What are Segregated Funds and How do They Work?

For Canadian investors who want the growth benefits of investing, but the security of an insurance product, you have a unique option—the segregated fund.

Segregated funds have attractive “principal guarantees” that allow you receive 75% to 100% of your initial investment, not to mention some unique features like death benefits and creditor protection. 

What exactly are segregated funds? How do they work, and are their benefits worth the costs? Let’s break them down and find out. 

What is a segregated fund?

A segregated fund is a contract between you and a life insurance company that allows you to invest in an underlying asset (usually a mutual fund) at a lower risk than normal. 

Recall that funds are baskets of investments (stocks, bonds, commodities, or other securities) that help you diversify your investment portfolio.

Segregated funds follow this idea, but with a twist: instead of purchasing your fund through a brokerage, you buy a segregated fund through an insurance company. And, instead of taking on 100% of the market risk, your segregated fund guarantees you’ll get back 75% – 100% of your starting investment. 

When you buy a segregated fund, an insurance company will take your initial investment and reinvest it in various underlying assets (stocks, bonds, or a fund). Just like mutual funds, a segregated fund is actively managed by a fund manager, usually a financial expert who’s trying to beat the market and make your fund grow. 

How do segregated funds work?

As a hybrid between insurance and investing, segregated funds are far different than any other investment products. To show you how a segregated fund works, let’s break it down into five essential parts: 

1. Segregated funds are sold by life insurance companies

A segregated fund isn’t technically an investment product: it’s an insurance contract that protects a portion of your deposit for a specific amount of time. 

Keep in mind: segregated funds are owned by life insurance companies, not you. Once you sign your contract, you’re giving your money to the company, and you’ll have limited access to it until your contract ends. 

2. They have principal guarantees

Perhaps the most attractive feature of a segregated fund is the guaranteed return of 75% to 100% of your initial deposit (the “principal”). While the earnings aren’t guaranteed, you can be confident you’ll still get something at the end of your contract, less any withdrawals you may have made. 

The more you’re guaranteed to get back, the higher the fees on your segregated fund. A segregated fund with an 100% principal guarantee, for example, will be more expensive than a fund with a 75% guarantee. 

3. Segregated funds are time-sensitive

Every segregated fund comes with a contract, which usually lasts 10 years, though some can be as long as 15 years. Once you put money into a segregated fund, you’re no longer in control of it until your contract ends.

4. They come with death benefits

Another attractive feature of segregated funds is the death benefit. If you were to pass away unexpectedly before your contract ends, the death benefit allows you to pass your segregated fund to a beneficiary: your spouse, kids, or someone else you named in your contract. 

Once your death has been confirmed, your life insurance company will give your beneficiary one of two things: either the guaranteed principal (the 75% to 100% of your initial deposit) or the market value of your fund’s investments, whichever one is higher. 

5. You can customize your payouts

Once your contract ends, the fund starts (finally, right?): you get your money back, hopefully with some earnings from your investments. You can choose to get all your money at once (the “lump sum” option), or you can schedule monthly, quarterly, or even yearly payouts, if you want to spread your money out. 

What are the advantages of segregated funds? 

Segregated funds can help you hedge market risk, as well as earn some extra money off the underlying investment. Here are some major advantages to adding one to your investment portfolio.  

1. You can protect your initial deposit

A segregated fund promises you something most investments can’t: a guaranteed return of a portion of your initial investment. As long as you respect the terms in your contract, you’ll get all or a portion of your deposit back—no matter what happens in the market.

2. Segregated funds come with creditor protection

Many segregated funds offer creditor protection, which means no creditor can seize the money in your fund, even if you file bankruptcy. The same applies to your fund’s beneficiaries, too. 

3. Death benefits avoid the probate process

If something happens to you before your contract ends, your life insurance company will pay your beneficiaries directly. Yes, that means your beneficiary doesn’t have to go through the long (and often expensive) probate process to get their money. 

What are the disadvantages of segregated funds?

Segregated funds can certainly help you balance investing risks, but don’t think they’re free. Before you buy a segregated fund here are some disadvantages you should consider. 

1. Segregated funds can be costly

Expect to pay fees. Lots of fees. Because segregated funds protect a portion of your initial deposit, they’re far more expensive than mutual funds. Here are the main fees you can expect to pay. 

• Management fees are what you pay to your segregated fund’s manager. These fees cover the services they’re providing to you (investment advice, managing the portfolio, making investment decisions).
• Operating costs cover all the administrative and accounting work related to your account. 
• Insurance fees are what you pay to enjoy the principal protection. These fees depend on how much of your principal you choose to get back (75% to 100%), as well as any additional benefits you might add to your policy. 

If you buy a segregated fund through an insurance agent, you may have to pay agent fees. Typically, the insurance company who issues the segregated fund will pay commissions directly to their agents (not you), though sometimes those costs are built into your management fees. 

2. You have limited access to your money

Once you give your money to an insurance company, you forfeit your right to access it. If you have an emergency, and you need to withdraw money from your segregated fund, it’s going to cost you. You’ll lose your principal guarantee, and you may have to pay an early withdrawal penalty.

3. Investments tend to be conservative

When you think of an insurance company, do you think of an aggressive investor capitalizing on growth companies? Nope. Insurance companies, by nature, want to take the path of minimum risk.

Because of this, don’t expect your fund manager to buy and sell investment with an eye toward big gains. More than likely, they’ll buy conservative investments with only a moderate level of growth. 

How to start investing in segregated funds?

Here are three steps to begin your investments.

1. Pick a company

You’ll typically buy a segregated fund through a licensed insurance agent or directly through a life insurance company. Be strategic about the company you choose. Look for a history of good returns, as well as compare costs between different insurance companies. 

2. Choose your funds

While you won’t have as many investing options as a mutual fund, many insurance companies will allow you to invest in certain indexes or market sectors (energy, mining, technology, real estate).

3. Read your contract carefully

Be sure you understand how the fee structure works, as well as how much you might pay if you make an early withdrawal. 

Are segregated funds right for you? 

Segregated funds are best suited for conservative investors who don’t want to risk losing a large portion of their retirement fund to a volatile market. Likewise, if you’re near retirement, and you want to sock away a lump sum, segregated funds can give you some growth potential, without the risk of losing it all. 

Segregated funds aren’t for everyone, though. If retirement is a few decades away, or you want to take a more aggressive approach to investing, you can invest in an ETF or a mutual, both of which help you diversify your investments (read: lower market risks) at a much lower cost than segregated funds.

Alternatively, you could invest in Canadian growth stocks, which could really put some fire under your investment portfolio.