It is easy to understand why segregated funds – investment products similar to a mutual fund with an insurance component that offers certain guarantees – are a favourite investment vehicle for many financial planners. They have a great marketing gimmick, a rosy benefits story that makes them an easy sell, the payout to advisers is great, and currently, they do not fall under transparency rules like mutual funds with the Customer Relationship Model (CRM).
Strategic Insight data show that seg fund assets increased from $110.7-billion to $116.8-billion between June, 2016, and June, 2017. If we look at these products objectively, they do have some theoretically appealing features for certain clients, but many clients would be better served in other investment vehicles. Now that the Canadian Council of Insurance Regulators (CCIR) is recommending greater transparency of industry, will seg fund growth continue to be as robust as it has been in the past?
The CCIR recommends changes to seg fund disclosure rules to bring that information more closely in line with the information clients receive about their mutual fund investments. Specifically, the CCIR outlines a list of information that must be included on seg fund investors' annual statements, including:
- All charges for the year, in dollar amounts, with the management expense ratio (MER) broken out to show management fees, distribution costs and insurance costs explicitly;
- All remuneration paid during the year for the provision of services in connection with the contract;
- Changes in the net asset value of the contract in dollar amount;
- Redemption value;
- Total personal rate of return, net of charges, calculated using the money weighted method for the last year, three years, five years, 10 years and since issue;
- Various other items.
This new disclosure framework seeks to ensure consumers are informed of not only the performance of their segregated funds, but also all of the details of what they cost. As well, that disclosure provides a better understanding of the product. Financial planners who sell seg funds need to be ready to have this discussion with their clients.
Segregated funds are considered to be like mutual funds with an insurance policy wrapper that give investors the following benefits:
- Downside risk protection, that is, guarantee of capital after 10 years and resetting privileges to lock in growth;
- Protection of assets from creditors;
- Guarantee of capital at death;
- Probate protection.
All these benefits are priced into seg funds, and with a greater focus on costs through the proposed disclosure rules, clients are going to want answers. The MERs of seg funds tend to be higher than mutual funds to cover the cost of the insurance features. The fund filter on GlobeInvestor.com shows that the management expense ratio for the 20 most-widely available Canadian equity seg funds range from 2.57 per cent to 3.25 per cent. MERs for the 20 largest Canadian equity mutual funds run from 2.05 per cent to 2.39 per cent. In order to determine if the benefits are worth the extra cost, let's examine these features.
Downside risk protection
Salespeople tell clients that seg funds are safer than mutual funds because they guarantee a certain amount of principal to their investors, typically ranging between 75 and 100 per cent, as long as they hold it for a determined period, usually 10 years. If the fund value rises, some segregated funds also let you "reset" the guaranteed amount to this higher value (which also resets the length of time that you must hold the fund). This is a vehicle that has all the upside of a mutual fund and no downside because your capital is guaranteed, so why wouldn't everyone buy it?
While they are appealing to an investor's peace of mind, the first problem is that you have to lock your money in, because if you cash out before the maturity date, the guarantee won't apply.
The second issue is that since stock markets have historically risen over the long term, the likelihood of actually needing the guarantee to get your original capital back after 10 years is small. In fact, since 1900, the only two short-lived periods when the S&P 500 was negative over 10 years were the periods ending in the late 1930s following the Great Depression and those ending in 2009 at the lows of the subprime mortgage crisis. So 98 per cent of the time, 10-year returns were positive for U.S. stocks.
For Canadian stock markets, since 1960, more than 90 per cent of the time the S&P/TSX composite has returned more than 6 per cent over 10 years. And in no 10-year period have TSX returns been negative.
Protection of assets from creditors
Creditor protection is a key benefit for business owners in particular but has also served as a selling feature for individuals. The first issue with this is that there is a way to achieve creditor protection without paying a higher fee for your investments. Instead of structuring a business as a sole proprietor or a partnership, small business owners can incorporate. If a business is big enough that it faces the chance of large losses, or if it is risky enough that there is concern about solvency, then incorporation may be more suitable.
Also, the new disclosure initiative has the potential to create a scenario where creditor protection may be lost and a court can rule that you had set up the seg fund to avoid your debts. There are circumstances where the creditor protection may not apply:
- The creditor protection feature could be challenged if the investor purchases the fund knowing that they may eventually face financial difficulties. In other words, the seg fund must be purchased in good faith. This falls under fraudulent conveyances provincial legislation.
- Seg funds may not provide creditor protection from the Canada Revenue Agency if income tax liabilities are outstanding in a non-bankruptcy situation.
- Claims under family law may take precedence over creditor protection in a court of law to provide for a dependant.
Here is where the proposed disclosure requirements come into play. The more knowledgeable the consumer of seg funds is on this point, the more likely creditor protection will not be available. Seg funds may not be able to provide creditor protection where it can be proved that the purchaser was in financial difficulty ahead of the purchase.
Fraudulent conveyance, dependant relief claims, property claims in marriage breakdown as well as CRA claims are instances where creditor protection may be affected, so the feature is not as enticing as it is laid out to be.
Guarantee of capital at death
This is a benefit that makes a lot of sense if you think you are about to die and you also think the markets are about to crash.
Seg funds fees are generally an additional charge to clients of roughly 1 per cent per year above a comparative mutual fund. This 1-per-cent additional charge is paid each year they are locked into the product. Probate fees, on the other hand, are a one-time charge of about 1 to 2 per cent. As such, there is limited value in using seg funds as a way to avoid probate fees, since clearly paying a fee once is better than recurring annual charges.
What an investor ends up with in segregated funds is a portfolio with higher-than-normal fees, marginal performance and features they may not really need. The peace of mind of seg funds comes with a cost, but has that cost become too high? As exchange-traded funds and pay-for-performance pooled funds gain ground, segregated funds must hold their own if they want to carve out a place among the solutions offered to increasingly cost-sensitive investors. Market trends in the coming years indicate money management costs will be a greater focus. If you currently sell segregated funds, it is time to prepare for the inevitable disclosure requirements. It may also be time to re-evaluate your options and entertain alternative solutions.
Chris Ambridge is the president of Transcend, a pay-for-performance service delivering sophisticated investment management for a low cost.