial Inc. in Vancouver. “Some are out-of-the-question expensive and don’t offer value for money.” But in some case, he adds, they are relatively cheaper than ordinary mutual funds and may provide the same level of returns.

Lutrin argues that all seg funds cannot be blanketed under one pricing structure, and
investors must make sure the funds they buy meet their investment objectives. From an investment standpoint, it’s not a question of whether mutual funds or seg funds are better.
They have similar features, whether growth or value, equity, fixed-income or balanced, he says: “They can also be redeemed or switched between funds whenever the investor chooses.”

Some seg funds, he cautions, can be “smoke and mirrors” when it comes to the definition of the guarantees they provide, and clients must be certain they understand these guarantees.

Essentially, seg funds are sold through insurance contracts that guarantee investors will get back at least 75%, but sometimes up to 100% of their gross investment at a specified maturity date, typically no less than 10 years from the date of the original investment or upon death — regardless of the investment’s market value.

Seg funds sometimes allow investors to lock in their gains by periodically resetting the guaranteed amount. Therefore, if the value of the investment rises, investors have the option of having the guarantee based on the higher amount. However, this also extends the normal 10-year guaranteed holding period of the investment. Some funds may have an age restriction on the reset feature, meaning investors over a certain age will not be allowed to reset the guarantee.

If the market value of the segregated investment is less than the death benefit guarantee upon death, the insurer will normally top up the difference. However, the death benefit guarantee may, in certain cases, be subject to restrictions — based on age or a minimum number of years of deposits — and may guarantee only on the initial investment, not higher amounts resulting from the reset feature.

When seg funds are held in a registered plan, the entire death benefit is taxable unless the beneficiary is a spouse, common-law partner, son or daughter. The beneficiaries can transfer the death benefit to another registered plan to defer taxes. Otherwise, they must report and pay taxes on the lump-sum death benefit as income.

“Higher fees charged by seg funds can have a substantial impact on the value of a registered portfolio over time,” says Philip Kung, president of Markham, Ont.-based RGI Financial Inc. “Given the availability of cheaper investments, seg funds are not necessarily an attractive choice, unless the investor is looking for principal or creditor protection.”

Shane Dewling, senior financial consultant with Stratos Wealth Management in Toronto, favours low-cost, high-quality products. “Cost is one of things you can control in your investments,” he says. From that perspective, he adds, “The higher management fees associated with seg funds may be justified if personal circumstances match their unique features, such as long-term creditor protection and the long-term return of capital guarantee.”

@page_break@“But,” says Kung, “if you don’t need these features, you’re paying more for what you don’t need.”

Lutrin says seg funds’ estate-planning and creditor-protection features are “undersold” and too much emphasis is placed on principal guarantees. “Investors can save estate-planning and probate fees when they invest in seg funds.” So, if a named beneficiary receives the guaranteed death benefit, he or she does not have to pay probate, executor or lawyers’ fees.

Tina Tehranchian, branch manager of Assante Capital Management Ltd. in Richmond Hill, Ont., believes seg funds offer her business-owner clients useful creditor protection.
“The additional features are worth the higher fees,” she says. When a seg fund contract is held inside a registered plan and the contract owner declares bankruptcy or fails to pay a debt, creditors cannot seize the seg fund’s assets — as long as the contract was not entered into to shield the assets from creditors.

“Seg funds have a course to run for the guarantees to stick,” says Lutrin. And the more guarantees, the higher the fees. But these products may allow investors to choose riskier investments, yet remain protected. IE